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Incentive Ratemaking in Illinois: The Transition to Competitive Markets

Fortnightly Magazine - July 15 1995

of cost savings. Although the notion of price-cap regulation is hardly new, the Illinois plan was one of the few price-cap plans in the country that did not include a profit-sharing component. Like firms in a competitive economy, Ameritech-Illinois can maximize profits subject to the constraints of the price cap and the constraints faced by competitive firms (em namely input cost minimization.

Illinois law requires any alternative regulatory plan for telecommunication companies to include benefits for consumers. Therefore, as a first step, a rate case was conducted to determine whether rates were reasonable going into the plan. Although that rate case was initiated after a consumer group complained of excess earnings, and was not required by state law before approving an alternative regulatory plan, it provided an excellent base from which to measure consumer benefits.

In addition, it was equally important from a policy perspective that the plan not harm actual or potential competitors. Granted, the price-cap plan was never meant to improve and foster competition. But while it did not increase competition, neither did it erect any new barriers to entry. In other words, it was competitively neutral.

The plan approved by the

ICC grouped Ameritech's

noncompetitive services into four distinct categories or "baskets" (em residential, business, carrier, and other (em and applied a price-cap index (PCI) to each basket. On average, the revenue-weighted baskets cannot increase above the PCI. Individual services within a basket can increase by the PCI plus a maximum of two percentage points, given a corresponding percentage (not absolute) reduction in prices for other services within the basket. However, some services included in the residential basket (those services determined to be highly inelastic) are capped and can only decrease throughout the life of the plan.

At the heart of the price-cap plan is the PCI. The PCI constrains prices and must produce just and reasonable rates over the life of the plan and provide an incentive for the company to become more productive and efficient by holding down costs. For Ameritech-Illinois, we set the PCI at the Gross Domestic Producer Price Index (GDPPI) minus an offset of 4.3 percent. The offset represents three factors:

s Productivity (em reflecting post-divestiture data

s Input prices (em the difference between the GDPPI and the company's input costs

s Consumer dividend (em a "stretch factor" measuring how far the company's future productivity should exceed its historical productivity, due to changes in regulation that help maximize profits.

We added two safeguards to the PCI to protect both consumers and the company. A service-quality component was included to give the company an incentive to maintain service quality. Second, since the goal of price-cap regulation was to give the company an incentive to reduce costs under its control, an exogenous factor was included to compensate the company for changes in costs outside its control, such as accounting procedures or changes in federal and state tax law.

Choosing the appropriate productivity offset was crucial. Think of the offset as a hurdle that the company must clear. Thus, underestimating the offset would set the hurdle too