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Incentive Ratemaking in Illinois: The Transition to Competitive Markets

Fortnightly Magazine - July 15 1995

low and overcompensate the company (em boosting profits not because of the incentive mechanism per se, but because of errors in the formula. An overestimation would set the hurdle too high and deny the company a reasonable return on its investment. This is why many public utility commissions include a profit-sharing component in their plans that calls for the utility to refund a percentage of the profits over a commission-specified rate of return. This profit-sharing component functions as a safety net to compensate for any errors in choosing the appropriate offset. All else equal, a plan that includes a profit-sharing component would typically feature a lower offset than would a plan without profit sharing, as we approved for Ameritech-Illinois.

The opportunity to implement a price-cap plan with no provision for profit-sharing was appealing because it increased the likelihood of accomplishing two outcomes that arise in a competitive environment. First, a plan with a higher offset and no provision for profit-sharing does not reduce the company's incentive to be productive. Although the logic behind the idea of profit-sharing is valid and legitimate, it is possible to encourage productivity and innovation using a better tool. After examining many profit-sharing proposals, we decided that the higher offset accomplishes what profit-sharing is intended to achieve (em namely, reducing "excess" profits (em without reducing the company's incentive to be productive.

Also, a price-cap plan without profit-sharing would have a greater effect on prices, sending superior market signals to consumers. By contrast, a

profit-sharing scheme allows the utility to refund profits in a lump-sum payment to ratepayers after the fact, without any effect on prices.

In the final analysis, any incentive-based plan must be shown to benefit ratepayers. Under rate-of-return regulation, rates could have remained fixed until the next company-initiated rate case, or until excess earnings impelled the ICC to ask the company to justify its rate of return. But in adopting a price-cap plan with a relatively higher productivity offset, the ICC increased the likelihood of price decreases over the life of the plan. In fact, the first annual adjustment to prices produced a revenue decrease of over $39 million.4

The fact that telecommunications currently exhibits declining costs improves the likelihood that Ameritech-Illinois can decrease rates by the amount mandated by the price-cap formula, and yet gain compensation through productivity improvements. The electric industry, however, poses new challenges.

Electrics (em The Next Step

On May 22, 1995, the Illinois General Assembly approved a bill that, if signed by the governor, will allow Illinois electric utilities to petition the ICC for approval of incentive-based or alternative forms of regulation. This legislation allows the ICC to consider such incentive-based programs on an experimental basis through the end of the century. This legislation will give high-cost electric utilities the tools necessary to improve their uncompetitive positions, while also enabling lower-cost utilities to enhance their competitive positions.

Much is at stake in determining the future of the Illinois electricity industry: economic development, financial stability, and the overall business climate of the state. We believe that this legislation marks a first step