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Performance-based Ratemaking

Fortnightly Magazine - July 15 1995

Performance-based ratemaking (PBR) departs from the cost-of-service standard in setting just and reasonable utility rates, but that departure isn't as easy as it looks.

Up until now, cost-of-service ratemaking has provided relatively stable rates, while enabling utilities to attract enormous amounts of capital. Of late, however, regulators appear to be heeding the argument that changing markets warrant a second look. Throughout the country and across the utility industry, some regulators appear willing to abandon cost of service as a proxy for competition, instead favoring performance-based methods that would rely on competitive forces.

These performance-based schemes vary in their details but generally afford utilities the opportunity to increase profits by exceeding targets for efficiency and cost savings. Moreover, these plans purport to streamline the regulatory process. Annual, accounting-type reviews replace rate hearings. Cost-of-service studies might not be required at all once initial rates are fixed.

Nevertheless, these PBR plans rely on cost-based rates as a starting point and still contain safeguards to protect ratepayers. PBR falls short of true deregulation. As the Massachusetts Department of Public Utilities (DPU) noted recently in an order approving a PBR variant known as price-cap regulation for New England Telephone and Telegraph Co., "price-cap regulation is not deregulation; it is merely another way for regulators to control the rates charged by a firm." Re New Eng. Tel. & Tel. Co. dba NYNEX, D.P.U. 94-50, May 12, 1995 (Mass.D.P.U.).

Competition (em Goal or Prerequisite?

PBR has moved beyond the novelty stage. Some states, Alabama and Mississippi for example, have had performance-based rate plans in place for their utilities since the early 1980s.

In Massachusetts, the state government has espoused PBR official policy. In a 1994 report, a task force jointly led by the DPU and the state Division of Energy Resources announced that ratepayers, and the economy as a whole, would benefit from "a shift from the current regulatory system that provides utilities with a regulated rate of return, to a system that rewards or penalizes utilities based on how well they perform." The task force encouraged utilities to submit innovative PBR proposals to the DPU.

Last winter, the DPU issued PBR guidelines describing PBR as an interim framework "before competition's potential is fully realized." It added that it had taken steps in that direction for several years, approving incentives for generating unit performance, gas margin-sharing, demand-side management, and price caps. All the same, the DPU hedged its bets and also ruled that a move to PBR would improve the current state of affairs "regardless of the competitive state of the industries."

The DPU admitted that "very little empirical data exists on the long-term effects" of PBR. But it concluded that well-designed incentive mechanisms should provide utilities with greater incentives to reduce costs than under cost-of-service regulation.

It saw several advantages, including,

s "X-efficiency" (em the degree to which a firm maximizes the production of goods and services with a given combination of inputs

s "allocative efficiency" (em how much a firm can minimize total costs by finding the optimal combination of production inputs

s "dynamic efficiency" (em increased