[BETA] Fortnightly

When economic reformers in the old Soviet Union searched for a metaphor to describe their move to a market economy, they a spoke of a horseman jumping a ditch. The true test of a strategy was that it carried you to the other side. It was no time for half-measures.

Electric utility regulators face a similar challenge. The political, market, and technological changes driving the restructuring of the electric power-supply sector could very quickly place investor-owned utilities at a disadvantage in the very markets in which they should be most competitive.

Performance-based, or "incentive," regulation (PBR) supplies an important bridge to a competitive electric power market. However, regulators and utility managers alike feel understandable discomfort about new ratemaking methods like PBR. Both yearn for the relative comfort of traditional rate-base, rate-of-return regulation.

Some of the more recent efforts at PBR reflect that natural tendency to revert to the familiar and the known. Rather than elegantly simple, they appear garish, heavy-handed, ornate. They violate what I believe should be one of the essential elements of PBR:

simplicity. Rates are still based on the utility's cost structure, and are set to produce a consistent flow of "reasonable" profits. But in a competitive industry, what counts is price and quality, not cost. Profits may fluctuate widely from quarter to quarter.

In the transition to a more competitive, market-oriented electric industry, regulators must make sure the horse they ride will clear the ditch.

Traditional Shortcomings

Three primary reasons require modification of traditional ("cost-of-service") regulation. These three failings reveal opportunities for cost reduction and greater efficiency through PBR.

First, traditional regulation does not provide adequate incentives for electric suppliers to cut costs and increase efficiency and productivity. Under traditional regulation, if utility management spends additional hours finding ways to improve efficiency and

reduce costs, those savings are taken from the company in its next rate case and the benefits are transferred to the company's customers. Unless the firm and its shareholders retain a generous portion of the financial benefit of cost reductions and efficiencies, managers will lack any incentive (there is, actually, a negative incentive) to stay late at the office looking for a better way.

Second, traditional regulation places too much emphasis on capital investment. Since the utility's profit is the return earned on capital investment in physical plant (rate base), incentives encourage investment in plant (generating plants, transmission lines, and so on) rather than services, such as demand-side management programs. Moreover, the "used and useful" principle can promote inefficiency. As long as profit is tied to rate base, no incentive arises to shut down or sell uneconomic assets and run more efficient plants that may be fully depreciated. Utilities can't afford reductions in rate base.

Third, traditional regulation is highly litigious, adding substantial regulatory costs, financial and otherwise. The sheer amount of time consumed in the process can

render decisions outdated or moot by the time they finally arrive.

In response to these shortcomings, Congress has opened the wholesale electricity market to competition, and given access to the transmission network to third-party suppliers and buyers.