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Price-Based Regulation: The Elegance of Simplicity

Fortnightly Magazine - January 15 1996

State legislatures and regulatory commissions across the country are exploring retail wheeling or direct retail access for electric consumers. The long-term goal of increased competition in electric power is to achieve economically efficient prices.

I submit that state commissions should change their orientation from cost to price. They should become less concerned with whether earned return is too high or too low, and more concerned about whether prices are stable or falling. And they should strive for the elegance of simplicity in their PBR models.

Shedding Profit Envy

Commissions and commission staffs understand traditional regulation. They have procedures, databases, and precedents in place, as well as a high level of comfort and familiarity. Regulators also feel a degree of skepticism and suspicion about incentive ratemaking models, fearing they could unjustly enrich utility shareholders at the expense of customers. (I must confess that, as chairman of the Missouri Public Service Commission, I once described price caps for telecommunications companies as "a get-rich-quick scheme.") Some consumer advocates oppose

performance-based rates, in part, because of a deep-seated belief that it is inequitable or immoral for a regulated utility to "make too much money." In fact, some intervenors also find reason to oppose the move from cost-based rates.

To insist that any earnings above a commission-authorized return are "excessive" recalls behavior that renowned economist Alfred Kahn describes as "profit envy." Ultimately, it is counterproductive, since the opportunity to earn higher returns could actually drive utility rates lower for all customers. Higher returns could benefit not only shareholders, but low-income customers, business customers, and the state's economy as a whole.

Prices, Not Costs

With competition, attention must naturally turn from costs to prices. Yes, costs matter to the producer, and may ultimately determine whether it can stay in business. But competitors do not compete on their relative original costs; they compete on price and customer satisfaction.

One unlooked-for benefit of price competition may be new services and technologies. The telecommunications industry has certainly proved that point over the past 10 years. If price is the only discriminator in an unregulated market, profit margins decline quickly, as we have seen in the airline industry. A utility can avoid this situation only by differentiating itself with superior quality or new services.

Electric transmission and distribution remain in some sense natural monopolies. The major role of the regulator of the future may be to set a market price for transmission and distribution services.

As competition grows in electric power markets at all levels, regulators must assure that the rules remain fair, not that profits are fair. Fair and efficient competition will drive prices to their correct level. Of course, a competitive environment will revalue utility assets to their long-run marginal cost (or "fair value"), irrespective of depreciated original cost book value. The effective value of a utility's above-market assets would fall, and the value of below-market assets would rise, based on their profitmaking potential.

During the transition to a competitive market, regulators might choose among several new methods to move the focus from cost to price, such as rate moratoria,