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Price-Based Regulation: The Elegance of Simplicity

Fortnightly Magazine - January 15 1996

price caps, or a scheduled phase-in of prices from a cost to a market basis (see sidebar).

One advantage of any of these approaches is that they are in place for a period of years, rather than months. The absence of full-scale traditional rate cases every year or two adds stability and predictability to prices, and offers incentive to cut costs and boost efficiency by allowing utilities to retain savings. The gradual price reductions under the "target market" price approach, and the productivity offset under the price cap, allow customers to share the benefits of cost savings.

If utilities can achieve prices at or below market levels, regulators (and consumer advocates) should no longer worry about return on book equity. Such an argument, at that point, would clearly seem to fit Dr. Kahn's concept of "profit envy."

Allowing for Contingencies

In addition to simplicity and price orientation, an effective PBR model should include an

adjustment mechanism to respond to unexpected deviations from the assumptions that underlie the model. Such contingency planning is a common practice in drafting long-term coal supply contracts, where adjustment clauses are often automatic and unambiguous.

For example, the PBR Phase I electricity price for small retail customers in a particular jurisdiction might be set at 8¢ per kilowatt-hour, with a contract reopener based on the cost of natural gas. If gas costs change up or down more than 25 percent during Phase I, an automatic adjuster could split the difference between the utility and its customers. There could be other reopeners as well, but they should remain limited in application and scope, and should operate as much as possible on objective, "mechanical" tests.

Such adjustments serve the legitimate regulatory function of balancing the interests of shareholders and ratepayers,

The Case for Simplicity

The 14th Century scholar William of Ockham summed up the principle of simplicity: One should not multiply entities beyond necessity. If two alternate solutions are proposed to a logical problem, Ockham's Razor holds that the simplest is more likely to be correct.

The competitive world requires quick analysis and quick response to the needs of customers. New services must be marketable

without prolonged regulatory approval processes; market-driven price changes must be implemented without 11-month rate cases.

A rate moratorium, a price cap, or a "phase-in" to target market rates would prove dramatically simpler and more effective than traditional regulation. Although depriving some long-time participants in commission proceedings of the enjoyment of yet another protracted, complex, and litigious rate case, a moratorium or a straightforward evaluation of the company's rates in comparison with a predetermined index and productivity offset, or in comparison to target market rates, would provide real incentive for improved financial and operating performance. At the same time, they would achieve the important objective of simplifying, and reducing the cost to society, of the traditional regulatory process.

In the end, the garish gargoyles and byzantine complexities of the old regulatory structure should yield to a new model marked by sleek elegance and graceful

lines. t

William D. Steinmeier is a former chairman of the Missouri