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Revenue Caps or Price Caps? Robust Competition Later Means Healthy Choices New

Fortnightly Magazine - May 1 1996

The debate over restructuring the electric industry has encompassed a revisiting of the traditional rate-of-return (ROR) pricing model. Parties of widely divergent interests increasingly advocate alternatives. Under the label "performance-based regulation," these new pricing models share the objective of strengthening incentives for electric utilities incentives to pursue some specified "socially desirable" outcome. Conservationists, for example, argue that ROR regulation provides utilities with a disincentive to promote energy efficiency on the demand side of the meter.1 Economists also consider ROR regulation an inferior mechanism for promoting economic efficiency, especially when a utility lacks complete monopoly power.2 Overall, interest groups and independent analysts seem to agree that ROR regulation, at least in its current form, will not survive the transition to a more competitive power industry.

Revenue caps are one alternative that has gained some credibility in the regulatory community.3 The major privately owned electric utilities in California as well as utilities in several other states currently operate under revenue-cap-type plans.4 Advocates argue that revenue caps operate similarly to price caps, but produce greater energy efficiency.5 Price caps, they contend, give utilities an incentive to oversell electricity (em an outcome that runs counter to the objectives of a proconservation, environmentally benign industry.

Increasing pressure to institute revenue caps leaves many state public utility commissions (PUCs) facing a choice between price caps and revenue caps (em a choice between significantly different consequences. Price caps are superior to revenue caps both in accommodating competition and in advancing generally accepted regulatory objectives.6 Further, revenue caps exhibit shortcomings that can seriously undermine the primary objectives of public utility

regulation. As the electric industry moves toward competition, revenue caps are not only ill-advised, but unlikely to survive.

Worse Than the Disease?

Utility regulation was formed to correct economic distortions that arise if a monopolist is constrained only by market forces. Therefore, its primary objective is to prevent the utility from pricing above costs, earning supranormal profits over a sustained period, and engaging in excessive price discrimination. Over time, state PUCs have broadened their responsibilities (em by promoting economic development within their states, for example (em but mostly they have kept to their original mandate to enhance economic efficiency and ensure reliable and safe service.

Revenue caps do not keep utilities in line with long-standing regulatory objectives. To the contrary, revenue caps inflate prices above marginal cost, discourage utility marketing when economical, elicit underconsumption of utility services, reduce incentives to provide high-quality service, and shift the risks associated with bad management decisions to consumers. Perhaps most damaging for the future, revenue caps create utility incentives diametrically opposed to those that motivate firms in competitive markets. As a

ratemaking mechanism for achieving higher energy efficiency in the power industry, revenue caps are not only highly inefficient but socially detrimental.

Figure 1 (see sidebar on page 30) depicts the short-run effects of a hypothetical revenue cap imposed on a competitive industry.7 Although the revenue cap was intended to improve consumer welfare, the outcomes prove quite the opposite. The revenue cap places consumers and society as a whole in a worse position than

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