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Big City Bias: he Problem with Simple Rate Comparisons

Looking beyond ranking utilities on price.
Fortnightly Magazine - December 2002

distribution facilities, a high proportion of small customers, relatively poor load factors (due to disadvantageous customer mix and higher air conditioning loads), stricter environmental standards, and higher costs of transmitting power from distant generation sources.

Lessons for Regulators

Rate comparisons play an increasingly prominent, though usually implicit, role in utility regulation. And, in theory, rate comparisons can help identify efficient utilities and reward superior performance. Overall, several approaches alternative regulation, such as yardstick regulation or modified price cap regulation, have been developed specifically for that purpose. 3 Even in the traditional regulatory model, overall firm performance can (and should) be taken into account as a "non-cost factor" in the determination of "just and reasonable rates" and a utility's allowed earnings. 4 Still, due to the well-known difficulties with direct rate comparisons, their applicability and practicality in rate regulation is limited. While applied somewhat more frequently overseas and in other industries, 5 there are only a few U.S. examples in which a utility's retail rates are determined explicitly with reference to benchmarks such as industry averages or a selected group of comparable companies.

These observations suggest a word of caution for regulators. If constructed appropriately, comparisons of retail rates between utilities can be used to enhance the efficiency of the regulatory process, by identifying and rewarding superior utility performance. However, simplistic comparisons can systematically disadvantage utilities operating in high-cost service territories, such as major metropolitan areas. A more accurate picture of relative utility performance can be achieved by either selecting an appropriate standard for comparison (, a truly comparable group of companies) or by controlling for the differences in operating conditions faced by the utility relative to the costs faced by a broad-based sample of companies. Simple rate comparisons-standing alone-can greatly distort the true picture.

If the additional costs of serving customers in large metro areas are not considered explicitly in rate comparisons or other benchmark analyses, the regulatory process will deny due recognition for superior performance to utilities serving our large cities. This would not only be unfortunate for the utilities and their shareholders, but undermine the very incentives able to elicit such performance. It would also, unavoidably, lead to higher costs and higher rates for consumers.


  1. See, for example, Robert W. Crandall and Leonard Waverman, "Who Pays for Universal Service?" Brookings Institute, 2000.
  2. In fact, some may anticipate that the increased population density might lower average costs, such as is the well-documented case in telecommunications.
  3. Note, however, that the common practice in regulated industries has not been to employ a "yardstick" analysis for rate levels, but rather for changes in rate levels. This practice better reflects the inherent complexities associated with making comparisons across regulated firms that are not identical in all respects. For a summary of performance-based in U.S. utility regulation, see Sappington, Pfeifenberger, Hanser, and Basheda, "The State of Performance-Based Regulation in the U.S. Electric Utility Industry," , October 2001, pp. 71-79.
  4. Precedent of the Federal Energy Regulatory Commission, for example, provides that "the Commission will not lower a pipeline's ROE if its lower risk is the result of