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Commission Watch

Incentive regulation is not a cure-all for the continuing controversy over return on equity.
Fortnightly Magazine - July 2004

COS regulation, a utility's realized ROE will depend on its after-the-fact costs. But, unlike COS regulation, earned ROE also depends on the parameters of the incentive mechanism. Specifically, a utility's actual ROE will depend on its baseline costs and how that baseline is set initially to provide the utility with economic incentives to increase its productivity. This differs from COS regulation because, unlike COS regulation, the allocation of above-normal earnings is not explicitly defined.

In Figure 1, the dashed horizontal line reflects COS regulation: the utility is allowed to earn the expected ROE on its prudent investments. The shaded area in Figure 1 refers to earnings under a price cap: relative to the cost of equity the utility could earn under traditional COS regulation, its ROE could fall anywhere within the shaded area. The horizontal portion of the area corresponds to a "dead band," outside of which the utility's earnings can be adjusted to account for normal variation in operation costs. As drawn, therefore, the utility's realized return on equity in the deadband could be either higher, lower, or the same as under traditional COS regulation. The question, therefore, is what objective measures would allow regulators to set the return on equity in that range?

Still Hope?

Implicitly or explicitly, a utility's cost of service will establish the baseline ROE in the dead band. Assuming that this return is set consistent with the "comparable risk" standard established in , the answer lies with comparing the utility's risk profile under incentive regulation with its risk profile under traditional COS regulation. This risk profile will depend on a number of factors, including the structure of the market the utility operates within, the structure of the incentive scheme, and the certainty of the incentive scheme. It is important to address the incremental risk associated with IR, since a changing market structure would require adjusting ROE even under COS regulation.

Market structure can affect a utility's comparable business and financial risk by changing the shape and volatility of the supply and demand curves that determine earnings and ROE. For example, a distribution-only utility operating in an environment with retail competition probably faces a different risk-reward structure than a traditional, vertically integrated utility in an unrestructured market. 5 The distribution utility's regulatory obligations, such as serving as a provider of last resort and maintaining specific reliability criteria, also will affect its business and financial risk profile. Moreover, its risk profile may be affected by broader federal, regional, or state issues, including FERC-mandated transmission pricing systems, the financial stability of unregulated generation providers (a lá Enron), and the relative economic health of its service area.

The volatility of supply and demand reflects the difference between movements along a supply or demand curve (referred to as changes in the quantity demanded or supplied) versus shifts in the curves themselves. Lowering the price of electricity increases the quantity of electricity demanded by consumers; enticing consumers to purchase home computers for Internet "surfing" increases the demand for electricity at any given price. A vertically integrated utility operating in a closed market