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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

faces competition from other providers of energy services (, space and water heat), as well as distributed generation and demand-side management providers. However, the supply and demand curves for electricity and distribution services are complementary: The utility's electricity supply decisions that increase (decrease) the embedded prices it charges will decrease (increase) the quantity of electricity demanded and decrease (increase) the demand for distribution services. How these variations are reflected in earnings will determine the volatility of the utility's earnings under COS and incentive regulation.

The structure of the incentive regulation scheme itself affects risk. A utility that operates under an earnings-sharing mechanism coupled with a price cap will confront a different set of risks than one operating under a revenue cap. Clearly, any incentive scheme that adversely affects a utility's earnings by treating gains and losses asymmetrically will magnify the utility's business and financial risk relative to a symmetric risk sharing that has the same expected return. This will increase the utility's cost of capital and ultimately increase costs to ratepayers.

Additionally, the regulatory incentive structure should be based on the market(s) within which the utility operates. For example, a stand-alone local distribution company faces a different set of financial risks than does a stand-alone transmission company, and both face different financial risks than a vertically integrated utility. Moreover, the ability of a distribution-only company to increase productivity (the so-called "X-factor" in many price cap schemes) will likely differ from opportunities for a vertically integrated utility to increase its productivity. Thus, the X-factor itself will affect earnings risk.

Finally, a utility that increases its realized ROE under incentive regulation should not have the incentive system revised simply to ratchet down profits; nor should a utility whose realized ROE declines necessarily have the reins loosened. Any incentive scheme requires time for both the utility and its regulators to adjust. Assuming the incentive regulation scheme is neither toothless nor draconian, financial markets will require some time to evaluate the new risk profile faced by the utility. Impatient regulators who adjust a utility's incentive plan after the first higher earnings report, especially in ways that "raise the bar" for the utility, may be interpreted by financial markets as creating additional financial risk and, just as with asymmetric incentive schemes, ultimately harm ratepayers by increasing the cost of capital.

The net effect of these three factors will be to introduce additional volatility into earnings and realized ROE. This is shown in Figure 2 for both traditional COS regulation and incentive regulation. In both cases, ROE increases as earnings increase. Depending on the vagaries of weather, fuel costs, and other factors affecting supply and demand, there will be a probability distribution associated with the utility's earnings and its realized ROE.

If earnings are capped under traditional COS regulation, as shown on the left-hand side of Figure 2, then the probability distribution of ROE also will be truncated. On the right-hand side of Figure 2, the probability distribution of earnings depends on the symmetry of returns under the IR scheme: If up-side profits are shared with consumers to