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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

(CDF) of ROE under COS and incentive regulation.

Cumulative distributions reflect the probability that a value will be less than a given value. For example, in Figure 3, suppose the expected ROE under COS regulation is 10 percent. We can also determine the probability that ROE is less than any given value. Suppose the probability that actual ROE will be less than 12 percent is 0.90 (, there is a 90 percent chance that the utility's ROE will be less than 12 percent). Similarly, the probability that ROE will be less than 13 percent might be 0.99, and so forth. 7 The cumulative probability distribution just graphs this relationship, as shown in Figure 4.

It turns out that there are well-defined relationships between the "riskiness" of different uncertain outcomes, like a utility's realized ROE, and the position of their CDFs. 8 For example, suppose, as shown in Figure 4, that the CDF under a proposed incentive regulation is always to the right of the CDF under COS regulation. If so, then the utility is absolutely better off with the incentive regulation because it always has a better chance of realizing a higher ROE than under COS regulation. The risk would no longer be comparable. It would be as if the bank were paying a risk-free interest rate on savings accounts that was greater than the highest return that could be achieved in the stock market.

As shown in Figure 4, the CDF with incentive regulation is always below and to the right of the CDF under COS regulation. This situation implies that the base ROE under incentive regulation has been set too high: Given the same underlying conditions, the utility will always realize a higher ROE under incentive regulation. To solve the problem, the utility's base ROE under incentive regulation should be reduced. 9 The effect is shown in Figure 5. Here, E IR is slightly greater than the ECOS, but that compensates for the greater volatility of realized ROE under incentive regulation. The next step is to determine whether the difference between the two expected ROEs is "reasonable." To do this, examine the areas under the two CDFs. Moving from the left (i.e., the lowest values of ROE), if the area under the COS regulation CDF is always less than the area under the incentive regulation CDF, then the base rate under incentive regulation is "too high." 10 If so, the base ROE under incentive regulation can be reduced until this is no longer the case. That point represents the upper bound on the base ROE for incentive regulation. The lower bound will be where the expected ROEs are the same, since no investor would prefer incentive regulation if it offered a lower expected ROE and greater uncertainty than under COS regulation. Thus, as long as the volatility of realized ROE under incentive regulation is greater than the volatility of realized ROE under COS regulation, the base ROE under incentive regulation should be set higher than under COS regulation.

Incentive regulation can provide benefits both to utility shareholders and customers by