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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

encouraging greater efficiency. But even if incentive regulation supplants traditional COS regulation, regulators and utilities still will need to confront the same basic ROE questions that have vexed both for many years. Because the base ROE under incentive regulation will be an integral part of the incentive structure itself, it ought not to be done as an afterthought. The approach described here is one way to address this important issue.

Endnotes

  1. A typical price-cap, for example, establishes an initial unit price based on the utility's cost of service, then allows for adjustments to that price over time that account for inflation and productivity gains.
  2. Traditional cost-of-service regulation has always been directed to improving what economists call "allocative efficiency," which basically refers to setting prices correctly. Incentive regulation, however, focuses more on what economists call "X-inefficiency," which focuses on whether the mix of goods and services is produced at the lowest possible cost. The latter is why incentive regulation usually involves "X-factors" that reflect expected productivity increases.
  3. See, for example, my article, "DCF Utility Valuation: Still the Gold Standard?" in the Feb. 15, 2003, issue of .
  4. This problem was discussed in light of the Supreme Court's 1989 decision in stemming from a prudence disallowance of the construction costs associated with four canceled nuclear plants. See, A. Lawrence Kolbe and William B. Tye, "The Duquesne Opinion: How Much 'Hope' Is There for Investors in Regulated Firms?" 8 (1991), at 127.
  5. For example, Cragg, et al., argue that a standalone transmission company faces higher risks and thus requires a higher ROE than does a vertically integrated utility. "Assessing the Cost of Capital for a Standalone Transmission Company," , January/February 2001, pp. 80-88.
  6. For example, one could construct a probability distribution of weather and, knowing the historic relationship between weather and electricity sales, develop a simple Monte Carlo model that would generate an overall probability distribution of electric revenues. Although a "how-to" menu of how this is accomplished is beyond the scope of this article, readers interested in additional details should feel free to contact the author.
  7. The cumulative distribution is really just the area under the probability curve up to a given value. Therefore, it always lies between 0.0 and 1.0.
  8. The technical term is called "stochastic dominance." Interested readers, or those wishing to cure lingering insomnia, are welcome to contact the author for additional information and references.
  9. The allocation of benefits between shareholders and customers could also be changed, but this is less likely to occur because it would entail a wholesale reworking of the incentive regulation plan.
  10. If this is the case, it turns out that any risk-averse investor will still prefer the incentive regulation scheme.

 

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