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Cross-Subsidies: Getting the Signals Right

Fortnightly Magazine - December 2004

give market participants a vested interest in society's success. However, the legacy of regulations designed to ensure that utilities do not earn unfair profits have made most utility regulations quite proscriptive, incorporating many sticks but few carrots. Current rates are rife with opportunity for more market-driven efficiency, from cost-plus rate making that discourages cost-control measures and encourages inefficiency, to the lack of transparent price signals that could guide end-users in rationalizing their energy demand during peak-pricing periods.

Indeed, many benefits that existing cross-subsidies are designed to create can be achieved more efficiently with a market-based approach. For example, many service quality protocols penalize utilities for failing to deliver some base level of grid reliability, but they provide no financial incentive for exceeding those targets. This necessarily encourages a lowest-common-denominator approach to reliability planning. Instead, why not allow utilities to earn a greater rate of return on their system assets as their system reliability increases? Better yet, why not link that to the return they earn on depreciated assets so as to provide an incentive to seek reliability in the most capital-effective way possible?

The absence of such incentives in the regulated utility sector forces ratemakers to encourage these benefits through less efficient means, and the creation of such measures often leads to debates over cross-subsidies and their socio-political goals. It is much better to get the market signals right, and then allow businesses to respond accordingly.

Recommendation #3

Consider the goals and objectives of other regulatory agencies when crafting utility rates.

Utility regulators should establish broad goals that are consistent with goals of other state officials, and then craft rates that are consistent for all. Too often, rate cases are narrowly focused on the acceptability of a particular rate and are thus structurally unable to address broader state objectives. Commissioners typically have neither the time nor the resources to ask how rates could be best designed to achieve state policy objectives when they are instead focused on the minutiae of accepting or rejecting specific rate filings. This leads to a multitude of utility rates that stand in direct opposition to broader state policy goals, and no controlling authority exists to rectify the inconsistency.

As an example, consider utilities that have been "unbundled" through legislatively-mandated deregulation so as to promote competition in the electric sector. In many cases, the resulting distribution utilities are no longer permitted to own generation assets, but commissioners still (reasonably) insist that such utilities take a "least-cost approach" to planning future load growth. By exempting generation from the planning process, it is a virtual certainty that commissioners will approve too many over-expensive (but regulated) wires and too few cost-effective (but unregulated) generators to serve future load growth. Thus, the legislature's objective to inject competition and reduce electric costs is implemented through a planning process that relies exclusively on the services of a single regulated utility and conspicuously fails to include many of the most cost-effective mechanisms to serve a growing load.

Many similar disconnects exist between utility rates and environmental policy, which on the one hand reward utilities for