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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

raised the X factor to a single option 6.5, a doubling over the initial X factor set in 1991. Over the course of the 1990’s major price cap, LECs’ ROE also more than doubled, reaching 29 percent in 1999. Over this same period, inter-exchange carriers’ (IXC) ROEs fell to 2.1 percent. LECs’ ROEs would have ranked third highest out of 42 industries and IXCs would have ranked last. 13

Recall the FCC set its PF for LECs by averaging its short and long-term estimates to obtain 2.8. However, highly relevant information seems to have been under appreciated or ignored by the FCC. For example, observers in the FCC proceeding noted that the California Public Utilities Commission had begun its incentive regulation of Pacific Bell with an offset of 4.5. Observers also noted that in 1989 OFTEL raised BT’s productivity offset from 3.0 to 4.5 due to excessive profits. In fact, in 1991, the first year of the LEC price-cap plan, BT’s offset was raised to 6.25. Finally, and importantly, in 1993, the year before the FCC’s option menu was implemented, OFTEL increased the offset to 7.5.

Clearly, given the FCC-noted concern for the incentive-blunting effects of earnings sharing, the commission was trying to incent higher performance. In addition, the FCC must have been keenly interested in adding to its understanding of potential productivity performance in the telecommunications industry by resolving the analytical inconsistencies among its studies. While the FCC’s intention was commendable, its implementation was a bit lacking. Critically, the upper end of X factor options only was equal to the recent average LEC productivity performance, even before adjusting for the error associated with an absent input price differential (which would have made the effective value of the 5.3 say, 4.3 or lower). The FCC would have been much better served had the range of options spanned a wider and higher value, say 4.5 to 7.5, with an intermediate option at 6.0.

PBR in Ontario

By the 1990s, more than 300 municipal electric utilities (MEUs) varying in size from several hundred to over 200,000 customers operated in the province of Ontario. Some critics maintained that mergers among the publicly-owned MEUs would create efficiencies due to privatization and increased scale. In 1998, Bill 35, the Energy Competition Act, 1998, was enacted. While the Energy Competition Act affected the electric sector broadly, restructuring Ontario Hydro and enabling the IESO (the Ontario ISO and power pool), transferring regulatory authority to the Ontario Energy Board and charging the board to examine performance-based regulation, it also undertook a fundamental restructuring of the MEUs.

Under the Act, MEUs were to be corporatized and recapitalized, placed under municipal shareholder control for possible sale, and placed under the regulatory oversight of the OEB and its yet-to-be-determined PBR. Not only was ownership and capital structure up in the air, but MEUs were subject to a new regulator and its unknown regulations. These policies made the restructuring of the MEU sector alone arguably one of the most complex regulatory restructurings in the world. 14

Faced with the recent transfer of almost 300