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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

improvement which is simply that shareholders will earn a high return… In designing the overall price or revenue cap mechanism, it is therefore reasonable to base it on the presumption that the productivity offset that is adopted is likely to be conservative. That is, the productivity offset will not fully recognize embedded inefficiency that can be eliminated under a PBR regime or the full extent of productivity improvements that are reasonably achievable. Put simply, the mechanism will be biased, making it far more likely that the regulated companies will earn a higher return under PBR than they would under rate base rate of return regulation than that they will earn a lower return… For the reasons noted above, it is reasonable to anticipate that the PBR regime will not achieve this ideal symmetry. In the interest of caution and conservatism, the PBR regime that is implemented will almost certainly be biased in favour of the incumbents being able to earn an above-normal return because the productivity offset that is adopted will be low.

The regulator still can create an endogenous process through which the firm itself reveals similar behavior as that under YC. With some antecedent information covering productivity performance for such a utility, the regulator can construct a menu that pairs data on a range of probable productivity performances with the associated return on equity that would be permitted with each productivity choice. In addition, such a structure also mitigates the inherent tendency to impose downwardly biased productivity factors discussed above.

Furthermore, the menu is a natural solution to the issue of diversity that exists among the local distribution companies (LDCs). Firms in different circumstances can base their incentive regulation choices to reflect these differences. And, by judicious pairings of the productivity factor (PF) and ROE choices, a menu easily can be structured to reach explicit sharing goals between rate payers and shareholders. As the OEB’s 1st Generation Implementation Task Force noted: 9

Given the interplay between the productivity factor and earnings sharing, it is our recommendation that the PBR scheme adopted in Ontario explicitly recognize that there is a trade-off between the productivity offset that is selected and the adoption of an earnings-sharing mechanism. The selection by the muni of a combined X-factors and earnings sharing mechanism from a menu of possible options would allow the company to choose the combination that best meets their PBR expectations at the outset of the PBR period ( e.g., there could be several X-factors, some of which would involve earnings sharing, while another, set at a challenging level, would not). This approach deals with the incentive for companies to understate their ability to achieve productivity improvement by providing an incentive to “reveal” their true expectations. In addition, it would allow MEUs to make different choices based on their individual circumstances.

Telecom Precedent

In 1991, the Federal Communications Commission (FCC) instituted a price-cap PBR for local exchange carriers (LECs). The initial LEC price-cap plan was based on two FCC staff studies by Spavins-Lande and Frentrup-Uretsky, which employed the price-dual approach. Similar staff analyses