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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

cases, ( e.g., the extent of initial inefficiency), regulators seemingly ignored earlier, critical research findings.

Unlike the majority of implemented PBRs, alternative design paradigms are available that minimize data requirements and allow firms to reveal performance potential. One approach relies on group performance and competition to inform the regulator. The second, while it can, and has been, applied within a peer setting, requires only that the regulator have some information on the range of potential outcomes and the returns that would be associated with such results.

Yardstick Competition

In 1985, economist Andrei Schleifer 4 introduced a model of yardstick competition (YC) (see sidebar, Yardstick Origins) . YC describes the simultaneous regulation of identical or similar firms. Rewards to an individual firm depend on its standing vis-à-vis a shadow firm. Participants in the tournament (the competition with the shadow firm) reveal information about their cost structure and productivity potential to the regulator. With correlated underlying costs, the regulator can use performance information from a group of firms to better define the efficiency frontier and the time path necessary to attain it for inefficient competitors. YC has been effectively employed by European regulators in service quality regulation to identify and benchmark underperforming circuits or districts. Cronin and Motluk (2009) review these efforts as well as a potential application in North America. 5

Such YC effectively handles the “principal-agent” problem of regulators with asymmetric information. Indeed, this approach requires a minimum amount of information—only service prices for each competitor. Initial efficiency differences among utilities are revealed by using correlated cost information from like firms. Allocative inefficiency is benchmarked by using total cost comparisons, not just data on changes in output-input ratios. And, rather than regulator-imposed productivity factors and adjustment periods, potential efficiency improvements and the adjustment periods are revealed by endogenizing the process through the tournament. As Scheifer notes: “Yardstick Competition works because it does not let an inefficient cost choice by a firm influence the price and transfer payment that that firm receives. It is essential for the regulator to commit himself not to pay attention to the firms’ complaints.” 6

Clearly, the asymmetric information problem presents a challenge, especially when dealing with one regulated firm. When such is the case (one regulated firm), the regulator may not have the option of employing YC 7 to induce the firm(s) to endogenously define potential performance. This was noted by the Ontario Energy Board (OEB) in its Implementation Task Force Report on 1st Generation PBR . The report discussed the inherent, asymmetric risk in setting the productivity target: 8

Furthermore, it is understandable that regulators may set the productivity target that is embedded in the price cap formula conservatively because the risks associated with over-and underestimating the reasonably achievable productivity gains are asymmetric. The risk associated with overestimating productivity gains is that the incumbents will not earn an adequate return, will have difficulty raising adequate new capital, and may be put financially at risk by the regulatory regime. This risk is far more serious than the risk associated with underestimating the achievable rate of productivity