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Regulatory Reform in Ontario

Successes, shortcomings and unfinished business.

Fortnightly Magazine - November 2009

of index-based PBR plans, to which they refer as “exogenously determined PBR plans,” as well as a number of more specific points regarding the 3rdGenIRM. Their main general concerns are repeated:

“Due to the principal-agent problem between regulators and the monopolies they regulate, regulators don’t have the information necessary to correctly set parameters in exogenously determined PBR plans. In such an asymmetric environment, determining the appropriate inflation escalator and productivity offset can be complicated, confusing, time consuming and divisive. Often, the necessary data is as difficult, or more difficult, to obtain than the process of determining the firm’s cost of service. Thus, exogenously determined PBR plans often suffer from the same shortcomings as cost of service rate of return plans …” ( see “ Dealing With Asymmetric Risk ).

There’s no analysis or evidence supporting any of these assertions, which either are incorrect or greatly exaggerated. The first sentence above is inaccurate: the “principal-agent problem” in regulation is one that depends on the difficulty of obtaining accurate cost information from regulated firms when they are subject to cost-based regulation. This is inaccurate because PBR indexing plans use industry TFP and inflation measures rather than company-specific cost information to calibrate rate-adjustment mechanisms. These industry and economy-wide metrics are external to the regulated utility in question, meaning that no regulated firm can influence the values of these variables through its own actions. Because no regulated firm is able to influence the terms of its PBR rate-adjustment formula, this formula is not affected by the textbook “principal-agent problem.”

The other claims are exaggerated. There’s a well-established and accepted paradigm for setting the terms of PBR-indexing formulas in North America. Implementing this paradigm requires measures of industry TFP and input price trends. While estimating these measures isn’t trivial, they can be developed using techniques that are generally accepted and far less controversial than the typical estimate of a utility’s revenue requirement. The idea that estimating productivity and inflation measures is “more complicated, confusing, time consuming and divisive” than a cost-of-service rate case easily is disproved by examining any proceeding that includes both a cost-based rate rebasing and a PBR plan that adjusts those initial rates for a known term. For example, there were more than 2,000 data requests related to establishing the cost-based cast-off rates that took effect for Boston Gas in late 2003. In the same proceeding, there were less than 200 data requests related to the PBR-adjustment formula that adjusted those rates for the following 10 years. The controversies and regulatory burdens associated with setting cost-of-service rates for a single year therefore were approximately 10 times greater than the analogous costs incurred for setting updated rates for 10 years. On a per-annum basis, the cost-of-service portion of the Boston Gas rate case therefore was about 100 times more contested and costly than Boston Gas’s approved PBR plan. 10

The authors also don’t accurately convey the PBR experience in Ontario. Most important, they present a detailed description of the menu approach that was proposed for first-generation PBR ( pp. 50-51 ), but omit the