For the past several decades, utility regulation at the state level dealt with secure local markets and truly captive customers. A regulatory compact flourished that offered reasonable prices to customers, while guaranteeing the monopolist the opportunity to earn a fair rate of return on prudently incurred investments. Cost-based, rate-of-return regulation provided a means to this end.
Unlike the past, the future portends unknowns for ratepayers, incumbent monopolists, competitors, and regulatory agencies. To accommodate that future, we believe a properly designed, incentive-based mechanism will prove superior to traditional rate-of-return regulation because it will allow the incumbent utility to compete with new market entrants on an even plain, while protecting the captive ratepayer and not interfering with competition.
Technology and Regulation
Whether engendered from product innovation (as in telecommunications) or process innovation (such as cost savings in the electricity industry), technological change lies at the heart of emerging competition and is the principle reason why changes in regulation are beginning to occur.
Technological developments in telecommunications have dropped the cost of market entry, forcing a reexamination of the natural monopoly argument. Digital and fiber-optic technologies allow the network to handle enormous quantities of voice, video, and information data. Coupled with the explosion of wireless technology and the potential of personal communications services, a dynamic industry has emerged with new and never-before-imagined services. And though not as spectacular, new technologies are beginning to emerge in the electric industry that are forcing regulators to rethink how they regulate. New generation technologies have lowered average generation costs and have enhanced the carrying capacity of transmission. These changes open doors for competitors of all types, undermining the assumptions of traditional regulation.
But rate-of-return regulation, through its inherent internal inconsistencies, fails to penalize inefficient producers or reward efficient ones. It does not create the incentives needed to lower costs or innovate (em two crucial
aspects of a technologically driven industry.1
The design of any incentive plan must take into account the dynamic movements of the regulated market relative to the current regulatory mechanism. Brown, Einhorn, and Vogelsang (1991) developed a set of criteria to evaluate any new regulatory structure.2 In no particular order, they suggest that any regulatory structure should, at a minimum:
1 Meet revenue requirements
2 Encourage cost minimization
3 Allow cost reductions to ben-
4 Maintain high service quality
5 Improve pricing efficiency
6 Ensure sustainability
7 Recognize fairness concerns
8 Streamline regulatory
9 Use easily measured data.
In addition, we would add:
10 Promote innovation
11 Provide flexibility.
Regulators must assign a priority to each of these items when evaluating incentive-based regulatory structures. But cost-based, rate-of-return regulation does not meet requirements 2, 5, 6, 8, 10, or 11. We believe these criteria are vitally important. In our opinion, the imperfections of rate-of-return regulation are overcome in the alternative regulatory plan approved for Ameritech-Illinois.
In October 1994, the Illinois Commerce Commission (ICC) enacted price-cap regulation for Ameritech-Illinois.3 Price-cap regulation focuses on constraining the company's prices, within a given degree of flexibility. Profits are allowed to fluctuate with the degree of cost savings. Although the notion of price-cap regulation is hardly new, the Illinois plan was one of the few price-cap plans in the country that did not include a profit-sharing component. Like firms in a competitive economy, Ameritech-Illinois can maximize profits subject to the constraints of the price cap and the constraints faced by competitive firms (em namely input cost minimization.
Illinois law requires any alternative regulatory plan for telecommunication companies to include benefits for consumers. Therefore, as a first step, a rate case was conducted to determine whether rates were reasonable going into the plan. Although that rate case was initiated after a consumer group complained of excess earnings, and was not required by state law before approving an alternative regulatory plan, it provided an excellent base from which to measure consumer benefits.
In addition, it was equally important from a policy perspective that the plan not harm actual or potential competitors. Granted, the price-cap plan was never meant to improve and foster competition. But while it did not increase competition, neither did it erect any new barriers to entry. In other words, it was competitively neutral.
The plan approved by the
ICC grouped Ameritech's
noncompetitive services into four distinct categories or "baskets" (em residential, business, carrier, and other (em and applied a price-cap index (PCI) to each basket. On average, the revenue-weighted baskets cannot increase above the PCI. Individual services within a basket can increase by the PCI plus a maximum of two percentage points, given a corresponding percentage (not absolute) reduction in prices for other services within the basket. However, some services included in the residential basket (those services determined to be highly inelastic) are capped and can only decrease throughout the life of the plan.
At the heart of the price-cap plan is the PCI. The PCI constrains prices and must produce just and reasonable rates over the life of the plan and provide an incentive for the company to become more productive and efficient by holding down costs. For Ameritech-Illinois, we set the PCI at the Gross Domestic Producer Price Index (GDPPI) minus an offset of 4.3 percent. The offset represents three factors:
s Productivity (em reflecting post-divestiture data
s Input prices (em the difference between the GDPPI and the company's input costs
s Consumer dividend (em a "stretch factor" measuring how far the company's future productivity should exceed its historical productivity, due to changes in regulation that help maximize profits.
We added two safeguards to the PCI to protect both consumers and the company. A service-quality component was included to give the company an incentive to maintain service quality. Second, since the goal of price-cap regulation was to give the company an incentive to reduce costs under its control, an exogenous factor was included to compensate the company for changes in costs outside its control, such as accounting procedures or changes in federal and state tax law.
Choosing the appropriate productivity offset was crucial. Think of the offset as a hurdle that the company must clear. Thus, underestimating the offset would set the hurdle too low and overcompensate the company (em boosting profits not because of the incentive mechanism per se, but because of errors in the formula. An overestimation would set the hurdle too high and deny the company a reasonable return on its investment. This is why many public utility commissions include a profit-sharing component in their plans that calls for the utility to refund a percentage of the profits over a commission-specified rate of return. This profit-sharing component functions as a safety net to compensate for any errors in choosing the appropriate offset. All else equal, a plan that includes a profit-sharing component would typically feature a lower offset than would a plan without profit sharing, as we approved for Ameritech-Illinois.
The opportunity to implement a price-cap plan with no provision for profit-sharing was appealing because it increased the likelihood of accomplishing two outcomes that arise in a competitive environment. First, a plan with a higher offset and no provision for profit-sharing does not reduce the company's incentive to be productive. Although the logic behind the idea of profit-sharing is valid and legitimate, it is possible to encourage productivity and innovation using a better tool. After examining many profit-sharing proposals, we decided that the higher offset accomplishes what profit-sharing is intended to achieve (em namely, reducing "excess" profits (em without reducing the company's incentive to be productive.
Also, a price-cap plan without profit-sharing would have a greater effect on prices, sending superior market signals to consumers. By contrast, a
profit-sharing scheme allows the utility to refund profits in a lump-sum payment to ratepayers after the fact, without any effect on prices.
In the final analysis, any incentive-based plan must be shown to benefit ratepayers. Under rate-of-return regulation, rates could have remained fixed until the next company-initiated rate case, or until excess earnings impelled the ICC to ask the company to justify its rate of return. But in adopting a price-cap plan with a relatively higher productivity offset, the ICC increased the likelihood of price decreases over the life of the plan. In fact, the first annual adjustment to prices produced a revenue decrease of over $39 million.4
The fact that telecommunications currently exhibits declining costs improves the likelihood that Ameritech-Illinois can decrease rates by the amount mandated by the price-cap formula, and yet gain compensation through productivity improvements. The electric industry, however, poses new challenges.
Electrics (em The Next Step
On May 22, 1995, the Illinois General Assembly approved a bill that, if signed by the governor, will allow Illinois electric utilities to petition the ICC for approval of incentive-based or alternative forms of regulation. This legislation allows the ICC to consider such incentive-based programs on an experimental basis through the end of the century. This legislation will give high-cost electric utilities the tools necessary to improve their uncompetitive positions, while also enabling lower-cost utilities to enhance their competitive positions.
Much is at stake in determining the future of the Illinois electricity industry: economic development, financial stability, and the overall business climate of the state. We believe that this legislation marks a first step toward regulatory reform and transforming the state's electric utility industry.
The question is no longer whether open access will come, but when. Regulatory agencies cannot impede these changes by delaying competitive alternatives. Rather, they must play a role in this dynamic process by focusing on the questions posed by the transition, not whether a transition should occur. Uncertainty and inaction are costlier and more pernicious to business than a plan of action with clear objectives and timetables. Passage of this legislation is a first, albeit small, step in that direction.
In the nascent stages of competition, regulatory decisions have a tremendous impact on the development of markets. Errors (em big
or small (em can significantly delay the formation of a mature and competitive market. With the ability to consider alternative forms of regulation, we are taking the first steps in a long journey to meet the myriad challenges facing Illinois utilities. Any alternative to traditional rate-of-return regulation will be judged on how well it makes the transition from the currently controlled market to competition. In Illinois, that judgment will be made not through speculation and conjecture, but rather by actual market performance. t
Agustin J. Ros and Terry S. Harvill are policy advisors to chairman Dan Miller of the Illinois Commerce Commission, assisting on issues concerning telecommunications, electricity, natural gas, water, and transportation. Dr. Ros received his BA in economics from Rutgers University and his MS and PhD in economics from the University of Illinois at Urbana-Champaign. Mr. Harvill received both his BS and MS in economics from Illinois State University. The views and opinions expressed in this article are those of the authors and are not necessarily those of the ICC or any Commissioner.
The Illinois Electric Reform Bill, SB 232
Be it enacted by the People of the State of Illinois, represented in the General Assembly.
[as edited, and with emphasis added]
Sec. 9-244. Performance-based rates. Notwithstanding any other Sections of this Act of the Commission's Rules, the Commission, upon petition by a public utility and after hearing, may authorize for that utility on an experimental basis, the implementation of one or more programs consisting of (1) alternatives to rate-of-return regulation, or (b) other regulatory mechanisms that reward or penalized utilities through the adjustment of rates based on utility performance.... Before authorizing ... [(a) or (b), above] ... the Commission shall:
(1) make a finding that the implementation of such programs is in the public interest;
(2) make a finding that the implementation of such programs will produce fair, just, and reasonable rates ...;
(3) where appropriate, make a finding that the programs respond to changes in the utility's industry that are in fact occurring;
(4) specifically identify how the programs' departure from traditional rate-of-return ratemaking principles will benefit ratepayers through the realization of one or more of the following: efficiency gains, cost savings, or improvements in productivity.
Any such programs shall not extend beyond the public utility's service territory and shall not extend beyond June 30, 2000.
1. Clearly, rate-of-return regulation functions differently in different jurisdictions. Some PUCs have been able to keep prices low through the system while others have not. This is a key fact in understanding why the current paradigm is flawed.
2. Brown, Einhorn and Vogelsang, "Toward Improved and Practical Incentive Regulation," Journal of Regulatory Economics, Vole 3, No. 4 (December 1991), pp. 323-338.
3. Re Illinois Bell Tel. Co., Nos. 92-0448, 93-0239, Oct. 11, 1994, 156 PUR4th 121 (Ill.C.C.).
4. Re Illinois Bell Tel. Co., No. 95-0182, June 21, 1995 (Ill.C.C.).
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