In the alphabet soup of regulatory acronyms, performance-based ratemaking (PBR) may help shape events well into the next century. At present, PBR is being implemented, or considered by, public utility commissions (PUCs) in over 20 states. By 2000, PBR is likely to reach most of the 50 states as well as the Federal Energy Regulatory Commission. The pressures of a global economy have raised the stakes. State regulators as well as politicians are increasingly aware that major industrial sectors such as electricity, gas, and telecommunications can play a key role in creating (em or destroying (em competitive advantage. This concern over economic competitiveness is fueling the PBR experiment.
Proponents tout PBR as an evolutionary reform of traditional regulation for so-called "natural monopoly" industries such as electricity and gas distribution. PBR is also being promoted as a useful transitional step or "bridge" toward complete deregulation of electricity generation.
The basic premise of PBR is that traditional, cost-plus regulation does not teach utility managers to minimize costs but rather to strategically conceal their firm's true minimum cost curve. Why?
Because a set of "perverse incentives" encourages managers to inflate the firm's operation and maintenance expenses, "goldplate" or overinvest in capital, avoid optimal risk-taking, and otherwise operate inefficiently.
Though touted as a solution to this problem, PBR presents three paradoxes:
1) The PBR regulator seeks to encourage a utility to operate at minimum cost, but does not know the firm's true cost structure.