When economic reformers in the old Soviet Union searched for a metaphor to describe their move to a market economy, they a spoke of a horseman jumping a ditch. The true test of a strategy was that it carried you to the other side. It was no time for half-measures.
Electric utility regulators face a similar challenge. The political, market, and technological changes driving the restructuring of the electric power-supply sector could very quickly place investor-owned utilities at a disadvantage in the very markets in which they should be most competitive.
Performance-based, or "incentive," regulation (PBR) supplies an important bridge to a competitive electric power market. However, regulators and utility managers alike feel understandable discomfort about new ratemaking methods like PBR. Both yearn for the relative comfort of traditional rate-base, rate-of-return regulation.
Some of the more recent efforts at PBR reflect that natural tendency to revert to the familiar and the known. Rather than elegantly simple, they appear garish, heavy-handed, ornate. They violate what I believe should be one of the essential elements of PBR:
simplicity. Rates are still based on the utility's cost structure, and are set to produce a consistent flow of "reasonable" profits. But in a competitive industry, what counts is price and quality, not cost. Profits may fluctuate widely from quarter to quarter.
In the transition to a more competitive, market-oriented electric industry, regulators must make sure the horse they ride will clear the ditch.
Three primary reasons require modification of traditional ("cost-of-service") regulation. These three failings reveal opportunities for cost reduction and greater efficiency through PBR.