Revenue Caps or Price Caps? Robust Competition Later Means Healthy Choices New

Fortnightly Magazine - May 1 1996

The debate over restructuring the electric industry has encompassed a revisiting of the traditional rate-of-return (ROR) pricing model. Parties of widely divergent interests increasingly advocate alternatives. Under the label "performance-based regulation," these new pricing models share the objective of strengthening incentives for electric utilities incentives to pursue some specified "socially desirable" outcome. Conservationists, for example, argue that ROR regulation provides utilities with a disincentive to promote energy efficiency on the demand side of the meter.1 Economists also consider ROR regulation an inferior mechanism for promoting economic efficiency, especially when a utility lacks complete monopoly power.2 Overall, interest groups and independent analysts seem to agree that ROR regulation, at least in its current form, will not survive the transition to a more competitive power industry.

Revenue caps are one alternative that has gained some credibility in the regulatory community.3 The major privately owned electric utilities in California as well as utilities in several other states currently operate under revenue-cap-type plans.4 Advocates argue that revenue caps operate similarly to price caps, but produce greater energy efficiency.5 Price caps, they contend, give utilities an incentive to oversell electricity (em an outcome that runs counter to the objectives of a proconservation, environmentally benign industry.

Increasing pressure to institute revenue caps leaves many state public utility commissions (PUCs) facing a choice between price caps and revenue caps (em a choice between significantly different consequences. Price caps are superior to revenue caps both in accommodating competition and in advancing generally accepted regulatory objectives.6 Further, revenue caps exhibit shortcomings that can seriously undermine the primary objectives of public utility

regulation. As the electric industry moves toward competition, revenue caps are not only ill-advised, but unlikely to survive.

Worse Than the Disease?

Utility regulation was formed to correct economic distortions that arise if a monopolist is constrained only by market forces. Therefore, its primary objective is to prevent the utility from pricing above costs, earning supranormal profits over a sustained period, and engaging in excessive price discrimination. Over time, state PUCs have broadened their responsibilities (em by promoting economic development within their states, for example (em but mostly they have kept to their original mandate to enhance economic efficiency and ensure reliable and safe service.

Revenue caps do not keep utilities in line with long-standing regulatory objectives. To the contrary, revenue caps inflate prices above marginal cost, discourage utility marketing when economical, elicit underconsumption of utility services, reduce incentives to provide high-quality service, and shift the risks associated with bad management decisions to consumers. Perhaps most damaging for the future, revenue caps create utility incentives diametrically opposed to those that motivate firms in competitive markets. As a

ratemaking mechanism for achieving higher energy efficiency in the power industry, revenue caps are not only highly inefficient but socially detrimental.

Figure 1 (see sidebar on page 30) depicts the short-run effects of a hypothetical revenue cap imposed on a competitive industry.7 Although the revenue cap was intended to improve consumer welfare, the outcomes prove quite the opposite. The revenue cap places consumers and society as a whole in a worse position than before. Further, the industry becomes less efficient, as well as more profitable under certain conditions. The industry's overall performance also moves closer to an environment in which individual firms possess market power.

Figure 2 (see sidebar on page 32) illustrates the effects of a revenue cap imposed on a declining-cost electric power industry. As in the previous scenario: 1) consumers are worse off, 2) total economic welfare declines, 3) prices move farther from marginal cost, 4) average cost rises, and 5) the utility enjoys higher profits in the amount of the reduced costs.

A cap set below prior revenues (as in Figure 1) produces fairly similar results (em although the utility's profits may not increase. In other words, these adverse

outcomes hold true even when consumers pay lower bills and the utility faces lower total costs.

Flawed Diagnosis?

Clearly, a reduction in total

bill and total costs does not, as revenue-cap advocates claim, also ensure progress toward social or regulatory objectives. State regulators could inflict great harm on the general public by approving a revenue-cap plan, especially in a time of increasing competition in the industry.

First, total bill is a flawed measure of consumer benefits. Revenue caps presume that consumers always benefit when their electricity bills decline. Yet electricity consumers directly benefit from greater quantity and quality of electric service. Thus, a consumer with a lower electricity bill may actually receive lower net economic benefits from the consumption of electricity than other consumers.

Consumer welfare is properly measured as "consumer surplus" (em the value received from a product or service minus the expenditure outlay. For example, if price falls and the price elasticity of demand exceeds one, both the total bill and the consumer surplus would increase. Since consumers are undeniably better off when price falls, price, rather than total bill, correlates with consumer welfare. That is, all other factors remaining constant, an unbroken inverse relationship exists between consumer welfare and the price of a product or service. This relationship does not hold true between total bill and consumer welfare.

Second, revenue caps tend to produce higher prices than price caps or ROR regulation. Price-sensitive customers suffer because utilities become reluctant to offer discounted rates. As additional consumption increases total costs by more than total revenues, utilities find little incentive to offer prices that reflect actual market conditions.

In fact, utilities find clear disincentive to reduce prices for core customers or services (where the price elasticity of demand is less than one). Lowering price to increase consumption would increase total costs while reducing revenues, causing profits to decline. This result holds true even if the existing price exceeds marginal cost. In other words, revenue caps discourage utilities from expanding sales even under economical conditions (e.g., surplus capacity), because they truncate the marginal revenues actually received by the utilities.

Third, revenue caps convey improper price signals by widening the price/marginal-cost cap. When consumption falls, for example, utilities could increase price even though marginal cost falls or at least stays constant. The ability to raise prices when demand falls obviously runs contrary to a well-functioning electric power market.

Fourth, revenue caps deemphasize the role of prices in utility markets. Competitively motivated, efficient utilities do not attempt to directly minimize a consumer's bill; market forces compel them to set prices at marginal cost or some other profit-maximizing level. The other component of total bill, consumption, depends on consumer response to the price, as well as the quality of service.

Fifth, revenue caps encourage utilities to reduce total rather than unit (average) costs. Additional sales under a revenue-cap regime tend to cause total costs to increase by more than total revenues.8 Thus, utilities gravitate toward practices that reduce rather than improve sales. They tend to operate to the left of the minimum point on their average-cost curves, because of the distorted price signals provided to consumers. Over time, technological change would suffer, since productivity

improvements are largely driven by a company's expectation of selling more products or services as it reduces its average cost. Revenue caps negate this motivation.

Sixth, revenue caps can cause volatile price changes. Utilities can vary their prices according to changes in consumption. Competitive markets do not permit a company to increase its price when demand falls. In efficient markets, declining demand translates into declining prices. Since utility sales could fluctuate widely from year to year in a more competitive market, revenue caps will likely result in more unstable and unpredictable prices.

Seventh, revenue caps induce excessive energy conservation on the basis of a market test. Competitive markets rely on a market test to evaluate the need for energy conservation; revenue caps, however, rely on a cost-effectiveness test.9 A market test offers utilities no incentive to promote energy conservation unless marginal cost exceeds price.10 The cost-effectiveness test, according to some analysts, provokes excessive energy conservation that cannot be sustained in a competitive environment.11

Although revenue caps promote cost-effective DSM,12 their built-in bias elicits too much utility-funded DSM. Their misplaced emphasis on minimizing DSM costs for a targeted level of energy conservation ignores the larger question: How much DSM should a utility stimulate? Whereas revenue caps give utilities an incentive to overspend on energy conservation, price caps encourage utilities to produce at the level where marginal revenue equals marginal cost. Where marginal revenue equals price, utilities are correctly motivated to sell more when price exceeds marginal cost, and sell less when marginal cost exceeds price.

Eighth, revenue caps reduce a utility's incentive to maintain service quality. Unlike price caps (em which fall short in this regard, nonetheless (em revenue caps enable utilities to increase price to compensate for lost sales due to poor service quality. Utilities can do this as long as revenues do not rise above their previous level. To a large extent, companies maintain service quality to avoid sales and revenue losses. Revenue caps, however, enable utilities to increase price to compensate for lost sales due to poor service quality. More disturbing, some utilities may even discover an incentive to offer lower-quality service. If declining service translates into reduced output and costs, a utility could increase its profit by increasing price (em a perversion that runs counter to sound economics and regulatory policy.

A Second Opinion

Under revenue caps, energy efficiency comes at a high potential cost to consumers and society as a whole (em at the cost of serious economic distortions. The price is clearly too high. Less perverse mechanisms are available if policymakers approach energy efficiency from both sides of the meter. Price caps offer such a mechanism.

Price caps have been wrongly criticized for deemphasizing energy efficiency. In fact, price caps give utilities a strong incentive to innovate and to deploy supply-side facilities with greater energy efficiency. Improved energy efficiency means lower costs; price caps reward lower costs by allowing a utility higher profits for a number of years. Competitive markets provide a similar incentive.

On the demand side of the meter, price caps encourage market-based energy efficiency by allowing a utility to price services as low as its marginal cost. This flexibility, limited by the condition that prices cannot fall below marginal cost, ensures correct price signals.

Price caps promote energy efficiency in a way that corresponds to market realities. Revenue caps create incentives that are incompatible with both a competitive marketplace and generally accepted regulatory objectives. As the electric power industry proceeds on a procompetitive path toward unbundled service and customer choice, revenue caps will prove increasingly inappropriate. A competitive market has no use for a mechanism that shifts the risks of lost sales to consumers, distorts price signals, promotes inefficient technologies, and produces excessive prices. Indeed, a mechanism that fails to recognize the true barometer of consumer welfare (price) is fundamentally at odds with a market in which competition is for the consumer.

Kenneth Costello is associate director of the National Regulatory Research Institute in Columbus, OH. The views and opinions of the author do not necessarily reflect those of NRRI, the National Association of Regulatory Utility Commissioners (NARUC), or NARUC member commissions. This article is adapted from material the author presented in a 1995 debate before the NARUC Committee on Energy Conservation. The opposing viewpoint in that debate was presented by Ralph Cavanagh of the Natural Resources Defense Council.

Tying Caps to Rate of Return: No Better

Assume that the cap constraints revenues at their prior value (i.e., R = Q(m) x P(ror).* Under rate-of-return regulation, the firm would price at average cost (P(ror) = AC), produce at Q(ror) and earn a normal profit. As in Figure 1, equilibrium lies at e(rc).


. Consumers are worse off (by area C + A)

. Total economic welfare declines (by area A + E)

. Prices move farther from marginal cost

. Average cost rises

. Utilities profit by the amount of the reduced costs (area B).

These adverse outcomes generally apply even when consumers pay lower bills and the utility incurs lower total costs.

*This assumes that the price elasticity of demand between the relevant points on the demand curve equals one. In figure 1, because revenues decline in moving from point e(1) to point e(re), the price elasticity of demand between these two points exceeds one.

1. See, for example, Eric Hirst, "Regulatory Discintives and DSM," Public Utilities Fortnightly (July 1, 1994); 45-48.

2. See California Public Utilities Commission, Division of Strategic Planning, California's Electric Services Industry: Perspectives on the Past, Strategies for the Future (San Francisco, CA; California Public Utilities Commission, February 1993).

3. In this article, "revenue caps" denotes both revenue decoupling and net-lost-revenue adjustment mechanisms. These mechanisms all break the link between sales and revenues. Specifically, they allow utilities to increase prices when sales decline.

4. See John L. Landon, "Performance-Based Regulation," presentation before the Regulatory Matters Committee of the Public Utilities Commission of Ohio, Columbus, OH, January 8, 1996; and Robert J. Graniere and Anthony Cooley, Decoupling and Public Utility Regulation (Columbus, OH: The National Regulatory Research Institute, 1994), Chap. 2. Among the states are New York and, until recently, Maine and Washington.

5. In Eric Hirst, Eric Blank, and David Moskovitz, "Alternative Ways to Decouple Electric Utility Revenues from Sales," The Electricity Journal 7, no. 6 (July/August 1994):47, the authors stated:

[I]nstead of price-cap regulation, which would penalize a utility for running DSM programs, commissions could implement revenue-cap regulation. Such revenue-cap regulation, adjusted from year to year for inflation and productivity, would encourage utilities to be innovative and aggressive in their cost cutting, while ensuring that shareholders are rewarded for running cost-effective DSM programs.

6. See, for example, Wayne P. Olson and Kenneth W. Costello, "Electricity Matters: A New Incentives Approach for a Changing Electric Industry," The Electricity Journal 8, no. 1 (January/February 1995): 28-40.

7. The analysis of revenue caps presented here follows the analysis of rent control as a revenue constraint. In the real world, the ceiling on rents represents a constraint on the rents allowed for a housing unit (em i.e., the price of housing services times the quantity of housing services. See, for example, Mark Frankena, "Alternative Models of Rent Control," Urban Studies 12 (October 1975); 303-08; and Richard Arnott, "Time for Revisionism on Rent Control," The Journal of Economic Perspectives 9, no. 1 (Winter 1995): 99-120.

8. This may not always be true. A technological change could simultaneously increase sales and reduce total costs if it causes the cost curve to shift down far enough.

9. The cost-effectiveness test says that a utility should invest in energy conservation when it is less expensive than an "equivalent" amount of electricity delivered to consumers.

10. See, for example, Larry E. Ruff, "Equity vs. Efficiency: Getting DSM Pricing Right," The Electricity Journal 5, no. 9 (November 1992): 24-25. The market test would justify utility-funded subsidies for energy conservation up to the difference between the marginal cost and the existing price as a response to a pricing failure (i.e., prices lying below marginal cost).

11. See, for example, Douglas A. Houston, Demand-Side Management: Ratepayers Beware! (Houston, TX: Institute for Energy Research, May 1993).

12. See, for example, The Regulatory Assistance Project, "Performance-Based Regulation: A Policy Option for a Changing World," Issues Letter (September 1994):3.


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