The Road Not Taken

Revisiting performance-based rates with endogenous market designs.

More than 20 years ago in the pages of this publication, economist William Baumol outlined a method by which the regulation of public utility monopolies could be streamlined while simultaneously providing incentives for efficiency and productivity growth.¹ Baumol proposed a productivity incentive clause that adjusts rates automatically according to the formula,

where, is the allowable annual rate change, is the annual change in input prices, and is the annual productivity requirement.

This now familiar formula describes a price-cap mechanism. Such rate adjustment mechanisms have found widespread applications in performance-based regulation (PBR) of telecommunication monopolies (for which Baumol originally proposed the mechanism), as well as restructured electricity and water utilities. However, is it possible that regulators selected the wrong market design in their restructurings during the past two decades? If so, what were the consequences? What market design should regulators have employed to mitigate these problems?