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?

The Hope and the Reality

Baumol identified several advantages to this method that still are used to promote price-cap regulation: increased productivity growth, decreased regulatory lag, and reduced regulatory burden. Unfortunately, what appeared at first glance to be a simpler and more straightforward approach to ratemaking has not worked out that way. Unanticipated and unforeseen complexities in setting the inflation and productivity parameters have made the regulatory process for determining the price-cap formula complex and contentious. Add-ons, off-ramps, and other side agreements (such as earnings-sharing mechanisms or cost pass-through mechanisms) imposed by regulators or demanded by interested parties limits the efficiency incentives and further complicates the process. Finally, and perhaps most importantly, errors in specifying plan parameters are not market neutral and can be costly to consumers and other regulated firms.

Due to the nature of the process by which regulators and the monopolies they regulate react to each others' conflicting interests (the principal-agent problem), regulators do not have all of the information necessary to correctly set the parameters in these exogenously determined PBR plans, and the regulated firms have little incentive to give them this information, even if they know it. In such an asymmetric environment, determining the appropriate inflation escalator and productivity offset can be complicated, confusing, time-consuming, expensive, and divisive. Often, the necessary data is as difficult, or more difficult, to obtain than the process of determining the firm's cost-of-service. Thus, exogenously determined PBR plans often suffer from the same shortcomings as rate-of-return/cost-of-service plans, and may in fact result in worse outcomes, if plan parameters are significantly off the mark.

Good News and Bad News

The good news is that regulated firms do respond to the incentives presented to them. For example, research on 48 electricity distributors in the province of Ontario finds that utilities increased their average annual growth in total factor productivity (TFP) by 2.3 percent after the imposition of a variable offset PBR (, price freeze), rising from -0.2 percent prior to the freeze to 2.1 percent after its imposition. ² This increase was pervasive among individual distributors and consistent across size classes. On average, small, medium and large utilities had relatively similar