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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

Unlike the majority of implemented performance-based rate (PBR) designs, alternative design paradigms are available that minimize data requirements by allowing firms to reveal performance potential. One approach relies on group performance and competition to inform the regulator. The second, while it can, and has been, applied within a peer setting, requires only that the regulator have some information on the range of potential productivity outcomes and the returns that would be associated with such results. The regulated firm is then offered a menu of options representing the productivity factor—return on equity (ROE) choices.

Due to the principal-agent problem between regulators and the monopolies they regulate, regulators don’t have the information necessary to correctly set parameters in exogenously determined PBR plans. 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 cost-of-service rate-of-return plans, and in fact might result in worse outcomes, if plan parameters significantly are off the mark.

However, regulated firms do respond to incentives, and this can be used to structure more effective regulation. For example, research on 48 electricity distributors in Ontario, Canada 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 ( i.e., price freeze), rising from -.2 percent prior to the freeze to 2.1 percent after its imposition. 1 This increase was wide-spread among individual distributors and consistent across size classes. Firms understood the incentives and responded to them.

However, critical design issues such as asymmetric information, allocative inefficiency, initial efficiency differences, and adjustment dynamics have not been resolved, and in some cases, not even addressed. Despite the opportunity provided by group restructurings in network industries in the United States, Canada and the U.K., and the potential for application of endogenously determined PBRs, regulators opted for exogenously imposed, fixed factors based only on estimates of technical efficiency improvements, rather than PBR predicated on inter-firm-based competition. 2 Such unresolved issues are the direct legacy of decisions to implement PBR in a data intensive, regulator-imposed, exogenous framework, rather than the minimalist information, endogenous shadow market advocated by some researchers. In some cases ( e.g., adjustment dynamics or periods), regulators have opted to impose productivity offsets and performance periods with little to no research upon which to base their parameters. 3 In other