Regulators must be aware of the challenges to performance-based regulation to avoid harming public interests.
Performance-based regulation is in vogue in utility regulatory circles. But like the beer with the same acronym, Pabst Blue Ribbon, performance-based regulation can also leave an awful taste. A poorly designed and executed performance-based regulation framework can harm utility customers and act antithetically to the public interest.
Performance-based regulation is a utility regulatory framework that, instead of prescribing how a utility company should operate, sets performance goals and rewards or penalizes a utility based on its outcomes.
Performance can relate to all sorts of things, such as safety, customer satisfaction, utility financial health, service reliability, and energy efficiency. When selecting a utility activity for performance regulation, two key factors to consider are its importance to the public interest and the degree of managerial control over outcomes.
But performance is often mistaken for consequences. Improved performance is only good when it promotes the public interest. For example, it is conceivable to have “too much of a good thing.” This outcome can occur under performance-based regulation when it provides stronger incentives for utilities to perform better in some activities than others.
Many observers argue that traditional cost-of service ratemaking—setting prices that allow companies to earn a reasonable return above their costs—no longer fits today’s energy landscape, which is defined by distributed energy resources, engaged utility customers, smart grids, energy efficiency, large capital investment, and energy storage. In the United States, there has been an increased interest in performance-based regulation. This is especially true in states that have undergone electric-industry restructuring. The concern is that present utilities have weak or even perverse incentives to satisfy new goals and objectives.
Consumer groups are generally skeptical of performance-based regulation. They see utility companies exploiting their information advantage by manipulating a performance-based regulation mechanism to increase their profits or reduce their risk at the expense of their customers. Consumer groups tend to favor prudence reviews, management audits, and regulatory lag—the gap in time between when a regulated entity’s costs change and when those changes get incorporated into rates.
Performance-based regulation has features distinguishable from these traditional approaches for improving utility performance, such as its formula-based structure its mitigation of retrospective reviews, ex post regulatory evaluations of a utility’s past costs and decisions, and the upfront sharing of benefits between utility and customers from superior or subpar utility performance.
The formula used to calculate the impacts of performance-based regulation involves mapping the influence of actual costs incurred by the utility, the share of cost savings retained by the utility, and the “benchmark”—or baseline—costs, onto the costs flowed through to customers. The formula has three generic parts: the target or benchmark, the sizes of the rewards and penalties—such as the share of “gains” and “losses” allocated to utility shareholders and customers—and the maximum rewards and penalties provided to the utility. These features of performance-based regulation for energy utilities date back several decades.
Performance-based regulation has the potential to strengthen utilities’ incentives to improve performance. It does so by rewarding utilities for superior performance that benefits customers—for example, through more cost-effective energy-efficiency initiatives. Performance-based regulation can also impose penalties when utilities perform poorly. At first glance, it seems clear that utilities will perform at a high level when facing these kinds of incentives.
But the real world poses several challenges to regulators in structuring and implementing performance-based regulation. Both elements are crucial for successful performance-based regulation. A structure may seem appealing on the “blackboard” but falls short of expectations when introduced into the real world.
One such challenge is choosing a preferred mechanism and performance metric that best addresses the problem at hand. Regulators might require a performance-based regulation mechanism for a utility in response to a history of poor customer service or rapidly rising maintenance costs.
Another challenge is establishing the appropriate benchmark or reference point, such as peer group or a utility’s past performance. The benchmark is crucial for dividing up the gains between the utility and its customers. But gamesmanship by utilities, such as biased cost revelation— a utility proposing an inflated costs to the regulator that justifies a higher rate increase—and incomplete information, can result in the wrong benchmark. As a result, the regulators find it difficult to know the “true” benchmark: What costs should the utility incur under prudent management? What would the utility’s costs be in the absence of a performance-based regulation mechanism? What is a reasonable outcome deserving of neither a reward nor a penalty?
Inevitably, the utility will propose a benchmark that will facilitate earning a reward and avoiding a penalty. The utility may present its cost opportunities to be lower than what they really are. The utility may argue, for example, that it has certain constraints in reducing costs when, in fact, it has no such constraints. Utilities could then recover all of their costs even when they perform poorly.
Regulators also must resolve conflicting objectives, such as the tradeoff between low cost and high service reliability. One often-overlooked concern is that a performance-based regulation that incentivizes improvements in one objective at the expense of others. For example, a utility may be motivated to overspend on safety while compromising on cost-consciousness. Uneven incentives across functions can lead a utility to overinvest in one area, resulting in a decline in its overall performance that harms customers and the broader public interest.
Information asymmetry between utilities and regulators adds another layer of complexity. Utilities know their capabilities to perform better than regulators do, and this information asymmetry has two important consequences. The first is that a utility can misrepresent its performance to regulators. The second is that regulators should exercise caution in interpreting a utility’s performance. Subsequent problems can arise when regulators wrongly penalize utilities, such as by blaming low reliability levels solely on bad utility management, or wrongly allow a utility to recover all of its costs, such as by approving a biased cost benchmark that unduly favors the utility. Either of these outcomes is antithetical to the public interest.
Determining the sizes of rewards and penalties presents yet another challenge. They should be high enough to induce improved utility performance but not to severely damage a utility’s financial condition.
Finally, measuring and verifying the benefits resulting from performance-based regulation is crucial. Regulators should ask: What benefits do customers receive when utility performance improves? Do these benefits at least cover the additional revenues that customers pay utilities as a reward for exceptional performance? When customer benefits fall short of additional revenues, the utility receives a windfall at the expense of customers. Pulling the plug on a performance-based regulation mechanism or modifying its structure would be justified if the benefits to customers under the extant mechanism is negative, which has happened for some mechanisms that were poorly designed.
Utility exploitation is a distinct possibility that regulators cannot ignore in reviewing and approving a performance-based regulation mechanism. When designed according to theory and implemented properly, performance-based regulation can benefit both utility customers and society. As with many regulatory actions, however, a fine line exists between doing something right and doing something that unexpectedly goes wrong. The latter outcome results in what public-policy analysts call unintended consequences. Performance-based regulation can produce such an outcome when not done judiciously.
