Transcript Slide 1

Center for Energy Studies
Regulation & Incentives
Michigan State University, Institute of Public Utilities, Annual
Regulatory Studies Program
David E. Dismukes, Ph.D.
Center for Energy Studies
Louisiana State University
August 12, 2014
Table of Contents
1.0
Theory of the Firm
2.0
Profit Maximization & Regulated Firms
3.0
Incentives & Regulatory Lag
4.0
Asymmetric Information
5.0
Incentives, Regulation & Performance
6.0
Tracker Mechanisms
7.0
Conclusions
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Section 1: Theory of the Firm
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Theory of the Firm
Theory of the Firm
First codified by Ronald Coase in is 1937
work entitled The Theory of the Firm.
Purpose was to explain and provide a
theoretical
construct
for
primary
economic unit of business/industry (“the
firm”).
Coase addressed and provided a framework
for understanding:
Ronald Coase
• Why do firms exist?
• How are they organized?
• How do they behave?
• How do they interact with market and other market
participants?
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Theory of the Firm
Why Do Firms Exist?
Coase posited that firms arise when the transactions costs of utilizing the
market are too high given informational costs (or, when the cost of
“internalizing” an activity is lower than seeking that activity in the market).
Relaxes an important competitive market assumption (the presence of
perfect information) but introduces another one (constant returns to
scale industry).
A constant returns to scale firm internalizes activities up to the point, at the
margin, where costs equals benefits.
Firm size in various industries can be explained by the
information/transactions costs in the market place. The higher the
transactions costs in any given industry, the likely the larger the firms.
Wide range of literature opened up in the 1960s to critically examine,
challenge, and/or expand upon this basic idea and the role of
information and transactions costs on firm organization. (i.e., Baumol,
Williamson)
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Theory of the Firm
Profit Maximization
One of the single largest contributions from Coase’s work is the
conclusion that firms are “profit maximizing.” This is
fundamental tenet underlying modern microeconomic theory.
Incentives for competitive firms in competitive markets is to
reduce costs and maximize profits relative to prices given to
them by competitive marketplace.
The firm’s goal is to maximize profit (Profit = Total Revenue
minus Total Cost). According to the cost-benefit principle, a firm
should increase output as long as marginal benefit exceeds the
marginal cost:
This means the profit-maximizing quantity can be found
where marginal benefit equals marginal cost.
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Theory of the Firm
Analytics of a Firm’s Profit Maximization Decision
In the example below, there are no “excess” or “economic” profits since prices are equal to
marginal costs for this particular (marginal) firm.
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Theory of the Firm
Can Excess Profits Arise?
• Compare the price in the market to the firm’s total
cost per unit (average total cost)
• If P> ATC, the firm is making an “economic profit.”
Note – economic profits is not the same as “profits”
or a rate of return on capital invested.
• Firms do receive “profits,” or a return on investment –
they do not receive “economic profits” which are
returns beyond what regulators would think of as a
“fair rate of return.”
• If P<ATC, the firm is making a loss:
– If P>AVC, the firm will stay open in the short-run, but will
eventually stop producing.
– If P<AVC, the firm will shut-down in the short-run.
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Theory of the Firm
Analytics of Firm Making “Economic Profits”
Excess profits since average costs (and marginal costs) are well below the going market price.
In this example, the marginal firm is very efficient relative to the going market price.
Economic profits are “bid away” over time as potential firms (entrepreneurs) see
excess profit opportunities and enter the market until, at the market, no more
“economic profits” are left.
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Theory of the Firm
Analytics of Firm Making Economic Losses
Marginal firm in this example is losing money in the short run.
The shut-down point is the lowest value of AVC, if price falls below this point the
firm will immediately shut-down and stop producing in the short-run
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Theory of the Firm
The Market Equilibrium Returns
Consumer Surplus: difference
between the price consumers are
willing to pay (MB) and the
market price.
Producer Surplus: difference
between the market price and the
cost of production (MC)
Total Surplus in a market gives
a measure of efficiency: where,
at the margin, costs equals
benefits (MB = MC).
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Theory of the Firm
Summary: Incentives & Competitive Firms
So, in summary, profits incent competitive firms to employ
factors of production, invest resources, take risks, and
produce costs and services.
Higher prices, holding costs constant, leads to more profits.
However, firms in competitive markets have no control
over prices – so, lower costs, holding prices constant,
results in higher profits.
Competitive firms expand total profits by reducing costs
and increasing output.
The incentive to maximize profits, through cost
efficiency, is the competitive market discipline that keeps
prices low. This is one important outcome the regulatory
process seeks to emulate.
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Section 2: Profits & Regulated Firms
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Regulated Firms
Incentives and Regulated Firms
Are incentives for regulated firms the same
as those for competitive firms?
Yes…
regulated
firms
are
profit
maximizing – hence their requests for
allowed rates of return.
The role of profits for a regulated firm,
however, differs since it is not a constant-cost
firm like one underlying the Coasian theory of
the firm.
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Regulated Firms
How are Prices and Output Determined in Perfectly Competitive Markets
In competitive markets, prices are set where marginal costs equals the marginal
willingness to pay (demand). Thus, prices are set at costs, where costs reflect the
cost of providing goods and services to the market.
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Regulated Firms
How are Prices and Output Determined in Perfectly Competitive Markets
“Natural” monopolies, however, do arise in certain high sunk cost infrastructure
industries. These industries have declining costs throughout their entire range of
relevant production, making the most efficient outcome one where there is a
single, not multiple firms (a contradiction to the traditional competitive market).
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Monopoly Characteristics
Monopoly
Regulated Firms
Characteristics of a monopoly
• One firm selling a product which has no close substitutes
• Monopoly supply is the same as industry supply
• There are significant barriers to entry for new firms
Barriers to entry: legal or technical conditions that
make it impossible or prohibitively costly for a new
firm to enter a given market.
Costs: declining costs throughout relevant range
of production can lead to “natural monopoly”
conditions.
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Regulated Firms
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What Would Happen if We Didn’t Regulate?
The unregulated profit maximizing solution for a monopolist is to price at a point
on the demand curve where marginal revenue equals marginal costs. This raises
price, and restricts output: MONOPOLISTS ARE STILL PROFIT MAXIMIZING,
they just do so in a way different than competitive firms.
Price
Monopoly profits or “rents.”
A monopolist makes profits by
restricting output and
raising price – this is an
important distinction from
competitive firms.
Pm
S = MC
PC
D
Qm
MR
Quantity
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Regulated Firms
The Natural Monopoly Problem: Setting Prices at Optimal Levels
If we were to set prices equal to marginal costs in a declining cost industry, a firm
would be unable to earn a return of and on its investments. This would result in a
loss, other things being equal. Note, the socially optimal level is “unattainable.”
Have to seek a “second-best” solution.
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Regulated Firms
Comparison of Various Monopoly/Regulated Pricing Outcomes
The “fair-return” price is set at average total costs (average cost pricing). This
results in lower prices and higher output than the monopoly profit maximizing
level, but one not as good as the socially optimal price.
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Monopoly
Regulated Firms
What are the Incentives for Regulated Firms
A natural question arises from the regulatory
process:
• If regulation eliminates “economic profits” then
what motivates utilities to reduce costs and to be
efficient?
The answer rest with a concept referred to as
“regulatory lag” which is thought to incent
firms to reduce costs and to increase
efficiencies between rate cases.
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Section 3: Incentives & Regulatory Lag
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Regulatory Lag
Definition: Regulatory Lag
Regulatory lag can have a number of
definitions:
• Can be defined as the period of time between when a
utility’s rates go into effect, and its next rate case.
• May also be represented as the period between when a
utility investment is made and the time it enters into
rates.
• Can also be interpreted as the time in which a utility’s
achieved rate of return (meaningfully) differs from its
allowed rate of return.
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Regulatory Lag
Who Controls Regulatory Lag?
• Typically, utilities control the duration between rate
cases.
• In most states, utilities have the statutory ability to
request a change in rates.
• While state utility commissions and other stakeholders
can, in theory, request a utility be “brought in” for a
rate case, this rarely happens.
• Ronald Braeutigam and James Cook, surveyed state
utility rate cases during the period 1948 to 1978 and
found that over 350 of the 363 surveyed rate cases
(96 percent) were brought by a regulated utility,
with the smaller number attributable to regulators or
consumer groups.
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Regulatory Lag
Control of Regulatory Lag and Risk Relationships Under Traditional Regulation
Timing of rate case rests with utility – gives utility the ability to
shift the risk of regulation and regulatory lag away from itself
and onto ratepayers.
Utility has “option value” creating a price floor to buttress value.
This price floor allows shareholders to retain benefits created by
regulatory lag, as well as the option to defend against
challenges to those benefits through the timing of a rate case.
Joskow (1973) reached similar conclusions noting that utility
commissions tend to defend against rate increases, but are
less aggressive in pursuing rate decreases when rates are
stable or decreasing in real terms.
Source: Graeme Guthrie. (2006) “Regulating Infrastructure: The Impact on Risk and Investment.” Journal of Economic Literature.
44 (December):925-972. Paul L. Joskow. (1973) “Pricing Decisions of Regulated Firms: A Behavioral Approach.” The Bell Journal
of Economics and Management Science. 4 (Spring):118-140.
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Regulatory Lag
Is Regulatory Lag Inherently “Unfair” or “Confiscatory”?
The premise that regulatory lag is somehow unfair is simply
antithetical to 40 years of utility regulation research and practice.
Regulatory lag is long recognized as imposing discipline on utility
operational and investment decisions.
Regulatory lag prevents utility regulation from devolving into a
“cost-plus” regulatory approach that simply passes through costs
on a dollar for dollar basis to ratepayers, and can lead to cost and
investment inefficiencies.
The cost-plus regulatory approach also shifts a considerable
amount of performance-related risk away from utilities and onto
ratepayers and leads to inefficient outcomes, which was recognized
as early as the 1960s and has come to be known as the “AverchJohnson” or “A-J” effect.
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Regulatory Lag
What is the Averch-Johnson Effect?
Harvey Averch and Leland Johnson and
published in the American Economic Review
in 1962, posited that rate of return regulation
creates an incentive for regulated utilities
to overcapitalize, resulting in an inefficient
utilization of resources and higher than
optimal rates.
This finding, however, was premised upon
a model with a number of assumptions,
one of which presumed there was no
regulatory lag and that rates were set on a
period-to-period basis: in other words, rates
were set on a “cost-plus” regulatory
approach.
Source: H. Averch and L. Johnson. (1962) “Behavior of the Firm under Regulatory Constraint.” American Economic Review.
52:1052-1069.
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Regulatory Lag
Follow-Up A-J Research
Soon after its publication, Averch’s and Johnson’s article was met
with a flurry of scholarly research attempting to empirically verify
the A-J effect, as well as examining the conditions under which the
effect would, and would not, be sustained.
Rejoinders to the research noted that two characteristics of the
regulatory process tended to temper the likelihood and prevalence of
the A-J effect:
1. the possibility of disallowances through the prudence
review process and
2. the positive efficiency incentives created by regulatory
lag. In fact, a series of articles published soon afterwards
noted that regulatory lag typically creates incentives for
utilities to seek efficiency opportunities between rate cases
since the gains (profits) from those investments inure to
shareholders instead of ratepayers.
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Regulatory Lag
First Articles Identifying the Benefits of Regulatory Lag
William Baumol and Alan Klevorik (1971) was
the first of what was to become a series of
articles showing that regulatory lag actually
diminished incentives to avoid
overcapitalization, since the earnings gained by
avoiding these inefficient actions passed directly
to shareholders.
Soon after, Klevorik, writing separately from
Baumol, built upon this model by explaining
how multi-year year regulatory lags, coupled
with demand and cost uncertainty, created
strong incentives for efficiency to maintain
profitability. One of his additional findings at the
time, however, was that these incentives might
also discourage regulated firms from investing in
research and development.
Source: William J. Baumol and Alan K. Klevorik. (1970). “Input Choices and Rate-of-Return Regulation: An Overview of the
Discussion.” The Bell Journal of Economics and Management Science. 1 (Autumn):162-190.
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Regulatory Lag
Other Works: The Role of Regulatory Lag and Innovation
Elizabeth Bailey, who also served as an
economic researcher at Bell Laboratories,
addressed this issue, as well as other issues
associated with the incentives created by
regulatory lag, during this active period of
regulatory scholarship.
Bailey found that regulatory lag helped to
facilitate, not reduce, the incentives for a
cost-reducing innovations. Bailey’s work
built upon earlier work that she did with Roger
Coleman in 1971 that further supported the
conclusions of Baumol and Klevorick, that
regulatory lag induces profit-maximizing
firms to adopt minimum-cost production
alternatives.
Source: Elizabeth E. Bailey. (1974). “Innovation and Regulation.” Journal of Public Economics. 3: 285-295. Elizabeth E. Bailey
and Roger D. Coleman. (1971). “The Effect of Lagged Regulation in an Averch- Johnson Model.” Bell Journal of Economics and
Management Sciences. 2 (Spring): 278-292.
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Regulatory Lag
Alfred Kahn: The Economics of Regulation
In his seminal work in utility economics and
regulation, Alfred Kahn noted the
following about regulatory lag:
Freezing rates for the period of the lag
imposes penalties for inefficiency,
excessive conservatism, and wrong
guesses, and offers rewards for their
opposites; companies can for a time
keep the higher profits they reap from
a superior performance and have to
suffer the losses from a poor one.
Sound familiar? These are the same forces that discipline competitive
markets.
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Regulatory Lag
Summary: Arguments Supporting Regulatory Lag (“Good Thing”)
• May impose discipline on utility operational and
investment decisions: encourages efficiency.
• Prevents utility regulation from devolving into a “costplus” regulatory approach.
• Reduces incentives to avoid overcapitalization,
since earnings gained by avoiding inefficient actions are
passed directly to shareholders.
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Regulatory Lag
Summary: Arguments Against Regulatory Lag (“Bad Thing”)
• Utilities view regulatory lag as a problem because rates
do not keep up with rising costs.
• Hinders infrastructure development / capital
expenditures and investment in “non-revenue
generating” system improvements (i.e., safety,
reliability, resiliency).
• Theory of regulatory lag is “time-dated” – it may have
held merit in a high growth/high productivity
environment but holds less merit today with low energy
demand growth and infrastructure replacement
challenges.
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Regulatory Lag
Center for Energy Studies
Historic Utility Earnings Compared to Estimated Allowed ROE for Industry Overall
Who’s right? Empirically, likely depends on time period, but more often than
not, lag has benefited utilities.
16%
14%
(Percent)
12%
10%
8%
6%
4%
2%
0%
1996
1998
2000
2002
Estimated Achieved Return
2004
2006
2008
2010
Estimated Allowed Return
Note: Estimated achieved return is calculated as Net Income divided by Proprietary Stock (less preferred stock).
Source: Federal Energy Regulatory Commission; and Public Utilities Fortnightly.
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Section 4: Asymmetric Information
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Asymmetric Information
Expansion of the Literature, Emergence of Informational Economics
Coase’s work led to a new body of literature, “informational
economics,” that discuss the role of information, its costs,
and how economic decisions (and incentives) are influenced.
Early challenges to the literature began to incorporate real
world structural considerations into the theory of the firm
such as the differences of incentives between
“managers” and “shareholders.”
Early work question the asymmetric information between
“managers” and “shareholders” in terms of profit
maximization:
for instance, do managers act in
shareholders’ best interest?
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Asymmetric Information
Definition: Asymmetric Information
What do we mean by “asymmetric information?”
Definition: when one contracting party has a different set of
relevant information relative to another contracting party.
The difference in information held by the two parties can
lead to differing incentives, and can lead to differing
economic outcomes that are usually “not efficient.”
Led to wide range of literature known as “moral hazard”
which, consistent with above, is said to occur when one party
can take a particular action that cannot be closely observed
by another.
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Asymmetric Information
Moral Hazard
Moral hazard occurs in instances where an economic
agent facing a certain degree of risk behaves
differently when it is insulated from that risk than it
would if the risk were not insured.
Moral hazard is, in effect, the behavioral difference that
results from the presence or introduction of
insurance.
Moral hazard results in a “market failure” or inefficiency
because the agent receiving the insurance does not
have to bear the full responsibility for its actions.
Source: W. Nicholson. Intermediate Microeconomics and Its Applications. 5th Edition. (1990) Chicago: Dryden Press, 695.
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Asymmetric Information
Examples of Moral Hazard
Moral hazard has significant implications across a wide
range of industries that rely heavily on contracting and
performance, particularly insurance and finance.
Examples:
Banking: “too big to fail”
Insurance: Life insurance and risky behavior.
Moral hazard arises when the presence of “insurance”
causes a party to behave differently. This impacts behavior
and “incentives.”
Here, “insurance” can be almost anything that provides a
certain guarantee that is not entirely tied to performance
(or imperfectly set to performance).
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Asymmetric Information
Moral Hazard and Regulation
Moral hazard has been recognized in
regulatory theory and practice. In
fact, incentive regulation is based upon
a special case of a moral hazard called
the “principal-agent” problem.
Bonbright, et.al. defines moral hazard
as:
A moral hazard is involved when someone other than the purchaser
pays for the purchase and hence the purchaser acts, unconstrained
by ethics or other institutions, as if there is no resource cost on
society from his or her purchases. In other words, moral hazard
increases the risk of an event turning out favorably because there
may be positive rewards or at least insufficient penalties for
opportunistic behavior.
Source: J. Bonbright, A. Danielsen, and D. Kamerschen. (1988) Principles of Public Utility Rates. Arlington, VA: Public Utility
Reports, 138.
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Asymmetric Information
Moral Hazard in Practice
Not difficult to see how moral hazard can become a problem
in any form of regulation including banking, insurance,
environmental, and utilities.
Regulated firms typically have more information about
their operations and industry than regulators. Couple this
with resource differentials, and the case for the presence of
moral hazard becomes strong.
What are moral hazard outcomes in utility regulation?
Typically cost inefficiencies and overcapitalization (Gold
plating/X-inefficiencies).
Disallowances have historically been the “active” deterrent
that regulators have used to address these moral hazard
outcomes.
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Asymmetric Information
What is Gold Plating?
The “A-J Effect,” is commonly thought to create an
incentive to over-capitalize, also referred to as “goldplating.”
“Gold-plating” is usually related to capital
expenditures and can take a number of different forms
from over-emphasis of capital, to the adoption of
questionable
technologies,
to
excess
capital
expenditures.
Differs from “X-inefficiencies” which tend to be
associated with operating expenditures, not a factor
considered in the A-J literature, but one recognized in
the practice of regulation.
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Asymmetric Information
Prudence as a Active Deterrent to Gold Plating
• While the older literature has shown that “regulatory lag”
creates a “passive” disincentive towards gold-plating,
more “relatively” recent developments in the literature of
shown that regulatory disallowances can serve as an
“active” disincentive towards over-capitalization.
• The prudence standard has existed for a long time in
state public utility regulation. The first recorded use of
the prudence standard was exercised by the
Massachusetts Public Service Commission in 1914.
The concept was used to ensure that only prudently
incurred capital expenditures would be allowed in
rate base.
Source: National Regulatory Research Institute, The Prudent Investment Test in the 1980s (Columbus, Ohio: National Research
Regulatory Institute, 1985), p. 2.
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Asymmetric Information
Definition of Prudence
The definition of a prudent investment was
expressed by U.S. Supreme Court Justice Louis
Brandeis in 1923:
The term prudent investment is not used in a critical
sense. There should not be excluded from the finding
of the [rate] base, investments which, under ordinary
circumstances, would be deemed reasonable. The
term is applied for the purpose of excluding what
might be found to be dishonest or obviously
wasteful or imprudent expenditures. Every
investment may be assumed to have been made in the
exercise of reasonable judgment unless the contrary
is shown.
Source: Separate, concurring opinion of Justice Brandeis, Missouri ex rel. Southwestern Bell Telephone Company v. Missouri
Public Service Commission, 262 US 276, PUR1923C 193 (1923).
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Asymmetric Information
Regulatory Disallowance – Historical Perspective
Historically, prudence disallowances were rare until late
1970s.
According to a 2005 study, between 1981 and 1991
there were more than $19 billion of prudence-related
rate recovery disallowances associated with new
power plant construction projects.
o More than 95 percent of disallowances were
related to nuclear power plant delays and cost
overruns.
Since early 1990s, prudence disallowances are again the
exception, and not the norm.
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Asymmetric Information
Prudence Effectiveness
Some could question the effectiveness of the use of the
prudence standard in addressing all of the uneconomic
investment costs of the 1970s-1980s.
The presence of a substantial level of stranded costs
suggests that the process was not very effective; particularly if
a comparison to market costs is used as the standard (which
is challengeable).
How did regulation respond/adapt to this experience?
(a)
introduction of competition.
(b)
alternative forms of regulation.
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Section 5: Incentives, Regulation &
Performance
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Incentives & Performance
Moving to Differing Regulatory Paradigms
The less than satisfactory outcome with the disallowance
experiences of the 1980s highlighted the asymmetric
information problem for both regulators and regulated
companies.
While the introduction of competition was the preferred
solution to the disallowance experience, some states did
begin the process of exploring alternative forms of
regulation (either independently or through the restructuring
process itself).
There was a significant development of regulatory theory
during the prudence period (late 1970s-1980s) exploring
alternative forms of regulation. Theoretic basis was the
recognition of moral hazard in the regulatory process.
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Incentives & Performance
Consideration of Alternative Regulation
The purpose of alternative regulation was to improve utility
performance through the use of incentives.
Moral hazard notes that often, the informational asymmetry
between regulators and regulated companies, prevents traditional
regulation from forcing the most optimal outcome.
While optimal costs are difficult to observe, profits are not.
Regulated firms are profit maximizing: thus, tying regulatory
outcomes to observable output-based information (profits) was
seen as preferable to unobservable input-based information
(costs).
Movement to alternative regulation presumes that these
unobservable efficiency opportunities actually exist and the
benefits of changing regulation are greater than the costs.
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Incentives & Performance
How Do Regulators Affect this Change?
Starts with a certain policy leap of faith: regulators have to be
willing to allow prices (or revenues) become “decoupled”
with traditional (utility-specific) measures of costs.
Alternative forms of regulation inherent recognize that there
are (a) information asymmetries and (b) there may be
certain risks for utilities in pushing themselves to achieve
certain efficiency improvements.
Alternative regulation moves the traditional regulatory process
away from governing inputs to defining acceptable
outputs.
The process is not unbridled since regulators often build in a
hedge that sets boundaries on the program (so, this should
not be interpreted as “deregulation”).
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Incentives & Performance
Similarities Between Traditional and “Alternative” Regulation
Note that all forms of “alternative regulation” incorporate an
important component of “traditional regulation:” regulatory lag.
Recall that regulatory lag can create incentives for efficiency
since utilities can keep a portion of those increased efficiencyinduced returns, but:
• only a portion is allowed to be kept since the process does
still govern returns.
• Efficiencies are not constant – they exhibit diminishing
returns and can become difficult (and uncertain) to attain
over time.
• Utilities may have to take certain risks to achieve
efficiencies that requires (i) more pricing flexibility and/or (ii)
higher incremental returns depending upon the action/utility.
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Incentives & Performance
Institutionalizing Regulatory Lag
Alternative
regulation
effectively
regulatory lag in a type of contract.
“institutionalizes”
Alternative regulation recognizes the presence of a certain
degree of moral hazard and defines the terms and conditions
under which the gains from efficiency will be kept by the
utility, or shared with its ratepayers.
Alternative regulation reduces the risk that efficiency gains
will get “scooped” in the regulatory process, and rewards
utilities for enhanced (not normal or sub-normal) behavior – it
also penalizes utilities for sub-par performance.
Alternative
regulation,
therefore,
institutionalizes
performance since only through performance can profits
increase.
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Incentives & Performance
Definition: Alternative Regulation
What is alternative regulation?
No universally-recognized definition and often means differing
things to different individuals.
May also have a legal/statutory definition that trumps a
textbook definition.
Generally, an approach that allows for increased earnings
(beyond a traditional allowed rate of return) if certain
performance-based criteria are met.
Premised upon the theory that dynamic efficiency gains will
become greater than what may appear in short run as
monopoly profits (i.e., earnings above “normal” rate of return).
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Incentives & Performance
Forms of Alternative Regulation & Components
Common forms of alternative regulation:
(a)
Fixed price/fixed revenue approach.
(b)
Variable price/variable revenue approach.
Both forms will usually have the following components:
(a)
Incents efficiencies through increased earnings.
(b)
A fixed term or duration
(c)
Start with an initial rate case.
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Incentives & Performance
Fixed Price/Fixed Revenue
Prices or revenues are fixed for a set period of time (three to five
years – or “stay-out” period ) after an initial rate case review.
Utility allowed to retain a certain share (or large share) of excess
earnings that arise from efficiencies arising during the “stay-out”
period.
Rates are recalibrated and program effectiveness is reviewed at
the end of the stay-out period.
Examples include post-merger rate freezes, retail restructuring rate
freezes.
Inherent assumption in these (fixed) mechanisms is that there are
enough accumulated inefficiencies that can be garnered over
time that will self-fund the efficiency improvements.
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How Does Earning Sharing Work?
This hypothetical example defines a sharing range above the allowed rate of
return and fixed sharing percentage between shareholders and ratepayers over
a five year period.
ROE
Earnings in excess of
allowed ROE are
shared on 75/25
percent basis to some
capped (threshold)
level.
ROET
ROEA
1
2
3
4
5
Time/Period
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How Does Earning Sharing Work?
This hypothetical example defines various sharing ranges above the allowed
rate of return, with increasing sharing percentages between shareholders and
ratepayers over a five year period.
ROE
25/75 sharing range.
50/50 sharing range.
ROE1
75/25 sharing range.
ROEA
1
2
3
4
5
Time/Period
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Incentives & Performance
Why is Timing/”Stay Out” Period Important?
Commonly set in three to five year range, although some
are set for much longer periods that can include up to one
decade.
Length is often part of the regulatory bargain between
utilities and regulators and likely determinant on other
program components (like earnings sharing bands).
Determination of stay-out period itself is one subject to a
certain degree of moral hazard since the utility will have a
better understanding of its short and long run efficiency
improvement opportunities.
Does not eliminate opportunism since utilities often have
statutory (constitutional?) provisions allowing them to “break”
the contract.
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Incentives & Performance
Why is Timing/”Stay Out” Period Important?
Argument for long stay-out periods: longer periods give
utilities the opportunity for making longer-run investments
that will yield efficiency gains (and returns) over a period of
time. Longer stay out periods help to create opportunity to
attain the full return from the investments.
Arguments for short stay-out periods: allowing long
periods of time can result in a significant disconnect
between rates and costs without recalibration and can lead
to utilities earning the same monopoly returns regulation is
intended to eliminate.
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Incentives & Performance
Variable Rates/Variable Revenue Approaches
These approaches allow rates/revenue to grow based upon a predetermined formula; utilities share in excess earnings.
Not the same as “formula-based rates.” While this can also be
thought of as an alternative form of regulation, it is simply costbased regulation that can be exceptionally weak in encouraging
efficiency (by itself). Usually cost-plus regulation or inflation plus
costs regulation.
Price cap or performance-based regulation (“PBR”) allow
rates/revenues to grow for inflation less productivity offset.
Presumption is that utility is already reasonably efficient at what it
does but could improve to above-average or best practices with
additional incentives in the form of pricing flexibility.
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Incentives & Performance
Revenue Caps
A revenue cap restricts the rate of growth in average revenues (revenues
divided by output); accounting for inflation, growth in productivity and
output, and various exogenous factors.
Where pi is the price of service i, qi is the quantity demanded at price pi, Q
is an aggregate index of outputs, and p0 is the maximum average price
allowed based upon price-cap formula.
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Incentives & Performance
Price Caps
Designed to limit the ability of utilities to earn more than normal profit, while
incentivizing the utility to attempt to reduce input costs and invest in
productivity improvements.
Price caps typically take the following form:
∆𝑷𝑰 ≤ ∆𝑷 − 𝑿 ± 𝒁
Where:
∆𝑷𝑰 = the rate of change in the price index of regulated prices
∆𝑷 = a measure of price inflation
X = total factor productivity, or an index of expected efficiency gains
Z = a factor capturing other relevant variables
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Incentives & Performance
Revenue Cap/Price Caps Challenges
Implementation of revenue and price caps can be contentious
since the analytics of the formula has to be estimated.
•
•
•
•
Issues on “bundling” services and good for a revenue cap.
Issues on measuring inflation and productivity.
“Average” vs “best practices.”
Accumulated inefficiencies for underperforming utilities.
The entire formula has to be taken into context with the
program duration (stay-out period) and earnings sharing.
Note – price inflation and productivity offsets can be
negotiated against duration and earnings share – more
guaranteed up front benefits can be offset with less “backend” earnings upside or longer durations.
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Tracker Mechanisms
Section 6: Tracker Mechanisms
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Tracker Mechanisms
Definition of Tracker Mechanisms
 Mechanisms that remove cost and/or revenue recovery from
base rates to a separate rider or tariff.
 Can be for the collection of new costs not included in base rates
or true-ups of revenues or expense items from levels that differ
from the test year.
 Recovery typically periodic and more frequent than rate cases.
 While mechanisms can include surcharges and credits they
should not be automatically considered “symmetrical.”
 Mechanisms originally developed with fuel-cost recovery, but
have expanded to a variety of other sales, capital and expenserelated changes.
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Tracker Mechanisms
Tracker Mechanism Examples
Tracker Mechanism
Recovery Type
Purpose
Asset Replacement Riders
Capital
Replace aging or inferior assets.
Inflation Riders
Expense
Inflate costs to match general inflation
or other measure.
Asset Development Riders
Capital
Facilitate preferenced assets like
baseload generation, smart meters.
Energy Efficiency Riders
Expense
Recover energy efficiency expenses as
incurred.
Renewable Energy Riders
Capital
Recovery renewable energy
development costs, rebates, and/or
PPAs.
Environmental Cost Riders
Capital/Expense
Recovery of capital investment or air
emission credits.
Weather Normalization Clauses
Revenue
Recovery of changes in sales due to
weather.
Revenue Decoupling
Revenue
Recovery of changes in sales due to
other factors.
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Commonly Cited Rationales for Trackers
Rationale
Driver
Volatile and unknown cost
changes.
Recent increases in commodity
costs and inflation.
Remove disincentives to purse
public policy goals.
Energy efficiency, renewables,
fuel diversity.
Required by “Wall Street.”
Capital crisis/recession.
Required to ensure recovery of
revenue requirement.
Changes in UPC, climate change,
other “exogenous factors.”
Reduce rate cases.
Increase in recent number of
rate cases.
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Tracker Mechanisms
Tracker Expansion
While some of these mechanisms are somewhat older in
implementation (e.g., WNA, revenue decoupling), others are
relatively new (asset development, inflation riders), and
others are being modified and expanded (energy efficiency,
renewables, environmental cost).
Another recent theme in tracker proposals is the “multiple
proposal” approach being pursued by utilities in various
regulatory filings (numerous as opposed to individual tracker
proposals).
Increased adoption by some state commissions has led
some utilities to refer to these mechanisms as the “new
traditional regulation” or “new chapter” in utility regulation.
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Tracker Mechanisms
Tracker Shortcomings
Practice/Theory
Traditional Approach
Tracker Approach
Cost recovery and
regulatory lag under
“regulatory compact.”
Utilities have traditionally been
tasked with proposing projects,
developing projects, and incurring
the cost to develop projects.
Utilities would incur costs for
projects often no defined ex
ante, and recover the costs
of these projects, as they are
incurred, in rates.
Afterwards, the utility must prove
that the investment is used and
useful and developed a reasonable
cost.
Asymmetric
information in utility
regulation and
performance-based
regulation.
Regulated firms know their cost
structures better than regulators.
Thus, best policy is to use
regulatory lag, or incentive
regulation (benchmarking) to drive
utilities to efficient outcomes.
Afterwards, regulators and
other parties would be
required to show that the
investments were not needed
and the costs were
unreasonable.
Presumes that regulators can
easily determine the
reasonableness of all capital
investments and their costs
within a matter of months
and can comfortably adjust
rates accordingly.
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Tracker Mechanisms
Risk Shifting
Risk Type
Risk Shifting Perceptions
Potential Consequence
Regulatory Risk
Ratepayers have higher burden to
prove investments are imprudent
rather than utilities proving that they
are prudent.
Takes away, or significantly
reduces the power of a
regulatory disallowance that is
long recognized as a powerful
regulatory tool in minimizing
cost and expense inefficiencies
and offsetting potential “A-J” or
“X-inefficient” outcomes.
Performance
Risk
Ratepayers have higher burden to
Effectively paying for a service
prove that tracker objectives were not before it has been rendered.
met on sometimes illusive (qualitative)
cost and investment decisions.
Sales Risk
Ratepayers will make utilities whole
for any change in sales regardless of
reason (economy, price, weather).
Decoupling revenues from sales
is likely to lead to a decoupling
of costs from revenues in a
regulated cost-based industry.
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Section 7: Conclusions
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Conclusions
Perspectives of Regulatory Effectiveness (NREL Report)
Source: Comnes, G. A., S. Stoft, N. Greene and L.J. Hill; Performance-Based Ratemaking for Electric Utilities: Review of
Plans and Analysis of Economic and Resource Planning Issues; November 1995; Lawrence Berkeley National Laboratory.
NA=not applicable
FCC= Federal Communications Commission
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companies.
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Conclusions
Conclusions
Incentives matter and the economics of regulation, like other
fields in economics, have attempted to understand those
incentives and the interaction that informational asymmetry
and other market failures play in effective regulation.
Movement away from traditional regulation is a policy call
based upon a regulator’s belief that other forms of regulation
will be more effective.
Measurement, benchmarking and analysis is the first step in
this process since effectiveness is relative.
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Conclusions
Conclusions
Interesting time for the consideration of alternative gas/electric
regulation given other policy agendas (reliability, resiliency,
replacement) and their corresponding ratemaking mechanisms
(trackers).
(Most) trackers are the antithesis to PBR since they are not tied to
performance, are periodic, and cost-plus based. PBR should be
thought of as a substitute, not compliment to tracker-based
regulation and may be an alternative for “tracker-fatigued”
commissions.
Do utilities want PBR and rewards for efficiency or do they want
insulate themselves from cost-recovery risk?
While PBR/incentive regulation “decouples” rates and costs, it
“recouples” performance not found in tracker-based approaches.
Was thought to be a very effective form of regulation in
telecommunications and the concurrent advances in technology.
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Conclusions
Conclusions
Interesting time for the consideration of alternative
gas/electric regulation given other policy agendas (reliability,
resiliency, replacement) and their corresponding ratemaking
mechanisms (trackers).
(Most) trackers are the antithesis to PBR since they are
not tied to performance, are periodic, and cost-plus based.
PBR should be thought of as a substitute, not compliment
to tracker-based regulation and may be an alternative for
“tracker-fatigued” commissions.
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Conclusions
Conclusions
Do utilities want PBR and rewards for efficiency or do they want
insulate themselves from cost-recovery risk?
Utilities in today’s environment may not be supportive of
performance based approaches since it requires them to bear
performance risk of their investments.
Utilities may not preference PBRs since they are uncertain about
the likely performance effectiveness of these reliability,
resiliency, and replacement investments. If this is the case, it raises
new set of issues related to cost-recovery, prudence, and
performance.
While PBR/incentive regulation “decouples” rates and costs, it
“recouples” performance not found in tracker-based approaches.
Was thought to be a very effective form of regulation in
telecommunications and the concurrent advances in technology.
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Comments & Questions
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