Performance Based Ratemaking: Time to look again?

Branko Terzic

The privatization was accompanied by the application of the “RPI-X” price cap scheme designed by Professor Stephen Littlechild. He had earlier published a significant paper on regulation which proposed this “performance based” method of regulation.  Littlechild, who was appointed the United Kingdom’s first electricity regulator, had studied the US “cost of service/rate of return” system and came up with a variant in the form of a PBR.

The scheme was relatively simple. The newly privatized utilities started with their rates under government ownership. For a five-year period rates would be adjusted up or down based on the formula “Retail Price Index minus X an annual productivity factor.” So, if the RPI was 3% per year and X was set at 2% then rates could be adjusted up 1%= 3%-2%   The X was considered the minimum improved productivity a management would experience.  Thus, electric rate increases would always be below the inflation rates. At the end of six years the base rates would be adjusted to the new lower levels. If the utility earned in excess of the authorized return, it would keep the excess, If the utility did not earn the authorized it could not ask for an increase.

The US showed interest in Littlechild’s RPI-X system. The Energy Policy Act of 2005 for example mentioned incentives and the FERC issued a policy statement in 1992 on incentives in Docket No. PL92-1-000 Incentive Ratemaking for Interstate Natural Gas Pipelines, Oil Pipelines and Electric Utilities of October 30, 1992.  Yet, in the US today true incentive ratemaking or PBR schemes are few and far between. Part of the problem goes back to the 1992 FERC Policy Statement, in my opinion.

As a commissioner on the FERC, I was appointed by Chairman Martin Allday to Chair the FERC Task Force on Incentive Rates which led to the policy statement. The task force report was a well-reasoned and clearly written document. It contained all the elements necessary to guide the FERC or a state regulatory commission in consideration of an incentive ratemaking proposal.  The final policy statement announced five regulatory “standards’ against which a proposal for incentive ratemaking would be tested.

Four of the five standards were clear and could be implemented with little controversy. One standard made it impossible, in practice, for any regulated utility to apply the policy statement. This fifth standard was, in fact, unworkable.

FERC’s Incentive Ratemaking Standards

1. Incentive mechanisms must be prospective.
2. Participation must be voluntary.
3. Incentive mechanisms must be understood by all parties
4. Quality of service must be maintained.
5. Benefits to consumers must be quantified.

It was the last standard on “quantification of benefits” which stopped incentive ratemaking at the FERC dead in its tracks.

Since ratemaking is prospective the last standard called upon the utility to provide a number of projections. This in itself is acceptable and normal regulatory practice for any utility filing a rate case. The problem with the “quantification” standard in this case is that the utility now found itself in the position of having to project future decisions of the FERC, the regulator and defend these projections on the witness stand during the ensuing proceedings.  The applying utility could, of course, make such projections. The problem is that the regulator must either accept the utility’s projections of the regulator’s future rate decisions, or the staff of the regulator must provide its projections in order to test the hypothesis that rates under the new incentive scheme will be better than rates under continuing regulatory scheme. That was and is the dilemma.

At the time the standards were written into the FERC policy statement, I thought that it might be possible to get agreement between applicants and regulators over the projections of future regulatory actions. I was wrong. The “quantification” standard has been shown to be an unworkable standard. Perhaps now, thirty years later, when the FERC or state regulators revisit the question of incentive or performance-based regulation they will take that lesson into account.

I would caution the reader that many states as well as the FERC have some “incentives” in rate orders which allow for higher or lower returns when certain benchmarks are met. However this is not PBR.