Performance-based regulation

Performance-based regulation ("PBR") is an approach to utility regulation designed to strengthen utility performance incentives. Thus defined, the term PBR is synonymous with incentive regulation. The two most common forms of PBR are award-penalty mechanisms (“APMs”) and multiyear rate plans (“MRPs”). Both involve mathematical formulas that can lower regulatory cost at the same time that they encourage better performance. This constitutes a remarkable potential advance in the “technology” of regulation. Economic theorists whose work has supported the development of PBR include Nobel prize-winning economist Jean Tirole.

An APM is designed to strengthen performance incentives in targeted areas. It is sometimes for this reason called a targeted performance incentive. Basic components of such mechanisms include a key performance indicator (called an “output” in Britain), a performance appraisal that compares the utility’s value for the indicator to a benchmark value, and a mechanism for adjusting utility rates to reflect the performance appraisal. Here are some common performance areas targeted by APMs.

APMs targeting cost are often used to bolster incentives when a regulatory system features a mechanism, such as a fuel cost adjustment clause, that is believed to weaken cost containment incentives.

MRPs are the most common approach to PBR around the world. An MRP features a moratorium on rate cases which typically lasts three to five years. An attrition relief mechanism (“ARM”) adjusts rates or revenues automatically between rate cases to reflect inflation and other changes in business conditions. Some costs are typically addressed separately using cost trackers. Some MRPs feature earnings sharing mechanisms that share surplus or deficit earnings between the utility and customers when the return on equity deviates from its target. Plans may also feature an efficiency carryover mechanism that incentivizes long term performance gains and discourages the opportunistic timing of expenses by permitting the utility to keep a share of cost savings (or absorb a share of high costs) when rates are trued up to cost at the end of the plan.

Since infrequent rate cases lessen concerns about cost allocations and cross-subsidies, MRPs can permit regulators to sanction greater marketing flexibility. Most MRPs also include APMs to balance incentives for cost containment with incentives to pursue other goals (e.g. reliability or energy conservation) that matter to customers.

The design of the ARM is a key issue in a proceeding to approve an MRP. Several approaches to ARM design are well established.

In North America, MRPs have been especially popular where utilities need marketing flexibility. Such plans have helped railroads, oil pipelines, and telecommunications utilities provide a complex array of services to markets with diverse competitive pressures from a common set of assets. Most of these plans featured index-based ARMs called "price caps". Early papers encouraging the use of input price and productivity research in ARM design include Sudit (1979) and Baumol (1982).

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