The following is a contributed article by Kenneth W. Costello, a regulatory economist and independent consultant who has worked for the National Regulatory Research Institute, the Illinois Commerce Commission and Argonne National Laboratory.
Pabst Blue Ribbon (PBR) is a popular beer among urban hipsters and others. But it has a reputation for being a low-quality beer. It’s not hard to find “putdowns” of the beer on the website: “This beer doesn't have any taste…It's like drinking water…Actually water is better…A taste of laundry soap and aroma. This is the worst beer I taste among all…PBR is shower beer in which you don't really care if it all accidentally spills.” You get the picture.
The connection with performance-based regulation, also commonly referred to as “PBR," is that, although in vogue in regulatory circles, PBR can also leave an “awful taste.” A poorly designed and executed PBR mechanism can harm utility customers when the intent is to benefit them.
Today’s growing interest in PBR
Performance can relate to all sorts of things: Reliability, safety, customer satisfaction, utility financial health, energy efficiency, costs for specific functions, power plant performance, innovation and asset management. Key elements in choosing a utility function are its importance to the public interest and the discretion of management to influence performance.
Many observers contend that the status quo or traditional cost-of service ratemaking is a poor fit in an environment where distributed energy resources, engaged utility customers, the smart grid, energy efficiency, high investment requirements, and energy storage prevail. There is increased interest in the U.S. for PBR. This is especially true in states that have undergone electric industry restructuring.
The issues are complex, sometimes latent, requiring much effort to achieve stakeholder agreement on various aspects of PBR. Regulators in several states are considering PBR, either for specific utility functions or comprehensive utility performance that would motivate utilities to achieve public policy goals and, simultaneously, enhance the value customers receive from utility service. These mechanisms commonly reflect an incremental ratemaking change that (1) rewards (penalizes) exceptional (subpar) utility performance and (2) provides utilities with incentives to advance customer and society-wide interests.
The positives of PBR
When PBR focuses on a specific utility function, it typically has three basic parts: (1) the target or standard, (2) the sizes of the rewards and penalties (e.g., the share of “gains” and “losses” allocated to utility shareholders and customers), and (3) the maximum rewards and penalties to the utility. It is a common form of PBR for energy utilities that goes back several decades.
PBR explicitly allows utilities to recover certain costs based on their performance. Distinguishing features of PBR are its formula-based structure, its substitution for retrospective reviews, and the predetermined sharing of benefits (losses) between utilities and their customers from exceptional good (bad) performance.
PBR can strengthen regulatory incentives for utilities to perform better. It does that by rewarding utilities for superior performance that benefits customers, for example, through lower rates or higher quality of service. PBR can also penalize utilities when they perform poorly.
How could one dispute that these outcomes won’t motivate utilities to perform better? Isn’t regulation’s central purpose to induce high-quality performance from utilities?
The risks of PBR
Regulators face several challenges with PBR:
- Selecting the PBR mechanism that best addresses the problem at hand; the regulator might require a PBR mechanism for a utility in response (say) to its history of poor customer service or inflated maintenance costs;
- Utility performance depends on both management competence and factors beyond a utility’s control;
- Knowing the proper benchmark or reference point (e.g., peer-group average performance, a utility’s past performance); this is crucial for avoiding the utility profiting in the absence of any benefits to its customers or enjoying an undue share of the performance gains from a PBR mechanism;
- Accounting for the tradeoff between the different objectives; for example, low cost and high service reliability;
- Recognizing that the utility has an advantage in bargaining with the regulator, especially for determining the benchmark for rewarding or penalizing a utility; regulators lack the ability to determine the minimum level of costs compatible with a utility operating efficiently;
- Determining the sizes of rewards and penalties; they should be high enough to induce improved utility behavior but not excessive to have a significant effect on the utility’s financial condition; and
- Measuring and verifying the benefits; this task requires the regulator to conduct a counterfactual analysis that predicts how the utility would have behaved in the absence of a PBR mechanism.
- Performance depends on two broad factors: The first is management competence; the second is market and business conditions, as well as other factors beyond the control of a utility. Proper use of PBR depends on the regulator’s ability to separate out the effects of external and internal factors on performance.
Service quality depends on several factors, some within the control of a utility, others outside its discretion. The challenge for regulators is to distinguish between these two factors. Without this divide, applying PBR becomes more difficult to justify and even counterproductive - for example, punishing a well-run utility or letting a poorly-run utility go unpunished.
The classic problem for regulators is what analysts call information asymmetry, where they observe only a utility’s performance, not management competence in cost control, service quality, and other outcomes. It has two critical implications: The first is that utilities can misrepresent their performance to regulators. The second is regulators need to exercise caution in interpreting a utility’s performance. The first implication may result in regulators setting a skewed benchmark or standard for a PBR mechanism that unduly favors a utility over its customers.
The benchmark is crucial for dividing up the gains between the utility and its customers. A major task for regulators under a PBR mechanism is to set the correct benchmark. The wrong benchmark can result from: (1) gamesmanship by utilities (e.g., biased cost revelation by the utility), and (2) incomplete information. The regulator therefore finds it difficult to know the “true” benchmark: What costs should the utility incur under “reasonable” management? What would the utility’s costs be in the absence of a PBR mechanism? What is a reasonable outcome deserving of neither a reward nor a penalty?
Inevitably, the utility will argue for a benchmark that will facilitate earning a reward and avoiding a penalty. The utility might reveal its cost opportunities to be lower than what they really are; the utility may argue 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.
One often-overlooked problem that should concern regulators is a PBR that advances a single objective while compromising one or more other objectives. One possibility is for a PBR to motivate a utility to be more cost conscious at the expense of service quality, with an overall decline in the public interest: A utility can overperform in one area of operation because of stronger incentives relative to those incentives it faces in other operational areas, with an overall adverse effect on its customers.
The tough job for regulators is to determine what constitutes a well-performing utility. They also have to define what is acceptable performance. This involves knowing the benchmark or standard that separates satisfactory from unsatisfactory performance.
A poorly structured PBR mechanism can even lead to unintended consequences. Specifically, strategic behavior or gaming by a utility can result in no or negative gains to customers, while producing higher profits for the utility. Distortive utility behavior can result when the utility devotes excessive resources to the functional area targeted by the PBR mechanism, which decreases the overall performance of the utility. One possible outcome is a higher average cost of utility service.
Doubts about PBR
Many observers believe that PBR can overcome the major infirmities of traditional, cost-of-service regulation in serving the public interest. Regulators, utilities, legislatures and “green” groups have shown increased interest in PBR to address these shortcomings. New public policy goals and objectives, and new technologies partially explain this heightened interest. The concern is that presently utilities have weak or even perverse incentives to satisfy those goals and objectives.
Consumer groups in general are skeptical of PBR, and rightly so. They see utilities exploiting their information advantage by manipulating a PBR mechanism to increase their profits or reduce their risk at the expense of their customers. Consumer groups tend to favor prudence reviews, audits and regulatory lag, which have their own problems, to motivate better performance from utilities.
In conclusion, utility exploitation is a real possibility that regulators cannot ignore in reviewing and approving a PBR mechanism. Making good beer requires the right ingredients and skill in brewing. Assuring that PBR benefits utility customers demands well-informed and unbiased decision-making by regulators. My main message is that satisfying this condition may be harder than what first meets the eye.