The Incentive Theory

I was an early proponent of what has been called incentive ratemaking, price cap regulation or performance based ratemaking for public utilities. I’m cognizant it is not a new idea at all. 

During the 1980’s, the government of the United Kingdom, under Prime Minister Margaret Thatcher, decided to privatize the nation’s utilities. The utilities had been nationalized in the 1940’s. The UK rejected the US regulatory model, selecting a variant with annual rate adjustment. 

UK rates were set for a six-year period. Under an annual inflation with productivity adjustment formula, expressed as RPI-X. 

This incentive regulation method had been proposed in 1981 by Professor Stephen Littlechild. He was named the first electricity regulator in 1989 for the UK’s newly privatized electric power industry. 

RPI-X was applied to all the utility industries. There was a different X productivity factor for each industry: electric, water, gas and telephone.

The incentive theory of utility regulation, however, goes back to the turn of the last century. The 1918 edition of Valuation and Ratemaking: Conflicting Theories of the Wisconsin Railroad Commission 1905-1917, by Robert Hale, contains Chapter V: The Incentive Theory. 

The chapter begins with a discussion of how a commission should determine the fair return, and then reminds us that “the methods of securing efficiency…involve a judgment by the commission as to the best business practice.”

The 1918 text observes that “the alertness of management might come about through the effort to secure in fact the extra percentage of earnings which would be permitted by law.”

So the recognition that regulation could create a scheme to incent greater efficiency in public utility operations was among the initial considerations and deliberations of state regulators in the US, and elsewhere, in the early 1900’s. 

Hale points out examples of a “sliding scale arrangement in use in England.” As well as a scheme for the Boston Gas Company. 

The risk of incentive regulation was also well recognized in 1918.

“Any scheme of encouraging efficiency by permitting the enjoyment of additional profits where they can be earned, must be safeguarded by making the enjoyment of such exceptional profits conditional on the rendering of exceptional service.”

In 1992, I led a FERC Task Force on Incentive Ratemaking for Interstate Natural Gas Pipelines, Oil Pipelines and Electric Utilities. The result was a recommendation that incentive ratemaking be implemented for jurisdictional utilities.

Unfortunately, the final order contained a clause which made it almost impossible to apply for the new treatment. The clause required the applicant to demonstrate that rates under the new incentive scheme would be lower in the future than rates would otherwise be, as approved by FERC. 

Who could do that? Who would do that? 

That is, who would have the temerity to presume that they could forecast what FERC would do in the future, as to FERC-set rates for their specific company?

As New York REV considers various regulatory schemes, perhaps it’s time to take another look at incentive regulation for monopoly utilities.

One of the most popular columnists in Public Utilities Fortnightly, Branko Terzic keeps us laughing about utility regulation and policy and reminds us that very many contentious issues we face today have been contended with during our industry’s past.