Performance based regulation in electricity and cost benchmarking: theoretical underpinnings and application

Performance based regulation (“PBR”) directly regulates public utilities’ prices or revenues with the goal to provide greater incentives for achieving efficiencies and other cost savings than cost-of-service (profit) regulation provides. PBR plans typically include a formula capping the allowed prices or revenues with the cap calculated to reflect what we would expect to observe in competitive markets in the long run: prices are set to equal input prices minus productivity “I–X”, where I represents inflation and X represents industry-wide productivity. The PBR formula may also include a consumer stretch factor (“stretch factor”)—sometimes referred to as a consumer productivity dividend. Some regulators view the stretch factor as a one-time component meant to share between the company and customers the immediate expected increase in productivity growth as the regulated firm transitions from cost of service to PBR regulation. Other regulators view it more as a permanent component of PBR meant to incentivize the regulated firm beyond the initial switch to PBR by benchmarking its costs to a comparable group of companies and rewarding (penalizing) it for superior (inferior) cost performance. This paper focuses on economic aspects of utilizing the stretch factor as a permanent feature of PBR, and importantly, on the theoretical underpinnings of utilizing cost benchmarking to determine the stretch factor in a PBR plan. We provide a review of the academic literature on econometric cost benchmarking and assess that literature with respect to the stretch factor. We provide an econometric cost benchmarking analysis, using data on U.S. electricity transmission.