Framework for Incentive-Based Ratemaking

We have long considered incentive-based ratemaking superior to command-and-control regulation. PBR mechanisms send the important message that minimizing costs without sacrificing service quality and reliability can result in greater rewards with "less" regulation than traditional cost-of-service regulation. In order to provide these incentives, we must necessarily break the link between rates and costs. Cost-of-service regulation uses the utility's own costs in setting rates and often results in inefficiency, because utilities are rewarded by increased rates for increased costs.

We have established several goals to be addressed by incentive regulation for energy utilities. In our comprehensive rulemaking (R.94-04-031) and investigation (I.94-04-032) addressing proposed policies on electric restructuring and reforming regulation, we stated our intention to replace cost-of-service regulation with performance-based regulation. It is worth reviewing the goals stated in that document:


"First, prices for electric services in California are simply too high. The shift to performance-based regulation can provide considerably stronger incentives for efficient utility operations and investment, lower rates, and result in more reasonable, competitive prices for California's consumers. Performance-based regulation also promises to simplify regulation and reduce administrative burdens in the long term. Second, since the utilities' performance-based proposals currently before us leave both industry structure and the utility franchise fundamentally intact, consumers can expect service, safety and reliability to remain at their historically high levels. Third, the utilities' reform proposals are likely to provide an opportunity to earn that is at a minimum comparable to opportunities present in cost-of-service regulation. Finally, performance-based regulation can assist the utilities in developing the tools necessary to make the successful transition from an operating environment directed by government and focussed on regulatory proceedings, to one in which consumer, the rules of competition, and market forces dictate." [all footnotes omitted.] (R.94-04-031/I.94-04-032, mimeo. at pp. 35-36.)

In D.94-08-023, we adopted an experimental base rate PBR mechanism for SDG&E and stated our goals and objectives for improving regulation:


"1. To provide greater incentive than exists under current regulation for the utility to reduce rates.


"2. To provide a more rational system of incentives for management to take reasonable risks and control costs in both the long and short run. This includes extending the relatively short-term planning horizon associated with the three-year GRC cycle and reducing the company's incentive to add to rate base to increase earnings.


"3. To prepare the company to operate effectively in the increasingly competitive energy utility industry. This entails providing greater flexibility for management to take risks combined with a greater assignment of the consequences of those risks to the company.


"4. To reduce the administrative cost of regulation.


"Again, it is not sufficient to define these objectives for a regulatory reform experiment. We must also ensure that the achievement of regulatory reform does not come at the expense of the primary purpose or other relevant objectives of regulation. We reiterate the standards for review ... which the parties generally purport to embrace. The experiment must have a reasonable potential for improving on existing regulation without jeopardizing regulatory goals, and therefore, (1) respond to the goal of safe, reliable, environmentally sensitive service at reasonable rates; (2) be designed to enable the Commisison to judge the success of the experiment when it is over; and (3) not in itself create unreasonable risks. ... we accept and adopt the following additional criteria:


"1. To the extent that an individual program component or the proposal as a whole imposes greater risks on ratepayers, it should also remove, reduce, provide compensation for, or transfer those risks to the utility. This does not necessarily mean ...that we need to require rate reductions in return for ratepayer assumption of risk, notwithstanding our objective of rate reduction. It does mean that the program, taken as a whole, should provide a reasonable balancing of the attendant risks and rewards. There should be an equitable sharing of the benefits that reform is intended to achieve.


"2. The adopted regulatory program should maintain system quality, reliability, safety, and customer satisfaction even as expected cost reductions occur. Thus, it should ... prevent or discourage long-run disinvestment in the system that could otherwise result in unintended system degradation.


"3. The program should avoid or minimize unintended consequences in interplay among various regulatory programs, including DSM incentive, low income rate assistance programs, etc.


"4. The experimental program should be flexible enough to allow needed changes during its term, yet sufficiently fixed in form and content to provide a predictable framework for management planning and to allow evaluation.


"5. There should be explicit provisions for a program of monitoring and evaluation which will enable us to become aware of problems requiring solution during the term of the experiment and which will provide information needed to decide on the program of regulation which will be implemented at the conclusion of the experiment." (55 CPUC 2d 592, 615-616.)

Our Preferred Policy Decision (D.95-12-063, as modified by D.96-01-009) in the electric restructuring rulemaking and investigation reiterated these goals and directed California's three major investor-owned utilities, including SDG&E, to file applications to establish separate generation and distribution PBRs:


"Our goal is to have an improved regulatory process that offers flexibility and encourages utilities to focus on their performance, reduce operation cost, increase service quality, and improve productivity. At the same time, we must ensure that safety, quality of service, and reliability are not compromised. There is broad but not universal consensus that Performance Based Ratemaking (PBR) can accomplish these objectives by providing clear signals to utility managers with respect to their business decisions and helping them make the transition from a tightly regulated structure to one that is more competitive. Under PBR, utility performance is measured against established benchmarks. Superior performance, above the benchmark, would receive financial rewards, and poor performance would result in financial penalties to the shareholders. By providing financial incentives to utilities, we will encourage them to operate more efficiently to maximize their profits." (Preferred Policy Decision, mimeo. at p. 82.)

In both D.96-09-092 (adopting a PBR mechanism Edison) and D.97-07-054 (adopting a PBR mechanism for SoCalGas), we confirmed our goals for developing PBR mechanisms:

· Moving rates for all customer classes, in real dollars, steadily down the national average for investor-owned utilities;

· Maintaining a reasonable opportunity for the utility to earn a fair rate of return; and

Taken together, these established goals help us to develop the framework for considering SDG&E's distribution PBR proposal.

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