Challenges of incentive regulation – What are the key challenges that need to be addressed when introducing incentives?

[Response by Sophie Trémolet and Diane Binder, November 2010]

Lewis and Garmon (1997) define incentive regulation as “the use of rewards and penalties to induce the utility to achieve desired goals where the utility is afforded some discretion of the manner of achieving goals”. Incentive regulation can be introduced through a variety of regulatory tools, including price setting regimes with inbuilt incentives; efficiency reviews focused on controllable costs; benchmarking; and the setting of performance targets associated with both rewards and penalties. Note that incentive regulation is only one way of conducting price level regulation, others being cost plus or tariff indexing[1], and often hybrid systems are being found.

Price setting regimes with in-built incentives have been developed in England (initially by Stephen Littlechild) to overcome the perceived lack of incentive power in traditional US rate-of-return regulatory approaches. To illustrate the lack of encouragement for efficient service provision these provided, Averch and Johnson showed that the rate of return (RoR) regulation regime encourages utilities to inflate their asset base through overinvestment and inefficient resource allocation. Incentive-based price regulation, also referred to as RPI-X, was supposed to remedy this: under that type of regime, the regulated entity is allowed to increase its tariffs annually by the level of the Retail Price Index (RPI) minus a target efficiency factor (X). This system is intended to provide incentives for efficiency savings, as any cost savings above the predicted rate X (in other terms, any kind of outperformance by the regulated company) can be passed on to shareholders in form of extra profits, at least until the price caps are next reviewed (usually every five years). The period during which efficiency gains above the target set by the regulator can be retained is sometimes referred to as a regulatory lag.[2] At the next price review, the regulator can decide on the appropriate sharing of the realized efficiency gains between the regulated entity and its customers by adjusting the base tariff for the net regulatory period. A key part of the system is that the X factor is based not only on a firm’s past performance, but also on the performance of other firms in the industry. As a result, this type of regulation is supposed to replicate the incentive properties of a competitive market.

Incentive-based regulation is now commonly used in the UK, Australia, some Latin American countries and in the telecommunications sector in Asia and the US. Few developing countries have adopted pure incentive regulation: in most cases, low-capacity and high-risk countries have opted for hybrid regulation (Alexander and Shugart, 1999; Alexander and Harris, 2001). Decisions about whether a price-cap, a revenue-cap or some hybrid form of tariff regulation should be used will depend on the type of operator (for example, state-owned firms[3] do not respond to incentives as effectively as private ones as they commonly do not have the same profit incentives), the situation faced by the company (for example, if there is limited metering, a company will effectively face a revenue-cap even if the tariff regime is presented as a price-cap, as volume-related prices will not likely to be effectively estimated), and the tariff structure. Cost pass-through or tariff indexing are often pragmatic solutions to adjust for significant costs affecting the company, which are outside its control[4].

Incentive regulation creates a number of challenges, as highlighted below:

• Maintaining incentives for cost reduction while adjusting prices to underlying costs . In order to provide incentives for short-term efficiency, prices must be set so that the regulated firm benefits from cost reduction which represents an outperformance over and above the forecast reduction. However in the absence of perfect foresight, prices and costs will inevitably diverge (either up or down), leading to pressure to reset prices in line with costs, thereby undermining the incentive to reduce costs in the long term (Mumssen and Williamson, 1999). To the extent that utilities anticipate that a substantial share of their efficiency gains (and associated cost reduction) will be passed on to customers, the incentive to make such savings is diminished.
• Ensuring that firms have a reasonable assurance of cost-recovery, while limiting the scope for “gold-plating” [5] due to guaranteed returns on investment: firms will only invest if sunk costs can be recouped via retained cost savings and / or additional revenue allowances.
• Ensuring that operators continue to invest in the long-term development of the service, i.e. that “efficiency gains” on capital outlays are not equivalent to under-investment or investment at a lower standard that will not last;
• Ensuring that operators do not skimp on quality i.e. that “efficiency gains” from reducing operating costs are not equivalent to reducing service quality – hence the need for parallel regulation of quality, safety and reliability (also summarized as ‘performance’), based on performance indicators;
• Determining how much reward is needed to induce the operator to improve its performance and assess whether this additional efficiency gain is worth the cost of an additional reward. This issue is related to estimating efficiency targets[6].
• Making a decision on the length of price control period: the longer the period between price resets, the greater the opportunity for cost differentials to arise, especially in highly uncertain environments, and for the operator to make significant profits or losses. The higher risk introduced by uncertain environments has often meant that price control periods in developing countries are short, which reduces the power of some incentive mechanisms (such as the regulatory lag). The challenge is therefore to introduce incentives for the company whilst not creating too great a risk of excessive gains or losses. The length of the price setting periods can vary substantially, from four years for electricity transmission in England and Wales up to 10 to 20 years for US electricity and gas distribution. Yearly price resets would equate to a rate-of-return regulatory regime.

Due to such challenges, whereas incentive regulation is in theory primarily concerned with setting efficiency targets and allocating the benefits of efficiency gains between the operator and its customers, in practice, a regulatory regime reliant on incentive-based regulation also needs to be concerned with controlling performance and ensuring that adequate investments are made. Further details on how this can be done in practice are provided in the answers to other FAQs, which are concerned with efficiency (targets and measures) and investment incentives (including coverage expansion).
 

Footnotes

1. Tariff indexing consists of adjusting tariffs based on uncontrollable external events, such as inflation, devaluation
2. Regulatory lag is “the retention of unanticipated efficiency by the company for a minimum period to create an incentive to make those additional efficiencies”.
3. See questions related to state-owned enterprises, State Owned Enterprises.
4. See related question in FAQ : “Cost pass-throughs – Should bulk tariffs be transferred directly to final consumers through adjustment clauses or comparable pass-through mechanisms?“
5. See Incentive Features and Other Properties in the BoK .
6. See related question in this section of FAQ