This leaves us with a dilemma. If we remove regulation from the utility, then it will act like a monopolist. This is bad for consumers. But if we keep rate of return regulation in place, then the utility has incentives that are also bad for consumers. What should we do about this?
One alternative is to try to improve regulation. Several attempts in both the US and in other countries have been made to remove the incentive problems with utility regulation. Here we will briefly summarize a few of them. After reviewing the list, please read the paper by Mark Jameson (on Canvas) on Price Cap and Revenue Cap regulation, which has been one of the more popular ways of attempting to improve utility regulation.
A first model of improving utility regulation involves a kind of profit-sharing model. Suppose that a utility could find a way to reduce its costs of meeting electricity demand. Under rate of return regulation, imposing such cost saving measures might lead to rates going down, which is good for customers but not so good for the utility and its shareholders. The idea behind the benefit-sharing model of regulation is that if utilities are able to reduce costs, then those savings are shared between the utility and customers. For example, if a cost-saving measure might reduce overall utility costs by 10%, then in a benefit-sharing policy the utility's rates might drop by only 5%. Both consumers and the utility would benefit from the cost saving measure.
A second model of improving regulation, known as "yardstick regulation," dispenses with the connection between utility costs and the utility's allowed rate of return. Under the yardstick model, a utility's rate of return (and thus its profits) are set based on the performance of another utility or based on the performance of some market index, like the utility's stock price. The yardstick model sounds nice in theory, but in practice has not been applied widely. It can be hard to find a good comparison utility, and it is not clear why the ratepayers of one utility should be rewarded or punished for good or bad decisions made by another utility. You'll be asked to think about another reason that yardstick regulation is difficult in a homework question.
A third model, which is described in more detail in the Jameson paper, is known as "performance based regulation" and has become very popular in both the US and in the United Kingdom. Performance based regulation sets performance targets, like targets for cost reductions, and then rewards the utility if those targets are beaten.
Generally, under performance-based ratemaking the utility is allowed to change prices based on a formula involving the general retail price level (RPI), utility investment (K), and a target level for improved productivity or lower cost (X):
The use of the general price level in the rate equation (6.4) has led to this type of regulation sometimes being called "RPI - X regulation."
While performance-based regulation has been popular, and has been implemented either as controls on prices (as in equation (6.4)) or as controls on revenues (just replace "price" with "revenue" in equation (6.4)), it is not always clear that all of the problems with rate of return regulation are avoided. Jameson describes some of these problems at the end of his paper.