Incentive - Regulation in The Utility Sector

Regulation in The Utility Sector

Incentive-based regulation can be defined as the conscious use of rewards and penalties to encourage good performance in the utility sector. Incentives can be used in several contexts. For example, policymakers in the United States used a quid pro quo incentive when some of the U.S. incumbent local telephone companies were allowed to enter long distance markets only if they first cooperated in opening their local markets to competition.

Incentive regulation is often used to regulate the overall price level of utilities. There are four primary approaches to regulating the overall price level: rate of return (or cost of service) regulation, price cap regulation, revenue cap regulation, and benchmarking (or yardstick) regulation.

With benchmarking, for example, the operator's performance is compared to other operators' performance and penalties or awards are assessed based on the operator's relative performance. For instance, the regulator might identify a number of comparable operators and compare their cost efficiency. The most efficient operators would be rewarded with extra profits and the least efficient operators would be penalized. Because the operators are actually in different markets, it is important to make sure that the operators' situations are similar so that the comparison is valid, and to use statistical techniques to adjust for any quantifiable differences the operators have no control over.

Generally regulators use a combination of these basic forms of regulation. Combining forms of regulation is called hybrid regulation. For example, U.K. regulators (e.g. Ofgem) combine elements of rate of return regulation and price cap regulation to create their form of RPI - X regulation.

Incentive Rates are also prevalent in the utility sector, under any of the utility regulatory frameworks noted. Incentive rates are a vehicle for the utility to induce large commercial or industrial customers to locate or maintain a facility in the utility service territory. The incentive is provided in the form of a discount from the utility's standard tariff rates, terms or conditions. In the U.S., incentive rates (also known as Economic Development Rates and/or Load Retention Rates) are a common component of the utility strategy for supporting the economic development efforts of a particular geographic region or political entity.