In some areas, traditional cost-of-service regulation is being supplemented with incentive regulation also known as performance-based ratemaking or PBR. Incentive-based ratemaking creates shareholder incentives for utilities to lower costs and reduce rates.
As market-based rates become common in the wholesale marketplace, it will be harder for a utility to prosper under traditional regulation. Any time market rates are lower than the utility’s cost of energy, intervenors will claim the utility performed unreasonably and that shareholders should bear some of the excess costs. Thus many utilities may prefer to accept the risks and rewards of incentive regulation. Under incentive regulation, utilities can increase profits by achieving or exceeding standards or market-based targets set by the regulator.
An example of incentive regulation is SoCalGas’s Gas Cost Incentive Mechanism. Under this mechanism, actual costs of commodity purchased by SoCalGas are compared to a monthly index calculated with various inputs. If costs are within a tolerance band, either above or below the index, ratepayers pay the actual costs of natural gas. However, if the costs are either above or below the tolerance band, the additional costs or savings are shared between ratepayers and shareholders. This mechanism takes the place of a reasonableness review (decreasing risk) and offers SoCalGas the opportunity to earn an incentive for below-market procurement of natural gas. In recent years, the incentive has been as high as $13.7 million.