Introduction

In January of 1995, NGSA developed a paper on Performance Based Regulation.¹ This has been one of the fastest-evolving areas of the natural gas industry over the last two years. An internal review of our paper revealed that, while all of the principles advocated are still valid, several new issues have entered the public debate. In order to ensure that our paper is still a valid reference resource, we have prepared this updated version.

NGSA's interest in this matter derives from the fact that state public utility rate-making methodologies create price signals that impact all aspects of the natural gas industry, including producers' ability to find and develop natural gas supplies.

The Issue

One of the primary purposes of regulation is to attempt to achieve the same result in a monopoly industry, that would be achieved in a competitive one. While there is societal consensus that the result is worth it, there are nonetheless some societal burdens that come with the regulatory process. One is that both government and process participants must expend significant resources to determine the appropriate, market-mimicking result. Another is that traditional cost pass-through rate design methods have not always provided the same incentives that drive efficiency in unregulated industries.

The desire to address these two shortcomings is what makes exploration of Performance Based Regulation concepts of interest to all stakeholders in the industry. Fewer rate cases could save resources of the taxpayers, Public Utility Commissions, the utilities, and the intervenor customer groups. If properly devised, the rates themselves could provide a reward to the utility for improved efficiency, which is missing under current methodologies. Most importantly, customers could benefit from lower rates. Clearly, if properly constructed, a Performance Based Regulation system could be a win/win/win result for all parties. As always, however, developing implementing details is far more difficult than developing the concept!

Discussion

This paper does not advocate or oppose specific proposals for Performance Based Regulation. The creativity of the industry in devising proposals is unlimited. The circumstances of each utility and regulatory jurisdiction are unique enough, that trying to pass judgment on a proposal's appropriateness would require a much more detailed analysis than would fit in the intent of this paper. Therefore, we have focused on discussion of broad-based issues and principles. Hopefully, that approach will provide a useful reference source for readers to evaluate any specific proposal.

A: Performance Based Regulation should provide quantifiable benefits to all parties.

This should be the first and most important test applied to any proposal. An approach that benefits only a utility, or some customer classes but not others, should not be appropriate. Furthermore, the benefits should be largely quantifiable. While it is true that some things of clear value are not easily translatable into quantifiable form, the majority should be. Beware of a proposal that tries to float through on intangibles. Finally, the benefits should be demonstrable. Proponents of a particular program should have the burden of explaining, in detail, exactly how the proposal will work, and exactly how each customer class will reap tangible benefits. A proposal that "asserts" good things but cannot "connect the dots" is probably flawed. ²

B: Reward should be paired with risk.

A utility should be able to improve its rate of return by improving efficiency and benefiting its customers. Conversely, failure to do so should result in an impaired rate of return. Programs that provide an upside for achievements, but no downside for mismanagement, are asymmetrical and flawed. The same thing is true of a program that provides a reward for the utility without rate reduction for customers. Hence, the type of proposal whereby rates are indexed to inflation (perhaps minus a "productivity factor") is fundamentally flawed, because rates could never go down on an absolute basis (absent deflation!).

C: All of a utility's costs and revenues should be included in the Performance Based Plan.

Most components of a gas utility's costs and services have at least an imperfect substitute. For example, mainstream interstate pipeline capacity can be at least partially replaced by market-area storage. Gas commodity prices could be lowered by increasing storage and buying more summertime gas, when it is presumably less expensive. There is nothing wrong with these strategies in and of themselves. However, a "reward" based only on reducing gas commodity cost could influence a utility to lease uneconomic incremental storage, just to cut the commodity cost, yet total costs to customers might actually increase. For this reason, NGSA believes the wisest course is to focus on total costs, not specific cost components.

D: Explicit Service and Safety standards should be agreed to as part of a Performance Based Regulatory scheme.

One potential way to reduce costs is to reduce or eliminate service. Another is to skimp on maintenance or safety-related expenditures, that might not cause an immediate, noticeable decline in standards. As part of the process of implementing a Performance Based Regulatory scheme, all parties should agree up front with regard to exactly what is expected in the way of safety standards and minimum service quality requirements.

E: Before implementing a Performance Based Regulatory scheme, ensure that the starting point is appropriate.

NGSA believes that all customers should be able to choose and pay for only those services which they desire, and that the prices they pay for services chosen should reflect the costs incurred to provide those services. Many utilities offer no or an incomplete array of unbundled services. There often exist cross-subsidies between and among various services, and also between and among different customer classes. A Performance Based Regulatory scheme has the potential to institutionalize or even worsen any historical inequities that may exist on a given utility. This is particularly true of schemes that would operate formulaically, or with stretches of time between full rate cases that are long by historical standards.

Commissions may wish to consider "clearing the decks" of inequities first, before implementing Performance Based Regulation. At the very least, some forum must be maintained whereby aggrieved parties can raise these issues and present evidence to support their position. The advantage of "clearing the decks" first is that later changes won't disrupt the delicate balance set up under the Performance Based program.

F: A Performance Based Regulatory system shouldn't lose sight of macroeconomic objectives.

A potential danger of a Performance Based Regulatory scheme is that it becomes so internally focused that it loses sight of older, still valid objectives. For example, the scheme should do nothing to inhibit or distort the transmission of market signals between and among participants. It also shouldn't perversely do anything to inhibit maximum use of the distribution system.

G: A Performance Based Regulatory plan should have monitoring and compliance requirements.

All performance based rate proposals must contain a review process. This would require the LDC to provide specified information for the review of all parties. Implementation and quality of service would be evaluated so that appropriate corrective action could be taken where necessary. In addition, the respective Public Utility Commission should aggressively monitor and publicly report on the performance of the LDC to maximize customer awareness.

Conclusion

Performance Based Regulation offers many conceptual improvements over the status quo. However, there are just as many potential pitfalls as improvement opportunities. Evaluating individual proposals and designing appropriate implementation plans will require a great deal of care. NGSA hopes this paper will prove helpful to all industry participants in achieving Performance Based regulatory schemes that are of benefit to all gas industry stakeholders.

For further information, please contact:
Bruce A. Craig
Director, State Regulatory Affairs
Natural Gas Supply Association
805 15th Street, NW - Suite 510
Washington, DC 20005
(202) 326-9300

This page was last updated August 31, 1997.