For over 50 years, a wide variety of reforms has been tried to correct the flaws of traditional methods of utility regulation generally and rate-making specifically. One category of reforms implemented by many jurisdictions to remedy some of those flaws is called performance incentive mechanisms (PIMs). PIMs are based on quantifiable and measurable indicators that translate into financial rewards or penalties for the utility and can be designed to address specific priority areas such as better reliability, reduced low-income customer arrearages, fewer interconnection delays, or accelerated energy efficiency investment.

Experience to date with these explicit outcome-based financial incentives has been mixed or inconclusive. This paper asks: How can we make performance incentives a more effective tool to accelerate the modernization of the electric system and achieve other regulatory goals? Among other factors, this requires that regulators shift their ultimate focus away from accounting measures, such as profits or achieved return on equity (ROE), and toward a utility’s stock price and all the underlying factors that drive it.

In this paper, the authors propose that an internally consistent, valuation-based cost of equity estimation can be a driver of utility business model reform, forming the foundation upon which regulators can build more effective incentive mechanisms. The paper lays out a four-step process to integrate performance incentives, both rewards and penalties, into rate-making for investor-owned utilities:

1. A properly estimated cost of equity. This includes reasonable estimates of the cost of equity using the discounted cash flow model, the capital asset pricing model, or equity risk premium analysis — but not the comparative earnings method because it does not utilize market information to estimate the cost of equity.
2. A cost-of-service estimate must be included to set base revenue levels for the utility. Under the relevant legal principles, reasonable allowances to cover utility costs to serve must be built into rates, with both traditional and more innovative methods for estimating those costs.
3. An incentive-setting process should have a robust stakeholder discussion about the key policy goals, relevant outcomes and data-driven metrics that feed into the performance incentive framework.
4. The actual formulas for performance incentives, either rewards or penalties, must be determined.

Many different solutions could be reasonable and policy priorities will certainly differ across jurisdictions, but building on the framework presented in this paper should help policymakers and stakeholders design more effective policies. However, the authors believe Alfred Kahn articulated over 50 years ago a key feature of a good solution: If utilities perform well, with performance defined and properly measured by the regulator, they should expect to earn returns in excess of the cost of equity. If they perform poorly, they should expect to earn only the cost of equity, not more and perhaps less.