Using market prices to regulate the costs of a utility's inputs

This paper analyzes the problem of determining allowable cost of a utility's inputs when the price of these inputs may be highly Volatile and when hedging and long-term contracting are the norm in the supply of these inputs. In such an environment, benchmarks based upon the observable market price of an input are natural regulatory mechanisms to consider. This paper studies such incentive-based regulation. The first section uses contingent claims analysis to investigate a representative contract currently in place. The analysis indicates that this regulation may impose an important monitoring role on the regulator in order to prevent the utility from taking extremely risky positions in fuel markets. Further investigation of benchmark-based regulation is undertaken in a principal-agent framework in which the utility has the dual role of choosing a fuel portfolio and undertaking expenditures to reduce fuel costs. In this setting, it is shown that benchmark-based compensation is, at best, ineffective. Within the same setting, contracts based upon cost sharing are studied and found to be superior at obtaining a tradeoff between risks and cost reduction.