Connecting Quality with Compensation

A monopoly market structure does not, on its own, align compensation with performance.  How well does the regulatory process address this challenge?

Utility regulation does not guarantee profits (except in very, very rare situations). The regulator’s obligation is only to set rates that give a prudent utility a reasonable opportunity to earn a fair return.  Performance is not a direct feature of this equation.  Instead, regulators usually address performance in performance-specific proceedings:  investigations into headline-producing outages and proceedings to establish standards with rewards and penalties.  So performance is connected to compensation, but only at the margin; not as an integral part of the revenue requirement process. 

Basing compensation on performance is a special challenge when there is no ready alternative to the incumbent.  Customers dissatisfied with the service at Restaurant X will start eating at Restaurant Y.  Restaurant X suffers a financial penalty; if Restaurant X fails and closes, there is no public concern.   Were this the case with the local utility, if alternative companies were willing, able and ready to enter and perform well, utility commissions would be less hesitant to condition compensation on performance – like holding back rent until the landlord fixes the leaking roof.  A century of decisions making incumbency near-permanent is the origin of this awkwardness. It is worth more regulatory effort to address the question:  Is there a way to preserve the economies of scale associated with a local natural monopoly, but make incumbency less certain?

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