Incentives to Improve Electric Utility Performance

This report uses material from a recent Arizona Public Service Company rate case, and published literature, to address several issues generic to the electric utility industry: the effects on utility incentives and on rates to customers of including "construction work in progress" (CWIP) in the rate base; the use of prudence tests by regulators to determine what costs should, and which should not, be passed on to ratepayers; and the use of incentive programs, with explicit rewards and penalties, to reduce the construction costs of large power plants and to improve their operating performance after they go into service. It draws three major conclusions: (1) Economic principles do not support the notion that cost recovery from ratepayers should begin only after a plant is used and useful. (2) Traditional accounting practices produce rate shocks that force prices upward at the very time that the costs of using a plant are declining. Putting CWIP in the rate base is one of the ways rate shocks can be reduced. (3) Although including CWIP in the rate base may generate perverse incentives, the exclusion of CWIP from the rate base can also generate perverse incentives for utilities faced with severe cash flow problems.