A utility will naturally propose a benchmark that makes it easy to earn a reward.
Across the regulatory landscape, a growing number of states are turning to performance-based frameworks to govern utilities — trading prescriptive oversight for outcome-driven incentives in an era of smart grids and distributed energy. The promise is elegant: reward efficiency, penalize failure, and let markets do the rest. Yet the distance between theory and practice is proving vast, as information gaps, misaligned incentives, and the quiet art of benchmark manipulation threaten to transform a reform meant to serve the public into a mechanism that enriches utilities at customer expense. The deeper question regulators must now confront is not whether performance can be measured, but whether the right things are being measured — and for whose benefit.
- Utilities hold a structural information advantage over regulators, and they are using it — proposing favorable benchmarks, obscuring true costs, and framing poor performance as circumstances beyond their control.
- Incentive structures designed to reward one goal — say, safety spending or cost reduction — are quietly eroding others, leaving reliability, affordability, and efficiency in tension with one another.
- Consumer advocates are sounding alarms, arguing that the older tools of prudence reviews and management audits, however slow, at least gave regulators the standing to ask hard questions after the fact.
- Some performance-based schemes have already been scrapped or restructured after failing the most basic test: customers were paying more in utility rewards than they were gaining in lower bills or better service.
- Regulators are now being pressed to verify, rigorously and continuously, that customer benefits from improved utility performance actually exceed the additional revenues flowing to those utilities — or risk institutionalizing a windfall.
Utility regulators across the country are embracing performance-based regulation — a framework that replaces prescriptive operational rules with outcome targets, rewarding utilities that hit their marks and penalizing those that miss. The appeal is real: in an era of distributed solar, smart grids, and energy storage, traditional cost-of-service oversight can feel like an ill-fitting tool. If a utility knows it will earn more by cutting costs and improving reliability, the theory goes, it will work harder to do both.
But implementation is proving far more complicated. The entire system hinges on setting an accurate benchmark — the baseline cost against which performance is measured. Utilities, knowing their own operations far better than any regulator does, have every incentive to propose benchmarks that make rewards easy to earn. A regulator who accepts a biased number may end up allowing a utility to recover all its costs even when it performs poorly, hollowing out the incentive structure entirely.
Conflicting objectives compound the problem. A utility chasing rewards for safety investment may neglect cost control. One pursuing efficiency gains may quietly erode service reliability. When incentives are unevenly distributed across functions, utilities tend to overinvest in rewarded areas and underinvest in others — an outcome that harms customers even as the utility's balance sheet improves.
Consumer advocates have long preferred older regulatory tools — prudence reviews, management audits, regulatory lag — precisely because they allow regulators to look backward and ask hard questions. Performance-based regulation, by contrast, rewards outcomes in real time, leaving less room to scrutinize whether those outcomes were genuinely earned or cleverly manufactured.
The rewards and penalties themselves must also be calibrated carefully: too small and they fail to change behavior; too large and they threaten the utility's financial stability. But perhaps the most important question — and the one regulators most often neglect — is whether customers are actually better off. When a utility earns a performance reward, do the benefits flowing to customers outweigh the extra revenue flowing to the company? Several schemes have already been dismantled because the answer was plainly no. Any regulator serious about this framework must be willing to measure that balance honestly, and to act when it tips the wrong way.
Across the country, utility regulators are embracing a new framework that sounds sensible in theory: stop telling companies how to operate, and instead set performance targets, then reward them when they hit those targets and penalize them when they miss. Performance-based regulation has become fashionable in regulatory circles, especially in states that have restructured their electricity markets and worry that traditional oversight no longer fits a landscape of distributed solar panels, smart grids, and energy storage. The logic is straightforward. A utility that knows it will earn extra revenue for cutting costs or improving reliability should work harder to do both. But regulators who have implemented these schemes are discovering that the real world is far messier than the blackboard theory suggests, and a poorly designed framework can end up harming the very customers it was meant to protect.
The basic mechanism is simple enough. Instead of the old cost-of-service model—where regulators set rates to allow utilities to recover their costs plus a reasonable profit—performance-based regulation creates a formula. The utility gets a baseline cost target, called a benchmark. If it spends less than that benchmark, it keeps a share of the savings. If it spends more, it absorbs a share of the losses. The formula also specifies how much reward or penalty the utility can receive, and how any gains or losses are split between the company and its customers. The appeal is obvious: utilities face real incentives to perform better, and customers share in the benefits when they do.
But the moment a regulator tries to put this into practice, problems emerge. The first is choosing the right benchmark. That number is crucial—it determines whether a utility gets rewarded or penalized, and how much. A utility will naturally propose a benchmark that makes it easy to earn a reward. It might claim its costs are higher than they actually are, or argue that it faces constraints on cost reduction that don't really exist. The utility has better information about its own operations than the regulator does, and it will use that advantage. A regulator who accepts a biased benchmark might end up allowing the utility to recover all its costs even when it performs poorly, defeating the entire purpose of the incentive scheme.
Then there is the problem of conflicting objectives. Utilities are supposed to be safe, reliable, affordable, and efficient all at once. But a performance-based regulation that creates strong incentives for one of these goals can weaken incentives for the others. A utility might become so focused on earning rewards for safety spending that it neglects cost control. Or it might chase efficiency gains in a way that undermines service reliability. When incentives are uneven across different functions, a utility can end up overinvesting in one area and underinvesting in another, harming overall performance and ultimately hurting customers.
Consumer advocates have long been skeptical of performance-based regulation for exactly this reason. They worry that utilities will exploit their information advantage to manipulate the system and boost profits at customer expense. They prefer the older tools: prudence reviews that examine whether a utility's spending was reasonable, management audits that assess overall performance, and regulatory lag—the delay between when a utility's costs change and when those changes show up in rates. These methods are slower and more cumbersome, but they give regulators a chance to look back and ask hard questions.
Information asymmetry runs through every aspect of performance-based regulation. A utility knows its own capabilities better than any regulator does. It can misrepresent its performance. It can claim that poor reliability was due to circumstances beyond its control when in fact it was due to inadequate maintenance. A regulator might wrongly penalize a utility for problems it did not cause, or wrongly allow a utility to recover costs it should have controlled. Either mistake undermines the public interest.
Then comes the question of whether the rewards and penalties are the right size. They need to be large enough to actually change a utility's behavior, but not so large that they threaten the utility's financial stability. Get this wrong and you either fail to create real incentives or you destabilize the company.
Perhaps most important is a question that regulators often fail to ask: Are customers actually better off? When a utility improves its performance and earns a reward, does the benefit to customers—lower bills, better service, more efficiency—exceed the extra revenue the utility receives? If not, the utility is getting a windfall at customer expense. Some performance-based regulation mechanisms have been so poorly designed that they have had to be scrapped or restructured because the answer to that question was no. A regulator implementing performance-based regulation must be willing to measure the actual benefits to customers and to pull the plug if those benefits do not justify the cost.
Notable Quotes
A poorly designed and executed performance-based regulation framework can harm utility customers and act antithetically to the public interest.— regulatory analysis
When customer benefits fall short of additional revenues, the utility receives a windfall at the expense of customers.— regulatory analysis
The Hearth Conversation Another angle on the story
Why has performance-based regulation become so popular if it has all these problems?
Because the old system—cost-of-service regulation—really does struggle with the modern grid. Utilities have weak incentives to innovate or cut costs when they know they'll recover whatever they spend. But popularity doesn't mean it works well. It just means regulators are looking for something better.
So the core problem is that utilities have better information than regulators?
That's one core problem. But it's not just about information. It's that utilities have every incentive to use that information advantage. They'll propose a high benchmark, claim they have constraints they don't have, misrepresent their performance. A regulator has to assume the utility will do exactly that.
Can't regulators just set the benchmark based on what other utilities spend?
They can try. But utilities are different—different geography, different customer base, different infrastructure age. And even if you use peer comparisons, a utility can still game the system by claiming its circumstances are unique. The benchmark problem doesn't have a clean solution.
What about the conflicting objectives issue? That seems like a design problem, not an information problem.
It is. You can't create a formula that perfectly balances safety, reliability, cost, and efficiency. When you weight one heavily, you inevitably create perverse incentives for the others. A utility will optimize for what you're measuring and let everything else slide.
So how do you know if a performance-based regulation scheme is actually working?
You have to measure whether customers are better off. Are their bills lower? Is service more reliable? Is the utility more efficient? And you have to compare that benefit to what the utility earned as a reward. If the utility made more money than customers saved, the scheme failed. Some regulators have discovered this the hard way, after years of a mechanism that was harming customers.
Is there a way to design performance-based regulation that actually works?
Maybe. But it requires regulators to be skeptical, to invest in understanding utility operations, to set benchmarks carefully, to monitor outcomes rigorously, and to be willing to change course if the data shows the scheme isn't serving the public interest. Most regulators don't have the resources or the will to do all that.