This note reviews PEG’s “incentive power” model. It is based on the descriptions in Incentive Power and Regulatory Options in Victoria, Pacific Economics Group 2005, and the associated technical appendix, submitted by the Victoria ESC in its submissions to the AEMC’s TFP review.

The context of this review is the question of how to give regulated network companies in Australia incentives to improve efficiency. More specifically, the debate is around whether TFPbased approaches would give stronger incentives for efficiency than the current building-blocks approach.

The Victorian ESC expresses some conclusions about the strength of incentives to control costs under various regulatory regimes based on PEG’s incentive power model and its claimed results. We find some of PEG’s conclusions from the model to be uncontroversial. However, ESC and PEG’s conclusion that TFP gives stronger incentives than building blocks is based on unreasonable and flawed assumptions: PEG’s building-blocks scenarios contain a price reset, while PEG’s TFP scenarios do not.

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