On the design of regulatory price adjustment mechanisms

Price adjustment mechanisms are employed in the electric utility industry to pass changes in fuel costs on to consumers without formal rate review by a regulatory commission. The predictability of this pass-through and the regulator's limited ability to observe the actions of a firm can create potential incentive problems associated with the choices of technology and fuel supply. This paper is concerned with the regulatory design of pass-through formulas when a factor price is uncertain. The optimal design involves deviating from the full-information optimal price formulas in order to mitigate the incentive problems.