After years of conspicuous success, the Performance-Based Rate (PBR) regime applied to much of Europe’s electricity distribution industry appears to be reaching the end of its useful life. First adopted in Great Britain in 1990, the PBR model requires regulators to set lower rates each year while allowing distributors to keep any value they generate by reducing their costs below the resulting revenues. Distributors thus have an economic incentive to improve their operations, which has led many formerly state-owned monopolies to become significantly more efficient, increased their margins and profits, and made them more reliable for consumers.

But the benefits of this policy are diminishing. Many European distributors can’t reduce their costs much more without reducing service levels. Moreover, if rates continue to drop, distributors won’t be able to finance the investments required to renew and upgrade their networks in the future. Nor will they have the means to promote a wider set of objectives by investing in new technologies, such as smart grids that distribute electricity generated with renewable sources and smart meters that discourage consumption at peak times.

We have identified three guiding principles for companies and regulators embarking on an effort to create a new regulatory regime:...