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An 11 percent drop in the cost of local phone service may appear to be the highlight of hearings scheduled this week before the Utah Public Service Commission.

But a more long-term issue will also be at stake: A radical change in the way US WEST Communications, formerly Mountain Bell, is regulated.A change in regulatory policy is part of a settlement US WEST negotiated with regulators to handle excess earnings of the phone company, while requiring it to reduce rates by $31 million from past excess revenues.

US WEST and the state's Division of Public Utilities and Committee of Consumer Services are asking the PSC to approve switching from rate-based regulation to so-called incentive-based regulation for a three-year trial. The proposed change would allow US WEST to keep half of its profits exceeding authorized levels and return the other half to ratepayers.

US WEST and the state agencies also negotiated a drop in the utility's authorized return on stockholders' equity from 14.2 percent to 13.75 percent. Under the agreement, any earnings exceeding 13.75 percent of stockholders' investment would be split 50-50 between US WEST and ratepayers. US WEST said the negotiated proposal, which would settle a battle over how to handle the phone company's excess profits, also gives the company an incentive to improve productivity by allowing it to keep some of the benefits.

While the PSC would like to get $20 million of the negotiated rate reduction in place as soon as possible - which would drop phone rates 11 percent - it doesn't want to move too fast in endorsing the proposed change in regulatory policy.

"Incentive-based regulation is something that we just don't know very much about," said PSC chairman Ted Stewart.

The commission's staff is also leery of hastily considering the matter - which could also impact how Utah regulates its gas and electric utilities - and drafted a two-page memo of questions and issues that should be addressed during the hearings, scheduled for Thursday, Friday and Monday.

The memo says too many questions surround incentive-based regulation to vote either for or against it. The staff warns against cutting short the information gathering process and instituting new regulatory policy with little examination.

Among the questions staffers want the commission to demand answers to: What led to selection of the shared excess earning plan as the best alternative? What evidence exists to show profit sharing would increase company efficiency or, what cost-cutting measures would be adopted?

If the new policy is approved, will other regulated utilities demand similar treatment? Why does the utility continue to earn excess profits? And, how can reasonable rates be determined without a thorough review of revenue requirements?

Stewart said those questions must be answered before the commission can sign off on the three-year experiment.

"If our questions are answered to our satisfaction then we will approve the settlement, if they are not then we will not approve it," he said.

US WEST spokesman Ken Hill said the settlement must be approved entirely or not at all - in other words, the rate reduction through the earnings pay-out cannot be approved without the incentive-based provision.

"If any part of it is changed then we will have to go back and renegotiate it," he said.

US WEST's swelling profits - along with the utility's aggressive push for regulatory reform - brought regulators and the utility to the bargaining table initially to strike the deal now before the PSC.

Regulators had been monitoring US WEST's revenues for several months and found it had earned $30 million over its authorized rate of return in the past year and earned 18 percent on equity during the first four months of 1988.

US WEST doesn't apologize for its healthy financial performance. The utility said it came as a result of cost cutting and tax breaks and it points out that it hasn't requested a rate increase in three years.

But, the division called for a rate case in January to reexamine the utility's rates and profits, and the committee requested US WEST's past excess earnings be subject to refund after the rate case. US WEST countered that regulators had no authority to order past earnings be refunded. The apparent impasse resulted in the parties hammering out a settlement to pay out excess earnings to customers - $20 million effective Sept. 1 and another $11 million effective Jan. 1 - and to handle future excess earnings problems with incentive-based regulation.

A rate case is still on schedule for January to determine how US WEST's costs should be allocated among its various types of customers, thus determining how rate decreases and increases should be spread among ratepayers.