Economics of Regulation Rate of Return

8/13/2019 Economics of Regulation Rate of Return

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Economics of Regulation

Rate-of-Return Regulation



Definition

where Pi is the price of the ith service

qi is the quantity of the ith service

n is the number of services

s is the allowed rate of return

RB is the rate base; a measure of the value of theregulated firm's investment



Definition

Regulatory authority must

• A. determine the allowed expenses, allowed RB

and s

• B. determine mix of prices that will achievethat revenue requirement



Practical Difficulties

A. Determining COC.

• 1. Needs a fair rate of return that is sufficiently

high to attract new investment for newprojects. To economists this is the opportunitycost of capital.

•

2. Important court case - Hope Natural Gas(1944) stated that return "should becommensurate with return on investments inother enterprises having corresponding risks."

to maintain its credit and to attract capital."




[continued...] And "should be sufficient to assureconfidence in the financial integrity of the

enterprise so as• 3. Firms finance through bonds and stock. COC

of bonds is easy - paid a fixed interest rate.Shareholder equity return is harder. Riskinessis an element

• 4. Methods of determining ROE - DCF; CE; E-Pratio; CAPM.




• 5. Discounted Cash Flow - DCF -

where P is the price of the stock , D1 is expected dividend in year 1, D2 is expected dividend in year 2, Di is expected dividendin year I

k is cost of equity capital

this solves to K = D sub 1 over P + g

or current dividend yield e.g. 8% plus constant growth rate of

dividends e.g. 7% so that k = 15%.




6. Comparable earnings (Kolbe, Read & Hall,p. 41) aka comparable industry or

comparable risk - select a sample of firmsbelieved to be of comparable risk andcalculate ROE.

7. Earnings-Price ratio - r=E/P (simplifiedDCF]




8. Capital Asset Pricing Model (CAPM)

• E(ri) = rf + i * [E(rm) - rf]

• where ri is the expected ROR for firm I

• rf is risk free ROR

• Bi is firms beta (measure of riskiness)

• rm market return for that level of riskiness







B. Determining Rate Base

• 1. Assets - Accumulated depreciation

• 2. How much is depreciation? Economicdepreciation versus accounting depreciation

• 3. What to do with appreciation?




• 4. What are prudent investments?

"In May 1987, California PUC staff

recommended that of the $5.518 billion thatPG&E spent before commercial operation of theDiablo Canyon Nuclear Power Plant only $1.150billion should be allowed to be collected inrates. The staff alleged that unreasonablemanagement was to blame for a large part ofthis cost overrun."




C. Regulatory Lag - once new prices are set,they remain unchanged until the next rate

case. Hence, the period during whichprices remain fixed provides an incentivefor the company to be cost efficient.




• 1. Rate cases usually involve significant resources(manpower and money); cost studies; demand studies,COC studies. Expensive to initiate. Typically last for 2

years - need forward planning.

• 2. What happens to all those people between ratecases?

•

3. Usually initiated by the company. No incentive tobring rate case if COC falls, costs fall, etc.




D. Rate Structure (Viscus p. 391)

• 1. Has to do with how prices vary across

customer classes & products.

• 2. Fully Distributed Cost (FDC) pricing




Consider a two-product natural monopolyselling electricity to two classes of customers:

residential buyers X and industrial buyers Y.(They are different products because it islower voltage to residential customers).

– To produce X alone: Cx = 700+20X

– To produce Y alone: C y = 600+20Y

– To produce both: Cxy=1050+20X+20Y

– Joint production of X & Y is subadditive.




Common costs are distributed on the basis ofsome physical measure of utilization such as

minutes, circuit-miles, cubic feet, or kilowatt-hours employed or consumed by each. Or theymay be distributed in proportion to the coststhat can be directly assigned to the various

services.




Suppose some reasonable method leads to anallocation of 75% to product X and 25% to product Y.Then ACx = 787.5/X + 20 and Ac y = 262.5/Y + 20.

Demand function: Px =100-X and P y=60-0.5Y , we get

Px =ACx =$31.5; X = 68.5; P y=AC y=$23.6; Y = 72.8

So FDC leads to TR=TC but not economically efficient.

Ramsey prices would be Px =30; P y=25; X = 70; Y = 70.

Issues of fairness in pricing (more later)




E. Incentive problems - no incentive toinnovate or reduce costs.



Averch-Johnson Effect

A. Profit = Revenue (K,L) - wL - rK subject to{R(K,L)-wL}/K=s

• where w is wage rate, L is quantity of labor, r iscost of capital, K is quantity of capital, s isallowed rate of return.




B. Key assumptions of the model

• 1. Firm seeks to maximize profit

• 2. Market cost of capital is constant

• 3. Allowed rate of return exceeds cost ofcapital (s>r)

• 4. No regulatory lag






D. Simpler version

Profit = TRa-TC=(expenses + sK)-(expenses+rK)=(s-r)K. On every extra $ of Kthe firms earns s-r more.

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Economics of Regulation Rate of Return