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 the regulated firm's investment

Definition
Regulatory authority must

A. determine the allowed expenses, allowed RB and s B. determine mix of prices that will achieve that revenue requirement

Practical Difficulties

A. Determining COC. 1. Needs a fair rate of return that is sufficiently high to attract new investment for new projects. To economists this is the opportunity cost of capital.

2. Important court case - Hope Natural Gas (1944) stated that return "should be commensurate with return on investments in other enterprises having corresponding risks." to maintain its credit and to attract capital."

Practical Difficulties
[continued...] And "should be sufficient to assure

confidence 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. Riskiness is an element 4. Methods of determining ROE - DCF; CE; E-P ratio; CAPM.

Practical Difficulties
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 dividend in 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%.

Practical Difficulties
6. Comparable earnings (Kolbe, Read & Hall,

p. 41) aka comparable industry or comparable risk - select a sample of firms believed to be of comparable risk and calculate ROE.
7. Earnings-Price ratio - r=E/P (simplified

DCF]

Practical Difficulties
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

Practical Difficulties

Practical Difficulties
B. Determining Rate Base

1. Assets - Accumulated depreciation 2. How much is depreciation? Economic depreciation versus accounting depreciation 3. What to do with appreciation?

Practical Difficulties
4. What are prudent investments? "In May 1987, California PUC staff recommended that of the $5.518 billion that PG&E spent before commercial operation of the Diablo Canyon Nuclear Power Plant only $1.150 billion should be allowed to be collected in rates. The staff alleged that unreasonable management was to blame for a large part of this cost overrun."

Practical Difficulties
C. Regulatory Lag - once new prices are set,

they remain unchanged until the next rate case. Hence, the period during which prices remain fixed provides an incentive for the company to be cost efficient.

Practical Difficulties
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 rate cases?

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

Practical Difficulties
D. Rate Structure (Viscus p. 391)

1. Has to do with how prices vary across customer classes & products. 2. Fully Distributed Cost (FDC) pricing

Practical Difficulties
Consider a two-product natural monopoly selling electricity to two classes of customers: residential buyers X and industrial buyers Y. (They are different products because it is lower voltage to residential customers).
To produce X alone: Cx = 700+20X
To produce Y alone: Cy = 600+20Y To produce both: Cxy=1050+20X+20Y

Joint production of X & Y is subadditive.

Practical Difficulties
Common costs are distributed on the basis of some physical measure of utilization such as minutes, circuit-miles, cubic feet, or kilowatthours employed or consumed by each. Or they may be distributed in proportion to the costs that can be directly assigned to the various services.

Practical Difficulties
Suppose some reasonable method leads to an allocation of 75% to product X and 25% to product Y. Then ACx = 787.5/X + 20 and Acy = 262.5/Y + 20. Demand function: Px=100-X and Py=60-0.5Y, we get Px=ACx=$31.5; X = 68.5; Py=ACy=$23.6; Y = 72.8 So FDC leads to TR=TC but not economically efficient. Ramsey prices would be Px=30; Py=25; X = 70; Y = 70. Issues of fairness in pricing (more later)

Practical Difficulties
E. Incentive problems - no incentive to

innovate 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 is cost of capital, K is quantity of capital, s is allowed rate of return.

Averch-Johnson Effect
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 of capital (s>r) 4. No regulatory lag

Averch-Johnson Effect
C. Solution: Mpk/MPl={r-a}/w where

a = (s-r)/(1-) > 0
0<<1; s-r>0 proper equality would be

Mpk/MPl=r/w so this induces the firm to use more capital and less labor than is socially efficient.

Averch-Johnson Effect
D. Simpler version Profit = TRa-TC=(expenses + sK)-

(expenses+rK)=(s-r)K. On every extra $ of K the firms earns s-r more.