EBF 483
Introduction to Electricity Markets

6.1 Problems with Rate of Return Regulation

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The reading on Canvas, "Notes on Regulation and Restructuring," contains a detailed discussion of the inherent incentive problems with rate of return regulation. While rate of return regulation created a highly stable environment for utilities, it also gave them incentives to make some poor decisions, which cost electricity consumers a lot of money.

You should read this material first, and then the more detailed notes.

The figure below shows the price of electricity, in inflation-adjusted terms, from the late 1800s to the present. You'll note that for nearly eight decades the price of electricity fell almost every year. This was largely the result of big improvements in technology and also economies of scale as utilities could spread fixed costs over larger territories and more customers.

Beginning in the 1970s, however, the price of electricity began to rise. This was unprecedented, and angered large industrial users of electricity who were beginning to feel a pinch from global competition. In the space of just over a decade through the mid 1980s, electricity prices rose more by around 50%. There were a lot of reasons for this. The rate of growth of electricity demand suddenly slowed in the 1970s because of a slumping U.S. economy and because of public policies that encouraged energy conservation. Declining demand, however, meant that the costs of the grid were spread over fewer kilowatt-hours sold and prices rose. Fuel costs also increased dramatically in the 1970s with the Arab oil embargoes. (In the 1970s fully 20% of electricity in the U.S. was generated with oil, while today virtually none is.)

Graph showing the trend of the price of residential electricity.
Residential price of electricity 1890 - 2015.
Source: Seth Blumsack

Electric utilities also proved themselves to be unable to build new types of power plants at a reasonable cost. Nuclear power was especially vulnerable to massive cost over-runs, and regulators in many cases allowed customers (rather than utility shareholders) to pay those inflated costs through higher rates.

In summary, there were basically three strikes against the rate of return model for electric utilities.

  1. The guaranteed rate of return encouraged inefficient behavior by utilities;
  2. Utilities had little incentive to be business-savvy and embrace or develop new technology;
  3. Public Utility Commissions suffered from a poor understanding of the industry and "regulatory capture."

We'll now briefly discuss each of these problems in turn. Additional detail is provided in the Canvas reading.