For nearly a century, the electric utility sector operated under a stringent type of regulation known as "rate of return regulation" or "cost of service regulation," as was discussed in this Lesson. The essence of rate of return regulation is that a utility's electric rates are set to reflect long-run average costs, plus a regulated profit margin for the utility. The rationale for this type of regulation was that electric utilities are natural monopolies - in other words, a single company could serve a given geographic area with lower marginal and average costs than could a large number of competitive firms. We also learned about the fundamental rate of return regulation equation, which states that a utility's revenue requirement (the amount of money that it has to bring in from customers - not to be confused with "Average Revenue Requirement" of a power plant) is equal to its operational costs for labor, fuel, and taxes, plus its stock of non-depreciated capital, plus its allowed profit. The key insight from the rate of return equation is that utilities earn profits on capital investments, not on fuel or other operational costs. This gives electric utilities strong incentives to make capital investments in power plants, substations, transmission lines and other equipment.
Reminder - Complete all of the Lesson 5 tasks!
You have reached the end of Lesson 5! Double-check the to-do list on the Lesson 5 Introduction page to make sure you have completed all of the activities listed there before you begin Lesson 6. In particular, please make sure that you read the Jamison reading carefully before starting the homework assignment for Lesson 5.