EBF 483
Introduction to Electricity Markets

5.3 Rate of Return Regulation


5.3 Rate of Return Regulation

Recall from earlier in the lesson what was involved in the regulatory compact:

  • The utility is given a monopoly to provide service in a specific geographic area. No other company may try to enter that particular market.
  • The utility must provide universal or "nondiscriminatory" service at prices set by the regulator. These prices are referred to as "rates."
  • The regulator must allow the utility to charge prices that are "just and reasonable."

The concept of a price that is judged to be "just and reasonable" or "fair" is fairly unique. In economics prices are usually signals of marginal value and marginal cost, so a price is neither fair nor unfair - it is what it is.

Rates for regulated utilities, however, are set to achieve very specific goals for customers and for the utility company:

  • Allow the utility company to pay for the fixed and variable costs of providing service;
  • Pay off its debts related to capital investments needed to provide reliable service;
  • Earn a "fair" amount of profit.

Because the utility's profitability is effectively determined by the regulator, we often refer to this type of regulation as "rate of return" regulation. It is also sometimes called "cost of service" regulation in reference to the fact that rates are set based on the costs of providing service.

The "fair" level of profit in electric utility regulation has a very specific meaning - a level of profit is "fair" if it is high enough that the utility is able to go out into capital markets (debt and equity markets) and raise money to make investments in electricity infrastructure. If the utility's profits are too low, it will have trouble raising capital because investors may find higher returns for a similar level of risk. If the utility's profits are too high, then customers wind up with higher electric bills.

The mechanics of setting utility rates to achieve these three goals are described in the reading "Rate of Return Regulation" by Mark Jamison (available on Canvas). At this point in the lesson you should have a good look at this reading. We'll just summarize the most important points here.

First, the regulator must set rates in accordance with the fundamental equation of rate of return regulation:

R = B × s + E + d + T

Note that I am using slightly different notation than Jamison. R here is the "revenue requirement," or the total amount of money that the utility must bring in each year (through rates); B is the "rate base," which is the utility's total stock of non-depreciated capital, s is the rate of return (Jamison uses r here, I use s to differentiate the utility's rate of return from its discount rate that it uses for investment project decision-making), E is all operational costs including labor and fuel, d is annual depreciation on existing capital, and T is taxes.

The rate of return equation is very important. In particular, it says that the utility cannot earn any profits on its operating costs. So the utility cannot, for example, mark up its fuel expenses in order to increase its profits. All utility profits come from investing in capital equipment like power plants, transmission lines and substations.

Second, the regulator needs to determine the size of the rate base. This is very important because the rate base determines the utility's profits. In order for capital equipment to be included in the rate base, it must meet two criterion, which are described further in the Jamison reading. One criterion is that the capital equipment must be actively employed to provide electric service to customers, and that service would suffer if that equipment were not in place. This is called the "used and useful" criterion. The other criterion, known as "prudence," says that the utility must have paid a fair price for any capital equipment and must have installed the equipment at a reasonable cost. The prudence criterion keeps electric utilities from artificially inflating capital costs in order to increase profits.

Third, the process of arguing over what gets included in the rate base, the correct value for the rate of return, and how the utility's revenue requirement should be spread over different types of customers, are all settled in an administrative legal proceeding known as a "rate case." While utilities will generally go through a rate case with their regulator every few years on a regular basis, extenuating circumstances such as rapid changes in fuel prices or the need to make large capital investments on short notice may trigger irregular rate cases.

The outcome of a rate case is a set of documents called "tariffs," which are basically contracts between the electric utility and different types of customers. The utility tariffs outline how much the utility is allowed to charge various types of customers and defines the quality of service that the utility is expected to provide.

If by some chance you have ever had the opportunity to sit through a rate case, they can be excruciatingly boring and controversial all at the same time. Much of what happens in a rate case involves arguing over accounting model assumptions and similar issues. This is controversial because there is often a lot of money on the line for the utility (and for customers, if rates go up). Increases in electricity rates, even small ones, are very politically controversial in the United States.

But lots of important things happen in rate cases. Remember the fights between utilities and solar power providers that we mentioned at the beginning of the lesson? Those are, for the most part, resolved through rate cases. Many utilities in the United States are facing decisions as to whether they should retire old power plants that have high pollution costs. Some people would like to see these types of power plants shut completely. Others want to see the plants continue to operate as long as possible because they produce such cheap power. These issues are also resolved in rate cases.