Congratulations! You are a regulated electric utility. You have a guaranteed (i.e., risk-free) rate of return for all capital investments in your rate base, on behalf of your kind ratepayers. Because you are risk-free, investors are happy to lend you money at low rates (say, 6%). Your guaranteed rate of return is consistent with market returns (say, 10 - 12%). How much capital investment do you want to make?
The answer is, of course, "as much as possible!"
While the example here is silly, it illustrates a fundamental problem with the incentives given to electric utilities. Remember our equation for the rate base from the previous lesson - the more capital that the utility builds, the more profit that it earns. As long as a utility can convince the regulator that a capital investment is needed to maintain a reliable power grid, then ratepayers must fund the cost of that capital investment.
The collective incentive problem here is often referred to as the "Averch Johnson" effect, after the two economists who originally described it. The theory here is as follows: imagine that an electric utility produces electricity using various inputs. We'll be fairly simple here and say that there are two inputs: Labor (L) and Capital (K). (You can think about fuel as a third important input, one whose total cost varies with the level of production like Labor.) The production function for the utility is R(K,L), w is the cost of labor and r is the cost of capital.
The utility wants to maximize profits:
From standard microeconomics theory we know that profit maximization requires that the ratio of the marginal products of the inputs be equal to the ratio of costs:
The utility's regulator fixes the cost of capital at s, which we recognize from the rate of return regulation as the rate of profit that the utility earns on its rate base.
If the regulator sets s = r (the market rate of capital) then there is no problem. But utility regulators tend to set s larger than r to ensure that utilities are able to acquire investment capital. If s > r and the utility maximizes its profits, we get:
This means that the utility tends to use capital and other inputs in inefficient quantities. It will use more capital when a non-capital expense (like energy efficiency or the use of different fuels) might have done the same job.
The Averch Johnson effect is sometimes called "gold plating," which is a term implying that too much money is spent on capital. One result of the Averch Johnson effect is certainly that utilities spend too much money, but it does not mean that utilities always spend $2 billion on a power plant that should only cost $1 billion. It does mean that the utility might choose to build a $1 billion power plant when cheaper alternatives might be available.