“The formula gives the utility little incentive to reduce operating costs as these are passed through allowing full recovery. As long as the rate of return (rr) is above the cost of debt, the rate base can be inflated by spending more capital than necessary. The rr is almost always well above the cost of debt.”
Regulated utilities, each granted a territorial monopoly by the state, are allowed to recover their cost of doing business and earn a return on invested capital. The so-called revenue requirement is expressed in this formula:
…Rev = Oc + (V-D)rr
Where:
Rev = Revenue justified by cost and return
Oc = Operating cost including depreciation
V = Value, always first costs
D = Depreciation
rr = Rate of return allowed by regulators
(V-D) = Rate base, this is the current book value of assets and the un-recovered part of depreciable assets and other amortized capital.
CONSOLIDATED UTILITIES (ConU) COMPANY ANNUAL REPORT
Management’s Letter to Stockholders
Dear Fellow Shareholders:
By now you have heard news reports of ConU’s $1 billion cost overrun on the construction of our nuclear plant. However, that’s just part of the good news we have to report. If all goes according to plan, we will be able to overrun another $1 billion before the project is complete. You are, of course, aware this extra $2 billion in our capital base will mean higher earnings for decades to come with increased dividends for us all.
This achievement brings with it challenges that your management team is well equipped to handle. While these wonderful cost overruns and the profits associated with them are something we can all be proud of, they come with increased public criticism, an enormous expenditure of political capital and problems for our regulatory allies.…
“Tell me, JJ, what’s this capital request all about?”
“Boss, this is for a heat exchanger that will use our cooling-tower water for meeting our air conditioning needs when it’s cold outside. I figure it will save 5% of the power we now use for operating our chiller. The project should come in at around $10,000 and have a payback of less than a year.”
“Saves energy, does it? We can use this project to get greenie points towards obtaining Polar Bear level on our Politically Correct Building certification.”
“Maybe, but getting that certification takes a lot of paperwork and costs about $50,000.”
“Include a bicycle rack in this project, which gets points also. And does this thing use electricity?”
“A little bit, for controls and automatic valves.”
“Good. Include a solar panel to power it and put it over the entrance to the building so it can be seen. …