“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.
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.
If the utility has a capital structure of 50% debt, as most regulators encourage, then: rr = .50 rd + .50 re
Where: rd = return on debt and re = return on equity
So if the utility is allowed an 8% overall rate of return and obtains debt for 5% (rd), its return on equity will be 11% (re). If the allowed rr is raised to 9% then the re will be 13%. Once the rate of return is set if the cost of debt decreases, the return on equity will increase.
Operating capital, storm damage, conservation programs and other “regulatory assets” all go into rate base where the un-amortized portion earns the rate of return. Utilities prefer long amortization and depreciation periods. They borrow money at low rates and invest in guaranteed high-return capital projects.
The regulatory formula provides an understanding of how and why utilities operate and invest the way they do. There is a strong bias for capital projects like nuclear generators. There is also a great incentive to have cost overruns, if the utility has the political clout to get excessive capital into the rate base. Hence regulated utilities spend a great deal of money on lobbying and strategic contributions to gain the political capital necessary to get their mistakes into the official ratebase.
Perverse Incentives
A public-utility-regulated business is the carnival mirror image of a real business. Many of the same terms used to describe regular companies are used, but their meanings are distorted. There is no incentive to innovate because operating cost reductions must be passed on to customers.
Regulated utilities don’t care if environmental rules require heavy investment in emission control equipment, that’s just more capital in place and subsequent earnings. They actually like having coal plants shut down. They get to collect depreciation and return on the abandoned coal-fired asset; plus they get to invest in a new asset to replace the power output. Double dipping capital recovery and return for same amount of power.
Reform Needed
So how can the monopoly-regulatory system be reformed? There has to be free and open competition so the most efficient users of capital can gain market from the over-capitalized incumbents. This means competition in the delivery system too; not the mandatory access with full recovery of toxic assets that has been tried.
Let potential competitors also offer the wiring from generators to customers. Threatened with seeing their infrastructure become obsolete, incumbent utilities will develop sharing arrangements. Other industries, and even utilities in certain circumstances, have developed such working agreements.
Utility regulation came into being through political means as protection from competition. Much of the previous misunderstandings about economics have been cleared up in the past hundred years. Long-term contracts between organized buyers and the provider can ‘privatize’ regulation. Such exit contracts blessed by a public utility commission as its final act could transition providers from the cushy regulated world into the entrepreneurial free-market world.
There is no sound reason the services offered by regulated utilities cannot be performed in a market setting.