The Application of Finance Theory to Public Utility Rate Cases
Volume: Volume 3, No. 1
Issue: Spring 1972
Pages: pp. 58-97
Authors: Stewart C. Myers
Title: The Application of Finance Theory to Public Utility Rate Cases
Abstract: The purpose of this paper is to formulate the implications of finance theory for rate of return regulation. A variety of problems in finance and the law and economics of regulation are reviewed. Also, a regulatory procedure based on finance theory is proposed for practical use.
Finance theory suggests that the "comparable earnings" standard for rate of return regulation ought to be based on utilities' costs of capital. The cost of capital is difficult to measure, since it is defined in terms of investors' expectations. But plausible estimates can be obtained for utilities. The following principle is proposed for use of these estimates: Regulation should assure that the average expected rate of return on desired new utility investment is equal to the cost of capital. This is a definition of "fair return" based on the theory of competitive equilibrium. The principle is consistent with the comparable earnings standard. Only the most obvious, "straightforward" approach to implementing this principle is examined in detail; but this approach is practical and logically sound. It is particularly attractive when combined with conscious use of regulatory lag as an instrument of regulation. There are some difficulties, however, when such a lag is combined with the usual regulatory practice of basing the allowed rate of return on embedded rather than current debt costs.
The problem of determining the appropriate rate base is also discussed. Regulation based on the book value rate base will not generally lead to efficient price, output, or investment decisions. A "competitive market value" rate base would be better from the standpoint of efficiency, since it would lead to long-run marginal cost pricing. However, long-run marginal cost pricing is not generally consistent with the principle that utilities ought to be able to expect to earn their cost of capital on new investment.