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Session Objectives. Rate-of-return regulation Revenue requirements Rate base Rate of return Expenses Price caps Other cost models. Quality of Service Regulation. The supplier usually exercises initiatives. Acts to recover costs Expands rate-base Avoids public criticism

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Session objectives
Session Objectives

  • Rate-of-return regulation

    • Revenue requirements

    • Rate base

    • Rate of return

    • Expenses

  • Price caps

  • Other cost models

TLMN 602.9040 Fall 1999 Session 5


Quality of service regulation
Quality of Service Regulation

  • The supplier usually exercises initiatives.

    • Acts to recover costs

    • Expands rate-base

    • Avoids public criticism

  • The regulator usually imposes constraints.

    • Sets minimum standards

    • Requires resolution of customer complaints

    • Requires non-compensatory services (e.g., “lifeline”)

TLMN 602.9040 Fall 1999 Session 5


The unregulated monopoly problem
The Unregulated Monopoly Problem

  • From Session 2:

    • Prices above competitive levels

    • Output below competitive levels

    • Therefore, wealth transferred from consumers to producers

  • Must impose rate regulation to fix the problem

TLMN 602.9040 Fall 1999 Session 5


Goals of rate regulation
Goals of Rate Regulation

  • Emulate competitive mix of price, output, and profits

  • Fair prices to customers

    • Price = Money/unit (of quantity or quality)

  • Avoid destructive competition

  • Control price inflation

  • Allow enough earnings to stay in business

TLMN 602.9040 Fall 1999 Session 5


Revenue requirements
Revenue Requirements

R = E + B  r, where

R = revenue requirement

E = operating expense (including depreciation)

B = rate base (i.e., capital investment)

r = rate of return on investment (i.e., cost of both debt and equity capital)

Carriers tend to inflate both E and B.

Difficult to set r

TLMN 602.9040 Fall 1999 Session 5


Price mix
Price Mix

  • For a multi-product firm, also

    R = pi vi, i = 1,2,…n (subscript i), where

    p = price of the ith product

    v = volume of the ith product

    n = number of products

TLMN 602.9040 Fall 1999 Session 5


Rate base method of valuation
Rate Base: Method of Valuation

  • Set by method?

    • Reproduction cost (best for company)

    • Original investment, i.e., book value (best for regulator and consumer; ascertainable, at least)

    • “Fair value” (some combination)

  • Or by end results?

    • Maintain financial integrity

    • Attract capital

    • Compensate investor risk

    • Provide acceptable service

TLMN 602.9040 Fall 1999 Session 5


Rate base property included
Rate Base: Property Included

  • Assets used for production

  • Assets under construction (pre- or post- approval)

    • Construction work in progress (CWIP)

    • Allowance for funds used during construction (AFUDC)

  • Cancelled plants and excess capacity

    • May be disallowed as

      • Imprudent

      • Not used and useful

    • May be allowed in part

TLMN 602.9040 Fall 1999 Session 5


Expenses depreciation
Expenses: Depreciation

  • Proper depreciation rate

    • Linear?

    • Accelerated (creates low-tax windfall)?

  • Effect on tax expense (number games)

  • Original or reproduction cost? (i.e., may cost $2 million today to replace a $1 million switch bought 15 years ago.)

  • Charging full depreciation and cost of capital implies “full-cost” pricing, not “marginal-cost”

TLMN 602.9040 Fall 1999 Session 5


Rate of return
Rate of Return

  • Commission mediates between investor interest and consumer interest

  • No “right” answer-- “zone of reasonableness”

    • Minimum needed to attract capital

    • Maximum is what traffic will bear.

    • Sooner or later, must recover “full cost” instead of short-term marginal cost

TLMN 602.9040 Fall 1999 Session 5


Cost of capital
Cost of Capital

  • Whose cost? The firm’s or the industry’s?

    • Allow incentive for efficiency and innovation

  • Cost when? Then or now?

  • Or stock’s earnings/price ratio?

    • But these are estimated future earnings!

  • Sensitive to capital mix, because interest is deductible but ROE is taxable

  • By earnings of non-regulated industry at comparable risk?

TLMN 602.9040 Fall 1999 Session 5


Operating costs
Operating Costs

  • May disallow

    • Exaggerated costs

    • Too rapid depreciation

    • Extravagance

      • In advertising and public relations

      • Charities

      • Large management salaries and expense accounts

    • Inflated equipment prices from affiliated suppliers

    • “Gold-plating”

  • Uniform System of Accounts as basis of expenses

TLMN 602.9040 Fall 1999 Session 5


Price caps transition to competition
Price Caps: Transition to Competition

  • Initially set prices to yield fair estimated return on equity, ROE, e.g., 13.5%

  • Thereafter, cap prices each year for svc “baskets”

    • Allow economy’s inflation rate

    • Disallow differential telco prod’vy gain & input drops

      • Reacts on rates and forces productivity

    • Allow miscellaneous adjustment(s)

  • If actual ROE exceeds fair ROE,

    • Carrier may keep part as incentive

    • Subscribers may get part as rebate

TLMN 602.9040 Fall 1999 Session 5


Price cap example
Price Cap Example

PCI(n) = PCI(n-1)(1 + s - p + m) where

PCI(n) = price cap index for year n

s = percent price inflation

p´ = percent telco inflation offset

m = percent miscellaneous adjustment

Require actual price index PCI(n), for year n

Example of values

PCI(n) = PCI(n-1)(1 - 3.0%)

for s = 2..0%, p = 5.3%, m = 0.3%

TLMN 602.9040 Fall 1999 Session 5


Gdp changes in general
GDP Changes in General

G = SV = SPF = where

G = gross domestic product

S = price of “average” product

V = volume of “average” product

P = V/F = total factor productivity

F = total input factors of production

d ln G = d ln S + d ln P + d ln F, or

dG/G = dS/S + dP/P + dF/F or, as percent increases,

g = s + p + f and s = g - p - f

TLMN 602.9040 Fall 1999 Session 5


Other cost models
Other Cost Models

  • Total element long range incremental cost (TELRIC)

    • Cost of a hypothetical, state-of-the-art local service network

    • Results in lower cost than actual network

  • Hybrid Cost Proxy Model

    • A model based on engineering detail and costs

    • Know that it exists, but skip details.

TLMN 602.9040 Fall 1999 Session 5


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