The Determination of the Allowed Rate of Return in a Formal Regulatory Hearing

1. The Determination of the Allowed Rate of Return in a Formal Regulatory Hearing

2. The regulatory agency, in a consistent fashion, makes use of the information provided to it in the regulatory hearing • The ROR allowed by the commission is shown to depend on the size & relative reasonableness of the firm’s request, the presence or absence of cost of capital testimony supporting the firm’s request, the presence of absence of interveners presenting conflicting rate of return testimony, the type of firm making the rate of return request, and a subjective evaluation of the efficiency of the firm making the request • The results also suggest that commission behavior changes in response to problems faced by the regulatory process Conclusion

3. Introduction • Key Idea (Profit maximizing monopoly firm subject to a fair ROR constraint, where the fair ROR lies somewhere between the profit maximizing rate of return & the market cost of capital) • What factors affect the rate of return set by the regulatory authority? • The model is based on the regulation of the gas & electric industries in New York by the New York State Public Service Commission

4. Formal Hearing Structure *The formal hearing structure for setting public utility prices is generally similar from one state to the next 1)The utility commission seeks to determine the elements of the firm’s capital stock that will be included in the firm’s rate base 2) The commission attempts to determine which elements of the firm’s costs & revenues are to be allowed for regulatory purposes & whether or not specific changes which have occurred since the test year will be taken into consideration 3) The commission must determine what the fair ROR is for the firm *There are NO LEGAL RULES SPECIFYING THE PROPER METHOD FOR CALCULATING THE ALLOWED RATE OF RETURN

5. ROR Model • COMMISSION DECISION EQUATION = The allowed ROR determination of the commission • The commission must set a ROR that is not “to low” that the firm cannot perform its service function adequately & not “so high” that the firm is being allowed earnings above the amount needed to maintain the desired level of service quality • FIRM REQUEST EQUATION = The request made by a firm in a given proceeding

6. Horrendous Problems with the Structure • There is a great deal of controversy, even among the experts who present rate of return testimony, over what the market cost of capital actually is. Moreover, it is doubtful that more than a handful of state regulatory commissioners have the ability to critically scrutinize the sometimes complex analyzes employed by cost of capital witnesses, let alone make their own cost of capital calculations. • DATA = New York State Public Service Commission during the period 1960-1970 (21 Rates Cases Natural Gas & Electric)

7. COMMISSION DECISION EQUATION

8. COMMISSION DECISION EQUATION

9. FIRM REQUEST EQUATION *Variable C1 is not a center of controversy…controversy arises over the assessment of the cost of equity capital C2 …therefore the differences over the assessment of this value constitute the major source of conflict between the firm’s request & the intervener’s recommendation *α & β are the proportions of debt & equity in the firm’s capital structure, C1 is the embedded cost of debt, & C2* is the estimated cost of equity capital adjusted for risk characteristics

10. Expectations of the Signs on the Firm Request & Commission Decision COMMISSION DECISION FIRM REQUEST

11. Empirical Results *The fact that b1 > 1 is somewhat troublesome *b2 indicates that the presence of cost of capital testimony is worth on average 0.40% points in the allowed ROR *b3 indicates that the presence of an intervener can have an effect of up to reducing the allowed ROR by 0.40% points *b4 indicates that the commission does discount the requests of gas companies more than electric companies by an average of 0.20% points *b5 being negatives suggests that “aggressive” firms that request more than “typical” firms will have their requests cut more *b6 gives weak support that highly efficient firms are treated better by the commission once they enter a formal hearing process *A 1% point increase in the embedded cost of debt will lead to an increase of 0.64% points in the firm’s request *Gas departments of combination companies will to add a premium of 0.44% points to their request *Firms with outside capital structures will tend to discount their request by 0.33% points relative to other types of firms with the same calculated cost of capital

12. Why is the coefficient of the firm request variable >1? • “Inflation Premium” hypothesis? • In an effort to make up losses that result from regulatory lag in an inflationary world the commission may allow a higher proportion of “corrected” firm requests during periods of rapid inflation than it would in a period of relatively stable prices

13. COMMISSION EQUATION SIMPLE MODEL (Inflation Consideration)

14. Final Thoughts • What the commission will allow is determined by the size & relative reasonableness of the firm’s request, the presence or absence of interveners, the type of the firm making the request, & the judgement of the commission • Once the firm’s request is made, the type of firm determined, the presence of interveners established, etc. the allowed ROR can be predicted • The rate of return phase may be used to give compensation to firms for losses incurred because of regulatory lag & inflation…in a period of inflation, higher than normal rates of return may be allowed as a method of anticipating inflation & to forestall the immediate return of a firm for a rate increase