 Revenue Requirement  Operating cost  Capital cost  Firm is allowed to make a return on investment called allowed revenues, valued added of the regulated activity, permissible revenues, rate base, regulated revenues, tariff base, total revenues, revenue requirements  Determining revenue requirements  Investments must be prudent  Used and useful  Known and measurable

 The test year  Used to forecast future costs under normal operations  Past years  Future test years (actual data & projected data)  Vetting costs  Determining what is known and measurable can vary between regulators  Costs  Private vs. social  Original vs. replacement  Short-run vs. long-run

 RR=O&M+A&G+T+D+(WACC*RB)  Operation and maintenance  Administration and general  Depreciation  All taxes  Weighted average cost of capital (represents capital plus rate-of-return and includes income taxes)  O&M+A&G  Deferred (recovered) vs. accrued (not recovered)  Different rate classes (resid, comm, indust)  Direct vs indirect (joint and common costs)

 Public Ownership  Opposite of ‘free market’  Private vs. public ownership based on efficiency  Meyer (1975) study of electricity utilities  Public ownership has lower AC  Ownership vs regulation?  Pescatrice and Trapani (1980)  Public ownership lower AC  Controls for different techonolgies (public has more hydro and less capital)  Controls for input prices  Caused by regulation  Atkinson and Halvorsen (1986)  Control for competitive vs monopoly market structure  Only examines steam generation  Finds no cost difference between the two  Both are inefficient

 Award one firm an exclusive right to produce and sell the good in a particular market.  The firm that wins the right is one of many bidders.  Competition among bidders should drive the price down.  Production Technologies alone does not justify regulation  Contract must be well-specified.  Consumers must be knowledgeable in price-quality tradeoff  New bidders must have access to existing capital

 Similar to example of weak monopoly with no barriers to entry  Contestability Theory  Does not work for strong natural monopoly

 Determining winner on well-specified criteria  Price  Quality  Reliability vs price  Duration of contract must be specified  Long term contract – more durable  Short term contract – easier to punish for bad quality  Setting price  Ensuring multiple bidders with equal footing  Existing supplier’s capital  Price? Fair-value? Competitive purchase? Depreciation?  Agency to run negotiations  Engineers, legal, accountants, and economic experts

 Create Incentives to promote cost-minimizing behavior  Adopt penalties for inefficient behavior and decreased quality  Difficulties to measure quality  Electricity  Reliability  Average Heat Rate of Baseload Generators  Passenger Trains/Railroad  Punctuality  Car-cleanliness

 COS regulation and regulatory lag  Performance based regulation (PBR) (reduce costs)  Incentive regulation  Price cap regulation  Sliding Scales  Partial Adjustment Mechanisms  Yardstick competition (reduce asymmetric informations)  All three share a common structure shown but differ in the rules they set.  Revenue Requirement  tariff model  (rules)prices and conditions for service

 All of these methods provide incentive to reach a specified objective  Vary greatly by industry and objective, but the theoretical model typically used to analyze them are the principal-agent problem. (Joskow and Schmalensee 1986)

 Provides incentive to firms to increase operating efficiency  Firms can increase ROR by decreasing their operating costs  Reduces the regulatory lag (time between actual costs occur and the time those changes affect RR and COS)  Firms face a set price

 CPI-X plan  Regulate firm is constrained so that a weighted average of its prices increase by no more than the CPI less X percent  Pros:  Possible cost reduction, incentives for cost-minimization  Protest core customers from monopoly prices  Reduces regulatory burden  Problems:  CPI vs. other price index  Still need to visit rate of return periodically

 Best in industries with asymmetric information  Prices are based on the AC in the industry so firms compete and the most efficient firms are rewarded  Problems include  Collusion  Comparability  Commitment

 1) Cost-plus mechanisms are rarely optimal.  Regulatory lag, partial adjustment, and using fuel price indices can increase the incentive to search, negotiate, and use forward markets  2) Scheme should depend on economic conditions  Uncertainty requires more flexibility. Frequent regulatory modification (short vs. long run impacts)

 3) Compensation measure should focus on overall measure of performance.  Examples, using CPI as benchmark, or emphasizing the electricity-generating unit availability  4) Developments not under managerial control should not be rewarded or punished  Examples, risky cost or demand conditions (nuclear plant shut down) should be reflected in the rate of return

 5) Long-run viability cannot be jeopardized  If rewards only occur when prices are low, then prices may rise  6) A firm commitment to stick to incentive mechanism will be difficult  Political feasibility

 7)New schemes must be easily compared with traditional regulation  Needed in order to gauge impact  8) Perfection is not possible with incentive schemes  Some programs can result in greater incentives for cost minimization and should be given priority  Regulation is not a zero-sum game