Chapter 5 Cost Measurement

Figure: The framework for Developing Regulated Services and Prices Pricing and Services Regime Tariffs Pricing Structure Terms and Conditions of Service Other Charging Policies: Connection Policy Tariff Exceptions Special Services Obligations to Serve

Steps to calculate regulated prices: (1).Set the revenue requirement (this chapter) (2).Functionize costs (Activity 1, Activity 2, Activity… Activity N) (3).Classify costs (Fixed costs, Variable costs, Customer Costs) (4).Allocate costs (Customer Class1,…Customer Class M) (5).Set rates and tariffs (Prices Class 1,…Prices Class M, Other Prices.)

Figure: The Three Sets of Books Accounting and Technical Data Statutory Books How are we doing? Were we profitable? Tax Books: What must we pay? Regulatory Books What may we charge?

Design of Accounting Systems: Uniform System of Accounts, used by all public utilities. Institutions decide how to collect data: Ex: Financial Accounting Standards Board (FASB): relevant and reliable Securities and Exchange Commission (SEC): objectivity and reproducibility American Institute of Certified Public Accountants (AICPA): reasonableness

2. Data Envelope Analysis (DEA)” uses linear programming technique, determine and efficient frontier (“envelope”) On the frontier:=100; Within the frontier: <100 Based on a sample of similar firms Problems: (1) too-small sample sizes; (2) ignores many attributes that underlie a firm’s cost structure; (3) inconsistent—high efficiency standard; average return to investors.

3.Ordinary Least Squares and Corrected OLS (COLS): Compare with DEA: Similarities: all use econometric approach to estimate cost; Difference: OLS & COLS do not estimate relative efficiency levels like DEA. 4. Stochastic Frontier Analysis (SFA): --another empirical technique to estimate an efficiency frontier. It breaks the error term into two components. Problems: same with OLS&COLS: too few samples.

 The Efficient Markets Hypothesis All above lies in a fundamental hypothesis: capital markets are efficient. (1) allocative efficiency—distribution of goods and services to their highest values (2) exchange efficiency—the ability to transfer funds bw one another at the lowest possible cost

Three types (Eugene Fama): (1) Weak form: all past market prices are completely reflected in current prices. No investor can earn excess returns by developing trading rules based on past price info. (2) Semi-strong form: No investor can earn excess returns from any publicly available info, such as corporate Annual Reports, 10-K forms, Wall Street Journal columns. (3) Strong form: No investor can earn excess returns using any info, whether public or not.

4. The Risk Premium Model (RPM): Based on: the fact that for an investor, common equity capital is riskier than debt. Potential investors in a company require a premium on top of the cost of debt issued by that company to induce them to provide equity capital. Compare to CAPM: Similarity: both use Beta Difference: RPM incorporates both systematic and unsystematic risk (CAPM: only systematic)

5.5 Deferred Costs and Regulatory Assets Not all prudently incurred regulated costs are flowed through to customer rates immediately. A deferred cost is one that the firm has paid for but which has not been included in its rates. Regulatory assets( a type of deferred cost): a deferred cost that is included in rate base, where it earns a rate of return.