[BETA] Fortnightly

It is hard tyo foresee abandoning the discounted cash flow method relied upon so heavily for the past couple of decades.

In the Feb. 15, 2003, edition of , Jonathan Lesser says that regulators need to rethink the traditional discounted cash flow (DCF) method for finding the cost of capital, or "at the very least, regulators should no longer rely solely on the DCF to set allowed returns."

This is an old issue. Lesser may (or may not) be aware that commissions in the United States have been searching for a way to streamline utilities' rate of return investigations for decades, and yet they still generally rely on the DCF method. For practical purposes, this is unlikely to change in the United States, despite the recommendations of those like Dr. Lesser and those before him who have recommended a different path.

The topic of the fair rate of return continues to be a vexing part of utility regulation. No one, anywhere, has yet devised a way to make the process agreeable. Why has the process been so difficult?

It is not possible to assess the adequacy of particular rate of return techniques without looking more broadly at how those techniques fit into the larger regulatory process.

The Current State of the Ratemaking Process

The current ratemaking process is tortuous and often unpleasant, for commissions, utilities and ratepayers. A Mississippi Supreme Court Judge captured a quintessential aspect of the process when he said:

"Utility rate litigation has become sport, a vent for passions. Each contest satiates for the moment, then fuels the appetite for further fight. We shrink from the thought of the season ending." ¹

That was true when this quote was written(1989), and it's true today. It is not, however, the direct consequence of the actions of attorneys, consultants, intervenors, commissioners, or staff that creates this problem. It is the regulatory process that makes it almost inevitable that rate case issues are subject to repeated, increasingly detailed, and costly inquiry. This regulatory framework not only provides a questionable incentive for efficient operation for utilities, it also is expensive. Both of these features create an environment for contentiousness over the issue of rate of return.

Incentives for Efficiency

The current regulatory framework sets efficient utility behavior as its goal but always seems to fail to reach it. Why?

First, the definition of efficiency is elusive. It is difficult for regulators, consultants, accountants, and sometimes the company itself, to distinguish efficient behavior from inefficient. While measures of utility efficiency have been developed (e.g., labor productivity, total factor productivity, number of complaints, etc.), there always will be a large component of utility performance that falls outside of what can be objectively analyzed and measured.

This inability to effectively monitor performance means that hands-on regulators are doomed to steer a course between dangerous rocks and a powerful whirlpool. By steering away from the pure cost-plus contract, where ratepayers face runaway costs, regulators risk being drawn into periodic and sometimes large disallowances that threaten utility financial integrity and ratepayer security.

Second, this failure to have objective