The governors of New Jersey and Maryland have embarked on a crusade that could topple competitive energy markets in their states—and perhaps beyond. Glen R. Thomas, former chairman of the...
standards for efficiency is compounded by "information" and/or "agency" problems. It is difficult for outsiders or those without years of experience to evaluate the decisions of utility managers (or to even know what those managers do). Utility managers are likely always to be more informed than regulators or their staffs regarding the company they manage. It is terribly difficult to monitor utility decisions when the information flow is so incomplete or when regulators must rely on utility managers to volunteer information on poor decisions.
Third, and most pertinent to rate of return, objective confirmable standards may never exist to confirm estimates of costs. In the case of rate of return, there is no way of knowing what the true fair rate of return is (or was), even in hindsight. All we ever have is forward-looking rate of return estimates and historical earned returns. This is not so for any other cost category. For example, estimates of depreciable lives can always be updated by experience with actual capital assets. The same is true with estimates of marginal cost-experience will tend to confirm better estimates in the future. But the "true" rate of return is always unverifiable.
Cost of the Process
The second major problem with the current ratemaking process is its cost. Not only does the process serve us poorly, it is very expensive. There have been attempts by the Federal Energy Regulatory Commission (FERC) and the New York Public Service Commission to regularize the rate of return component of rate cases. Both have failed to do so. The Generic Financing Proceeding in New York, conducted in the early 1990s, despite its staggering price tag in professional fees and the loss of productive time for utility and commission employees, failed, as FERC's did before it, to streamline the process.
The Evolution of Rate of Return Analysis
The fair rate of return became a hotly contested issue in the early 1970s, when the electric utility business was undergoing the "triple threat" of unprecedented inflation, rapid fuel price increases, and the end of decades of impressive technical advances in lower-cost generating technology. The DCF and capital asset pricing model (CAPM) methods got their start at this time and have survived nearly unchanged as the primary rate of return methods, with the DCF the virtual default method in practically all U.S. regulatory jurisdictions.
Improvements in the theoretical accuracy, objectivity, and reliability of these methods have come at a snail's pace and generally address only minor issues. For example, more than 20 years ago, arguments raged in rate of return proceedings over whether to use forward-looking, rather than historical, information in the financial models used to calculate the rate of return. 2
A dozen years ago, the argument had progressed to smaller issues (in terms of the potential effect on rate of return) such as the ex-dividend date adjustments and the inclusion into the sustainable growth model of an allowance for the selling of stock at prices above book value.
Meanwhile, every seeming advance in rate of return analysis is followed by a retreat. Historically based "comparable