Commission Watch

Incentive regulation is not a cure-all for the continuing controversy over return on equity.

Regulated utilities are all too familiar with the contentious disputes that surround how the allowed return on equity (ROE) is set in a traditional cost-of-service setting. These disputes, which are reappearing as numerous utility rate-stabilization plans signed as part of deregulation come to an end, are likely to hinge, as always, on the riskiness of utility operating environments.

Moreover, there will likely be the usual disputes surrounding appropriate empirical methods (e.g., discounted cash flow, capital asset pricing model, etc.), the assumptions that underlie those methods (e.g., earnings growth rates, risk premiums, etc.), and appropriate capital structures that balance the lower cost of debt with the higher financial risk of greater leverage. Incentive regulation has sometimes been regarded as a cure-all for these ROE woes, meaning the controversy over what ought to be the utility's ROE will go away. Not hardly.

Within the context of any incentive regulation scheme, establishing an initial, or baseline, allowed ROE is still critical. What changes, however, is how that initial ROE value is used. For example, in a typical price-cap system, a utility's ROE may not be set explicitly. Instead, once the price cap is established, ¹ the utility is free to earn as much as possible as long as it maintains prescribed operational and service-quality attributes. But in establishing the price cap itself, a baseline ROE must be defined as part of the utility's cost of service. The question is, how should this initial ROE value be set: Should it be higher, lower, or the same as a correctly set ROE under cost-of-service regulation? The answer depends on a number of factors, all of which boil down to the risk a utility faces under an incentive regulation scheme vis-à-vis a traditional cost-of-service regime. ²

Risk Comparable to What?

Since the Supreme Court's 1923 decision in , later affirmed in the court's 1944 decision, the basis for establishing ROE has been "corresponding risk." The court in wanted to know whether the return established was equivalent to other firms having corresponding, or comparable, risk to the utility. Although the analytical tools used to determine comparable returns have mushroomed in the 60 years since (as have the controversies surrounding those methods), ³ the basic goal has remained a "just and reasonable" ROE.

Under traditional cost-of-service (COS) regulation, a utility's actual cost of service will be determined, in part, by its allowed ROE. In Figure 1 (see p. 21), this is shown as the dashed horizontal line, with the ROE set to ROE0. The actual ROE can differ, of course, declining if the utility's cost of service is higher than expected and increasing if the cost of service is lower than expected. A utility's cost of service subsequently will be adjusted to re-establish an ROE that is consistent with the expected return of investments having similar risk, even though some regulators have mistakenly interpreted this ROE as an absolute ceiling on return, rather than an expected value. ⁴

Under incentive regulation (IR), like traditional