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Rate-Case Mania: Lessons for a New Generation

Fortnightly Magazine - February 2006

under COSR, the more money it made. The commission did not have its own independent information about the utility’s costs, so it could not verify if the AC and MC curves were genuine or inflated. To deal with this informational asymmetry between the regulator and the utility, economists created the principal/agent model of decision making in the 1980s. 1

In this model, regulatory mechanisms had to be designed that would induce the utility to produce the optimal amount of electricity (Q2 in the figure) using the optimal amounts of inputs such as capital, fuel, and labor without requiring the regulator to know the quantities of outputs and inputs beforehand. In the end, this process became very time-consuming and expensive. Utilities and commissions had to hire staffs and give them enormous budgets to prepare and review “rate cases.”

Public-Hearing Fallout

Since it was not uncommon to hold extensive and contested public hearings on the rate cases that often ran into several years, a phenomenon known as “regulatory lag” came into being. During times of declining average-cost curves, the regulatory lag worked in the utility’s favor. In addition, cost-of-service regulation gave the electric utility an incentive to artificially inflate the rate base, since that was the key to higher earnings. However, during times of rising costs, such as the decades of the 1970s and beyond, the regulatory lag worked against the utility. As electric prices rose to unprecedented levels in much of the globe, caused by higher inflation rates and rising oil prices, regulatory commissions adopted a practice of disallowing large portions of utility costs in what were termed “prudence reviews.” This caused further problems for the utilities and did little to slow the rate of growth in electric rates. Customers continued to complain about rate hikes causing a problem known as “rate shock.”

Over time, it became evident that the generation of electricity was no longer characterized by declining average costs. New generation technologies increasingly were cost-effective and the economies of scale that had long characterized power generation no longer were visible. So, to lower electric rates, governments in most countries made a decision to stop regulating the generation of electricity on a cost-of-service basis and to allow competitive suppliers to enter the business. If enough new suppliers enter the market, they would create competitive market conditions and ensure that prices are based on marginal costs, the first-best solution in any market.

In such a market, the key issue becomes one of monitoring market power and ensuring that suppliers are not colluding to charge high prices. In other words, the emphasis shifts from cost-based pricing to market-based pricing with regulatory oversight to prevent collusion between suppliers.

A key feature of well-designed competitive-power markets is a provision for customers to reduce their demand for electricity in response to higher prices. This demand response is a crucial ingredient of success. It simultaneously helps mitigate the market power of generators by lowering prices in wholesale markets and helps reduce peak load, diminishing the need for expensive peaking capacity and lowering revenue requirements.

In the transmission and