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A Brief History of Rate Base: Necessary Foundation or Regulatory Misfit?

Regulators today must define earnings for energy retailers virtually bereft of fixed assets.

Fortnightly Magazine - July 2006

to measure, the weakness in the “prudent investment” or “original cost-of-service” standard is that these “costs” may not always equate to “value.” Consequently, returns based on costs may sometimes provide little or no incentive for efficiency and may, under some conditions, produce hopelessly disastrous business and economic outcomes.

The original cost-of-service approach to utility regulation was ushered in over Justice Robert Jackson’s dissent in the Hope case. Jackson argued that it was ill-advised to apply the concept of a prudent investment to set the price of a commodity such as natural gas. He asserted that the prudent-investment theory had relative merit in setting rates for a utility that creates its service through its investment. Thus, Jackson thought the prudent-investment theory could be applied to transportation services that consumers receive from common carriers. Customers receive a service provided by the carrier’s property, but do not take or receive any of the carrier’s property. Thus, Jackson saw merit in applying the prudent-investment standard to the value of service provided by natural-gas pipelines, which essentially provide a transportation service.

However, Jackson found lacking the merits of applying original or prudent-investments principles in setting the price of the natural gas itself. He argued that attempting to set a rate base for the commodity was elusive. It was easier and more logical to set the price of the commodity based on its value. Jackson argued that the prudent–investment theory “has no rational application where there is no such relationship between investment and capacity to serve. There is no such relationship between investment and amount of gas produced.” The value of the service provided is measured by what is taken from the ground, not by what is invested to get the gas from the ground. As Jackson colorfully put it, “There is little more relation between the investment and the results than in a game of poker.” In a prescient statement, Jackson wrote that “we must fit our legal principle to the economy of the industry and not try to fit the industry to our books.”

Nevertheless, the majority in Hope adopted a standard whereby the result was important, not the means by which the result was obtained. The majority ruled that “the fact that the method employed to reach that result may contain infirmities is not then important” and that it is not “important in this case to determine the various permissible ways in which any rate base on which the return is computed might be arrived at.” In his dissent, Jackson argued that regulating unique businesses required new approaches that required adopting “concepts of ‘just and reasonable’ rates and practices and of the ‘public interest’ that will take account of the peculiarities of the business.”

Over the decades following the Hope decision, regulation mostly evolved into new, somewhat formula-driven regulation, in which rate base and empirical estimates of return on equity became paramount. Some jurisdictions have adopted very prescriptive and narrow approaches. Others were willing to review a broader array of measurements and concepts. Most regulators interpreted the input as a starting point and engaged in