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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

regulated service businesses, it cannot serve as a regulatory lynchpin.

The sheer size and importance of a utility company’s prudently invested capital meant that a regulator could attach to the return associated with this rate base all sorts of additions and deletions. These were meant either to encourage good things (such as better performance, replacing older more costly or more polluting technologies, improving customer safety or service, etc.) or to discourage or penalize bad actions (such as cost over-runs, bad choices, or rising consumer complaints).

Regardless, regulators often learned that relatively small refinements to their authorized rate of returns and the frequency of their rate cases could reward or punish a utility because these adjustments, albeit often relatively minor, would be leveraged through the huge rate base that most utility companies carried on their books.

• Third, the most significant single rate-case variable was rate base. When original cost was adopted, the dollars included were matters of record. In a word, they could be measured “objectively.” Issues related to prudence and acquisition premiums existed, but rate base could be measured objectively when original cost became the regulatory standard. Accumulated depreciation, the cost recovery and reduction variable used to determine “net” invested capital or rate base, also was objectively measured because prior rate periods reflected the depreciation taken as operating expenses. Rate-base regulation persisted for decades because it could be determined objectively and rate base remained the largest cost component of regulation.

• Fourth, utility regulation began to change in the 1980s. Consumers and policymakers began to find costs as well as benefits in energy growth. Some fuels were deemed worse than others. Some utility and some regulatory/political mistakes were made. Perhaps the biggest change that led to restructuring in the utility industry was the end of the “benign cycle.” Until the 1970s, the average or unit prices reflected in utility bills generally declined in both nominal and real terms. Technology and scale offset inflation and increasing labor costs. The two oil shocks, double-digit inflation, and extraordinarily high interest rates caused utility rate shock and ended the benign period. Some utilities fared worse than others.

These unhappy events ushered in a comprehensive review of energy companies and their virtual monopoly status. Deregulation in transportation and telecommunication were viewed as creating consumer choice and lower prices for unbundled services. This drew attention to a similar policy of restricting electricity and natural-gas industries. Independent power producers (IPPs) began to emerge and to introduce the concept of selling megawatt-hours as electricity is produced, not as power plants are built. Conservation, global warming, and other environmental concerns grew in importance.

The first regulatory response to all of this often was to tweak rate-base regulation. Some jurisdictions mandated different types of purchases and investments. Some required utility companies, and therefore consumers, to subsidize specific customers that did something deemed beneficial on the customer side of the meter ( e.g., add solar energy, more insulation, etc.).

This tweaking added costs and caused increases in utility prices. Tweaking often yielded to regulatory hammers when prudence, used and useful, and