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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

a process to let their judgments, not the metrics, rule.

Regulators in recent decades have made major modifications to the original cost structure. Most were made transparently. Sometimes these deviations were favorable to utility companies. Sometimes these deviations were not so favorable, such as nuclear cost-recovery disallowances, ex post prudence reviews, and used-and-useful cost reductions.

Original-cost rate base could, after all, be measured relatively objectively. Specific disallowances for prudence, used and useful, and cost could be decided and memorialized. Therefore, rate-base measurement was mostly a function of original-cost accounting and depreciation policies that regulators established for rate-setting purposes.

The handy objective accounting way to measure rate base and the formula used for establishing returns are just two of the many variables regulators used to yield revenue requirements and authorized returns. Nevertheless, regulation had a neat and tidy appearance. However, regulatory judgment still ruled and courts were mostly unwilling to address the various pieces or factors considered in isolation that yielded the end result. In addition, regulated authorized earnings were not reported to investors. Investors were interested in actual net income. Reporting actual net income was required and used to explain how well a regulated business performed.

Prior to Hope, regulators needed to juggle several concepts that were inconsistent and, as economist Alfred Kahn points out “distressingly vague, and the court was also vague about how it wanted all of them, along with ‘other matters’, combined into a composite ‘fair value’ figure.”

One objective of Hope was to eliminate vagueness and uncertainty. Kahn explains that Hope may have reduced “vagueness” related to the appropriate conceptual definition and measurement of value. Nevertheless, the invitation to embrace an “end result” test may, according to at least one jaundiced view, introduce new regulatory challenges. Consider, for example, noted economist and economics professor Ben Lewis opined:

As we begin in sheer disgust to move away from the debacle of valuation, we will probably substitute a new form of Roman Holiday—long drawn-out, costly, confusing, expert—contrived presentations, in which the simple directions of the Hope and Bluefield cases are turned into veritable witches’ brews of statistical elaboration and manipulation.

For many, this rather acerbic forecast of regulation post- Hope was prescient. It also may be one of the reasons why traditional regulated industries today mostly are being restructured, and competition expanded.

Rate Base vs. Fair Value

Somewhat lost in this regulatory shift is the fact that rate base and fair (or fair market) value were no longer conceptually similar. The differences were further obscured because some regulators continued to attach the words “fair” or “fair value” to rate base. Regardless, rate base no longer was conceptually close to fair value as that concept was used in condemnation and tax treatments. In the context of evaluation, Bonbright, et al. observed:

In any event, it now seems generally agreed, at least by all experts, that a fair-value measure of rate base is not the same thing as a fair-value standard in taxation, in the law of damages, or in most other legal appraisals.

Bonbright, et al. observed that this shift