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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

other disallowances emerged in the 1980s. Regardless, utility rate increases were ubiquitous. Regulated monopolies could keep their customers. Regardless, higher prices added to the calls for restructuring, unbundling, competition, and choice. Rate base and cost-of-service regulation began to be seen as the problem, not the goal. Imperfect regulation was compared to hybrid models that ushered in competition.

Regulation in a New Competitive Era

Recently, competition, deregulation, and restructuring have emerged in which formerly vertically integrated regulated transportation, telecommunications, and energy utilities have been unbundled, divested, and forced to compete. New forms of service-oriented companies have emerged that lack a traditional utility rate base.

It is into this mix and against this historical background that an energy service company’s relative lack of a meaningful rate base must be reviewed. Since the services provided and value added by energy service companies are not investment related, a strict adherence to an original-cost rate base would and does effectively mean that the services provided by such a company would not be valued reasonably. This, in turn, translates into an undervalued and mostly inadequate return based on invested costs, not the value that is provided to customers or which is, or should be, captured in its inherent value.

The principal concept for regulating these new service-oriented companies should be to reject rate-base regulation. It does not apply. It is an anachronism, one that has failed. One goal that is prompting jurisdictions to restructure is to achieve consumer and economic benefits and to reduce waste and inefficiency. Interestingly, one of Justice Jackson’s stated goals in suggesting that services provided to customers be provided at fair value was to encourage the conservation of scarce natural-gas resources. One way in which these goals can be achieved is for regulators to adopt a new regulatory standard that is tethered to how comparable competitive retail firms assess performance and value.

A New Paradigm

A broad regulatory public-policy purpose is to seek the cost savings of monopoly suppliers while restricting earnings to comparable competitive industries. Accordingly, accounting standards used to establish rate base should be given no more weight than an unregulated business gives to its historic original plant costs. Profits depend upon incremental costs and current revenues, not historic original plant costs.

That said, regulators should replace rate base with a benefit or value provided approach to regulating energy service companies. Rate base is not a complete regulatory standard. It does not even, if called original cost, become a new definition of the old ambiguous “fair value” concept. Regulators need to find the right alternatives to set “fair value” when they confront new issues and new circumstances. The place to look is comparable retail service firms and industries.

It is important to identify other firms and industries that are: (1) comparable financially; (2) have a similar customer service focus; and (3) have much more in common with energy service companies in terms of business and risk than the more traditional or typical investment-in-the-ground utility model. We propose that return margins can provide a reasonable way in which to regulate the newly emerging