Incentive regulation is not a cure-all for the continuing controversy over return on equity.
Dr. Jonathan Lesser is president of New England Economics Group.
Regulated utilities are all too familiar with the contentious disputes that surround how the allowed return on equity (ROE) is set in a traditional cost-of-service setting. These disputes, which are reappearing as numerous utility rate-stabilization plans signed as part of deregulation come to an end, are likely to hinge, as always, on the riskiness of utility operating environments.
Moreover, there will likely be the usual disputes surrounding appropriate empirical methods (e.g., discounted cash flow, capital asset pricing model, etc.), the assumptions that underlie those methods (e.g., earnings growth rates, risk premiums, etc.), and appropriate capital structures that balance the lower cost of debt with the higher financial risk of greater leverage. Incentive regulation has sometimes been regarded as a cure-all for these ROE woes, meaning the controversy over what ought to be the utility's ROE will go away. Not hardly.