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


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

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

Fortnightly Magazine - July 2006

In places that have restructured, the “duty to serve” principle of regulation has mostly morphed into a “duty to protect” smallish retail customers. Transition plans have become semi-permanent. With these changes, plus an increasing need to invest in generation and transmission, traditional rate base, also known as cost-of-service regulation, has re-emerged.

This may be reasonable to vertically integrated energy utilities, but applying the traditional rate-base concept to the new hybrid companies—built around retail-service providers and wholesale competitive markets—is where the gap between the old and the new regulatory paradigms resembles a deep schism.

For example, rate base does not apply to newly formed retail energy service providers that do not own any generation but may or may not own pipes and wires. Similarly, wholesale energy marketers or traders frequently do not own anything akin to a rate base. State and federal regulators recently have been called upon to set just and reasonable earnings for entities that are in the energy commodity business virtually without rate base.

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A more fundamental matter is whether regulation is even necessary for these new entities. In competitive markets, the forces of supply and demand control retail and wholesale margins or mark-ups. In the mixed regulatory competitive-hybrid approach, regulators often seek to establish just and reasonable profit or earnings margins using traditional cost-based rate-making principles.

Initial approaches often have attempted to find a balance sheet or rate-base proxy. The guiding premises are that: (1) “cost of service” establishes “just-and-reasonable” rates; and (2) rate base is the cornerstone of cost-of-service ratemaking. The applicability of these premises is questionable, as is the narrow thinking that supports these causal links.

Just as the fair-value concept of ratemaking enunciated in Smyth v. Ames was replaced by original-cost ratemaking by Federal Power Commission v. Hope Natural Gas ,and modified by its progeny, one should remember that the concepts first discussed in the Smyth decision never were abandoned. They simply were embodied in other aspects of regulatory decisions. The current shifts in regulation should cause regulators to revisit and reconsider the fair-value concepts that once reigned supreme in ratemaking. To be sure, this process already is underway.

Regulation Post Smyth v. Ames

In the United States, transportation and utility regulation initially were guided by the dictum in the U.S. Supreme Court’s decision in Smyth v. Ames , which established the requirement that regulation should seek and adhere to a “fair return” or “fair value.” In  Smyth, the court was called upon to decide the constitutionality of a Nebraska statute that established maximum rates for intra-state railroad transportation within that state. Finding that the rates established by the Nebraska study would in many instances result in the railroads being forced to operate their local transportation business at a loss, the court found that the statute violated the 14th Amendment, amounting