Regulators today must define earnings for energy retailers virtually bereft of fixed assets.
Charles Cicchetti is a co-founder of the Pacific Economics Group. Colin Long has co-authored numerous articles with Cichetti. Contact Cicchetti at firstname.lastname@example.org.
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. Stateand federalregulators recently have been called upon to set just and reasonable earnings for entities that are in the energy commodity business virtually without rate base.
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. Ameswas 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 to “the taking of private property for public use without just compensation.”
The court further stated that in ascertaining what would constitute just compensation, the interests of both shareholders and consumers must be considered. This balancing cannot be accomplished, according to the court, without considering the “fair value of the property used for the public, or the fair value of the services rendered.” Thus, the “basis of all calculations as to the reasonableness of the rates to be charged … must be the fair value of the property being used by it for the convenience of the public.”
The key aspect of this decision is that a company is entitled to a fair return on the value of the property employed for the public convenience, and the public is entitled to demand that it pay no more than the reasonable worth of the services received. Smyth established a “law of the land” whereby “value” and its equivalent “fair value” formed the cornerstone of utility, pipeline, telecommunication, and transportation rate-making. Thus, Smyth created a rather elaborate approach for establishing fair returns based on value, one whose basic concepts remain embedded in modern day cost-of-service regulation.
While the standard of “fair value” was worthy, most practitioners and courts in the United States eventually found the standard to be ambiguous and confusing in practice. Modern regulation in the United States is the result of various Supreme Court decisions in the 1920s through the 1940s that have interpreted and revised Smyth. During that regulatory era, vigorous debates were waged by those who favored fair value, replacement (or reproduction) cost, and original cost.
Regulation Post Federal Power Commission v. Hope Natural Gas
The Hope case represented a paradigm shift of major proportion in utility regulation. In that case, the Supreme Court found that the “end result” of a myriad of factors and judgment should be used to establish regulated tariffs and authorized returns. Hope diluted the Smyth decision’s conceptual standard of value and left regulators to consider a combination of many factors, most of which were initially non-uniform. The Hope decision left something of a conceptual void, which the various legal and regulatory findings that followed attempted to fill. Many regulators, including the present-day Federal Energy Regulatory Commission (FERC) and its Federal Power Commission predecessors, began to search for a conceptual anchor to secure the judgments they made to alter, tweak, and adjust the formulas and accounting data used in rate-making. Into this void, original-cost rate base emerged as that anchor for most regulators. Rate base is an accounting tool to measure what was prudently invested, less depreciation. It is based on standards dictated by regulators, not tax collectors or financial reporting.
Although the concepts and purposes supporting the fair value concept remain valid, practitioners sought and eventually replaced Smyth’s vague fair-value standard with a more precise, albeit not necessarily more accurate, surrogate. That surrogate came to be called “prudent investment” and “original cost-of-service,” with the inherent benefit of being somewhat easier to quantify with a reasonable degree of objectivity than “fair value.” While relatively easy to measure, the weakness in the “prudent investment” or “original cost-of-service” standard is that these “costs” may not always equate to “value.” Consequently, returns based on costs may sometimes provide little or no incentive for efficiency and may, under some conditions, produce hopelessly disastrous business and economic outcomes.
The original cost-of-service approach to utility regulation was ushered in over Justice Robert Jackson’s dissent in the Hope case. Jackson argued that it was ill-advised to apply the concept of a prudent investment to set the price of a commodity such as natural gas. He asserted that the prudent-investment theory had relative merit in setting rates for a utility that creates its service through its investment. Thus, Jackson thought the prudent-investment theory could be applied to transportation services that consumers receive from common carriers. Customers receive a service provided by the carrier’s property, but do not take or receive any of the carrier’s property. Thus, Jackson saw merit in applying the prudent-investment standard to the value of service provided by natural-gas pipelines, which essentially provide a transportation service.
However, Jackson found lacking the merits of applying original or prudent-investments principles in setting the price of the natural gas itself. He argued that attempting to set a rate base for the commodity was elusive. It was easier and more logical to set the price of the commodity based on its value. Jackson argued that the prudent–investment theory “has no rational application where there is no such relationship between investment and capacity to serve. There is no such relationship between investment and amount of gas produced.” The value of the service provided is measured by what is taken from the ground, not by what is invested to get the gas from the ground. As Jackson colorfully put it, “There is little more relation between the investment and the results than in a game of poker.” In a prescient statement, Jackson wrote that “we must fit our legal principle to the economy of the industry and not try to fit the industry to our books.”
Nevertheless, the majority in Hope adopted a standard whereby the result was important, not the means by which the result was obtained. The majority ruled that “the fact that the method employed to reach that result may contain infirmities is not then important” and that it is not “important in this case to determine the various permissible ways in which any rate base on which the return is computed might be arrived at.” In his dissent, Jackson argued that regulating unique businesses required new approaches that required adopting “concepts of ‘just and reasonable’ rates and practices and of the ‘public interest’ that will take account of the peculiarities of the business.”
Over the decades following the Hope decision, regulation mostly evolved into new, somewhat formula-driven regulation, in which rate base and empirical estimates of return on equity became paramount. Some jurisdictions have adopted very prescriptive and narrow approaches. Others were willing to review a broader array of measurements and concepts. Most regulators interpreted the input as a starting point and engaged in 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 from fair value to rate base is one that represents a regulatory “shift from the realm of the appraisal engineer to the realm of the accountant.”
Further, Bonbright et al. observe that the “value of the property in any definitive sense of the term ‘value’ cannot qualify as an acceptable measure of rate base.”To this, we add the observation: and vice versa.
In a more positive way of explaining what matters here, Bonbright et al. conclude:
For ratemaking purpose, the value of corporate assets must cease to be identified with their market value, or their value in private property to the corporation or to its investors.
Instead, the relevant values must refer to the potential values of the assets as instruments for the performance of service to the community of ratepayers. If these assets were not utterly irreplaceable, their value to the ratepay- ers would be set by whatever rates of charge for service the ratepayers would be willing to pay rather than go without—set, in short, by what the traffic would bear. But if the assets are replaceable, their potential value to the consuming public is limited by their replacement costs.
These choices and reasoning are precisely how tax and other fair-market appraisals conceptually are defined and evaluated. Bonbright et al. observe, in effect, that original-cost rate base, which rejects all the above metrics and concepts, is devoid of any meaningful measure of value. When combined with other factors to establish regulated tariffs, rate base becomes an input to the process, not an end result measure of value since, in effect, there is no rate base that reflects an energy-service provider’s or energy marketer’s true value to retail energy consumers, owners, or society.
Why did rate-base regulation rule for so long? Four factors are most relevant.
• First, in the last century, growth in utility sales meant more energy for people and the economy. Quality of life and economic progress were viewed as important benefits. The engineering focus of energy utilities meant that we could simply “live better” with more electricity.
Jackson’s logic that the benefits provided should be the regulatory focus of how utility returns should be set was adopted implicitly. This was because utility investments expanded energy supplies and use. Consumers and the economy benefited as utility companies invested capital. Utility earnings increased as utilities invested more and the amount the utilities invested increased and tracked societal benefits to the invested capital. Developing countries over the latter part of the 20th century understand that each percentage increase in electricity investment/output will be matched to a 1 percent growth in GDP and national quality of life and economic benefits.
• Second, vertically integrated, traditional utility companies are capital intensive. One measure of this is that annual sales to total assets, or invested capital, are typically less than 1.0. Another measure is that in the late 1970s and early 1980s, electricity and natural-gas utility companies frequently invested more new capital each year than all other industries combined in the United States. When rate base is no longer the focus of 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 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 energy-service companies based on the value of the services provided to customers.
Two measures of return are given some primacy in retail businesses. These are: “margins on sales” and “margins on cost of goods sold.” The former is based on the full retail purchase price. The second is based on the “cost of goods sold,” which for an energy-services company would include the energy and perhaps the delivery charges for distribution and transmission that would be passed through to the consumer.
Not all retail industries are comparable to energy service companies. Nevertheless, those industries that are comparable can form the basis for establishing return margins for energy service companies.
Initially, two factors seem particularly relevant in determining which industries and companies are comparable to energy service companies: (1) skills and functions; and (2) sales to total assets. The first is a qualitative factor that involves judgment. The second is an often reported financial metric.
Most traditional utilities have a corporate structure centered on engineering skills, financing skills, and building complex capital-intensive vertically integrated utility systems. Competition and restructuring have broken the traditional vertically integrated utility monolith. Choice and market forces establish different prices and risk-related packages. One important result is that “customers” and their “needs” are the focus of these new entities.
The best approach for regulating energy service companies would replace return on investments with an adder-to-sales or margin-on-sales approach. The margin would reflect both return/profit and elements of risk not recovered elsewhere with explicit cost-of-service adders. Consumers expect to pay a mark-up for wholesale/retail sales. Industries such as grocery, department, restaurant, sports, and entertainment are predicated on a retail mark-up. Energy service companies are in the retail customer-service business. Customers have other choices. In competitive markets, if a retailer, regulated or not, is to stay in business, it must recover a profit margin. A margin approach such as the one we propose here would look to margins in other retail-oriented competitive industries to establish a reasonable sales margin for energy service companies.
1. See In the Matter of the Commission’s Inquiry into the Competitive Selection of Electricity Supplier/Standard Offer Service, Order No. 78400, Case No. 8908, Maryland Public Service Commission, 2003 Md. PSC Lexis 5; 224 P.U.R. 4th 185 (April 29, 2003); Formal Case No. 1017. A settlement established a wholesale competitive procurement methodolgy to implement Maryland’s standard offer service (SOS). The settlement approved by the MPSC adopted a per kilowatt-hour of SOS load administrative charge. For example, the residential administrative charge was set at 4 mills (4 cents) per kWh. The administrative charge was broken into four components: (1) a utility return component; (2) an incremental cost component; (3) uncollectibles; and (4) an administrative adjustment component. See also In the Matter of the Development and Designation of Stanard Offer Service in the District of Columbia, Order No. 13268. Public Service Comission of the District of Columbia, Order No. 1017-E-275 (Aug. 19, 2004). The Public Service Commission of the District of Columia (PSCDC) determined the appropriate compo- nents of the administrative charge and a calculation methodology for Potomac Electric Power Co. (PEPCO). PEPCO proposed and the PSCDC approved, a margin component to the administrative charge that was “designed to compensate PEPCO for any regulatory and market risk it assumes as the administrator of SOS.” In approving the margin component, the PSCDC stated, “the margin proposed here by PEPCO is akin to the return on equity that utilities earn in traditional rate cases. Its purpose is to compensate PEPCO for the risks associated with serving as the SOS provider. In contrast, PEPCO’s cash working capital and capital investment costs are direct costs that will increase as a result of PEPCO’s obligation to serve as SOS provider. As such, these costs are incremental in nature and recover- able through SOS rates.” In Enmax Energy Corp., Decision 2006-001 2005 Regulated Rate Tariff non-Energy, (Jan. 13, 2006), the Alberta Energy and Utilities Board approved a non-energy margin of 6 percent on forecasted non-energy charges and an energy margin of 1 percent, for a notional composite margin of about 1.6 percent.
2. See San Diego Gas & Electric Co. v. Sellers of Energy and Ancillary Services Into Markets Operated by the California Independent System Operator and the California Power Exchange, Order of Clarification, 112 FERC ¶61,249 (Sept. 2, 2005) FERC stated that its intent was to “establish a weighted cost of capital return percentage as a substitute for a rate-of-return established by traditional discounted cash flow.” Thus, the commission substituted a 10 percent rate of return for a more traditional rate-of-return percentage calculated with a discounted-cash-flow analysis. This 10 percent return was then to be applied to the company’s long-term investment in plant or cash pre- payments (cash equivalents). In an earlier decision in AEP Power Mar- keting, Inc. et al., Conference on Supply Margin Assessment, Order on Rehearing, 108 FERC ¶61,026 (July 8, 2004), the commission found that in the limited instance of power sales of one week or less, it was “just and reasonable to price sales of power at the applicant’s incremental cost plus a 10 percent adder.” Here, the 10 percent adder was used as a “backstop” if an applicant chose not to propose its own mitigation. The commission concluded that “incremental costs plus 10 percent represents a conservative proxy for a reasonable margin available in a competitive market.” However, in the California refund case, the commission specifically stated that its reference to the AEP case was done to support the 10 percent as a reasonable return percentage. In that case, the 10 percent was applied, as we noted, to long-term investment in plant or cash prepayments, and not to incremental costs as was done in the AEP case.
3. 169 U.S. 466 (1898).
4. 320 U.S. 591 (1944).
5. Volume I, p. 37.
6. Volume I, p. 41.
7. Volume I, p. 41, footnote 51.
8. Bonbright, James C., Albert L. Danielsen, David R. Kamerschen, Principles of Public Utility Rates, Public Utility Reports, Inc., Arlington, Virginia. 1988 (First Printing 1961), p. 217.
9. Bonbright, p. 212.
10. Bonbright, p. 218.
11. Bonbright, pp. 219-220.