Charles Cicchetti is a managing director at Berkeley Research Group.
It is time to examine why regulators should change traditional rate-making regulation. More than sixty years ago, the United States adopted an approach to regulation known as cost-of-service (COS) regulation. The primary regulatory revenue determinant under COS is known as rate base, which is the original amount investor-owned utilities invested, less accumulated depreciation.
Regulated earnings and many of the annual revenue requirements are determined through a mechanism that provides an opportunity for IOUs to recover what is called a return on and of the rate base. Given the formula-driven COS regulation, IOUs do not earn any specific returns on the services they provide.
Utility income and returns depend on rate base and in some states on hybrids such as performance-based regulation or PBR.1 Some states also adjust regulated prices in response to fuel and purchase power costs, as well as deviations between actual and forecasted sales. These do not affect earnings because typically there are no mark-ups on fuel or purchase power.
The historic growth in rate base was tied to generating stations that IOUs built and owned. Some generating units are now being retired for a combination of economic and political reasons. Other utility-owned and operated generating stations are being displaced or replaced with purchases in competitive wholesale markets and purchase power agreements.