What it means
Some businesses, like pipes and power lines, are natural monopolies because it makes no sense for several firms to build competing networks. Without competition, nothing stops the owner from charging too much.
Regulators step in to set prices that are fair to both customers and investors. Under rate of return regulation, the regulator first works out the company's rate base, which is the value of the assets used to serve customers, usually the original cost less depreciation.
It then decides an allowed rate of return on that base, based on what investors need to fund the business. The company's revenue requirement is its operating costs plus depreciation plus taxes plus that allowed return.
The system gives investors stability and encourages continued investment in reliable infrastructure. Customers benefit because prices are tied to genuine costs rather than monopoly pricing.
The regulator reviews the numbers in periodic rate cases, in which the company, customer groups and the regulator argue about costs and return. Critics point to a drawback known as gold-plating.
Because the company earns a return on its asset base, it may have an incentive to invest more than is strictly needed, since a larger base means higher allowed profit. This has led some regulators to adopt alternatives, such as price caps that reward cost efficiency.
The nuance is that the allowed return is only a permission, not a guarantee. If the company's costs rise faster than expected or demand falls, its actual return can fall short of the allowed level.
Setting the right return is a matter of judgement, with the regulator weighing the cost of capital against customer bills. The process is built around evidence.
The company must show that its costs were prudently incurred, and the regulator may disallow spending it considers wasteful. Hearings, expert witnesses and public comment make the final decision slow but well documented.
In practice
Real-world examples.
Example
A regional electricity distributor applies for a tariff increase after investing in new substations. The regulator adds the new assets to the rate base and approves a higher revenue requirement. Customers see a modest rise on their bills.
Example
A gas pipeline company argues that its allowed return is too low to attract capital for upgrades. The regulator reviews comparable returns on investments of similar risk and raises the allowed return slightly. The company announces a new investment programme.
Example
A consumer group challenges a water utility's request, claiming that some assets in the rate base are not used to serve customers. The regulator removes those assets, which lowers the revenue requirement. Bills rise by less than the company requested.
Formula
Calculation
Revenue requirement = operating expenses + depreciation + taxes + (rate base x allowed rate of return)
A regulated water utility has a rate base of $200,000,000 and an allowed return of 8%. Its operating expenses are $60,000,000, depreciation is $20,000,000 and taxes are $4,000,000. The allowed return in dollars is 200,000,000 x 0.08 = $16,000,000. The revenue requirement is 60,000,000 + 20,000,000 + 4,000,000 + 16,000,000 = $100,000,000, which sets the total that customer tariffs are designed to collect.Case study
Seen in the real world.
Riverbend Power is an illustrative, fictional electricity utility with a rate base of $500,000,000 and an allowed return of 7.5%, which gives it a permitted profit of $37,500,000 a year. The company planned a $100,000,000 grid upgrade and asked the regulator to include it in the rate base.
The regulator agreed that $80,000,000 of the project was necessary and excluded the remaining $20,000,000 as unnecessary. The rate base rose to $580,000,000, and the allowed profit increased to 580,000,000 x 0.075 = $43,500,000.
The company had won most of what it wanted, but the exclusion showed that spending is checked for prudence. The illustrative lesson is that under rate of return regulation, only investment judged necessary earns a return.
Watch out
Common mistakes.
- Assuming the allowed return is guaranteed profit, when the company's actual return can be higher or lower.
- Ignoring the rate base, which has as much effect on the revenue requirement as the allowed percentage.
- Believing regulated prices are set only on costs, when the regulator also decides the return and which assets count.
Questions
People also ask.
Why is the rate base so important?
Because the return is calculated as a percentage of it, so a larger or smaller base directly changes the profit the company is allowed to earn.
What is gold-plating?
It is the tendency of a regulated firm to over-invest because it earns a return on every dollar added to the asset base.
What are the alternatives?
Price-cap regulation, which limits price increases over time and lets the firm keep any savings it finds, is the most common alternative.
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