RATE OF RETURN REGULATION

Why we regulate?  Public Interest Theory  Monopoly power & abuses  Improved regulator procedures, greater accountability of regulatory authority, more consumer interest  Example, IL Tollway Authority  Capture Theory  Starts with consumer interest  Ends with firm’s interest  Close ties between regulatory firm and regulating agency  Example, Illinois Power Authority

Economic Theory of Regulation  Stigler (1971), Peltzman (1976)  Groups demand gov’t favors that result in wealth transfers  Gov’t supplies transfers in form of regulation  Gov’t supplies to those most influential: votes, fund, future political favors  Successful groups Greater expected net benefit Concentrated benefits (smaller vs. larger groups)

Economic Theory of Regulation  Stigler (1971), Peltzman (1976)  Win-win Consumers want lower prices Firms want restricted entry  Regulatory authority is simply contract enforcer

Ways to regulate?  Entry  Example, PURPA  Price & Cost Allocation  PLP  Ramsey Pricing  FDC Pricing  Quality/Reliability matters  Assumes TR>TC  Rate-of-Return Regulation

Rate-of-Return Regulation  Costs are reviewed  Unnecessary costs are eliminated  ROR on certain costs determined to be fair  Price is determined  Profit Maximization Problem Subject to Rate-Return Constraint

Problems with ROR Regulation  Allowable Costs  Firm wants to exaggerate costs  Depreciation Expenses  Falls into rate-base and tax bill  Accelerated depreciation vs. straight line depreciation  Incentives for Cost reduction  Failure to seek out least cost solutions  Rate-base Determination  Used and useful, known and measureable, just and reasonable