Risk and Return for Regulated Industries

Bente Villadsen, Michael J. Vilbert, Dan Harris, Lawrence Kolbe

• Publisher: Academic Press
• Year: 2017
• ISBN:
  9780128125885
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

Risk and Return for Regulated Industries provides a much-needed, comprehensive review of how cost of capital risk arises and can be measured, how the special risks regulated industries face affect fair return, and the challenges that regulated industries are likely to face in the future.

Rather than following the trend of broad industry introductions or textbook style reviews of utility finance, it covers the topics of most interest to regulators, regulated companies, regulatory lawyers, and rate-of-return analysts in all countries. Accordingly, the book also includes case studies about various countries and discussions of the lessons international regulatory procedures can offer.

• Presents a unified treatment of the regulatory principles and practices used to assess the required return on capital
• Addresses current practices before exploring the ways methods play out in practice, including irregularities, shortcomings, and concerns for the future
• Focuses on developed economies instead of providing a comprehensive global reviews
• Foreword by Stewart C. Myers

Chapter 1

Motivation

Why a Book Now on the Required Rate of Return?

Abstract

In recent decades, many countries have switched from public to private ownership of large companies in the energy and transportation fields. Private ownership may come with a need for public oversight of the prices the company can charge. The private ownership–public oversight model has long been used in Canada and the United States (US), and well-established legal and administrative procedures in those countries are potential models for newly privatized companies elsewhere. Those models, which focused heavily on the fair rate of return companies required on the capital they invested, were explicitly rejected by the United Kingdom (UK), the pioneer in the privatization movement. Instead, the UK focused on regulating price trends in the belief that explicit analysis of the required return on capital would prove unnecessary. However, this belief proved incorrect. This book examines rate of return principles and associated practices in many countries to serve as an introduction for novices, a reference for the experienced, and a source of insight from the institutions used elsewhere in the world.

Keywords

Natural monopoly; Private ownership; Public ownership

Introduction

In recent decades, many countries have switched from public to private ownership of large companies in the energy and transportation fields. Private ownership may come with a need for public oversight of the prices the company can charge. The private ownership–public oversight model has long been used in Canada and the United States (US), and well-established legal and administrative procedures in those countries are potential models for newly privatized companies elsewhere. Those models, which focused heavily on the fair rate of return companies required on the capital they invested, were explicitly rejected by the United Kingdom (UK), the pioneer in the privatization movement. Instead, the UK focused on regulating price trends in the belief that explicit analysis of the required return on capital would prove unnecessary.

As we will explain in Chapter 2, this belief turned out to be incorrect in that price-trend regulation in the UK did not reliably balance regulated firms' profits with consumer welfare. Today, the fair return on capital must be assessed in countries around the world. The practices vary around the globe with an explicit treatment of inflation by, for example, UK’s Ofgem, while most US regulators ignore the impact of inflation on the capital invested.

The authors and their colleagues at The Brattle Group have participated in numerous regulatory proceedings in a variety of countries and venues. We believe that a unified treatment of the regulatory principles and practices used to assess the required return on capital in different countries will provide useful insights for regulators, regulated companies, regulatory lawyers, and rate of return analysts in all countries. They are the target audience of this book.

However, we do not assume that all members of that audience are equally experienced. For example, some newly appointed (or elected) regulators may not have previous regulatory experience and may come from fields with little direct applicability to regulation. Similarly, attorneys or company employees may be newly hired or assigned to work on regulatory matters. This chapter provides some brief background on why regulation exists and why the fair return is a concern. More generally, the book covers basic principles as well as more technical topics. Our hope is that the book will provide an introduction for novices as well as a reference for the experienced. We also hope that members of the regulatory communities in different countries will find helpful insights for how local procedures might constructively evolve.

Why Regulate Prices in the First Place?

The prices a company charges are sometimes subject to oversight by public regulatory bodies. Some forms of oversight, such as rent control, are based on social priorities. Also, monopoly power may be created by a government (via the grant of a franchise, for example) that may or may not be based on economic considerations. Other forms of regulation are plainly grounded in economics. A major form of regulatory oversight concerns pricing by monopoly providers of public services. While in antitrust contexts regulation focuses on promoting competition and preventing the formation of monopolies, there are certain cases in which monopolies are considered unavoidable or even beneficial. A classic economic reason is “natural monopoly”—a business in which economies of scale always make a single service provider cheaper than two competing providers. In the context of a natural monopoly, the goal of price regulation is to promote efficient investment and service while preventing the economically inefficient exercise of monopoly pricing power.

For example, one set of wires or pipes per street is cheaper than two competing sets for local delivery of electricity, natural gas, or water. This was also true of the telephone service provided via wires to each house. Additionally, for many decades, continuing technological advances meant that newer, bigger electric power plants were always more efficient than older, smaller ones. Regulation of “network” industries, such as electricity transmission grids, railroads, and gas or oil pipelines, can be complicated, particularly once investment has been sunk in an existing network. Parts of such networks may face competition that mitigates or removes the need for regulation, while other parts may remain localized natural monopolies.

The difficulty, of course, is that an unrestrained monopoly is not an overall efficient solution. Although an unrestrained monopolist may use efficient production technology, it is unlikely to pass the efficiency benefits through to customers. Instead, an unrestrained monopolist will inefficiently restrict supply to increase profits, leading to a loss of overall economic benefits to society. A longstanding public policy issue, then, is how to achieve the efficiencies of large scale investment in such industries without the costs of monopoly pricing.

In much of the world, the problems raised by natural monopolies were addressed via public ownership of the affected entities. Public entities continue to be used in North America and elsewhere. Examples include municipal water (and some power or natural gas) systems, provincial power systems, and federal agencies such as the Bonneville Power Administration (BPA) or the Tennessee Valley Authority (TVA), as well as Canadian Crown corporations such as BC Hydro or SaskPower.¹ However, Canada and the US have long made extensive use of an alternative model, wherein privately owned monopoly service providers are overseen by public regulatory bodies. As noted at the outset, the private ownership–public oversight model has expanded dramatically in other countries in recent decades.

Across all nations and jurisdictions, public regulators of privately owned companies are saddled with a number of goals and constraints. These inevitably generate trade-offs. Some goals or constraints stem from the language of the statutes under which regulators operate. For example, rates may be required to be “just and reasonable” and not to be “unduly discriminatory.” Rates typically must balance customer and investor interests.² Court decisions may interpret the statutes and further constrain regulators' freedom to satisfy the competing goals. In such an environment, approaches found legally and politically acceptable tend to persist until a compelling need arises to change them. The resulting inertia can make dealing with change very difficult, particularly when change is rapid.

This book focuses on how to determine an adequate but not excessive return on private investment in regulated industries, which turns out to be a harder problem than is typically recognized in regulatory proceedings.

Why is Determining Reasonable Profits Hard?

Suppose a government has decided to regulate the prices a company can charge because the scale of investment required or the network effects naturally raise the likelihood of monopoly power. It is common to think of regulated companies as having low risk. However, the investments such companies must make to provide service have high, not low, intrinsic risk.

Sinking a liquid asset such as cash into an illiquid, immobile, long-lived asset such as a gas pipeline or electric transmission line is inherently a very risky move. Changes in technology or in patterns of customer demand could render the asset underutilized and therefore unprofitable. Unregulated companies making such investments typically try to shift this risk to their customers in advance by negotiating long-term contracts for service. Those who instead plan to sell spot services from such investments must expect to earn unusually high profits, preferably as soon as possible, to compensate for the risk that the asset eventually will be unprofitable or even unused.

A useful analogy is a building used partly for office space and partly as a hotel. The office space rents under long-term leases. The hotel rents rooms by the night. The rent per square meter is cheaper for the office space, because the lessee has guaranteed that each square meter will earn cash on a defined price trajectory for a fixed number of years. The hotel rooms are at risk of standing empty, particularly when economic times are hard, and room rates may have to be cut to keep them full. Conversely, the hotel can raise its rates when the economy is booming and vacancies are hard to find. Yet office rates on existing leases remain the same as the economy fluctuates. Space in the same building is priced in two very different ways, reflecting the allocation of risks between renters and the landlord.

In most places, society trusts the market to keep hotel rates from going too high on a sustained basis. If the economic boom is expected to continue, more hotels are built. If too many are built or the boom ends, room rates collapse, and money is lost. Yet while the room shortage persists, existing hotels make very high profits. Office space is subject to the same market forces, but the revenues are much less variable. If office space is overbuilt and rates fall sharply on new leases, the ongoing high rates on existing leases cushion the blow.

Market forces cannot do the same job for a privately owned natural monopoly, so regulators must. If voluntary investment is to be forthcoming from a regulated company, the laws and rules governing the prices it will be able to charge must address the high intrinsic risk of such investments. This must be done either by reliably shifting risk to customers or by providing compensation—in the form of higher expected profits—to the investors who bear it. At the same time, there is no point to regulation if it permits monopoly rates of return. Regulators must find an acceptable balance.

Most of the time, striking an appropriate balance involves repeated implementation of established procedures, but the task is no less challenging for its repetition. In the US and Canada, for example, debates over the rate of return the company should be allowed are a major topic in regulatory proceedings. Much of this book deals with the challenge of finding the appropriate return given the regulatory rules in place.

However, occasionally the task becomes dramatically harder, when a “Black Swan” event intrudes. A Black Swan event is one that few, if any saw coming that can raise solvency-threatening risks.³ Several such unexpected shocks have affected US utilities industries in the last 50 years. For example, many US electric utilities faced crises in the 1970s as oil price shocks slowed the growth of electricity demand just as the longstanding truism that bigger electric generating stations were always cheaper ceased to hold true. US natural gas prices were deregulated in, to put it gently, a less than ideal way in the 1980s, which created a crisis for natural gas pipelines. US electric power markets were opened to competition under rules with unforeseen consequences in the late 1990s, leading to the California energy crisis in 2001. Today, breakthroughs in natural gas production (e.g., fracking) are creating major new risks for pipelines designed to deliver gas to locations suddenly awash in it. And a combination of new technologies may create a fresh set of solvency-threatening risks for the electric “wires” business in coming years. Of specific interest is the continued development of distributed generation such as rooftop solar panels, which reduces electric load for electric utilities. Parts of this book address such unforeseen problems.

Plan of the Book

Chapter 2: Legal Foundations and Regulatory Frameworks for a Fair Return

The regulatory system in place in a particular country provides the framework for addressing the high intrinsic risk of large, illiquid investments. Each existing system has a history that both determines how it now operates and reveals the assumptions explicit or implicit in its procedures. Chapter 2 reviews some of the history and structure of existing regulatory systems. It particularly focuses on the US and the UK, since the UK system was explicitly designed to ove...

Table of contents

• Cover image
• Title page
• Table of Contents
• Endorsements Continued From Back Cover
• Copyright
• Foreword
• Acknowledgment
• Dedication
• Disclaimer
• Chapter 1. Motivation: Why a Book Now on the Required Rate of Return?
• Chapter 2. Legal Foundations and Regulatory Frameworks for a Fair Return
• Chapter 3. Financial Asset Pricing Principles
• Chapter 4. The Capital Asset Pricing Model and Variations
• Chapter 5. Discounted Cash Flow Models
• Chapter 6. Multifactor and Other Cost of Capital Estimation Models
• Chapter 7. Effects of Capital Structure on Cost of Capital
• Chapter 8. Approaches to Rate Base Measurement
• Chapter 9. Rate of Return Practices in Use
• Chapter 10. Asymmetric Risk: Theory and Examples
• Chapter 11. Emerging Issues and Implications for Cost of Capital
• Appendix A. Features That Affect Capital Structure
• Appendix B. Further Reading on Approaches to Rate Base Measurement
• Bibliography
• Glossary of Terms
• Index