This section covers the following topics:
For an assessment of the advantages and pitfalls of rate of return regulation, compared to price caps, click here.
Overview of Rate of Return Regulation
Rate of return regulation is a way of regulating the prices charged by a firm. It restricts the amount of profit (return) that the regulated firm can earn. Rate of return regulation has been used extensively to regulate utilities in many countries. It has been used in the United States since public utility regulation began in the early 1900s.
There are two steps to implementing rate of return regulation:
- First, determine the economically appropriate revenue requirement. This is based on prudently incurred expenses and a “fair” return on invested capital, and
- Second, set prices for individual services so revenue earned from all the regulated services is not greater than the revenue requirement.
Calculating the Revenue Requirement
The revenue requirement is generally calculated using the following formula:
Revenue Requirement = Operating Expenses %20 Depreciation %20 Taxes %20 (Net Book Value * Rate of Return)
The rate of return used is the post-tax rate of return the firm is permitted to earn. This is also known as the opportunity cost of investor capital. It is based on a weighted average of the cost of debt and equity financing.
Operating expenses should include only those expenses the firm has prudently incurred to provide the regulated services.
The net book value of the firm’s capital assets should include only those capital assets used by the firm specifically to provide the regulated service. The formula includes an allowance for depreciation, so only the book value of the assets net of depreciation should be included in this amount.
Setting Prices for Regulated Services
The regulator needs to set prices that allow the regulated firm to collect its revenue requirement. This requires that the sum of total expected revenue for each regulated service is no greater than the permitted revenue requirement. This can be expressed mathematically as:
Where Pi and Qi are, respectively, price and quantity of service i and N is the total number of regulated services. RR is the revenue requirement. As the formula shows, in order to calculate prices under rate of return regulation the regulator first needs a reasonable forecast of demand for the regulated services.
For a multiple-service firm, there is an element of discretion in allocating the revenue requirement amongst different services. As a guiding principle, the regulator should ensure that prices of individual services are set at prices that minimize distortion of customer behaviour.
The costs used to determine prices under rate of return regulation are the actual embedded costs of the firm, not forward-looking economic costs.
Under rate of return regulation, the firm can request rate increases if, for whatever reason, it believes revenues are not sufficient to achieve a normal return on invested capital.
RELATED INFORMATION
Why Regulate Prices?
Incentive Regulation
Rate of Return Regulation versus Price Caps
International Benchmarking of Prices