Regulation is back in the spotlight. Moody's, the bond rating agency, just issued a review of regulation worldwide, that started with these words: "Prudent regulation key to mitigating risk…" The bond rating agency put its emphasis on mitigating the risk of carbon mitigation but pretty much opened up the relevance to other risks. What about regulation itself as a risk factor, especially when the regulators decided to change policies? American regulators, we know, have begun to re-examine their policies in light of experiments elsewhere designed to encourage utilities to operate more efficiently and then pass on savings to consumers—- most notably the British effort that began in 1990 which failed to radically reduce prices but did line the pockets of the utilities. Whether shifting American regulation to the British model will reduce risk is a big question. Evidence indicates that it won't, but who knows?
What's wrong with American-style regulation? Critics oppose it because it focuses on rate of return. The regulator sets prices calculated to cover all operating costs plus a fair return on the investment in assets dedicated to serving the public. Thus, the American utility has no incentive to reduce costs because it can pass on all costs to customers, and it has every incentive to over- invest because it can earn a guaranteed return on that investment.
Way back in 1962, two economists, Harvey Averch and Leland Johnson, published an article making that case, and policy makers — including the British— have latched onto the Averch-Johnson Effect ever since. But maybe the policy makers missed the point, which economists, incidentally did not. Namely that no sensible managers will invest capital unless they expect that investment to produce a return in excess of its cost.
Financial theory tells us that when a company earns more than its cost of capital, its stock sells above its book value. Successful companies generally earn more than cost of capital, so no big deal. Regulated utilities, though, have given up their right to earn a high return profit in exchange for protection from competition. Regulators, instead, set a fair return, generally defined as cost of capital. Yet, the price of utility stocks in the post war period fell below book value in only 14 of the 71 postwar years. (Twelve of those fourteen years encompassed the nuclear building disaster and the Energy Crisis.) Furthermore, the stocks generally sold substantially above book value. Financial experts agree that utilities should earn more than cost of capital, as a precautionary matter, but how much more?
Perhaps, then, the real issue is not whether rate of return regulation itself encourages expensive over -investment but rather whether regulators set the correct return. As for whether alternative regulatory formulas encourage greater efficiency in operations, studies show that they do, but they also increase the cost of capital.. So, for the alternative system to work for consumers over the long term, the additional operating efficiencies must exceed the increase in cost of capital.
We can understand the desire of policy makers to do something different, but perhaps doing the job they presently have better might be a good start.