Rate-of-return regulation

Rate-of-return regulation was used most regularly to determine reasonable prices for goods supplied by utility companies. This regulation is considered fair due to the fact that they give the company the opportunity to recover costs incurred by providing consumers with their goods or services while simultaneously protecting consumers from paying exorbitant prices that would provide these companies with monopolistic profits. Under this method of regulation, government regulators examine the firm's rate base, cost of capital, operating expenses, and overall depreciation in order to estimate the total revenue needed for the firm to fully cover its expenses.

Rate-of-Return regulation was mainly used due to its ability to be sustainable in the long-term and resistant to changes in the company's conditions as well as its popularity among investors. While regulation of this type prevents monopolies with the potential to make large profits from doing so, such as electricity companies, it provides stability. Investors will not make as large dividends off of regulated utility companies; however, they will be able to make fairly constant, substantial returns despite fluctuations in the economy or firm composure. Investor risk is minimized since the regulator's prudence in price setting is constrained by the method used to set the regulation rate. Therefore, investors can depend on consistency, which can be an attractive offer, especially in a volatile world market.

Furthermore, regulation of this sort protects the firm from negative public opinion while providing the consumer with ease of mind. Throughout history, due to their large profits, public opinion has turned against monopolies, which eventually resulted in severe anti-trust laws in the early 20th century. Unregulated monopolies such as Standard Oil that pulled vast profits quickly became the subjects of negative public opinion, the original source of regulation of monopolies. With rate-of-return regulation, consumers can rely on the government to ensure that they are paying fair prices for their electricity and other regulated services, and not feeding into a business of trusts and greed.

The central problem with rate-of-return regulation, the reason most countries with economic regulation have switched to alternate methods of regulating such firms, is that rate-of-return regulation does not provide strong incentives for regulated firms to operate efficiently. The main form of this weakness is the Averch-Johnson effect.

Firms regulated in this manner will engage in disproportionate capital accumulation, which in turn will heighten the price level allotted by the government regulator, raising the firm's short-term profits. By spending on unnecessary capital and other extravagant expenses, the firm's revenue requirement (R) is raised as a result of both an increase in operating expenses (E) and depreciation costs (d). Depreciation costs rise due to the fact that as a firm obtains more capital, that physical capital will depreciate over time, therefore raising the overall depreciation cost. In order to subvert the system, regulated-monopolies can purchase capital they don't necessarily need or use, which will be left in the factory merely to depreciate, thereby raising their regulated price level as allocated by the government.

The right of states to prescribe rates was affirmed in the United States Supreme Court case of Munn v. Illinois of 1877. This case generally allowed states to regulate certain businesses and practices within their borders, including railroads, which had risen to substantial power at the time. This case was one of six that were later dubbed the "Granger Cases", all concerning the proper degree of government regulation on private industry.

While the political sentiment of the early 20th century was increasingly anti-monopoly and anti-trust, government officials recognized the need for some goods and services to be provided by monopolies. In specific cases, a monopolistic economic model is more efficient than a perfectly competitive model. This type of firm is called a "Natural monopoly" due to the fact that the cost-technology of the industry is markedly high, suggesting that it is more effective for only one or a few firms to dominate production. In a monopolistic market, one or several firms can make the large investment necessary, and in turn provide a large enough percentage of the output to cover the costs of their large initial investment. In a competitive market, numerous firms would be required to spend large sums on the necessary capital only to produce a small quantity of output, thereby sacrificing economic efficiency.

The system of rate setting was developed through a series of Supreme Court cases beginning with the Smyth v. Ames case in 1898. In this so-called "Maximum Freight Case", the Supreme Court defined the constitutional limits of governmental power to set railroad utility rates. The Court stated that regulated industries had a right to "fair return." This was later overturned in the Federal Power Commission v. Hope Natural Gas Company case, but it was important to the development of rate-of-return regulation and more generally, to the practice of government regulation of private industry.

As the concept of rate-of-return regulation spread throughout the anti-trust leaning America, the question of "what profit should investors receive?" became the main decisive issue. This was the question the Hope case set out to answer in 1944.

Failing prices in the late 19th century raised the issue of whether profit should be based on the amount the investors originally invested in assets years earlier, or on the lower current asset value resulting from a drop in overall price level. The Hope case settled on a compromise for asset valuation. With respect to debt capital, Hope accepted the original historic cost as reasonable for valuating the debt portion of the asset rate base and allowing the historically agreed upon interest rate as its rate of return. However, with respect to equity capital, Hope determined that the current return value would be acceptable. Therefore, asset valuation was to be calculated by regulators based on a combination of historical cost and current return value.

Rate-of-return regulation was primarily used in the United States to regulate utility companies that provide goods such as electricity, gas, telephone service, water, and television cable to the general public. Despite its relative success in regulating such companies, rate-of-return regulation was gradually replaced in the late 20th century by new, more efficient forms of regulation such as Price-cap regulation and Revenue-cap regulation. Price-cap regulation was developed in the 1980s by British Treasury economist Stephen Littlechild and was gradually incorporated globally into monopoly regulations. Price-cap regulation adjusts firm prices according to a price cap index which reflects the inflation rate in the economy generally, efficiencies a specific firm is able to utilize relative to the average firm in the economy, and the inflation in a firm's output prices relative to the average firm in the economy. Revenue-cap regulation is a similar means of regulating monopolies, except instead of prices being the regulated variable, regulators set revenue limits. These new forms of regulation gradually replaced rate-of-return regulation in the American and global economies. While rate-of-return regulation is very susceptible to the Averch-Johnson effect, new forms of regulation avoid this loophole by using indexes to properly evaluate firm efficiency and use of resources.

• Braeutigam, Ronald E. & Panzar, John C. (1993). "Effects of the Change from Rate-of-Return to Price-Cap Regulation". American Economic Review. 83 (2): 191–198. JSTOR 2117663.
• Jamison, Mark A. "Rate of Return: Regulation". American Economic Review.
• Sharkey, W. (1982). The Theory of Natural Monopoly. Cambridge University Press. ISBN 978-0-521-27194-3.
• Features of Price Cap and Revenue Cap Regulation from the Body of Knowledge on Infrastructure Regulation
• Sherman, Roger (1989). The Regulation of Monopoly. Cambridge University Press.