Abstract:

“Rate of Return Regulation Revisited”
Stephen Jarvis (The London School of Economics and Political Science) and Karl Dunkle Werner* (U.S. Treasury; affiliation listed for identification purposes only, not speaking in an official role.)

Utility companies recover their capital costs through regulator-approved rates of return on debt and equity. In the US the cost of raising money via bonds or stocks has fallen dramatically in the past 40 years, but utility rates of return have not. Using a comprehensive database of utility rate cases dating back to the 1980s, we estimate that the current average return on equity could be around 0.5–5.5 percentage points higher than various benchmarks and historical relationships would suggest. We discuss possible mechanisms and show that regulated rates of return respond more quickly to increases in market measures of the cost of capital than they do to decreases. We then provide empirical evidence that higher regulated rates of return lead utilities to own more capital. A 1 percentage point rise in the return on equity increases new capital investment by about 5%. Overall we find that consumers may be paying $2–20 billion per year more than they would otherwise if rates of return had fallen in line with capital market trends.

*Denotes presenter