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We show that regulators' price-setting, rate base, and allowed rate of return decisions are inextricably linked if prices are set so that regulated firms just break even whenever they are forced to invest. Breaking even ex ante is a necessary condition for Ramsey pricing to be sustainable over time. Unless regulators adopt traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the approach to price-setting described by Marshall et al. (1981) [Marshall, William J., Yawitz, Jess B., Greenberg, Edward, 1981. Optimal regulation under uncertainty. Journal of Finance 36 (4), 909–921]. In particular, the practice of ‘optimizing’ inefficient assets out of the regulated firm's rate base, as occurs in total element long-run incremental cost calculations in telecommunications, exposes the firm to demand risk. The firm requires an economically significant premium for bearing this risk, and this premium is a function of both the systematic and unsystematic risk of demand shocks. In addition, we argue that if the firm is to break even under incentive regulation then the level of the rate base will exceed the optimized replacement cost by an amount which we interpret as the value of the excess capacity of the firm's assets. If this component is excluded from the rate base, incentive regulation will not be sustainable.

A regulator needs to make three decisions when setting the prices which a regulated utility may charge. It needs to choose the appropriate cost of the firm's assets (the rate base), the rate of return the firm is allowed to earn on this rate base, and the prices the firm is allowed to charge. Marshall et al. (1981) show how the last two decisions are inter-related. However, because they focus on traditional rate of return regulation, they do not discuss the effect of the choice of rate base. Nor do they consider the implications of irreversible investment, which characterizes most industries subject to price regulation.1 In this paper we show that the choice of rate base can have a crucial impact on the other two decisions, and that the reason for this is the irreversibility of investment. In particular, we demonstrate that the regulator's choice of rate base and the form of regulation impact on the risks which the regulated firm faces, and thus on the rate of return it should be allowed to earn. The Ramsey-pricing process for regulating a natural monopoly firm is, in a static setting, second-best welfare optimal in that it maximizes welfare subject to a zero profit constraint. We show how to implement the zero profit condition in a dynamic setting where the regulated firm is forced to make irreversible investments in order to meet demand. If welfare is to be maximized and the firm is to be financially viable in the long run, then the firm must just be able to cover the anticipated cost of worthwhile investments on a forward-looking basis.2 We find, for a variety of forms of regulation, the rate of return that achieves this goal: our approach admits a mixture of markets supplied and products offered by the regulated firm. The way in which the zero profit condition is implemented is determined in large part by the regulator's choice of rate base, and this choice will affect the sharing of risk between consumers and producers, and thereby the overall level of welfare.3 There are two widely applied rate bases. Traditional rate of return regulation uses the depreciated historical installation cost of existing assets as the rate base. When combined with forecast operating expenditure, this yields the revenue requirement that, along with forecast demand, is used to set prices.4 The historical cost rate base continues to be used in some situations, including elements of the electricity transmission system in the US. Historical cost rate of return regulation was widely used until the 1980s when it was gradually replaced with incentive regulation, where prices are set in ways that seek to mimic competitive markets. A common approach is to periodically set prices using a rate base that is calculated using the least cost bundle of assets required to service existing customers, known as optimized replacement cost (ORC).5Newbery (1999, Chapter 7) argues that in telecommunications, where ORC is the total element long-run incremental cost (TELRIC) of a service, use of an ORC rate base will yield price paths that approximate, as well as is possible, those of competitive markets.6 The TELRIC approach in telecommunications has been applied widely in the UK and the US, and is recommended by the European Commission (Newbery, 1999, p. 339). We introduce a new rate base, optimized deprival value (ODV), that measures the cost to the firm if it is deprived of its assets. ODV exceeds ORC by an amount equal to the present value of expected cost savings resulting from the firm's ‘excess’ capacity. Our work suggests that use of ODV is necessary if the firm's allowed revenue is to be determined solely by the cost structure of a hypothetical efficient replacement firm; that is, the rate base should be ODV, and not ORC, in order for incentive regulation to be credibly implemented. The revenue which the regulated firm requires if it is to break even equals the sum of expected operating costs, expected economic depreciation and a reasonable rate of return earned on the rate base. We show that if the regulator imposes a historical cost rate base, then the only risk that the firm must bear is the risk that demand and operating cost experience shocks after the price-setting process is complete (and before prices are reset in the future). If, instead, the regulator adopts ORC or ODV as the rate base, then the firm is also exposed to the risk of capital price shocks and, because fluctuations in demand affect the capacity of the (hypothetical) assets on which the optimization calculation is based, to the risk of future demand shocks at the time prices are reset. Despite the fact that our analysis is performed with the Capital Asset Pricing Model (CAPM) as our valuation model, the irreversible nature of investment means that unsystematic demand risk, as well as its systematic counterpart, affects the required rate of return when the rate base is subject to optimization. In fact, greater unsystematic risk compounds the impact of the systematic component of demand risk. For example, the firm's ORC falls if demand falls, since falling demand means that even more units of capacity are under-utilized. In contrast, rising demand only raises replacement cost to the point where all existing assets are fully utilized; larger increases have no further impact. This asymmetry means that increased unsystematic demand risk, which (by definition) has no effect on the covariance of demand with market returns, increases the covariance between the firm's ORC and market returns. This, in turn, raises the systematic risk of the firm's cash flows. Using simulations, we show that the effect on the firm's allowed rate of return is economically significant for reasonable parameter values. Rate of return regulation is most plausible where entry is prevented and technologies are changing slowly, whereas incentive regulation more readily allows price regulation to co-exist with some entry and decentralized decisions about investment. Recently, incentive regulation has been preferred over rate of return regulation because, to an extent that depends on the particulars of the regime, it removes the link between prices and firm-specific costs and profits, thereby providing incentives for firms to behave efficiently.7 The widespread adoption of incentive regulation renders it extremely important that its implementation does actually promote efficiency over other forms of regulation. The effect on investment is particularly important through its effect on dynamic efficiency.8 Our model addresses the dynamic efficiency over time issue discussed by Littlechild (2003, pp. 304–306). We show that if the firm is forced to supply and is expected to break-even on new investment, then the rate base should equal ODV.9 Drawing on the analysis of TELRIC of Mandy and Sharkey (2003), Littlechild (2003) argues that the use of ORC shifts the risk of forecast errors to the regulated firm and raises its cost of capital because it is impossible to predict with accuracy the future path of cost, technology, and demand.10 He goes on to say that acceptance of this risk by the firm may improve the prospects of competition because prices are much more stable where the firm takes on the regulatory-price setting risk. Hausmann (1997) uses the option to invest to argue that the use of TELRIC to price elements of a network underprices the economic cost of the services provided and will adversely affect investment. Jorde et al. (2000) argue that the common practice of using TELRIC in pricing elements of telecommunications networks that are unbundled by mandate raises the cost of equity of firms that own the networks, and consequently reduces investment in these networks. We set up our model in Section 2 and outline the various regulatory possibilities we consider in the following section. The analysis of Marshall et al. (1981) is adapted for irreversibility and applied to the different regulatory regimes in Section 4. We examine the dependence of demand risk allocation on regulatory policy in Section 5, where we present some numerical measures of the implications of our analysis. We conclude in Section 6.

We have identified various ways in which regulators can ensure that regulated firms just break even whenever they are forced to make irreversible investments in infrastructure. This condition, which extends Ramsey pricing to a dynamic setting, is necessary if provision of infrastructure is to be sustainable over time. The different approaches vary according to the rate base set by the regulator. One rate base, optimized deprival value (ODV), leads to allowed revenue which is forward-looking—that is, which does not depend on past investment decisions. In contrast, we show that if more traditional rate bases, such as historical cost and optimized replacement cost (ORC), are implemented in a way that treats sunk costs sustainably (that is, in such a way that the firm breaks even when it is forced to invest) then allowed revenue is backward-looking—that is, it depends on past demand (via its dependency on past investment decisions). Our work shows that if incentive regulation is to be sustainable over time then the rate base should be ODV, which exceeds ORC by an amount equal to the present value of expected cost savings resulting from the firm's ‘excess’ capacity. Further, if firms are to break even on new investments then the allowed rate of return should be sufficient to compensate for the extra risks implied by incentive regulation. Technology shocks are especially important since they can affect both capital prices and demand. For both ODV and ORC rate bases, the firm must be compensated for anticipated changes in technology through an allowance for expected economic depreciation; it must be compensated, ex ante, for unanticipated changes through the allowed rate of return. Systematic risk may be increased by the introduction of specific unsystematic risks because of the truncation resulting from irreversibility and the requirement to supply. Not using this rate base specification or allowing for these risks will incorrectly compensate the firm for its investment and thereby adversely affect investment and dynamic efficiency.24 There are two sets of measurement issues suggested by our analysis. The first is that it is not sufficient to draw comparator firms from the same industry where benchmark comparisons are made in the process of setting regulatory parameters—they must also be subject to the same regulatory environment. For example, European and US firms' rates of return under regulation, even if drawn from the same industry, will likely differ as a result of different regulatory regimes. The second measurement issue relates to assessing the profitability of regulated industries. Those industries that are subject to rate of return regulation can be expected to have lower ex ante and ex post rates of return than those subject to incentive regulation. Under incentive regulation, the risks of demand and capital price fluctuations are borne by the firm rather than consumers; the reverse is true for rate of return regulation. This difference between the regimes is exacerbated where regulation seeks to enhance competition and thereby introduces further risk to the incumbent's business. Although it is a policy issue for the firm and regulators, and a topic deserving further research, we have not investigated the decision to invest in advance of demand. Where there are economies to be achieved by investing in asset configurations for which capacity is not expected to be attained until some future date, such investment may be economically desirable. We conjecture that use of the ODV rate base would allow the firm to just break even if it could include in its ODV assets that are installed in anticipation of demand. These assets would be assigned a value equal to the potential cost savings that they implied, leaving the firm the cost saving as inducement for efficient investment prior to demand; assets for which there is no prospective use would have no future cost savings, and hence contribute nothing to ODV. The allowance of future cost savings associated with the calculated ODV is critical to specifying the rate base that allows the expected recovery of investment, and it has a significant speculative component that the regulator will generally want to assess. In this respect, and in the verification of ODV more generally, these sorts of incentive regimes may require detailed monitoring and regulator-decision-making that approach those of rate of return regulation.