6 'Just and Reasonable' Prices in Non-competitive Markets: Cost-Based Rates Set by the Regulator

AuthorScott Hempling
6.A. The rate-setting equations
6.B. What does “just and reasonable” mean?
6.B.1. Statutory purpose: Seller and buyer interests
6.B.2. Constitutional constraint: The Takings Clause
6.B.3. Regulatory discretion under the “just and reasonable” standard
6.B.4. Roles of legislature, commission and court
6.C. Imprudent actions and inactions: Who bears
the cost of inefciency and waste?
6.C.1. Prudence principles
6.C.2. Imprudent actions
6.C.3. Imprudent inaction
6.C.4. Defense against disallowance: The “management prerogative”
6.C.5. Burdens of proof on prudence and imprudence
6.C.6. Financial consequences of cost disallowance
6.D. Prudent actions but uneconomic outcomes: Who bears
the cost of bad luck?
6.D.1. Prudence does not guarantee cost recovery
6.D.2. Three points on the risk-assignment spectrum
6.D.3. Four limits on regulatory actions
6.E. Variations on cost bases
6.E.1. Area rates
6.E.2. Price caps
6.E.3. Alternative form of regulation
6.F. Departures from cost bases
6.F.1. Is the departure necessary to carry out a statutory purpose?
6.F.2. How does the rate compare to cost?
6.F.3. Loosening the connection between rate and result
Just and Reasonable” Prices
in Non-competitive Markets
Cost-Based Rates Set by the Regulator
ENV Hempling Pub Util Final.indd 215 8/7/13 4:37 PM
The corporation may not be required to use its property for the benet of the public with-
out receiving just compensation for the services rendered by it. How such compensation
may be ascertained, and what are the necessary elements in such an inquiry, will always
be an embarrassing question.1
Without competitors, an unregulated utility could raise prices at will, restrained only by its
customers’ readiness to reduce consumption. To prevent this abuse, statutes direct regulators
to set rates that are “just and reasonable.” In this no-competition context, regulators base
rates on some measure of “cost.” The law places on regulators a dual obligation: to protect
the consumer from unreasonable costs, and to provide the utility a reasonable opportu-
nity to earn a fair return. These obligations are the subject of this chapter. They apply to
both state and federal regulators—to any commission engaged in cost-based ratemaking.
The phrase “cost-based rates” can confuse newcomers because there are different types
of “costs” and different types of “bases.” The phrase refers to rates set by the regulator
based on some measure of costs. Contrast the phrase “market-based rates” (the subject
of Chapter 7), which refers to rates set by the seller and disciplined by competitive forces.
More specically, the phrase “cost-based rates” is usually shorthand for “embedded cost
rates”: rates based on costs that a specic utility has actually incurred or expects to incur—
including both xed costs (e.g., generators, pipelines, pumps, land, headquarters building
and vehicles) and variable costs (e.g., fuel, labor and taxes). But as this chapter will dis-
cuss, “embedded cost” is not the only path to “cost-based” rates. We will encounter “area
rates,” “rate caps,” “performance-based rates,” and FCC-mandated wholesale rates based
on “total element long-run incremental cost” (TELRIC). Each variant has some connection
to some type of “cost,” and each has satised the statutory test of “just and reasonable.2
To explain the legal principles and their applications to the “cost-based” variations, this
Chapter covers the following topics:
(a) The rate-setting equations for embedded cost rates
What does “just and reasonable” mean? Statutory purpose and constitutional limit
(c) Imprudent actions and inactions: Who bears the costs of inefciency and waste?
(d) Prudent actions but uneconomic outcomes: Who bears the costs of bad luck?
1. Smyth v. Ames, 169 U.S. 466, 546 (1898).
2. For a peerless discussion of ratemaking from an economic perspective, see the rst volume of A
K, T E  R: P  I (1970, 1988). Every page is
worth the reader’s attention. For this author’s eulogy of Alfred Kahn, see http://www.scotthemplinglaw.
Chapter Six216
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(e) Variations on costs and their bases
(f) Departures from cost bases
6.A. The rate-setting equations
The most common method for setting cost-based rates is utility-specic ratemaking, known
variously as “rate of return regulation,“rate base regulation,” “embedded cost regulation”
or “revenue requirement regulation.” Using data on the utility’s xed and variable costs
(sometimes historic, sometimes predicted, sometimes both), the regulator sets rates calcu-
lated to give the utility a reasonable opportunity to recover its prudent costs and earn a
“fair” return on capital invested. Those calculations are based on assumptions about the
likely number and type of customers and level of sales.
Embedded cost ratemaking uses two simple equations. The rst equation describes the
“annual revenue requirement”: the total dollars the utility must receive during a specied
future year (called a “rate year”) as reasonable compensation for providing obligatory
service. If the utility sells enough service to earn those dollars, it can cover its reasonable
expenses (e.g., operating expenses, taxes and depreciation) and the interest on its debt and
still have enough left for its shareholders to receive a reasonable return on their invest-
ment. Here is the equation:
Annual revenue requirement = expenses + cost of capital
expenses include operations and maintenance costs (e.g., labor and fuel), taxes,
and depreciation; and
cost of capital includes (a) interest payments to lenders plus (b) return on shareholder
equity (the latter dened as commission-authorized return on equity multiplied by
total equity).
Terminology note: The phrase “cost of capital,” which refers to the cost of debt plus the
return on equity, is sometimes referred to as “rate of return” multiplied by “rate base.” In
that denition,
• rate of return is the weighted rate of return for debt and equity; and
rate base is the sum of all capital investment, whether funded by debt or equity, less
accumulated depreciation.3
3. An excellent explanation of depreciation and its role in the revenue requirement appears in Louisiana
Public Service Commission v. FCC, 476 U.S. 355, 364–65 (1986):
217“Just and Reasonable” Prices in Non-competitive Markets
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