Part Two. Pricing: How Much Can Sellers Charge?and Who Decides?

• Author: Scott Hempling
• Pages: 213-214

213

Setting prices for utility services is time-consuming and contentious. The applicable law

boils down to three simple-sounding phrases. The rst two appear in nearly every regu-

latory statute: Rates must be “just and reasonable,” and they must not grant any “undue

preference or advantage.” The third phrase appears in the U.S. Constitution’s Fifth Amend-

ment: once a utility has spent money to perform an obligatory public service, it is entitled

to “just compensation.”

Empowered and constrained by these phrases, and the hundreds of court opinions

interpreting them, regulatory rate-setters have used two major approaches:

• Cost-based rates and their variants: The regulator sets or caps the price based on

some measure of cost. The permissible cost bases range from “embedded cost”

of sunk investments to long-run incremental cost of future technologies. Rates in

this cost-based category include variants of “performance-based rates” like “price

caps” and “alternative forms of regulation”—concepts that use cost as a starting

point but give the seller some degree of pricing discretion.

•

Market-based rates: The regulator authorizes the seller to set its own prices, subject

to regulatory oversight. That oversight has two components: an advance nding

that the seller has no “market power,” and subsequent monitoring to prevent the

seller from gaining and exploiting market power.

Cost-based and market-based ratemaking have a common purpose: to induce all sellers

to perform cost-effectively. Each method draws from the other. When setting cost-based

rates, regulators look to market prices for benchmark comparisons. When monitoring

market-based rates, regulators compare them to generic costs to see if sellers are pricing

above reasonable costs—evidence of possible market power. And in markets where sellers

PART TWO

Pricing

How Much Can Sellers Charge—

and Who Decides?

ENV Hempling Pub Util Final.indd 213 8/7/13 4:37 PM