Regulatory Finance: Financial Foundations of Rate of Return Regulation.

• Author: Kilpatrick, Henry E., Jr.

By Howard E. Thompson. Boston: Kluwer Academic Publishers, 1991. Pp. xii, 243 . $52.50.

This monograph, which is one in editor Michael A. Crew's "Topics in Regulatory Economics and Policy Series," may be unusual in that the author, Howard E. Thompson, demonstrates a genuine understanding of the nuts and blots of the public utility regulatory process, particularly as it applies to the determination of a regulated utility's "allowed" rate of return. This alone may create a measure of positive economic value, given that the economics literature is replete with treatises on regulatory economics written by those who do not appear to have the foggiest notion of what actually transpires in the regulatory arena.

While the book does include some of the knowledge contained in the author's twenty-five years of research in the field, it is best classified a "survey" book, since it synthesizes existing regulatory finance literature. In the author's words, it is his goal to:

...provide a framework for developing the conceptual and

theoretical as well as empirical bases for rate

of return analysis [p. 212].

He painstakingly derives and critically examines both contemporary and historical rate of return methodologies. These include the more traditional comparable earnings and discounted cash flow (dcf) approaches; and the more modern capital asset pricing model (CAMP), with the closely related arbitrage pricing theory. Also included is a chapter on "valuation of contingent claims" analysis, which as the author admits is not useful for determining the allowed rate of return, but is valuable as tool in an analysis of how the regulatory process itself affects a utility's cost of capital.

While Thompson makes every effort to fairly and rigorously evaluate each methodology, the reader is left with the distinct impression that, given his "druthers," he prefers the dcf approach, as modified to reflect a market-to-book ratio of one. This is the methodology he employs in his own referenced studies. However, he maintains, the use of multiple methodologies combined with expert judgement is an event better approach, particularly for rate of return witnesses. This, he tells us, is because there is no way to ultimately assess which methodology is best. A reader might conclude that his judgement on this issue, while prudent, is entitled to a low rate of return commensurate with its risk.

Thompson...