Regulation us-style

In the USA, utilities such as electricity, gas, water and telecommunications have for the most part always been private companies (although a few are state owned). To prevent the abuse of monopoly power, the utilities are regulated by federal or state governments through regulatory commissions. Unlike in the UK, where prices are regulated according to an “RPI minus X” formula, the prime focus of US regulation is the company’s “rate of return” (i.e. its rate of profit).

The system involves limiting prices to a level which will give a normal rate of profit. In other words, the company will be allowed to charge a price equal to the average cost of production, where average cost includes a “fair rate of return on capital”. The actual calculations are normally done using total revenue and total cost according to the following formula: TR = TVC + K, where TR is the maximum permitted total revenue for that year (known as the “revenue requirement”), TVC is total variable costs (known as “operating expenses”), K is the total replacement cost of capital (known as the “rate base”) and  is the permitted annual rate of return, as a percentage of the rate base.

To give an example: if a firm’s variable costs (TVC) were $4 million, the rate base (K) were $20 million and a normal rate of return () were judged by the regulatory commission to be 10 per cent, then according to the formula, the firm would be permitted to charge a price that would yield a revenue requirement (TR) of:

$4m + 0.1($20m) = $6m.

There has been growing concern in the USA over the effects of using rate-of-return regulation. The argument is that it encourages inefficiency.

First there is the problem of allocative inefficiency. The US system will entail the company setting a price equal to long-run average cost. The socially efficient position, however, is where price equals long-run marginal cost.

Then there is the potentially more serious problem of productive or technical inefficiency (not using factors in the way that maximises output) and X inefficiency (lack of motivation to cut wasteful expenditure and to introduce cost-cutting measures). What is the incentive for a regulated firm to produce at a lower cost? If it introduces new technology or improved working practices that have the effect of increasing profit, the regulator will insist on a lower revenue requirement and hence a lower price. The extra profit will simply be taken away.

In fact, there is an incentive for the firms to let costs rise. The costs of higher salaries and more luxurious offices, for example, can simply be passed on to the consumer in higher prices!

With unregulated monopolies, at least there is pressure from shareholders for the firms to be efficient. There is also competition on the market for corporate control: managers are afraid that if their firm is inefficient, other firms may mount a takeover bid. With the regulated utilities in the USA, however, these pressures are absent. Shareholders have nothing to gain from increased efficiency if profits are not allowed to increase as a result. Also there is no benefit to other firms in mounting a takeover bid. If they were successful, they would merely find themselves the subject of regulation.

Then there is the problem of regulatory lag. In periods of rapidly rising costs, it may take some time before the regulatory commission sanctions a price increase (through a higher revenue requirement). In the meantime the firm may be forced to operate at a loss.