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Regulatory Finance : Financial Foundations of Rate of Return Regulation - Howard E. Thompson

Regulatory Finance

Financial Foundations of Rate of Return Regulation

Hardcover Published: 31st March 1991
ISBN: 9780792391432
Number Of Pages: 243

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This monograph is concerned with the determination of the allowed rate ofreturn in rate cases which, in part, determines the rates ofcharge to customers of public utilities. Rate of return determination has been a central topic in utility regulation for a century. Recent changes in the traditionally regulated markets - electricity, gas, and telephone - have shoved discussion of rate of return determination into the background, replacing it by technology changes, competition, downsizing, deregulation, and reg'ulatory incentive systems. These new issues have made the regula- tory sector, which had the reputation of being stodgy and uninteresting, an exciting field ofstudy. But rate ofreturn is not dead. It will playa key role in whatever the new structure ofthe regulated sector. Separating generation from transmis- sion and distribution will not eliminate the need for rate of return analysis in the electric utility industry. Rather, it may well increase the number of companies for which the rate of return needs to be determined. It will playa fundamental role in the new regulatory environment. Incentive systems in the regulated sector may be the wave of the future but they will use the required rate ofreturn as a benchmark. Rate case will persist. Most rate cases include opposing testimony as to the "fair" rate of return or even the cost ofcapital for a public utility whose rates are at issue.

I The Institutional Setting for Rate of Return Determination.- 1 Rate of Return in Rate Cases: The Institutional Setting.- 1.1 Regulatory Practice: The Rate Case.- 1.2 Regulatory Practice: The Cost of Capital.- 1.3 Regulatory Practice: The Experience.- 2 Earned Rates of Return, Allowed Rates of Return and the Cost of Capital in a Historical Setting.- 2.1 Estimating the Cost of Equity with a Random Coefficients Regression Model.- 2.2 Deficiencies in Equity Returns 1963-1981.- 2.3 The Deficiency Index, Regulatory Climate and the Cost of Capital.- 2.4 Implications for Rate Case Testimony.- II Theory of Rate of Return Determination.- 3 Traditional Models: DCF and Comparable Earnings.- 3.1 The Conceptual Basis for Both Methods.- 3.2 The Value of a Firm with Internal and External Equity Financing.- 3.3 Determining the Allowed Rate of Return with DCF.- 3.4 Determining the Capitalization Rate, p.- 3.5 Determination of the Allowed Rate of Return with Comparable Earnings.- 3.6 Summary.- 4 Traditional Models: CAPM and Risk Analysis.- 4.1 The Investor and the Discount Rate.- 4.2 Growth and Risk.- 4.3 Using the CAPM Rate as a Discount Rate.- 4.4 Using the CAPM in Rate Cases.- 4.5 Summary.- 5 Recent Models: Arbitrage Pricing Theory.- 5.1 The Arbitrage Pricing Theory (APT).- 5.2 The Applicability of APT.- 5.3 More on the Applicability of APT.- 5.4 Some Observations on APT and Rate of Return Determination.- 6 Recent Models: Valuation of Contingent Claims and Regulation.- 6.1 The Brennan-Schwartz Model: Description, Extensions, and Solutions.- 6.2 Effects of Regulation on the Required Rate of Return.- 6.3 Implications of the Contingent Claims Model for Estimating the Cost of Capital.- 7 Issues in the Theory of Rate of Return.- 7.1 "Accurate" Models to Predict the "True" Required Rate of Return.- 7.2 A Theoretical Comparison of the Models.- 7.3 Summary.- III Methodologies for Rate of Return Determination.- 8 Methodology of Comparable Earnings and DCF.- 8.1 Methodological Issues Associated with Comparable Earnings.- 8.2 Methodology for Application of the DCF Model.- 8.3 The Dividend Yield-Growth Approach.- 8.4 The Market-to-Book Ratio-Earnings Approach.- 8.5 Summary.- 9 The Methodology for Risk Analysis.- 9.1 A Straightforward Application of CAPM.- 9.2 Issues in the Calculation of Beta.- 9.3 Issues in the Calculation of E(rm)-rf.- 9.4 Issues in the Calculation of rf.- 9.5 Calculating pin Practice.- 9.6 Summary.- 10 Methodology of Arbitrage Pricing Theory.- 10.1 Methodology for Determining the Number of Factors and Their Impacts.- 10.2 Determining the Identity of the Common Factors and Calculating the Required Rate of Return.- 10.3 Determining the Allowed Rate of Return Using APT.- 10.4 Conclusion on the APT Methodology.- 11 Issues in Methodology for Determining the Rate of Return.- 11.1 Comparison of Methodologies.- 11.2 Combining Methodologies.- 11.3 Some Observations on Methodology for Required Rate of Return Determination.- IV Judgment and Rate of Return Determination.- 12 The Past and the Present: Adapting to Change.- 12.1 A Simple Framework for Analysis of Changes: Application to Dividend-Yield Plus Growth.- 12.2 The Behavior of Other DCF Estimates.- 12.3 The Behavior of CAPM Estimates.- 12.4 The Behavior of APT Estimates.- 12.5 Summary and Conclusion.- 13 Factors Not Incorporated into the Models.- 13.1 Inflation and the Required Rate of Return.- 13.2 Capital Structure and the Required Rate of Return.- 13.3 The Regulatory Setting and the Required Rate of Return.- 13.4 Only Change is Constant.- 14 The Reliability of Rate of Return Judgment.- 14.1 Theory, Statistical Methods, and Reliability.- 14.2 The Prospects for Reliability.- 14.3 The Reliability of Judgments.- 14.4 A Final Comment.- 15 Beyond Rate of Return Regulation.- 15.1 Rate of Return Regulation and Disallowance Decisions by Regulators.- 15.2 Rate of Return Regulation and Economic Incentives.- 15.3 The Impact of Regulation on the Cost of Capital.- References.- List of Symbols.

ISBN: 9780792391432
ISBN-10: 0792391438
Series: Topics in Regulatory Economics and Policy
Audience: Professional
Format: Hardcover
Language: English
Number Of Pages: 243
Published: 31st March 1991
Publisher: Springer
Country of Publication: NL
Dimensions (cm): 23.5 x 15.5  x 2.54
Weight (kg): 1.19

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