RoR incentive regulation (3) Flashcards
(18 cards)
Why was rate-of-return regulation developed?
To regulate utilities with fixed networks that require large investments.
Specifies allowed (fair) rate of return on investment
What is the equation for rate-of-return regulation?
check ppt 12
Why do investors need to be compensated?
Otherwise they wouldn’t invest
What are tasks for the regulator when setting RoR regulation?
Decide on allowed returns (set s determine B)
select pi
What are rate hearings?
A court hearing where rates are set for a specific time until next review
How are expenses determined?
Firm can submit evidence of its costs
What are the different ways to determine the rate base?
original cost method
reproduction cost
replacement cost
What do: original cost method,
reproduction cost and replacement cost consist of?
Original cost method - use original cost minus depreciation adjusted for inflation
Reproduction cost - current cost of replacing the plant
Replacement cost - cost to replace capacity with newest technology
What is the effect of s and B being fixed till the next review?
Firms actual return increases if costs decrease
incentive to increase productive efficiency
greater incentive to reduce costs if regulatory lag is longer
What is the Averch-Johnson affect?
allowed rate of return depends on rate base (capital)
regulated firm substitutes capital for other inputs
too much capital causes inefficiently high cost of production
What are some issues with RoR pricing?
weak incentives for productive efficiency as prices are set to cover costs
What are the aims of incentive regulation?
to lower cost, improve quality, innovate and adopt efficient practices.
What are the three mechanisms that aim to create incentives?
Earnings sharing
Price caps
Yardstick regulation
What is earnings sharing?
Firm and consumers share excess earnings from increased efficiency
What are Price caps?
firms set prices subject to a price cap, any cost reduction will increase the firms profit
What are some potential issues with price caps?
Too high - deadweight loss
too low - prices don’t cover costs
cost reductions may decrease quality
How can regulators maintain quality while using price caps?
If they can mandate minimum quality levels, can impose penalties if quality falls below the set level
What is yardstick regulation?
Instead of setting prices based on a firm’s own costs, regulators compare it to similar firms to determine what is fair and efficient.
