Rate-of-return Regulation - History of Rate-of-Return Regulation

History of Rate-of-Return Regulation

The right of states to prescribe rates was affirmed in the United States Supreme Court case of Munn v. Illinois of 1877. This case generally allowed states to regulate certain businesses and practices within their borders, including railroads, which had risen to substantial power at the time. This case was one of six that were later dubbed the "Granger Cases", all concerning the proper degree of government regulation on private industry.

While the political sentiment of the early 20th Century was increasingly anti-monopoly and anti-trust, government officials recognized the need for some goods and services to be provided by monopolies. In specific cases, a monopolistic economic model is more efficient than a perfectly competitive model. This type of firm is called a "Natural monopoly" due to the fact that the cost-technology of the industry is markedly high, suggesting that it is more effective for only one or a few firms to dominate production. In a monopolistic market, one or several firms can make the large investment necessary, and in turn provide a large enough percentage of the output to cover the costs of their large initial investment. In a competitive market, numerous firms would be required to spend large sums on the necessary capital only to produce a small quantity of output, thereby sacrificing economic efficiency.

The system of rate setting was developed through a series of Supreme Court cases beginning with the Smyth v. Ames case in 1898. In this so-called "Maximum Freign Case," the Supreme Court defined the constitutional limits of governmental power to set railroad utility rates. The Court stated that regulated industries had a right to "fair return." This was later overturned in the Federal Power Commission v. Hope Natural Gas Company case, but it was important to the development of rate-of-return regulation and more generally, to the practice of government regulation of private industry.

As the concept of rate-of-return regulation spread throughout the anti-trust leaning America, the question of "what profit should investors receive?" became the main decisive issue. This was the question the Hope case set out to answer in 1944.

Failing prices in the late 19th Century raised the issue of whether profit should be based on the amount the investors originally invested in assets years earlier, or on the lower current asset value resulting from a drop in overall price level. The Hope case settled on a compromise for asset valuation. With respect to debt capital, Hope accepted the original historic cost as reasonable for valuating the debt portion of the asset rate base and allowing the historically agreed upon interest rate as its rate of return. However, with respect to equity capital, Hope determined that the current return value would be acceptable. Therefore, asset valuation was to be calculated by regulators based on a combination of historical cost and current return value.

Rate-of-return regulation was primarily used in the United States to regulate utility companies that provide goods such as electricity, gas, telephone service, water, and television cable to the general public. Despite its relative success in regulating such companies, rate-of-return regulation was gradually replaced in the late 20th Century by new, more efficient forms of regulation such as Price-cap regulation and Revenue-cap regulation. Price-cap regulation was developed in the 1980s by British Treasury economist Stephen Littlechild and was gradually incorporated globally into monopoly regulations. Price-cap regulation adjusts firm prices according to a price cap index which reflects the inflation rate in the economy generally, efficiencies a specific firm is able to utilize relative to the average firm in the economy, and the inflation in a firm's output prices relative to the average firm in the economy. Revenue-cap regulation is a similar means of regulating monopolies, except instead of prices being the regulated variable, regulators set revenue limits. These new forms of regulation gradually replaced rate-of-return regulation in the American and global economies. While rate-of-return regulation is very susceptible to the Averch-Johnson effect, new forms of regulation avoid this loophole by using indexes to properly evaluate firm efficiency and use of resources.