Methods of Regulation Rate of return Incentive systems –Rate freeze –Rate bands or ranges...
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Transcript of Methods of Regulation Rate of return Incentive systems –Rate freeze –Rate bands or ranges...
Methods of Regulation
• Rate of return
• Incentive systems– Rate freeze– Rate bands or ranges– Price Caps
Uses of Rate of Return Method
• For regulatory commissions– At the state level, used as the basis for rate
cases: carriers’ requests for a rate increase– At the interstate level, used as the basis for
ratemaking for interstate toll and for access charges
• Within the Bell system– Used as basis for division of revenues
Flow of information
Keep chart of accounts according to Part 32
For Interstate, do ROR for
AT&T “toll pot”/later for access charges
For Intrastate, do ROR for
state commission
Do Jurisdictional Separation
Rate of Return Regulation
• “Cost Plus” regulatory method that covers a carrier’s “revenue requirement”
• Revenue Requirement: the amount of revenue the carrier requires to cover expenses and provide the “allowed return” on “rate base”
• Rate Base: the carrier’s investment in plant and facilities
• Allowed Return: the percentage of earnings approved by the regulator
Issues of concern
• How to determine the rate base?– Valuation method, “used and useful”
• What are allowable expenses?
• How to determine an allowed return?– Cost of Capital method—firm’s capital
structure• Market-determined standard versus comparable
earnings standard
Revenue Requirement Example
• Assume Telco has – $3 million in expenses– Rate base of $50 million– Allowed return of 10%
• Telco’s revenue requirement is calculated:– RR = $3 million + (10% x $50 million)
= $3 million + $5 million = $8 million
Use of Revenue Requirement
• Carriers can set their rates so that the revenue requirement is realized
• For example:– Assume Telco provides local service and state
toll– Assume Telco’s local rates are $10 per month
and their long distance rates are $.15 per minute– Assume Telco has 50,000 local lines and that
callers made 5 million calls
Use of Rev Reqt continued
• Telco has billed:– Local service of 50,000 x $10 x 12 months = $6 million
– Toll service of 5 million calls x $.15 = $750,000
• Telco has a short fall of $1,250,000– Revenue Requirement of $8 million
– Billings of only $6,750,000
• Telco can now raise its rates to generate an additional $1,250,000
The traditional approach
• To get $1,250,000 from local would have to raise local rates by about $2.08 (to $12.08)
50,000 x 12 months x $2.08 = $1,248,000
• To get $1,250,000 from toll would have to raise toll rates by $.25 (to $.40)
5 million calls x $.25 = $1,250,000• The traditional approach has been to raise the
toll rates first---Why???
Logistical issues
• Determination of the allowed return
• Arguments about the “test year”– Historical with adjustments
• Arguments about what is “used and useful”
• Problems with “regulatory lag”
ROR and access charges
• To deal with regulatory lag, access charges were based on forecasted costs and demand
• Rates were set prospectively; adjustments were made after the fact
The basic approach
• A = Forecasted rate base
• B = Forecasted expenses
• C = Allowed rate of return
• D = Forecasted demand
• Forecasted RRQ = B + (A x C)
• Price = RRQ/D
An example
• Telco forecasts the following– Rate base of $200 million– Expenses of $30 million– Allowed return of 10%– Demand of 100 million minutes
• So,– Forecasted RRQ = $30 M + (10% x $200 M)= $50 M
– Price = $50 Million/100 million minutes = $.50
True-up after the fact
• Assume Telco’s actuals were:– Rate base of $190 Million– Expenses of $35 Million– Demand of 110 million minutes
• Then,– Actual revenue was 110M minutes x $.50 = $55M
– Actual earnings were ($55M-$35M)/$190M= 10.5%
– Telco over-earned
Problems with the ROR method?
• Leads to “gold plating”
• Lack of incentive to be efficient
• Lack of incentive to be innovative
Price Caps
• Regulate price movement, instead of cost• Attempt to control cross subsidization by creating
baskets of services– Regulate how prices move within a basket
• In theory, was to create incentive to be innovative and efficient by not controlling earnings– Did continue to monitor earnings, however
– Created a sharing mechanism
Price Cap Approach
• Use of Indexing
• What are indexes and how do they work?
• Example: Consumer Price Index (CPI)– Market basket of consumer goods– Price monitored over a period of time
Consumer price index example
• Year 1: market basket costs $25– Initialize the index at 100%
• Year 2: market basket costs $25.50– The index is 102% from Year 1
• Year 3: market basket costs $26.55– The index is 104% from Year 2– The index is 106.2% from Year 1
Price Cap Process
• First Step is the calculation of Price Cap Index (PCI)– PCI = an index of changes in inflation, carrier
productivity and any changes beyond the carrier’s control
– PCInew = PCIlast yr+ change in GNP-PI – productivity offset + (increase of decrease caused by cost changes)
PCI example
• Assume the following:– Last year’s PCI was 101%– The change in the Gross National Product-
Producer Price Index since last year was +5%– The productivity offset is 3%– There are no pertinent cost changes
• PCInew= 101% + 5% - 3% = 103%
The next step
• Calculating the Actual Price Index (API)
• API = index of proposed prices weighted by base period demand and pricing
• API cannot be greater than the PCI
How do you calculate the API?
• Refer to the handout provided in class– This is just to complicated to do on a slide
Effects of Price Caps
• Expedited tariff filing period• Return to historical demand data• Continued reliance on cap on earnings, at
least for awhile; but carriers did get to keep more of their earnings
• Shifted the discussion away from cost—to demand
• Got away from a purely cost plus approach