(Notes from Energy Law at Duke, 2011.)

In some industries, like electricity production, economies of scale are so large the market can be most efficiently served by one firm, with no competing firms. This is called a natural monopoly. In cases of a natural monopoly in the U.S., a regulating agency (such as the state public utility commission (PUC)) will allow that firm (such as an electric utility company) to operate as a monopoly, but the regulating agency (the PUC) will control the rates that that electric utility may charge.

The PUC must prevent the utility from charging extremely high monopoly rates, while at the same time allowing it to charge enough to operate its power plants and stay in business. How does the regulating agency determine what the electricity rates should be? It uses what's called a "rate base," but for reasons explained below, calculating the rate base is difficult and controversial.

The Rate Base

A firm's rate base is the value of all of its assets. It deploys those assets to produce a (regulated) product, and by producing that product it hopes to earn a high rate of return on its assets (its rate base). We'll be using the example of electric utilities here. An electric utility's rate base is the value of all of its power plants, its electricity infrastructure, its office buildings, its fleet of repair trucks, everything. To stay in business and provide reliable electricity service, it has to maintain all of those things.

To make a simple example, say an electric utility consists of one power plant and nothing else. The value of the power plant is $1,000, and it produces electricity which it sells to customers. It has operating costs of $100 per year, which includes things such as repair costs and fuel costs. To buy f

1 kilowatt (kW). If it runs continuously for a year, then its total production is (1 kW)(24 hours/day)(365 days)=8,760 kWh (kilowatt-hours). It can sell those kilowatt-hours to customers to earn revenue. If it requires $500 per year to buy fuel and operate the power plant it must charge enough to earn at least $10; (8,760 kWh)*($/kWh)=$500, so the rate is ($500)/(8,760 kWh) =$0.06/kWh.

by earning a  Determining a firm's rate base is controversial because it factors into the setting of maximum rates. A firm wants to establish a large base rate, and consumers want a firm to have small rate base. The four fundamental issues of establishing a rate base will be considered in turn.

5.2.1 Method of Valuation

The method of valuation is usually set by the regulatory agency. Four factors to consider (suggested in Smyth vs. Ames) in setting the “fair value” of a rate base are:

  1. the market value of a firm's stocks and bonds
  2. the earning capacity of the property under particular prescribed rates
  3. the original cost of construction, less depreciation
  4. the present cost of replacing the property.

The first two are circular; the market value of a firm and its earning capacity will be determined largely by the rate, which is what we are trying to set in the first place. These first two methods are not used.

Today, most legislatures use original cost, or a combination of original cost and replacement cost in determining a firm's rate base. The firm wants to establish a large rate base in order to justify higher rates, and consumers want to establish a smaller rate base to keep rates low. Each side will argue for using original cost or replacement cost as is beneficial to that side. If original construction took place during a recession and was done cheaply, consumer groups would want to use original cost to establish rate base. But if new technology makes replacement cheap, they would argue for using replacement cost to establish rate base.

Where poor financial records make original costs uncertain, regulators may wish to use replacement cost, which can be estimated. However, if reliable records exist, then original cost may be a better indicator, since it is not an estimate but an actual figure. Recently, many economists support the reproduction cost method.

The depreciated original cost method creates temporal bias due to inflation and depreciation. This method results in valuing an asset at twice its economic value at the beginning of the time period and less than half its economic value 20 years later. Thus, a regulated firm with new assets charges artificially high rates, and one with older assets charges artificially low rates. This leads firms to under-use as asset at the beginning of its life and creates an incentive to use old facilities over more efficient new facilities.

To address these and other issues, agencies have increased their interest in establishing rate bases based on tools such as trended original cost, which adds the inflation component each year. This links the ratemaking value more closely with the actual economic value, which enables more robust competition.

Another method to mitigate the temporal bias of traditional ratemaking formulas is to use the market to value a firm's base rate, for example by using competitive contracting.

5.2.2 Properties Included in Base Rate

Not every asset owned by a regulated firm is included in its rate base. To decide what goes in, ask two questions:

  1. Is the asset “used and useful” to the firm in producing the regulated product?
  2. Was the firm's decision to invest in the product “prudent?”

If a firm produces regulated and unregulated products, only those assets used to produce the regulated product are included in the rate base. Two corollaries to this:

  1. If an asset is used for both regulated and unregulated products, split the value of the asset. But this can be hard to determine. E.g., a natural gas pipeline must invest in equipment to extract liquid hydrocarbons from the gas before transportation in the pipeline (a regulated product). Those liquid hydrocarbons can then be sold (an unregulated product).

  2. If an asset is used for products regulated by two agencies (e.g. state and federal), the asset is split between the two jurisdictions.

If an asset is no longer used in the production of a regulated product, it should be removed from the rate base. But what if it breaks down prematurely, prior to its estimated lifetime and before it was fully depreciated? The regulatory agency can either allow the firm to include its write-off expenses in the rate base (thus rewarding the firm for overestimating the life of the asset), or should it ignore the error and force the firm to suffer a loss?

If the firm was found to be “imprudent” in investing in an asset, or imprudent in managing the asset, then that asset can be excluded from the rate base. An asset can be partially excluded if the firm was found to have imprudently over-payed for an asset, imprudently experienced cost overruns in an asset's construction, or imprudently invested in too much capacity.

The prudent investment test is difficult, and is typically based on knowledge the firm had at the time it made the investment decision.

Including in the rate base working capital (cash on hand, investments, etc, less liabilities), which can fluctuate greatly, is usually determined based on historical averages.

Construction Work in Progress (CWIP)

Since it has to be “used and useful,” an asset under construction can't be included in the rate base. However, some agencies allow partial valuing through two complicated accounting techniques known as Construction Work in Progress (CWIP) and Allowance for Funds Used During Construction (AFUDC).

If CWIP is allowed, the firm simply adds its investment in the new construction to the rate base each year, as construction progresses. If it's not allowed, then its rate base suffers, so it may use the AFUDC approach.

The AFUDC approach is as follows: During construction, the firm pays construction expenses out of its unregulated arm; that is, the construction and all the costs associated with the construction are not included in the rate base. But the firm can put in a separate account an amount each year that represents its cost of capital for the money used in the construction of the new asset. Then, when construction is complete, the new asset is moved into the rate base, and the full AFUDC account is added to the rate base, so the rate base is slightly bigger than it would have been, allowing the firm to finally earn a return on its construction investment, albeit not until after construction is complete.

Firms usually prefer the CWIP approach, because investors don't like AFUDC accounts. Money sitting in an AFUDC account requires clever accounting, and might earn a better return elsewhere. Furthermore, investors realize that conversion of this account to the rate base is not a certainty. If a new power plant under-performs or proves to have been built with too great a capacity, or if the agency deems the whole investment “imprudent,” then only a portion (or even none) of the AFUDC will be added to the rate base. To a firm and its investors, AFUDC accounts add risk.

Consumers, on the other hand, oppose inclusion of CWIP in the rate base for three reasons:

  1. It grows the rate base sooner than later, resulting in higher rates for consumers
  2. If the asset under construction under-performs, it's easier to disallow the inclusion of an AFUDC than it is to reverse a CWIP already added to the rate base
  3. If CWIP is included in the rate base, present customers pay for benefits that may only go to future customers.

Canceled plants and Excess Capacity

Sometimes a firm begins construction of an asset based on the justifiable belief that the asset will be required to serve consumers, only to discover in mid-construction that the asset is unnecessary. Then the regulatory agency must decide whether and to what extent to allow the firm to recover its investment in the abandoned project, or in the case of completed construction, how to deal with the excess capacity.

Misguided forecasts in the 1970s lead to the construction of hundreds of nuclear power plants. In the 1980s these plants were canceled, and energy utilities attempted to recover the cost of their capital investment. The bad forecasts, however, weren't necessarily avoidable; unforeseen geopolitical moves and changing energy trends couldn't have been predicted. And in many cases, the utilities' decisions to cancel plants were genuinely in the interests of society. In other cases, the cost of completing a then-unnecessary plant was so low that the utility decided to complete it instead of canceling the whole project. In all cases, utilities sought to recover their costs through increased rate bases.

Allowing the rate base increase would lead to higher rates for customers who don't benefit from canceled or unneeded plants, and disallowing the rate base increase exposes the utility to increased cost of capital (because banks view them as more risky and would then charge them higher interest rates on loans) or bankruptcy.

Agencies responded in four ways:

  1. Disallow the cost as imprudent (utility pays all)
  2. Disallow the cost as not “used and useful” (utility pays all)
  3. Allow full recovery of cost, including a return on investment (consumers pay all)
  4. Allowance of recovery of construction cost, but no return on investment (utilities and consumer both pay).

By the end of the 1980s, regulatory agencies had disallowed scores of billions of dollars in utility investments, thereby precipitating the bankruptcy of several utilities, and harming nearly all electric utilities. On the one hand, utilities shouldn't have been suprised, since the “prudent” doctrine and the “used and useful” doctrine went back to the 1930s. However, the scale of the disallowances was unprecedented: Those of the 1980s represented more than 99% of all disallowances up to that point, and the investors and utilities considered it an unfair changing of the rules in the middle of the game. In one case, when the Duquesne Light Company in PA canceled three plants, the rules did change. The construction and cancellation were found to be prudent, and Duquesne's request for a rate base increase based on the canceled plants was approved. Then the Pennsylvania PUC added a rule that canceled plants can't be included in rate bases, and disallowed the inclusion. The Supreme Court eventually sided with the state.

Because of the massive disallowances of the 1980s, utilities today are wary of investing in new power plants. They prefer to purchase power from independent generating companies.


A firm's rate base can also be reduced, primarily through depreciation of an asset. If an asset has a 10-year lifetime, is purchased for $12 and has an end-of-life salvage value of $2, then the total amount to be depreciated is \$12-\$2=\$10 (because the utility can sell it for $2 at the end). This amount is depreciated over the whole 10-year lifetime, or in this case, $1 per year. It will have $12 of value to the rate base in year, $11 in year 2, and so forth. This is called straight line depreciation. An alternative is to use accelerated depreciation, where the $12 asset would depreciate by $5 in its first year, $3.50 in the second year, and so forth.

Depreciation is offset by an increase in operating expenses, so the actual rate base usually doesn't change because of depreciation. In reality, estimating the useful life and depreciation rate of an asset is difficult and subjective.

An alternative method of depreciation is akin to the “replacement cost” approach to rate base setting. By establishing a replacement cost of an aging asset, you take into account inflation and may get a better estimate of present value. Valid arguments support the use of both methods. Recently, some agencies have embraced methods that increase convergence between economic value and accounting value.