Once the regulator has accounting records in hand that comply with the USOA and accounting separation requirements, and if the regulator is using U.K.-style price cap regulation or some form of rate of return regulation, the regulator then determines who – customers or shareholders – will pay these costs and under what conditions. There are two components of this analysis. The first component is earnings assessment, which identifies the received rate of return on the regulated operations. The second component is the measurement of the cost of capital. Some forms of regulation, such as pure price cap regulation,1 do not rely on operator accounting information for establishing overall price levels, so earnings assessments and estimates of the cost of capital are unnecessary in these situations.
Determining the earnings of the operator’s regulated operations involves asset valuation, assessing the prudency and usefulness of the operator’s expenditures, setting depreciation rates, and determining the treatment of unpaid bills, customer or government-provided capital, and imputed revenue.2 With respect to valuing assets for regulated services (called the rate base or regulated assets), there are two basic approaches: the cost-based approach and the value-based approach. The cost-based approach, also called original cost or historical cost accounting, values assets at what the operator originally paid for the assets. There are two value-based approaches. The first of these – the fair value approach – values the assets based on the profits they can generate for shareholders. This can create circularity when asset value also enters into the formula for determining profits. The second value-based approach is called current cost or replacement cost accounting, which values assets each year at what it would cost to acquire them that year.3 The original cost approach is commonly used for assessing returns to shareholders. The current cost approach is most commonly used for determining economic costs for rate design.
When setting the overall price level for regulated services, the regulator generally allows capital and operating expenses that are prudently incurred – i.e., that are cost minimizing given the level of output and service quality required by the market and by regulation – and used and useful to be covered by regulated prices. Used and useful means that the inputs purchased are used for and needed for providing the regulated service.
The regulator also often requires that costs be known and measurable, which means that the operator must justify with documentation, facts, and accepted methodologies that the costs it reports to the regulator are its actual costs. Acceptable evidence that costs are known and measurable would include detailed demonstration that the costs are needed to perform the operator’s duties and obligations under its license or franchise agreement, audits that assure that the accounting information accurately reflects the service provider’s actual operations, and paper trails that verify that the accounting records can be traced to original invoices and payments. If costs are forecasted, then the regulator would be expected to approve the forecasting methodologies and inputs.
The regulator often allows amounts of unpaid bills to be reflected in prices if the amounts represent normal business experience. The justification for this is that the operator generally cannot expect all customers to always pay their bills, so the lost revenue must be recovered elsewhere if the operator is to remain financially whole. The regulator often disallows the recovery of excessive unpaid bills if the regulator believes the operator is not exerting sufficient effort to collect unpaid bills.
The regulator may also impute revenue to the operator’s regulated accounting books if the regulator believes that the operator failed to record on the regulated accounting books all of the revenue that should be attributed to regulated operations. An example might be a secondary business, such as directory advertising, that is profitable because the operator is a telecommunications provider.
Generally long-lived assets are capitalized and the regulator, when regulating the overall price level, allows investors the opportunity for return of the investment through depreciation and a return on the investment through the allowed rate of return. An exception is capital provided by customers or by the government, if it takes the form of an interest-free loan. An example of customer-provided capital would be a customer’s contribution to pay for extension of the network to the customer’s location. The regulator may consider customer-provided capital to be an interest-free loan to the operator, in which case the operator receives no return on that portion of its regulated assets, or the regulator may impute to the operator an interest payment on the customer-provided capital, the effect of which is to lower the operator’s regulated prices. Interest-free government-provided capital, such as a universal access subsidy, may be treated as interest-free capital.
The regulator generally allows the operator to recover corporate income or profit taxes that are related to regulated services, from customers of regulated services. However, differences between regulatory depreciation and tax depreciation cause a mismatch in cash flows. Regulators can address this by creating a special reserve account that “holds” the taxes that customers pay through prices until the operator actually pays the taxes. This reserve is customer-provided capital until the operator uses it, so it is deducted from the rate base.
Under rate of return regulation and some forms of price cap regulation, the rate base is the original cost minus accumulated depreciation. Only assets that are prudently obtained and that are used and useful for utility services are included in the rate base. If the assets are forecast, the treatment of differences between forecast and actual investment at the next price review are important. Over forecasts (or under investment) could be the result of the operator returning excess cash flow to investors or from improved efficiency. If the regulator believes forecast investment exceeded actual investment and that this resulted from a forecasting error or under investment, the regulator may use claw back, which returns the excess in amount to customers. Claw back gives the operator an incentive to over invest if forecasted investment exceeds actual investment needs.
Regulators generally incorporate income or profit taxes in the cost of capital. However, differences between regulatory deprecation and tax deprecation cause a mismatch in cash flows. Regulators can address this by creating a special reserve account that “holds” the taxes that customers pay through prices until the operator actually pays the taxes. This reserve is customer provided capital until the operator uses it, so it is deducted from the rate base. Other taxes, unless specifically passed through to customers on their bills, are part of the operator’s cash flow and are generally considered as such during a price review.
- Pure price cap regulation is almost never practiced.
- See Ring Fencing and Control of Cross-Subsidization.
- Identifying Informational Requirements also considers valuing assets in situations with high inflation.