It is very rare for incentive regulation to not involve extensive financial analysis1. Such analysis includes determining the operator’s cost of capital, historical costs, and projected costs. The cost of capital consists of two elements, the cost of debt and the cost of equity. Regulators typically obtain debt costs from operators’ financial reports, where the operators list their long-term debt instruments and the interest rates paid. Estimates of the operator’s cost of equity can be obtained using financial models. Regulators combine the operator’s cost of debt and cost of equity into a weighted average, called the Weighted Average Cost of Capital (WACC).
Some regulators, such as those in the U.K., use historical and projected operating and investment costs to set X-factors. (Historical information alone is generally used in rate of return regulation.) The operator’s historical operating and investment costs can be obtained from the operator’s accounting records. Care must be taken when using historical accounting data in situations where accounting standards were historically weak or inconsistent over time. In the U.K. approach, projected operating and investment costs, existing net investment in regulatory assets or rate base, and projected net investment are used in a net present value or equivalent analysis to establish X-factors. This method involves making demand forecasts, identifying investment requirements to meet the projected demand, and the forecasting of associated operating expenses. These projections are analyzed and adjusted by the regulator to determine how the operator’s overall price level should be allowed to change relative to inflation.
When using accounting costs, whether they are historical or projected, regulators place below the line any costs that are not needed to provide the utility service or that are considered excessive. The effect of this below the line treatment of costs is that prices for regulated services are not intended to provide revenue to cover the costs. Costs for items needed to provide the utility service are considered to be used and useful and so are kept above the line, which means that they can be recovered through prices charged for regulated services. Costs that are excessive, perhaps because the operator paid too much for an item or made an avoidable mistake in an investment are considered imprudent and the excess is placed below the line.
- See also the section on Financial Analysis.