Earnings sharing is a popular form of hybrid regulation. With earnings sharing, the regulator allows the operator to keep some portion of the earnings it receives from the market and requires the operator to give the rest to customers, perhaps through price reductions, refunds, or increased investment. A typical earnings sharing mechanism might work as follows. The regulator establishes a price level that equates the rate of return r that the operator receives from the market with the operator’s cost of capital k.1 The regulator also establishes a range with endpoints above and below the cost of capital, say from rl to rh, within which the operator retains all of the earnings it receives from the market place, i.e., no earnings between k and rh are given to customers through a price decrease or other mechanism, and the operator is not compensated for earnings between rl and k. Below rl and above rh, the regulator establishes another range, say between rL and rH. For earnings between rL and rl, customers bear some of the difference between the rL and rl, and for earnings between rh and rH, the operator shares some of its earnings with customers. Customers bear the entire burden and receive all of the benefits for earnings below rL and above rH.
- See Determination of Cost of Capital regarding estimating the cost of capital.