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