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Valuing the Rate Base
Public service commissioners as a rule have two principal problems to solve, namely: (1) what should be the allowed rate of return (s)? ; and (2) what method should be used to measure the value of the rate base (RB)? Problem (2), as it turns, is particularly thorny--and the stakes are high for both consumers and regulated firms.
Referring back to the accounting equation, it is straightforward to see that the valuing of RB has major implications for rate levels.
Methods of valuing the rate base (RB)
 | Method 1: Historic cost method. Value RB at "historic cost"--i.e., original construction/acquisition cost minus depreciation. |
| Method 2: Replacement cost method. Value RB at the cost that would be incurred if plant, equipment, infrastructure, etc. had to be replaced today. |
| Method 3: Market capitalization method. The market value of bonds and equity capital issued by the regulated firm is taken as the measure of RB. |
Notes on the three methods
| Regulatory commissions do not face any legal constraints with respect to the method used to estimated RB. This much was established in the Federal Power Commission v. Hope Natural Gas (1944) decision. | |||
| Method 1is the approach least fraught with complications--you merely determine the book value of assets using generally accepted accounting standards. | |||
| Consumer advocacy groups favor method 1 over method 2.Due to inflationary trends in the construction/heavy machinery industries, method 1invariably gives a lower estimate of RB than method 2. | |||
| Regulated firms, by contrast, typically lobby for method 2 , unless the market valuation of outstanding shares and bonded indebtedness is expected to be greater than the replacement cost of tangible assets; in which case they prefer method 3. | |||
| Method 3 has a significant conceptual problem. Specifically, the valuation of shares presumably reflects the assessment of the market concerning current and future profits. Moreover, estimates of current and future profits are partly based on profits in previous accounting periods--a variable that public service commissions are obviously in position to influence. Hence using method 3, our estimate of RB is "endogenous"--meaning, it is strongly conditioned by past estimates of RB (and also past commission decisions about the value of s). | |||
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Note that the California Public Utilities Commission (PUC) would not allow the full amount expended by Pacific Gas & Electric for the Diablo Canyon Nuclear Plant to be included in the rate base. The issue of cost overruns on nuclear construction projects has been a controversial one in many states. | |||
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Method 1 had the widest use among public service commissions in the 1990s.
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