Rate-of-return regulation
Based on Wikipedia: Rate-of-return regulation
The Government's Impossible Balancing Act
Imagine you run the only electric company in town. You own the power plants, the transmission lines, the whole operation. Your customers have nowhere else to go. You could, in theory, charge whatever you want.
This is the nightmare scenario that kept early twentieth-century regulators up at night. And the solution they devised—rate-of-return regulation—shaped how Americans paid for electricity, gas, water, and telephone service for the better part of a century.
The basic idea sounds almost quaint in its fairness: let the company earn back what it costs to serve customers, plus a reasonable profit. Nothing more, nothing less. But as with most things that sound simple, the devil lurks in the details.
How It Actually Works
Government regulators sit down with a utility company and perform what amounts to forensic accounting. They examine everything: the company's physical assets (called the "rate base"), its cost of borrowing money, what it spends on day-to-day operations, how much its equipment depreciates each year, and its tax obligations.
From all this, they calculate a "revenue requirement"—the total amount of money the company needs to collect from customers to cover all its costs and earn an approved rate of return on its investments. This revenue requirement then becomes the target for setting prices.
Think of it like a landlord who owns an apartment building. The government says: you can charge enough rent to cover your mortgage payments, maintenance costs, property taxes, and a fair return on your investment. But you cannot charge a penny more just because your tenants have no other options.
The Five Tests of Fairness
Regulators developed five criteria for determining whether a rate of return was appropriate. These criteria reveal the competing pressures that make utility regulation so difficult.
First, the return must be high enough to attract investors. This might seem obvious, but it creates a fundamental tension. If regulators set returns too low, no one will invest in power plants or water treatment facilities, and customers end up without essential services. The protection meant to help consumers could backfire catastrophically.
Second, prices should promote efficient use of services. Ideally, what customers pay should reflect the actual cost of producing the next unit of electricity or gallon of water. This encourages conservation and prevents wasteful consumption.
Third, regulators must verify that the company itself operates efficiently. This is where things get tricky. How do you know if a utility is genuinely spending money wisely or padding its expenses to justify higher prices? A company might claim it needs expensive new equipment when cheaper alternatives exist.
Fourth, the company's long-term stability matters. Utilities are not like restaurants that can close and reopen elsewhere. If your electric company goes bankrupt, you cannot simply switch to another provider. Regulators must ensure the company can survive and thrive for decades.
Fifth, investors deserve fair treatment in their own right. This differs subtly from the first criterion. Attracting capital is about offering enough to get investors in the door. Fairness is about treating them honestly once they have committed their money.
Why Investors Loved This System
Rate-of-return regulation created something unusual in the investment world: boring predictability.
Most investments carry significant risk. Stock prices swing wildly. Real estate values crash. Businesses fail. But a regulated utility offered something different—steady, reliable returns that changed little regardless of economic conditions.
When the economy boomed, utility shareholders did not get rich like technology investors. But when recessions hit, they kept receiving their dividends while other portfolios collapsed. For investors seeking stability over excitement, regulated utilities became beloved holdings. Widows and orphans, as the old saying went, could safely own utility stocks.
This stability also protected the companies themselves from public backlash. In the late nineteenth and early twentieth centuries, Americans developed intense hostility toward monopolies. Standard Oil, the railroads, and other dominant corporations became symbols of unchecked corporate greed.
Rate-of-return regulation offered monopolies a kind of legitimacy. Yes, we are the only game in town, utilities could say, but the government ensures we cannot exploit that position. Customers could trust—or at least hope—that their electric bills reflected genuine costs rather than monopolistic price-gouging.
The Fatal Flaw
Despite its elegant logic, rate-of-return regulation contained a fundamental weakness that economists identified early on. The problem has a name: the Averch-Johnson effect, named after Harvey Averch and Leland Johnson, who described it in a landmark 1962 paper.
Here is the perverse incentive: if your allowed profit is calculated as a percentage of your assets, you make more money by owning more assets.
Consider a utility deciding between two options for generating electricity. Option A costs fifty million dollars and works perfectly well. Option B costs one hundred million dollars and works equally well. A normal company would choose the cheaper option. But under rate-of-return regulation, the company might prefer the expensive choice—because owning one hundred million dollars in assets means earning returns on one hundred million dollars, not fifty million.
This tendency toward unnecessary capital accumulation became known as "gold-plating." Utilities built power plants more lavish than necessary, installed equipment more sophisticated than required, and maintained facilities more elaborate than prudent.
The result was exactly the inefficiency that regulation aimed to prevent. Customers ended up paying for unnecessary investments, all perfectly legal under the rules.
A related problem emerged with operating expenses. If regulators allow companies to recover all their costs, what incentive exists to minimize those costs? A utility might keep extra workers on staff, maintain luxurious corporate offices, or neglect to bargain hard with suppliers. Every dollar of waste simply got passed through to customers.
The Legal Foundations
The constitutional basis for rate regulation emerged from a series of Supreme Court decisions, beginning with a case about grain elevators in Chicago.
In 1877, the case of Munn versus Illinois established that states could regulate businesses "affected with a public interest." The grain elevators at issue held a chokepoint position in the agricultural economy—farmers had no choice but to use them. The Court ruled that such businesses surrendered some of their freedom to charge whatever they wished.
This principle soon extended to railroads, which had grown enormously powerful after the Civil War. The railroad companies controlled essential transportation infrastructure and frequently abused that power. A series of cases known as the "Granger Cases" (named after the farmers' organizations that brought them) affirmed governmental authority to set railroad rates.
Twenty years later, the 1898 case of Smyth versus Ames addressed a harder question: what limits existed on the government's rate-setting power? The Supreme Court declared that regulated industries had a constitutional right to earn a "fair return" on their investments. The government could prevent monopolistic profits, but it could not confiscate investors' property by setting rates too low.
This created an ongoing tension. Too high, and customers suffered. Too low, and the Constitution was violated. Regulators walked this tightrope for decades.
The Valuation Wars
A technical-sounding question proved enormously consequential: how should regulators value a company's assets?
Imagine a railroad that laid track in 1870 for one million dollars. By 1920, due to inflation and changing conditions, replacing that track would cost five million dollars. Should the company earn returns based on what it originally paid or what the assets are currently worth?
The difference matters enormously. If the company originally invested one million dollars and earns a ten percent return, it gets one hundred thousand dollars annually. But if regulators use the five million dollar replacement cost, that same ten percent yields five hundred thousand dollars per year.
This question plagued regulators during the late nineteenth century, when a general deflationary trend meant that historical costs often exceeded current values. Companies wanted to use the higher historical figures; customers and regulators preferred the lower current values.
The 1944 case of Federal Power Commission versus Hope Natural Gas Company finally established a workable compromise. For debt—money the company borrowed—regulators would use historical cost and the original interest rate. For equity—ownership investment—regulators would look at current market values. This hybrid approach, while imperfect, provided enough clarity to make the system functional.
The Natural Monopoly Problem
Understanding rate-of-return regulation requires understanding why some industries become monopolies in the first place.
Consider what it takes to provide electricity to a city. You need power plants costing hundreds of millions of dollars. You need transmission lines crossing thousands of miles. You need a distribution network reaching every home and business. These investments are staggeringly expensive.
Now imagine two companies trying to compete. Each would need to build its own power plants, its own transmission lines, its own distribution network. The result would be massive duplication of infrastructure—two sets of wires running down every street, two power plants where one would suffice. This wasteful duplication would drive costs far higher than a single provider would face.
Economists call this a "natural monopoly"—an industry where the most efficient structure involves a single firm serving the entire market. The monopoly is "natural" in the sense that it emerges from technological and economic realities rather than anticompetitive behavior.
But natural monopolies create an obvious problem. Without competition to discipline them, what prevents these companies from charging outrageous prices? The answer, for most of the twentieth century, was rate-of-return regulation.
The Decline and Fall
By the late twentieth century, the weaknesses of rate-of-return regulation had become impossible to ignore. The Averch-Johnson effect meant utilities routinely overinvested in capital. The cost pass-through mechanism meant little incentive existed to operate efficiently. And the regulatory process itself had become a cumbersome bureaucratic exercise.
A British economist named Stephen Littlechild developed an alternative approach in the 1980s. His innovation, called price-cap regulation, worked on fundamentally different principles.
Instead of allowing utilities to recover whatever costs they incurred, price-cap regulation sets maximum prices in advance based on expected inflation and expected efficiency improvements. If a company finds ways to cut costs below the cap, it keeps the savings. If it fails to control costs, it absorbs the losses.
This flipped the incentive structure entirely. Under rate-of-return regulation, a dollar saved on operations was a dollar of revenue lost. Under price-cap regulation, a dollar saved was a dollar of profit gained. Companies suddenly had powerful motivations to innovate and economize.
Revenue-cap regulation works similarly but limits total revenue rather than prices. Both approaches spread from Britain throughout the world, gradually replacing the rate-of-return model that had dominated for nearly a century.
Health Insurance: The Last Holdout
Interestingly, profit margin caps—a close cousin of rate-of-return regulation—survive in one major American industry: health insurance.
The Affordable Care Act of 2010 requires health insurers to spend at least eighty percent of premium revenue on actual medical care (or eighty-five percent for large group plans). If insurers spend less than this threshold on healthcare, they must rebate the difference to customers.
This creates incentives remarkably similar to the old utility regulations. An insurer that wants higher profits can achieve them by having higher total costs—because a fifteen percent margin on a larger number is bigger than fifteen percent of a smaller number. Critics argue this discourages aggressive negotiation with hospitals and drug companies, since every dollar of medical cost reduction shrinks the allowable profit pool.
Whether this concern is valid remains debated. But the parallel to the Averch-Johnson effect is striking.
Lessons for Today
Rate-of-return regulation represents a particular philosophy of government's relationship with essential industries. It assumes that monopolies are sometimes necessary, that private ownership and investment should be preserved, but that unregulated monopoly power is dangerous.
The approach worked reasonably well for decades. Utilities received the capital they needed to build the infrastructure that electrified and connected America. Investors earned steady returns. Customers received essential services at prices they could afford. The system was not perfect, but it functioned.
Its replacement by price-cap and revenue-cap regulation reflects changing beliefs about what motivates efficient behavior. The old system trusted regulators to identify reasonable costs and fair returns. The new system trusts market-like incentives to push companies toward efficiency.
Neither approach is obviously correct. Rate-of-return regulation protected companies from the risk of efficiency improvements that did not pan out—but also protected them from the consequences of inefficiency. Price-cap regulation creates powerful incentives to cut costs—but also incentives to cut corners on safety, maintenance, and service quality.
The debate continues in every discussion about how to regulate essential services. How much should we trust companies to behave responsibly without oversight? How much should we trust regulators to know what costs are reasonable? How do we balance the interests of investors who provide capital against customers who pay the bills?
These questions have no permanent answers. Rate-of-return regulation represented one generation's best attempt. Future generations will surely devise their own approaches to the eternal challenge of managing necessary monopolies in a free society.