Guaranteed Return Regulation: a
Case Study of Regulation of Water
in California
Michael A. Crew
Rutgers Business School
Rami Kahlon
California Public Utilities Commission
Outline
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1. Motivation, Background and Introduction
2. Regulation of Monopoly Rents
3. Case: California Water
4. Conclusions and Implications
Motivation
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Regulation and consumers
Simple monopoly graph
Unregulated monopoly - OE
Regulation cannot provide efficiency of
competition
• OF’ with consumer getting all the rents at
second best optimum
P
E
A
F
B”
F’
B’
C’
B
AC
C
MC
MR
0
AR
Q
Figure 1: Monopoly Rents
Rents attract
• Replication of competitive P = MC not feasible
because of dominant scale economies
• Second best optimality a less clear concept
• Determination of Average Cost – OF’
• Regulator’s ability to estimate cost limited by
asymmetric information
Dissipation of Rents
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Labor and the firm
Politicians, consumers and regulators
Environmental policies
Public utility commissions (PUCs) determine
the distribution of rents
• Effective vehicle to enforce state
environmental policies
• State conservation mandates
Regulation cannot eliminate rents
• Mechanism for redistribution
• Opaque more effective way than taxes
• Politicians oppose a tax to support
environmental projects
• Use utility rates
• Partial immunization for legislators
Regulatory Institutions
• Regulation originated in the US over a century
ago
• Specialist “Independent” Commissions
• Cost of Service (CoS) or Rate of Return (RoR)
dominant form
• Process ostensibly simple – protect from
monopoly exploitation and financial viability
Cos/RoR
• Regulated firm typically makes its case in
administrative law tribunal
• RR = O + s(V-D)
• O = Operating Expenses
• s = Allowed Rate of Return
• V = Gross value of its property (rate base)
• D = Accumulated Depreciation
Asymmetric Information
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Firm’s superior information on its costs
Firm’s incentive to pad costs because
RR increases as revealed costs increase
Weakness of COS in cost control ->
Price cap regulation (PCR)
• UK’s extensive privatization and adoption of
PCR
• Except for telecom PCR not employed
significantly in the US
• Took different form – Crew and Kleindorfer
(1996)
• Littlechild’s (1983 and 1986) influential papers
• 1983 paper sees PCR is transition
What is PCR?
Definitions
• CPI = Consumer Price Index or similar inflation
measure
• X = X factor or real price decrease
• Y = Exogenous factors, e.g. taxes
• T = Term of the price cap
PCR Deceptively Simple
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Provides incentives for X-efficiency
But at a price
Laffont and Tirole demonstrate that efficiency
Requires commitment by regulator
Firm retaining information rents
Rents contested
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PCR X-efficiency with rents to firm
CoS incentives for X-inefficiency
Consumer faces other contenders for rents
Notably government employing regulation to
promote its social and environmental policies
• PCR difficult to fund renewables and conservation
• PCR drives the firm to maximize profits
• Conservation contrary to this
PCR, CoS and rents
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PCR Firm retains rents
Commission discretion reduced
Contrast cost of service regulation
With considerable discretion to regulator
But COS limited in ability to implement certain
policies
Regulation to Implement Policy
• E.g. conservation and increasing block rates
• Policies ostensibly motivated by fairness
• PCR provides little scope to implement such
policies
• The reverse - PCR promotes sales
• CoS offers more but not sufficient scope
Evolving form of regulation
• New form of regulation providing
implementation possibilities
• Decouple revenue requirements from output
e.g. conservation and weather
• Permits implementing policies through
regulation
• Appeals to notions of fairness – unjust
enrichment
Guaranteed Return Regulation (GRR)
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Energy efficiency programs
Separation of distribution and generation
Including conservation programs in CoS
Cross subsidies of renewables in CoS
Attempt to “guarantee” returns
Traditionally opportunity to earn return was
guaranteed
The Guarantee in GRR
• Guarantee return comes at a price
• Firm faces more regulation
• Loses ability to earn on increased sales in
return for compensation if sales fall short
• Further disincentives for X-efficiency
• Lower costs normally mean greater profit not
with GRR
2005 CPUC Water Action Plan
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1. Maintain Highest Standards of Water Quality
2. Strengthen Water Conservation Programs to a
Level Comparable to those of Energy Utilities
3. Promote Water Infrastructure Investment
4. Assist Low Income Ratepayers
5. Streamline CPUC Regulatory Decision-making
6. Set Rates that Balance Investment,
Conservation, and Affordability
Achieving Objectives
• Less than successful but arguably unattainable
under PCR
• Guarantee Elusive
Year
Adopted Revenue
Requirement in
Aggregate
Net aggregate
WRAM Under
collection
Average WRAM
Under collection
Percentage
2012
2011
2010
$795,204,287.
$806,482,389.
$630,115,859.
$53,853,477.
56,786,925.
$37,174,377.
6.77%
7.04%
5.90%
Median
WRAM
Under
collection
Percentage
8.09%
8.60%
5.18%
Explaining Shortfall
• Incentive for DRA to over-forecast volume – a
partial explanation
• Recession
• Weather
• Despite objectives GRR limited in ability to
guarantee a return
• Forecasting distortions and accuracy problems
Conclusions and Implications
• More accurate forecasts limited by exogenous
factors and rent seeking for consumers by
public advocates
• Ex post adjustments for exogenous factors –
weather!
• Snow cap exogenous variable in rate setting
• Potential future paper