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

• 1. Motivation, Background and Introduction

• 2. Regulation of Monopoly Rents

• 3. Case: California Water

• 4. Conclusions and Implications

Motivation

• 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’ AC B C MC MR AR

0 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

• 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

• 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)

Price Cap Regulation

• 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

• 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

• 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

• 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)

• 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

• 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

Median

WRAM

Under

collection

Percentage

2012 $795,204,287. $53,853,477. 6.77% 8.09%

2011 $806,482,389. 56,786,925. 7.04% 8.60%

2010 $630,115,859. $37,174,377. 5.90% 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