F return regulation has allowed natural gas distribution utilities to systematically earn returns in excess of their costs of capital. These excess returns represent an inefficiency of regulation, or what economists refer to as regulatory failure. If we are interested in achieving true economic efficiency, then actions should be taken to eliminate these excess returns.
Theory: Market Value Should Equal Book Value
Determining a fair rate of return for public utilities requires an understanding of legal and financial principles. There is a rich history of legal precedents in this area dating back to the turn of the century.' Suffice it to say that the courts have called for a balancing of ratepayer and investor interests when determining the fair rate of return for a utility.
This paper focuses on the financial concepts of rate-of-return regulation. Financial principles indicate that the utility's cost of capital is the efficient rate of return. That is, setting the rate of return equal to the cost of capital fully compensates investors without being excessive. The public utility finance literature embraces the concept of the cost of capital as the efficient return: "The regulator should set the allowed rate of return equal to the cost of capital so that the utility can achieve the optimal rate of investment at the minimum price to the ratepayers."2
Steven G. Kihm, CFA, is a senior financialand pricing analyst in the Natural Gas Division of the Public Service Commission of Wisconsin. The views expressed here are those of the author and not necessarily those of the Public Service Commission of
Wisconsin.