Session Objectives

1. Session Objectives • Rate-of-return regulation • Revenue requirements • Rate base • Rate of return • Expenses • Price caps • Other cost models TLMN 602.9040 Fall 1999 Session 5

2. Quality of Service Regulation • The supplier usually exercises initiatives. • Acts to recover costs • Expands rate-base • Avoids public criticism • The regulator usually imposes constraints. • Sets minimum standards • Requires resolution of customer complaints • Requires non-compensatory services (e.g., “lifeline”) TLMN 602.9040 Fall 1999 Session 5

3. The Unregulated Monopoly Problem • From Session 2: • Prices above competitive levels • Output below competitive levels • Therefore, wealth transferred from consumers to producers • Must impose rate regulation to fix the problem TLMN 602.9040 Fall 1999 Session 5

4. Goals of Rate Regulation • Emulate competitive mix of price, output, and profits • Fair prices to customers • Price = Money/unit (of quantity or quality) • Avoid destructive competition • Control price inflation • Allow enough earnings to stay in business TLMN 602.9040 Fall 1999 Session 5

5. Revenue Requirements R = E + B  r, where R = revenue requirement E = operating expense (including depreciation) B = rate base (i.e., capital investment) r = rate of return on investment (i.e., cost of both debt and equity capital) Carriers tend to inflate both E and B. Difficult to set r TLMN 602.9040 Fall 1999 Session 5

6. Price Mix • For a multi-product firm, also R = pi vi, i = 1,2,…n (subscript i), where p = price of the ith product v = volume of the ith product n = number of products TLMN 602.9040 Fall 1999 Session 5

7. Rate Base: Method of Valuation • Set by method? • Reproduction cost (best for company) • Original investment, i.e., book value (best for regulator and consumer; ascertainable, at least) • “Fair value” (some combination) • Or by end results? • Maintain financial integrity • Attract capital • Compensate investor risk • Provide acceptable service TLMN 602.9040 Fall 1999 Session 5

8. Rate Base: Property Included • Assets used for production • Assets under construction (pre- or post- approval) • Construction work in progress (CWIP) • Allowance for funds used during construction (AFUDC) • Cancelled plants and excess capacity • May be disallowed as • Imprudent • Not used and useful • May be allowed in part TLMN 602.9040 Fall 1999 Session 5

9. Expenses: Depreciation • Proper depreciation rate • Linear? • Accelerated (creates low-tax windfall)? • Effect on tax expense (number games) • Original or reproduction cost? (i.e., may cost $2 million today to replace a $1 million switch bought 15 years ago.) • Charging full depreciation and cost of capital implies “full-cost” pricing, not “marginal-cost” TLMN 602.9040 Fall 1999 Session 5

10. Rate of Return • Commission mediates between investor interest and consumer interest • No “right” answer-- “zone of reasonableness” • Minimum needed to attract capital • Maximum is what traffic will bear. • Sooner or later, must recover “full cost” instead of short-term marginal cost TLMN 602.9040 Fall 1999 Session 5

11. Cost of Capital • Whose cost? The firm’s or the industry’s? • Allow incentive for efficiency and innovation • Cost when? Then or now? • Or stock’s earnings/price ratio? • But these are estimated future earnings! • Sensitive to capital mix, because interest is deductible but ROE is taxable • By earnings of non-regulated industry at comparable risk? TLMN 602.9040 Fall 1999 Session 5

12. Operating Costs • May disallow • Exaggerated costs • Too rapid depreciation • Extravagance • In advertising and public relations • Charities • Large management salaries and expense accounts • Inflated equipment prices from affiliated suppliers • “Gold-plating” • Uniform System of Accounts as basis of expenses TLMN 602.9040 Fall 1999 Session 5

13. Price Caps: Transition to Competition • Initially set prices to yield fair estimated return on equity, ROE, e.g., 13.5% • Thereafter, cap prices each year for svc “baskets” • Allow economy’s inflation rate • Disallow differential telco prod’vy gain & input drops • Reacts on rates and forces productivity • Allow miscellaneous adjustment(s) • If actual ROE exceeds fair ROE, • Carrier may keep part as incentive • Subscribers may get part as rebate TLMN 602.9040 Fall 1999 Session 5

14. Price Cap Example PCI(n) = PCI(n-1)(1 + s - p + m) where PCI(n) = price cap index for year n s = percent price inflation p´ = percent telco inflation offset m = percent miscellaneous adjustment Require actual price index PCI(n), for year n Example of values PCI(n) = PCI(n-1)(1 - 3.0%) for s = 2..0%, p = 5.3%, m = 0.3% TLMN 602.9040 Fall 1999 Session 5

15. GDP Changes in General G = SV = SPF = where G = gross domestic product S = price of “average” product V = volume of “average” product P = V/F = total factor productivity F = total input factors of production d ln G = d ln S + d ln P + d ln F, or dG/G = dS/S + dP/P + dF/F or, as percent increases, g = s + p + f and s = g - p - f TLMN 602.9040 Fall 1999 Session 5

16. Other Cost Models • Total element long range incremental cost (TELRIC) • Cost of a hypothetical, state-of-the-art local service network • Results in lower cost than actual network • Hybrid Cost Proxy Model • A model based on engineering detail and costs • Know that it exists, but skip details. TLMN 602.9040 Fall 1999 Session 5