Uses of Rate of Return Method

1. Uses of Rate of Return Method • For regulatory commissions • At the state level, used as the basis for rate cases: carriers’ requests for a rate increase • At the interstate level, used as the basis for ratemaking for interstate toll and for access charges • Within the Bell system • Used as basis for division of revenues

2. Flow of information Keep chart of accounts according to Part 32 Do Jurisdictional Separation For Interstate, do ROR for AT&T “toll pot”/ later for access charges For Intrastate, do ROR for state commission

3. Rate of Return Regulation • “Cost Plus” regulatory method that covers a carrier’s “revenue requirement” • Revenue Requirement: the amount of revenue the carrier requires to cover expenses and provide the “allowed return” on “rate base” • Rate Base: the carrier’s investment in plant and facilities • Allowed Return: the percentage of earnings approved by the regulator

4. Issues of concern • How to determine the rate base? • Valuation method, “used and useful” • What are allowable expenses? • How to determine an allowed return? • Cost of Capital method—firm’s capital structure • Market-determined standard versus comparable earnings standard

5. Revenue Requirement Example • Assume Telco has • $3 million in expenses • Rate base of $50 million • Allowed return of 10% • Telco’s revenue requirement is calculated: • RR = $3 million + (10% x $50 million) = $3 million + $5 million = $8 million

6. Use of Revenue Requirement • Carriers can set their rates so that the revenue requirement is realized • For example: • Assume Telco provides local service and state toll • Assume Telco’s local rates are $10 per month and their long distance rates are $.15 per minute • Assume Telco has 50,000 local lines and that callers made 5 million calls

7. Use of Rev Reqt continued • Telco has billed: • Local service of 50,000 x $10 x 12 months = $6 million • Toll service of 5 million calls x $.15 = $750,000 • Telco has a short fall of $1,250,000 • Revenue Requirement of $8 million • Billings of only $6,750,000 • Telco can now raise its rates to generate an additional $1,250,000

8. The traditional approach • To get $1,250,000 from local would have to raise local rates by about $2.08 (to $12.08) 50,000 x 12 months x $2.08 = $1,248,000 • To get $1,250,000 from toll would have to raise toll rates by $.25 (to $.40) 5 million calls x $.25 = $1,250,000 • The traditional approach has been to raise the toll rates first---Why???

9. Logistical issues • Determination of the allowed return • Arguments about the “test year” • Historical with adjustments • Arguments about what is “used and useful” • Problems with “regulatory lag”

10. ROR and access charges • To deal with regulatory lag, access charges were based on forecasted costs and demand • Rates were set prospectively; adjustments were made after the fact

11. The basic approach • A = Forecasted rate base • B = Forecasted expenses • C = Allowed rate of return • D = Forecasted demand • Forecasted RRQ = B + (A x C) • Price = RRQ/D

12. An example • Telco forecasts the following • Rate base of $200 million • Expenses of $30 million • Allowed return of 10% • Demand of 100 million minutes • So, • Forecasted RRQ = $30 M + (10% x $200 M)= $50 M • Price = $50 Million/100 million minutes = $.50

13. True-up after the fact • Assume Telco’s actuals were: • Rate base of $190 Million • Expenses of $35 Million • Demand of 110 million minutes • Then, • Actual revenue was 110M minutes x $.50 = $55M • Actual earnings were ($55M-$35M)/$190M= 10.5% • Telco over-earned

14. Problems with the ROR method? • Leads to “gold plating” • Lack of incentive to be efficient • Lack of incentive to be innovative