Cost of service regulation

What Is Cost of Service Regulation?

Cost of service regulation is a method of economic regulation where the prices a company can charge for its services are set to cover its prudently incurred operating costs and provide a reasonable rate of return on its invested capital. This approach is primarily used for public utilities, such as electricity, natural gas, water, and telecommunications companies, which often operate as natural monopolies due to the high cost of duplicating their infrastructure ⁶⁷, ⁶⁸, ⁶⁹. By regulating prices based on costs, the aim is to prevent these monopolistic firms from exploiting their market power by charging excessive prices, while ensuring they remain financially viable enough to provide essential services and make necessary investment ⁶⁴, ⁶⁵, ⁶⁶. It falls under the broader category of regulatory economics.

History and Origin

The origins of cost of service regulation can be traced back to the early 20th century in the United States, as the rapid expansion of essential services like electricity, gas, and water led to concerns about monopolistic abuses and unfair pricing⁶³. Before widespread regulation, utility companies often operated with little oversight, leading to issues such as price discrimination, unreliable service, and a lack of accountability⁶².

To address these market failures, states began establishing public utility commissions (PUCs) or similar regulatory bodies. A key piece of legislation in the U.S. was the Public Utilities Act of 1935, which aimed to regulate the rapidly growing electricity and natural gas industries. This act, and similar state-level initiatives, introduced the concept of "parity pricing" to ensure that utility companies could charge rates that covered their costs and allowed for a reasonable profit, balancing consumer interests with the financial stability of the utilities⁶¹. The framework has since evolved but continues to underpin much of the regulation of public utilities ⁵⁹, ⁶⁰.

Key Takeaways

Cost of service regulation sets prices based on a utility's operational costs and a fair rate of return on its investments.⁵⁸
It is predominantly applied to natural monopolies, like electricity or water utilities, to prevent price gouging and ensure service availability.⁵⁶, ⁵⁷
The system requires detailed accounting and regulatory oversight to determine allowable operating expenses and capital expenditures.⁵⁵
While designed to protect consumers, it can sometimes reduce incentives for cost efficiency and lead to regulatory lag.⁵³, ⁵⁴

Formula and Calculation

Under cost of service regulation, the core objective is to determine a utility's "revenue requirement," which is the total amount of money it needs to collect from customers to cover its costs and earn a fair return. This can be conceptualized by the following formula:

\text{Revenue Requirement} = \text{Operating Expenses} + \text{Depreciation Expense} + \text{Taxes} + (\text{Rate Base} \times \text{Allowed Rate of Return})

Where:

Revenue Requirement: The total amount of revenue a utility is allowed to collect from its customers to cover its costs and provide a reasonable return to investors.
Operating Expenses: The day-to-day costs of running the utility, such as fuel, labor, maintenance, and administrative costs.
Depreciation Expense: The accounting allocation of the cost of tangible assets over their useful life, reflecting the consumption of capital assets.
Taxes: All applicable taxes, including income taxes.
Rate Base: The total value of the utility's assets (e.g., power plants, pipelines, distribution networks) on which it is allowed to earn a return. This generally includes prudently incurred investments that are "used and useful" in providing service.
Allowed Rate of Return: The percentage return that regulators deem fair for the utility to earn on its rate base. This is set to attract and retain investment capital.⁵²

Regulators review and approve each component of this formula, often through a formal rate case proceeding, to establish the allowed revenue.⁵¹

Interpreting Cost of Service Regulation

Cost of service regulation is interpreted as a balancing act between the interests of consumers and the financial health of the utility. When a regulatory body approves rates based on this method, it signals that the prices charged are deemed "just and reasonable"—meaning they are high enough for the utility to recover its costs and earn a fair profit, but not so high as to exploit consumers.
⁴⁹, ⁵⁰
A successful application of cost of service regulation aims to promote economic efficiency by ensuring that necessary infrastructure is built and maintained, while protecting consumer surplus. Regulators meticulously examine a utility's expenses to ensure they are "prudently incurred" and that the "rate base" only includes assets that are "used and useful" for providing service. ⁴⁷, ⁴⁸Deviations from these principles can lead to challenges in rate-making, as regulators seek to avoid passing on inefficient or unnecessary costs to customers.

Hypothetical Example

Imagine "Metro Power Co.," an electric utility serving a major metropolitan area, operating under cost of service regulation. In a given year, Metro Power Co. incurs the following:

Operating Expenses: $500 million (for fuel, maintenance, employee salaries, etc.)
Depreciation Expense: $100 million (for its power plants and distribution network)
Taxes: $50 million
Rate Base: $2 billion (the value of its approved power plants, transmission lines, and other assets)
Allowed Rate of Return: 8%

To determine its revenue requirement, the regulators apply the formula:

Revenue Requirement = $500M (Operating Expenses) + $100M (Depreciation) + $50M (Taxes) + ($2B (Rate Base) * 0.08 (Allowed Rate of Return))
Revenue Requirement = $500M + $100M + $50M + $160M
Revenue Requirement = $810 million

Therefore, Metro Power Co. would be allowed to collect $810 million from its customers over the year through its electricity rates. The regulatory body would then set specific tariffs (e.g., cents per kilowatt-hour) designed to generate this total revenue, considering different customer classes and their usage patterns. This process ensures that Metro Power Co. can cover its costs, including its operating expenses and capital expenditures, and earn a reasonable return to maintain its financial health.

Practical Applications

Cost of service regulation is extensively applied in sectors characterized by natural monopolies, primarily public utilities.

Electricity and Natural Gas: State public utility commissions and federal agencies like the Federal Energy Regulatory Commission (FERC) use cost of service principles to determine rates for electricity transmission and distribution, as well as natural gas pipelines. ⁴⁴, ⁴⁵, ⁴⁶This ensures that consumers receive reliable service at fair prices while utilities can invest in maintaining and upgrading their infrastructure.
⁴³* Water and Wastewater Services: Municipal and state-level regulators typically employ this framework to set rates for water and sewer utilities, covering the costs of treatment, delivery, and system maintenance.
Telecommunications: Historically, traditional landline telephone services were subject to cost of service regulation, particularly for local services. While this has evolved with deregulation and competition, basic principles still influence some aspects of network access pricing.
Transportation (limited): Certain regulated transportation services, particularly those with significant fixed assets like some airport services or port authorities, may also have elements of cost-of-service regulation.

The principles behind cost of service regulation ensure utilities can recover their costs and earn a return to facilitate continued investment in essential services. ⁴²However, there is a trend towards incorporating elements of incentive regulation and performance-based rates, particularly in the electricity sector, which aim to encourage greater efficiency than traditional cost of service approaches alone. ⁴⁰, ⁴¹This shift is in response to evolving market dynamics and a desire for utilities to bear more risk for their operational costs.
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Limitations and Criticisms

While designed to ensure fair pricing and service provision, cost of service regulation faces several criticisms and inherent limitations:

Lack of Incentive for Efficiency: A primary critique is that this method may not strongly incentivize utilities to minimize their costs. ³⁷Since companies are guaranteed to recover prudently incurred expenses plus a return, there can be less motivation to innovate or reduce operating expenses. ³⁵, ³⁶This can lead to what is sometimes called the "Averch-Johnson effect," where a utility might over-invest in capital assets because it earns a return on those assets, even if a less capital-intensive approach would be more efficient.
³⁴* Regulatory Lag: Rate cases are often complex and time-consuming, meaning that approved rates can lag behind actual changes in costs, such as increases due to inflation. ³², ³³This can negatively impact a utility's financial health if costs rise faster than rates, or conversely, benefit a utility if costs fall.
Information Asymmetry: Regulators face challenges in obtaining complete and accurate information about a utility's true costs and operational efficiencies. ³⁰, ³¹Utilities generally possess more detailed knowledge about their operations, which can create an information imbalance that makes effective oversight difficult.
²⁸, ²⁹* Disincentive for Shareholder Value: The focus on cost recovery rather than market competition can limit a utility's ability to create additional shareholder value through superior performance.
Complexity and Administrative Burden: The process of reviewing and approving costs can be highly bureaucratic and resource-intensive for both regulators and utilities, requiring extensive documentation and expert testimony.
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These limitations have led many jurisdictions to explore or adopt alternative regulatory models, such as incentive regulation or price caps, to introduce stronger incentives for efficiency and innovation.
²⁴, ²⁵

Cost of Service Regulation vs. Price Cap Regulation

Cost of service regulation and price cap regulation are two distinct approaches to economic regulation, primarily applied to monopolies or industries with limited competition, like utilities. The core difference lies in how prices are set and the incentives created for the regulated entity.

Feature	Cost of Service Regulation	Price Cap Regulation
Pricing Basis	Prices are set to recover the utility's prudently incurred costs (operating expenses, depreciation, taxes) plus an allowed rate of return on its rate base.	Regulators set a ceiling on prices (the "price cap") based on an inflation index minus an X-factor (representing expected productivity improvements). The utility can adjust prices below the cap. ²³
Incentive for Efficiency	Provides weak incentives for cost efficiency. If costs rise, rates can generally be adjusted upward. May encourage over-investment in capital (Averch-Johnson effect). ²¹, ²²	Strong incentives for efficiency. If a utility can reduce costs below the X-factor's expectation, it keeps the difference, at least until the next review. ¹⁹, ²⁰
Risk Bearing	Regulators and consumers typically bear more of the cost risk, as the utility is largely guaranteed to recover its approved costs.	The utility bears more of the cost risk. If it cannot achieve the expected efficiency gains, its profits suffer. This increased risk can lead to a higher cost of capital. ¹⁸
Regulatory Review	Requires detailed and frequent (though not annual) review of all cost components and financial statements in rate cases, which can be time-consuming and resource-intensive. ¹⁷	Reviews are less frequent and focus on adjusting the price cap formula (e.g., every 3-5 years) rather than line-item cost approval. ¹⁶
Application	Traditionally applied in the U.S. to electricity, gas, and water utilities. ¹⁴, ¹⁵	Gained popularity in the U.K. during privatization and adopted elsewhere, particularly in telecommunications and increasingly in electricity, to foster competition and efficiency. ¹³

While cost of service regulation aims to ensure fairness by directly linking prices to verified costs, it can sometimes be criticized for not providing strong incentives for utilities to operate as efficiently as possible. ¹²Price cap regulation, in contrast, offers stronger efficiency incentives by allowing utilities to retain cost savings below the cap, but it requires careful setting of the initial cap and periodic adjustments to remain effective. ¹⁰, ¹¹Both approaches continue to evolve, and some regulatory frameworks combine elements of both to balance consumer protection with efficiency incentives.
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FAQs

What is the main goal of cost of service regulation?

The main goal is to ensure that essential services provided by public utilities (like electricity or water) are offered at fair and reasonable prices that cover the utility's operational costs and provide a sufficient rate of return on its investments, without exploiting its monopolistic position.

⁸### Which industries typically use cost of service regulation?
This type of regulation is most commonly used in industries that are considered natural monopolies, such as electricity, natural gas, water, and historically, local telephone services. These industries require substantial infrastructure investments that are impractical to duplicate.

⁶, ⁷### How does cost of service regulation affect utility companies?
It provides utilities with a stable and predictable revenue stream, as their costs are recovered and a reasonable return is allowed. However, it may reduce incentives for aggressive cost reduction and innovation since efficiency gains do not directly translate into higher profits, which can sometimes impact shareholder value.

⁴, ⁵### What are "prudently incurred costs"?
In cost of service regulation, "prudently incurred costs" refer to expenses that are deemed necessary and reasonable for the efficient operation of the utility and provision of service. Regulators review costs to ensure they were incurred with sound management judgment, preventing the utility from passing on wasteful or excessive expenses to customers.

², ³### Is cost of service regulation still widely used today?
Yes, cost of service regulation remains a fundamental framework for regulating many public utilities in the United States and other parts of the world, particularly for the transmission and distribution components of electricity and gas, and for water services. While alternative models like price caps or incentive regulation are increasingly used or combined with cost-of-service principles, it continues to be a prevalent approach.¹