Consistent Regulation

As a former regulator and someone who lectures regularly on the need for good regulatory policy around the world, I include the concept of regulatory consistency (sometimes referred to as “stability” or “predictability” of regulation) as part of my advocacy of progressive regulation. The concept here is that with the same laws, under similar circumstances and similar facts; reasonable regulation should produce the same results.

This consistency of regulatory treatment is related to the issue of regulatory risk. Predictability reduces business risk and hence benefits consumers through lower cost of capital.  Professor Roger Morin explains this in his Regulatory Finance: Utilities’ Cost of Capital (PUR 1994) as:

Regulation can compound the business risk premium if it is unpredictable in reacting to rate hike requests both in terms of the time lag of its response and its magnitude. (P. 39)

I recognize that there is a uniqueness in utility rate regulation as compared to price setting in the general economy. While regulated electric utilities face many, but not all, of the risks experienced by competitive enterprises in our economy there is an additional risk in the potential uncertainty of the regulation itself.

It has long been observed that uncertainty leads to both lower achieved earnings for investors and higher costs of capital for the consumer. Some have included “regulatory lag” as an aspect of uncertainty. That is the situation when a utility invests in a new asset and then must wait for a future rate case so that the investment may be included in the revenue requirement

As a regulator and utility executive I have seen how uncertainty of regulatory treatment, timing and action increases risks. In the case of one source of risk, delaying a regulatory decision i.e. regulatory lag, Professor Myron J. Gordon, writes in his text The Cost of Capital to A Public Utility (Michigan State University 1974) that ”…regulatory lag increases the uncertainty as to the realized rate of return and thereby raises the cost of capital.” (P.211)

Other analysts, such as Justice Richard A. Posner have observed that “regulatory lag” could also be viewed as an “incentive” mechanism. He mentions that “…for in the periods between regulatory determinations the regulated firm has a profit incentive to become efficient.” (Natural Monopoly and its Regulation, Cato Institute 1999). I’ll also include the statement by, as I remember, Professor Alfred Kahn that “all regulation is incentive regulation” and leave it at that.

The issue of risk and regulation is universal and not unique to state or federal regulation in the US. With the expansion of US style utility regulation to the countries of the European Union, Asia and Africa it is there also widely recognized that regulatory commissions control some risks.

Professor Dr.  Burkhard Pedel, a German economist, observed in his book Regulatory Risk and the Cost of Capital: Determinants and Implications of Rate Regulation (Springer, Berlin 2006) that

“The regulatory commission…directives are one of the major risk drivers or even the most important risk driver for the regulated firm.”(P. 29)

Conversely public utility regulators can reduce unnecessary risk. Providing consistency in accounting and regulatory treatments and removing procedural uncertainty are two techniques which do so. Consistency, in regulation, does have its place.