III. Fundamental Concepts

Economic theory of competition: It is important to understand the fundamental concepts that underlie the reasoning used by the Commission to determine the correct allocation of the gain from the sale of a utility asset. Our policies should be based on a clear understanding of how markets work. Economic theory provides this understanding. Under the economic theory of the firm in a competitive, unregulated⁴ market, the owners of the firm will recoup their costs if the prices they are able to charge for their products are high enough. There is no guarantee that prices will be high enough for the owners to make a profit, or even recoup their investment costs. Firms have no control over this price, and this is a financial risk borne by firms in competitive markets.

If the market price is high enough, the firm will make a positive profit in addition to having all its costs, including depreciation, covered. The profits will accrue to the owners of the firm as a reward for providing the product and bearing the risk of the investment. Similarly, if the firm sells an asset, the sale price may provide a gain over the asset's book value. This gain accrues to the owners as well to encourage investors to bear financial risks.

One indispensable aspect of competition is ease of entry and exit by suppliers. Entry drives the price of output down, keeping it close to production costs. Entry also keeps profits low, so this is another risk borne by the competitive firm.

Monopoly regulation: In the case of the regulated monopoly, the firm does not face a competitive market and is sheltered from many of the risks borne by competitive firms by the regulator. The monopoly's prices are limited, often within a particular range. This range includes all costs associated with the output, plus a return on the shareholders' investment that is considered reasonable by the regulator. The customer has few if any alternative suppliers to which they might take their business, and the product has few if any viable substitutes. Under monopoly regulation, structural limitations and the regulatory compact restrict entry by competitors into the utility's market.

Under the implicit compact enforced by this Commission, regulated utilities face few financial risks, and ratepayers cover almost all costs associated with the assets acquired by the utility. The corollary of limited shareholder risk is limited shareholder profit. The Public Utilities Code entitles a utility to charge its customers rates that cover its costs and are otherwise considered just and reasonable. Once the company prudently purchases an asset that is deemed needed for provision of the service, the shareholders' outlay is added to the utility's ratebase, and shareholders have the opportunity to earn a reasonable rate of return on that asset. All reasonable costs the utility bears are covered by the ratepayers, including a return of the investment through depreciation, maintenance, insurance, taxes, fees, administrative costs, and interest expense, and all other costs associated with that asset (often collectively called "carrying costs").

If the asset is taken out of service before it is fully depreciated, the undepreciated amount, if not covered by the asset sale price, is usually paid for by the ratepayers. Once again, there is essentially no risk borne by the shareholders from the sale of the asset when it is paid for by ratepayers.

The special case of land: Because it needn't be replaced, land is not depreciated, as in the case of buildings or machinery. However, the entire acquisition cost of the land is put into ratebase and the shareholder receives a return on that amount for as long as the land is in ratebase. Ratepayers still pay for carrying costs such as maintenance, taxes, insurance, administrative costs, and interest expense for the land. Further, in the unlikely event that the land is sold at a loss, ratepayers usually cover the loss in rates. Once again, the shareholders bear no financial risk.

The impact on investment of the allocation of the gain: It is sometimes argued that if some or all of the gain from the sale of an asset is not given to the shareholder, this will suppress future investment. This conclusion is not supported by economic theory. Owners invest their capital in response to what profits are available in the various sectors of the economy. High profits act as a signal to investors that they should move their capital to that sector, because the society has decided that they want more of that good produced. Such flows improve economic efficiency.

However, profits are earned on an ongoing basis by the firm, not on a one-time basis. One well-known conclusion of economic theory is that fixed costs do not affect how much profit-maximizing entrepreneurs invest. Similarly, fixed benefits are equally irrelevant to the investment decision of the firm.⁵

Another way to look at this process is to consider why the regulated utility purchases an asset for its production process. The profit-maximizing management is not considering the potential gain in value of the asset twenty years hence, but is looking at the increase in output and/or decrease in average cost represented by the introduction of this new asset, in line with the utility's underlying requirement to provide service. Management is attempting to increase the yearly return to the shareholders, not the boon that might materialize at the end of the asset's useful life. As the shareholders have not shouldered any of the risk of the investment, it would be lagniappe to allow them to use this rationale to retain the gain when the asset is sold.

Example. The following simplified example shows how, for a regulated utility, shareholders typically bear no risk when they acquire an asset for utility service. For this example, we assume that the acquisition price of a building is $1,000 and that it is expected to last five years. The method used to calculate depreciation is straight-line, so that every year $200 is depreciated from the book value of the building. Also, $200 each year is added to the costs paid by ratepayers in their rates.

Also, for this example we assume that the rate of return deemed reasonable by the Commission is 11% for each of the five years the asset is in use. Finally, we assume that maintenance, taxes, insurance, administrative costs, and interest expense for the building totals $100 per year. The following table summarizes these various costs and payments over the five-year life of the asset:

Thus, under the assumptions of this example, ratepayers have paid a total of $1830 to shareholders ($1000 + $330 + $500) for the use of this asset. Ratepayers have paid for the asset, paid the opportunity cost of the initial investment, and have covered other costs associated with the asset. Ratepayers have paid $1850 over 5 years for the use of a $1000 asset that is now ostensibly useless. If, in fact, it has salvage value, a determination of whether shareholders bore risk, and how much, must precede an allocation. While it is possible that a similar investment in a competitive, unregulated market would provide similar or even greater returns to the owners, it is also entirely possible that market conditions would not support prices high enough to cover even the initial investment, let alone the associated costs or rate of return. This is the differential nature of risk faced by regulated utilities and unregulated firms, and forms the basis upon which we reach our conclusion that the gain should go to the party that bears the financial risk of the investment.