On the Conceptual Inadequacy of the Original Cost Regulatory System

Abstract

The original cost regulatory system, as currently used in the regulation of utilities and natural gas pipelines, cannot emulate the response of a competitive firm to high and varying inflation. Although there can be many problems introduced by regulatory lag and by high administrative and hearing costs for all parties, these do not cause the difficulties we are concerned about here. The response of the original cost system to inflation, even when it is applied with no errors or lag, will be non-competitive, socially wasteful, and politically unsatisfactory. The system is conceptually flawed in a fundamental fashion that causes it to breakdown in times of high and varying inflation. It is possible to design a version of original cost regulation that responds appropriately to changes in expected inflation by using changes in interest rates, but such a system still won't deal properly with actual inflation when it differs from expected inflation. To emulate the response of a competitive return to actual inflation, we must use a version of original cost regulation that makes use of changes in a price index rather than changes in market interest rates.