Prices based on current cost or historical cost: How different are they?

Abstract

In 1996, The Federal Communications Commission (FCC) prescribed total element long-run incremental cost (TELRIC) to determine rates incumbent local exchange carriers (ILECs) charge for most mandated wholesale services. TELRIC, which bases prices on a hypothetical incumbent that serves current volumes with completely new equipment, was a major departure from the predominant use of historical (or original) costs for regulated prices. The FCC made two exceptions: total service resale of local exchange services and rental of space by cable television providers and competitive local exchange carriers on poles and conduit owned by electric utilities and ILECs are based on original cost calculations. The FCC’s use of both current cost and historical cost methodologies recalls the fierce debates over whether regulated rates should be based on replacement (current) costs or original (historical costs) that preceded the US Supreme Court’s 1944 FPC v Hope decision. Parties advocating low rates favored replacement costs when equipment costs were expected to decrease, but original costs when such asset prices would be expected to increase. The Hope decision upheld the Federal Power Commission’s use of original costs, which subsequently were widely used by federal and state regulators. While rates based on current costs have, indeed, differed in the expected way from the corresponding rates based on historical costs, this paper demonstrates that (1) the large differences expected by conventional wisdom are the result of faulty application of the current cost methodology and (2) proper application substantially narrows the difference between the rates produced by the respective approaches.