The Effects of Alternative Regulatory Policies on Utility Investment Strategies

Abstract

The environment for planning and constructing power plants has undergone substantial changes since the early 1970s. After this decade of change, many utilities are completing costly plants that are larger than necessary to satisfy current demand and requesting that the plants be added to the rate base. The Used and Useful (UU) and the Prudent Investor (PI) criteria have been applied by increasing numbers of regulatory commissions to determine whether excess capacity plants should be included in the rate base. This paper considers whether these criteria will induce firms to invest efficiently. Much of the discussion of these criteria has focused on developing an appropriate method for allocating excess capacity costs between consumers and investors.' It is widely recognized that allocating some of the excess capacity costs to investors increases the risk faced by utilities.2 This increased risk both increases the market cost of capital and reduces the utility's incentive to invest efficiently in new plants in the future. Consumers therefore trade lower current expenses for higher capital and operating costs in the future. The importance of these concerns depends on the answers to two questions: (1) how soon will new capacity be needed and (2) to what extent will the current policy affect future allowed rates of return and capital investment? In response to the first question, some analysts indicate that the situation of current excess capacity will be reversed in the early 1990s.3 This paper explores the second question by developing a simple model to consider the relation between the UU or PI policies, the allowed rate of return, and the level of future investment. This important relationship is complex. Some writers have emphasized capital market con-