The Pig in the Python: Is Lumpy Capacity Investment Used and Useful?

Abstract

A recurring issue in the regulation of public utilities is whether the firm should be permitted to recover the cost of particular assets through its allowed rates. The traditional standards have been the backward-looking prudency test and the forward-looking used-and-useful test. Under the latter, the utility may recover the cost of a particular asset, including a competitive return on that capital, if the asset is actually used by the utility and is useful in providing service to consumers. The option value of excess capacity helps to explain the difference between foresight and hindsight models for the bearing of market risk in the regulated network industries. We provide an economic answer to the question, When is an investment beneficial? A utility's investment in seemingly excess capacity confers an immediate option on consumers, an option having substantial economic value. In that sense, excess capacity is a capital investment that not only is currently used by the utility, but also is currently useful to consumers. Excess capacity is a form of insurance for consumers to protect them when demand unexpectedly surges, supply unexpectedly collapses, or both occur simultaneously. But a regulator's view of whether the investment in a particular asset is used and useful is limited by her personal experience and the institutional memory of the regulatory body. To borrow from the language of statistics, that personal experience and institutional memory aids the regulator in making in-sample predictions of whether consumers will, over some relevant period of time, indeed exercise the option inherent in the utility's excess capacity. That experience, however, provides little if any guidance about out-of-sample market conditions, such as the California electricity crisis of 2000-01. Yet it is especially for such outlier events that insurance confers its greatest advantage on the insured-in this case, the very consumers whom public utility regulation exists to protect.