Dynamics of Rate-of-Return Regulation

Dynamics of Rate-of-Return Regulation

By Madhav V. Rajan, Stefan J. Reichelstein, Alexander Nezlobin
2011Working Paper No. 2041

Under Rate-of-Return regulation, a firm’s product prices are constrained by the requirement that investors do not earn more an allowable return on the firm’s assets. This paper examines the dynamic properties of the Rate-of-Return regulation process when the regulated firm periodically undertakes new capacity investments. Our analysis identifies prices that correspond to stationary values of the regulation process. It is shown that the underlying depreciation rules for property, plant and equipment determine whether these stationary prices will be above, equal to, or below the long-run marginal cost of providing the regulated service. We provide conditions under which the Rate-of-Return regulation process is dynamically stable so that prices indeed converge to their stationary values. The overall efficiency of this regulation method is shown to depend on how well the applicable depreciation schedule matches the productivity pattern of the assets in use.

Also see Stability Properties of the Rate-of-Return Regulation Process.