Alternative cost-of-capital concepts in regulation
At the present time two cost-of-capital concepts are more widely used than any other in regulation as a basis for determining the cost-of-equity capital. One of these is the discounted-cash-flow (DCF) concept which is based on a dividend valuation model of common stock prices. The other concept widely used in regulation is the comparable-earnings concept. The economic rationale for comparable earnings as a cost-of-capital concept presumes that investors have the opportunity to invest in direct investment and that the earnings on book value of alternative comparable investment opportunities is therefore properly considered to be the opportunity cost of capital. According to the National Association of Regulatory and Utility Commissioners, more than half of the state commissions presently rely upon or accept comparable earnings as a method of determining the cost of equity for public utilities. Only about one-third of the state commissions have indicated an acceptance of DCF. The paper begins with a review and critique of the comparable-earnings concept as it is applied in regulation, and argues, among other things, that the comparable-earnings approach violates a fundamental marginal condition necessary to achieve efficiency in the allocation of capital, and generally results in an overestimate of the cost of equity. The paper then reviews the corresponding strengths and weaknesses of the DCF approach and suggests that DCF embodies a proper concept of return at the margin that makes it preferable to comparable earnings as a regulatory tool for determining the cost of equity for public utilities. (MCW)
- Research Organization:
- Iowa State Commerce Commission, Des Moines
- OSTI ID:
- 7060298
- Journal Information:
- Land Econ.; (United States), Vol. 54:3
- Country of Publication:
- United States
- Language:
- English
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Related Subjects
POLICY AND ECONOMY
PUBLIC UTILITIES
CAPITAL
REGULATIONS
ALLOCATIONS
COMPARATIVE EVALUATIONS
COMPETITION
ECONOMICS
EFFICIENCY
INCOME
INVESTMENT
MARKET
REVIEWS
RISK ASSESSMENT
DOCUMENT TYPES
293000* - Energy Planning & Policy- Policy
Legislation
& Regulation
290200 - Energy Planning & Policy- Economics & Sociology