The Determination of the Allowed Rate of Return in a Formal Regulatory Hearing

This paper presents an attempt to specify and estimate a simple model of the rate of return phase of a formal regulatory hearing. The specification of the model derives from the author's intensive study of the regulatory decision-making process in New York State. Although well-defined legal rules for the calculation of the allowed rate of return have not evolved in most regulatory jurisdictions, the results indicate that the regulatory agency, in a consistent fashion, makes use of the information provided to it in the regulatory hearing. The rate of return allowed by the commission is shown to depend on the size and relative reasonableness of the firm's request, the presence or absence of cost of capital testimony supporting the firm's request, the presence or absence of intervenors presenting conflicting rate of return testimony, the type of firm making the rate of return request, and a subjective evaluation of the efficiency of the firm making the request. The results also suggest that commission behavior changes in response to problems faced by the regulatory process in a world characterized by rapid inflation.