Incremental costs of capital and a reasonable rate of return

The current costs of capital are and should be of greater significance than historic or embedded costs for the determination of a reasonable rate of return for a utility company. This article develops the thesis that current costs represent the incremental cost of capital to a utility and, as such, they are the costs on which any reasonable rate-of-return calculation should be based. What is suggested is really a refocusing of attention in terms of the rate-making formula. For the most part, adjustments to compensate for changes in the value of money, changes in economic conditions, and differences in risks can more properly and effectively be made by varying the rate-of-return portion of the formula. The time seems right for such an approach. Returns on bonds and equity securities have risen dramatically within the last decade. The inflationary rate has also risen sharply during this period, and regulated companies have been affected by it to a greater extent than unregulated companies because of their inability to respond as readily with price changes. Thus, the risks attendant upon regulated companies have increased to a greater extent during this period than have the risks attendant upon unregulated companies. The result has alteredmore » the historical concepts that regulated companies are subject to relatively low business risk. Emphasis must be placed upon compensation for the current risks which a particular utility must face, and its increasing rate of return must not be limited by historical capital costs.« less