Chapter 5 Cost Measurement
Figure: The framework for Developing Regulated Services
and Prices
Pricing and
Services Regime
Other
Charging Policies:
Connection Policy
Tariff Exceptions
Special Services
Obligations to Serve
Tariffs
Pricing Structure
Terms and
Conditions
of Service
• Steps to calculate regulated prices:
(1).Set the revenue requirement (this chapter)
(2).Functionize costs
(Activity 1, Activity 2, Activity… Activity N)
(3).Classify costs
(Fixed costs, Variable costs, Customer Costs)
(4).Allocate costs
(Customer Class1,…Customer Class M)
(5).Set rates and tariffs
(Prices Class 1,…Prices Class M, Other Prices.)
Figure: The Three Sets of Books
Accounting and
Technical Data
Statutory Books
How are we doing?
Were we profitable?
Tax Books:
What must we pay?
Regulatory Books
What may we charge?
• Design of Accounting Systems:
Uniform System of Accounts, used by all public utilities.
Institutions decide how to collect data:
Ex:
 Financial Accounting Standards Board (FASB): relevant
and reliable
 Securities and Exchange Commission (SEC): objectivity
and reproducibility
 American Institute of Certified Public Accountants
(AICPA): reasonableness
2. Data Envelope Analysis (DEA)”
• uses linear programming technique, determine and
efficient frontier (“envelope”)
• On the frontier:=100;
Within the frontier: <100
• Based on a sample of similar firms
Problems:
(1) too-small sample sizes;
(2) ignores many attributes that underlie a firm’s cost
structure;
(3) inconsistent—high efficiency standard; average return
to investors.
3.Ordinary Least Squares and Corrected OLS (COLS):
Compare with DEA:
Similarities: all use econometric approach to estimate
cost;
Difference: OLS & COLS do not estimate relative
efficiency levels like DEA.
4. Stochastic Frontier Analysis (SFA):
--another empirical technique to estimate an efficiency
frontier. It breaks the error term into two components.
Problems: same with OLS&COLS: too few samples.
The Efficient Markets Hypothesis
• All above lies in a fundamental hypothesis: capital
markets are efficient.
(1) allocative efficiency—distribution of goods and
services to their highest values
(2) exchange efficiency—the ability to transfer funds bw
one another at the lowest possible cost
• Three types (Eugene Fama):
(1) Weak form: all past market prices are completely
reflected in current prices. No investor can earn excess
returns by developing trading rules based on past price
info.
(2) Semi-strong form: No investor can earn excess
returns from any publicly available info, such as
corporate Annual Reports, 10-K forms, Wall Street
Journal columns.
(3) Strong form: No investor can earn excess returns
using any info, whether public or not.
4. The Risk Premium Model (RPM):
• Based on: the fact that for an investor, common equity
capital is riskier than debt.
• Potential investors in a company require a premium on
top of the cost of debt issued by that company to induce
them to provide equity capital.
• Compare to CAPM:
Similarity: both use Beta
Difference: RPM incorporates both systematic and
unsystematic risk (CAPM: only systematic)
5.5 Deferred Costs and Regulatory
Assets
• Not all prudently incurred regulated costs are flowed
through to customer rates immediately.
• A deferred cost is one that the firm has paid for but
which has not been included in its rates.
• Regulatory assets( a type of deferred cost): a deferred
cost that is included in rate base, where it earns a rate of
return.