Rate of Return Mechanics

Regulators invented rate-of-return oversight to prevent utilities from exploiting their monopoly. What they accidentally created was a financial incentive to build as much physical infrastructure as possible, whether customers needed it or not.

Rate-of-return regulation sets allowed revenue through a formula: Allowed Revenue = O&M + Depreciation + (Rate Base x Authorized ROE). O&M covers fuel and labor, recovered dollar-for-dollar. Depreciation returns asset costs over their useful life. Rate base times ROE is where profit lives: the larger the asset base, the larger the permitted earnings. Regulators set ROE at typically 9-11% on equity.

The Averch-Johnson effect (1962) describes the predictable result: utilities have a structural incentive to over-invest in capital relative to what is efficient. Adding a transmission line grows the rate base and therefore grows profit. Finding a cheaper solution does not.

A simplified utility: O&M $400M, depreciation $100M, rate base $2B, ROE 10%. Allowed revenue = $400M + $100M + ($2B x 0.10) = $700M. The utility proposes a $500M transmission upgrade.

Which component of the formula increases, and by how much?

Rate base rises to $2.5B. Revenue becomes $400M + $100M + ($2.5B x 0.10) = $750M. The utility earns $50M more per year from that one investment. A utility choosing between a $500M build and a $200M demand-response program delivering the same reliability has a strong financial reason to prefer the build.

This bias is why restructured markets were designed to separate generation from regulated wires, and why current debates about utility spending on grid modernization involve the same capital incentive.

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