Information asymmetry: the traditional framework of cost of service ratemaking was adopted early on as a reasonably simple tool to regulate a monopoly business. However, the success and effectiveness of this form of regulation predicates on the ability of the regulator to ensure prudent investment decisions by the utility. Yet, there exists an information asymmetry between the two entities, as it is only the utility that can be certain of its needs and associated costs.
Incentive to increase the capital base: the way in which cost of service ratemaking is structured means that utilities are incentivized to increase their capital base in order to increase their profits – leading to gold-plated networks and over capacity. Similarly, operating expenses can also balloon as approved costs are passed on and recovered from customers under the cost of service approach. While the regulator does review and approve these costs, the regulator’s staff may not always be able to examine all costs in detail, in order to correctly identify any exaggerated estimates.
Incentive to promote greater consumption: as utilities need to demonstrate the need for capital investments in rate reviews, their increased investments (in order to increase profits) also necessitates greater utilization of the growing rate base. This means that utilities have an incentive to promote greater consumption by customers. At the same time, any increase in sales for a given rate base increases the profits as well (so long as marginal variable costs are lower than the marginal revenues) – this is known as a throughput incentive.
Risk aversion to innovation: another drawback of cost of service ratemaking stems from the certainty provided to the utility of receiving a return on its capital investments. This leads to risk-aversion on the part of the utility’s management, where uncertain returns for innovation or any radical changes means that they are deemed to be too risky compared to the status quo.
Regulatory lag: there is an unavoidable regulatory lag between the moment when costs change for a utility and the time the regulator approves a change in the utility’s rates. This lag may work against the utility’s bottom line, but it also may result in excess profits if costs decline (or do not increase as fast as anticipated) before rates are revised to reflect this.