Academic journal article Contemporary Economic Policy

Testing Regulatory Consistency

Academic journal article Contemporary Economic Policy

Testing Regulatory Consistency

Article excerpt


Consistency is generally deemed to be a key principle of good regulation. (1) It is also often demanded by regulated businesses. (2) Although no genera] definition for regulatory consistency exists, it usually means a requirement for equitable treatment; different firms under identical conditions regulated by different regulators should expect to be treated in the same way.

An important issue, and the starting point of this paper, is that there does not seem to be a clear articulation of how one should measure consistency. The approach followed in legislation often seems to rely on ensuring that particular regulatory parameters are the same. For example, the weighted average cost of capital (WACC) parameters that will apply to all electricity distribution businesses across Australia for regulatory proposals submitted between April 1, 2009 and April 1, 2014 will be identical "unless there is persuasive evidence provided in individual distribution proposals that justify a departure" (3) from the standard rate set by the regulator.

Without detailed knowledge of the regulatory process, an outside observer may be tempted to equate consistency of specific regulatory parameters such as the WACC with regulatory consistency. This focus could be rationalized by the view that the WACC is based on the firms' capital requirements, which can be objectively assessed. This view, however, can be misleading as it ignores the discretionary nature of the choice of the WACC and other regulatory parameters by the regulator.

Consider, for example, two identical firms that are assessed by different regulators. It is clear that the regulatory decisions should yield the same return on capital. Suppose further that the WACC parameters are identical across the two decisions but there are two different methods for setting the regulated asset base. In this simple example, identical WACC parameters will result in inconsistent returns on capital. This example highlights that regulators typically set both the WACC and other regulated parameters simultaneously. This is different from the role that the WACC plays in unregulated markets where the value of assets is determined by the market. Therefore, using the WACC to measure regulatory consistency might be misleading.

Perhaps the focus on specific parameters such as the WACC is understandable; it is easier to compare the WACC across decisions than to compare more multidimensional criteria such as asset valuation methods. However, as the example illustrates, focusing on the WACC as a measure of regulatory consistency may be misleading. This observation provides one motivation for this paper, namely, to provide an alternative measure of regulatory consistency which has the advantage of being one-dimensional but avoids the disadvantage of focusing on a single parameter such as the WACC.

We propose to measure consistency as the proportion of firms' revenue requirement claims (proportion of disallowed claims |PDC]) disallowed by the regulator when determining the maximum revenue. This measure aggregates a wide variety of inputs into the regulatory process and also focuses on a concrete outcome which both the firm and the regulator care about. This measure also has the advantage of not requiring any detailed knowledge of how the regulatory decision was arrived at. One limitation is that for some countries the data to construct PDC will not exist. However, this data will be available for many countries including those that use rate-of-return regulation (like the United States) and others that undertake a building blocks approach (like for some industries in the United Kingdom, New Zealand, and other countries).

A second motivation for this paper is to propose an approach for testing regulatory consistency across jurisdictions and industries. We do not specify a model of the regulatory decisionmaking process, instead taking an econometric approach which allows for, but does not impose, systematic differences across time, industry, and regulator. …

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