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Regulatory Finance: Financial Foundations of Rate of Return Regulation.

By Howard E. Thompson. Boston: Kluwer Academic Publishers, 1991. Pp. xii, 243 . $52.50.

This monograph, which is one in editor Michael A. Crew's "Topics in Regulatory Economics and Policy Series," may be unusual in that the author, Howard E. Thompson, demonstrates a genuine understanding of the nuts and blots of the public utility regulatory process, particularly as it applies to the determination of a regulated utility's "allowed" rate of return. This alone may create a measure of positive economic value, given that the economics literature is replete with treatises on regulatory economics written by those who do not appear to have the foggiest notion of what actually transpires in the regulatory arena.

While the book does include some of the knowledge contained in the author's twenty-five years of research in the field, it is best classified a "survey" book, since it synthesizes existing regulatory finance literature. In the author's words, it is his goal to:

...provide a framework for developing the conceptual and

theoretical as well as empirical bases for rate

of return analysis [p. 212].

He painstakingly derives and critically examines both contemporary and historical rate of return methodologies. These include the more traditional comparable earnings and discounted cash flow (dcf) approaches; and the more modern capital asset pricing model (CAMP), with the closely related arbitrage pricing theory. Also included is a chapter on "valuation of contingent claims" analysis, which as the author admits is not useful for determining the allowed rate of return, but is valuable as tool in an analysis of how the regulatory process itself affects a utility's cost of capital.

While Thompson makes every effort to fairly and rigorously evaluate each methodology, the reader is left with the distinct impression that, given his "druthers," he prefers the dcf approach, as modified to reflect a market-to-book ratio of one. This is the methodology he employs in his own referenced studies. However, he maintains, the use of multiple methodologies combined with expert judgement is an event better approach, particularly for rate of return witnesses. This, he tells us, is because there is no way to ultimately assess which methodology is best. A reader might conclude that his judgement on this issue, while prudent, is entitled to a low rate of return commensurate with its risk.

Thompson believes the value of his work is in presenting a framework by which to analyze rate of return testimony that is presented in a rate case. While the book is well written and accomplishes this goal, the book must compete in a very thin market with Kolbe, Read, and Hall's cost of capital handbook [1]. The reader needs a background in the arcane discipline of regulatory finance to understand the material in Thompson's monograph, it is not presented as an elementary approach to this subject. Kolbe, Read, and Hall, on the other hand, present a more rudimentary study of the cost of capital in a regulatory arena, which the reader trained in economics and finance should be able to comprehend. Thompson's work is more objective in comparing the balance between the customers' right to "just and reasonable" rates and a utility's entitlement to the "opportunity to earn" a fair return. Kolbe, Read, and Hall preach a bit more about a utility's ability, or lack thereof, to obtain a fair rate of return. While Thompson favors the dcf methodology, Kolbe, Read, and Hall's tastes lean more towards CAMP. Both show an understanding of the regulatory process and the role judgement plays in both the expert's testimony and the commission's pronouncements.

The reader who is both interested in and has the background to grasp the concepts presented in Thompson's book will probably find its purchase is not necessary. It contains little fresh material. What would be useful for many economists is an expanded Part 1: "The Institutional Setting for Rate of Return Determination." However, those who wish to own a regulatory finance book must choose between Thompson and Kolbe, Read, and Hall. The aspiring witness, commissioner, or expert should choose Kolbe, Read, and Hall, while one who is already an expert in the field should choose Thompson. Henri E. Kilpatrick, Jr. Federal Energy Regulatory Commission

References

[1]Kolbe, A. Lawrence, James A. Read, Jr., and George R. Hall. The Cost of Capital. Cambridge, Mass.: The MIT Press, 1984.
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Author:Kilpatrick, Henry E., Jr.
Publication:Southern Economic Journal
Article Type:Book Review
Date:Apr 1, 1992
Words:716
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