Total Factor Productivity and Electric Utilities Regulation

Regulators base electricity prices or rates on the average operating cost of producing electricity and on a "fair" rate of return on capital for a given year.

There are two shortcomings with this procedure. First, it does not consider the dynamics of average total costs and its components. Regulations may influence the incentives of utilities to innovate and overcapitalize as well as the demand for electricity which, in turn, may influence utility operating costs.

Second, regulators consider only tangible input factors (capital, labor, fuel, material) in the calculation of average costs. Intangible input factors (workers’ discipline, managerial skills, returns to scale, for example) are not considered in the regulatory price mechanism because they have no explicit and measurable prices and their effect on utility output and costs is difficult to measure.