Incentives for Accruing Costs and Efficiency in Regulated Monopolies Subject to ROE Constraint

Incentive problems arise in the electric utilities industry as a consequence of the institutional and legal arrangements of the cost-plus pricing regime under which natural and statutory monopolies operate. In the United States, such monopolies operate under a cost recovery system that gives the firm a mechanism by which it can shift all or part of the cost of moral hazard risk to consumers, who then become the residual claimants (Sherman [1980]). In this setting, expense accruals have a more direct link to the firm's cash flows than is the case in unregulated industries. In particular, pricing a monopolist's output at cost-plus means that accruing expenses generates sales revenues for utilities. Consequently, agency cost can be included in the allowable cost passed on to consumers. The result is that the residual loss is shared between the consumers and shareholders with two competing consequences: (1) it would be in the best interest of shareholders to provide managers with incentives to shift all costs to the consumer; and, by the same token, (2) it would be in the consumers' interest to persuade regulators to challenge the cost assumptions underlying the firms' requests for revenue requirements.