The Utility of Finance

35 Pages Posted: 29 Jun 2017

See all articles by Shlomit Azgad-Tromer

Shlomit Azgad-Tromer

Columbia University - Law School

Eric L. Talley

Columbia University - School of Law

Date Written: June 28, 2017

Abstract

Public Utilities Commissions (PUCs) are charged with regulating a public utility’s rates at levels that serve the public’s interest while allowing the utility’s investors to earn a rate commensurate with that expected by businesses facing similar risks. Although the process of adjusting rates for risk is a staple of modern finance, we know surprisingly little about how well accomplish their regulatory mandate when judged against the benchmarks of financial economics. This article analyzes a dozen years’ worth of gas and electric rate-setting decisions from PUCs in the United States and Canada, demonstrating empirically that allowed returns on equity (ROE) diverge significantly and systematically from the predictions of accepted asset pricing methodologies in finance. Our analysis suggests that current regulatory practice more plausibly reflects an amalgam of other non-finance desiderata, including political goals, incentive provision, and regulatory capture. For example, elected PUCs award significantly lower ROEs than appointed ones. We nevertheless conjecture that the divergence of observed regulatory behavior from asset-pricing fundamentals may be due (in part) to a lack of financial valuation expertise among regulators. To test this conjecture, we study a unique field experiment that exposed commissioners and their staffs to immersion training in finance. We find evidence that treated PUCs began to issue ROE rulings that were (moderately) more aligned with standard asset pricing theory than those of untreated placebo groups. Our results suggest that it is possible to train non-expert legal and regulatory decision-makers to exhibit greater fidelity to principles of financial economics.

Keywords: Rate regulation; financial economics; public utilities; regulation

JEL Classification: K2; K23

Suggested Citation

Azgad-Tromer, Shlomit and Talley, Eric L., The Utility of Finance (June 28, 2017). Available at SSRN: https://ssrn.com/abstract=2994314 or http://dx.doi.org/10.2139/ssrn.2994314

Shlomit Azgad-Tromer (Contact Author)

Columbia University - Law School ( email )

435 West 116th Street
New York, NY 10025
United States

Eric L. Talley

Columbia University - School of Law ( email )

435 West 116th Street
New York, NY 10025
United States

HOME PAGE: http://www.erictalley.com

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