Anyone who has sat through a rate case has heard the complaint: cost-of-service regulation rewards spending. Build more, earn more. It’s a fair complaint, and it’s behind most of the reform energy in the industry right now — performance incentives, multi-year rate plans, the various pitches to “break from cost of service” altogether.
But if it isn’t about cost, how do you price?
Work through the alternatives and the answer turns out to be short — which is exactly why every serious reform, here and abroad, keeps circling back to cost.
Three pricing families
There are only three ways to set the price of anything: cost, value, or market. Every pricing method is a variation inside one of those three.
A competitive business rarely has to choose — the market does it for you. Bids, willingness to pay, and cost of production all get reconciled at a market price.
A monopoly has no market to do that work, which is the whole reason it’s regulated. The regulator has to pick an anchor deliberately. That forces the three families into the open — and since two of them are bad choices, it all comes down to the cost variations.
The supply side is all about cost, however you look at it
There are a lot of options on the cost side, but they’re still all cost:
- Your own embedded cost — cost.
- A peer benchmark, the “yardstick” approach used in the Netherlands and Norway — someone else’s cost.
- A forecast expenditure baseline, as used in the UK and now Italy — expected cost.
- An avoided-cost or non-wires benchmark — the cost of a substitute provider.
- A productivity-trended revenue cap — a cost starting point escalated by a cost-trend estimate.
- The rate base itself — depreciated historical cost. Even a replacement-cost or fair-value base is still a cost concept.
This matters because benchmarking is often sold as an escape from cost of service. It isn’t. Yardstick regulation is an escape from your own cost into other people’s cost — a genuinely useful move, since it stops the utility’s own spending decisions from setting its own allowed revenue, the corrupted signal economists have flagged since the 1960s. But it’s still cost. The anchor never left the family. It just moved to a different member of it.
Value pricing means high pricing
The second family is value — what the service is worth to the customer, or what they’d be willing to pay. It’s a real anchor, and it isn’t cost-based at all. It’s also exactly what you don’t want.
My husband, who spent his career in competitive industries rather than monopolies, used to describe simply “taking price”: the firm wanted more earnings, so it raised the price. No rate case. No justification. Just whatever the market would bear.
For a near-essential service delivered by a monopoly, willingness to pay is close to unlimited. People need the lights on. A value anchor would justify revenue far above cost — which is exactly what regulation exists to prevent. The entire regulatory bargain is built to override the value anchor and hold the monopoly down near cost.
So value is out.
A market price works — in limited cases
The third family is a market: an auction, a solicitation, a settlement. Where a competitive process can run, the winning bid is the price — neither your cost nor a benchmark of anyone’s cost, but a revealed clearing price. This is the only genuine break from cost.
It works exactly where you’d expect, but only for parts of the utility business that can support competition: generation through auctions and power purchase agreements, competitive transmission solicitations, distributed energy and capacity procurement. In each case, more than one party can credibly offer to do the job, so a market can form.
It doesn’t work for the wires. Distribution and transmission networks are non-contestable by definition — you’re not running a second set of poles down the street to create competition. (It happened once, for gas service in Augusta, Maine — the town eventually settled on one supplier anyway.)
You could try to shrink the monopoly instead — push storage, EV charging infrastructure, and similar services out to the competitive market where they belong. But for the core wires business, the market anchor — the one true escape from cost — mostly isn’t available.
We’re left with cost
So there’s really no choice here. If it’s a monopoly, the pricing has to be cost-based. Value is off the table — that’s the harm regulation exists to prevent. Market is off the table for the non-contestable wires — no market can form there. That leaves cost, in one variation or another, as the anchor for allowed revenue.