How the regulator overpays investor? A simple exposition of the principles of tariff setting

In this teaching note, we discuss the basic principles for tariff setting. Tariff setting is very important for regulated industries, such as water and power. The tariff should provide an appropriate risk-adjusted return to the investor. If the tariff were too low, then the investors would not be willing to invest. On the other hand, if the tariff were too high, then it would reduce the consumers’ welfare. We examine the Rate of Return method for calculating the tariff in a regulated firm. In the rate of return method, the tariff compensates the investor for all the costs that the investor incurs, including a fair return. We use the discounted cash flow approach to value the return that the investor receives. The results of both calculations must be consistent. In particular, using simple examples, we show that in the presence of a positive expected inflation rate, the typical tariff calculation, Rate of return method, is an overestimation of the required payment to the equity holder.