Capital recovery for the regulated firm under certainty and regulatory uncertainty

Abstract

This paper examines the rate-of-return regulated firm's incentives in negotiations over cost recovery. It develops optimal recovery paths for the firm facing certainty versus uncertainty of discretionary regulatory policy. Front-loaded capital recovery is not generally optimal under certainty, which is contrary to Financial Accounting Standards Board (FASB) rules. However, with the consideration of regulatory uncertainty, the optimal recovery path is remarkably close to FASB-approved rules. The optimal recovery under certainty becomes time-consistent if the discretionary power of the regulators to alter a previously agreed upon plan is removed.