GIFT OF 
 
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 THE 
 
 FIXED "RATE OF RETURN " 
 ON UTILITIES 
 
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 HENRY I. LEA 
 CONSULTING GAS ENGINEER 
 
 PEOPLES GAS BUILDING 
 
 CHICAGO 
 
INTRODUCTION 
 
 One of the most vital points in the regulation of 
 utilities by state commissions is found in the rate of 
 return allowed. 
 
 The fixed rate of return does not meet requirements. 
 
 It is believed that the variable rate of return, as 
 herein suggested, will be found not only equitable but 
 capable of yielding to the communities served and to 
 the utilities themselves, the maximum of benefit. 
 
 The advantages to community and to utility are 
 mutual. 
 
 Henry I. Lea. 
 
 299529 
 
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 (Article Reprinted from the 11/25/14 Issue of\ 
 "The Gas Record"— Chicago / 
 
THE FIXED "RATE OF RETURN" 
 ON UTILITIES 
 
 This Serious Error of Present Commission 
 Regulation is shown to be Against the Best 
 Interests of All Concerned and a Practic- 
 able Solution of the Difficulty is Suggested 
 
 By Henry I. Lea 
 
 A uniform wage among men has been shown to result 
 in the over-payment of many men, the under-payment 
 of a smaller number, and the stifling of ambition and 
 effort in many of those most capable of development. 
 
 I presume it is safe to say that none of the leaders 
 in any line of effort has been developed except through 
 the hope of attaining a position considered in some way 
 more attractive than that of the average man. 
 
 There must have been in each of such cases a constant 
 incentive to greater and more efficient effort. 
 
 Even those men who have become leaders may be 
 seen to relax when, through conditions beyond their 
 control, the abilities of such men along proper chan- 
 nels are no longer fairly rewarded. 
 
 All of this is so well known that it would hardly be 
 worth repeating here were it not for the fact that it has 
 apparently been overlooked in the regulations of some 
 of our public utility commissions. 
 
 The results from the operation of any public utility 
 are, of course, very largely determined by the attitude 
 of the individuals operating that utility; and, if those 
 
individuals do not have before them a continuous in- 
 centive to greater and more efficient effort, it is obvious 
 that the community must suffer. 
 
 In all lines of bargaining between man and man, it is 
 accepted as proper and right that the seller shall be 
 entitled to a larger profit if by any proper device he can 
 give to the buyer a larger value for the unit price. 
 
 Recognition of this principle is certainly one of the 
 most potent causes of our present industrial develop- 
 ment. 
 
 Such dealings as are fair and right between man and 
 man should be fair and right between the public 
 utility and the community served; yet the public utility 
 commissions of several of our states have seen fit to 
 place arbitrary limits upon the earning capacities of the 
 utilities in such manner as to injure not only the util- 
 ities but also (and in greater degree) the communities 
 served. 
 
 There is no valid objection to the control by com- 
 missions of the rates (and through the rates, the earn- 
 ing capacities) of public utilities, provided such regula- 
 tion be brought about in such manner as to be of 
 greatest benefit to all concerned. 
 
 It is impossible to realize the greatest benefit to all 
 concerned if the utility is restricted in its earning capac- 
 ity to a fixed percentage of its rate-making value, because 
 when a given utility has reached the maximum earnings 
 allowable under such regulation, the men responsible 
 for its operation will naturally relax their efforts toward 
 
greater economies of operation and greater volume of 
 sales and further reductions in selling price of the 
 product. 
 
 The interests of the community served can be best 
 protected by holding before the management of the 
 utility a continuous incentive to further effort. 
 
 Such incentive is not provided by the type of rulings 
 made to date by public utility commissions in the mat- 
 ter of rate of return. 
 
 The rate of return should not be fixed at a given per- 
 centage of the rate-making value, but should be variable 
 and largely determined by the efficiency of the manage- 
 ment as viewed from the standpoint of the community 
 served. 
 
 In other words, if a given utility can, by any proper 
 device, bring about a reduction in the average selling 
 price of its product, such utility should be allowed a 
 relatively larger rate of return than considered proper 
 under the higher selling price of its product. 
 
 Let us assume that two given cities have the same 
 population and the same characteristics (in so far as 
 the cost of gas-plant construction and of gas manu- 
 facture and distribution are concerned) and that these 
 two cities are supplied by separate companies, each 
 selling gas at a dollar per thousand and each having the 
 same volume of sales. 
 
 If, through the coming years, the first of these gas 
 companies continues selling gas at a dollar per thousand 
 cubic feet, while the second plant, through more 
 
efficient management, succeeds in increasing its sales 
 or in reducing its operating expenses (or both) to such 
 extent as to allow of a reduction in the average selling 
 price per thousand cubic feet, it is obvious that the rate 
 of return allowed to the second company (other things 
 being equal) should be greater than that allowed the 
 first company, because the second company, through its 
 reduction in the average price of gas, will have effected 
 for the community a distinct and measurable saving. 
 
 As between man and man, there should be no ques- 
 tion as to the propriety of allowing a higher rate of 
 return in the second instance than in the first. 
 
 No community will receive its maximum benefit 
 from the use of gas until the sales in that community 
 are at a maximum. 
 
 Such maximum sales will not be obtained until the 
 schedule of rates adopted places gas in a strong com- 
 petitive position throughout its entire range of pos- 
 sible use. 
 
 As the maximum earnings of the gas company cannot 
 be reached except through maximum sales of its prod- 
 uct, it is clear that the interests of the community and 
 the interests of the gas company are very largely iden- 
 tical; it is also clear that such maximum benefits to 
 the community as well as to the company will never be 
 obtained except through the active co-operation of all 
 concerned. 
 
 It is unfair to demand and illogical to expect relative- 
 ly increased benefits for the community through use of 
 
the product of the utility, without relatively increased 
 reward to the utility. 
 
 As previously indicated, the rate of increase in reward 
 to the utility should be determined by its rate of in- 
 crease in efficiency as viewed from the standpoint of 
 the community. 
 
 In the tabulation accompanying these notes, I have 
 shown a specific method of measuring such efficiency. 
 
 In preparing this tabulation it is assumed that a rate- 
 making body shall have examined, in the year 191 5, a 
 gas property having, at the beginning of that year, a 
 rate-making value of $10,000,000. 
 
 It is also assumed that during that year this company 
 shall have sold 2,000,000 M cubic feet of gas, and that 
 the average net revenue received from such sales shall 
 have been $1.00 per thousand cubic feet sold, yielding 
 a net total revenue for the year of $2,000,000. 
 
 It is also assumed that for that year this company 
 shall have had operating expense (exclusive of bond 
 interest and dividends) of 65c per thousand cubic feet 
 sold, or a total operating expense for the year of 
 $1,300,000. This would leave, for bond interest and 
 dividends, 35c per thousand cubic feet sold, or a total 
 of $700,000. 
 
 It is also assumed that to the rate-making value at 
 the beginning of 191 5 there shall have been added 
 $909,000 during the year. The amount of $700,000 
 available for bond interest and dividends during 191 5 
 would therefore represent 6.69% on the average rate- 
 
TABLE SHOWING RELATIVE IMPORT A 
 OF OPERATION UNDER V: 
 
 1915 IQl6 1917 1918 
 
 Rate-making value at beginning of year $10,000,000 $10,909,000 $11,869,000 $12,881,000 
 
 Additions to same during year 909,000 960,000 1,012,000 1,065,000 
 
 Gas sold during year (thousand cubic 
 
 feet) 2,000,000 2,200,000 2,420,000 2,662,000 
 
 Increase over sales of previous year 10% 10% 10% 10% 
 
 Average net revenue per thousand cubic 
 
 feet sold $1.00 $ .985 $ .970 $ .955 
 
 Total net revenue per year $2,000,000 $2,167,000 $ 2,347,400 $2,542,210 
 
 Operating expense (exclusive of bond 
 
 interest and dividends) per thousand 
 
 cubic feet sold $ .65 $ .632 $ .614 $ .596 
 
 Total operating expense (exclusive of 
 
 bond interest and dividends) $1,300,000 $1,390,400 $1,485,880 $1,586,552 
 
 Available for bond interest and dividends 
 
 per thousand cubic feet sold $ .35 $ .353 $ .356 $ .359 
 
 Total available for bond interest and 
 
 dividends ( = net earnings) $700,000 $776,600 #861,520 $955,658 
 
 Rate of return on average rate-making 
 
 value throughout year 6.69% 6.8i% 6.96% 7-12% 
 
 Net earnings required to yield 6.69% on 
 
 average rate-making value through- 
 out year $700,000 $761,924 $827,888 $897,363 
 
 Actual net earnings in excess of 6.69% 
 
 return o $14,676 $33,632 $58,29$ 
 
 Minimum actual saving to community 
 through reduction in average price of 
 gas: 
 
 On volume sold during 1915 o 
 
 On increase during 1916 
 
 " 1917 
 
 " 1918 
 
 " 1919 
 
 " 1920 
 
 " 1921 
 
 " 1922 
 
 " 1923 
 
 " 1924 
 
 Total 
 
 Minimum actual saving to community in 
 percentage of t 
 munity for gas 
 
 percentage of total payment by com- 
 fo 
 
 $30,000 
 
 
 $60,000 
 
 3,000 
 
 
 $90,000 
 
 6,000 
 
 3,300 
 
 
 
 * ..... 
 
 $30,000 
 
 $63,000 
 
 . $99,300 
 
 1.38% 
 
 2.68% 
 
 3-90% 
 
fe to community and to company 
 Viable rate of return 
 
 1919 
 
 1920 
 
 1921 
 
 1922 
 
 1923 
 
 1924 
 
 1925 
 
 1 #13,946,000 
 1,118,000 
 
 $15,064,000 
 
 1,171,000 
 
 $16,235,000 
 1,224,000 
 
 £17,459,000 
 1,276,000 
 
 $18,735,000 
 1,325,000 
 
 $20,060,000 
 1,372,000 
 
 $21,432,000 
 1,415,000 
 
 2,928,200 
 10% 
 
 3,221,020 
 
 10% 
 
 3,543,122 
 10% 
 
 3,897,434 
 
 10% 
 
 4,287,177 
 10% 
 
 4,715,894 
 
 10% 
 
 5,187,483 
 10% 
 
 £ .94 
 
 $2,752,508 
 
 i .925 
 $2,979,444 
 
 $ .91 
 $3,224,241 
 
 £ .895 
 
 $3,488,203 
 
 $ .88 
 $3,772,716 
 
 $ .865 
 $4,079,248 
 
 $ .85 
 $4,409,360 
 
 $ .578 $ .560 $ .542 $ .524: $ .506 $ .488 $ .47 
 
 $1,692,500 $1,803,771 $1,920,372 $2,042,255 $2,169,312 $2,301,356 $2,438,117 
 
 $ .362 $ .365 $ .368 $ .371 $ .374 $ .377 $ .38 
 
 $1,060,008 $1,175,672 $1,303,869 $1,445,948 $1,603,404 $1,777,892 $1,971,243 
 
 7.30% 7-51% 7-71% 7-98% 8.26% 8.56% 8.90% 
 
 $971,054 $1,046,952 $1,127,064 $1,210,689 £i,297,693 £1,387,907 $1,481,133 
 
 ,954 $128,720 $176,805 $235,259 $305,7" $389,985 £490, 1 10 
 
 $120,000 
 
 $150,000 
 
 $180,000 
 
 $210,000 
 
 $240,000 
 
 £270,000 
 
 £300,000 
 
 9,000 
 
 12,000 
 
 15,000 
 
 18,000 
 
 21,000 
 
 24,000 
 
 27,000 
 
 6,600 
 
 9,900 
 
 13,200 
 
 16,500 
 
 19,800 
 
 23,100 
 
 26,400 
 
 3,630 
 
 7,260 
 
 10,890 
 
 14,520 
 
 18,150 
 
 21,780 
 
 25,410 
 
 
 
 3,993 
 
 7,986 
 
 n,979 
 
 15,972 
 
 19,965 
 
 23,958 
 
 
 
 
 4,392 
 
 8,784 
 
 13,176 
 
 17,568 
 
 21,961 
 
 
 
 
 
 4,832 
 
 9,663 
 
 14,494 
 
 19,326 
 
 
 
 
 
 
 5,315 
 
 
 10,629 
 
 5,846 
 
 
 15,944 
 11,692 
 
 6,431 
 
 £139,230 
 
 £183,153 
 
 $231,468 
 
 $284,615 
 
 £343,076 
 
 £407,382 
 
 $478,122 
 
 5.05% 
 
 6.14% 
 
 7.17% 
 
 8-15% 
 
 9-09% 
 
 9.98% 
 
 10.84% 
 
making value of this property throughout the year. 
 
 It is also assumed that the public utility commission 
 (or other rate-making body) shall have determined that 
 6.69% is a fair rate of return for this property under the 
 conditions found in 191 5. 
 
 Now, my suggestion is that, instead of maintaining 
 this same 6.69% on the then rate-making value as con- 
 stituting a fair rate of return through each of the years 
 to follow, the rate of return allowable to the company 
 shall be increased from year to year by an amount in 
 money not exceeding the saving effected for the com- 
 munity during such year by the company. 
 
 As will be seen from this table, I have assumed that 
 the sales of gas by this company can be increased from 
 2,000,000 M cubic feet in 191 5 to more than 5,000,000 
 M in 1925. 
 
 Accompanying this increase in sales will, of course, 
 be a very material increase in the property of the com- 
 pany and consequently in its rate-making value, al- 
 though such increase in rate-making value usually will 
 be proportionately less than the increase in sales. 
 
 It is further assumed that throughout this period the 
 company finds itself able to make such modifications 
 of its gas rate schedule as will result in a reduction of 
 i>£c per M, each year in the average selling price of 
 gas, and that the company also will be able, in this 
 period and with the sales indicated, to reduce its operat- 
 ing expenses from 65c in 191 5 to 47c in 1925. 
 
It is understood, of course, that the uniform rates of 
 increase and decrease here shown are not realized in 
 practice, and that they are used here merely to illustrate 
 the method of this calculation. As a matter of fact, 
 such attractive decrease in operating expense as here 
 indicated could be brought about only in a property 
 showing constant gains in number of consumers per 
 mile of main, gas sold per meter, etc., etc. 
 
 Referring now to the year 1916, it will be seen that 
 the gas sales for that year are shown to be 10% in excess 
 of the sales for 191 5, that the average net revenue per 
 thousand cubic feet sold for that year is 98J/2C, and that 
 the operating expense has been reduced to an average 
 of 63.2c. 
 
 Such operating conditions would result in leaving 
 35.3c per thousand cubic feet sold, or $776,600 
 available for bond interest and dividends; but this 
 amount of money represents 6.81% on the average 
 rate-making value for the year and is $14,676 more 
 than would be allowed if the 6.69% rate of return had 
 been maintained. 
 
 It therefore becomes necessary to show that the 
 company has actually saved to the community a sum 
 in excess of this $14,676, which I claim should now be 
 allowed in addition to 6.69% return on the then rate- 
 making value. 
 
 During the year 1916 an increase in sales of 200,000 
 M cubic feet is shown. It is possible that a portion of 
 this increase might be traced directly to the reduction 
 
of i^c per thousand in the average selling price, but 
 as the percentage will be difficult if not impossible to 
 determine, that portion of the saving to the com- 
 munity is ignored; but it is very clear that the equiva- 
 lent of those consumers who used 2,000,000 M cubic 
 feet in 191 5 at $1 per thousand, have used in 1916 
 the same quantity at i>£c less per thousand cubic feet. 
 
 The minimum actual saving to the community 
 through this reduction in the price of gas for the year 
 1916, will therefore have been $30,000. 
 
 This actual saving to the community in the sum of 
 $30,000, then, is the measure of the increase in net 
 earnings which the company should be allowed (if able 
 to earn it) over the 6.69% determined as a fair rate of 
 return under the conditions of 191 5. 
 
 For each of the years the calculation is carried for- 
 ward in this same manner. 
 
 For example, in 1917 the savings on increase in sales 
 during that year are ignored, but the sales during 191 5 
 are carried forward at a saving of 3c per M, and the 
 increase in sales during 1916 are carried forward at a 
 saving of ij^c per thousand sold, for the average net 
 revenue of 191 7 is shown as 97c per M. 
 
 These cumulative savings for 191 7 aggregate $63,000 
 and this is the sum which should represent (for the 
 year 1917) the maximum increase in earnings allow- 
 able to the company in excess of the 6.69% established 
 in 1915. 
 
It will be noted that under the conditions here 
 assumed the actual net earnings of the company, in 
 excess of the 6.69%, would not exceed the minimum 
 actual saving to the community through the several 
 reductions in the price of gas until the year 1925. 
 
 When such a condition has been reached, it may be 
 that there should be made for the following year a 
 relatively greater reduction in the average selling price, 
 if the operating expenses per M of 1925 can be main- 
 tained or reduced. 
 
 This method of determining rate of return, while 
 bringing about important savings to the community, 
 would offer to the company a continuous inducement 
 to the increasing of its sales, the reduction of its oper- 
 ating expense and the reduction of the average selling 
 price of gas. 
 
 To all intents and purposes, it would make the gas 
 consumers preferred share-holders in the gas company. 
 
 It would also bring about savings to the community 
 constantly increasing not only in the total amount, but 
 also in the percentage that such amount bears to the 
 total paid by the community for gas. 
 
 For example, the minimum actual saving to the 
 community, through the reduction in price, in 1916 
 would represent a saving of 1.38% of the total amount 
 paid by the community for gas, whereas in 1925 the 
 minimum actual saving to the community would repre- 
 sent 10.84% °f tne corresponding total; in the mean- 
 time the net earnings of the company would have in- 
 
creased at a slower rate — viz., from 6.69% in 191 5 to 
 8.90% in 1925. 
 
 There is no intention that the figures here shown 
 shall be considered applicable as they stand to any 
 given community or utility, but the method indicated 
 in this calculation can be applied to any utility in any 
 community. 
 
 It is an established fact that the flow of capital into 
 the public utilities has, since the coming of public 
 utility commissions, been seriously retarded. 
 
 The writer knows personally of utilities which have 
 been prevented from coming into being only by the 
 fixed rates of return already established by commissions 
 in connection with existing utilities. 
 
 It must be borne in mind that the final judge of the 
 sufficiency of any rate of return is not the community, 
 nor the commission — it is the man whose money is to be 
 used. 
 
 The argument of the existing companies in hearings 
 before commissions, has been directed toward securing 
 an increase in the fixed rate of return thought proper by 
 the commissions. 
 
 While an increase in the fixed rate of return would 
 doubtless be of some advantage, through providing 
 some further incentive, it still seems clear that a vari- 
 able rate of return, determined by the efficiency of the 
 utility from the standpoint of the community, will 
 prove of much greater and more certain value to the 
 
community than any fixed rate of return can be ex- 
 pected to prove. 
 
 With a variable rate of return, such as here sug- 
 gested, the community would be assured that every 
 effort of those responsible for the conduct of the utility 
 would, at all times, be bent toward securing greater 
 sales and greater efficiency in operation and a lower 
 average price of its product; for the increase in volume 
 of sales, in connection with the reduction in average 
 selling price of the product, would determine the 
 amount which the company would be allowed to earn in 
 addition to the fixed percentage determined at the time 
 of original hearing. 
 
 Operation under such a plan would encourage the 
 establishment of new utilities in communities not now 
 supplied and would cause existing utilities to be of 
 vastly greater assistance in the building up and general 
 growth of communities served. 
 
UNIVERSITY OF CALIFORNIA LIBRARY 
 
 THIS BOOK IS DUE ON THE LAST DATE 
 STAMPED BELOW 
 
 JUL 19 t91S 
 
 MAR 9 W25 
 
 
 
 
 V* 
 
 
 
 ■W/27 1929 
 
 30m-l,'15 
 
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