The level set for the allowed rate of return for a regulated firm is a critical input in many regulatory determinations. Regulators typically recognise that the welfare losses that might arise from errors in estimation of the allowed rate of return may not be symmetric, and have often tried to account for this by selecting ‘conservative’ values for some of the key input variables. This paper discusses the drawbacks of these essentially ad hoc procedures, and proposes a more systematic approach to the determination of the allowed rate of return, based on simulation and welfare loss functions. Such an approach could help promote greater consistency in making such determinations across the regulated sector.
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