Why building more was always the right answer — for the utility.
In 1962, two economists named Harvey Averch and Leland Johnson published a paper that would haunt utility regulation for decades. Their insight was simple but devastating: if a regulated firm earns a fixed return on its capital investment, and if that return exceeds the cost of borrowing money, the firm will always want to invest more capital — even if those investments are wasteful.
The math is merciless. If a utility can borrow money at 5% and its regulator allows a 9% return on invested capital, every dollar of new investment earns a 4% spread. The incentive is not to minimize costs, but to maximize the asset base on which profit is calculated. Economists called this the "Averch-Johnson effect." Utility executives called it good business.
Every few years, a utility would file a "rate case" — a massive regulatory proceeding where lawyers, accountants, and engineers would spend months arguing over whether the utility had spent its money prudently. Intervenors representing consumer groups would challenge costs. Utility witnesses would defend them. Commission staff would render opinions. And at the end, the commission would issue an order setting the rates customers would pay.
The system was exhausting, legalistic, and extraordinarily expensive. Rate cases for large utilities could cost tens of millions of dollars. The costs were, of course, passed on to ratepayers. And utilities learned to play the game expertly — timing rate cases strategically, front-loading capital investments, and exploiting the regulatory lag between when costs were incurred and when rates could be adjusted.
The Averch-Johnson effect reached its apex with nuclear power. In the 1960s and early 1970s, utilities looked at nuclear plants — enormously expensive to build, but cheap to run — and saw the perfect rate-of-return machine. A nuclear plant that cost $500 million to build might generate a return for decades. Utilities ordered them by the dozen.
The plants cost twice what engineers projected. Then three times. Construction stretched from 5 years to 15. Regulators, under pressure from consumers, began refusing to allow construction cost overruns into the rate base. Utilities were left holding billions in unrecovered "stranded costs." Several utilities went bankrupt. The nuclear bet had become a cautionary tale about the dangers of guaranteed profits without competitive discipline.
The central problem with rate-of-return regulation was the absence of any mechanism to reward efficiency. A utility that figured out how to generate power 20% cheaper than its peers would simply earn a lower rate case outcome, not a higher profit. There was no prize for innovation, no penalty for waste. In competitive markets, companies that cut costs keep the savings — at least temporarily. Under rate-of-return regulation, cost savings were passed to ratepayers almost immediately, eliminating any incentive to find them in the first place.
This is not an argument against regulation per se. Natural monopolies with no substitutes require oversight. But it is an argument that the design of regulation matters enormously — that poorly designed rules can create the very inefficiencies they were meant to prevent.
Pacific Northwest, July 25, 1983. When the Washington Public Power Supply System announced it could not repay $2.25 billion in municipal bonds, it triggered the largest municipal bond default in U.S. history at the time. The project had seemed reasonable in the early 1970s: five nuclear plants to meet the region's projected electricity demand, authorized under the same rate-of-return rules that had rewarded every prior utility capital project. But rate-of-return regulation had no mechanism to punish cost overruns — utilities simply passed them through to ratepayers. Construction costs ballooned from an initial $4.5 billion estimate to $24 billion. Two plants were abandoned at partial completion. Ratepayers and bondholders absorbed billions in losses, and "WPPSS" (pronounced "Whoops") became shorthand for the perverse incentives built into cost-of-service regulation.
UPI Archives — "Giant nuclear plant builder collapses into record bond default," July 31, 1983 Hagens Berman — WPPSS Securities Litigation background