What Is Fair Rate of Return?

Mary McMahon

A fair rate of return is a reasonable profit based on operating expenses and obligations to shareholders. This term typically arises in a regulatory context, when government officials want to control pricing for the benefit of customers. Price controls can be seen with certain utilities, rents, and insurance charges, depending on the view taken by national regulators. Advocates of such policies argue that they control costs to make services accessible to consumers, while critics believe they interfere with free market conditions.

The tools used to calculate a fair rate of return can vary, in part because the definition of “fair” can be slippery.
The tools used to calculate a fair rate of return can vary, in part because the definition of “fair” can be slippery.

The tools used to calculate this rate can vary, in part because the definition of “fair” can be slippery. Regulators typically look at operating costs, including payroll, facilities maintenance, and investment in business activities. An electric utility, for example, may need to be able to expand capacity to serve customers, and might also need to invest in new control systems to replace outdated equipment. It must have capital available to do so, and relies on customer fees to meet its needs.

Utilities can also be publicly traded companies, in which case they have an obligation to generate returns for shareholders. A fair rate of return may need to account for shareholder benefits commensurate with those seen in shares with similar companies. Utility shares tend to pay out below the rate of the rest of the market, but offer more stable and reliable investments because they are less prone to volatility.

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Similar calculations can be used to set price controls for property rents, usually in the interest of making affordable housing available. Property owners need to be able to maintain their property and generate some profits to make the venture worthwhile, and a fair rate of return must account for these needs. The same issue can be seen in insurance, where subscriber fees fund a risk pool the company uses to pay claims, but it also needs to generate profits to pay administrative costs and compensate shareholders.

Economists with an interest in price regulation have discussed a number of ways to calculate and evaluate fair rate of return. Industries subject to this kind of regulation typically play an active role in the rule making process to advocate for themselves. Individual companies may submit requests for review and waivers if they feel the fair rate of return determined by regulators does not meet their needs. For example, a landlord might ask for a rent increase on the grounds that severe weather conditions led to a number of unexpected expenses not covered by insurance policies.

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