Modeling welfare loss asymmetries arising from uncertainty in the regulatory cost of finance

The allowed rate of return (AROR) is a critical input in the regulatory assessment of revenue requirements, price caps and other controls. Errors in estimating AROR impact on investment incentives and price setting and hence can induce welfare loss. It is often suggested that the welfare losses that arise from under-estimation of the AROR may be significantly greater than arise from over-estimation. However, to date, this proposition has not been examined in any detail. This paper assesses the extent of welfare loss asymmetry and its implications for the choice of AROR.