October 2002
The General Efficiency
Assumption: Setting X in RPI-X
A Report for Water UK
Project Team
Bill Baker
Brian Williamson
Helen Lay Jung
NERA Economic Consulting
15 Stratford Place
London W1C 1BE
United Kingdom
Tel: +44 20 7659 8500
Fax: +44 20 7659 8501
www.nera.com
Contents
Contents
Contents ........................................................................................................................................... i
Executive Summary ......................................................................................................................... i
I.
Introduction..........................................................................................................................1
II.
A.
B.
C.
D.
E.
What X Is, And What It Is For.............................................................................................2
X Centres on Anticipated Cost Efficiencies ........................................................................2
X Can be Modelled or Directly Calculated, but Should be the Same..................................3
Incentives Depend on Fixed Caps, Outperformance, and Clear Method ............................3
The Consequences of Setting X too High or too Low Differ Greatly .................................4
X reflects Productivity and Input Prices Relative to the Whole Economy..........................5
A.
B.
C.
D.
E.
F.
G.
UK Methods For Setting X - Opex & Overall.....................................................................7
Overview and Trends in UK Methods .................................................................................7
Bottom up (Engineering-Economic) Investigations ............................................................8
Comparisons of Company Cost or Productivity Levels ......................................................8
International Comparisons of Cost (or Productivity) Levels...............................................9
Projecting Cost Trends.........................................................................................................9
Projecting Underlying Productivity & Input Price Trends ................................................10
Allowing for Changes in Output Volumes or Quality .......................................................13
III.
IV.
Issues in Interpreting Empirical Evidence .........................................................................15
A. Inference from Sector Productivity Trends........................................................................15
B. Allowing for Productivity Boosts to Wear Off..................................................................16
C. Water Industry Opex Trends..............................................................................................16
V.
Lessons From International Experience.............................................................................19
VI.
Proposals For X-Setting in UK Water ...............................................................................21
Annex A.
A.1.
A.2.
A.3.
A.4.
A.5.
A.6.
A.7.
A.8.
Regulatory Developments since 1999 ...................................................................23
Summary ......................................................................................................................23
CAA - BAA Airports (March 2002)............................................................................25
Water Industry Commissioner for Scotland (November 2001)...................................25
Ofgem - Transco (September 2001) ............................................................................26
Oftel - BT & Concert’s Network Charge Controls (February 2001)...........................27
ORR – Railtrack Access Charges (October 2000).......................................................27
Competition Commission – Water Industry Appeals (August 2000)..........................29
Ofgem - Public Electricity Suppliers (December 1999) ..............................................30
Annex B.
Literature Update ...................................................................................................31
B.1. Summary ......................................................................................................................31
B.2. National Audit Office (March 2002) ...........................................................................32
NERA Economic Consulting
i
Contents
B.3.
B.4.
B.5.
B.6.
B.7.
B.8.
B.9.
B.10.
B.11.
B.12.
Nicholas Crafts (April 2002) .......................................................................................32
Mary O’Mahony (February 2002) ...............................................................................32
Mary O’Mahony & Willem de Boer (March 2002).....................................................32
Nicholas Crafts & Mary O’Mahony (2001).................................................................33
INTOSAI (October 2001) ............................................................................................34
Saal and Parker (2001).................................................................................................35
Bernstein & Sappington (2001) ...................................................................................37
HM Treasury (November 2000)..................................................................................37
Bernstein & Sappington (1999)...................................................................................37
Jeff Makholm & Michael Quinn (October 1997)........................................................38
Annex C.
C.1.
C.2.
C.3.
C.4.
General Empirical Update......................................................................................40
Summary ......................................................................................................................40
Input prices...................................................................................................................40
Productivity..................................................................................................................43
Partial Update of Previous Forecasts ...........................................................................44
Annex D.
International Experience ........................................................................................45
D.1. US ................................................................................................................................45
D.2. Australia.......................................................................................................................48
D.3. Europe ..........................................................................................................................48
NERA Economic Consulting
ii
EXECUTIVE SUMMARY
Water UK asked NERA to examine the setting at price cap Periodic Reviews of the general
efficiency target X which is used with the RPI in the RPI-X formula – especially considering
studies since 1999 and the efficiency target for operating expenditure. In this report we put
on one side all the other factors which will affect the pre-RPI price cap level, such as
anticipated changes in the volume and quality of outputs to be delivered, also any incentive
rewards and penalties for past company performance against targets.
What is X, and what is it for?
In the UK the overall X “emerges” from use of disparate data, analysis and judgements to
determine a series of deductions of hypothesised cost savings from projected opex & capex
amounts. The separate deductions from the projected inputs lead, via financial modelling, to
derivation of pre-RPI price cap levels which are lower - by the amount X. By contrast, the
focus of the academic literature, and of regulators in North America, is on use of evidence to
calculate an overall X to be applied year by year to adjust the output price cap directly, preRPI – after at the start of the period base year prices have been brought into line with
observed base year costs. However the two approaches, if soundly applied, should produce
the same overall efficiency target X.
X should not be thought of as a “stick” which will drive companies to make efficiency gains.
Rather, having the price cap fixed until the next Review gives companies an incentive to
reduce costs in the meantime, to increase profits until the Review reduces prices to cover only
the lower cost level. The incentive may be strengthened, as in England and Wales water, by a
mechanism at Review which increases the company retention of past cost savings. However
the magnitude of X, provided revenues are sufficient to finance the companies operations,
affects the timing with which anticipated cost savings are to be passed to customers: either
immediately they are expected to be made (via the pre-set X deduction), or at the next
Review (if the company saves more). Financial constraints aside, X-setting should centre on
determining the reasonably anticipated cost savings, so that the projected output prices can be
set no higher than they need to be to track reasonably projected costs.
In the RPI-X formula X specifies how company output prices will move relative to output
prices in the whole economy, since the latter move at the RPI. Changes in the costs of
delivering outputs – for a company or the whole economy - are the combined result of
changes in input prices and productivity. So X must reflect anticipated productivity and input
price movements for the company or sector relative to productivity and input prices in the
economy as a whole – the latter being covered by RPI.
This report discusses setting X so that anticipated output prices track the anticipated costs of
delivering outputs, after adjustment for anticipated input price and productivity movements.
However, anticipated effects are uncertain, so in determining the price cap the regulator will
need to consider the different consequences of different mistakes. If X is set too low then
customer enjoyment of some cost saving is delayed until the next Review. If X is set
unattainably high and the financial position is tight the company will face an increased cost
of capital and in the extreme be unable to finance its functions. In these circumstances a
regulator may legitimately adopt a conservative position in gauging the reasonably
anticipated cost savings and determining X.
i
Methods for setting opex efficiency targets
A range of methods have been applied by UK regulators in determining opex efficiency
targets, including: analysis of historical industry real opex trends; top-down (econometric)
benchmarking; bottom-up (engineering) benchmarking; international comparisons; and
forecasts based on anticipated movements in productivity and input prices for opex
components. Some methods are sounder than others, but their relative merits also depend on
data availability.
Company cost level comparisons, including the results of econometric benchmarking and
engineering benchmarking, cannot discriminate between unexplained cost differences &
genuine efficiency differences. Also, they do not yield any direct information on the feasible
future rates of change in costs which are needed to set efficiency targets.
International cost level comparisons are even less reliable in setting X, due to the many
differences in regulation, input price levels etc which may affect costs, and the assumptions
about exchange rates which are required to make quantitative comparisons. In addition, cost
differences may not be able to be closed – it may be more reasonable to anticipate that
productivity differences internationally in the water sector will persist as they do between
other sectors & between whole economies. For example, the US has had higher productivity
than the UK for the past century or so.
Past cost trends are not directly informative about expected efficiency gains since they reflect
a combination of underlying productivity and input price movements, either or both of which
may vary differently in future. Materials prices in particular are known to be fairly volatile.
The combination of productivity and input price trends provides a more robust basis for
forecasting opex efficiencies. At the 1999 water Review the forecasts by Europe Economics
and Professor Nick Crafts for Ofwat (EE), and by Professors Bosworth and Stoneman for
Thames Water (B&S), both treated productivity and input prices separately. The two
approaches and their results were very different. Comparing and contrasting them suggests
that implausible aspects of such forecasts would be much more apparent if an explicit and
transparent framework were to be used to check the consistency of the labour and materials
input prices and productivity estimates with each other, and with sector and comparatorgroup history.
Sector TFP & input price trend estimates, relative to the economy as a whole, would allow
consistency checks of the Xopex elements to be extended to Xopex and Xcapital together,
addressing the question of whether all components of overall X are internally consistent and
consistent with sector history.
We contend that as long as there is a need to rely on disparate data and judgements in setting
X they should be employed within explicit and transparent frameworks which ensure that X
is based on internally consistent positions consistent with the evidence. Development work
on the framework and on the evidence seems very useful.
Empirical Evidence
While neither nominal nor real cost trends are a reliable basis for projecting X, June and July
return evidence can be inspected. In the last two Review periods the companies in aggregate
ii
reduced real operating costs substantially for water and for sewerage, in each case by more
than the regulator had assumed for X at the previous Review. In the first two years of the
latest period the company’s rate of real water opex reduction is more than that assumed by
the regulator. However the sewerage service aggregate real opex figures have been fairly flat
for five years now, by contrast with the regulators assumption of ongoing strong reductions in
the current Review Period.
Saal & Parker (2001) develop a quality adjusted output measure for the water sector (sum of
WaSCs), and using this they find TFP improvement and increased labour productivity
throughout the 1990s in the water industry. The TFP improvement is found to be falling off,
and the authors attribute this to declining returns to environmental investment, whereas the
derived labour productivity growth was faster in the second quinquennium than the first.
National accounts based productivity estimates for the gas, electricity & water sectors as a
group by O’Mahony & Boer (March 2002) point to high rates of labour productivity & TFP
growth during the 1990’s, with a modest slowdown for labour productivity growth in the
second half of the 1990’s. For the group annual average TFP growth relative to the UK
economy was 2.31% during 1989-99, substantially higher than the figure in the US (0.13%), France (1.23%), or Germany (-0.35%). This difference may be the result of the
more extensive introduction of competition in the UK energy sectors in that period, and
may not be sustainable.
Recent Office of National Statistics nominal manufacturing input price data (one possible
proxy for water materials input prices) point to a reversal of the decline of around 20 per cent
between 1995 and 2000. Commercial forecasts are for an increase in input prices, but recent
updates have been revising this increase downward by about 1% per year from the 1999
forecast.
The recent published productivity studies do not provide a ready basis for updating the
projections of water cost savings or updating the X set at the last Review. Similarly, no new
studies of input prices drawing implications for X have been published. Speculatively, if
future water materials prices are now anticipated to be 1% lower than at the 1999 Review
then this will increase the anticipated X. For instance, the original B&S forecast of –0.2%
annual change in Real Unit Operating Costs in the 2000-2005 period would have then been
lower, at –0.87%.
International approaches
US regulators have converged on the use of industry specific TFP & input price trends as a
basis for setting an overall X applied to base year revenues, rebased to cover actual total
costs. Company forecasts are not used.
In some States anticipated TFP and input prices for the sector relative to the economy as a
whole are combined and applied as X alongside an RPI equivalent index (as discussed
above). In other States anticipated sector TFP is taken directly as X and an index of actual
sector specific input prices is used instead of RPI. The two approaches are equivalent in
iii
expected revenue terms. They differ in data requirements and the allocation of input price
risks.
In other parts of the world a diversity of methods have been applied to set X. Companies in
the Netherlands (DTe) and Victoria Australia (ORG) have successfully challenged the
regulators’ intended use of data envelope analysis and benchmarking in setting allowed
revenues.
Recommendations
Achieving agreement between companies and regulator about the general nature of X and a
framework for considering the consistency of elements of X will help reduce unnecessary
argument at the next Review. It should be possible to reach agreement that:
•
Within an RPI-X framework, X should reflect anticipated water sector productivity
and input price growth relative to those in the economy as a whole
•
Methods for setting the operating cost efficiency assumption and overall X factor
should be transparent and consistent to improve the predictability of the approach and
outcome.
•
The operating efficiency assumption should be expressed in terms of productivity &
input prices, for labour and materials, and checked against past sector or comparator
experience.
•
To reduce subjectivity comparator sector evidence should be transparently and
cautiously used, with sector evidence preferred. To help with this, water sector
estimates of labour and materials productivity, of TFP, and of input price trends
should be developed.
iv
I.
Introduction
Water UK commissioned NERA to review issues arising in the setting of the general
efficiency assumption (X) at Periodic Reviews of the price caps (RPI-X limits) of water and
sewerage companies, especially covering work since 1999 and efficiency assumptions
applied to operational expenditure (opex), though not exclusively. This report discusses:
•
The nature of X (section 2)
•
Methods for setting X (section 3)
•
Recent empirical work with a bearing on X (section 4)
•
Some relevant international experience in setting X (section 5)
•
Recommendations for improving X-setting in the 2004 Periodic Review (section 6).
A series of more detailed reviews of aspects of X-setting appear in the Annexes to this report:
•
Annex A draws out relevant points from UK price controls set since the Periodic
Review of the Water industry in 1999.
•
Annex B provides a selective survey of recent published literature, both on how to set
X and on measure of productivity growth.
•
Annex C provides an update of other published high level studies and statistics of
input prices and productivity, potentially relevant to the water industry X.
•
Annex D summarises some illustrative international experience with X-setting.
1
II.
What X Is, And What It Is For
A.
X Centres on Anticipated Cost Efficiencies
In incentive regulation, as implemented through the RPI-X price caps in England and Wales,
many factors influence the regulators’ determinations at Periodic Reviews of the future real
change in the price cap level. Among these factors are past or anticipated changes in the
costs due to providing a different volume or quality of service; changes in the rewards, as
past efficiency gains are transferred to customers; anticipated future efficiency gains; changes
in tax and financing costs; and so-on. Thus for England and Wales water at the last Review
the determination of the future price cap was presented as the base year customer bill:
•
Less past efficiency savings (having been kept by companies for four years)
•
Plus or minus a reward or penalty for a service performance
•
Less anticipated future efficiency improvements
•
Plus improvements to quality
•
Plus improvements to service performance
•
Plus improvements to maintain the supply demand balance.
We are concerned in this report only with the third factor, anticipated future efficiency gains.
UK regulators have been accustomed to taking account of this by making a series of separate
adjustments to the projected cost components (opex, capex) to reflect expected or hoped for
changes in efficiency. Generally these are reductions in the use of inputs, or reductions in the
unit price of those inputs. The adjustments (usually deductions from today’s cost levels) are
made to individual cost lines and then percolate upward through the financial modelling to
have an effect on (usually lowering) the regulator’s determination of the future revenues or
price cap, as represented by RPI minus a now specific X.
We refer to these adjustments for anticipated efficiency savings collectively as “the general
efficiency assumption”, or just “X” in reflection of the effect of the adjustments on the real
revenue determination. In places below we also refer to Xopex and Xcapex (etc) for the
separate adjustments made to the cost components on account of anticipated efficiency
savings which together amount to or lead to the aggregate X.
In principle the projected efficiency assumption can vary from year to year. In many
determinations there is a large (P0) adjustment in the first year. This will typically take
account of many past events and bring revenues into line with costs as they evolved during
the last price cap period. In the UK the P0 includes an aggregated X element for the
efficiencies anticipated for the first year.
In this report we are putting on one side all the other factors which affect the determination of
P0 and later years’ price cap changes, to focus on the general efficiency assumption X. The
initial question is how a regulator can find that X which, when used with the RPI to generate
the annual increase in nominal revenues, will give anticipated revenues which match the
2
projected nominal (P&L) costs after deduction of anticipated cost efficiencies. That X will
hold projected profitability constant at the allowed Rate of Return, assuming there is no extra
unanticipated outperformance, and putting aside the influence of all other factors. However,
as the sections below set out, the regulator may have good reasons to take a more
conservative approach to setting X.
B.
X Can be Modelled or Directly Calculated, but Should be the Same
A potential source of confusion in discussing X is that the practice in the academic literature
and in some other countries is to approach exactly the same X-setting issue from a different
direction. In the UK approach the aggregate X “emerges” from a process where the regulator
makes adjustments to separate cost components and performs financial modelling to identify
the year to year revenue or price cap change. The alternative approach is to make analyses of
possible cost efficiencies and calculate an overall annual X to go directly into the price cap
for use with the RPI to limit the annual price adjustments – after base year prices have first
been adjusted to allow revenue to equate to actual total (P&L) costs. That is, in the
alternative approach X is calculated directly rather than emerging from financial modelling as
in the UK.
The two approaches should produce the same result. This suggests that consistency checks
should be undertaken: the regulator’s line by line opex and capex adjustments, plus financial
modelling, should lead to the same X as that produced by a direct calculation method.
C.
Incentives Depend on Fixed Caps, Outperformance, and Clear
Method
In the UK the setting of X has sometimes been discussed in terms that suggest that the size of
the cost efficiency adjustments (referred to by some regulatory staff as “challenges”), and the
associated level of allowed revenues (after RPI-X), provide water companies with a
motivation for cost reduction. In this view, X is a “stick”. This view is at odds with the
academic literature on X-setting, which considers X-setting in terms of the incentives
provided to regulated companies to reduce costs.
The literature starts from the premise that in a price cap regime the incentives for cost
reduction arise from the fixed nature of the cap, giving a regulatory lag between changes in
costs and the resetting of allowed revenue. There is a review period of five years in the case
of England and Wales water, though this now is operated with a continual four and a half
year efficiency-gain-retention mechanism. Water companies can increase profits for this time
by finding cost efficiencies. In other words the literature views the “carrot” of profit
opportunities between reviews as the motivator of cost reduction, not the “stick” resulting
from setting a “challenging” X factor.
Consistent with this is the view that – provided today’s outperformance does not lead to
ratcheting up of the future X - setting an X factor which firms are anticipated to outperform
to a degree should not undermine incentives for cost reduction. Limited variations in X
therefore influence the timing of the transfer of efficiency benefits to customers, not the
amount of benefits generated. This is because the company would be expected to achieve
very similar efficiency gains, which would be transferred to customers partly through the X
3
year by year, with each year’s balance of gains transferred at the next Review – or after four
years under the England and Wales water incentive retention scheme. It is a well established
result in the literature that incentive regulation must involve a reasonable prospect of
increased profit to motivate regulated companies to discover and reveal the efficient cost
levels over time.
A recent UK regulatory review expressed a similar view explicitly “ERG has no wish to take
an aggressive approach to the scope for NATS to make efficiency gains, and recognises that
the incentive provided by the PPP and price cap regulation (in contrast to rate of return
regulation) will deliver achievable efficiency gains in due course“.1
More widely, company incentives to reduce costs today will be affected by their expectations
of future X-setting methods, and especially by links between current company
outperformance and future setting of P0, “challenges”, and X. These links are known as
“ratchet effects.” Strong apparent links will undercut the company’s efficiency incentives.
So will uncertainty about the links. Transparency about future determination methods,
enabling water companies to see that a ratchet effect will not be operated via X-setting – i.e.
via the imposition of ever higher “challenges” - will enhance the incentives for companies to
find efficiencies.
D.
The Consequences of Setting X too High or too Low Differ Greatly
A separate consideration in setting X, and in setting every other factor which affects allowed
revenues, is the consequences of “mistakes.” Given that outturns will inevitably diverge
from projections over time, the regulator needs to consider the consequences of mistakenly
setting X too high or too low. The “recourse” actions available to the company and the
regulator - e.g. IDOK and shipwreck clause - may affect the ultimate consequences, which
include the financial position and potentially investment performance and service quality.
The importance of the possible financial consequences of mistakes will depend on the
financial headroom or cushioning available to the company at the projected time. The water
companies of England and Wales are currently projecting a worsening financial position, so
the importance of possible mistakes is increasing.
The tradeoff the regulator faces is one where setting a smaller X which companies beat will
delay customer receipt of efficiency benefits, while setting a larger X which turns out to be
unattainable may limit the ability of the company to raise finance to fund investment at the
margin, or may in the extreme result in company insolvency. Where the anticipated financial
position is “tight” the regulator may therefore justifiably conclude that the uncertainties about
possible efficiency savings, and the different consequences of upward and downward
mistakes, warrant determination of an X which is more conservative than the central estimate
of anticipated efficiency gains.
1
Economic Regulation Group of CAA (August 2000). “National Air Traffic Services Public-Private
Partnership – Setting the Charge Control for UK En Route Services for the First Five Years”. Advice to
DETR. Page 24.
4
E.
X Reflects Productivity and Input Prices Relative to the Whole
Economy
For the whole economy, movements in input prices (say 5%) and productivity (say 2.4%) are
both reflected in the RPI (say RPI=5%-2.4%=2.6%). It is well established2 that this means
that, to correctly produce the projected nominal revenues, the general efficiency factor X in
the RPI-X formula must represent:
i.
The anticipated difference in the productivity trend between the industry and the
economy as a whole; COMBINED WITH
ii.
The anticipated difference in input price trends between the industry and the economy
as a whole.
The Competition Commission (2000) noted the importance of the productivity difference (i
above), but did not discuss the need to allow for the input price difference (ii above), in
discussing the price cap appeals by Mid Kent Water and Sutton & East Surrey Water:
“Movements in the RPI broadly reflect productivity improvements in the economy as a whole.
We need, therefore, to predict efficiency improvements relative to the economy as a whole.”
Bernstein and Sappington (1999) draw out an implication which helps show the effect of X
being “relative to the whole economy”. This implication is that an RPI-X regulated industry
facing the same input price inflation and making the same productivity improvements as
other firms in the economy should have an X of zero:
“if producers in the regulated industry faced the same input price growth rate and could
reasonably be expected to achieve the same rate of productivity growth as other firms in the
economy, then expected profits in the regulated industry, as elsewhere, could be held at zero
simply by allowing regulated output prices to rise at exactly the economy-wide rate of output
price inflation”. (Page 11).3
In this situation setting an X factor of zero does not mean that no productivity improvements
are expected. Rather it means that the regulated firm still needs to make productivity
improvements at the same rate as the economy as a whole, so that the firm’s revenues
growing by RPI will be enough to cover the input price growth experienced by the firm and
in the whole economy.
There are several ways of correctly undertaking the derivation of sector assumptions for
productivity and input prices, and of undertaking subsequent financial modelling, so that the
aggregate X which is derived is consistent with having an RPI-indexed price cap (with its
implicit whole economy input price and productivity assumptions). However it is also easy
to make mistakes and double-count or under-count the whole economy effects in setting an X
to accompany RPI.
2
3
Bernstein & Sappington (1999). “Setting the X Factor in Price-Cap Regulation Plans” Journal of Regulatory Economics; 16:527.
Here zero profit refers to economic profit after allowance for an appropriate return to investors (their
opportunity cost of capital) on capital invested.
5
Little detail has been published to date on this aspect of UK price cap determinations. As a
result it is not possible to be sure that the regulators have applied an internally consistent
approach and produced an X which is appropriately set relative to whole economy trends and
therefore appropriately set for use alongside RPI. A higher degree of transparency, and
agreed methods for developing and applying the productivity and input price assumptions in
setting X, would help avoid mistakes and help provide companies with sound efficiency
incentives.
6
III.
UK Methods For Setting X - Opex & Overall
A.
Overview and Trends in UK Methods
A number of methods have been applied in deciding on deductions of opex and other
anticipated efficiency gains for the water industry and other regulated sectors in the UK.
These methods include analysis of historical industry opex trends, comparison of opex trends
across regulated sectors, top-down (econometric) benchmarking, bottom-up (engineeringeconomic) benchmarking, international comparisons, and developing cost projections based
on anticipated movements in productivity and input prices separately. In practice in the UK
judgement is applied to the results of a range of methods and the precise reasoning behind X
in regulators’ determinations is generally opaque.
This reliance on a range of methods, judgement, and opaqueness in setting X has – at least in
the past and by some regulators - been thought to be a good thing, as evidenced by the
following observation in relation to the early experience of UK price cap regulation:4
“RPI-X and rate-of-return regulation have certain common features…Nevertheless, there are
significant differences between the two systems, which give RPI-X a potential advantage with
respect to incentives and efficiency… in setting X the UK regulator has more discretion and
less need to reveal the basis of his decisions than does his US counterpart. The US tradition
is to place all evidence and reasoning in the public record. In the UK, there is less pressure
for due process. The UK regulator is deemed to be a person to whom public policy may be
safely delegated, subject only to judicial review on the question of whether his actions are
legitimate in terms of the Act. In the UK, neither governments nor regulators have given
detailed reasons for decisions on X. This reduces the basis for challenge (by company,
competitors, or customers).”
However, more recently in the UK there has been increasing emphasis on transparency and
predictability in regulation (as promoted by the Better Regulation Task Force and some
regulators including the current water regulator). Also, the growing body of evidence and
experience with regulation in the UK arguably narrows the legitimate scope for discretion.
Regulators are also working jointly to develop consistent and transparent methods in a range
of areas (though not as far as we know in setting X):5
“The purpose of our joint working is not to aim at a single approach but rather to develop
approaches which are consistent and transparent about both similarities and differences
between sectors.”
Over time a desire to improve transparency and predictability may lead to there being a
preferred UK method or framework for setting opex targets &/or the overall X – perhaps
analogously to the emergence in the UK of increasingly mutually-understood frameworks for
companies and regulators to discuss the weighted average cost of capital (WACC) which is
4
Beesley M E & Littlechild S C (Autumn 1989). “The regulation of privatised monopolies in the United
Kingdom”. The RAND Journal of Economics, Vol 20. Pages 452-72.
5
Callum McCarthy (July 2001). “Regulators publish statement on joint working”. Press release PN 56.
7
the basis for the allowed rate of return. Such a development would help avoid mistakes and
improve incentives.
For as long as a range of methods and judgement continue to be used in setting X, it would be
useful for UK companies and regulators to develop explicit views on the relative merits of the
different methods, and to develop a set of checks for consistency between the results of the
different methods, to narrow uncertainty about the results. In this light we offer comments on
some of the individual methods below.
B.
Bottom up (Engineering-Economic) Investigations
Engineering/economic investigations of company activities are sometimes used as a basis for
gauging performance, but risk blurring the distinction between regulatory and operational
accountability so must be used sparingly by regulators. Also, this detailed analysis tends to
be inherently partial and may therefore fail to identify the full scope for efficiency gains. If
potential gains forma partial analysis are extrapolated simplistically to all activities, this risks
over counting the potential savings. In addition, detailed bottom up scrutiny may act to
reduce innovation since deviations from “standard practice” risk being judged inefficient, and
since there is a risk that speculative efficiency possibilities identified internally will be
adopted by regulators as hard evidence of potential savings.6
C.
Comparisons of Company Cost or Productivity Levels
Comparisons of England and Wales water company activity cost levels are made by the
regulator using econometric techniques to isolate unexplained differences in costs. There are
many justifiable criticisms of Ofwat’s applications of these techniques, but they are not the
focus of this paper. However, whatever technical improvements Ofwat make, these
comparisons can never incorporate all of the factors that may explain cost differences, and
therefore ultimately cannot discriminate between unexplained cost differences and efficiency
differences. In addition, estimated differences in normalised cost levels are not sufficient to
establish the feasible rate of change in a company’s costs, which is what is required to
anticipate opex efficiency gains.
That is, to the extent that cost level information is used in deciding company specific
efficiency factors, judgement must be exercised not only over the assumed balance between
efficiency differences and unexplained cost differences, but also over the feasible rate of
“catch-up”.
In relation to the average efficiency factor X for the sector as a whole it is arguable that
company cost level comparisons do not yield any information that should alter the choice of
this overall efficiency factor. Past productivity trend information for the sector incorporates
both “catch-up” and “frontier” movements in companies’ efficiency. Expectations about
future sectoral productivity gains should likewise reflect both elements, so information on
unexplained cost differences between companies may in practice only serve to differentiate
efficiency targets between companies.
6
The bottom up analysis by Mazars Neville Russell for Ofgem as input to the 2002 Transco price control
involved specific instances of the latter.
8
D.
International Comparisons of Cost (or Productivity) Levels
International comparisons of cost levels face a more extreme version of the problem of
ensuring a like with like comparison between companies in England and Wales. Factors such
as differences in the regulatory environment, quality standards, input prices and exchange
rates must also be taken into account. In addition, international differences in relative input
prices imply different efficient production technologies, for example in relation to the
efficient mix of capital and labour, and it is unlikely that such differences can be adequately
allowed for in judging relative efficiency across national boundaries.
However, even if sector specific international differences had been more or less adequately
accounted for, the residual differences in “efficiency” (really, in unexplained cost) have no
simple and direct implications for the choice of efficiency target. International differences in
productivity are well known to be large, persistent, and difficult to explain let alone correct for example, the US has had higher income per capita and productivity than the UK for
around a century, and the “productivity gap” has grown steadily over that time. The causes
of this – whatever they are - are also at least potential reasons to expect that any productivity
differences between the UK and US water sectors will be difficult to eradicate.
International productivity differences are likely to have much more to do with the general
institutional framework, for example the degree of respect for private property rights and the
labour laws than with company specific conduct. The lessons if any from international
benchmarking of regulated firms are likely to relate just as much or more to the regulatory
and broader policy environment.
E.
Projecting Cost Trends
Real cost trends are widely used by regulators as an input to judgements about future
operating cost efficiency targets. However, the validity of extrapolation of real cost trends
rests on an assumption that the underlying productivity and input price trends are both stable
over time. Empirical evidence for input prices shows that this assumption is false, meaning
that real cost trends per se are uninformative about expected cost or productivity trends.
Figure 3.1 illustrates the volatility in input prices, in the form of ONS data for manufacturing
input prices.
9
Figure 3.1
Volatile Input Prices
(ONS Seasonally Adjusted Nominal Producer Input Prices for Manufacturing)
105
100
95
90
85
80
p9
M 0
ar
-9
Se 1
p9
M 1
ar
-9
Se 2
p9
M 2
ar
-9
Se 3
p9
M 3
ar
-9
Se 4
p9
M 4
ar
-9
Se 5
p9
M 5
ar
-9
Se 6
p9
M 6
ar
-9
Se 7
p9
M 7
ar
-9
Se 8
p9
M 8
ar
-9
Se 9
p9
M 9
ar
-0
Se 0
p0
M 0
ar
-0
Se 1
p0
M 1
ar
-0
2
Se
M
ar
-9
0
75
All manufacturing
An observed decline in real manufacturing costs during the period 1995-00, for example,
would therefore be substantially attributable to the falling input prices, added to by any
increase in manufacturing productivity. Assuming such a decline in costs would continue
would be false. Projections of real cost or real unit cost trends – where not built up from
underlying input price and productivity movement – must therefore be treated with caution as
a basis for efficiency adjustments and X.
F.
Projecting Underlying Productivity & Input Price Trends
The problem identified in relation to real cost trends in the section above can be overcome by
decomposing cost-of-output trends into their separate productivity and input price drivers,
further broken down into their input factor types. Unless there is some reason to expect
future to differ from past long run productivity and input price trends, projections of these by
factor input will provide a more robust basis for forecasting future opex. For example, the
water real opex can then be forecast as follows:
⎛ MATERIALSINPUTPRICE / RPI ⎞
⎛ LABOURINPUTPRICE / RPI ⎞
REALOPEX = LABOURSHARE ⎜
⎟
⎟ + MATERIALSSHARE ⎜
⎝ MATERIALSEFFICIENCY ⎠
⎝ LABOUREFFICIENCY ⎠
The use of RPI in this formula correctly establishes a real opex projection which is “relative
to the whole economy” in respect of both input prices and productivity, for both the labour
and materials categories which we assume are the only two opex inputs for purposes of this
exposition. Given projections of labour and materials productivity and prices, of their shares
10
in opex, and of RPI, the projected real opex could be used for financial modelling in real
terms to set the price cap; i.e. to establish X. The price cap RPI-X formula will then over
time convert the real revenue allowance back to allowed nominal revenue which will cover
the nominal opex – though of course the formula will use the RPI outturns rather than the
forecast RPI in the above formula.
Just as for opex, a similar approach can be applied for projecting total costs, though the
appropriate approach to productivity is then to allow for Total Factor Productivity (TFP),
estimated from the ratios of changes in output amounts to changes in the amounts of labour,
materials and capital inputs. An advantage of a total cost approach is that it captures
efficiencies resulting from substitution between operating and capital inputs and helps ensure
consistency between operating and capital components of X.
Real opex forecasts based on productivity and input price assumptions were produced by
Europe Economics and Professor Nick Crafts (EE) for Ofwat and Professors Bosworth and
Stoneman (B&S) for Thames Water7 at the 1999 price control review. The two approaches
were however very different and the projections differed significantly with EE forecasting a
decline in real unit operating base expenditure of 2.5 to 3.5 per cent per annum, while B&S
forecast a decline of 0.2 per cent per annum in real operating costs, for the period 2000-2005.
A number of lessons can be learned from comparing the approaches.
EE did not follow the direct TFP based approach to setting total cost targets mentioned
above. Instead they started with a postulated initial aggregate TFP trend of 0.99 per cent per
annum, estimated for a group of comparator sectors, predominantly not utilities. The
comparator set was then juggled to give another comparator set for which the aggregate TFP
trend was 1.8-2.1 per cent per annum. A “privatisation effect” was then added to derive a
TFP projection for the water sector of 2.5-3.5 per cent per year. Whole-economy capital
productivity was then deducted to derive water opex productivity as a residual, and a real
materials and labour input price change of 0.6% per year was added to obtain the final real
unit opex forecast of a 2.5-3.5 per cent decrease per year.
By contrast B&S built up their real unit operating cost forecast directly from separate labour
and materials productivity and input price estimates based on evidence from the water
industry and a set of comparator sectors identified by detailed and explicit comparison of
their properties with those of the water sector. The derived water-comparator relationships
allowed macro-economic forecasts to be used as a basis for water forecasts. For 2000-2005
B&S forecast for water: real unit labour prices increasing at 2.3% per year; labour
productivity improvement of 4.7% per year; real unit materials prices increasing at 1% per
year; material productivity change of –0.2% per year; all of which combine to form a real
unit operating cost forecast of –0.2% per year.
Comparing and contrasting the two approaches suggest that:
7
NERA managed this project for Thames Water
11
•
the derived Xopex for use with RPI is sensitive to both the real input price projections
and the productivity projections, so both should receive careful attention
•
the TFP and its component labour, materials and capital productivity trends are
sensitive to the choice of comparator sectors, as the Competition Commission noted
in the water price cap appeal cases, so checks against water history are required.
•
estimating sector operating productivity by subtracting estimated whole economy
capital productivity from estimated sector TFP introduces an inconsistency into the
Xopex (for use with RPI) if the sector TFP estimate differs from the whole economy
TFP estimate implicit in RPI. This subtraction introduces a second inconsistency if
the regulator uses a different capital productivity assumption in establishing their
capital efficiency adjustments separately – as Ofwat did in the 1999 Periodic Review.
•
The unresolved divergence in the two forecasts suggests that it would be useful to
develop a framework for checking the consistency, reconciling, and refining
projections of different types from different sources. For consistency all the
components of X should essentially “add up” from bottom to top.
•
At the bottom labour and materials productivity forecasts should accord with direct
sector specific and (perhaps) broader experience. The B&S forecast drew on such
experience, and the EE opex productivity forecast could have been decomposed into
labour and materials components (up to a range) to allow such checks to be made.
Had they been made by the regulator in 1999 the EE productivity growth assumption
may have been revealed to be implausibly large relative to historical water sector and
comparator experience, for instance.
•
A full and very useful consistency check would first require construction of direct
evidence of TFP, productivity components, and input prices for the water sector
relative to the economy as a whole. This would inform the judgements about the
anticipated separate components and aggregate, so that the final combined opex and
capex efficiency factor X could be thoroughly checked for consistency against the
water history.
Baldwin & Cave (1999) conclude:8
“Efficiency and cost reduction are the major objectives of regulation. However, regulators
must contend with a deficit in their information concerning the true productive potential of
the firms they regulate. Benchmarking and comparative competition are two ways of making
up part of this deficit, but they are imperfect devices and regulators have to rely, in making
projections of productivity growth, on the accumulation of a variety of disparate data and,
ultimately, on judgement.” (Page 247).
8
Baldwin & Cave (1999). “Understanding Regulation – Theory, Strategy and Practice”. Oxford University
Press.
12
Our contention is that for as long as there is a need to accumulate disparate data, and to rely
on judgements, both should be employed within explicit and transparent frameworks which
ensure that X is based on internally consistent positions consistent with the evidence.
G.
Allowing for Changes in Output Volumes or Quality
Output volume and/or quality may be changing between companies, sectors, or countries, or
over time, and influencing productivity estimates. Productivity may be measured with output
allowed to vary, or held constant. If volume or quality growth is expected to change over
time, or productivity growth from a different country or sector is used as a benchmark, then
care must be taken to allow for the impact of any such changes on costs. The same
qualification applies to drawing inferences from TFP estimates that use different definitions
of output.
In comparing cost levels, unit costs or other scale variables have sometimes been used to
control for volume effects. However, little explicit account has been taken of output quality
differences in the UK. Not only can these be material,9 they may also be difficult to factor
into cost comparisons since efficient quality levels themselves depend on individual
companies’ cost functions and customer preferences.10
In comparing cost trends the concern is perhaps less acute. The issue then is not with the
change in the volume or quality of output, but rather whether the rate of change in volumes
and quality will be similar in the future to that in the past (or between the industry in question
and a comparator). If trends in quality-adjusted output are relatively constant then the
historical trend may serve as a direct benchmark. If not, then one of two broad approaches
may be followed:
•
Treat quality and output related expenditures separately from base expenditure and
X in deriving an overall price cap constraint – the approach followed for England
and Wales water; or
•
Estimate productivity holding output constant and then also use forecast output
changes to adjust allowed revenues using estimated quality and volume cost
elasticities – the approach applied in benchmarking Railtrack UK against US rail
infrastructure TFP trends.
A different tack is to make adjustments for output changes automatic over time, by careful
design of volume or quality terms in the price cap, or semi-automatic, by establishing IDOK
or equivalent “recourse” possibilities for output changes. Some adjustments of revenue for
volume changes are automatic within the structure of the England and Wales water price cap,
and there is now an explicit reward for delivered service performance (some aspects of
quality) at the end of each price cap period. Also, there are IDOK and informal logging-up
9
For example, Ofgem targets for the frequency and duration of interruptions to electricity supply for 2004/05
vary five and three fold respectively across distribution companies.
10
Brian Williamson (January 2002). “Ofgem's IIP and the Longer-Term Regulatory Framework of Incentives
for Service Quality”. Power UK, Volume 95, pages 31-34.
13
possibilities when quality changes are externally imposed. The past and future operations of
these features need to be allowed for when inferences are drawn from the past evidence on
sector productivity and price changes and used to form projections.
14
IV.
Issues in Interpreting Empirical Evidence
A.
Inference from Sector Productivity Trends
Economy wide TFP growth rates tend to be relatively stable over time, averaging 1.23 and
1.13 per cent per annum over the periods 1950-99 and 1989-99 in the UK (Crafts and
O’Mahony, 1999). However, sector specific TFP growth can vary significantly over time and
between sectors. For UK manufacturing TFP growth was 2.45% and 0.35% per cent per
annum during 1989-95 and 1995-99 respectively, while TFP growth rates varied by almost 5
percentage points across sectors during 1989-99. Short run series therefore provide poor
benchmarks, and benchmark productivity growth may be highly dependent on the choice of
comparator sectors.
TFP levels for the economy as a whole, and for electricity, gas and water combined were
higher in the US at 129 and 145 respectively versus 100 in the UK for 1999, according to
Crafts and O’Mahony. However, international differences in productivity levels appear to be
sustained over very long periods of time, suggesting there may be no easy or quick way of
closing identified “productivity gaps”. Inferences for UK regulation are therefore difficult to
draw.
For UK electricity, gas and water as a group O’Mahony & de Boer (2002) estimated TFP
growth of 3.45% per annum during 1989-99. These growth rates are substantially higher than
those for the same sectors in the USA, France, or Germany. They may reflect the extensive
liberalisation in the UK energy sectors during that period, and therefore prove unsustainable.
Saal & Parker (2001) report TFP growth (calculated on a quality-adjusted basis) for
combined water and sewerage companies of 2.3, 2.1 and 1.0 per cent per annum for 1985-90,
1990-95, and 1995-99 respectively. They suggest that the decline in TFP growth reflects
diminishing returns to environmental investment. The TFP growth estimate was also
sensitive to the choice of the capital opportunity cost measure.
Saal and Parker also report increasing water and sewerage labour productivity throughout the
1990’s. An increase in water and sewerage labour productivity is to be expected from
declining employee numbers but will be offset by any substitution of other operating costs
(e.g. outsourcing) or capital (e.g. automation) reducing productivity elsewhere.
Undoubtedly output quality improvements have been a major driver of water and sewerage
investment so need to be brought into productivity measures. However doing this increases
the difficulty of interpreting the Saal and Parker productivity measures and using them as a
basis for projections: will quality change similarly in future? This question clouds the
formation of TFP and labour productivity estimates. Also, capital opportunity costs are well
known as difficult to estimate for a utility where assets have no alternative use in the main,
and the adjustment of labour input measures, to avoid double-counting when fixed assets are
being formed and labour is involved with this, is not straightforward. Improved productivity
evidence would be very useful in setting X robustly.
15
B.
Allowing for Productivity Boosts to Wear Off
If high TFP and labour productivity growth for utilities in the UK during the 1990’s reflect
privatisation and the introduction of price caps an important question is to what extent the
boost to productivity is one-off, and how quickly it will fall back. The Competition
Commission (2000) put the question as follows “We must therefore consider whether water
companies may have already made a large proportion of the exceptional savings expected
following privatisation, conversion to plc status and/or the introduction of competition.”
In the US when price caps are first introduced a modest “stretch factor” or “consumer
dividend” (up to 1 per cent per annum) is sometimes added to historical TFP trends to reflect
the anticipated gains of moving to a more powerful incentive regime. The difficulty is to
estimate the likely boost. In the UK the problem is now the reverse – judging how the
privatisation “stretch factor”, already observed, will fall away. A careful comparison of US
and UK utility TFP growth rates relative to the economy as a whole might help inform this
question.
C.
Water Industry Opex Trends
Opex trends for water and sewerage services in England and Wales can be derived from June
and July Return data for the period 1992/93 to 2001/02. Both base service opex trends and
total opex trends (the latter covers the effects of quality improvements) can be calculated.
These past cost trends alone are not a sound basis for extrapolating future potentials for cost
reduction, because:
•
past cost trends depend in part on input price movements which are highly variable
over the medium term – deflating by RPI to show and extrapolate cost trends in real
terms is not a full solution to this issue because sector input prices my not follow RPI;
•
during the past period the volumes and quality of services delivered have been
changing, and they will change again in future. Working with unit costs is not a full
solution to this issue because they do not allow for quality changes. Working with
base opex is not a full solution either, because it does not allow for volume changes,
or for the effect of yesterday’s quality improvement becoming today’s base service
requirement, and quality-opex efficiencies must be gauged separately.
The observed changes in real water and sewerage opex are summarised in Table 4.1 and
shown in Figure 4.1.
16
Table 4.1
Changes in Real Opex
(deflated by RPI)
(% per year)
1992/93 – 2001/02
1994/95 – 1999/00
1999/00 – 2001/02
Water, all companies, Total opex
-2.4
-2.3
-4.2
Base opex
Ofwat Target for Base opex
Sewerage, all WaSCs, Total opex
Base opex
Ofwat Target for Base opex
-3.1
-2.9
-2.0*
-1.3
-4.1
-2.0*
-4.9
-2.4*
-1.6
+0.1
-3.1*
-0.9
-2.4
Source: NERA calculations using June and July Returns data
* Ofwat annual average 1994/95 – 1999/00 and 1999/00 – 2004/05, exact annual profile unknown, from Future
Charges (1994) and Final Determination (1999)
In real terms total and base water opex and base sewerage opex declined substantially during
1992/93-2001/02, whereas real total sewerage opex decreased less. During the last price
control period total real opex declined less than base real opex for both water and sewerage.
Figure 4.1 shows the annual fluctuations in decline rates for opex for the companies as a
whole. These fluctuations appear to be related to the five yearly Review periods and the
associated contracting and improvement cycle. This is more marked in the total opex
numbers which are presumably more changeable – reflecting changing quality obligations –
than the base opex requirement. The sewerage opex declines appear to have levelled off,
with both base opex and total opex showing no decline over the past five years.
As outlined in section 3 above, it would be informative to deflate the observed opex series by
a direct measure of the change in the water and sewerage sector opex input prices, to produce
a series closer to opex productivity change (volume and quality differences would remain to
be accounted for).
17
Figure 4.1
All Companies’ Real Opex
(£m rebased to 1998-99 prices using RPI)
1900
1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
1992-93
1993-94
1994-95
Water Base Opex
1995-96
1996-97
Water Total Opex
1997-98
1998-99
1999-00
Sewerage Base Opex
2000-01
2001-02
Sewerage Total Opex
Source: NERA calculations using June and July Returns data
18
V.
Lessons From International Experience
In the US a preferred method for setting X in RPI-X price caps is emerging as these are
introduced over the cost-of-service foundations. The preferred X-setting method is based on
industry wide TFP trend analysis.
Two distinct types of price caps are applied – those incorporating an industry specific
measure of input prices in place of RPI or any other general output price measure (California
& Ontario), and those including an output price deflator analogous to RPI (approximately rest
of US, analogous to UK RPI-X).11 For consistency the treatment of productivity and input
prices differs between the two types – as the following sets out:
Type 1: %Priceindustry = %Input Priceindustry - %TFPindustry
Type 2: %Priceindustry = %RPI – X,
where X = (%TFPindustry - %TFPeconomy) – (%Input Priceindustry - %Input Priceeconomy),
since %RPI = %Input Priceeconomy - %TFPeconomy
The Type 1 approach is intuitive – adjusting for experienced industry input prices less
anticipated industry productivity growth. The Type 2 approach is equivalent, but because (as
in the UK) its RPI (or similar) index implicitly allows for whole economy input price and
productivity movements, its X must incorporate the difference between industry and
economy wide TFP and input price growth for consistency.
Figure 5.1 shows the TFP results from a recent calculation based on data for electricity
distribution in the Western US which were used as a basis for estimating X for a Canadian
electricity distribution business.
11
Typically the GDP output price deflator is used in the US rather than the RPI as in the UK, but the difference
between these measures is negligible in the UK.
19
Figure 5.1
TFP Growth for Western US Power Distribution Companies
8%
6%
Rate of Annual TFP Growth
4%
2%
0%
-2%
-4%
-6%
00
20
98
99
19
97
19
19
96
95
19
19
93
94
19
92
19
19
91
90
19
19
89
88
19
19
86
87
19
85
19
84
19
83
19
19
82
81
19
19
80
79
19
19
77
78
19
76
19
75
19
19
73
19
19
74
-8%
Source: Makholm (November, 2001)
Average annual TFP growth for the period 1972-2000 was 0.72 per cent, though it is clear
from Figure 5.1 that productivity growth fluctuates very considerably from year to year. The
TFP estimate was used as a basis for proposing an X factor for UtiliCorp Networks Canada of
negative 0.02 per cent, after subtracting annual Canadian economy TFP growth of 0.74 per
cent.
In relation to input prices a comparison of electricity sector and total economy input price
movements showed a difference of 0.97 per cent per annum over the full period, though this
was statistically insignificant. However, short to medium-term input price deviations were
significant, and the inclusion of cost and/or input price pass through provisions is a common
feature of US price control formulae to reduce short term pressures or “windfall” profits.12
Outside the UK and US a diversity of approaches have been applied to X-setting and one
high-level lesson emerges. This is that where administrative or judicial appeals mechanisms
are available in relation to elements of methodology, their application tends to constrain
regulators in the extent to which they can rely on benchmarking or hypothetical gains in
setting efficiency factors. Instead the judicial process pushes them towards more reliance on
actual base year costs. Recent successful challenges of proposed revenue allowances in both
Victoria (Australia), and the Netherlands, illustrate this point.
12
Note that cost pass through for industry wide input price shocks mimics competition since common input
price shocks, such as changes in oil prices, are substantially passsed through to final prices in competitive
markets.
20
VI.
Proposals For X-Setting in UK Water
A review of the literature, and of UK and international experience in setting operating
efficiency and overall X factors, enables conclusions to be drawn about what X is and how it
should be set at Periodic Review for use alongside RPI in water company price caps:
•
X should centre on reasonably anticipated cost efficiencies
•
the overall X can emerge as the result of making separate adjustments to cost lines, or
can be directly calculated, but should be the same in each case
•
X should not be viewed as a “stick” designed to drive out efficiency savings. Rather,
the fixed nature of the price cap provides the “carrot” of profit opportunities to
motivate efficiency savings
•
X-setting methods must leave a reasonable prospect of profit improvement to
motivate companies to reveal efficiency improvements
•
X-setting methods should avoid “ratcheting” future targets up when current efficiency
improves, and be transparent and predictable, to enhance incentives
•
setting X conservatively may be warranted where the financial consequences of
mistakenly setting unattainable X targets are severe
•
water company or international cost comparisons may be misleading about X because
inefficiency cannot be separated from unexplained costs, and because cost differences
may not be able to be “caught up”
•
water sector cost studies and cost trends may be misleading about X because they
subsume input price and productivity differences and trends. It is better to examine
evidence and projections for each of these directly, checking their combined effect.
Effort to establish direct productivity and input price measures for the regulated
sectors would be valuable
•
where X is to be used with a whole economy output price index such as RPI both
productivity and input price movements should be measured relative to anticipated
whole economy movements
•
changes in output volumes or quality must be allowed for in interpreting past
productivity evidence and extrapolating this to the future as a basis for X
•
changes over time in the context, such as the wearing-off of any privatisationproductivity boost, must be considered in setting X
21
•
to set Xopex both labour and materials productivity and input prices must be
considered and the combined effect of the four elements checked against the opex
history
•
in setting Xcapital, productivity and input prices must be considered
•
Xopex and Xcapital productivity and input price measures and projections should be
consistent with each other and with aggregate X measures and projections (including
sector Total Factor Productivity).
•
productivity and input price measures differ substantially across sectors and time
periods so in drawing inferences from comparator sector groups great care and
transparency are needed to avoid subjectivity
•
international differences make it very difficult to draw any robust implications for X
from comparisons between countries’ water sectors
•
internationally, preferred methods for X-setting on the basis of sector productivity and
input price histories are emerging, and appeals processes are tending to limit
regulators’ reliance on cost level benchmarking
•
for as long as X is to be based on disparate data and regulatory judgement, both
should be employed within explicit and transparent frameworks which ensure that
internally consistent positions, consistent with the evidence, are arrived at.
22
Annex A.
Regulatory Developments since 1999
A.1. Summary
•
Regulators in the UK have applied a wide range of methods in setting X factors with
as yet no framework for discussion emerging analogous to that for the WACC, used
to assess the cost of capital. In general, operating costs and capital expenditure are
considered separately.
•
Benchmarking of cost levels is applied widely, in most instances applied alongside
other information on the scope for efficiency gains. In particular, sine 1999:
-
Econometric and engineering comparisons were used in deciding company
specific catch-up factors for regional water and electricity distribution
companies (in practice the overall industry average X factor may be
determined more by trend rates of cost reduction).
-
The CAA benchmarked BAA airports cost levels against airports
internationally, but did not apply the analysis in proposing a price control.
However, estimated long run costs of new capacity at Heathrow and Gatwick
suggested that incremental costs were well above average costs. CAA
accepted BAA’s cost projections (subject to some scrutiny by airlines).
-
Oftel applied benchmarking of BT against US telecommunications operators.
Oftel also considered a network model in assessing BT’s efficiency.
-
Efficiency comparisons between Scottish Authorities and Water Companies in
England and Wales were used as the basis for setting X for the Scottish Water
Authorities.
•
Within the set of UK regulators there is evidence of “philosophical” differences over
whether X should be set to drive efficiency gains, or whether X is a benchmark
designed to reflect and pass to customers anticipated gains (or losses), with the actual
productivity outcomes being driven by the companies’ opportunity to profit from
outperformance irrespective of the level of X.
•
Analysis of industry or comparator sector productivity trends played an important part
in the reviews of BT, electricity distribution and water. In the case of BT the analysis
decomposed trends into volume (via the cost elasticity of volume changes), input
price and productivity effects. However, industry specific TFP trend analysis, as
applied widely in the US, was not carried out by the regulator for any UK sector.
23
•
In general automatic cost pass through provisions, aside from the RPI, are not applied in addition to X.
Table A.1 summaries the approaches adopted in the different reviews.
Table A.1
Summary of Approaches Used in Setting General Efficiency Targets
Are there uncontrolled
costs, exempt from
efficiency targets?
Bottom up
analysis or
comparisons?
Top down cross
sectional
comparisons?
Top down time
series?
Are productivity
improvements in whole
economy double counted?
N/A - No targets are
applied
Yes
Some investigative
work; not pursued
-
N/A
Water Industry
Commissioner for
Scotland
No
-
Yes
Secondary
Ofgem – Transco
Oftel – BT and Concert
ORR – Railtrack
Competition
Commission – Water
Industry Appeals
Ofgem – Public
Electricity suppliers
Yes
No
Yes
No
Yes
Yes
-
No
Yes
No
Yes
Yes
Yes
Yes
Yes
Will replicate any double
counting by Ofwat in PR99
because uses its projections
No
No
Not clear
No
Yes
-
Yes
Yes
Not clear
Review
CAA – BAA Airports
24
A.2. CAA - BAA Airports (March 2002)13
The circumstances in relation to airports differ somewhat from those of other regulated sectors
since intermediate users – the airlines – provide an independent source of scrutiny of costs. In
essence the CAA decided against providing an independent challenge of BAA’s own operating
cost assumptions. The CAA recommendations are currently under consideration by the
Competition Commission. The CAA is expected to publish the Competition Commission report
and its own decisions in September 2002.
In relation to Heathrow (similar conclusions were reached in respect of Gatwick, while for
Stansted the price control is not expected to be binding so CAA did not consider detailed
scrutiny of BAA’s projections justified) the CAA said:
“As part of its work programme leading up to these recommendations, the CAA investigated the
possibility of benchmarking as a basis for challenging BAA’s cost projections. Ultimately the
results are not robust enough to support a full efficiency comparison, but neither do they suggest
that BAA should be seen as a particularly high cost airport operator in relation to Heathrow.
The CAA has not received other evidence that BAA is a high cost operator in relation
Heathrow.” (Paragraph 1.59)
“While the CAA has not undertaken an in depth review of operating efficiencies it does not
believe that BAA’s current operating cost projections look unreasonable. It is in the nature of
price cap regulation that actual performance may well exceed ex ante projections, and the CAA
does not see value in attempting to pre-judge the magnitude of any out-performance or to
‘disallow’ BAA’s forward projections of operating costs. This is particularly justified where
prices are, and will continue to be, well below market clearing levels and long run incremental
costs.” (Paragraph 1.60)
A.3. Water Industry Commissioner for Scotland (November 2001)
The Water Industry Commissioner for Scotland (WICS) based operating efficiency targets for
the four Scottish water authorities on a comparison of controllable costs (excluding costs such as
depreciation, interest and Public Private Partnership costs) with the companies in England and
Wales.14 The targets were however applied to all costs and the WICS noted, “In the long term,
all costs, including those regarded as ‘fixed’, can be controlled.” (Page 75).
The comparative efficiency models used by Ofwat at the 1999 review were used, with marginal
adjustments. Based on a review of the performance of companies in England and Wales, the
WICS noted that they close over 80 per cent of the efficiency gap between themselves and the
leader during a regulatory period and therefore set the targets based on 80 per cent closure of the
gap against comparator companies chosen for their similarities in terms of assets, geographical
13
CAA (March 2002). Heathrow, Gatwick and Stansted Airports’ Price Caps, 2003-2008: CAA recommendations
to the Competition Commission.
14
Water Industry Commissioner for Scotland (October 2001). “Strategic Review of Charges - 2002-2006”.
25
area and type of property served (the comparator companies were Northumbrian Water and
Yorkshire Water for East of Scotland Water Authority and West of Scotland Water Authority,
and Welsh Water and South West Water for the North of Scotland Water Authority). Scottish
water authorities are expected to close 80 per cent of the efficiency gap to the expected level of
efficiency of the comparator companies in 2005.
The costs of standardised projects estimated by Ofwat were used to benchmark the Scottish
Water Authorities capital procurement efficiency. In addition, annual reductions in standard
project costs of 2.5 per cent per annum were assumed, and improvements in procurement at the
same rate as for the companies in England and Wales in the previous ten years were assumed.
Targets were set at 80 per cent of the assessed efficiency gap, or 34 per cent for each authority
over four years.
A.4. Ofgem - Transco (September 2001)
In setting the price control for Transco for the period April 2002 to April 2007 Ofgem considered
operating expenditure, capital expenditure and replacement capital expenditure separately.
Controllable operating costs were considered excluding formula rates, gas transporter licence
fees, depreciation and replacement expenditure (the price control included an automatic pass
through for changes in formula rates and gas transporter licence fees).15
Mazars Neville Russell (Mazars) carried out bottom-up analysis of Transco’s costs on behalf of
Ofgem. The analysis included, for example, a comparison of the level of wages and staff holiday
allowances against market medians and averages respectively.16 Mazars also identified
benchmarking analysis Transco themselves had commissioned which suggested that Transco
incurs comparatively high costs in some areas, and analysis by Transco or their consultants of
potential new techniques that could generate cost savings. Allowed revenues were adjusted
taking account of these potential savings. While benchmarking is claimed to improve incentives
- linking allowed revenue allowances to internal management efforts to identify potential best
practice could be expected to do the opposite. Mazars proposed an immediate downward
adjustment in allowed revenues based on their bottom up analysis of £137 per annum.
Mazars also appointed Europe Economics to carry out a top down analysis focussing on the cost
reductions achieved in other privatised utilities. EE concluded “that the evidence of cost
reduction from other privatised businesses suggests that Transco has scope to reduce RUOE by
2-4 per cent a year from current levels” (assuming current levels of quality and demand - EE
also identified evidence on the output-cost relationship that could be used to adjust allowed
revenues). EE also noted that if “the initial cost based reflects an “efficient” level of cost – for
example, following the application of a P0 reduction – then the ongoing reduction in real total
costs can be expected to lie in the range 0.2-1.3 per cent a year.”
15
Ofgem (September 2001). “Review of Transco’s Price Control from 2002 – Final Proposals”.
16
Mazars Neville Russell (7 September 2001). “Transco Price Control Review 2002-2007: Report to Ofgem”.
(Note that the version of the Mazars report available online from Ofgem does not include appendices B and C).
26
A.5. Oftel - BT & Concert’s Network Charge Controls (February 2001)
Oftel introduced different values of X for each basket of non-competitive services ranging from
RPI – 7.5 to RPI - 13 per cent.17 Oftel also extended the retail price control until 31 July 2002
with an RPI – 4.5 per cent formula.
The Oftel methodology for estimating an appropriate X factor has a number of components.
First, the actual rate of BT’s real unit cost reduction is calculated. This is then decomposed into
parts representing the contributions of volume growth (with a cost-volume elasticity significantly
less than one, volume growth leads to falls in average costs), catch-up of inefficiency existing at
the start of the period, and changes in real input prices and underlying efficiency gains.
Oftel commissioned NERA to study BT’s efficiency relative to that of appropriate comparator
companies, principally US LECs. NERA estimated that BT is between 1.2 and 4 per cent less
efficient than best practice, and Oftel assumed 2.5 per cent inefficiency in 1999/00. The
combined effect of updated financial data and the efficiency estimate yielded a forecast rate of
cost reduction of 2.15 to 3.27 per cent per annum including catch-up, but before volume effects
and input price changes.
Oftel also stated that:
“It is arguable that the NERA study may itself tend to underestimate BT’s inefficiency relative to
best practice because comparator companies, the US LECs, may not in fact be very efficient.
Indeed, it is quite likely that they are not since, as regulated dominant operators, there may be
little incentive on them to reduce costs. Therefore, Oftel is considering other indicators of BT’s
inefficiency… BT’s achieved rate of utilisation of its local exchange circuits is unusually low
compared to theoretical rules for the design of networks, and this could be indicative of
inefficient operation.” (Paragraph 4.22)
A.6. ORR – Railtrack Access Charges (October 2000)
The Office of the Rail Regulator (ORR) based the Railtrack’s efficiency improvement
assumption on a bottom-up assessments of the potential for efficiency savings (including a
review of contracting strategy and evidence of international best practice), comparisons with
other privatised industries, comparisons with the assumptions made by other regulators, and
benchmarking of productivity trends in other railways.18 The ORR July 2000 consultation paper
sets out in greater detail the results of the various approaches to assessing potential efficiency
savings.19
17
Oftel (February 2001). Proposals for Network Charge and Retail Price Controls from 2001.
18
Office of the Rail Regulator (October 2000). “The Periodic Review of Railtrack’s Access Charges: Final
Conclusions”.
19
Office of the Rail Regulator (May 2000). “The Periodic Review of Railtrack’s Access Charges: Draft
Conclusions”.
27
The bottom up assessment commissioned by ORR from Booz, Allen & Hamilton (BAH)20
identified particular opportunities to improve efficiency, for example, adopting North American
best practice in relation to track construction and maintenance. While the ORR had regard to
these findings they were guided largely by top-down comparisons in reaching a conclusion.
Europe Economics (EE) provided a comparison of savings made by comparable industries
(particularly UK utilities).21 The EE report focussed on direct comparisons of real unit cost
trends.22 Following work commissioned by Railtrack commenting on the EE report the ORR
considered the impact of volume and capital substitution adjustments to unit cost reductions and
concluded that the comparisons were robust (paragraphs 4.25-4.28 of ORR (July 2000)).
However, real unit cost trends do not necessarily provide an appropriate basis for setting a future
X factor since they are not independent of input price movements.
NERA provided a comparison of an efficiency analysis of overseas railways, primarily in the
US.23 NERA distinguished cross section analysis, which compares the efficiency of different
railways at a single point in time; and time series analysis, which examines changes in railways’
efficiency over time. NERA distinguished Partial Factor Productivity (PFP), Total Factor
Productivity (TFP) and Real Unit Cost measures noting that PFP measures do not capture the
impact of substitution between inputs, and that real unit cost measures reflect a combination of
changes in TFP and changes in input prices.
In relation to international TFP cross-section comparisons NERA concluded that it is very
difficult to ensure that comparisons are made on a like-with-like basis (particularly due to
different methods for the treatment of capital costs), and that while benchmark comparisons
suggest there is scope for catching up, it is difficult to draw conclusions about the genuine size of
these, while the benchmarking analysis tells us nothing about the feasible speed of such
adjustment.
In relation to TFP trends NERA estimated productivity growth net of scale effects (output
volume), and of density effects. TFP trend growth for US railroads of 3.3 to 3.9 per cent per
annum was estimated after allowance for scale and density effects.
Finally, EE noted on page 3 “When applying efficiency assumptions in the context of an RPI-X
pricing regime, due account needs to be taken of ongoing efficiency achievements within the
economy as a whole which are already implicit within published price indices”. There is no
evidence that the ORR took explicit account of this in deciding on X for Railtrack.
20
Booz, Allen & Hamilton (July 2000). “Response to Railtrack’s May 2000 Cost Submission”.
21
Europe Economics (December 1999). “Review of Railtrack Efficiency”.
22
The approach differed from that applied by Europe Economics in 1998 in assessing the potential for real unit cost
reduction in the water industry which derived labour and materials productivity as a residual after subtracting
capital productivity from a TFP estimate – see Section 4.2.2.
23
NERA (July 2000). “Review of Overseas Rail Efficiency”.
28
A.7. Competition Commission – Water Industry Appeals (August 2000)
The Competition Commission reports on appeals by Sutton & East Surrey Water and Mid Kent
Water commented on the scope for operating efficiency improvements (Appendix 7.1).24
The Commission note that there are two elements to operating efficiency improvements – catchup and frontier efficiency movements, and note that there are two elements to frontier efficiency
savings: improvements in labour or materials productivity; and changes in real labour and
materials prices. The Commission noted a number of points:
“Movements in the RPI broadly reflect productivity improvements in the economy as a whole.
We need, therefore, to predict efficiency improvements relative to the economy as a whole. If the
productivity of the most efficient water companies is expected to improve at the same rate as that
of the whole economy, the implication is that (for our purposes) there are not frontier efficiency
savings.” (Paragraph 5)
“Within the economy as a whole, manufacturing tends to improve its efficiency faster than
services. Since the RPI reflects efficiency changes in the economy as a whole, the real prices of
manufactured products tend to fall and those of services to rise. If water is considered more like
manufacturing than services, a positive real savings assumption is likely.” (Paragraph 6)
“EE relied heavily on its analysis of TFP improvements by privatised industries. We must
therefore consider whether water companies may have already made a large proportion of the
exceptional savings expected following privatisation, conversion to plc status and/or the
introduction of competition”. (Paragraph 30)25
“There is no reason to believe that reductions in raw materials and fuel prices were a major
factor in achieving these [cost reductions in water from 1992/93 to 1997/98 and for other
privatised industries from 1991 to 1997] reductions”. (Paragraph 40)
The Commission concluded: “…Ofwat’s projected reduction of 2.4 per cent a year seems a
reasonable judgement for the water industry as a whole.26 We consider that the industry still has
considerable potential for savings, although probably at a somewhat lower rate than in the
recent past” (Paragraph 41)
24
Competition Commission (August 2000). Mid Kent Water plc and Sutton and East Surrey Water plc – Reports on
the references under section 12 and 14 of the Water Industry Act 1991.
25
We note that Europe Economics relied on a set of comparator industries comprising (with weights in brackets)
extraction (10.7%), refining (19.7%), network (18.2%), construction (18.2%), manufacturing (9.0%),
financial/business services (14.3%), & chemicals (9.7%).
26
This excludes the sewerage service, for which the Director’s projection was 3.1 per cent.
29
A.8. Ofgem - Public Electricity Suppliers (December 1999)
Before carryout out comparative analysis Ofgem first removed around one third of operating
costs considered to be largely outside the control of companies including NGC exit charges and
distribution system business rates. The resulting base level costs formed the basis for further
analysis including work by Panel Kerr Foster (PKF) and PB Power, regression analysis and
assessment by Peter Warry (a senior industrial advisor).27
PKF made various adjustments to “controllable” operating costs in respect of capitalisation
policy, geographical factors such as London labour costs, and the allocation of costs between
distribution and supply functions. They also formed a judgement over the level of operating
costs potentially achievable by each company through the application of efficient operating
practices, for example, setting a benchmark cost per network kilometre of £575 based on the
costs from four of the better PESs. After various adjustments PKF and Peter Warry came to a
view about the potential catch-up savings for individual PESs.
PKF considered that, from the efficient level and before allowance for one off costs, PESs should
be able to achieve further reductions in controllable costs of around 2.5 per cent - on an annual
basis from 1998/99 to 2004/05, based on average productivity gains across the UK economy as a
whole (it is unclear how this related to economy wide productivity growth inherent in the RPI).
Ofgem also carried out regression analysis to estimate the scope for efficiency improvement by
individual PESs. A composite variable combining customer numbers, units distributed and
length of network was used to explain costs with weights of 0.5, 0.25 and 0.25 respectively).
However, the regression analysis was closely tied to the analysis of costs considered above in a
number of respects. First, the regression intercept was constrained to the fixed cost level
estimated by Ofgem’s consultants (£25 million per PES). Second, the regression line was rotated
about the fixed intercept to lie through two “frontier” companies costs – Southern and Eastern –
mimicking in spirit the PKF efficiency study in defining an efficient group of companies versus a
less efficient group, and including Eastern which had the largest downward adjustment reduction
in “controllable” costs from £151 million to £72 million.28
Capital expenditure was divided into load related and non-load related (asset replacement)
expenditure. Load related expenditure was divided into the costs of connecting new customers,
and expenditure on network reinforcement for demand growth. Information on unit costs was
then used to derive normalised load related expenditure for each company. Non-load related
expenditure was estimated based on responses to the business plan questionnaire relating to asset
age profiles, unit replacement costs, supplemented by PB Power’s own information on unit costs.
Benchmarking between companies was carried out with respect to numbers of assets to be
replaced and unit costs. Capital expenditure was benchmarked at a level between median and
upper quartile performance.
27
Ofgem (August 1999). Distribution price control review – draft proposals; and Ofgem (December 1999).
Distribution Price Control Review – Final Proposals.
28
Graham Shuttleworth (October 1999). Regulatory benchmarking: a way forward or a dead-end? NERA Energy
Regulation Brief 3.
30
Annex B.
Literature Update
B.1. Summary
i.
NAO (2002) is silent on how to set X. However, Appendix 5 of the NAO report by
Frontier Economics concludes “Yardstick competition, or increased user of benchmarks
for industries with only one service provider, may be the most effective high-powered
regime.”.
ii.
Makholm & Quinn (1997) and Bernstein and Sappington (1999 & 2001) note that the X
in price cap plans, for use with a whole economy index such as RPI should be set equal to
the anticipated productivity and input price growth rate differential between the regulated
industry and the economy as a whole.
iii.
Makholm & Quinn (1997) and Bernstein and Sappington (1999 & 2001) discuss “stretch”
factors to reflect the anticipated increase in productivity growth following moves from
rate of return to price cap regulation in the US. UK post privatisation observed trend
rates of growth implicitly include such “stretch factors”, and therefore provide an
overestimate of likely longer-term productivity growth for utilities.
iv.
Economy wide TFP growth rates tend to be relatively stable over time, averaging 1.23
and 1.13 per cent per annum over the periods 1950-99 and 1989-99 in the UK (Crafts and
O’Mahony, 1999). However, sector specific TFP growth varies significantly over time
and between sectors. UK manufacturing TFP growth was 2.45% and 0.35% per cent per
annum during 1989-95 and 1995-99 respectively, while TFP growth rates varied by
almost 5 percentage points between sectors during 1989-99. Short run series therefore
provide poor benchmarks, and benchmark productivity growth may be highly dependent
on the choice of comparator sectors.
v.
UK electricity, gas and water labour productivity and TFP growth were 8.22% and 3.45%
per annum respectively during 1989-99. These growth rates are substantially higher than
in the USA, France, or Germany, and may not therefore be sustained.
vi.
TFP levels for the economy as a whole, and for electricity, gas and water were higher in
the US at 129 and 145 respectively versus 100 in the UK for 1999. However, differences
in levels may be sustained over long periods of time and there may be no easy or quick
way of closing identified “productivity gaps”.
vii.
Saal & Parker (2001) report quality adjusted TFP growth for WASCs of 2.3, 2.1 and 1.0
per cent per annum for 1985-90, 1990-95, and 1995-99 respectively. They suggest the
decline in TFP growth reflects diminishing returns to environmental investment whereby
high capex levels are buying less quality improvement as the time goes on.
31
B.2. National Audit Office (March 2002)
The National Audit Office (NAO) note that:29
•
“The regulators have varied in the extent to which they analyse company expenditure
into its different components and the types of modelling undertaken. Both Ofwat and
Ofgem (for electricity distribution) have benchmarked operating and capital expenditure
separately. The modelling this entails can only be approximate and can potentially lead
to perverse incentives to alter the balance between expenditure type.” (Page 22).
•
“The level of X in RPI-X is not the same as the level of future efficiency savings assumed
by the regulator…” (Page 50). NAO list a number of factors in elaborating on this point,
however, the overlap between industry and economy-wide productivity trends is not
noted.
Appendix 5 of the NAO report (a paper by Frontier Economics) notes, in relation to greater
emphasis on yardstick competition, that “customers’ share of the benefits could be increased (for
example, by shortening the price control period) while maintaining incentives.” (Page 67).
Frontier Economics conclude, “Yardstick competition, or increased user of benchmarks for
industries with only one service provider, may be the most effective high-powered regime.”
(Page 73).
B.3. Nicholas Crafts (April 2002)
Crafts (2002)30 publication draws on previous publications including (see below) Nicholas Crafts
and Mary O’Mahony (2001).
B.4. Mary O’Mahony (February 2002)
O’Mahony (2002)31 Draws on O’Mahony and de Boer (March 2002), below.
B.5. Mary O’Mahony & Willem de Boer (March 2002)
The revised 2002 estimates were calculated on a different basis than the 1999 study including
changes in industrial classifications and different purchasing power parities (aside from the
availability of more up to date data).32 Some of the results differ significantly, for example, the
29
National Audit Office (March 2002). “Pipes and Wires”. Report by the Comptroller and Auditor General.
30
Nicholas Crafts (April 2002). “Britain’s Relative Economic Performance 1870-1999”. Institute of Economic
Affairs Research Monograph 55.
31
Mary O’Mahony (February 2002). “Productivity in the EU, 1979-99”. HM Treasury.
32
Mary O’Mahony & Willem de Boer (March 2002). “Britain’s relative productivity performance: Updates to 1999
Final Report to DTI/Treasury/ONS”. National Institute of Economic and Social Research. This report is
32
TFP productivity gap reported in O’Mahony and Willem de Boer (2002) for electricity, gas and
water for 1999 of 145 versus 100 for the USA and UK respectively is much larger than the
productivity gap reported in O’Mahony (1999) for 1995 of 115 versus 100. Table 3.1
summarises key findings from O’Mahony and de Boer (2002).
Table B.1
Relative Productivity Levels & Growth (% per annum)
Total Economy
TFP levels (1999)
Labour productivity growth: (1989-99)
TFP growth (1989-99)
UK
USA
France
Germany
100
1.46%
1.14%
115
1.91%
1.17%
106
1.32%
0.68%
103
2.67%
1.74%
Market sector†
TFP levels (1999)
100
129
104
Labour productivity growth: (1989-99)
1.86%
2.18%
1.08%
TFP growth: (1989-99)
1.02%
1.71%
0.26%
Gas, Electricity & Water
TFP levels (1999)
100
145
115
Labour productivity growth (1989-99)
8.22%
2.19%
2.76%
TFP growth: (1989-99)
3.45%
1.04%
1.91%
Manufacturing
TFP levels (1999)
100
143
110
Labour productivity growth (1989-99)
2.32%
3.38%
2.74%
TFP growth: (1989-99)
1.61%
2.47%
1.57%
Source: O’Mahony and Willem de Boer (March 2002).
†
All market sectors excluding health, education, public administration & residential building.
109
2.76%
1.37%
80
4.38%
1.39%
121
3.52%
1.90%
Economy wide TFP growth rates tend to be relatively stable over time, and averaged 1.14 and
1.17 per cent per annum over the decade to 1999 in the UK and US respectively. However,
sector specific rates of TFP growth vary significantly both over time and between sectors. For
example, UK manufacturing TFP growth averaged 2.45 per cent per annum during 1989-95, and
0.35 per cent per annum during 1995-99, while TFP growth varied from –0.08 to 4.65 per cent
per annum across sectors in the UK during the decade to 1999.
B.6. Nicholas Crafts & Mary O’Mahony (2001)
Crafts and O’Mahony (2002) reviews UK productivity performance, compares UK productivity
levels and rates of change with other countries, and discusses role of incentive structures and
competition.33 The paper focuses on the whole economy rather than utilities per se. The whole
economy results for Labour and Total Factor Productivity (TFP) are more up to date than those
essentially an update of O’Mahony (1999) “Britain’s Productivity Performance, 1950-1996: An International
Perspective”. National Institute of Economic and Social Research.
33
Nicholas Crafts & Mary O’Mahony (2001). “A perspective on UK Productivity Performance”. Fiscal Studies:
22(3): 271-306.
33
in O’Mahony (1999). Table 3.2 summarises the GDP per hour worked and TFP productivity
growth rates reported in Crafts and O’Mahony (2001).
Table B.2
Relative Productivity Growth Rates (% pa)
GDP per hour worked:
1950-99
1950-73
1973-99
1989-99
1995-99
TFP:
1950-99
1950-73
1973-99
1989-99
1995-99
UK
USA
France
Germany
Japan
2.53
2.99
2.13
1.92
1.30
1.67
2.34
1.08
1.47
2.08
3.53
4.62
2.56
1.32
1.16
3.65
5.18
2.29
1.87
1.15
4.23
6.11
2.78
2.70
1.22
1.23
1.30
1.17
1.13
0.88
1.01
1.66
0.43
0.86
1.42
2.29
3.13
1.55
0.61
0.84
2.74
3.98
1.64
1.44
0.97
2.14
3.39
1.18
0.66
0.80
Source: Crafts and O’Mahony (2001). Tables 1&2.
Recent TFP growth rates for the total economy in the UK are therefore around 1 per cent per
annum. TFP growth in the UK is relatively stable over the period 1950-99, varying less than
GDP per hour worked (a measure of labour productivity). TFP growth in the UK is higher on
average than in the USA.
B.7. INTOSAI (October 2001)
Guideline 17 “Encouraging supplier efficiency” states:34
“The regulator needs to consider how far it is possible for the supplier to improve efficiency.
This can be difficult. Suppliers may not appreciate how far it is possible for them to do so, and
even if they do they may be reluctant to tell the regulator. Regulators may also be concerned not
to put suppliers under too much pressure to improve efficiency for fear that to do so, for example
by cutting prices, would make it difficult for the supplier to afford to maintain services (guideline
4) and could put health and safety or environmental objectives in jeopardy (guidelines 9 and 14).
Among the measures that regulators can take are
•
34
requiring suppliers to report the levels of their costs and activities in a standard format
(guideline 7). In one country, for example, suppliers’ licences provide for the regulator to
INTOSAI (October 2001). “Draft Guidelines on Best Practice for the Audit of Economic Regulation”.
http://www.intosai.org/
34
issue detailed instructions for the monitoring and reporting of their costs [United
Kingdom].
•
understanding suppliers’ businesses in sufficient detail to have a clear picture of how
their costs are made up, and the scope for reductions, for example through better
management, capital investment or new technology (guideline 18).
•
benchmarking e.g. comparing the costs of suppliers with each other and with comparable
suppliers in other countries or industries, and understanding the reasons why suppliers’
costs can differ (guideline 12).”
B.8. Saal and Parker (2001)
Saal and Parker (2001)35 use a quality adjusted output measure for water based on the resident
supply population served and the ratio of the average percentage of each WASC’s water supply
zones that are compliant with key water quality parameters, relative to the average compliance
percentage in 1990.36 For sewerage output they use the population connected to treatment works
and a weighted average of river quality and bathing water quality measures.
The opportunity cost of capital was calculated as current cost depreciation and infrastructure
renewal costs, plus an inflation adjusted rate of return on the replacement cost of the fixed asset
base sufficient to provide a 6 per cent post-tax rate of return in real terms.37 The capital stock
was measured using modern equivalent asset (MEA) values and translated into current values
using the Capital Cost Index prepared by London Economics. MEA revaluations were removed
from the data.
Labour inputs were measured using data on the number of full time equivalent employees
available from company’s annual reports, and after adjustment for average weekly hours of
work, nominal unit labour costs were used to create an index of unit employment costs over time.
A measure of employment costs net of costs attributed to capital projects was generated to avoid
double counting of labour costs in labour productivity and TFP calculations.
Table 3.3 summarises the key productivity findings by Saal and Parker.
35
Saal & Parker (2001). “Productivity and Price Performance in the Privatized Water and Sewerage Companies of
England and Wales”. Journal of Regulatory Economics; 20(1); 61-90.
36
A physical measure of water usage was not used since figures for water delivered are not available for the preprivatisation period.
37
Saal and Parker note “It could be argued that the opportunity cost of many WASC assets is zero because they have
no viable alternative uses. Alternatively, it could be argued that capital costs have been overestimated because
the replacement cost of the fixed asset base exceeds its economic value. Alternative estimates were generated
assuming a lower opportunity cost of capital. The results, as to be expected given the lower capital input, show a
more favourable TFP growth trend in the 1990s. Instead of the decline in TFP growth after 1995 reported below,
there was no significant change in TFP growth in this period.” (Page 74).
35
Table B.3
Aggregate Water and Sewerage Company Performance
(with quality adjusted output measure)
Average Annual % Change
Labour Productivity
Non-Capitalized Labour Productivity
Total Factor Productivity (TFP)
85-90
90-95
95-99
90-99
4.5
4.4
2.3
4.8
5.8
2.1
6.3
8.2
1.0
5.4
6.8
1.6
Source: Saal & Parker (2001). Table 1.
The decrease in the growth rate of quality adjusted TFP productivity following privatisation,
with the increasing rates of labour productivity growth, suggest that increasing capital
investment was undertaken relative to the actual increase in output (as measured by Saal and
Parker in quality adjusted terms) in the post-privatisation period. In turn this suggests
diminishing marginal returns to environmental investment.
Saal and Parker’s company results also suggest that trends in TFP and labour productivity, as
measured by them, are not necessarily matching. While Welsh Water is estimated to have
achieved the second highest total increase in non-capitalised labour productivity since
privatisation, its average TFP growth is below that of the average WASC (though it accelerated
post 1995). In contrast, Southern Water has the highest estimated rate of TFP growth during the
post-privatisation period, although its non-capitalised labour productivity growth was below
average. Saal and Parker interpret this as suggesting that companies have scope for a range of
choices about input substitution in achieving improved quality-adjusted output.
In interpreting Saal and Parker’s results, and in considering them as a basis for projections of X it
must be remembered that they depend on the quality-adjustment made to outputs, and on the
measurement of inputs including the assumed opportunity cost of capital and the adjustment to
labour costs to reflect time spent developing capital projects, both of which require substantial
judgement. As well as depending on these, the labour productivity measures will reflect
company moves to outsourcing, which will act to increase labour productivity measures but will
be offset by decreased measures of the remainder of operational productivity, meaning
application of the labour productivity figures to the whole of opex would be wrong.
36
B.9. Bernstein & Sappington (2001)
Bernstein & Sappington (2001) offers a simplified restatement of Bernstein and Sappington
(1999), below.38
B.10. HM Treasury (November 2000)
HM Treasury (November 2000)39 draws on published work including O’Mahony (1999).
B.11. Bernstein & Sappington (1999)
Bernstein and Sappington (1999)40 conclude regulated prices should be allowed to rise, on
average, at a rate equal to the economy-wide rate of output price (PE in their terminology, the
RPI in the UK) less an offset (X). This offset is the sum of:41
i.
The difference in total factor productivity growth rates in the regulated industry and the
rest of the economy; and
ii.
The difference in input price growth rates between the rest of the economy and the
regulated sector.
Bernstein and Sappington note that one implication of this:
“if producers in the regulated industry faced the same input price growth rate and could
reasonably be expected to achieve the same rate of productivity growth as other firms in the
economy, then expected profits in the regulated industry, as elsewhere, could be held at zero
simply by allowing regulated output prices to rise at exactly the economy-wide rate of output
price inflation”. (Page 11).42
In other words an X factor of zero would nevertheless involve productivity growth equivalent to
that prevailing in the economy as a whole (assuming input price growth were the same).
Bernstein and Sappington note that, in the absence of structural changes in the industry,
historical productivity and input price growth rates can serve as reasonable estimates of
corresponding future growth rates. However, when a new regulatory regime (for example, a
38
Bernstein & Sappington (2001). “How to Determine the X in RPI-X Regulation: A User’s Guide”.
Telecommunications Policy 24: 63-68. Bernstein and Sappington (2001). “Corrigendum to ‘How to Determine
the X in RPI-X Regulation: A User’s Guide’”. Telecommunications Policy 25.
39
HM Treasury (November 2000). “Productivity in the UK: The Evidence and the Government’s Approach”.
40
Bernstein & Sappington (1999). “Setting the X Factor in Price-Cap Regulation Plans” Journal of Regulatory Economics;
16:5-27.
41
Assuming the regulated firms output price has a negligible impact on overall economy wide inflation.
42
Here zero profit refers to economic profit after allowance for an appropriate return to investors (their opportunity
cost of capital) on capital invested.
37
switch from rate-of-return regulation to price-cap regulation in the US or privatisation and pricecap regulation in the UK), and/or new competitive pressures can reasonably be expected to
motivate the regulated firm to enhance its realised productivity growth rate.
To account for this the basic X factor in price-cap regulation plans can be augmented by what is
called, in the US, a customer productivity dividend or stretch factor (for example, the Federal
Communications Commission imposed a customer productivity dividend of 0.5 per cent annually
in its price-cap plan for AT&T). To the extent that stretch factors are designed to reflect the
enhanced incentives that a new regulatory regime provides, it can be appropriate to implement a
stretch factor that declines in magnitude over time.
Although increased competitive pressures can induce the regulated firm to operate more
diligently and thereby increase its realised productivity growth rate directly, competitive
pressures can have additional indirect effects on the firm’s productivity growth rate. Some of
these can be serve to reduce productivity growth, thereby rendering ambiguous the net impact of
competition on the firm’s productivity growth rate, particularly in the short run. For example:
•
Competitive pressures may speed technological progress, while shifting sales from an
incumbent supplier to new entrants; thereby reducing the incumbents scale economies
and potentially raising costs.
•
Competition for scarce resources (such as skilled labour and specialised equipment) can
increase the prices of these resources in the short term, and thus total production costs.
B.12. Jeff Makholm & Michael Quinn (October 1997)
“Price cap plans for electricity distribution companies using TFP analysis”. NERA Working
Paper.
Makholm and Quinn (1997) note that price cap efficiency incentives depend on the
reasonableness and objectivity of the data and analysis used in their formation. An approach to
setting X in price cap plans is set out using past industry trends in TFP.43
The use of industry-wide, rather than company-specific, studies, is proposed to avoid introducing
an undue influence of current company-specific performance on the future price formula.
Individual TFP estimates can nevertheless be made for each year for each individual company,
and then weighted together. The method proposed for estimating TFP is to compare input and
output quantities over time – the difference in growth rate between the two is the rate of TFP
productivity growth.
In relation to the required sample of firms and time period for analysis Makholm & Quinn note:
43
Jeff Makholm & Michael Quinn (October 1997). “Price cap plans for electricity distribution companies using
TFP analysis”. NERA Working Paper.
38
“annual TFP growth for any company is affected by changes in inputs (changes in capital
investment or labor utilization) and by changes in outputs (the introduction of new services or
changes in service demand growth) each year. For this reason, TFP analysis must span a
sufficient number of years to smooth out the effects of annual swings in such factors. Major
capital replacements, for instance, would have the immediate effect of reducing measured TFP
because the investment would appear as an unusually large annual capital expenditure without
corresponding change in demand. However, over time, replacement of the old capital is likely to
increase productivity growth because it embodies new technology to serve demand more
efficiently. Five years may not be sufficient length of time for the consequences of such unusual
events on an individual company to be smoothed out. Combining data from a number of
companies, however, averages such changes over all companies in the sample, which dampens
their effect on average annual productivity growth.” (Page 10).
In applying measured TFP productivity growth in setting X, Makholm & Quinn note:
“The X factor in a price cap plan represents a target productivity growth differential between
the annual TFP growth of the industry and the economy as a whole adjusted for possible
differences between input price growth rates for the industry and the economy.” (page 19).
However, doubt is cast on the need in practice for a relative input price adjustment:
“To calculate a productivity offset on the basis that input prices are different, we would need to
perform a careful analysis of long-term input prices and find a statistically significant difference
between the growth rates of industry and economy-wide input prices. Without such a showing,
we must operate under the assumption that input prices have moved similarly in the industry as
in the economy as a whole”. (Page 19)
Finally, automatic cost pass through (other than via the RPI) is acknowledged as an important
component of price regulation:
“Adjustments to the price cap index (positive or negative) to pass through cost changes due to
exogenous events are theoretically sound and well-recognized component of price cap plans.
The permit cost changes for the regulated firm to affect prices in just the way that cost changes
affect prices in unregulated, competitive markets without distorting the incentives of the
regulated firm to reduce the costs in question.” (Page 4).
39
Annex C.
General Empirical Update
C.1. Summary
This section considers whether any recently published empirical studies have implications for the
projections of water and sewerage productivity and input prices; i.e. for X.
There are no new published studies which reach conclusions about these projections directly.
The implications of new examinations of productivity trends are inapplicable because they are
for wider sectoral groupings or are made on a different basis to that required for projecting X.
There are no new studies or projections of water and sewerage input prices. However, Bosworth
and Stoneman (1998) projected these input prices on the basis that they would track comparator
or manufacturing input prices with a constant offset. Assuming that this relationship continues
to hold (along with all other bases for the B&S projection), and drawing on a more recent
forecast of manufacturing input prices, suggests that the B&S 1998 forecast that real unit
operating costs for water and sewerage would change at –0.2% per year would now be revised to
–0.9% per year.
C.2. Input prices
There are no new published studies of water input price movements. B&S based their
projections on forecasts of manufacturing input prices. Figure 4.1 shows seasonally adjusted
nominal input prices for manufacturing as a whole, and manufacturing excluding the generally
more volatile – and so harder to forecast - food, beverages, tobacco and petroleum sectors.44
44
Office of National Statistics (ONS) series
40
Figure 4.1
Seasonally Adjusted Nominal Producer Input Prices (Including Climate Change Levy)
105
100
95
90
85
80
M
ar
-9
Se 0
p9
M 0
ar
-9
Se 1
p9
M 1
ar
-9
Se 2
p9
M 2
ar
-9
Se 3
p9
M 3
ar
-9
Se 4
p9
M 4
ar
-9
Se 5
p9
M 5
ar
-9
Se 6
p9
M 6
ar
-9
Se 7
p9
M 7
ar
-9
Se 8
p9
M 8
ar
-9
Se 9
p9
M 9
ar
-0
Se 0
p0
M 0
ar
-0
Se 1
p0
M 1
ar
-0
2
75
All manufacturing
All manufacturing excluding food, beverages, tobacco & petroleum
Assuming with B&S that opex input price movements in the water and sewerage industry move
approximately in line with those in manufacturing, the sharp decline during the last price control
period would have acted to lower costs in a way which will not be sustained given that nominal
input prices during 2000-2005 are not expected to repeat this fall. Figure 4.2 shows seasonally
adjusted quarterly input prices for the less volatile manufacturing series, along with a recent
published forecast of these prices from the second quarter 2002.45 46 (Forecasts of the wider
manufacturing input price series call for special treatment of oil prices, etc, and are not readily
available from published sources).
45
Office of National Statistics (ONS) series .
46
London Business School & Oxford Economic Forecasting (April 2002). Economic Outlook, 26(3). Table 26.
41
Figure 4.2
Seasonally Adjusted Producer Input Prices for Manufacturing
(1995 = 100)
105
100
95
Actual
"Economic Outlook"
Forecast (April 2002)
90
85
80
19
90
1
19
90
3
19
91
1
19
91
3
19
92
1
19
92
3
19
93
1
19
93
3
19
94
1
19
94
3
19
95
1
19
95
3
19
96
1
19
96
3
19
97
1
19
97
3
19
98
1
19
98
3
19
99
1
19
99
3
20
00
1
20
00
3
20
01
1
20
01
3
20
02
1
20
02
2
20
02
4
20
03
2
20
03
4
20
04
2
75
All manufacturing excluding food, beverages, tobacco & petroleum
Input prices are now forecast to rise following a dip post September 11, 2001. Over the period
March 2000 to March 2005, actual and forecast producer input prices for manufacturing
(excluding food, beverages, tobacco and petroleum) are expected to increase by 1.1 per cent per
annum in nominal terms. This compares with an observed decline of 2.6 per cent per annum
during the period March 1995 to March 2000.
Figure 4.3 shows medium term movements in retail prices, producer input prices for
manufacturing and producer input prices deflated by retail prices. The medium term trend in RPI
deflated producer input prices is negative, at about 1.1% per year. This is lower than the
forecasts originally drawn on by B&S which led them to conclude that manufacturing input
prices should be projected constant in real terms (and water input prices should offset these by
+1% each year).
42
Figure 4.3
Retail Prices, Producer Input Prices and Deflated Producer Input Prices for Manufacturing
200
180
160
140
120
100
80
60
40
20
n90
l-9
0
Ja
n91
Ju
l-9
1
Ja
n92
Ju
l-9
2
Ja
n93
Ju
l-9
3
Ja
n9
Ju 4
l-9
4
Ja
n95
Ju
l-9
5
Ja
n96
Ju
l-9
6
Ja
n97
Ju
l-9
7
Ja
n98
Ju
l-9
8
Ja
n99
Ju
l-9
9
Ja
n00
Ju
l-0
0
Ja
n01
Ju
l-0
Ja 1
n02
Ja
Ju
n89
l-8
9
Ju
Ja
n88
l-8
8
Ja
Ju
Ja
Ju
n87
l-8
7
0
RPI
PIP
PIP deflated by RPI
C.3. Productivity
O’Mahony and de Boer (2002) and O’Mahony (1999) are discussed above, but do not provide
productivity estimates for the water sector, rather reporting results for electricity, gas and water
combined. The implications for water alone are not clear from these studies which cover major
liberalisation in UK energy sectors.
Saal and Parker (2001), discussed above, report labour and TFP growth estimates for the water
and sewerage industry only, but use an output measure for water services based on the resident
water supply population adjusted for changes in water quality, and an output measure for
sewerage services based on the number of household connections adjusted for various quality of
service measures. They estimate labour productivity of 4.8 per cent per annum for 1990-95 and
6.3 per cent per annum for 1995-99, i.e. they estimate a modest labour productivity increase in
the latter period. However, as we outline in section B.8 above, the quality-adjustment,
measurement of capital opportunity costs, and measurement of non-capitalised labour costs
applied by Saal and Parker mean their estimates are not readily useful as a basis for projections
of X.
43
C.4. Partial Update of Previous Forecasts
C.4.1.Bosworth & Stoneman (B&S)
Bosworth and Stoneman (1998) forecast that real unit operating costs (RUOC) for water would
decrease by 0.2 per cent per annum during the period 2000 to 2005.47 The forecast was built up
from the following four components: labour and materials, with productivity and input prices for
each. They are weighted together by the estimated shares of labour and materials costs in the
water industry (39 and 61 per cent respectively).
The B&S forecast included an assumption that water and sewerage real materials prices fall at a
rate of one-percentage point per annum less than comparators, proxied by manufacturing.
Manufacturing was projected to have constant real materials prices in the period 2000 to 2005,
while current evidence and a recent forecast imply a real decline of 1.1 per cent per annum
(allowing for forecast RPI inflation of 2.2 per cent per annum). Assuming the
water/manufacturing price movement relativity is held constant (ie +1 per cent) this new forecast
implies a slight fall in real materials input prices for the water sector, which would in turn add
0.67 percentage points to the expected annual rate of decrease in RUOC originally forecast by
B&S, revising the rate to -0.87 per cent per annum or –0.9% rounded.
We note that in commenting on the implications of new information in relation to materials input
prices we have not taken any account of possible interactions among the components of the
forecast (for example, changes in the substitution effects originally assumed).
C.4.2. Europe Economics
Europe Economics (October 1998) used a different methodology to Bosworth and Stoneman in
estimating the potential for RUOC reductions in the water industry.48 Their forecast started with
estimates of TFP growth for comparator sectors, made various adjustments to the TFP estimate,
and then “subtracted” capital productivity to get a combined estimate of labour and materials
productivity. They further assumed real wage increases in line with the economy as a whole;
and that other input prices are constant in real terms. Europe Economics used labour and
materials shares of opex of 29 and 71 per cent. Overall, Europe Economics forecast that real unit
base operating expenditure (RUOE) for water would decline by –2.5 to –3.5 per cent per annum.
Europe Economics (p60) state that “For operating expenditure items other than labour, we
assume prices are constant in real terms, in the absence of clear reasons to believe otherwise”.
Whether the downward shift in forecast manufacturing input prices would cause them to revise
this view is not clear. A 1% decline in their non-labour opex price projection would lead to a
0.71% decline in the RUOE projection, all else equal, changing their projected RUOE range to
negative 3.2-4.2 per cent per year.
47
Derek Bosworth & Paul Stoneman (August 1998). “An efficiency study for the water industry”. A report for
National Economic Research Associates.
48
Europe Economics & Professor Nick Crafts (October 1998). “Water and Sewerage Industries General Efficiency
and Potential for Improvement”. Final Report for Ofwat.
44
Annex D.
International Experience
D.1. US
In the US telecommunications, gas and electricity distribution sectors the application of price cap
incentive plans is now relatively widespread (known in the US as performance based rate plans).
Price caps are typically indexed to the GDP output price deflator (as opposed to the Retail Price
Index in the UK).
As a basis for setting X under such plans, long term industry Total Factor Productivity (TFP)
trends have been estimated relative to TFP trends for the economy as a whole. Makholm and
Quinn (1997) set out the general approach which is summarised here, and illustrated with recent
experience.49 Makholm & Quinn note: “The X factor in a price cap plan represents a target
productivity growth differential between the annual TFP growth of the industry and the economy
as a whole adjusted for possible differences between input price growth rates for the industry
and the economy.”
Two distinct types of price caps are applied – those incorporating an industry specific measure of
input prices and no general output price measure (California & Ontario), and those including an
output price deflator (approximately rest of US, analogous to UK RPI-X).50 For consistency, the
treatment of productivity and input prices differs between the two approaches – as the following
sets out:
Type 1: %Priceindustry = %Input Priceindustry - %TFPindustry; or
Type 2: %Priceindustry = %RPI – X,
where X = (%TFPindustry - %TFPeconomy) – (%Input Priceindustry - %Input Priceeconomy),
since %RPI = %Input Priceeconomy - %TFPeconomy
The former approach is intuitive – involving input price pass less productivity growth. The latter
approach involves an X factor that incorporates the difference between industry and economy
wide TFP and input price growth – for consistency with the RPI term.
The method applied in calculating the productivity offset factor is to use a simple index based
approach to compare input and output quantities over time – the difference in growth rate
between the two is the rate of TFP productivity growth. Outputs are measured in terms of
physical units and are combined using revenue share weights. Possible measures of output
include customers, system capacity, and sales volumes, all disaggregated by customer type. To
ensure comparability output is measured excluding items which vary State by State such as
49
Jeff Makholm & Michael Quinn (October 1997). “Price cap plans for electricity distribution companies using
TFP analysis”. NERA Working Paper.
50
Typically the GDP output price deflator rather than the RPI as in the UK (the difference between these series is
negligible in the UK).
45
Demand Side Management. Labour, materials and capital inputs are considered separately –
with materials calculated as the residual after allowance for labour and capital.
Labour is measured by the number of full time equivalent employees. Measuring the capital
input (a rental equivalent) is more complex since both a quantity input price and a capital service
price must be constructed. The capital stock is adjusted for actual additions and actual
retirements, with capital assumed to deliver services at a constant rate until its retirement based
on average asset lives (“one-hoss shay” depreciation). A capital service price is also calculated
based on the relationship between the acquisition price of new capital goods and the present
value of all future services from these goods (a calculation that requires an estimate of the
opportunity cost of capital). TFP growth is then calculated as the change in annual output minus
the change in annual input.
In addition, a judgement is made as to whether an explicit “stretch factor” should be added to X
to reflect anticipated gains in productivity growth following the introduction of price caps (with
private ownership long established). Stretch factors, when applied at all, are typically modest.
Figure 1 shows the results from a recent TFP trend calculation based on data for electricity
distribution in the Western US which were used as a basis for estimating X for a Canadian
electricity distribution business.
Figure 1
TFP Growth for Western US Power Distribution Companies
8%
6%
Rate of Annual TFP Growth
4%
2%
0%
-2%
-4%
-6%
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
-8%
Average annual TFP growth for the period 1972-2000 was 0.72 per cent, though it is clear from
Figure 1 that growth fluctuates considerably from year to year. The TFP estimate was used as a
basis for proposing an X factor for UtiliCorp Networks Canada after subtracting annual
Canadian economy TFP growth of 0.74 per cent, leaving a difference of -0.02 per cent.
46
A comparison of electricity sector and total economy input price movements showed a modest
difference of 0.97 per cent per annum over the full period, though this was statistically
insignificant. However, Figure 2 shows the year on year differences exhibited considerable
variability.
Figure 2
Difference between Electricity Industry & Economy Wide
Input Price Movements
20%
Difference in Input Price Growth
15%
10%
5%
0%
-5%
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
-10%
In relation to general year on year fluctuations Makholm and Quinn note:
“annual TFP growth for any company is affected by changes in inputs (changes in capital
investment or labor utilization) and by changes in outputs (the introduction of new services or
changes in service demand growth) each year. For this reason, TFP analysis must span a
sufficient number of years to smooth out the effects of annual swings in such factors. Major
capital replacements, for instance, would have the immediate effect of reducing measured TFP
because the investment would appear as an unusually large annual capital expenditure without
corresponding change in demand. However, over time, replacement of the old capital is likely to
increase productivity growth because it embodies new technology to serve demand more
efficiently. Five years may not be sufficient length of time for the consequences of such unusual
events on an individual company to be smoothed out. Combining data from a number of
companies, however, averages such changes over all companies in the sample, which dampens
their effect on average annual productivity growth.” (Page 10).
Recognising the year on year variability of input prices relative to an economy wide index, cost
pass through provisions are a common feature of US rate plans.
47
D.2. Australia
In Victoria (Australia) the state’s Office of the Regulator-General (ORG) is required by Statute
to “utilise price based regulation adopting a CPI-X approach and not rate of return regulation.”
(where the CPI is the Consumer Price Index). During the first review of electricity distribution
tariffs the regulator adopted a “building blocks” approach that first year price cuts to bring prices
into line with costs, followed by a uniform X factor of 1 per cent a year for the next four years.
The ORG used modelled cost benchmarks to review some cost components. The ORG is
required under administrative law to give reasons for decisions, and determinations can be
appealed on grounds that there are “errors of fact in a material respect”. For those benchmarked
cost components subjected to review by an independent Appeal Panel, the Panel found that the
“the ORG should have relied on the actual figures.”
Some distributors argued for an approach that omitted any examination of firm-specific costs and
the use of a uniform X based on an estimate of industry-wide TFP applied directly to price levels
(rather than costs) prevailing at the close of the first price control period.51 The Appeal Panel
found that cost based review was consistent with price-based CPI-X regulation. However, TXU
Electricity challenged the determination in court claiming that the prohibition on rate of return
regulation required the Regulator-General to sidestep the process of re-calibrating prices to costs
and to set an X-factor based exclusively on external benchmarks.
On 17 May 2001 the Supreme Court of Victoria ruled that taking firm-specific costs into account
at a regulatory review was consistent with both the theory and practice of incentive regulation,
and effectively ruled out any future derivation of X-factors based exclusively on industry wide
benchmarks.52
D.3. Europe
Experience of explicit price control regulation is to date relatively limited in Europe outside the
UK – though experience is growing. In the Netherlands in 2000 the regulator – DTe – made use
of Data Envelope Analysis to compare the transmission network (TenneT) with other national
networks and 18 regional suppliers. NuonNet successfully appealed against the DTe’s
benchmarking model and the DTe published a modified report in which NuonNet’s score
increased from 0.65 to 0.95.53
51
Greg Houston (June 2001). “Re-setting CPI-X price caps: Australian Court Endorses Use of Firm-Specific
Costs.” NERA Energy Regulation Brief 9.
52
Victorian Supreme Court (17 May 2001). http://www.austlii.edu.au/au/cases/vic/VSC/2001/153.html
53
Enese Lieb-Dóczy & Graham Shuttleworth (May 2002). “The Sense and Nonsense of Benchmarking “. Energie
& Management, page 6.
48
NERA Economic Consulting
15 Stratford Place
London W1C 1BE
United Kingdom
Tel: +44 20 7659 8500
Fax: +44 20 7659 8501
www.nera.com
49