Sustainable Energy Systems
Theory of Regulation
PhD, DFA
M. Victor M. Martins
Semester 2
2008/2009
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
Models of regulation in practice ( cont )
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Yardstick regulation
Partial cost adjustment
Menu of contracts
Performance based regulation
Bibliography
Shleifer, A. 1985, "A Theory of Yardstick
Competition," Rand Journal of Economics, Vol. 16,
No. 3, pp. 319-327
Slide 2
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
{
In the yardstick regulation the performance of a regulated utility is
compared against of a group of comparable utilities: for example,
the mean of the costs of a peer group of firms can serve as
performance benchmark.
Equation:
n
Pi ,t = α C i ,t + (1 − α i )∑ ( f j C j ,t ) )
j =1
Where: Pi= overall price cap for firm i ; = share of firm's own
cost information; Ci = unit cost of firm; fj revenue or quantity
weights for peer group of firms j ; Cj = unit cost ( or prices )
for peer group of firms j; n= number of firms in peer group
Slide 3
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
Outline
{ Yardstick regulation
z
z
z
z
{
{
Regulatory framework and benchmarking
Benchmarking methods
DEA
COLS
Yardstick regulation and incentives
Yardstick regulation in practice
Slide 4
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
What is it?
{
{
{
In yardstick regulation the allowed prices or revenues
of a company depend on the performance of other
companies.
The performance can be regarded in three main
aspects: productivity, efficiency and quality
Productive efficiency and in particular cost efficiency
are the most commonly used measures in the
yardstick regulation of electric sector
Slide 5
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
Value of yardstick competition
{ Company level
z
{
Industry level
z
{
Improve technical and cost efficiency
Detect and follow up technology development
Regulation
z
z
z
Incentive system
Control of tariffs
Structural development
Slide 6
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
Î Efficiency measurement methods
The methods used for measuring efficiency are referred
to as frontier approaches
Frontier Analysis
Parametric
determini
stic
( COLS )
Non-Parametric
stochas
tic
(SFA )
DEA
FDH
Extensions
Slide 7
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
DEA - In a sample of companies with a k-input-m-output
production function with variable returns to scale ( VRS) the
measurement of cost efficiency using DEA method reduces to the
following minimization problem:
Min
λ, x
i
w´ x
i i
st : − yi + Y λ ≥ 0
xi − X λ ≥ 0
Ν´i λ = 1,
{
λ ≥0
w – vector of input prices ;x - vector of input quantities ; y –
vector of output bundle;X and Y are matrices; N and are
vectors
Slide 8
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{ Efficiency
z
Example
frontier
Distributor
Operating cost (M€)
Deliv power( MWh)
z
z
Benchmark
Cost/MWh
A
B
72.5
80
1115.5 1379
C
140
1500
D
120
1200
65
93
100
58
{ Questions
z
z
z
Is D an efficient utility?
Who is efficient?
Who are the peers to D?
Slide 9
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
Decomposing efficiency:
z
z
z
Technical efficiency
{ To avoid waste and slack
Scale efficiency
{ To operate at the right scale
Cost efficiency
{ To apply least cost technology
Slide 10
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
z
Efficiency frontier
Output
MWh
C
1500
B
1200
D
A
70 75
z
120 140
Input
M€
Technical Eff.: 75/120= 62.5%
Slide 11
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
z
Efficiency frontier
Output
MWh
C
1500
B
1200
D
A
70 75
z
120 140
Input
M€
Scale Eff.: 70/75= 93%
Slide 12
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
Information
z
z
Technical Efficiency : 62.5%
Scale efficiency : 93%
Input target
- OPEX 75 ( - 45, i.e. 120-75)
Slide 13
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
{
The minimization problem can be solved by LP methods. The LP
finds a piece-wise linear isoquant in the input space, which
corresponds to the minimum costs of producing the given
output at any given point.
The solution gives the minimum feasible costs for each
company namely, w´ix0i
, where xi* is the optimal output
bond for firm i. The cost efficiency of each production plan is
then estimated as the distance to the envelope. Namely, firm
i´s cost efficiency is therefore obtained by:
w´ x*
Eff i = i i
w´ x 0
i i
Slide 14
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
Example
Distribution Company
A
B
C
D
Opex (M€)
72.5
80
140
120
Labor (€/h)
87
77
70
135
1200
1200
1200
1200
90
95.4
175
187.5
Output( MWh)
Totex (M€)
Labor/MWh
73
64
58
113
Opex/MWh
60
66
117
100
Cost/MWh
75
80
146
156
Slide 15
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
z
Cost efficiency
labor €/h
140
135
D
187M€
63
M€
A
84
B
C
35
75 84
120
140
Opex
M€
Slide 16
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
Information
z
z
{
Cost efficiency : 187M€/63 M€=» 33,5%
Cost targets:
{ Operating costs: 35M€ ( -85)
{ Labor: 140€/h
( +5)
{ Total cost: 63m€ (-124M€ )
Yardstick regulation offers:
z
z
z
z
Real targets, norms and peers
Cost norms, low information rents
Observed technologies
Participation
Slide 17
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
{
{
Regression Method- COLS ( corrected ordinary least
squares )
Model: ln Ci = f( yi,wi )+ui
z
z
z
{
Ci – actual cost incurred by the company i
f( …) – cost function
ui-Stochastic error
After correcting the error term so that all residuals ui
become positive the COLS model can be written as:
ln Ci= f( yi,wi)+mini(ui)+vi with vi=ui-mini(ui) >0
where vi represents the firm inefficiency.
Slide 18
Theory of Regulation
Sustainable
Energy
Systems
Yardstick regulation
Technique of COLS ( corrected ordinary least squares )
C,c
B
Efficient
Frontier
E
F
EF/BF
Composite scale variable
Slide 19
Theory of Regulation
Sustainable
Energy
Systems
Regulation of utilities in selected countries
Countr
y
Regulati
on
Method
Benchmarking:
Method and
sample
Inputs and
outputs
From
benchmarking to
X-factor
Great
Britain
Revenue
cap
COLS / OPEX
I: OPEX
O: Composite
variable( 50% nº of
cust; 25% el dist;
25% length of
network
I: Capital+goods &
services +labor
O: Nº of customers,
en. del. Length lines
and cables
I: Total cost
O: Units, demand (
peak)
network
length,
customers
I: Total costs
O: Electricity
distributed, demand
Customer volume
High cost utilities
must move 75% of
the distance to
efficient frontier
during reg. period
14 Recs in GB
Norway
Revenue
cap
DEA: total
controlable costs
Regional networks
and distribution
Netherl
ands
Ex-ante
tariff
regulatio
n
DEA/Revenue
Spain
Revenue
Reference
network/revenue
Utilities revenue cap
for 1998-01 is
reduced 38.2%
OPEX and X: from 8
to -2 for individual
companies.
Eff. Requirement:
individual+ general
1,5%
Slide 20
Theory of Regulation
Sustainable
Energy
Systems
Incentive regulation -Partial cost adjustment
{
{
{
Another approach to incentive regulation is to link the price
adjustment to changes in utility's own cost observed in a
reference year.
The cost minimization is provided by price periodic adjustments
that are less than proportional to the actual changes in the
cost.
The following equation shows a partial cost adjustment
scheme:
Pi ,t = C * i + λ(Ci ,t ) − Ci* )
z
Where: Pi = adjusted price; C*i= reference cost per unit
output ; Ci= actual cost and lambda = sharing parameter
Slide 21
Theory of Regulation
Sustainable
Energy
Systems
Incentive regulation - Menu of contracts
{
{
{
The menu of contracts method is an innovative approach to
reduce the information asymmetry between the regulator and the
regulated firm
Under this scheme the regulator offers the utility a menu of
incentive plans with constant consumer welfare. The utility can
choose among the incentives and the flexibility in choosing
among the alternatives reveals its welfare-enhancing preferences
For example, a menu of incentives can be designed where the
utility's share of profits
or some specified reward is a function
of the deviation of the X-factor ( or price cap ) chosen by the
utility form a base X*:
α
α = f(X − X )
*
Slide 22
Theory of Regulation
Sustainable
Energy
Systems
Incentive regulation - Targeted regulation
{
{
{
{
Targeted incentive regulation pursue narrower
objectives than the broad incentive regulation
discussed in the above
The aim of these schemes is to target specific
aspects of the operation of the utility and achieve an
outcome that would not necessarily result from broad
incentive schemes
Targeted incentive regulation may be used to
promote environmental standards, technical
efficiency and improvement in the quality of service
These schemes have been criticized on the ground
that they distort efficient allocation of resources.
Slide 23
Theory of Regulation
Sustainable
Energy
Systems
Performance based regulation
{
{
{
Performance-Based Regulation ( PBR) has become
increasingly popular in many regulated industries in the US
and can be defined as the implementation of rules,
including financial incentives, that encourage a firm to
achieve certain performance goals, while affording the firm
significant discretion in how the goals are schived.
An effective PBR regime incorporates mechanisms to
overcome information asymmetries and decrease the need
for detailed regulatory intervention
A full PBR regime is characterized by two elements:
z De-linking a utility's own costs with its own allowed prices or
z
revenues,
Linking the utility's own allowed prices or revenues with the
costs of other, comparable utilities
Slide 24
Theory of Regulation
Sustainable
Energy
Systems
Performance based regulation ( cont)
The advantages of PBR over ROR are the following:
{ By not linking authorized revenues directly to realized operating
costs, PBR plans can provide companies with strong incentives to
control costs and increase other aspects of performance
{ PBR can provide improved rate predictability for customers
especially through plans like rate freezes and rate case moratoria
{ PBR such as earnings sharing plans can secure timely customer
participation in a company's improved financial performance
thereby making customers “ stakeholders” in the company's
operations
{ PBR plans can reduce administrative and regulatory costs by
avoiding regulatory micromanagement of company's operations
and by reducing the number of litigated rate cases
{ By providing an electric utility with incentives similar to those
faced by firms in competitive markets, well structured PBR Plans
can serve both as a tool to regulate traditional utility operations
and as a transitional mechanism to more competitive electricity
markets
Slide 25
Theory of Regulation
Sustainable
Energy
Systems
The evolution pattern of regulation
Incentives
Company specific
incentives
Quality
requirements
efficiency
requirements
First incentives
for cost
reduction
Rate of return
regulation
Incentive regulation
Menu of contracts
regulation
Slide 26
Theory of Regulation
Sustainable
Energy
Systems
Method of regulation of utilities in selected countries
Country
Model of regulation
Great Britain
Revenue cap
Netherlands
Revenue cap
Norway
Revenue cap
Australia
Revenue cap
California Southern
Chile
Price cap
Yardstick regulation
Slide 27
Theory of Regulation
Sustainable
Energy
Systems
Conclusion
{
Based on the experiences in several European
countries, the acceptability of regulatory models
among interest groups seems to be an essential part
of the development process
z
{
It has proven to be difficult to implement models that have
been unacceptable to the regulated companies
Difficulties in accepting regulatory models may
sometimes be due to the fact that they have become
very complicated
z
z
z
Regulatory models have often been developed piece by
piece
New adjustments, e. g. efficiency and quality have been
added on top of the existing regulatory formulas
There are some signs indicating that regulatory models
should become more simpler.
Slide 28