Sustainable Energy Systems
Theory of Regulation
PhD, DFA
M. Victor M. Martins
Semester 2
2008/2009
Theory of Regulation
Sustainable
Energy
Systems
Theory of Regulation: Models of regulation in pratice
Models of regulation in practice
4.1 Price cap regulation
4.2 ROR regulation
4.3 Incentives and regulation
5. Yard stick competition
{
Bibliography
{
{
Jamash, T. and M. Pollitt ( 2000) –Benchmarking and
regulation of electricity transmission and distribution:
lessons from international experience
Jamash, T., Nillesen, P and M. Pollitt ( 2004)- Strategic
behavior under regulatory benchmarking- Energy
Economics, 26, 825-843
Slide 2
Theory of Regulation
Sustainable
Energy
Systems
Energy sector - electricity
{
From vertically integrated utility model
z
z
z
z
z
z
z
Central dispatch of generation
No entry
Costs are recovered at utility level and revenue is
distributed
Centrally planned investments
Risk of investments are passed through to
consumers
Regulator is the administration( Ministry)
Public ownership
Slide 3
Theory of Regulation
Sustainable
Energy
Systems
Energy sector - electricity
{
To unbundling
z
z
z
Main idea: possibility and desirability of
separation the transportation of the goods
transported
Electric energy as a product can be separated
commercially from transmission/distribution as a
service
Electricity tariff to be split into an electricity (
commodity) and system ( transportation) charges
Slide 4
Theory of Regulation
Sustainable
Energy
Systems
Energy sector - electricity
{
Legal requirements on unbundling-timeline
1st liberalisation
directive
Directive 96/92/
EC
Accounts
separated for TSO
& DSO
1996
2nd liberalisation
directive
Directive 2003/54/EC
Legal and functional
unbundling for TSO &
DSO
3rd liberalisation
directive
Proposals launched
on 19th September ownership unbundling
2003
2007
Full
implementati
on of 3rd
liberalisation
package
20??
Slide 5
Theory of Regulation
Sustainable
Energy
Systems
Regulation of TSO and DSO
{
Therefore
z
z
Competition functions ( production ) and monopoly
functions ( transport and distribution) should be
organized in separate companies ( corporate
unbundling ) in order to avoid cross-subsidization
and distortion of competition
Need for regulation of ( natural ) monopoly
functions and promotion of competition in
generation and supply
“ Ensure that transmission and distribution tariffs are nondiscriminatory and cost-reflexive” Directive 2003/54/EC
Slide 6
Theory of Regulation
Sustainable
Energy
Systems
Regulation in practice: Asymmetric information and regulation
{
An important goal of regulation is to find the balance
between the needs of different interest groups:
z Customers want reasonable prices and sufficient
quality of monopoly services
z Companies require that the directing signals of
regulation are consistent with the general planning
and operating principles of distribution networks
z Investors want returns on their investments
z The costs of regulation to the society should be in
relation with the presumable cost saving within the
industry
Slide 7
Theory of Regulation
Sustainable
Energy
Systems
Regulation in practice: Asymmetric information and regulation
{
Philosophy:
z
z
{
Regulation can focus either on profits of monopoly
companies or prices of monopoly services
In general, profit regulation gives incentives for
capacity expansion whereas price regulation gives
incentives for cost reduction
In practice
z
Regulatory models often have elements of both
Slide 8
Theory of Regulation
Sustainable
Energy
Systems
Models of Regulation in Practice
{
Models of regulation:
z
Rate of return
Price cap
Revenue cap
z
Price cap in UK
z
z
Slide 9
Theory of Regulation
Sustainable
Energy
Systems
Goals of regulation
{
Relation between goals and instruments
z
SustainabilityÎ tariff levels, subsidies, investment
z
Allocative efficiencyÎ tariff structure
z
Productive efficiencyÎ regulatory regime
z
Fairness Î tariff structure and various contractual
obligations, including investment levels, speed and quality.
Slide 10
Theory of Regulation
Sustainable
Energy
Systems
Models of Regulation in Practice
{
Rate of return regulation focuses on
profit and is often applied when regulation is
first implemented
z
z
It does not require that the regulator has
detailed knowledge about the cost factors of
monopoly companies
Regulators often use this period to gain more
information of the regulated business
Slide 11
Theory of Regulation
Sustainable
Energy
Systems
ROR regulation
{
The ROR regulation allows the utility to cover
operating and capital costs as well as a return
on capital.
z
Calculation of required revenue for firm i´s
targeted rate of return in year t from projected
costs:
RRi,t= OEi,t+Di,t+Ti,t+(RBi*ROR)t
z
RRi = required revenue; OEi=operating expenses;
Di= depreciation expense; T=Tax expense; RBi=rate
base; RORi= rate of return
Slide 12
Theory of Regulation
Sustainable
Energy
Systems
ROR regulation
{
Evaluation
ROR provides firms with incentives for capacity
expansion
But:
z Incentivizes overcapitalization ( A-J effect )
z And doesn't incentives for cost reduction and
efficiency improvements
z
This regulatory mechanism, mostly used in USA
before the 90´s, was intended to cover the
operational and cost of capital, considering a
previously defined return on capital
Slide 13
Theory of Regulation
Sustainable
Energy
Systems
Sliding Scale( ROR bandwidth)
{
{
{
In sliding scale or ROR bandwidth regulation, the
utility's allowed rate of return is benchmarked against
a target or reference ROR that lies within a prespecified dead-band.
During the regulatory lag, the actual ROR can vary
within the dead band without causing rate
adjustments
Equation of simple sliding scale regulation:
rt = rt −1 − λ(rt −1 − r * )
{
Where: rt is the rate of return in the t period; r* is the
benchmark rate and λ is the sharing parameter
Slide 14
Theory of Regulation
Sustainable
Energy
Systems
ROR bandwidth regulation or sliding scale
{
Disadvantage of this type of regulation
z
High administrative costs derived from the
regulatory task of being continuously monitoring
the profits of the regulated firm
Slide 15
Theory of Regulation
Sustainable
Energy
Systems
Models of Regulation in Practice
{
Price cap ( RPI-X-Y) regulation sets limits
on price of monopoly services
z
z
{
Requires annual efficiency improvements of the X
factor
Allows for pass-through of certain cost factors
outside of companies´ control ( Y factor )
Often, Y-factor is set equal to zero , which
forces the regulated company alone to face
the risks of external price shocks ( rate
moratoria ).
Slide 16
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation
{
{
{
Price cap regulation decouples the profits of the
regulated utility from its costs by setting a price ceiling.
The price cap, P, for each year is set based on the
retail price index ( RPI) and an efficiency factor ( X).
Equations:
{ Pit=Pit-1*
( 1+RPI-Xi) +/-Zi
{ P=p1q1+…pnqn
Where Pt represents an index of the “n”tariffs p1, …pn,
of the regulated firm and Z accounts for the effect of
exogenous extraordinary events affecting the utility's
costs.
Slide 17
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation
RPI ?
- Price can be indexed to the overall level of inputs
- Industry index of price increases
- CPI: consumer price index
- PPI producer price index
Any price index has limitations with its time fluctuations
so adjustment mechanism is needed
Slide 18
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation
X factor ?
X pose a significant, but not insuperable problem to
the regulator
Two main approaches to determine X factor:
z Historical productivity method:
Carry out TPF ( total productivity factor ) as basic offset
{ X value should be equal to the difference between the
productivity of the operator and the economy as a whole
{
z
Regulatory benchmarking method:
{
Adjustment on the base of yardstick competition
Slide 19
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation
Time period ?
-
-
The productivity should not be passed on to the
consumer at once to cause possible diluition of
incentives
A proper period should be between 3 to 5 years
-
OFTEL and BT – 4 years except the initial price cap for 5
years
Slide 20
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation
{
{
The price cap regulation developed by
Litlechild in 1983 and widely used in
telecommunication sector in UK and USA was
intended to introduce efficiency in the
settlement of prices.
Advantages:
z
z
{
Incentives for cost reduction
Freedom for price rebalancing
Disadvantages
z
Trade-off price quality
Slide 21
Theory of Regulation
Sustainable
Energy
Systems
Revenue cap regulation
{
The revenue cap method regulates the maximum
allowable revenue that a utility can earn
z
Equation
Ri,t = Ri,t-1 + CGAi * ∆Cust i ) * (1 + RPI − X i ) + / − Zi
Where: R is the authorized revenue; CGA is the
customer growth adjustment factor( €/customer);
= change in the number of customer; X
∆Cust
efficiency factor and Z adjustment factor for events
beyond management control
Slide 22
Theory of Regulation
Sustainable
Energy
Systems
Revenue cap regulation
{
{
Revenue cap regulation is a special case of price
regulation, but slightly different in the way it is
established.
This regulatory mechanism ( BT and BG ) establish
maximum allowable revenue that firms can earn,
giving them the incentives to maximize profit by
reducing costs
z
z
Advantage: Gives companies more freedom in setting prices
and this is considered to promote more efficient price
structures
Disadvantage: Appears when firms, trying to increase their
sales margin, limit competition inside the market
Slide 23
Theory of Regulation
Sustainable
Energy
Systems
Revenue and price cap regulation
CAP REGULATION
Price cap
Revenue cap
cap ( upper limit)
on earned revenue
cap ( upper limit)
on actual prices
Tariff basket
Individual price
Cap on wheight
average prices
( cap on prices only)
Variable revenue
Fixed revenue
( Cap linked only to
CPI-X)
( Cap linked to CPI-X
and other v.)
Revenue
yield
Hybrid
revenue
( cap on revenue
per unit of output)
( cap on revenue
and prices)
Slide 24
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation in UK
Applications: UK RPI-X
- UK use the building block approach
- Cap exp and OP ex are analyzed separately
- Cap exp must be audited ex-ante and expost
- Op ex separated : controllable versus
uncontrollable
- Reasonable WACC calculated
- Only part of measured inefficiency eliminated
z
Slide 25
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation in UK
Actual
revenue
A
X factor under total
benchmarking
Actual Opex
Allowed
revenue
excluding
taxes
2001
X factor under
Opex
benchmarking
Efficient Opex
B
C
Depreciation
Cost of capital ( WACC) x RAB
2005
Slide 26
Theory of Regulation
Sustainable
Energy
Systems
Price cap regulation in UK
Risks and limitations of UK RPI-X approach
- Weak incentives at the end of the period
- Investments incentives weak
- Regulation introduces risk
- Process viewed as burdensome
Solutions
- Standardise efficiency recovery period
- Clear guidelines for assessment of investment
- Develop consistency in cost of capital projections
- Review process ex-post
Slide 27