Chapter – 2
Principles of Tariff Fixation
2.1
In exercise of powers conferred on it by Section 22 & 29 of the Electricity
Regulatory Commissions Act 1998, and regulation 3 (1) of the Punjab State
Electricity Regulatory Commission Tariff Regulations 2002, the Commission for
fixation of tariff shall be guided by the following;
a.
The principles and their applications provided in Sections 46, 57 and 57
(A) of the Electricity (Supply) Act 1948 and the sixth schedule thereto.
b.
In the case of Board or its successor entities, the principles under Section
59 of the Electricity (Supply) Act 1948.
c.
That the Tariff progressively reflects the cost of supply of electricity at an
adequate and improving level of efficiency.
d.
The factors which would encourage efficiency, economical use of
resources, good performance, optimum investments and other matters which
the State Commission considers appropriate for the purpose of this Act.
e.
The interests of the consumers are safeguarded and at the same time the
consumers pay for the use of electricity in a reasonable manner based on the
average cost of supply of energy.
f.
The electricity generation, transmission, distribution and supply are
conducted on commercial principles
and
g.
2.2
National Power Plans formulated by the Central Government.
Section 59 (1) of The Electricity (Supply) Act 1948 reads as under “General Principles for Board's Finance.
The Board shall, after taking credit for any subvention from the State Government
under section 63, carry on its operations under this Act and adjust its tariffs so as
to ensure that the total revenue in any year of account shall, after meeting all
expenses properly chargeable to revenue, including operating, maintenance and
management expenses, taxes (if any) on income and profits, depreciation and
interest payable on all debentures, bonds and loans, leave such surplus as is not
less than three percent, or such higher percentage, as the State Government
may, by notification in the Official Gazette, specify in this behalf, of the value of
the fixed assets of the Board in service at the beginning of such year.
Explanation - For the purposes of this sub-section, value of the fixed assets of
the Board in service at the beginning of the year means the original cost of such
fixed assets as reduced by the aggregate of the cumulative depreciation in
respect of such assets calculated in accordance with the provisions of this Act
and consumers' contributions for service lines.”
The principles under section 59 of ES Act 1948 have been followed by the
Commission in determination of tariffs for PSEB for the year 2002-03 in line
with regulation 3 (1)(b) of the Punjab State Electricity Regulatory
Commission Tariff Regulations, 2002.
2.3
The principles of tariff determination and methodology proposed to be adopted
by the Commission are discussed below:
2.3.1
Price Regulation
There are different methods for regulation of electricity pricing (tariff) in a
regulatory regime. The methods normally used are:
• Rate of return Regulation (RoR)
• Performance or incentive based regulation (PBR)
2.3.1.1 Rate of Return Regulation
The Rate of Return Regulation known also as cost of service (COS) Regulation
is based on cost plus regulation. The purpose of regulation is to ensure that the
utility / licensee recovers all costs that are prudently incurred including a fair rate
of return on prudent investment. In RoR regulation, the rates are set to allow the
utility / licensee to raise certain amount of gross revenues known as Revenue
Requirement. The revenue requirement is usually determined by –
Revenue Requirement (RR) = Expenses + (RoR X CB or NFA)
Where RoR
CB
NFA
=
=
=
Rate of return.
Capital base.
Net fixed assets.
The expenses include fuel costs, purchase of power cost, operation and
maintenance expenses including
employees’ cost,
Administration
and
General expenses, depreciation expenses, interest on loans and taxes etc.
The rate of return (RoR) is on the capital base defined in the Sixth Schedule in
Electricity (Supply) Act 1948 in the case of licensee and on net fixed assets as
per Section 59 of Electricity (Supply) Act 1948 in the case of State Electricity
Board.
Under RoR regulation the utility has to provide all the required data to arrive at
the revenue requirement to the satisfaction of the Commission. The onus is on
the utility to prove to the Commission’s satisfaction that the proposed revenue
requirements include only prudently incurred costs and the sales and revenues
are reasonably estimated.
The advantages of RoR regulation are:
(i)
it is based on an allowed rate of return. Therefore, the prices for the year
are fixed and are unchangeable until next tariff revision.
(ii)
lowers the risk of utilities / licensees and would encourage them to invest
in plant and machinery to ensure efficient and reliable power supply.
(iii)
the method is conceptually simple and unambiguous in making use of
historic accounting data and
(iv)
the utilities are familiar with the data requirement for filing the data etc.
The disadvantages are:
(i)
since the utility’s earnings are linked to the amount of invested capital,
utilities tend to over invest.
(ii)
the cost plus nature of RoR regulation reduces the incentive for the
utilities to minimize costs and perform efficiently in the long run
(iii)
historic book values may not provide sufficient revenues for future
investment and may result in inadequate investments for future needs
and
(iv)
the regulatory process under RoR is long, litigious and costly.
The RoR regulation is most common method used to regulate the rates in
electrical and other regulated business or industry.
2.3.1.2 Performance Based Regulation (PBR)
The performance based regulation is also called incentive regulation (IR) and is
an alternative to RoR regulation. The performance based regulation focuses on
utility
incentives to attain particular results and its product performance (price and
service quality) rather than costs. Many regulatory systems have shifted or are
planning to shift to PBR as it has gained wide acceptance. Moreover it is
considered that RoR regulation generates inefficiency and is unsuitable when
competition is to be introduced.
Performance based regulation encompasses the following features:
•
Rates are initially established on a bench mark cost of service and
performance standards:
-
Performance could include quality of service, operating standards
such as plant load factor, T&D losses management, O&M expenses per
customer etc. as well as quality of service indices such as duration of
outage both brownouts and blackouts. Performance of these factors is then
periodically reviewed and the tariff adjusted for lower or higher
performance than the benchmark. This method rewards or penalizes the
utility based on its performance. This is not strictly cost based.
-
Tariff filing is not frequent as in the case of RoR but there is
periodical (annual) review of the performance and tariffs are adjusted
accordingly.
-
The method allows sharing the benefit of cost saving between
consumers and stake holders on predetermined basis.
The performance based regulations are:
a) Price Cap
The most commonly discussed PBR is price cap. Prices are fixed for
longer period of time (4 to 5 years) and are intended to provide incentive
to reduce costs. A well designed price cap scheme begins by setting the
initial rates for each class based on appropriate allocations of costs. The
price cap then allows for an increase from year to year for inflation.
However, the entire increase in input price is normally not compensated as
improvements in productivity are also factored in as given below:
Pmax ≤ Pt [1 + (I -X)] + Z
Where Pmax is the cap of price for the current period to be charged from
different classes of consumers.
Pt
- is the average price charged to the same class during the previous
year excluding the fuel component price.
I
- is the inflation factor.
X
- is the productivity factor and
Z
- represents any incremental costs that are not subject to the cap
such
as change in fuel expenses, tax laws, accounting procedures etc.
b) Revenue Cap
PBR mechanism can also be designed using revenue cap instead of price
cap (tariff per unit or kWh terms)
Revenue caps are based on same principle as price caps, where cap in a
particular year is based on the revenue earned in the previous year with
adjustments for inflation, customer growth adjustment and productivity.
This method places an upper limit on revenues thereby constraining the
price indirectly. As in the case of price caps, revenue caps do not constrain
profitability. Revenue cap regulation is preferred for utilities that face
high fixed costs. Its advantage is that it is easy to determine and monitor
than price cap. The disadvantage of this regulation is that estimates of
more parameters are needed for proper implementation and it could lead to
significantly distorted price. Some of the other shortcomings of the system
are:
-
Substantial data requirements to set the base line tariffs and
formulae for adjustment particularly as they relate to the assumed
capital expansion plan.
-
If the final tariffs are to be achieved by the application of price
adjustment formulae, the regulator must be satisfied that base line
tariffs are appropriate.
-
Unless performance system is carefully designed, there may be an
incentive for the regulated utility to lower service quality while
pursuing monetary incentives in other areas.
-
There is less public input to the tariff process under this system
because full tariff hearings are not held as frequently as RoR
regulation.
Conclusion
For proper design of a good PBR system comprehensive, reliable and
verifiable data is an essential requirement. Having considered the
pros and cons of the two forms of regulation and their
implementability immediately, it is considered appropriate now to
adopt RoR regulation with some modifications by introducing certain
performance targets such as reduction of T&D losses, better metering,
billing and revenue realisation and other quantifiable items.
2.3.2
Determination of Revenue Requirement
An utility, in order to be viable, must be given the opportunity to recover its
prudently incurred total cost of providing electricity services to its consumers.
The allowed revenue must be equal to the revenue requirement to enable the
utility to recover its costs and a reasonable return on the investment.
To
determine the overall revenue requirement of the utility, it is essential to arrive at
the total cost of providing the service by using accounting, financial and operating
data for the utility system as a whole. The total revenue requirement of the utility
can be worked out by the following formula.
R R = Expenses + (RoR x NFA)
Where
R R - Revenue Requirement
RoR - Rate of Return
NFA - Net Fixed Assets
The expenses include fuel and power purchase costs, operation and maintenance
costs, wages and salaries, depreciation, interest on loans, taxes etc. NFA is net
fixed assets on which the utility (SEB) is expected to earn a minimum of 3
percent rate of return according to ES Act 1948.
There are three approaches to determine overall revenue requirement.
•
Actual historical accounting cost.
•
Estimation of future accounting cost.
•
Estimation of marginal cost.
In actual historic accounting approach the regulator defines a specific 12 months
period in recent past as the historic test year data.
The future accounting
approach uses a forecast of future costs and future load expected in a specific 12
months period. The utility may not be able to produce forecasts with sufficient
degree of reliability. The marginal cost approach reflect the cost of expanding
the system efficiently to satisfy the load forecast over a long time horizon.
Estimation of long-term marginal cost is difficult and sensitive to many subjective
assumptions that must be made during the estimation process.
The approach based on historic accounting cost is being traditionally used in the
Indian power sector.
There is very little experience with the other two
approaches. The Commission has adopted the historical cost approach for
determining the total revenue requirement.
2.3.3
Consumer Tariff design
After the total revenue requirement of the utility / licensee is determined, it is
necessary to assign the total requirement to various class of services and to fix
tariff within those classes. The typical approaches include:
a)
-
embedded cost-based allocation.
-
marginal cost-based allocation.
-
social tariff making.
embedded cost based allocation.
The embedded cost based approach allocates the total revenue requirement
to various categories of consumers based on an analysis of the embedded
or historic costs of the utility. In such an analysis, the revenue requirement
is allocated to classes of service to fix tariff based on various allocation
factors. The factors can be the contribution of classes to the peak demand,
the energy purchased by each class as a percentage of total sales, the
number of consumers in the class etc.
The advantage of the embedded cost approach is that embedded costs and
allocation factors can be measured based on data that is recorded in the
books of the utility.
The main disadvantage of the embedded cost approach is that the
embedded cost based tariffs do not reflect the economic costs (cost to
serve) that consumers impose on the utility through their electricity
consumption. Embedded cost-based tariffs reflect the average historic
costs
of
supply
which
tend to significantly differ from the economic costs. For determination of
economic costs (cost to serve) incurred in delivering electricity or service
to each class of consumers a number of factors have to be taken into
consideration in working out the actual cost incurred to serve each class
of consumers.
The main factors are:
voltage at which the class of
consumers is served, T&D losses at each voltage level, the contribution
of the class to the coincident peak demand/non-coincident peak demand,
demand/energy, energy consumed by the class, nature of load etc.
The data has not been built up by the SEBs in India including PSEB to
arrive at the actual cost incurred in delivering electricity to each class of
consumers. Attempt has to be made to get the data in these aspects over
the next few years to adopt tariffs based on cost of service / cost to serve.
Marginal cost based Allocation
b)
According to economic theory, the most efficient assignment of the utility
revenue requirement results from the use of marginal costs on the basis for
class revenue development. This is done by:
i)
determining the level of revenue realisation if marginal costs were
charged as prices to each class.
ii) comparing the total to the revenue requirement of the utility and
iii) closing any gap in a way that minimizes the distortions in consumption
resulting in any necessary price deviations from marginal cost.
Marginal cost represents the economic value that the utility has to incur
in order to provide consumers with an additional unit of electricity. As a
result, marginal cost based tariffs provide efficient price signals to
consumers.
The main disadvantage of the marginal cost approach is that it does not
ensure appropriate cost for the utility, which is caused by the fact that the
marginal cost tends to be lower or higher than the average cost of supply
c)
Social Tariff
In social tariff approach, social policy objectives determine the level of
revenues from each class and there is no relationship between the costs a
consumer imposes in the system and the price consumer pays.
For
example the objective to provide highly subsidised power to agriculture
and other classes would lead to very low price to the consumer. The cost
of this measure however, would have to be recovered from external
source, such as government’s budget or from other classes of consumers.
If subsidized by other consumers the resulting cross subsidies have a
negative consequence.
Conclusion
Considering the different approaches discussed above, the embedded
cost approach which leads to charging the average cost of supply (as
against consumer class-wise cost of supply) with suitable modification
to allow for some socio economic factors is most appropriate in the
initial years till required data is built up on the pattern of
consumption for each class and categories of consumers.
Inverted block energy charge which leads to higher charge for
increased usage may result in incorporating the marginal cost
approach to some extent.
2.3.4
Subsidies & Cross Subsidies
Cross subsidy takes place when one consumer group pays a part of or all of the
cost imposed on the system of another consumer group. The current levels of
electricity tariffs in Punjab contain a large degree of cross subsidisation with
some categories of consumers like large industry, commercial and Railways
paying well above the average cost of supply as compared to other consumers
like agriculture and domestic. The task before the commission is to promote
efficiency, economical use of resources so as to improve the financial health of
the power sector and efficient utilisation of capital, etc.
The subsidy is the difference between cost of service and tariff charged to a
consumer class. In order to determine the amount of subsidy one must first
estimate the cost of providing service to the customer class. With a large number
of
un-metered users this becomes most difficult. In this context long term tariff
policy will target:
-
Determining the cross subsidies and shortfall in revenue caused by not
charging subsidised consumer their cost based tariff.
-
Developing a plan to reduce cross subsidies in electricity tariff
For the Commission’s Policy on tariff setting it is important for the State
government to clarify its stand on subsidy amount that it proposes to transfer for
compensating the gap between average cost of service to subsidised categories
and tariff charged to them.
The Commission will in any case, attempt to minimize cross subsidies over
a period of time.
2.3.5
Multi Year Tariff
The tariff filing ideally needs to be a long term multiyear regime to provide
stability to the market structure. Long-term tariff principles give indication to the
utilities/Licensees and also to investors of how the regulators work and provide a
long term view of their returns. However such a long term tariff determination
and implementation is possible only in a stable demand and supply framework,
not in a shortage situation and growth of 7 to 9 percent every year, where the
investments and costs have yearly fluctuations.
Hence to accommodate the
dynamic nature of the Indian Power sector and the State, a yearly tariff filing will
be necessary in the initial years with a transition to multiyear only when the
market conditions stabilize. The Commission proposes to go in for yearly tariff
filings. However, the desirable pace of reduction of T&D losses would be
inducted in a multiyear basis.
2.3.6
Commission’s Approach
In view of several advantages and disadvantages of various options
discussed above, the Commission proposes:
-
to adopt the Rate of Return Regulation (ROR) for determining the
revenue requirement with certain performance targets for better
performance of the utility.
-
to adopt average cost of supply approach in determination of tariff to
different class of consumers.
-
to develop a plan to reduce cross subsidization gradually with improved
efficiency of the utility.
- to suggest that tariff filings should be on yearly basis in the initial years till
demand and supply conditions as well as costs become stable.