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What is distribution? (2)
Distribution is a network activity
network expansion planning line construction maintenance scheduling maintenance work network operation Retailing (commercialization, supply) is a different activity
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Regulatory characterization of
the distribution activity
Natural monopoly that must be regulated Revenues, Quality of service, Access, Obligation of supply, Territorial franchise, Limited competition? A small (typically) risk business Distribution must be regulated separately from transmission less influence on the wholesale market large generators do not “use” it But, with distributed generation, some of these differences become blurred; the remaining significant differences are large number of facilities prevents individualized treatment direct effect on quality of service
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Case example: Great Britain
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Major topics in distribution
regulation
Investment, very much related to quality of
service & also to network losses
Pricing
Access
The increased presence of distributed generation & demand response is forcing to reconsider many aspects of distribution regulation
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Pricing
The objective
Objective: To allocate the global remuneration
of the distribution network to the individual users
Distribution charges are a component of
the “integral” tariff (for non-qualified consumers) the “access” tariff (for qualified consumers) Any charges to connected generators
Distribution charges should
be cost reflective completely recover the network costs
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Content of licenses (it could be also
specified in general secundary regulation)
Conditions that may be associated to the license (i.e. regulated items) Duration, conditions for renovation / loss Geographical franchise Obligation of supply connection, continuity, quality of voltage Regulated remuneration Access conditions Access & connection charges
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Outline
An introduction to distribution
Price control of regulated activities
The search for improved incentives
Review of alternative methods
RPI-X
The procedure The components of cost The estimation of cost
Regulation of the distribution activity
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Price control of regulated
activities (*)
Objectives (when determining the remuneration)
financial sustainability of the regulated company productive efficiency: service is produced as cheaply as possible , subject to minimum quality requirements apply the right incentives There are other objectives, such as equity (non discrimination) or allocation efficiency, that are only of interest when designing tariffs for the end-consumers
*** Some parts of this section are based on “Resetting price controls for privatized utilities”, R. Green, M. Rodríguez Pardina; The World Bank, 1999.**
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Some recommended references on “incentive regulation”
The fundamentals: P. Joskow, “Incentive regulation in theory and practice: Electricity distribution and transmission networks”, prepared for the National Bureau of Economic Research Conference on Economic Regulation, January 2006. Some recent reviews of experiences: Florence School of Regulation Workshop on Incentive-based Regulation in the Energy Sector, www.eui.eu/RSCAS/, Nov.
OFGEM on-going project to review RPI-X http://www.ofgem.gov.uk/Networks/rpix20/Pages/RPIX20.aspx
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Price control of regulated activities
Alternative approaches
1 Cost-of-service regulation
2 RPI-X or Price control every N years (developed
here in more detail) with price or revenue cap
with or without profit sharing different techniques of cost estimation estimation of cost-of-service reference models benchmarking
3 Yardstick competition
4 Light handed regulation
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1. Cost-of-service regulation (1)
It has been the dominant method of
regulation for many years
The regulated company is allowed to charge
prices that would cover its operating costs
and provide a fair rate of return on its
investment
allowed revenue = allowed operating expenses + +allowed rate of return x allowed investment (rate base) + depreciation It is meant to recover actual incurred costs allow for deviations of reality with respect to predictions
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1. Cost-of-service regulation (2)
Advantages
in principle the company recovers its costs cost of capital should be low (low risk) may result in optimal investment levels & quality of service (caution: trend to over-invest if rate of return is generous (Averch-Johnson effect))
Disadvantages
no incentives to keep costs down “prudential reviews” & “regulatory lags” (risk of no cost recovery) regulatory lags incentivate cost reduction &, when formalized, lead to RPI-X regulation
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2. RPI-X regulation (2)
Most price controls are scheduled to last for 4
or 5 years
any reduction in costs cannot be passed through into the price control until the next review stronger incentives to reduce costs (but less cost reduction to consumers) if the revised prices move smoothly from the present level to the new target (instead of adjusting them directly to the estimated costs of the company: one-off reductions)
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2. RPI-X regulation (3)
Different alternatives are open
Regarding the adopted technique to estimate the efficient costs for the review period Benchmarking, Reference models, Average incremental cost (some of these techniques are described in detail later) Leaving the possibility of sharing benefits or losses with customers (“profit sharing”) Use a “cost pass-through term” if there are significant costs that are beyond the firm’s control RPI-X+Y Much is left to the regulator’s perception
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3. Yardstick competition
Within a group of comparable firms the price that each one is allowed to charge is based on the costs of the rest of the group Sophisticated application requires a large data base of costs and relevant characteristics of comparable firms Then the adequate remuneration of any company is obtained from the existing data by statistical means Provides a strong incentive to reduce costs, since the method is exogenous to own costs
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4. Light-handed regulation
The utilities themselves determine non-
discriminatory charges for their customers
The regulator supervises the charges and may
impose mandatory changes
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RPI-X regulation
The two major versions
Like rate of return regulation, but with a formalized regulatory lag to give companies an incentive to operate efficiently in the interval between reviews “Price cap”: the company is required to keep the increase in a weighted average of its prices to less than the increase in a specified price index, less X per cent “Revenue cap” : the total regulated revenue of the company is required to evolve in time as the increase in a specified price index, less X per cent
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RPI-X regulation
Price cap control (1)
The firm is required to increase the weighted average of its prices in year t by less than the annual increase in the retail price index RPIt less the desired tightening X % in the price control
The regulator must determine the weights to be used in the formula (efficiency proportional to the quantities that would be sold at efficient prices) Under some regulations the regulator determines the price cap & also the prices complying with it
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RPI-X regulation
Price cap control (2)
The company just has to send a statement to the regulator showing that the proposed price increases comply with the formula simplicity But there is some room for gaming in the estimation of the volumes of consumption under each price The formula must allow the company to introduce new prices flexibility There is a strong incentive for the firm to encourage an increase of the volume of consumption, once the prices have been set preferably use revenue cap control instead
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RPI-X regulation
Revenue cap control (1)
The basic control formula for the total revenue of the firm is (all amounts in t): Total regulated revenue (t+1) = = Total regulated revenue (t) x (1+RPI-X) x
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RPI-X regulation
Revenue cap control (3)
Advantages
With revenue cap it is possible to adjust X so that the net present value of the revenues and the costs over the price control period are equal. (This is the key feature of the RPI-X method for price control) Once the prices have been set, the firm would also appear to have an incentive to increase its volume of sales, but, if deviations are applied on the next year to comply with the revenue cap formula & if the weighing factors are correctly set, the firm is neutral with respect to small deviations in the estimation of the revenue drivers (including the volume of sales)
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RPI-X regulation
Duration of the control
4 or 5 years strikes a good balance between incentives to reduce costs (productive efficiency) & the risk that prices will diverge much from costs (allocative efficiency & sustainability) but may be too short to incentivate innovation The price control may include a “reopener”, i.e. a provision to start the price control review process before the due date in the event that any pre specified significant changes with respect to the initial conditions might happen
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A variation on RPI-X
Profit-sharing regulation
Idea: share the cost reductions with consumers
more rapidly (i.e. between price reviews)
regulator monitors the cost evolution if it is much lower (higher) than initially estimated, the prices are reduced (increased) to absorb part of the saving (cost augmentation). It could be used as a refinement to RPI-X cumbersome to implement incentives to reduce costs are weakened variant: firm voluntarily reduces prices and the lost revenue is added to the next period’s revenue to smooth out the price transition
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Outline
An introduction to distribution
Price control of regulated activities
The search for improved incentives
Review of alternative methods
RPI-X
The procedure The components of cost The estimation of cost Discussion
Regulation of the distribution activity
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Present value calculations
The cost based approach
For each year: Required revenue (RR)= = Operating costs (OC) + Rate of return (r) x Opening assets (A) + Depreciation (D) Assume that all the costs & revenues for a year accrue at the end of that year all actual quantities have to be discounted to the beginning of the year by applying the discount factor d d = 1/(1+r) The asset base has to be updated every year to take account of depreciation & investment during the preceding year
Net present value of estimated incurred costs (2 year example)
Net present value of the estimated incurred costs: 63.636 + 57.025 = 120.
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Present value calculations
Calculation of X & the revenue cap
TCNPV is the net present value (NPV) of the estimated total incurred cost at the initial year t of the 4 year price control period Revenue cap trajectory & calculation of X: Match the NPV of costs & revenues for the control period
TCNPV = R(t).d + R(t).(RPI-X).d^2 + R(t).(RPI-
X)^2 .d^3 + + R(t).(RPI-X)^3 .d^4
NOTE (key issue): The effect of the expected change in the cost drivers (such as the supplied demand) is already included in TCNPV
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The myth of the efficiency factor X
Myth: “The X-factor is intended to capture the difference between the operator and the average firm in the economy with respect to inflation in input prices and changes in productivity” (The Body of Knowledge on Utility Regulation, http://www.regulationbodyofknowledge.org)
Alternative view: Once all the future costs of the firm for the control period have been somehow estimated, the value of X must be such that the net present value of the stream of estimated costs and revenues for the entire control period are equal
