Quantitative Techniques for Regulation in Practice

1. Quantitative Techniques for Regulation in Practice Price Control Reviews

2. Overview • Price cap - basic idea • Key aspects: RPI, X, etc • The periodic review • Processes, timetables, and consultations • Approaches to benchmarking Price control techniques

3. Price cap - basic idea A basket of goods and services is allowed to rise no faster than the general rate of inflation less a factor X Rate of inflation is measured by the retail price index: • Well known and understood • Timely Price control techniques

4. Features of original price cap • Initially restricted to a “basket” of rentals and local tariffs only • Much simpler than rate of return. • Incentive for efficiency: • If firms can cut costs, can keep savings (at least) until the price cap is reviewed in up to five years. Price control techniques

5. Features of original price cap • Only temporary for telecoms “until competition arrives” • but possibly permanent in water, gas and electricity (or parts thereof) Price control techniques

6. RPI: Expenditure shares formulation RPI = retail price index (CPI in most other countries) % change in RPI = (% change in price of item 1 times share of item 1 in retail spending) plus (% change in price of item 2 times share of item 2 in retail spending ) plus (% change in price of item 3 times share of item 3 in retail spending ) plus …etc. Price control techniques

7. What determines RPI? • Input prices e.g. wages, imports, fuel, etc. • Share of profit in output • Depends on competition (-), state of demand (+) • Productivity growth: • Faster productivity growth => lower RPI =>higher standard of living (other things equal) • Weighted by importance of each sector • Depends on demand growth as well as technology Price control techniques

8. What is X? • By definition, the amount by which an index of tariffs will be allowed to grow in any year over the next price control period. • In telecom originally 3% because digitisation was expected to lead to productivity growth 3% faster than the rest of the economy. This was basically a guess, subsequently revised. • X is sometimes called the productivity factor. Price control techniques

9. Setting X: the periodic review Littlechild 1986 on water industry Para 10.20: “In deciding how far to revise X … the economic regulator needs to examine the company’s production methods and investment programme. He must ascertain the scope for cost and price reductions through increased productivity and efficiency and the need for capital expenditure. He needs to predict the consequences of different levels of X on what the company will do, how it will do it, how consumers will be affected and others will react…. So permanent regulation is more complex than temporary regulation.” • Para 10.21: “It should now be evident that rate of return considerations are necessary implicit in setting and resetting X”. Price control techniques

10. Key features • 5 year cycle typically • Consultation on process, and aspects of detailed work, including draft proposals • Final proposals accepted/rejected by companies • Competition Commission as appeal tribunal • (except Airports: integral part of process) • Based on modelling of cash flows Price control techniques

11. Main elements of price cap calculations • Operating costs • Capital expenditure –maintenance, renewals, growth, quality enhancement • Return on capital (discount rate) Price control techniques

12. Overview of Process • Consultation on framework and processes • Consultation on main issues and how they are to be dealt with • Submission of business plans by companies • Analysis and response by regulator “draft proposals” • Responses by companies • Final determination • Acceptance or rejection (=> reference to CC) • Implementation and monitoring Price control techniques

13. Extract from Ofwat web site For distribution review just completed: • Phase one - Framework and issues • Phase two - Assessment of draft business plans and market research • Phase three - Decisions and determinations • Phase four - Implementation of price limits and evaluations of periodic review 2004 http://www.ofwat.gov.uk/aptrix/ofwat/publish.nsf/Content/pr04index Price control techniques

14. Consultations • Framework and processes • Scope, timetable, methods of working, definitions, possibly the financial model • Analysis of components: • Efficiency • Costs of capital • Capital spending • Draft determination • Prospects for prices Example: http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/3939_DPCR_Main%20doc_july03.pdf Price control techniques

15. Checks and balances Necessary for confidence building: • Consultations at each stage • Reference to Competition Commission • On substantive issues • Judicial review • On procedural issues: Reasonableness e.g. in recent cases was reason for decision sufficiently well supported by explanation and analysis? Price control techniques

16. Non controllable components of opex E.g.: • Rates • NGC exit charges • Costs of work done for other parties e.g. local authorities Price control techniques

17. Cost drivers Electrical system costs: optimal layout given demand patterns number and distribution of customers maximum demand at various points provision for responding to faults, repairs, damage, etc. deviations of actual from optimal growth, churn, etc. Non system costs Billing, finance, regulation some fixed elements, other related to customer numbers Price control techniques

18. Cost Empirical frontier Theoretical frontier Cost driver The frontier • Minimum possible costs, given the cost drivers Price control techniques

19. Investigating the frontier • Engineering investigation of practices: • intrusive, subjective • Comparative analysis • limited by paucity of observations • transco, NGC: no real comparators • but some use of inter-zonal comparisons in gas dist. • Distribution companies: 14 observations per year • International benchmarking? Difficulties • (Make deductions about relative importance of cost drivers from foreign studies?) Price control techniques

20. Types of comparative data analysis • Simple cost ratios • Regression analysis • Data envelope (DEA) and other frontier techniques Combination of cross section and time series? (panel data) Some scope for international comparisons, limited by data definition issues. Price control techniques

21. Movement of the frontier • Total factor productivity (“TFP”) analysis • compares movements of outputs and of inputs • long term trend • Energy industry plus other “similar” industries • Overseas industries Price control techniques

22. Example: Distribution costs Price control techniques

23. Composite output 1999 Component Relative weight Customers  1.00 kWh  0.25 Network length  0.25 Price control techniques

24. Engineering analysis 1 In order to assess the potential savings available to each PES, a number of techniques were applied as follows: —a cost per network kilometre benchmark of £575 per km, based on costs from four "top" PESs; —"engineering cost" based on a profile of its network assets using a best practice cost per asset; —comparison of historic savings achieved -- four of the top PESs achieved savings in engineering costs of up to 40 per cent from 1994/95 to 1997/98: in addition, the extent of savings in costs from 1990/91 to 1994/95 was also considered; —a review of each PES’s engineering organisational structures, field efficiency and operating practices; Price control techniques

25. Engineering analysis 2 • 1) methods of cost reduction in past • 2) plans for future • Examples: • new terms and conditions of employment • increased condition monitoring of assets • staff multi-skilling • => range of estimated savings feeding into targets Price control techniques

26. Key issues for operating costs • How much productivity gains for the whole sector? • How much weight to put on “efficiency" findings? • How much of residual is efficiency? • How much of efficiency gap to be made up? • How quickly should companies approach frontier? • How long should companies keep productivity benefits? • P0 versus X • five year profile issues Informed by analysis of past reviews How well did companies forecast? How far did they all surpass targets? How well did efficiency scores predict efficiency gains? Price control techniques

27. Further Reading 1. On the origins of the price cap The UK model of utility regulation. CRI. Papers by Littlechild and Stern 2. Visit Ofwat and Ofgem websites e.g. http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/5429_Elec_DPCR_second_consult_maindoc_18dec03.pdf • For an analysis of Ofwat’s efficiency models one by one: http://www.staff.city.ac.uk/j.s.cubbin/Consulting&Policy/Water%20UK%20Assessing%20Ofwat%20Final140404.pdf Price control techniques