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Introduction to Regulation. Single Regulator for industry. Industry self regulated. Unregulated. Multiple regulators by jurisdiction. Commodity Multiple providers Non-critical. Specialised products and services. Monopolies or oligopolies High public interface Not a necessity.
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Single Regulator for industry Industry self regulated Unregulated Multiple regulators by jurisdiction • Commodity • Multiple providers • Non-critical • Specialised products and services • Monopolies or oligopolies • High public interface • Not a necessity • Natural monopolies • Essential products • High public interface Product characteristics Unregulated except for competition monitoring aspects Industry self regulation on aspects like pricing and establishment of standards • Licensing • Industry regulation • Licensee regulated by exception • Benchmarks and standards • Licensing • Intrusive regulation of Licensees • High statutory powers Regulation features FMCG Advertising Telecom, Gas Electricity Typical industries Low High Degree of regulation Regulation is a substitute for competition - a proxy for the market
Medium regulation Highly regulated Deregulated • Annual determination of tariffs • Close regulatory monitoring • Tariff setting done on multi-year basis • Regulation by exception in the interim • Performance based incentives • Market driven tariff structures • Regulator monitors market trends and competition aspects Features • New regulatory structures • Data inadequacy • Sector undergoing structural change • Primarily state owned or newly privatised • Mature industry and regulatory structures • Availability of information and systems • Primarily private • Technology driven market mechanisms • Sophisticated forecasting and load management systems • Adequate cash & credibility Environmental conditions Typical examples T& D in India Latin America UK New Markets Mature Markets The form of regulation practised is not uniform...
Establishment stage Inception stage Operations stage • By CERC for project clearance and bid criteria (for mega projects) • By CERC/SERC for PPA terms • By CEA for Techno - economic factors • Unregulated except for PPA terms Generation • Licensing • By CEA for techno-economic clearance • By CERC/SERC for investment clearance • By tariff mechanism established as per EA/ERC Acts and regulations formulated Transmission • Licensing • By SERC for investment clearance • By tariff mechanism established as per regulations Distribution Inception Ongoing ….or even across the sector in a country
Issues to be addressed in design of tariff principles • Establishing the financial viability of the utilities • Necessary to attract private investment • To protect long term interest of the consumers • Inducing efficiency in the sector • Conforming with legislation • Acceptance by stakeholders • Need to incorporate regulatory commitment, e.g. tariff philosophy, • Recognising Government’s need to pursue social objectives through subsidy • Balancing between • The need to increase prices to cost reflective levels • Efficiency improvements that a regulatory regime may bring about to reduce the prices • Risk perception of the prospective private investors
Problems with the Regulatory Regime prior to the Electricity Act, 2003 – India as an example • Non-recognition of “true cost” • Inadequate recognition of “externalities” like Power Purchase cost and consumer mix • Lack of clarity on regulatory treatment of operating cost elements, investment approval, past losses, etc • High degree of regulatory involvement and discretion • Very low net capital base translating to a meager return • “Subsidy risk” • The Sixth Schedule, as it stood, was open to inconsistent interpretation • The large uncertainties, when compared to the returns available, make distribution business in India a very risky investment
At a more fundamental level, a cost plus framework typically encourages inefficiency • Tendency to pad up costs • No impetus to evaluate more economical alternatives in provision of service • Excessive reliance on regulatory supervision (and a convenient excuse as well. Little management initiative • “Fat Cat” salaries and hidden incentives • Poor service quality since annual cost plus regulation keeps regulatory focus on rate base and not on service standards
Incentive regulation attempts to address these shortcomings • The philosophical approach is based on the premise that utility rate and service regulation should simulate competitive market conditions • In a competitive market, individual companies are all price takers and are unable to influence prices by their actions. Therefore, there is a strong incentive for a company to boost productivity and reduce its cost per unit of output • Incentive regulation attempts to cap the prices that can be charged or the revenue that can be earned by the utilities. There is thus an incentive to reduce costs through improved productivity and reduced cost per unit of output
Incentive regulation attempts to address these shortcomings • Incentive regulation can play a role in balancing the interests of suppliers and consumers • Simulate competitive operating environment • Lower cost • More market-responsive rates and services • Benefits of superior performance shared with customers • Useful under a range of industry structures – particularly the emerging structures in India • Natural evolution of traditional regulation as the regulatory framework matures and data improves • Successful outcome promoted by • Economic reason • Empirical research • Willingness to share plan benefits • Can result in higher risks for suppliers and consumers if the regime is imperfectly designed
Incentive regulation attempts to address these shortcomings • Utility responsibility for performance on “controllable costs” • Typically applies to all internal cost elements • Typically would include system losses • May have certain external indexation (e.g employee cost allowance to CPI) • Utility encouraged to outperform targets • Mitigation of “uncontrollable costs” • Identify and address measurement issues • Pass-through external costs
Options • Cost Plus • Performance Based Regulation (PBR) • Price cap regulation • Revenue cap regulation • Targeted incentive mechanism • Hybrid approaches Within Performance Based Regulation there could be alternative approaches. For example, the approach in UK adopts historical (embedded) costs whereas in Latin America typically marginal costs are used
Performance Based Regulation Cost plus regulation Targeted incentive Options in regulatory framework design Hybrid options • Regulates by outcome and not by cost behaviour • Utility at liberty to manage costs and enhance profits • Initial rate setting based on cost of service • Two basic variants - price cap and revenue cap • Uses the basic PBR concepts but overlays them with risk mitigation mechanisms • Incentivises better metering and loss reduction • Prudent costs established by regulator • Limited but assured return allowed in cost estimates • Cost variations eligible for true-up • Limited or no incentive to outperform regulatory awards • Works on the basic cost plus framework but overlays incentives on cost plus • Identifies cost pass through and risk mitigation elements clearly Choice of framework will primarily depend on implementation capabilities
Design of Regulatory Framework - Options Incentive for Efficiency - A risk-return framework
Formulation of incentive regulation frameworks • Price caps Rate growth capped by external index (or frozen) growth Price Cap Index = Inflation - X • Revenue Cap/Benchmark incentive mechanism Compare performance indicators to targets CostAllowed = a CostActual - (1- a) CostBenchmark
Challenges in implementation • Setting the X factor • Data deficiencies affecting design/Information asymmetry • Cost padding by utilities during establishment of benchmarks • UK experience in 1995 (the Stock Market knows better?) • Pendulum regulation in Latin America • How much regulation during the control period? • Only quality of service or also costs? • The Capex-Opex trade-off • Sharing of benefits and risks
Performance incentives could envisage sharing with consumers - - ROE after sharing Consumers Consumers Share Share Surplus Surplus ROE ROE ROE ROE - - before before Consumers Consumers sharing sharing Share Share Shortfall Shortfall Deadband Deadband
Alternatively profits and losses could be capped Extent of benefit distributed back to the consumer Regulatory target levels set at the beginning of the year Adverse Performance Total Benefit Profit Cap Extent of benefit retained by the utility Superior Performance Total Loss In this variant of the open-ended scheme, the Regulator can prevent the utility from earning excessive profits. Here, if profits due to superior performance exceed a pre-determined threshold, the excess will be distributed back to the consumer
Version of standard price capping formula. Regulation sets maximum prices with total pass through of the costs of energy and with an indexation to the US price index. Wholesale spot market exists through which generators, distribution companies and large consumers buy and sell electricity. International Example - Argentina Type of Regulation Type of Restructuring and Privatisation “Outcomes” • Loss reduction • Achieved the benchmark 10% distribution system loss level by fifth to seventh year, averaging a reduction of 2.3% to 2.6% per annum. • Financial performance • Achieved breakeven within 2-3 years post-privatisation. • Price reduction • Retail Tariffs reduced on the average. • Quality of supply • Improved quality of supply and customer service. • 1989 - Restructuring started • 1992 - privatisation of generation and transmission. • 1992 - a regulatory framework and an independent regulator was set up. • 1992 - Unbundling of the sector started
International Example - Brazil Type of Regulation Type of Restructuring and Privatisation “Outcomes” • Immediately after the initiation of reforms and the introduction of new laws, the average supply tariff to consumers went up to R$60 per MWh. This was still not adequate to sustain investments required for the sector. • Due to the economic turmoil in Brazil and the move to check inflation, the government kept tariffs almost constant in the end-1993 to end-1995 period. Thereafter tariffs started to rise again and went up to around R$ 84 per MWh. • Value added distribution (VAD) tariffs are computed periodically (similar to the RPI-X system designed in the UK). • Energy acquisition costs are passed through • Generation privatised and open to competition. • Transmission and distribution privatised and regulated. • overstaffing led to increased costs and tariffs • Highly inefficient licensees • 1996 - Reform and privatisation started in 1996- The regulator, ANEEL, was created • A non-profit organisation (AOS) is responsible for planning, monitoring, dispatch and investment decisions in transmission
International Example - Chile Type of Regulation Type of Restructuring and Privatisation “Outcomes” • Full pass through of energy and transmission cost, plus a hybrid of Cost Plus and price cap on distribution. • Distribution charges are set every four years in a procedure that consists of determining the operating costs of an efficient firm operating in similar environment and setting rates to provide a 10% real return on the replacement value of assets. • The tariffs are set for five typical zones representing different load densities. • Restructuring was done in two stages, between 1974-1979 and 1979-1990. • During the first stage prices were adjusted to allow the public utilities to achieve self-financing and to prepare for the future private sector participation. • The second stage started with the separation of generation from transmission and distribution. • Legislation spelling out the main rules for regulation, allocation of licenses, pricing, investment, quality and safety was introduced in 1982. • Privatisation per se started in 1986, most took place within 4 years. • Electricity prices • Tthe average retail prices during the period 1988 to 1997 • 1988 8.05 • 1995 13.13 • 1997 11.83 • Increased consumption • Consumption has grown at an average 8 percent between 1986 and 1997. • Energy loss reduction • Energy losses are about a third of its historical levels (less than 8 percent in • recent years). • Efficiency • Labor productivity has doubled (from less than 300 clients/employee at the end of the 1980s to almost 600 by 1997).
International Example - UK Type of Regulation Type of Restructuring and Privatisation “Outcomes” • Reduced tariffs • The average household bill in UK is now (April 2001) 248 pounds compared to 364 pounds in April 1990 • Improved quality of service • Interruptions per 100 customers came down from 96 in 1989-90 to 77in 2000-01 • Minutes lost per customer came down from 184 in 1989-90 to 75 in 2000-01 • Generation, transmission and distribution are unbundled, • Transmission and distribution are regulated using a price cap formula. • The regulatory lag is 4 years for transmission and 5 years for distribution. • The price review is based on CAPEX and OPEX benchmarks established in comparison with companies operating under similar conditions. • Generation and distribution are subject to competition. • Energy costs are fully passed through to consumers, and retail competition is fully developed. • Generation, however, was partly privatised already during the 1980s, • Third-party access to transmission and distribution was opened up in 1980s. • The transmission and distribution in England and Wales were restructured in 1990 before privatisation • A pool for wholesale trading was established, which was replaced by new electricity trading arrangements in 2000.
Case study – England & Wales
UK – Performance in a MYT environment • Regulated access terms subject to RPI-X • 1990 initial price control for distribution networks not demanding: average RPI+1.3 • much concern about profits, “fat cats” • 1995 initial cut average 25% then RPI-3 • Significant underlying cuts in costs • eg 25% average reduction in opex 1994/5 to 1997/8 • 2000 initial cut average 26% then RPI-3 • includes 8% reallocation from distribution to supply • incentive price controls do reduce costs
Addressing the issues – The England & Wales - I example Regulation of generation Generation License required Director General of Electricity Supply (DGES) has responsibility to propose competition No direct price control BUT General Competition regulations Regulator advises Monopolies and Mergers Commission (MMC) Office of Fair Trading (OFT) Regulator recommends • Pool Price Caps • Forced divestments • Rejection of merger proposals In comparison Generation in India does need licensing and role of Competition Commission is yet undefined vis-à-vis the power sector
Addressing the issues – The England & Wales example Transmission • LICENSE CONDITIONS/RESPONSIBILITIES • Provides use of transmission network on non-discriminatory basis • Operates pool and settlement system (ring-fenced operation) • No cross-subsidies between different businesses National Grid had only License Natural monopoly subject to price controls RPI-X formula of Multi-year tariff
Addressing the issues – The England & Wales example Transmission - charges Use of system charges Connection charges Paid by generators (approx 25%) • Vary according to type of customer and level and location of activity • Generators pay per KW of registered capacity and actual generation • Suppliers pay per KW of their average demand at peak system load conditions • Exit Charges • Paid by suppliers and direct customers • Entry Charges • Paid by Generators Paid by suppliers (approx 75%) National Grid regulated as a unit under RPI – X mechanism
Addressing the issues – The England & Wales - I example Tightening of transmission price control X factors 1992 review 1990 control 1996 control
Addressing the issues – The England & Wales - I example Setting the X factor – the NGC example Capital expenditure Controllable costs • financing costs only • allowed in calculation • of allowable income • NGC estimated capital • expenditure of £290m • per annum • OFFER estimated • £180m per annum • required, but allowed • an additional £60m • 10% real fall per annum • since 1990 • NGC argued 2% real • reduction per annum • reasonable in future • OFFER estimated 4-6% • pa real reduction (but • accepted 4%) X-factor • one-off 20% cut • X-factor of 4% going • forward • reduction in revenue • of£1bn over • 4 years Asset valuation • market value approach, • not CCA • OFFER calculated • market value based on • REC flotation and NGC • flotation • valued transmission • assets at £4.2bn (CCA • value – £5bn) Rate of return • pre-tax weighted • average cost of capital • (pre-tax and financing) • range 6.5% to 7.5% • estimated by OFFER • NGC’s estimate of • WACOC in excess of • 7%
Addressing the issues – The England & Wales - I example Distribution • LICENSE CONDITIONS/RESPONSIBILITIES • No price discrimination • No cross subsidy between businesses RECs have only licenses Natural monopoly subject to price controls RPI-X formula of Multi-year tariff
Addressing the issues – The England & Wales - I example Distribution charges Connection charges Use of system charges For new or modified connection to the distribution system Payable by all suppliers (including supply business of each REC) • Component charges • Standing charge (service obligation charge) • Availability/capacity charge • Variable charge per unit Unregulated but closely monitored for restrictive practices Regulated activity Total revenues regulated as a unit RECs can set their own charges within this overall regulation
Addressing the issues – The England & Wales - I example Tightening of distribution price control X factors Incentive for capital investment 1994 review 1990 control 1995 control
Addressing the issues – The England & Wales example Supply 22,995,000 customers 70% of total demand 22,950,000 customers 50% of total demand Approximately 23,000,000 customers 100% of total demand MONOPOLY 50,000 customers 50% of total demand 5,000 customers 30% of total demand 100 kW 1 MW COMPETITION 1990-94 1994-98 1998 - • 1.Public Electricity Supply (PES) Licenses – given to RECs • Obligation to supply any customer <10 MW • No cross-subsidies between businesses • No discrimination between same type of customers • Own generation limits set • 2. Second tier licenses – given to suppliers other than incumbent RECs • PES requirements do not apply Supply License required
Addressing the issues – The England & Wales example Regulatory mechanisms in Supply < 1 MW < 100 kW Y factor Regulated based on RPI – X + Y formula X factor initially set at 0 Regulated based on RPI – X + Y formula X factor set at 2 • Covering pass through of costs of: • Pool administrative charges • Transmission costs • Distribution costs • Electricity purchase costs • Fossil fuel levy 1990 1994
Case study – Latin America
Distribution of electric power: wire & retail businesses • Distribution: a single name for two separate businesses: • Wire • Core business: “network capacity service” at lower voltages • Fact: Natural monopoly; requires regulated tariffs • Supply (retail) • Core business: Power & energy trading between producers or marketers and final users • Fact: Potentially competitive activity
Trends in competition and regulation • Retail business features • Potentially competitive. • Customer - size matters. • Large consumers can do it on their own. • Retail companies are needed to supply small consumers. • Maturity in the market is important. • Technical conditions must be set (i.e. metering and conciliation). • Some technical behavioral rules could be defined. • Development of the retail market • Freedom of choice is given first to large consumers. • Pre-defined schedule for progressive deregulation (freedom to choose power supplier) of categories of consumers
Starting Conditions of the Reform Process in Latin America • Distribution of electric power caused enormous economic waste and fiscal burdens: • Distorted pricing regimes • Low quality service • High losses (technical and non technical) • Low equipment availability • Inefficient investment decision and execution • Root causes were "institutional": sector policies, market structure, skills, lack of incentives and inadequate supervision.
Key Principles of Sector Reform in Latin America • The regulatory framework must guarantee that distribution firms • Meet all demand and provide adequate service in their specified service areas • Give open access to their networks to parties allowed to trade power (suppliers and large consumers) • Charge fair and reasonable tariffs that ensure business sustainability (allow to cover costs of supply and a reasonable return) if it is efficiently managed • Set quality standards accordingly with concession or license contract and monitor effective fulfillment .
L.A. Legal- Regulatory Framework • Principles of the new institutional and regulatory structure of the electric sector were defined through specific laws. • In Bolivia, Peru and Chile laws contain not only the principles but also the specific procedures (and even the formulae) to be followed for calculation of regulated tariffs (transmission and distribution). • In Argentina, the specific procedures and formulae are contained in the regulatory decrees and license or concession contracts.
L.A.- Legal - Regulatory Framework • To give more legal certainty to investors, key articles of the law and regulatory decrees are included as part of the concession or license. They will stay valid for these contracts even if repealed as norms of general application (Brazil, Uruguay). • The whole set of norms (law, decrees, contract) is in general VERY SPECIFIC (low flexibility for discretionary interpretation by involved agents). • MYT should be part of the “request for proposals” (RFP) documents of the bidding process for the selection of the private operators
