The Role of the Revenue Requirement

1. The Role of the Revenue Requirement • Revenue Requirement • Operating cost • Capital cost • Firm is allowed to make a return on investment called allowed revenues, valued added of the regulated activity, permissible revenues, rate base, regulated revenues, tariff base, total revenues, revenue requirements

2. Determining revenue requirements • Prudence and Prudent Management • Assume prudence • Need to prove the utility is not operating prudently • Example, -CEO cars and lavish offices • Gold-plating investments • Use and Useful • Criterion is that the asset provides service. • Net cost of capacity < Alternative investment

3. Determining revenue requirements • Known and Measurable • Firm must provide documents, facts, and methods used to estimate costs • Just and Reasonable • Regulatory compact between firm and regulator • Just price implies the regulated firm is not guaranteed to recover all of its costs

4. Factors affecting the revenue requirement • The test year • Used to forecast future costs under normal operations • Past years • Choose a year with ‘normal’ operations • Due to volatility in energy markets, many regulate firms have adopted ‘alternative regulation’ approaches that automatically adjust rates. • Future test years • Partial test year – part actual data, part projected data • Useful when history not a good predictor of future • Benchmarking • Using peer companies (either domestic or from other countries) to estimate the revenue requirement • Peru uses a theoretical ‘efficient’ company to determine the revenue requirement

5. Factors affecting the revenue requirement • Vetting costs • Determining what is known and measurable can vary between regulators • Costs • Private vs. social • Original vs. replacement • Short-run vs. long-run • Expensed vs. capitalized • Today’s customers vs. future customers

6. Calculating the Revenue Requirements • RR=O&M+A&G+T+D+(WACC*RB) • Operation and maintenance • Administration and general • Depreciation • All taxes • Weighted average cost of capital (based on debt & equity and includes income taxes) • RB – gross value of assets minus accumulated depreciation plus working capital • O&M+A&G • Deferred (recovered) vs. accrued (not recovered) • Different rate classes (resid, comm, indust) • Direct vs indirect (joint and common costs)

7. Chapter 12 – Alternatives to Traditional Regulation • Public Ownership • Opposite of ‘free market’ • Private vs. public ownership based on efficiency • Meyer (1975) study of electricity utilities • Public ownership has lower AC • Ownership vs regulation? • Technologies are different (public has more hydro) • Pescatrice and Trapani (1980) • Public ownership lower AC • Controls for different technologies • Controls for input prices • Caused by regulation • Atkinson and Halvorsen (1986) • Control for competitive vs monopoly market structure • Only examines steam generation • Finds no cost difference between the two • Both are inefficient

8. Franchising • Award one firm an exclusive right to produce and sell the good in a particular market. • The firm that wins the right is one of many bidders. • Competition among bidders should drive the price down. • Production Technologies alone does not justify regulation

9. Demsetz (1968) • Similar to example of weak monopoly with no barriers to entry • Contestability Theory • Does not work for strong natural monopoly

10. For Franchising to Work • Determining winner on well-specified criteria • Price • Quality • Reliability vs price • Duration of contract must be specified • Long term contract – more durable • Short term contract – easier to punish for bad quality • Ensuring multiple bidders with equal footing • Existing supplier’s capital • Price? Fair-value? Competitive purchase? Depreciation? • Agency to run negotiations • Engineers, legal, accountants, and economic experts

11. Regulating Quality • Difficulties to measure quality • Create Incentives to promote cost-minimizing behavior • Adopt penalties for inefficient behavior and decreased quality • Electricity • Reliability • Average Heat Rate of Baseload Generators • Water • Quality (hard vs. soft) • Pollution • Passenger Trains/Railroad • Punctuality • Car-cleanliness

12. Alternative Regulatory Structures vs COSR • COS regulation and regulatory lag • Performance based regulation (PBR) (reduce costs) • Incentive regulation • Price cap regulation • Sliding Scales • Partial Adjustment Mechanisms • Yardstick competition (reduce asymmetric information) – firms compete against one another • All three share a common structure shown but differ in the rules they set. • Revenue Requirementtariff model(rules)prices and conditions for service

13. PBR • Provides incentive to firms to increase operating efficiency • Firms can increase ROR by decreasing their operating costs • Reduces the regulatory lag (time between actual costs occur and the time those changes affect RR and COS) • Firms face a set price

14. Incentive Schemes (PBR) • All of these methods provide incentive to reach a specified objective • Vary greatly by industry and objective, but the theoretical model typically used to analyze them are the principal-agent problem. (Joskow and Schmalensee 1986)

15. Price Caps • CPI-X plan • Regulate firm is constrained so that a weighted average of its prices increase by no more than the CPI less X percent • Pros: • Possible cost reduction, incentives for cost-minimization • Protects core customers from monopoly prices • Reduces regulatory burden • Problems: • CPI vs. other price index • Still need to visit rate of return periodically

16. Yardstick • Best in industries with asymmetric information • Prices are based on the AC in the industry so firms compete and the most efficient firms are rewarded • Problems include • Collusion • Comparability • Commitment