Meghraj Capital Advisors Private Limited

1. Meghraj Capital Advisors Private Limited Infrastructure Advisory I Mergers & Acquisitions I Syndication I Capital Markets MYT-Features and Status of Implementation Nagpur- 25th February 2011 Vivek Mishra

2. Structure • Introduction to MYT • Conventional Tariff Setting Process and its Limitations • Concept of MYT • Rationale and Benefits • Framework and Options • Legal and Policy Framework • Current Status – India and International • Key Elements of MYT Framework Design • Options for MYT Framework Design • MYT Options in Detail • Cost plus Regulation • Targeted Incentive Regulation • Performance based Regulation – Price and Revenue Cap • Risk and Return Framework of various Options • MYT Options and Regulatory Objectives

3. I. Introductionto Multi Year Tariffs I. Introductionto Multi Year Tariffs I. Introductionto Multi Year Tariffs

4. I. Introductionto Multi Year Tariffs Conventional Process of Tariff Setting • Till recently, most of the State Electricity Regulatory Commission in India have followed the annual process of tariff determination • The mechanism involves: • Establishing of Prudent costs each year by the Regulator • Limited but assured return allowed in cost estimates (Concept Cost Plus Regulation) • Cost variations (above or below the approved figures) eligible for true-up at the end of each year • Limited or no incentive to outperform regulatory awards I. Introductionto Multi Year Tariffs

5. Key Limitations of Conventional Tariff Setting Process • Mechanism is not sufficiently stable to provide the certainty required to undertake long term investments • Principles are not clearly set and tendency to pad up costs • Annual evaluation and determination of “reasonable” costs • Possibility of change in regulatory principles from year to year • The annual framework does not provide the requisite incentive • Any savings on account of better performance taken away next year • Any cost on account of under-performance is subject to regulatory discretion, bringing in uncertainty • Process is very long leading to high cost of regulation MYT is an answer to make the tariff setting exercise more predictable, and to ensure that costs are recovered in a more mechanistic manner

6. MYT – The Concept “ A new system where the tariff setting exercise is done for a multiple years in one go, is termed as MYT” • Concept of MYT can mean several things: • Prescribing values/numbers on a multi-year basis for various elements of cost/ARR • Adherence to prescribed benchmarks • Instead of prescribing numbers/values principles governing the input costs and output prices for the multi year period can be done

7. Key Benefits of MYT • Predictability • Leads to regulatory certainty • Simplification of regulatory process • Innovation and Cost Reduction • Encourages utility to find innovative ways to reduce costs and improve efficiency • Accompanied by a transparent and stable system of incentives • Improvement in Customer service and satisfaction • There is a provision of reward/penalty to encourage achievement of the prescribed customer service and satisfaction levels • Risk allocation • Determines the best entity to bear a particular risk

8. II. Multi Year Tariffs – Framework and Options

9. Legal and Policy Framework • Section 61(f) of the Electricity Act, 2003 requires the Appropriate Commission to be guided by the principles of MYT in tariff determination • The National Tariff Policy notified by the Govt. of India in 2006 also provides for development of MYT framework by the States • As of 31st March 2009, 14 states have notified MYT regulations • Of the above 8 of them have issued one or more tariff orders • A no. of other SERCs are in process of development of MYT regulations • Internationally, MYT has been implemented in several countries • Latin America – Chile, Argentina, Brazil • Europe – UK, Spain • USA • Asia – Pakistan, Vietnam (in process), India

10. Key Elements of MYT Framework Design Measurability Materiality Controllability Predictability Measurability of the element around which incentivization will be planned is important for design and correct implementation Measurability of the element around which incentivization will be planned is important for design and correct implementation Risk Mitigation mechanisms become necessary around those elements that have the potential to significantly impact the performance of the utility The element will need to be controllable to the utility to enable them to beat regulatory targets The element will need to be predictable because the ability to determine a prudent level of regulatory target is crucial for the incentivization process

11. Performance Based Regulation Cost Plus Regulation Targeted Incentive Options in MYT Regulatory Framework Design Conventional Options for MYT Framework Hybrid option • 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 • Having elements of TI and PBR (few elements on Multi-year basis) • Uses the basic PBR and TI concepts • Incentivizes 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 • Also called “Benchmark Regulation” • 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 depend on implementation capabilities of the sector entities

12. III. MYT Framework Design – Options in Detail

13. Cost Plus Regulation or Rate of Return • Is the traditional form of US regulation and has been extensively used in India • In India, the approved costs are reviewed every year against the historic costs • Prices are set to allow the recovery of allowed costs and the required rate of return • Perceived as relatively less risky, the capital costs of the company is lower than under other approaches • Regulation becomes intrusive: • costs are assessed for their prudency • investments are assessed as to their ‘used-and-useful’ status • Company has the incentive to Gold-Plate Investments and has no compulsion to achieve efficiency savings • Profit volatility should be minimized but price and revenue volatility may be high

14. Targeted Incentive based Regulation • Specific targets set for some important operating elements for the duration of the control period • Losses • Collection Efficiency • Operating Expenditure • Quality of Service parameters etc • All other cost elements subject to normal cost-plus regulation • Improvements over and above the targets to the account of utility or shared with consumers and vice-versa • Most of the SERCs in India have adopted the Targeted Incentive approach

15. Performance Based Regulation (PBR) • Under PBR, rules of the road are better known up front • Reduced risk of prudence disallowance and greater flexibility for utilities, utilities prefer such regulatory structure • The frequency of rate cases is reduced and there are reduced administrative costs • Helps in reduction of overall cost of service to the customers and improve system reliability and quality of service to customers • In order to achieve public policy goals, the Regulator can set specific goals for utility management to focus on, such as promoting Demand Side Management, and supply diversity • Characterised by RPI-X+Y formula • Base cost set at beginning of control period based on historical cost data • Efficiency gains/losses to account of utility • Pass through of external costs (Y) allowed • Variants of PBR include “Price Cap” and “Revenue Cap”

16. Price-Cap • Price path established for a set price control period (in the extreme, to the end of the useful life of the asset, but normally for 3 to 5 years) • Price path is based on forecast of operating and capital costs • Provides the company with an opportunity, if it outperforms the forecasts, of earning a rate of return higher than required • Incentives are, however, linked with a higher required return, owing to the greater risk faced by the company • Regulation is, in theory, less intrusive and the more detailed price review only happens once every 3 to 5 years • Company has the incentive to game - especially by under estimating demand • No price volatility but revenue and profits may be volatile • Has been used in England, Chile, Brazil, Australia

17. Revenue-Cap • Rather than setting a price-path, revenue-cap regulation establishes a fixed revenue profile • Removes incentive to under-forecast demand • Limits the upside potential to the company to those cost aspects actually under the control of the company • Most useful for industries where the fixed costs dominate the cost base • Requires a correction factor in the formula so that any under or over-recovery of revenue can be corrected within the life of the price control • Can lead to moderate price and profit volatility • Has been used in Spain, Norway, Netherlands, Denmark

18. Risk and Return Framework of various Options Choice largely depends on the level of data availability, stability in the current regulatory framework, socio-economic and political considerations etc. An option could also be to gradually move from Annual CoS Regulation to more advance form of Performance based Regulation

19. III. Building blocks of MYT

20. Control Period • Implies the period for which the principles for determination of allowable revenue and the applicable norms remain unchanged • Provides regulatory certainty • Length of the control period determines the incentives available as the surplus available consequent to superior performance can be retained for the length of the control period • Converse is also true as losses too have to be retained for the control period • Several aspects need to be considered while deciding the length of the control period • Should be sufficiently long so that utilities have the incentive to investment as the probability for costs recovery is higher. Also the benefits accrue for a longer period • Should not be very long as this would result in inflexible MYT framework • Could lead to excess profits or losses for the utilities

21. Control Period contd.. • Commission determines the control period by taking into account: • licensees proposal • data regime in the state • preparedness of the licensees to implement the proposed changes • Involves periodic reviews by Regulator from time to time, and • Review at the end of the control period to factor in the “learning” for the next control period

22. MYT Control Period duration across states in India To start with the control period may be on the shorter side 22

23. Controllable Elements • Sales • System Losses – Transmission and Distribution • Power Purchase Cost (except variation in fuel cost & GCV) • Operating Parameters • Debt Equity Ratio • Operating Expenditure • Employee Cost • Administrative and General Expenses • Repair and Maintenance Expenses • Working Capital Requirement • Interest Cost and Interest Rate • Capital Expenditure • Quality of Supply • Collection Efficiency • Bad Debts There are divergent views on Sales & Transmission losses some consider these to be uncontrollable

24. Un-Controllable Elements • Price of Fuel – Coal or Oil • Gross Calorific Value of Coal/Oil • Terminal benefits of the employees • Force Majeure Events • Changes in law, judicial pronouncements and orders of the Central and State Government or the Commission • Economy-wide fluctuations like changes in inflation rates, market rates, taxes and statutory levies etc. Elements of cost and other parameters which are beyond the reasonable control of the Utility are considered uncontrollable

25. IV. Prerequisites for implementing MYT

26. Implementation Pre-requisites • Good baseline data for reasonable estimation of future costs and performance (and hence efficiency gains) • System losses, power demand, power purchase costs, operating expenditures, un-metered consumption etc. • All the should be estimated through actual measurement or scientific studies • Nevertheless, Regulatory process should not wait for perfect information to be first available • Process and mechanism can be introduced that improve the data regime in due course • However, reliable and timely information is an imperative, and all steps should be taken to achieve this • Strong and robust measurement and monitoring mechanisms through the control period • For approval of incentive/disincentive linked to actual performance • For incorporating the feedback in the subsequent control period

27. Key Imperatives for MYT Implementation (Prior to the control period) Generation Planning (Supply Side Analysis) Load Forecasting Study Study for estimation of un-metered consumption` Development of Regulations (Including incentive and monitoring framework) System and Network Planning Study Realistic Capex Estimation and Evaluation Framework Study on Actual Loss Estimation Revenue and Billing Analysis Collection Efficiency Assessment Opex Efficiency Targets and Verification Framework Determination of Power Purchase Requirement and Optimization Preparation of Business Plans/Account Separation ARR Projections Tariff Determination and Rationalization Plan for Meaningful Consumer Participation Dissemination Workshops for Stakeholders Monitoring and Verification Framework 27

28. Key Imperatives for MYT Implementation (During the control period) Overall System Audit Data collection process and system audit Capex Monitoring Corrective Actions – Implementation timelines Establishment of Robust MIS System Regular monitoring and generation of reports Monitoring of Controllable parameters Compliance of Directions Monitoring of uncontrollable parameters Assessment of Performance & Validation of Computations 28

29. Thank You