Regulatory Design Toolkit for Utilities, Stephen Labson slEconomics

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Form of Price Regulation

Regulatory Design Toolkit

For information on this document

please contact

Contact details

Dr Stephen Labson

Phone: + 61 412 599 693

Email: [email protected]

slEconomics

Economics Consulting in Utilities and Infrastructure

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slEconomics is a boutique economics consulting firm providing specialised

advice to governments, regulators and corporate clients in the area of utilities

and infrastructure. We are based in Sydney Australia and have an

international network of associates to bring global experience to local

initiatives.

www.slEconomics.com

Contact details

Dr Stephen Labson

Level 32, 101 Miller Street

North Sydney NSW 2060

Phone: 0412 599 693

Email: [email protected]

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Index

SECTION 1.0 – OVERVIEW AND CONCEPTUAL DESIGN 4

1.1 What the Regulatory Design Toolkit is meant to do 6

1.2 Regulatory Design Toolkit architecture and use 10

SECTION 2.0 – APPLICATION OF THE REGULATORY DECISION AID 24

2.1 The decision tool 27

- Decision trees for choosing forms of price regulation 31

2.2 Forms of price regulation – key performance characteristics 39

- Price Monitoring 42

- Pricing Principles 45

- Franchise Bidding 48

- Index Approach 52

- Cost Based Approach 56

2.3 Application rules 60

- Choice of target variables (revenue / price caps) 64

- Adjustment factors 66

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Section 1.0

Overview and conceptual design

Of the Regulatory Design Toolkit

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Guide to Section 1

In the first part of this section the basic nature of the Regulatory Design Toolkit (RDT) is explained .

The primary nature of the RDT

The application space under which the RDT has been constructed

The second part of this section specifies the RDT Architecture and analytical framework, setting out the:

Conceptual and analytical framework

Data sheets

Decision framework

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Section 1.1

What the Regulatory Design

Toolkit is meant to do

Contact:

+61 412 599 693

[email protected]

www.sleconomics.com

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The Regulatory Design Toolkit (RDT)

The RDT is meant to identify the following as set out in the project TOR

The forms of price regulation available to ESCOSA under the ESC Act

Characteristics, advantages and disadvantages of each form

Relevant market / industry circumstances in which each form would be an appropriate choice

The RDT is seen as a strategic tool

The logical foundation of the RDT is grounded in both theory and practice, however, for parsimony

references to the considerable literature which this work is based on have been placed in a supporting

Reference Document.

The RDT does not provide a legalistic or precedent based approach to regulation.

The RDT is not a tool for determining if price regulation is warranted.

It will be assumed that that matter would have been resolved prior to use of the RDT, although there would

be many common threads to the logic applying to the assessments of forms of price regulation.

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The Regulatory Design Toolkit (RDT)

The primary role of the RDT is to provide a tool for selecting the form(s) of price regulation appropriate for

industry specific application.

The available forms of price regulation span a spectrum of options – with the minutia of detailed application often

having a material impact on performance.

It would not be feasible or useful to build an RDT that recommended one unique form for a given

application.

The RDT will typically provide a narrowed set of workable options that provide broadly consistent

outcomes

The RDT allows the operator to set out in what circumstances one would tend towards specific forms

within the sub-set of options

An overly mechanistic approach to price regulation is not generally robust to practical application

The RDT has been built with the understanding that application to industry specific analysis would be

further assessed by ESCOSA against a range of less tangible factors not amenable to assessment within

the RDT.

The RDT has been designed such that it is robust to the range of industries ESCOSA may have regard to in

the foreseeable future.

The RDT has been designed to a level of detail that balances robustness against usefully detailed

findings.

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The Regulatory Design Toolkit (RDT) - Reference Document

The RDT is supported by a Reference Document

The Reference Document provides a summary of how price regulation has been applied in other Australian

jurisdictions, as well as a selected set of case studies sourced from domestic and international experience.

The case studies are supplied to highlight innovative approaches and archetypical forms of price

regulation.

The Reference Document is to be read in conjunction with the use of the RDT.

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Section 1.2

RDT architecture and use

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Forms of price regulation

•The forms of price

regulation defined as

mutually exclusive

approaches

•Spanning the range of

options available to

ESCOSA

Industry circumstances

•The “initial conditions” for

regulatory assessment

•Sets out the circumstances

unique to that industry which

suggest a particular form of

regulation

Key characteristics

•Key characteristics of each

form

•Identifies strengths and

weaknesses of each in

terms of stated assessment

criteria

To gain an understanding of the conceptual foundation of the RDT it is useful to think in terms of left to right, but the

actual assessment will start with the “initial conditions” of the market and industry at hand, and move from right to

left.

A conceptual overview of the RDT

Identification of key drivers

Assessment of preferred forms

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RDT architecture – forms of price regulation

Categories of price regulation and application rules

The “pure” forms of price regulation are meant to be mutually exclusive for analytical clarity

In reality, there are only grey areas

The detailed application rules required to operationalise a form of price regulation further complicate matters, and can

change the core characteristics of a particular form of price regulation

For example, the choice of revenue or price as the target variable (cap) has clear implications in regard to

the regulatory performance of that category of price regulation.

Categories of price

regulation

Description of each form

and key characteristics

Mutually exclusive forms

Price monitoring

Pricing principles Franchise bidding

Index approach Cost based approach

Application rules

Describe the practical

aspects of key operational

factors

Combinations applied to

forms of regulation

Target variables

(i.e. rev / price cap)

Productivity factors

Performance measures

Efficiency carryover

The basic forms

require specified

application rules

Application rules can

enhance or diminish

key characteristics of

the primary form of

regulation

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RDT architecture – assessment criteria

Criteria against which forms are assessed – reduction – and “reduced forms”

The assessment criteria have been defined covering the range of factors most relevant to regulatory performance,

and that appear to be consistent with the ESCOSA Act.

Assessment criteria

Performance incentives

Investment and renewals incentives

Allocation of risk

Benefit sharing

Propensity to allow excess profits

Propensity to allow in-sufficient profits

Technological bias (inputs, process,

investment choice)

Revelation of information / price discovery

Predictability of outcomes

Robustness to change and uncertainty

Facilitate efficient entry

Information intensity

Cost of administration and compliance

Reduced form assessment criteria

I. Power of incentive mechanism

II. Regulatory risk (Type I & II Error)

III. Information (asymmetry &

revelation) and administrative costs

IV. Robustness to change and

uncertainty

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Reduced form criteria explained

The specified assessment criteria are compactly grouped into reduced form criteria – this sets the

foundation of the RDT

These key concepts are described in the following pages.

Reduced form criteria

I. Power of incentive mechanism

II. Regulatory risk (Type I & II Error)

III. Information (asymmetry &

revelation) and administrative costs

IV. Robustness to change and

uncertainty

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Power of incentive mechanisms

A “high powered” incentive mechanism is one in which the firm bears a high proportion of costs at the

margin – and likewise captures the benefits from cost reductions

Leads to performance enhancements where better use of inputs, processes and technology leads to lower

costs per unit output

Has the potential to lead to performance reductions, when quality of service is a choice variable to the firm

and not easily measured, regulated or priced by the market.

For example, in the extreme form:

The index approach is a high powered incentive mechanism – where the firm captures cost savings

(perhaps benchmarked against an industry average)

The cost based approach (cost pass-through) is low powered – where the firm is largely indifferent to

either cost reductions or increases.

Practical matters to consider when using a high powered incentive mechanism.

Service quality - control and measurement. The regulator may have to set service standards (or payment

mechanisms) to off-set the incentive to under provide for quality of service.

Not easy to decompose controllable from non-controllable cost shocks – firm probably bears both (force

majeure is an example of trying to exclude non-controllable cost shocks from an incentive regime). Probably

more appropriate where the two can be separately identified.

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Regulatory risk – Types I & II Error

The regulation of firms in the position to exercise market power is in itself subject to considerable uncertainty

– with the concomitant risk of either under or over regulating in any given circumstance.

Regulatory risk is often considered in terms of risk of over-regulation, where there is the potential for the mis-application

of price regulation (i.e. from badly designed price controls) to impart net societal costs.

The RDT implicitly incorporates the more robust dual framework of regulatory risk which addresses:

Type I error - a propensity to ‘under-regulate’ when regulation is warranted – potentially leading to capture of excess

profits by the firm through the exercise of market power.

Type II error – a propensity to regulate when regulation is not warranted – potentially leading to insufficient profits to

the firm, and/or net societal costs from regulation.

And accordingly:

A form of regulation which has power with respect to Type I error would mitigate against Type I error

– thus not as likely to ‘under-regulate’.

A form of regulation which has power with respect to Type II error would mitigate against Type II error

– thus not as likely to ‘over-regulate’.

There is ultimately a trade-off for the regulator to determine:

Forms of price regulation which provide more certainty against the exercise of market power may have the potential

to impart unanticipated net societal costs through poorly designed (inappropriate) regulatory controls.

More benign forms of price regulation may have the potential to allow for unanticipated exercise of market power

and capture of excess profits by the firm.

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Information and administrative costs

The nature of information is crucial to the design of regulation

The preferred form of price regulation will, in part, be determined by information available to the regulator

Asymmetries in information between the regulator and the firm will suggest various forms of price

regulation over others.

In some cases, the form of price regulation might reveal market, cost or price information - or similarly -

provide more or less incentive to mis-represent information

The costs of information capture for both the firm and the regulator are real and need to be fully

considered in the assessment.

Examples:

Revelation of information

Demand forecasts

Revenue caps (or price caps

based on revenue

requirements) without

under/overs adjustment for

deviations from forecasts can

provide incentive to overstate

demand forecasts.

Administrative costs

SA ports price caps

Based on simple legacy

charges as opposed to a

rigorous albeit potentially costly

analysis of activity based ports

costs

Asymmetric information

Service quality

An index based (high power)

regime requires ongoing

measurement of service quality

(where market based

incentives to supply are

deficient).

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The various forms of price regulation will have different attributes with regard to change and uncertainty.

Anticipated industry and market dynamics might recommend forms of price regulation which better accommodate

changing structural factors. For example:

Anticipated “lumpy” renewals expenditure not closely correlated with increased volumes may suggest

implicit or explicit cost pass-through mechanisms.

Anticipated (deemed) productivity enhancements leading to reduced costs may require a concomitant

adjustment to price paths.

Anticipated growth in competition which diminishes the risk of long term exercise of market power may

suggest more flexible form of price regulation.

Uncertain outcomes represent risks that are allocated to the firm or consumers, with some clear and direct

implications for the forms of price regulation.

Volume risk is a key factor in regard to uncertainty across the range of forms considered in the RDT – the

form of price regulation employed will define the allocation of that risk to the firm or consumers.

Normative analysis typically suggests that risks should be allocated to those that are best placed to

manage that risk – identification of controllable and non-controllable risk is the first step in that analysis

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RDT architecture – industry circumstances

Industry and market circumstances form the “initial conditions” of the assessment.

The initial conditions set out the circumstances unique to the industry which suggest particular forms of price

regulation.

The industry circumstances provide a checklist against which the key criteria are assessed.


Is the industry (or firm) producing at its efficiency frontier? Are there multiple products, services or differentiated

customer classes?

Is the system at efficient operating capacity? Is substitution in input choice limited by the basic

technology?

Are there “missing markets” in terms of service quality,

and if so, is it feasible to measure and regulate quality of

service?

Are efficient costs observable by the regulator?

Is significant capital expenditure or renewals investment

in service quality required (expenditure not matched by

increased sales)?

Is the data required for a cost build-up easily (cost-

effectively) accessible?

Is there a high degree of concern over the potential to

expropriate consumer surplus through the exercise of

market power?

Are service features bundled with competitively supplied

services?

Is demand responsive to price (high elasticity of demand)

and/or the quantum of value significant?

Is the market subject to volatility - particularly in regard to

volumes or costs?

Are there significant spill-overs to other sectors of the

economy?

Is the market in transition to a more competitive

environment with the possibility of new entrants to the

market?

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The decision framework

Utilising the data sheets, a decision framework maps the relevant industry circumstances to appropriate

forms of price regulation.

The RDT sets out the key performance characteristics of the regulatory options when applied to a specific industry.

It is impossible to determine a unique (or optimal) form of regulation without a pre-defined objective function and

formal mapping of relationships.

The RDT is meant to provide a clear set of conditions under which certain forms of price regulation would

be appropriate.

A small and workable set of forms will become apparent from the analysis, within which ESCOSA can

then consider trade-offs.

The RDT provides a compact means of identifying and assessing the advantages and disadvantages stemming from

specific forms of price regulation when applied to a specific industry setting.

ESCOSA will then need to rank close alternatives based on an implicit “regulatory loss function” taking into

consideration the range of more subjective matters typical to regulatory assessments.

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Decision tool – overview of design

A compact decision tool has been designed which provides a set of four decision trees to be utilised for

each industry evaluation.

Power of incentive

mechanism

Regulatory risk

Information (properties

and requirements)

Robustness to change


as inputs

Suggested forms of

price regulation as

outputs

The assessment criteria are grouped by their

reduced forms - comprising each decision

tree.

Key characteristics of the various forms of

price regulation are mapped to industry

circumstances.

Appropriate forms of price regulation are

provided as output to the RDT decision tree.

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Decision tree – the template

The decision tree maps the key industry conditions relevant to that particular tree to appropriate forms of

price regulation.

Industry condition x (No) Industry condition x (Yes)

Industry condition y (No)

Industry condition z (No)

Industry condition y (Yes)

Industry condition z (Yes)

Suggested form(s)

Suggested form(s)

Suggested form(s)

Synthesis of forms of price

regulation suggested by negative

responses regarding industry

circumstances

Comments on key factors to

consider

Synthesis of forms of price

regulation suggested by positive

responses regarding industry

circumstances

Comments on key factors to

consider

Suggested form(s)

Suggested form(s)

Suggested form(s)

Reduced form assessment criteria

Example - power of incentive mechanism

Example - if yes, a high powered

incentive mechanism is warranted.

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Outputs

The individual decision trees have been grouped such that there would be a tendency to recommend a close

range of forms of price regulation within that grouping of assessment criteria and industry circumstances.

However, there may be a tension within or across the major groupings where ESCOSA will have to give a weighting

to the various assessment criteria .

For example, in regard to regulatory risk one form might be suggested, whereas in regard to robustness

to change a different form might be suggested – ESCOSA will have to determine which factor is of

greater importance to resolve this tension.

There could also be conflicting recommendations within a decision tree, where the specific assessment

criteria will again need to be given relative weightings to come to a conclusion.

The RDT will in these cases provide the key factors that would be considered in such cases – ideally providing clarity

to the analysis being undertaken.

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Section 2.0

Application of the Regulatory Design

Toolkit

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User’s guide to application of RDT

There are 3 steps in using the RDT

(1) Starting with the decision trees that take industry circumstances as inputs to provide a narrowed set options; (2) to

be further assessed by reading through the key characteristics sheets; (3) then assessing the choice of key

application rules to operationalise the preferred form of price regulation.

Step 1

Step 2

Step 3

•Work through decision trees in

section 2.1.

•Read key characteristics sheets in

section 2.2 for the narrowed set of

categories of price regulation

suggested in Step 1.

•Work through menu of application

rules in section 2.3 for the preferred

option obtained in Step 1.

•Obtain small (workable) set of


suggested by industry circumstances.

•Provides detail on strengths and

weaknesses of the narrowed set of


suggested in Step 1 – leads to a

preferred option.

•Use data sheets in section 2.3 to

choose preferred application rules to

be used in conjunction with the

preferred form of price regulation.

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Guide to Section 2

The first part of this section provides a decision tool which suggests appropriate forms of price regulation for

given industry conditions.

Decision trees provide a summary tool which sets out the key industry circumstances to be considered

against the assessment criteria – with recommendations for a narrowed set of categories of price regulation

as outputs.

In the second part of this section, the primary categories of price regulation assessed in the RDT are set out

in concise form.

A brief description of the form of price regulation is provided

The key performance characteristics of each category of price regulation are set out in tabular form

The third part of this section assesses important application rules which have a direct bearing on the

performance of the general categories of price regulation.

Critical features of application rules are provided in tabular form, which are to be considered in conjunction

with those categories of price regulation in which they might be employed.

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Section 2.1

The decision tool

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Guide to Section 2.1

The first part of this section provides a decision tool which suggests appropriate forms of price regulation for

given industry conditions.

Decision trees provide a summary tool which sets out the key industry circumstances to be considered

against the assessment criteria

Step 1

•Define the boundaries of the

service being considered for price

regulation:

•Disaggregate the services as

required such that industry

circumstances are are generally

consistent across the bundled set

of services being assessed.

•Work through each decision tree

starting on page 31 of this

document – considering the

assessment criteria for each

industry circumstance

•Obtain small (workable) set of


suggested by industry

circumstances.

•Where conflicting recommendations are

provided, sort by most relevant criteria

(i.e. if consumer protection is considered

more important than economic efficiency

factors)

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Defining the bundle of services for the purpose of price regulation

Relevant industry circumstances may vary between components of the industry or firm which is to be

regulated.

Where important industry circumstances vary across components of the regulated entity, so would the suggested form

of price regulation.

For example, the NEC differentiates between “prescribed distribution

services” and “excluded distribution services” (i.e. public lighting) whereby

excluded services are to be regulated under a more light handed approach.

The underlying logic is that industry circumstances (broadly

speaking) relevant to the choice of price regulation can and do vary

across closely related services.

With the above in mind:

Workably segmented service bundles must be defined such that it is appropriate to apply a single form of price

regulation to it.

Where diverse forms of price regulation are suggested by the RDT, it may be that further disaggregation is required

for the purpose of price regulation.

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Decision tool – review of design

A compact decision tool has been designed which provides a set of four decision trees to be utilised for

each industry evaluation.

Power of incentive

mechanism

Regulatory risk

Information (properties

and requirements)

Robustness to change


as inputs

Suggested forms of

price regulation as

outputs

The assessment criteria are grouped by their

reduced forms - comprising each decision

tree.

Key characteristics of the various forms of

price regulation are mapped to industry

circumstances.

Appropriate forms of price regulation are

grouped as output to the RDT decision tree.

A comment sheet is provided after

each decision tree which further

explains the critical factors being

assessed.

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Decision tree – Power of incentive mechanism

Industry circumstances Suggested form

Price monitoring

Pricing principles

Index based approaches

Franchise bidding (without cost

pass-through clauses)

Cost based approaches

Franchise bidding (with targeted

cost pass-through clauses)

Suggested form

Power of incentive mechanism

If no If yes

High powered forms strongly

suggested to promote cost based

productivity improvements.

Low powered forms of cost based

regulation can be employed if

otherwise warranted.

Are there “missing markets” in terms

of service quality, and if so, is it

difficult to measure and regulate

quality of service?

Is significant capital expenditure or

renewals investment in service

quality required (expenditure not

matched by increased sales)?

Is the industry (or firm) producing at

its efficiency frontier?

High powered forms appropriate

where quality is priced or regulated.

High powered forms appropriate

where less need of investment in

non-revenue generating areas.

Low powered forms limit perverse

incentive to minimise service quality

Low powered cost pass-through

approaches allow for investment in

non-revenue generating areas (due

to missing markets).

Is the system at efficient operating

capacity?

High powered forms strongly

suggested to provide incentive to

utilise excess capacity.

Low powered forms can be

employed if otherwise

warranted.

See next page for additional comments

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Explanatory comments – power of incentive mechanism

Power of incentive mechanism

Industry circumstances Explanatory comments

Is the industry (or firm) producing

at its efficiency frontier?

High powered forms provide an internalised incentive for the firm to undertake

efficient cost reducing initiatives (i.e. in use of inputs, processes, technology and

managerial expertise).

This factor would be given greater weight where cost reductions are seen as

critical. In a rather cost effective and static industry, it might be given less weight.

Is the system at efficient

operating capacity?

The firm captures increased revenue from incremental capacity utilisation under

high powered forms providing an incentive to optimise utilisation of assets.

This factor would be given greater weight where there is considerable excess

capacity in the system which could be efficiently utilised at appropriate prices.

Are there “missing markets” in

terms of service quality, and if so,

is it difficult to measure and

regulate quality of service?

There can be a perverse incentive to under-provide quality of service under high

powered forms where it is not either priced into the market, or explicitly regulated.

This factor would be given greater weight where it is not feasible to adequately

measure and regulate service standards where there is a willingness to pay for it

by consumers.

Is significant capital expenditure

or renewals investment in service

quality required?

This matter is closely related to the missing markets matter above. Low power

cost pass-through mechanisms may be required where (efficient) renewals

expenditure is not matched by a concomitant increase in revenue.

This factor would be given greater weight where there is the understanding that

significant renewals expenditure will be required - and that it is not well funded

through increased sales.

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Decision tree – Regulatory risk

Suggested form

Price monitoring

Pricing principles

Franchise bidding

Index based approach

Cost based approach

Suggested form

Regulatory Risk

Are there significant spill-overs to

other sectors of the economy?

If no If yes

Light-handed

approaches to price

regulation suggested.

Prescriptive price controls

suggested.

Is there a high degree of concern

over the potential to expropriate

consumer surplus through the

exercise of market power?

Is demand responsive to price (high

elasticity of demand) and/or the

quantum of value significant?

Are there limited numbers of

products, services or differentiated

customer classes?

Allocative efficiency suggests

prescriptive price control. Allocative efficiency not

material where demand

is in-elastic.

Macroeconomic (general

equilibrium) effects may

suggest prescriptive price

controls.

Suggests light-handed

approaches.

Prescriptive (uni-dimensional)

price structures can be

considered.

Flexibility in pricing

differentiated goods

promotes efficient

(Ramsey type) pricing.

Is substitution in input choice limited

by the basic technology?

Potential for regulatory bias of

production choices suggests light-

handed approach.

Regulatory risk in production choice

is lessened where inputs are limited

to fixed proportions .



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Explanatory comments – regulatory risk


Is there a high degree of concern

over the potential to expropriate

consumer surplus through the

exercise of market power?

Prescriptive price controls can provide greater regulatory certainly against the

expropriation of consumer surplus through the exercise of market power (or

otherwise put – capture of monopoly profits by the firm).

This factor would be given more weight where consumer protection is a primary

concern. Economic transfer is the focal point here – not economic efficiency

(which is addressed in the next cells of this table)

Is demand responsive to price

(high elasticity of demand)

and/or the quantum of value

significant?

The “dead weight loss” stemming from monopoly prices is directly proportional to

the price responsiveness of demand, and the over-all quantum of value.

In terms of simple allocative economic efficiency, the regulatory risk from “under

regulating” is greater when demand is highly responsive to price.

Are there significant spill-overs to

other sectors of the economy?

Economic efficiency can be considered in either a partial or total analysis. The

total context addresses potential spill-over affects to other services or products.

In terms of economic efficiency in a total analysis, the regulatory risk from “under

regulating” is greater when there are spill-overs to other sectors.

Are there limited numbers of

products, services or

differentiated customer classes?

Where there are multiple services or differentiated customer classes differentiated

prices can provide positive efficiency outcomes through “Ramsey oriented” prices.

However, the differentiated prices (or cost shifting) implied here has a clear

economic impact on individual consumer classes, which may run against the aims

of the regulator.

Is substitution in input choice

limited by the basic technology?

Prescriptive price controls can bias optimal input choices where there is the

technical flexibility to do so.

For example, a cost-based approach may provide perverse incentive over invest

in cap-ex, and under spend on op-ex. This factor is of greater importance t the

degree that managers have the ability to make such trade-offs.

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Decision tree – Information and administrative costs

Suggested form

Price monitoring

Pricing principles

Index approach

Franchise bidding

Cost-based approach

Suggested form


If no If yes

Is there an asymmetry of information

on the part of the regulator, and if so,

are cost/price comparators difficult to

obtain?

Forms that reveal costs are

suggested where feasible (franchise

bidding).

Efficient costs and prices observed by

the regulator, allowing for non-

intensive approaches such as

monitoring or index based price cap.

Low cost / non-intensive forms

suggested where the cost/benefit of

data collection and analysis is not

otherwise justified.

Are service features bundled with

competitively supplied services?

Ring-fencing of accounts may be

warranted to separate regulated and

non-regulated charges.


Is the data required for a cost build-up

easily (cost-effectively) accessible?

Informationally intensive

approaches may be warranted (cost-

based or disclosure rules).

Simple price monitoring or

index will be easy to

administer in an effective

manner.


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Explanatory comments – information and administrative costs


Is there an asymmetry of

information on the part of the

regulator?

If the regulator knows efficient costs and prices (or has valid comparators to use),

non-intensive forms such as price monitoring or price caps can be employed.

Alternatively, where the regulator is at a clear disadvantage in regard to

information, forms which reveal information (such as franchise bidding) or at least

do not provide incentives to mis-represent information are preferred.

Forms such as price monitoring or price caps become meaningless or difficult to

apply where efficient price are not known and there are no valid cost/price

comparators in which to asses monitored prices.

Is the data required for a cost

build-up easily accessible?

Where the regulator suffers from a lack of information, it may be deemed

necessary to direct the firm to disclose such information, and to asses that against

other sources to attain some level of confidence in its accuracy.

In this case, the costs of information collection and analysis to both the regulator

and the firm should be considered against the benefits stemming from the use of

informationally intensive forms of price controls.

While a formal cost/benefit analysis would be difficult in itself to undertake, it

should be feasible to form a broad (probably qualitative) view of relevant costs

and benefits of data collection and analysis.

Are service features bundled with

competitively supplied services?

Where regulated services are bundled with non-regulated services ring-fencing of

accounts may be required to mitigate cost-shifting between the two cost pools.

Where there is no material bundling, the less informationally intensive forms of

price regulation would be easy to administer in an effective manner.


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Decision tree – Robustness to change and uncertainty

Suggested form

Franchise bidding

Index approaches

Pricing principles

Price monitoring

Cost-based approaches

Suggested form


Is the market in transition to a

more competitive environment

with the possibility of new entrants

to the market?

If no If yes

Less flexible forms can be considered

where cost or volume risk is not seen

as material .

Is the market subject to volatility -

particularly in regard to volumes or

costs?

Robust forms suggested that adjust

to cost and volume risk.

Is significant capital expenditure or

renewals investment required

(where incremental expenditure is

not matched by increased sales)

Robust forms suggested that

facilitate investment where

incremental costs are not strongly

correlated with incremental sales.

Robust forms suggested that

facilitate entry by rivals.

Less flexible forms can be considered

that correspondingly provide greater

regulatory certainty.

Where there is no expectation of

competitive entry, franchise bidding

that excludes entry (ex post) would be

an option.



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Explanatory comments – Robustness to change and uncertainty


Is significant capital expenditure

or renewals investment required

(where incremental expenditure is

not matched by increased sales)

In many network services, incremental capital expenditure is not strongly

correlated with increased sales.

• When incremental cap-ex is not closely matched by increased sales, a pure

index approach - particularly when based on a price cap – will typically not

provide an adequate return on investment, and may require additional side

payments or adjustment factors to fund efficient capital expenditure.

• When incremental investment does lead to increased sales, the index based

price cap will likely provide incentive to invest. In this case, there may be excess

returns on investment if scale economies are obtained (which is likely to be the

case in network businesses).

Is the market subject to volatility -

particularly in regard to volumes

or costs?

It is important to consider volatility in costs and volumes. For example:

• Price controls do not typically provide the flexibility with regard to cost and

volume volatility that price monitoring and pricing principles would allow for.

Price controls will typically allocate windfall gains and losses to the operator.

• Further analysis would need to be undertaken to determine if such risk is best

placed with the operator or consumers.

Is the market in transition to a

more competitive environment

with the possibility of new

entrants to the market?

If there is the expectation that workable competition would develop in the medium

term, transitionary regimes would be put into place. Two key factors to consider

are:

• Facilitation of entry – ensuring that regulatory structures do not impede

competition.

• Attention to regulatory risk and administrative costs of more prescriptive and

informationally intensive forms of regulation.


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Section 2.2

Forms of price regulation – key

performance characteristics

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In the second part of this section, the primary categories of price regulation assessed in the RDT are set out

in concise form.

A brief description of the form of price regulation is provided.

The key performance characteristics of each form of price regulation is set out in tabular form.

Step 2

•Consider the detailed

characteristics of the narrowed

set of categories of price

regulation suggested under step

1.

•Where conflicting

recommendations are obtained

in step 1 – outline those factors

which would be given most

weight in the assessment.

•Given the weights (probably subjective and

qualitative) placed on specific factors,

determine a preferred category of price

regulation – setting out the reasons for

choosing between the small set of options

considered.

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Categories of price regulation assessed in the RDT

The primary categories of price regulation assessed in the RDT are:

Price Monitoring

Pricing Principles

Franchise Bidding

Index Approach

Cost Based Approach

These primary categories are seen as spanning the range of price regulation ESCOSA might consider and have been

defined as a starting basis in which to differentiate key aspects of price regulation.

However, in practice, there is more often an overlap between these categories forming hybrids, and the specific details

in application can have a considerable impact on the key characteristics of the regulatory mechanisms.

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PRICE MONITORING

For the purpose of the RDT “price monitoring” is more broadly and practically defined as including consideration of

prices, costs or profits of a business or industry, with oversight provision including :

Information disclosure – New Zealand’s oversight of electricity wires charges provides an example of the

use of information disclosure rules forming the basis of price monitoring (noting that it is currently being

augmented by the setting of price thresholds). In that case, distribution businesses are required to provide

annual reports on prices, asset valuation and quality of service performance.

Monitoring – which could include ad hoc assessments of price adjustments or more formula based trigger

mechanism under which a price review would be carried out.

Notification of price increases – which allows for light-handed approaches where the proponent develops the

framework for reporting, through to rather prescriptive approaches where guidelines are developed under

which the proponent is to comply. This form could potentially call for justification on a cost basis - leading in

the extreme to a de facto rate of return form of regulation.

Setting of prescribed price or profit thresholds – this is the system which New Zealand is apparently moving

towards in oversight of electricity wires businesses. Wires charges will be assessed in some form against

indexed price paths under which the charges are to sit.

Price monitoring can be applied such that it would be an extremely light-handed approach to price regulation, as well

as a rather heavy-handed approach where, for example, prescribed profit thresholds are applied that might lead to a

de facto rate-of-return form of regulation.

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Key performance characteristics sheet – PRICE MONITORING (1)

Assessment Criteria Transfer mechanism Key performance characteristics

Performance incentives The more light-handed forms of price

monitoring allow the firm to retain the gains

from efficiency improvements.

Profit thresholds would claw back such

gains.

High powered incentive mechanism – providing

strong incentive for cost minimisation.

Profit thresholds would act as a de facto cost

based approach – with correspondingly low

incentive power.

Investment and renewals incentives Flexibility by the firm to charge for capital

expenditure and renewals where such

expenditure is aligned with additional

revenue.

Appropriate incentives to invest in cost reducing

initiatives.

Potentially weak incentive for quality of service

related investment and renewals where there is

no market for quality of service.

Allocation of risk Typically apply an explicit or implicit ceiling

on prices but no support from below in the

form of a price floor.

Potential for asymmetric allocation of risk.

Wind-fall gains limited from above, but windfall

losses not supported by a floor.

Benefit sharing Provides the regulator with the ability to re-

align prices to costs where productivity

gains have been made.

Short term benefits captured by the firm – long run

can be clawed back for consumers.

Propensity to allow excess or in-sufficient

profits

The firm has considerable (short-run)

discretion in pricing services.

Requires knowledge by the regulator of

efficient prices.

Threat of intervention meant to limit extreme

divergence from efficient prices.

If a significant asymmetry of information exists

there is greater potential for capture of excess

profits by the service provider.

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Key performance characteristics sheet – PRICE MONITORING (2)



investment choices)

Not prescriptive – does not generally affect

the production choice of the firm.

Neutral with regard to production choices (inputs,

process and technology).

Facilitates static and dynamic productive

efficiency.

Predictability of outcomes Flexible form of price regulation. Standard commercial uncertainty – little regulatory

uncertainty.

Robustness to change and uncertainty Prices typically allowed to vary in relation

to external events.

Can be extremely robust to change and

uncertainty – depending on application rules.

For example, petrol prices adjust to real time

volatility in market fundamentals allowing for

appropriate returns on assets.

Revelation of information No internalised revelation of information –

relies on external disclosure rules.

Prescribed disclosure of information – but no

internalised revelation of information through

commercial actions of the service provider.

Information intensity (requirements) Requires information on efficient prices to

compare against

An asymmetry of information between the

regulator and firm will limit robustness of the

monitoring process – typically requires more

intensive disclosure rules.

Cost of administration and compliance Various levels of disclosure are required

depending on ability of the regulator to

assess efficient price levels.

Cost of administration and compliance dependent

on required level of disclosure.

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PRICING PRINCIPLES

Pricing principles are defined as a form of regulation for the purpose of the RDT and is characteristic of the “light-

handed” approach to price regulation, although when cost based reference tariffs are applied becomes more heavy-

handed in nature.

The use of pricing principles within regulatory structures is well established in Australia, with considerable use under

Part IIIA of the Trade Practices Act. Notable applications include gas transport, electricity transmission and distribution

networks, rail, and telecommunications.

In application, pricing principles can and have ranged from truly light-handed approaches in setting out appeals

processes and dispute resolution mechanisms, to rather prescriptive price setting regimes.

An illustrative range of examples includes:

Negotiate / arbitrate – possibly under pre-specified guidelines and dispute resolution processes

Outcome based – setting out features of pricing, such that it facilitates efficient investment, provides a return

on capital, and supports efficient use of the services provided

Price bands – such as a floor and ceiling based on stated parameters

Reference tariffs – spanning a range from tlight-handed posting of prices, to more heavy-handed application

based on pre-specified parameters (for example, recovery of efficient costs)

The negotiate/ arbitrate style of this form is most often applied when there a small number of parties purchasing

services, as multiple contracts would usually entail considerable (potentially inefficient) transaction costs. Reference

tariffs (or posted prices) can be used where there are a larger number of independent parties to contract with.

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Key performance characteristics sheet – PRICING PRINCIPLES (1)


Performance incentives Typically price based agreements – with

no explicit cost pass-through (except for

the extreme form of reference tariffs

prescribing cost-based approaches).

Typically a high power incentive mechanism in

terms of cost minimisation – although cost pass-

through limits power for those areas specified.

Allowance for rent capture by the operator

enhances the incentive to reduce costs though

innovation (ie superior use of technology,

resources or managerial expertise).

Investment and renewals incentives Pricing principles are often used where

there is a manageable number of parties

purchasing services.

Capacity and quality of service are

parameters that can often be specified in

the contracts between parties.

Pricing principles are amenable to multi-

dimensional price / quality agreements between

parties – providing financial incentive to invest in

capacity augmentations and quality of service

renewals based investment where there is a

willingness to pay.

Allocation of risk Risk is usually allocated on a commercial

basis – except for the extreme form of

cost-based reference tariffs, where

demand risk may reside with consumers.

Ideally, risk is priced into the agreements between

parties and would tend to be allocated on the

basis of who can manage it at least cost.

Benefit sharing Benefit sharing arrangements are

(explicitly or implicitly) agreed to by parties.

Asymmetry of information may bias the outcome

in the favor of the service provider. Disclosure

rules are sometimes employed to mitigate against

this - but may fall short of the goal in practice.


profits

Negotiate/arbitrate approach provides the

potential for workably competitive

outcomes in pricing and profits.

Prescribed price bands and cost-based

reference tariffs used to limit excess

profits.

A robust dispute resolution mechanism or use of

prescribed price bands or reference tariffs would

mitigate against capture of excess profits by the

service provider.

Windfall gains are more likely to be captured by

the service provider as compared to more

prescriptive approaches.

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Key performance characteristics sheet – PRICING PRINCIPLES (2)



investment choices)

Negotiate / arbitrate provides workably

competitive foundation for technology

choices.

Unlikely to be any technology bias stemming from

this approach – facilitating optimal choice of

inputs, processes and technologies.

Predictability of outcomes Typically commercial agreements entered

into by parties.

Prescribed price bands or reference tariffs

provide varying levels of discretion to the

regulator.

Potential for regulatory uncertainty when price

bands or reference tariffs are applied in a

discretionary manner.

Robustness to change and uncertainty Negotiate/arbitrate tailored to market

circumstances.

Reference tariffs typically set out ex–ante

price path.

Robustness to change of negotiated contracts

depends on ability to write complete contracts that

anticipate all significant contingencies.

Reference tariffs require review to adjust to

changing market fundamentals.

Revelation of information No internalised revelation of information –

may require external disclosure rules.

Not relevant.

Information intensity (requirements) Negotiate/ arbitrate typically requires broad

procedural guidelines.

Cost-based reference tariffs can require

full assessment of firm level expenditures

and demand forecasts across the

regulatory period.

Potentially light-handed approach requiring little in

the way of information.

Application of cost-based reference tariffs can

become informationally demanding.

Cost of administration, compliance and

transaction costs

Negotiate arbitrate typically undertaken for

each access seeker / consumer.

Reference price typically set price

available to any access seeker / consumer

(given ability to provide in a safe manner,

etc).

Transaction costs for access seekers / consumers

can be relatively large in the negotiate / arbitrate

approach.

Reference tariffs lessen transaction costs to

individual access seekers / consumers though

scale economy in transaction costs. Regulator

acts as agent for individuals.

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FRANCHISE BIDDING

Franchise bidding for the provision of services is common within the context of large infrastructure projects that

require long term contracts and a high degree of certainty by stakeholders – such as owners, financiers, and

governments as agents for consumers.

Franchise bidding has been employed in the provision of monopoly services such as:

Roads

Rail

Airports

Telecommunications

Water and wastewater

Electricity distribution

In many – if not most cases – end use prices are specified in the supporting concession bids and contracts, which

(ideally) facilitates competitive outcomes and revelation of information in the pricing domain. Once assigned, the

contract would prescribe a pricing framework and a dispute resolution mechanism.

While there are numerous examples of franchise bidding acting as a substitute for regulation, and entered into by

public or private parties without any regulatory oversight structure, they have also been extensively used as a

complement to regulation, with oversight by central agencies such as regulators or government ministries. For this

reason, franchise bidding (for the purpose of the RDT) is seen as a form of price regulation.

Key considerations in regard to franchise bidding include the ability to design complete contracts that are robust to

changing and uncertain market environments; provide incentives for efficient asset management and renewals; and

that mitigate against the incumbency problem at contract renewal – where it may not be feasible to provide for a

competitively level playing field.

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Key performance characteristics sheet – FRANCHISE BIDDING (1)


Performance incentives Under franchise bidding, the range of

service delivery outcomes is specified (to

the degree feasible) in a concession

contract.

Cost pass-through mechanisms are

sometimes specified for inputs with

uncertain prices (such as fuel).

Typically a high power incentive mechanism in

terms of cost minimisation – although cost pass-

through limits power for those areas specified.

Allowance for rent capture by the operator

enhances the incentive to reduce costs though

innovation (ie superior use of technology,

resources or managerial expertise).

Investment and renewals incentives Concession contract may set out

investment and renewals profile.

Cost pass-through clauses are sometimes

provided for funding of capital expenditure.

Complete contracts difficult to design in regard to

investment and renewals.

May be a tendency to run down the asset where

the contract tenure is finite, and subject to rebid.

Cost pass-through can be utilised as a balancing

mechanism to promote investment and renewals

expenditure.

Allocation of risk Allocation of volume risk usually set out in

the concession contract – typically biased

towards “take-or-pay” provisions or an

implicit or explicit underwriting of usage.

Cost pass-through provisions can be

utilised in regard to cost uncertainty.

The concession contract can be designed to

allocate risk in a direct and predictable manner.

Volume risk is typically the primary factor to

consider – allocated in terms of controllability (ie

service provider may be able to increase demand

by increasing quality of service).

Benefit sharing Contracts set out the nature of benefit

sharing (or lack of).

As a high powered incentive mechanism, most

unanticipated benefits are most often captured by

the operator.

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profits

Competitive bidding for the franchise

provides the potential for workably

competitive outcomes in pricing and

profits.

Contracts typically do not measure or limit

realised profits – although price levels may

be either pre-set, regulated, or subject to

re-evaluation.

Competitive bidding would tend towards an ex-

ante expectation of appropriate levels of profit.

Explicit or implicit ex-post adjustments can be

used to moderate windfall gains.

Unanticipated or non-controllable outcomes can

drive operator to insolvency.


investment choices)

Contracts can be designed to allow

operator to develop optimal (unbiased)

production choices by specifying outputs

rather than inputs.

Technology bias can be limited under output

based contract specification.

Cost pass-through mechanisms have the potential

to promote technology bias to those areas

covered by such mechanisms.

Predictability of outcomes Factors such as service quality and asset

management – if measurable – can be

specified explicitly in the contract

supported by penalty and reward

mechanisms.

While noting the impossibility of specifying

complete contracts, predictability of outcomes is

more certain than under the traditional implicit

“regulatory contract”.

Robustness to change and uncertainty The concession contracts underlying a

franchise bidding set out in a detailed but

finite set of contingencies .

The long-term fixed nature of concession

contracts and impossibility of completeness

makes them rather inflexible instruments in light of

change and uncertainty.

For example, technological change or demand

volatility can lead to unplanned allocations of

windfall gains or losses.

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Revelation of information Competitive bids are tendered in securing

the franchise to provide services .

Service levels, investment and renewals

profiles, and design of facilities can be

called for within the bidding environment

The competitive nature of the franchise bid has

the potential to reveal the workably competitive

prices for delivery of the stated service.

The bidding processes can reveal innovative

process designs and management structures

Information intensity (requirements) The robustness of the contract relies on an

understanding of the nature and materiality

of contingencies.

Cost recovery of pass-through items is set

out in the contract – requiring identification

and monitoring of such costs where

relevant.

The robustness of the concession contract

requires complete specification of contingencies.

The competitive nature of the franchise bid

mitigates against the need for firm level costs –

except where costs are passed through.

Cost of administration and compliance Administrative costs are usually front-end

loaded during the bid process for both the

purchaser and provider.

Compliance requirements are set out in the

contract (ie service quality, availability,

renewals expenditure, etc)

Complex or multiple contingencies will tend to

increase the cost of contract design and

monitoring of compliance with prescribed

outcomes.

Easily identifiable/measurable compliance factors

lessens the overall costs of compliance.

Effective dispute resolution mechanisms are vital

to lessening administrative costs

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INDEX APPROACH

The pure index based approach to price controls aim to provide a light-handed regulatory approach with low

compliance and regulatory costs through uncoupling allowed prices from the regulated organisation’s costs of

operation.

Importantly, starting prices are assumed to be (reasonably) efficient and taken as given. Allowed price movements are

then typically determined by reference to:

general cost index, such as the CPI

index measures of efficiency, such as total factor productivity

efficient production frontier or best practice benchmarking

Under the pure approach, if the regulated firm out-performs the external efficiency benchmark, it retains all of the

associated gains and alternatively suffers the consequences of under-performance relative to the benchmark, making

it a very high powered incentive mechanism in its pure form. One consequence is that over time windfall gains or

losses may accrue to either the enterprise or consumers as underlying factors, such as costs or quantities demanded,

change.

The pure form is most often augmented in practice by either triggers or regulatory review periods which aim to re-align

prices with changing underlying costs and revenue profiles – making it a less powerful incentive mechanism on the

one hand, while providing an adjustment mechanism in regard to unanticipated capture of rents by either the

enterprise of consumer.

The index based approach requires application rules in regard to the target variable – typically applying a form of

revenue or price caps, with hybrids including revenue yields, and weighted average tariff baskets – each having

significant performance characteristics of their own (addressed later in this document).

International experience has been that cost de-linked approaches have been adopted within mature regulatory

regimes where the existing price levels and initial cost base are ‘about right’ or in anticipation of transition to

competitive market environments. In addition, the regulatory regimes included established and effective regulatory

data collection, accounting and decision-making procedures.

53

Key performance characteristics sheet – INDEX APPOACH (1)


Performance incentives Requires an initial setting of price level,

which is adjusted by an external index

such as the CPI, further adjusted by

additional factors as appropriate to the

industry.

•In its pure form, would have a long time

frame without re-sets.

•In practice, typically augmented by either

trigger mechanisms or periodic reviews to

re-align with changing market factors.

High power incentive mechanism. Provides strong

incentive to minimise costs.

The use of trigger mechanisms or periodic

reviews lessens the incentive power of the index

approach.

The high power of the incentive mechanisms can,

in some circumstances, have a perverse outcome

on service quality, where there may be strong

incentive to minimise costs through diminished

quality of service. Balancing mechanisms (such

as minimum service standards) may need to be

introduced to mitigate against this.

Investment and renewals incentives The basic form of the index approach is a

simple price per unit of service provided

over time.

External adjustments can be provided to

account for anticipated investment or

renewals requirements

Limited investment and renewals incentive where

driven by quality of service (as above, when/if

quality is not priced into the service).

Appropriate incentives for cost reducing or

revenue enhancing expenditure.

Can overlay with additional mechanisms to

recover costs of major expenditures related to

quality of service, or use of minimum standards.

Allocation of risk The firm manages risk under an

exogenously set price profile.

Uncertain demand is the primary risk factor

to consider in application of the index

approach.

The index approach provides for an allocation of

risk similar to a competitive market.

Under a pure index based price control risks are

placed with the firm.

The firm bears cost and demand based risks.

These risks are amplified where costs are not

strongly correlated with volumes.

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Benefit sharing External factors are utilised to provide a

sharing of benefits stemming from

efficiency gains.

X factors can be designed to allocate

deemed productivity savings to

consumers.

(Note that in practice, the X factor is also

used as a simple smoothing mechanism

under a cost based approach – not to be

confused with a productivity share

arrangement)

External benchmarks are utilised in application of

the benefits sharing mechanism – otherwise all

benefits (and dis-benefits) accrue to the firm.


profits

Initial price setting ideally based on

identification of efficient prices.

Price profile set in a simplistic manner that

may diverge from efficient prices over time.

Direct price control limits likelihood of extreme

separation from efficient prices – dependent on

identification of initial price, and volatility of

underlying market factors such as costs and

demand.

Windfall gains and losses typically accrue to the

firm.

Price index approach potentially allocates rents to

the firm where excess capacity is available to sell

into the market without further capital expenditure.


investment choices)

No direct transfer mechanism in regard to

technology bias. Neutral in regard to

production choices.

Neutrality in regard to technology (broadly defined

as including input use, processes, and choice of

technology) does not distort the incentive for

optimal production choices - facilitating static and

dynamic efficiency in production by the firm.

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Predictability of outcomes With price as the control variable, firm

profits are more directly related to

uncertain market outcomes (i.e. cost and

demand shocks) thus variable.

Price path set against clear external

factors (i.e. Consumer Price Index)

Volatility of firm level profits more closely aligned

with external market factors – similar to

competitive outcomes.

Little regulatory uncertainty once price path is set

– providing predictable regulatory environment for

the industry.

Robustness to change and uncertainty In its pure form price is set without

adjustment for unanticipated events.

Force majure, triggers, or periodic review

can be used to provide flexibility to change

and uncertainty.

The price index can be linked to a specific

external factor that best tracks underlying

volatility (i.e. LNG prices indexed against

the the price of oil).

The index approach is not particularly robust to

external change and uncertainty.

The fixed price (profile) does not fully adjust to

changing market factors as would be the case in a

competitive market, or under other forms of price

regulation.

Revelation of information No internalised means to reveal

information.

Unlikely to self reveal information – may require

additional disclosure rules

Information intensity (requirements) Requires information on the index best

suited to setting the price profile

-i.e. CPI or other cost index

Generic indices often adjusted for industry

or firm specific factors

- i.e. benchmarked X factors

Once the initial price level is established, there

are few information requirements.

High power of incentive to cut costs may require

counter-balancing measurement of service quality

provided.

Cost of administration and compliance Basic compliance processes required to

monitor actual price against index

Typically low cost in terms of administration and

compliance, although depends on nature of

disclosure required.

Use of triggers would entail ongoing

administrative costs

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COST BASED APPROACH

The cost based approach to price regulation an often utilsed form of price regulation within the industry sectors

ESCOSA would have regard to.

In its extreme form (which is seldom utilised in practice) it provides for direct pass-through of prudent costs and is often

referred to as rate of return regulation. The basic approach most often encountered in Australian regulatory practice is

the building block approach, which defines the cost basis for pricing:

Return on capital

Depreciation

Operating expenditure

Capital expenditure

Taxes

In practice, cost based approaches most often employ application rules that have as an effect to allocate varying

degrees of risk and benefit sharing between the firm and consumers – leading to a range of important incentive

features that vary in accordance with the specific design of the application rules.

Some of the more significant design features include:

Exogenous or endogenous regulatory review (periodic regulatory review, or trigger based)

Treatment of uncertainty (risk allocation)

Out-performance of anticipated costs (benefit sharing)

There is a trend to set application rules to the cost based approach in the attempt to attain some of the more attractive

properties of high powered incentive mechanisms (such as the index approach). The success of these hybrids is

subject to considerable debate.

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Key performance characteristics sheet – COST BASED APPROACH (1)


Performance incentives Cost pass-though – typically ex-ante, with

some level of ex-post realised benefit

sharing and allocation of windfall

gains/losses.

Use of endogenous (triggers) or

exogenous (periodic) price reviews

Low power incentive mechanism. In its pure form,

provides weak incentive to minimise costs.

•Endogenous price reviews in the form of triggers

limit the incentive power of cost based regulation

•Exogenous price reviews in the form of periodic

review adds to the incentive power of cost based

regulation – efficiency carryovers further augment

incentive power.

Investment and renewals incentives Prudent expenditures authorised by

regulator.

Allows for a return on capital based on

benchmarked assessments.

Allows for a return of capital through

depreciation charges.

Potentially strong incentive for investment and

renewals.

Requires accurate appraisal of prudency of

expenditure, and appropriate return of and on

capital.

Allocation of risk Cost build-up based on anticipated forward

costs (either based on recent actuals or

forward estimates).

Annual revenue requirements typically set

over regulatory period.

“Unders & Overs” adjustment can be used

to reconcile forecast variables to realised

outcomes.

Under full cost pass through, risk is placed with

consumers.

Cost pass-through characteristics are amplified by

short regulatory periods (re-sets) and/or under

and over adjustments.

Benefit sharing Out-performance of anticipated costs

typically captured by the firm within a

regulatory period, and shared with

consumers across regulatory periods.

In its extreme, cost based regulation allocates

performance based benefits to consumers.

In practice, performance based benefits are

captured by the firm within periods, and shared

under efficiency carryover mechanism across

periods.

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profits

Periodic regulatory reviews attempt to align

costs to prices.

Within period under and over mechinims

are used to account for windfall gains and

losses.

Prescriptive approach limits extreme price

separation.

Windfall gains are typically clawed back for

consumers at the review period. The length of

the review period should anticipate volatility in

relevant factors in mind (i.e. short regulatory

periods for highly volatile market environments).


investment choices)

Prudent costs allowed by each major

expenditure class.

Cost pass-through for op-ex / return on

capital for cap-ex

Efficiency carry-over typically varies across

expenditure classes (substantial off-set for

op-ex, cost of capital only for cap-ex)

Cost recovery on an expenditure basis can bias

production choices

•Input use

•Processes

•Technology

The nature of efficiency carry-over mechanism

can further bias the production choice.

Predictability of outcomes Firm profits are assessed ex-ante, and

under and over adjustments can address

unanticipated divergence of realised

outcomes.

Provides rather predictable environment in terms

of firm profits, service delivery and price to end-

users.

Robustness to change and uncertainty Annual revenue requirements typically set

within regulatory periods.

Regulatory review taken across periods

adjusting for changing market

environment.

Adjusts to changing structural factors and allows

for price movements in accordance with

unanticipated factors.

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Revelation of information Typically calls for firm and market level

assessments from the regulated enterprise

on major expenditure classes and forecast

demand.

Has a tendency to promote biased estimates from

the enterprise regarding operating costs, optimal

investment and renewals expenditures, and

demand forecasts.

The use of efficiency carryover mechanisms

promotes some self revelation of efficient costs

ex-post where the firm reports on

Information intensity (requirements) Requires regulator to asses prudent costs

of service delivery and optimal expenditure

profiles across time.

Informationally intensive – requires firm level

expenditure and sales data and forecasts.

Where enterprise is bundled with competitive

businesses, requires ring-fenced accounts.

Allocation of common costs across regulated and

non-regulated businesses is informationally

demanding.

Cost of administration and compliance Typically costs expand on a periodic basis

during a price review. There are ongoing

compliance costs through provision of

regulatory account provided within

regulatory periods.

High administrative costs.

Requires data collection from enterprise, audits,

and prudency checks for expenditure plans, as

well as ex-post reviews of actual expenditure

against planned.

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Section 2.3

Application rules

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The third part of this section assesses important application rules which have a direct bearing on the

performance of the general categories of price regulation.

A “menu” of application rules to consider is provided relevant to each category of price regulation assessed

in the RDT.

Critical features of application rules are provided in tabular form, which are to be considered in conjunction

with those categories of price regulation in which they might be employed.

Step 3

•Using the menu of application

rules provided in this section,

identify the set of application

rules relevant to the category of

price regulation suggested in

steps 1 and 2.

•Work through the description

and key characteristics of the

relevant application rules to

obtain a high level understanding

of the key issues involved in

employing those rules.

•Undertake further assessment using the

Reference Document and external references

to develop the details of these application

rules.

Note: Application rules are often

technical in nature and a full

assessment and specification is beyond

the capability of the RDT

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Application rules assessed in the RDT

Detailed application rules are often required to operationalise the categories of price regulation. These

application rules can have important performance impacts on the forms of regulation utilised.

The application rules assessed in this section of the RDT are:

Choice of target variables (i.e. revenue / price caps)

Adjustment factors

•Productivity factors (X factors, benchmarks, yardstick comparators)

•Performance measures (PBR and S factors)

•Efficiency Carryover Mechanisms (ECMs and Glidepaths)

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Menu of application rules pertaining to each category of price

regulation

This menu is designed to set out the primary application rules that would be considered for a given category

of price regulation.

For example, light handed use of pricing principles does not require the use of these application rules. However, a

cost-based approach warrants considerable assessment of the various application rules at hand.

Category of price

regulation

Target variable Productivity factors Performance

factors

Efficiency carry-

over mechanisms

Price monitoring Depends on the type of

price monitoring

Depends on the type of

price monitoring

Probably not applicable Not applicable

Pricing principles Not applicable (except if

using prescriptive cost-

based reference tariffs)

Not applicable (except if









Franchise bidding Yes Yes Yes Probably not applicable

Index approach Yes Yes Yes Not applicable under

pure index approach

Cost-based

approach

Yes Yes Yes Yes

Note: A “Yes” only indicates that the application rule should be considered within the context of that category of price regulation

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Choice of target variables – (revenue / price caps)

Type Description Key characteristics

Pure

revenue

cap

Provides for gross revenue control – typically specified

in terms of an Annual Aggregate Revenue Requirement

(AARR) over a defined regulatory period.

The cap is usually subject to an annual adjustment for

deemed productivity gains and inflationary effects – or

often simply smoothed to account for anticipated lumpy

expenditures. The CPI-X form of the revenue cap is an

often used means of application.

With prices set against the AARR, actual revenue will

vary from expected revenue in line with realised

demand. An “unders & overs” account may be utilised

as a correction mechanism to reconcile actual and

prescribed revenue .

Volume risk is allocated to consumers when an under & overs

mechanism is used – providing an extremely high level of

predictability to the firm.

The use of a robust unders & overs mechanism limits the incentive

by the firm to mis-represent forecast demand profiles.

The administrative costs of applying a robust unders & overs account

is considerable – and can be difficult to administer in practice.

Fixed revenue caps may provide considerable discretion to

distributors to set prices for their services within the revenue cap.

Under ‘pure’ revenue caps, the firm is free to set prices as it wishes.

However, in practice, prices are often subject to side constraints to

minimise price shocks for customers or groups of customers

Revenue

yield cap

The revenue yield target is rather straight-forward –

defining revenue per (forecast) unit output as the target

metric for control.

Allowed revenue yield is typically based on a AARR as

above, with the target value set on an ex-ante basis

requiring forecasts of quantity demanded.

Under this approach, ex-post allowed revenue varies

directly with realised output without use of an unders &

overs mechanism (although corrections might be made

in subsequent regulatory periods).

As in the pure revenue cap – revenue yield is usually

subject to a CPI –X formula,

Volume risk is allocated to the firm, where realised demand diverges

from forecast levels.

Unlike a gross revenue cap, a revenue yield cap provides incentives

for the firm to satisfy increasing demand – particularly where excess

capacity exists in the system such that incremental costs of supply

are negligible.

Realised gross revenue and profits will be uncertain.

Provides incentive for the firm to mis-represent forecast demand.

The revenue yield approach is in some ways more similar to a price

caps, but allows considerably more discretion in the setting of

individual tariffs across the services provided. This flexibility is useful

where there are numerous services or multipart tariffs.

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Choice of target variables – (revenue / price caps)


Pure price

cap

Sets out prescribed price paths in conjunction with either

a pure index or cost-based approach.

When the price cap is applied in conjunction with a cost-

based AARR, the target value is set on an ex-ante basis

requiring forecasts of quantity demanded.

Under this approach, ex-post allowed revenue varies

directly with realised output.

As in the case of a revenue cap – the price cap is

usually subject to a CPI –X formula.

Prices would be set for each component of a tariff (multi-

part tariffs) and tariff classes.

Volume risk is allocated to the firm.

Provides incentives for the firm to satisfy increasing demand –

particularly where excess capacity exists in the system such that

incremental costs of supply are negligible.

Realised revenue and profits will be uncertain.

Provides incentive for the firm to mis-represent forecast demand

when used in conjunction with the cost-based approach and

calculation of an AARR.

Multi-part tariffs and multiple services (or customer classes) provide

for a level of complexity in design and administration of the pure

price cap.

Flexibility to rebalance prices across services or customers classes

is limited (in the extreme – not allowed)

Weighted

average

price cap

(tariff

basket)

Defines a pre-determined level of (weighted) prices

across the services or customer classes provided for

A number of weighted average price components may

be established for different services (or customer

classes) or a single, high level, weighted average price

can be used.

In deriving the weighted average price, the weights

chosen may be based on a range of factors. They may

be fixed by reference to the base year in which the

control is set, forecast levels, or lagged outcomes -

either on a proportionate volume (i.e. kWh) or value (i.e.

revenue) basis.

The weighted average price cap is usually subject to a

CPI-X formula.

Pricing discretion allows for rebalancing of tariffs in order to

maximise profits – would tend towards more efficient “Ramsey –

oriented” pricing, where prices are increased in those segments that

are less price elastic.

Risk allocation, perverse incentive to mis-represent forecast

volumes, and incentive to supply as for pure price cap.

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Adjustment factors


Productivity

factors

X factors, benchmarks, yardstick comparators

Productivity factors act as sharing mechanisms that

allocate benefits stemming from deemed efficiency

improvements.

In the form of an X factor – represents the percentage

by which current prices need to change to align with

forward looking cost benchmarks

Note: X factors are also commonly used for other

matters such as price and revenue smoothing, or one-

off adjustments to better align prescribed revenue to

costs.

Provides a benefits sharing mechanism between the firm and

consumers where ongoing efficiency improvements are anticipated.

Where the benchmarks are external, or pre-determined, the scheme

does not affect the incentive power of regulation.

Identification and estimation of comparable / appropriate benchmarks

is informationally intensive, costly, and has a significant propensity

for error.

Performance

measures

S factors and Performance Based Regulation

The provision of service quality incentives - or part of

what is called Performance Based Regulation in the

US – is a means of providing financial rewards and

penalties across a range of measured service

parameters.

An example in electricity is SAIFI; CADI; and SAIDI.

Requires an estimate of consumer willingness to pay

for quality of service across the defined service

parameters.

Addresses – to a degree – the “missing market” for quality of service.

Provides financial signals and incentives at the margin for the

provision of more or less quality of service.

Reveals information on the incremental cost of quality of service.

The efficiency of the scheme depends largely on the accuracy of the

willingness to pay estimates that form the basis of the reward

structure. Estimation of willingness to pay is problematic, thus

subject to considerable error.

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Adjustment factors


Efficiency

carryover

mechanisms

Efficiency Carryover Mechanisms (ECMs) and

Glidepaths

ECMs are designed to allow a carryover of efficiency

gains from one regulatory period to the next –

providing incentive to the firm to undertake efficiency

initiatives.

The efficiency gain is broadly defined as the

difference of deemed expenditure profiles from actual

expenditures.

Measurement is typically done at the level of

aggregate operating and capital expenditure.

Benefit sharing rules must be defined (ie specified

roll-forward period, glidepath reductions, etc)

Ad hoc rules define the allowance for efficiency gains

across time and expenditure classes. For example:

-The Victorian regime allows only

“incremental” op-ex gains which only account

for the additional improvement in efficiency in

a given year over and above the

improvements of the previous years.

-Op-ex is treated as a permanent gain, where

cap-ex is treated as a deferral, capturing only

its differed cost of capital (WACC times cap-

ex)

Treatment of losses are designed to align with the

specific benefit sharing rules – aimed at limiting the

timing bias of ECMs

ECMs are used to enhance the incentive power of inherently low

power cost-based regulation.

ECMs and glidepaths are rather specific to cost based forms of price

regulation, providing some of the incentive power found in the pure

index approach.

The detailed rules for allowance of gains has a direct affect on the

power of the incentive mechanism.

ECMs inevitably provide a bias in timing and focus of efficiency

programs.

-Rolling carryover mechanisms aim to provide neutrality with

regard to timing of initiatives – but are difficult to apply in

practice.

-Differential treatment of op-ex and cap-ex savings biases the

focus of efficiency initiatives and potentially lead to cost

shifting.

Subject to the limitations of the ECM stated above, they do reveal

some information on the underlying efficient costs of the firm.

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End of document

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Regulatory Design Toolkit for Utilities, Stephen Labson slEconomics

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