2001 electricity distribution price review the form of ... · office of the regulator-general...

Office of the Regulator-General

consultation paper no. 3

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2001 electricity distribution price reviewthe form of price control

Published by: Office of the Regulator-General1st Floor, 35 Spring Street Melbourne 3000

Tel: (03) 9651 0222 Fax: (03) 9651 3688

December 1998



PREFACE

The Office of the Regulator-General is required by the Victorian Electricity Supply Industry TariffOrder1to review and decide on new price controls for distribution use of system charges to be leviedby the distribution licensees (the 2001 price review). The new price controls and tariffs will comeinto effect from 1 January 2001 at the earliest and apply for at least five years.

The Office’s Consultation Paper No. 1, released in July 1998, sought public comments on theOffice’s proposal to adopt a building block approach to the 2001 price review and also addressed theroles of incentives for efficiency both within and across price review periods.

The Office also indicated in that paper that it would release for public comment a number of furtherconsultation papers dealing with specific regulatory issues, including the form of the price control.This deals with the translation of the benchmark revenue over the five year period of the pricedetermination into specific tariff proposals for each year.

Accordingly, this paper is being issued as a basis for seeking comments from customers, licensees andother interested parties on regulatory options and approaches in relation to the issue of the appropriateform of the price control mechanism to be employed in the next regulatory period.

Copies of the consultation paper are available from the Office by contacting Val Smith on (03) 96513931 or through http://www.reggen.vic.gov.au on the Office’s web site.

Comments on the consultation paper must be delivered to the Office by 15 February 1998 and shouldbe addressed to:

Mr Ian WilsonGeneral ManagerOffice of the Regulator-General1st Floor, 35 Spring StreetMelbourne 3000.

All submissions must be in writing. Substantial submissions should also be provided in electronicformat using Word 6 or 7. The Office will treat all submissions as public documents.

1 O rd e rs by th e Gove rnor in Council pursuant to th e Electricity Industry Act 19 9 3 issued in June 19 9 5.



Preface

1. Introduction 2

1.1. Purpose of the Consultation Paper

1.2. Choice as to the Form of Price Control

1.3. Structure of the Paper

2. Current Form of Price Control for Distribution Licensees in Victoria 6

3. Criteria for Assessing Different Forms of Price Control 8

3.1. Incentives on Licensees’ Behaviour

3.2. Relationship between Revenues and Costs

3.3. Risk Allocation

3.4. Summary of Criteria

4. Options for the Form of Price Control 11

4.1. Revenue Yield

4.2. Tariff Basket

4.3. Pure Revenue Cap

5. Hybrid Forms of Price Control 23

5.1. New South Wales

5.2. United Kingdom

5.3. Northern Ireland

5.4. Evaluation of Hybrid Approach

6. ISSUES FOR CONSULTATION 28

O ffice of th e R e gulator-General


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1. INTRODUCTION

1.1. Purpose of the Consultation Paper

This paper discusses the appropriate form of price control mechanism to be applied to theelectricity distribution licensees in Victoria following the 2001 price review.

In June this year, the Office of the Regulator-General issued its initial consultation paper onthe framework and approach it intends to take to the 2001 electricity distribution pricereview2. As noted in that paper, the Office considers that its legal and regulatory objectivesand the specific industry context for the 2001 review makes it appropriate for it to adopt a‘building block’ approach to determining the regulated target revenue for each distributionlicensee. Adopting a specific price control formula to translate the required revenue derivedinto specific tariff proposals is the final stage of this ‘building block’ approach.

In the June consultation paper3, the Office expressed reservations over the incentivesprovided to distribution licensees by the current form of price control, which regulatesrevenue on a per kWh basis. In that paper, the Office flagged its intention to publish a moredetailed consultation paper on alternative forms of price control mechanism and the balanceof incentives implied by each. This paper therefore sets out alternative options for the overallform of the price control to be applied to the distribution licensees, and calls for views andsubmissions as to which of these general approaches is most appropriate. Questionsregarding the specific formulation of the price control will be considered by the Office once adecision as to the general form of control has been made.

1.2. Choice as to the Form of Price Control

The form of price control to be adopted for the distribution licensees is not predetermined bythe Tariff Order4. The Office also interprets the requirements of the National ElectricityCode as allowing a choice as to the form of price control to be adopted.

The Office is required by the Tariff Order to adopt a price-based approach to regulation,using a ‘CPI-X’ approach, rather than rate of return regulation.5 The Office has interpretedthis requirement to apply a ‘CPI-X’ approach as giving unequivocal support to the use of

2 Consultation Paper No 1, Fram e w ork and Approach , 2001 Ele ctricity distribution price re vie w , O ffice of th e R e gulator-Ge ne ral, Victoria, June 19 9 8

3 Se ction 94 O rd e rs by th e Gove rnor in Council pursuant to th e Electricity Industry Act 19 9 3 issued in June 19 9 5.5 Tariff O rder, clause 5.10



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incentive regulation in shaping its approach to the review. However, various forms of pricecontrol fall under the general umbrella of the ‘‘CPI-X’ approach’, and are compatible withincentive based regulation. The form of price control to be adopted is not pre-determined bythe Tariff Order.

The National Electricity Code (‘the Code’) also requires distribution services to be regulatedon the basis of ‘CPI-X’, or an ‘incentive-based variant’ of ‘CPI-X’ (clause 6.10.5(a)). Withinthis general requirement, the Code explicitly permits various forms of price regulation.Specifically, clause 6.10.5(b) states that:

‘the Jurisdictional Regulator shall specify the form of economic regulation to be appliedto the Distribution Network Service Provider to be in the form of either:(1) a revenue cap; or(2) a weighted average price cap; or(3) a combination of the above.’6

[Italicised words are defined terms in the Code]

The Victorian derogations to the Code (contained in Chapter 9) also refer to the form ofeconomic regulation to be used for distribution services:

‘In regulating distribution service pricing in respect of a distribution network situated inwhole or in part in Victoria after 1 January 2001:

(1) the Jurisdictional Regulator must specify explicit price capping as the form ofeconomic regulation to be applied in accordance with clause 6.10.5(b);’7

As the Victorian derogations to the Code prevail over other clauses of the Code, when readtogether, clauses 6.10.5(b) and clause 9.8.7 of the Code effectively mandate that the Officespecify explicit price capping as the form of economic regulation to be applied to distributionnetwork service providers.

The term ‘explicit price capping’, however, is not a defined term under the Code and is not acommonly used term in economic regulation. Accordingly, the requirement that the Officespecify ‘explicit price capping’ as the form of economic regulation to be applied todistribution network service providers does not appear to constrain the regulator’s flexibility

6 Italicis ed w ords are d e fine d te rm s in th e Cod e .7 Clause 9 .8.7 of th e Cod e .



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in deciding on the form of price control to be adopted in the 2001 price review in accordancewith clause 5.10 of the Tariff Order.

In summary, the Office interprets the Tariff Order and the National Electricity Code asgiving unequivocal support to incentive-based regulation. Within this overall framework,however, the Office recognises that there remains considerable flexibility about the detailedform of the price control to be adopted for distribution services.

1.3. Structure of the Paper

The framework for this paper is as follows. Section 2 briefly describes the current pricecontrol mechanism applying to the electricity distribution licensees in Victoria.

Section 3 then sets out the criteria the Office intends to use in assessing the current form ofcontrol against alternatives. Section 4 describes in general terms three forms of price control,and assesses each form against the criteria adopted. The alternative forms of price controlconsidered are:

♦ a revenue yield control (as currently applying in Victoria);♦ a tariff basket control (or ‘weighted price cap’); and♦ pure revenue control.

Section 5 evaluates the ‘hybrid’ forms of price control adopted in a number of jurisdictions,and provides practical examples from NSW, England & Wales and Northern Ireland.

Finally, Section 6 sets out what the Office considers to be the key issues for consultation, aspart of the process of determining the appropriate form of price control to be adopted for thedistribution licensees in Victoria.



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2. CURRENT FORM OF PRICE CONTROL FOR DISTRIBUTIONLICENSEES IN VICTORIA

Charges for both transmission and distribution services are levied by the distributionlicensees as a single network tariff. Network tariffs recover distribution use of systemcharges, transmission use of system charges and transmission connection charges.

The current price control mechanism for the Victorian distribution licensees is set out inSection 5 of the Tariff Order. A distribution licensee must ensure that the weighted averageof its distribution charges (in c/kWh) in a given financial year, t, does not exceed themaximum average charge, MACt, set by the Office for that year. The weighted average tariffis calculated on the basis of the total revenue the distribution licensee is expected to earnfrom distribution charges in year, t, divided by a forecast of the total amount of electricitydistributed by the licensee in year, t, in kWh. The current control is therefore a revenue yieldform of price control (see Section 4.1).

The maximum average charge in cents per kWh for a financial year, t, MACt, is determinedin relation to the following formula:

MACt = (‘CPI-X’)*Pt-1 - Kt

Where:

CPI is the inflation rate

X is the ‘X’ factor that varies for each distributor

Pt-1 is the weighted average price for each distribution category in the base year (weightedby the volume of electricity forecast to be distributed in each category in year, t)

Kt is a composite correction factor that adjusts for under or over recovery of revenue as aresult of actual distribution tariffs being found to have not complied with the MACt,ex post.

Under the current price control, there is no limit on the definition or number of network tariffclasses which may be specified. Re-balancing of network tariffs between various customerclasses may take place, but the average per unit tariff for any individual class of customersmay not rise by more than CPI+2% from one year to the next.

For those customers who cannot yet choose their retail supplier (franchise customers), thedistributors are subject to an additional control, known as the maximum uniform tariff. Thiscontrol sets the maximum tariff that can be charged in a range of different tariff categories,inclusive of both the distribution and the retail charge. It also allows cost pass through to



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franchise customers in limited circumstances, eg, change in taxes related to the retailbusiness.



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3. CRITERIA FOR ASSESSING DIFFERENT FORMS OF PRICECONTROL

The first step in evaluating the current form of price control and the strengths and weaknessesof alternative forms of control is to establish appropriate criteria by which the alternativeforms of control can be assessed.

The objectives of the Office are set out under the Electricity Industry Act 1993 (EI Act), theOffice of the Regulator-General Act 1994 (ORG Act), and the National Electricity Code.These objectives consistently emphasise the importance of promoting efficiency,competition, protecting the interests of customers, and maintaining the financial viability ofthe electricity supply industry. In deciding on the appropriate form of price control, theOffice therefore needs to consider the extent to which alternative forms of control meet theseobjectives.

Consultation Paper No. 1 highlighted that the challenge for the 2001 review will be to adopta price control formula which strikes the right balance between the need to provide licenseeswith an incentive to maintain and expand distribution services to new and existing customers,without this being so strong so as to encourage perverse behaviour or to add unnecessarily tobusiness risk. The factors the Office intends to have regard in assessing alternative forms ofprice control are set out below.

3.1. Incentives on Licensees’ Behaviour

The form of price control adopted will impact on the incentives faced by the regulatedbusiness. A key criterion to be used in assessing alternative price control mechanisms is theextent to which they encourage efficient behaviour by the licensees.

The concept of efficiency in economic terms encompasses productive efficiency (ensuringservices are provided at minimum cost), allocative efficiency (ensuring that resources areused to produce goods and services that provide the maximum benefit to society) anddynamic efficiency (ensuring consumption and investment decisions lead to efficientoutcomes over time, in the face of changing conditions).

A key determinant of efficient behaviour is the pricing strategies adopted by licensees inresponse to the price control. In a competitive market, price signals encourage the efficientuse of resources and efficient investment decisions over time. Generally, they do this byaligning the additional revenue attributable to increased production with the additional cost ofan extra unit of output. Efficient network pricing signals guide investment decisions inelectricity generation and infrastructure, as well as having an important influence on theinvestment decisions (including location), costs and efficiency of downstream industries.



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A distortion of pricing signals will have an adverse impact on allocative and dynamicefficiency, resulting in a handicap to economic growth and development in the region.Consideration therefore needs to be given to the impact of the form of price control on theincentive for the distribution licensees to set efficient prices, particularly for individualcustomer classes.

The form of price control can also have an impact on the incentives for the distributionlicensees to invest in the network, and hence on productive and dynamic efficiency. Whereregulated income is linked to units distributed, the control may give licensees an artificialincentive to encourage increased demand, which in turn may require higher networkinvestment, relative to other options (such as demand management). Conversely, whereregulated income is not linked to units distributed or the number of connections, licenseesmay to have a disincentive to invest, resulting in consumers’ demand for distribution servicesnot being fully met.

3.2. Relationship between Revenues and Costs

Incentive based regulation requires that firms be allowed to retain for a period a proportion ofthe gains realised as a result of efficiency improvements, to provide them with an incentive tomake such improvements. Under the ‘CPI-X’ form of regulation, the allowed price cap is setfor each period under the control on the basis of changes in the general price level, rather thanon the actual costs of the regulated firms.

Notwithstanding the above, it is important for economic efficiency that the form of pricecontrol allows total revenue to track total costs, particularly where these are affected byfactors largely outside of the licensees’ direct control. Where this is not the case, there is adanger of systematic trends in cost or revenue drivers leading to persistently higher profits orlosses for the regulated firm. Consider, for example, a situation where the price control tiesrevenue closely to the volume of energy consumed, but underlying costs are not greatlyaffected by changes in volumes, ie, the variable cost of distribution is low compared to thefixed cost. If there is an unexpected increase (decrease) in demand, profitability will alsoincrease (decrease) under the operation of the price control, compared with the level initiallyanticipated.

Persistent excess profits are not consistent with the objectives of monopoly regulation inpromoting efficiency and protecting consumers. Persistent losses are inconsistent withsafeguarding the investment of regulated businesses, will discourage new investment andresult in a potential unwillingness by the firm to continue providing the regulated services. Aform of price control which permits revenues and costs to move out of line with each othertherefore exposes the regulated firm to a degree of risk, and is a sub-optimal outcome from aneconomic efficiency perspective.



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3.3. Risk Allocation

The fundamental risks associated with providing electricity distribution services (eg, demandvariability and asset stranding) will ultimately be borne by customers, in the price of theservice. The role of regulation is not artificially to introduce additional risks, which inflateprices for consumers more than is necessary.

The form of price control can have a direct impact on the income volatility of the regulateddistribution businesses, and has implications for the financial risk borne by them. An increasein financial risk generally increases the cost of capital for the regulated business. Where thisvolatility arises from factors largely outside the control of the regulated business, such anallocation of financial risk may not be optimal, and other businesses (eg, the retail business)or customers, may be better placed to bear the income risk. The form of price controltherefore has direct implications for the efficiency of risk allocation.

3.4. Summary of Criteria

The criteria the Office proposes to use in assessing different forms of price control are:

♦ the impact of the form of control on the licensees’ incentives for efficient behaviour;♦ the extent to which the controls ensure that total revenues track total costs; and♦ the implications of the form of control for risk allocation.

The Office seeks submissions on the extent to which the use of the above criteria areappropriate in deciding on the general form of price control to apply to the distributionlicensees.



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4. O PTIO NS FO R TH E FO R M O F PRICE CO NTR O L

The precise formulation of the price control to be applied to the distribution licensees after2001 is a matter which requires careful consideration by the Office. In particular, the choiceand definition of the variables to be included in the formula needs to be decided upon,together with the operation of any correction mechanism.

At this stage in the review process, the Office wishes to consult on the general principles thatshould underlie the choice of the form of price control, and to seek views as to theappropriateness of the underlying form of the control. Following the receipt of submissions,the Office will publish its views on the appropriate form of price control, and will thenundertake further technical work to derive a specific formulation for the control to apply todistribution licensees after 2001. Proposals for the specific formulation of the price controlwill be published by the Office at a later stage in the review process.

The Office has identified three main forms of price control, namely:

♦ a revenue yield control;♦ a tariff basket (weighted price cap); and♦ a pure revenue cap.

Variations of these forms of control have been directly adopted in a range of jurisdictions.As already noted, the distribution licensees in Victoria are currently subject to a revenue yieldcontrol. This was also the form of control initially adopted in England and Wales for theregional electricity companies. The tariff basket approach has been used fortelecommunications in the UK and for Manila Water in the Philippines. The pure revenuecap approach is used for the transmission licensee in Victoria and by several electricitynetwork regulators in the US.

In the remainder of this section we assess each of these three general approaches with respectto the criteria established in the preceding section.

4.1. Revenue Yield

4.1.1. Description

The distribution licensees in Victoria are currently subject to a ‘revenue yield’ form of pricecontrol, described in Section 2 of this paper. Under a revenue yield constraint, a cap is placedon the average revenue per unit the licensee is permitted to earn in any period, t, equal to Mt.Mt is then allowed to vary per year on the basis of a ‘CPI-X’ formula.



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The average revenue is calculated by taking the licensee’s total revenue from distributionservices and dividing it by total output. The operation of the control therefore requires theidentification of a homogenous unit of output, in order for a measure of ‘total output’ to beestablished. For electricity distribution businesses this unit of output has generally been eachkWh of electricity distributed.8

In order to comply with the control, the average revenue per unit, calculated on the basis ofthe actual prices and quantities sold by the licensee, must be less than or equal to themaximum allowed average revenue, Mt. The amount of revenue earned on each individualunit (as opposed the average revenue per unit) is not regulated. The firm therefore has acertain degree of flexibility in setting individual tariffs. This flexibility encompasses both thesplit between the fixed and variable elements of any one tariff category and the rebalancingof tariffs between different tariff categories.

Figure 1 illustrates the relationship between allowed revenue and volume under a revenueyield form of price control.

8 In som e case s d iffe re nt dim e nsions of output are w e igh te d toge th e r in orde r to arrive at a singlem e asure, e g, k W h of e le ctricity distributed by d iffe re nt voltage s m ay b e w e igh te d toge th e r to arrive at a single k W h total.

Figure 1. Revenue Yield Price Control

Allow e d R e venue(as % of

Expe cted R evenue )

Expe ctedVolum e

Volum e(k W h )

100%



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The level of the revenue yield control, Mt, is set on the basis of the benchmark revenueestablished by the regulator, together with a forecast of the expected volume of output. If thevolume of output turns out as expected, the regulated licensee will receive 100% of itsrevenue. Where licensees sell in excess of the volume expected, their revenue will be inexcess of the benchmark revenue. Conversely, if they sell less than the expected volumetheir allowed revenue falls below the level anticipated when the price control was set.

4.1.2. Incentives on Licensees’ Behaviour

Under a revenue yield constraint licensees have an incentive to minimise costs, sincethe permitted average revenue per unit of output, Mt, remains fixed whatever the cost ofproduction.

The total maximum revenue the regulated firm is allowed to earn under a revenue yieldcontrol is based on a common addition to allowed revenue for every unit sold. Eachadditional unit sold attracts the per kWh allowance, regardless of the actual tariffapplied to that unit, which may be greater than or less than the per kWh allowanceimplied under the price control. Moreover, the per kWh revenue allowed under thecontrol need not be closely aligned to the cost of producing the extra unit (see below).As a consequence, in those segments of the market where total demand can be increasedat relatively low marginal cost, firms have an incentive to lower prices beloweconomically efficient levels, in order to increase their overall profitability.

The Office seeks comment on the extent to which the current form of price controlencourages the distribution licensees to adopt pricing structures which encourageincreases in volumes distributed.

This bias towards inefficient pricing, in order to increase the volume of units distributed, willbe more significant where the distribution businesses and retail business are under commonownership, as is the case in Victoria. In general, the retail business is better placed toinfluence final demand through its pricing and marketing policies than is the distributionbusiness. There may even be an incentive for the retail business to price below marginal cost,since the loss sustained will be more than offset by the increased revenue allowance for thedistribution business, maximising the profitability of the business as a whole. The potentialfor pricing distortions of this nature becomes even more of a concern as the retail market isopened to competition. Distortions in incentives which result in under-pricing by the retailarms of distribution companies will bias the playing field against competitors, and may beregarded as predatory pricing.

One approach to the above distortion of incentives would be to increase the regulation ofinteractions between the retail and distribution activities of companies when these are under



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common ownership. An alternative is to remove the underlying incentive for such behaviour,by changing the form of price control.

The Office seeks views on the appropriate approach to limiting the potential distortions inpricing by the retail arms of the distribution licensees. In particular, if the current form ofcontrol were to be retained, should closer scrutiny and regulation of the relationship betweendistribution and retail businesses under common ownership also be considered.

Currently, the 2% rebalancing constraint in the Tariff Order limits the ability of thedistribution licensees to bias prices in order to encourage growth in low cost services, in theway described above. The constraint therefore mitigates against the potentially inefficientpricing incentives implied under the revenue yield control.9

The Office seeks submissions on whether the current 2% rebalancing constraint isappropriate and should be retained or whether there is room for some widening of this band.

Even if the licensees’ ability to rebalance tariffs is directly limited, the revenue yield form ofcontrol may still provide licensees with an incentive to increase the volume of unitsdistributed by alternative means. There is some evidence of Victorian suppliers offeringcustomers incentives to expand their demand, such as a $300 subsidy to customers installingan air conditioning unit. It is difficult to assess whether this particular initiative is inefficientwithout examining the underlying cost structures. To the extent that the use ofairconditioners has tended to contribute to the Victorian peak summer capacity problems,however, such subsidies are unlikely to enhance economic efficiency. In any case, itprovides an example of the type of action which licensees may have an incentive to pursueunder this form of price control.

The inherent incentive to expand volumes under a revenue yield constraint is in conflict withdemand management initiatives. The distribution licensees will have a strong disincentive toparticipate in such programmes, as it reduces the revenue they are allowed to earn under theprice control. Licensees may therefore fail to consider demand management initiatives, evenwhen it would be economically efficient to do so. This may also have important implicationsfor realising the federal government’s targets on greenhouse gases, arising from the Kyotoagreement.

9 It is note d th at th e re balancing constraint m ay h ave th e unintend ed consequence of pre ve nting lice nse e s fromre balancing tariffs in a w ay w h ich w ould b e d e s i rab le from an e fficiency pe rspective , in ord e r to re fle ct b e tte r th ecosts of providing diffe rent s e rvice s. Th e O ffice inte nds to publish a separate consultation pape r th at discusses th eine fficiencies in th e curre nt distribution tariff structure s , and th e n e e d to balance e fficiency obje ctive s w ith oth e rgoals such as equity.



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The Office seeks submissions on the extent to which the current revenue yield control affectsthe willingness of distribution licensees to participate in demand management initiatives.

4.1.3. Relationship between Revenue and Costs

Under the revenue yield approach, the allowed average revenue need not be systematicallyrelated to costs, since it is based on a single measure of quantities to proxy services which inreality have many different dimensions of output and unit costs. As output increases for oneservice, allowed revenues increase proportionately, whereas costs may not. This underliesthe incentive for licensees to expand volumes by the cheapest means possible, as discussedabove.

Since there is no necessary link between marginal revenues and marginal costs under arevenue yield formula, there is a danger of systematic trends in cost and revenue drivers, suchas a shift in demand conditions, leading to persistently higher profits or losses. Persistentlyhigher profits, not anticipated by the Office at the time the price control was set, may promptcalls for intervention to reopen a price determination. Persistent losses borne by the companywill put at risk its willingness and ability to continue to provide the distribution service. Thelack of a proportionate link between revenues and costs under this form of control thereforeexposes the licensees to a degree of risk, and may increase unnecessarily the cost of capital.

Some formulations of the revenue yield control incorporate separate cost pass-througharrangements for unpredictable costs, as a way of addressing these concerns. The TariffOrder provision for the distribution licensees to pass through any change in Network Taxes isone such example.10

The Office seeks submissions as to whether it is appropriate for a greater provision for costpass-through to be made if the current form of price control is maintained.

4.1.4. Risk Allocation

As illustrated in Figure 1, under the revenue yield approach allowed revenue is closely tied tothe quantity distributed, and therefore the distribution licensee bears considerable revenuerisk if load growth is significantly different from forecast. Costs, on the other hand, areunlikely to match movements in load so closely, given that distribution services tend to becharacterised by a high proportion of fixed costs. The distribution licensee is therefore likelyto bear a significant amount of financial risk, associated with the volatility in profits. Thevolatility in the profitability of the distribution licensees, particularly if this is coincident with

10 Tariff O rder, Clause 5.8



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trends in the macro-economy, will in turn be reflected in an increase in the cost of capitalinvested in the business, which must flow through to customer prices.

As already noted, the cost of the risk associated with demand volatility will ultimately beborne by consumers, through the price they pay for distribution services. The form of theprice control should not increase this risk (and therefore the associated cost) unnecessarily.Distribution licensees can influence demand only to a limited extent (though their associatedretail company is in a stronger position to influence demand). It is therefore a matter forconsultation as to the extent to which it is appropriate for the distribution licensees to bear therisk associated with demand volatility.

The Office seeks submissions on the extent to which the allocation of risk under the currentform of price control is acceptable, and its impact on the cost of capital of the distributionlicensee.

4.1.5. Summary

A revenue yield form of price control limits the average revenue per unit of output. It has thefollowing key features:

♦ each additional unit distributed attracts the per kWh allowance, regardless of theactual tariff applied to that unit;

♦ licensees have an incentive to expand volumes by the cheapest means, potentiallypricing below marginal cost, since this increases their revenue allowance at theaverage unit level;

♦ the link between volumes and allowed revenue may act as a disincentive on thedistribution licensee to undertake demand management initiatives, and may encouragelicensees to expand volumes by non-price means;

♦ the allowed average revenue need not be closely related to costs, which riskssystematically higher or lower profits within each regulatory period;

♦ financial risk is placed with the distribution licensee, which may not be appropriategiven that they have limited ability to influence demand; and

♦ the financial risk translates into a greater risk of earnings volatility, implying anincrease in the cost of capital for the regulated business.



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The current Victorian price control mechanism for the distribution licensees is subject tomany of the drawbacks discussed above. The 2% limit on the extent to which tariffs can berebalanced mitigates against the incentive to bias prices in favour of low (marginal) costservices. However, the limit may also preclude economically desirable tariff rebalancing.

4.2. Tariff Basket

4.2.1. Description

An alternative to the revenue yield form of price control is the ‘tariff basket’ approach, or‘weighted price control’.

Under a tariff basket, the limit on allowed price increases is expressed in terms of a weightedaverage of the prices of a basket of services, rather than on an average revenue.11 Theregulated company faces a cap on this weighted average price, Mt, which increases over timeon the basis of a ‘CPI-X’ formula. Regulated firms are free to rebalance tariffs within thebasket, increasing some more than others, provided that the ceiling on the overall weightedaverage price, Mt, is met12.

In deriving the weighted average price, the weights chosen may be based on a range offactors. Often the weights will be fixed in reference to the base year in which the control isset, eg, the quantity of service, i, sold in the base year, or the proportion of total revenuecontributed by service, i, in the base year. Alternatively, the weights may reflect actualquantities with a lag, eg, the weight attached to the price of service i reflects the quantity ofservice, i, distributed in the previous year. Such formulations break the link between allowedrevenue and the volume distributed in the current year.

The key difference between the tariff basket mechanism and the revenue yield form of pricecontrol is that the allowed revenue received for each additional unit varies according to theactual tariff for that unit, rather than some ‘average’ tariff. It also allows for more than onecharge, ie, connection or demand charges, as well as a volume element.


Under a strict interpretation of the tariff basket control, where weights are fixed in relation tothe base year and not reviewed, it can be shown algebraically that the distribution licensee

11 In th e cas e w h e re th e w e igh ts are ch osen to re fle ct curre nt q uantitie s of e ach prod uct, i, and th e tariff structure i s entire ly k W h bas e d , th e tariff bask e t control th e n e q uate s to th e re ve nue yie ld control.

12 Note , h ow e ve r, th at it is also poss ible to im pose s eparate constraints on th e e xtent to w h ich th e w e igh ted price forany individual custom e r class m ay ch ange in any ye ar.



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will have an incentive to adopt economically efficient prices. This incentive arises from thefact that, under these conditions, the licensee’s current output does not affect the futurerevenue it is allowed to earn. The licensee therefore has no incentive to bias prices in orderto expand current output above efficient levels. This implies a greater efficiency of outputunder a tariff basket control compared with the revenue yield control.

However, where the weights used in the price control are subject to review (eg, as part of thefive yearly review of the price control), or reflect current quantities with a lag, this conclusionno longer holds. The licensee’s current behaviour will then have an impact on the futurerevenue it is allowed to earn. The licensee will then face a trade off between short and longrun incentives when making its pricing decisions.

The Office seeks views on whether a tariff basket form of control provides the distributionlicensee with more incentives for efficient behaviour than does the current form of pricecontrol.

4.2.3. Relationship between Revenues and Costs

A key difference between the tariff basket form of price control and the revenue yield controlis that, under the tariff basket approach, variations in actual volumes yield additionalrevenues at actual tariff rates, and not at an ‘average price’. This removes the distortionbetween the additional revenue earned for an additional unit of output and the price at whichthat output is sold. To the extent that actual tariffs reflect marginal costs, there is therefore asystematic link between revenues and costs. The danger of the distribution licensee sufferingsustained losses, or making sustained profits not anticipated by the Office, due to changes inoutput, is therefore reduced.

The key caveat to the above discussion is the extent to which tariffs reflect marginal costs.For network businesses, a large proportion of costs are either sunk (ie, costs associated withprevious investment) or fixed (ie, do not vary with volumes). If the tariff structure adoptedby the licensee does not reflect these characteristics, then a distortion remains. For thedistribution licensees in Victoria, it is generally accepted that the present heavy reliance onthe per kWh element of tariffs does not currently reflect the extent to which the costs ofdistribution vary with demand.


The implications for risk allocation under a tariff basket control will depend on the precisetariff structure adopted by the regulated business. As noted above, where the tariff structurereflects underlying fixed and variable costs, revenues will move in line with costs as volumeschange. The distribution licensee will not therefore be exposed to risk associated with



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changes in profitability as volumes change. However, if the tariff structure does not reflectmarginal costs, then the distribution licensee will face profit risk as quantities change, sincerevenues and costs will vary in different proportions.

Under the revenue yield approach, the distribution licensee faces profit risk whatever tariffstructure it adopts. Under the tariff basket approach, the licensee has the potential to minimisefinancial risk through adopting a tariff structure where the various components better reflecttheir marginal costs. The distribution licensee therefore has the means and a potentialincentive to reduce the profit risk it faces.

The Office seeks views on the extent to which the tariff basket form of price control willprovide the distribution licensees with an incentive to minimise the profit risk they face.

4.2.5. Summary

The tariff basket approach limits price increases in terms of a weighted average of the pricesof a basket of services. The key features of this approach are:

♦ under a strict tariff basket approach, licensees have an incentive to adopt efficientpricing strategies - where the weights are reviewed over time, or reflect actual outputwith a lag, this conclusion no longer follows strictly;

♦ variations in volumes yield additional revenues at actual tariff rates; and

♦ where tariffs reflect marginal costs, total revenues will track costs as volumes change,limiting the financial risk faced by distributors.

4.3. Pure Revenue Cap

4.3.1. Description

The third general form of price control used in the regulation of network businesses is a directlimit on the allowed revenue firms may earn in any one year. This form of control is knownas a ‘pure revenue cap’, or a ‘total revenue cap’.

Under a pure revenue cap, the maximum revenue that can be earned in any time period, t, isequal to Mt. Mt is set in absolute monetary terms at the outset of the price control, and isadjusted in subsequent years by a ‘CPI-X’ formula. This form of control is currently appliedto the Victorian transmission licensee, GPU PowerNet, and has been adopted by several USutilities.

A pure revenue cap provides the distribution company with a guaranteed income, regardlessof volume distributed. Figure 2 illustrates the relationship between volume and expected



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revenue. Mt is established on the basis of the expected volume of units distributed. If thevolume of units distributed is greater or less than expected, the additional revenue is returnedto consumers, through some form of correction mechanism. Similarly, if the volumedistributed falls below that expected, the regulated business receives the shortfall in revenuein the following period. Allowed revenue received by the licensee is therefore always exactlyequal to expected revenue at the time the price control is set.


As illustrated in Figure 2, a pure revenue cap provides the distribution licensee with aguaranteed revenue, regardless of volume distributed.

Under a pure revenue cap, the licensee retains an incentive to minimise the cost of providingdistribution services, since allowed revenue will remain unaffected, resulting in improvedprofitability.

Completely severing the link between allowed revenue and volume may however lead to adeterioration in the licensees’ willingness to expand distribution services to both new andexisting consumers. Distribution licensees may be reluctant to attract new consumers within aspecific price control period, since to do so would imply an increase in costs without acorresponding increase in allowed revenue. Some formulations of a pure revenue control tryand compensate for this incentive effect by linking the allowed revenue to the number of

Figure 2. Pure Revenue Cap

AllowedRevenue(as % of

Expected Revenue)

Volume(k W h )

100%

ExpectedVolume



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customers. However, licensees still retain an incentive to minimise the volume distributed toeach customer, providing that the marginal cost of additional load distribution is non-zero.

Whilst such an incentive is broadly compatible with demand management objectives and maymove towards meeting greenhouse gas emissions targets, the incentives to reduce load undera pure revenue cap may be artificially strong. Licensees may reduce demand beyond thepoint where this is efficient. There may also be an incentive to be less vigilant about networkreliability standards, such as minutes of lost supply.

The Office seeks submissions on the implications for demand management programmes andreliability standards of the adoption of a pure revenue cap.

4.3.3. Relationship between Revenues and Costs

By definition, under a pure revenue cap the total amount of allowed revenue received eachyear remains the same. Under a strict formulation of the control, any changes in theunderlying cost drivers are not reflected in the allowed level of revenue. There is therefore adanger that the licensee will earn sustained excess profits, or face sustained losses, if costdrivers turn out to be different from forecasts. This risk has led to cost-pass throughformulations of some pure revenue controls, in order to take account of unpredictablechanges in costs.

Additional cost drivers may also be included in determining the appropriate level of the capfrom year to year, rather than solely the CPI. In particular, some measure of customernumbers or maximum demand may be used to proxy changes in costs arising from changes indemand. Under GPU PowerNet’s revenue control, the allowed revenue for each year isdependent on a forecast of summer maximum demand for that year.13

The Office seeks submissions on the additional cost drivers which it may be appropriate toinclude under a pure revenue form of price control.


Under a pure revenue cap approach, the distribution licensee is guaranteed a set level ofincome, regardless of the actual level of demand. The extent to which the distributionlicensee bears the risk associated with changes in demand will therefore depend upon theexact specification of the pure revenue cap, and whether or not customer numbers areincluded as one of the cost drivers under the control. Where the cap varies between years

13 Tariff O rder, Se ction 3.2.4



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solely in relation to changes in the CPI, the risk associated with cost changes followingfluctuations in demand will be borne directly by the distributor.

The Office seeks submissions on the extent to which the distribution licensees should beexposed to demand risk.

4.3.5. Summary

Under a pure revenue cap form of price control, distribution licensees are permitted to earn aspecified level of income, regardless of volumes distributed. Such a control has the followingfeatures:

♦ an error correction mechanism is required to account for over and under recoveries ofrevenue in individual years;

♦ potential for a deterioration in provision of distribution services, to both new andexisting customers, resulting from an incentive to reduce units distributed;

♦ no systematic relationship between revenues and costs, implying the potential forsustained profits or losses; and

♦ the risk associated with fluctuations in volume is borne directly by distributor, unlesscustomer numbers are included in the determination of the level of the revenue cap.



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5. HYBRID FORMS OF PRICE CONTROL

The previous section discussed three alternative price cap formulations: revenue yield,weighted price cap and pure revenue cap. Each of the three different forms of price controlhas differing implications for economic efficiency in the incentives it implies for thedistribution licensee, the relationship between revenues and costs, and the allocation of risk.

Several regulators of electricity networks in other jurisdictions have moved towards ‘hybrid’forms of price control, which include both fixed and variable revenue elements. This sectionoutlines the hybrid approaches which have been adopted in New South Wales, the UK andNorthern Ireland, and evaluates the general implications of a hybrid approach.

5.1. New South Wales

In New South Wales, IPART has adopted a hybrid revenue cap approach for regulating boththe distribution businesses and the transmission business, TransGrid.

IPART sets an absolute dollar limit on the revenue that each distribution licensee can earneach year. These limits were determined in 1996/97 in absolute dollar terms. The maximumrevenue cap is adjusted each year on the basis of a formula which takes into account changesin demand conditions, including both customer numbers, MWh distributed and (for ruraldistributors) circuit kilometres. The weighting for customer numbers and MWh sales isapproximately 70:30 for metropolitan distributors and 75:25 for rural distributors. The linkbetween allowed revenue and volume is therefore reduced for any one year, compared with arevenue yield control.

IPART has opted for this type of control in order to dampen the incentives for increasingelectricity sales, and therefore the potential bias against demand management initiativesinherent in a revenue yield control.14

5.2. United Kingdom

Following privatisation, the England & Wales distribution businesses were subject to arevenue yield price control. The effect of the price control was to constrain the averagerevenue per unit distributed. However, it did not constrain the structure of charges.

14 Indepe ndent and Regulatory Pricing Tribunal, Electricity Prices, 19 9 6



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In the 1994 price review the electricity regulator, OFFER, altered the form of the control sothat, whereas previously revenue increased proportionately with the number of units sold, itwould now increase at half the rate. The electricity regulator concluded that:

‘On the evidence available to me it does not seem that distribution business costs canbe said to move entirely with units sold. At the same time, I am conscious of theimportance of retaining a general incentive for companies to seek out and meet theneeds of their customers. To balance these considerations, I propose to halve from100 to 50 per cent the weight of units in the ‘revenue driver’ of the price control, andto relate the remaining 50 per cent to customer numbers. This should avoid anyartificial disincentive in the distribution price controls to the companies’ pursuit ofenergy efficiency, while at the same time retaining an appropriate marketingincentive’.15

OFFER also noted that a measure of peak demand in each part of the distribution networkmay be a more important determinant of costs than kWh distributed. However, if revenueswere to be made dependent on peak demand there might be an incentive for companies torebalance their charges to encourage peak demand. This alternative was not thereforepursued.

5.3. Northern Ireland

Northern Ireland Electricity plc (NIE) was privatised in 1993, and is responsible for operatingthe transmission and distribution networks in Northern Ireland, as well as for powerprocurement and retail services.

When the form of the price control was being determined for NIE, there was concern aboutthe incentive effects of both a revenue yield cap, as adopted at the time for the regionalelectricity companies in England & Wales, and a pure revenue cap. The price controladopted for the transmission and distribution businesses in Northern Ireland is therefore a‘hybrid’ approach, with the price control formula incorporating both a fixed monetarycomponent (Ft) and a variable component (Vt), which depends on the quantity transmitted anddistributed, in kWh. 16 Both Ft and Vt increase at a rate equal to the increase in the CPIadjusted by an X factor.

15 O ffice of th e Ele ctricity R egulator, Th e D istribution Price Control: Proposals, A ugust 19 9 4.16 Th e original price control form ula for NIE h ad th e fixe d com ponent, Ft, e xpre s s e d as an ab solute m one tary am ount.

Th is w as re vised in th e 19 9 6 price control re view , to a m one tary am ount pe r custom e r. H ow e ve r, custom e rnum b e rs are fixe d for th e duration of th e price control to th os e fore cast by th e com pany. Ft th e re fore re m ains afixe d e le m e nt



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The fixed and variable components in the price control formula are weighted together by afactor which has been set at 0.75. This means that if the volume of units transmitted anddistributed turns out as expected, the fixed component will account for around 75 per cent ofuse of system revenue for the year. NIE’s allowed revenues are therefore less sensitive to thevolume of units than they would have been under a revenue yield approach, but moresensitive than under a total revenue cap.

The weighting factor has been chosen to approximate the cost structure faced by NIE’stransmission and distribution businesses. The aim is to ensure that NIE is broadly indifferentto the volume of units distributed.

5.4. Evaluation of Hybrid Approach

5.4.1. Incentive on Licensees’ Behaviour

The hybrid approaches adopted by electricity network regulators elsewhere are aimed atminimising the economic distortions created by the adoption of ‘pure’ forms of price control.

In particular, a hybrid approach weakens the link between allowed revenue and volume,without eliminating it entirely, as shown in Figure 3.

Figure 3. Comparison of Alternative Forms of Price Control

Expected Volume Volume k W h

AllowedRevenue(as % ofExpectedRevenue)

100% Pure Revenue Cap

“H ybrid”

Revenue Yield



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The weakened link between volume and allowed revenue implies a reduced incentive onfirms to bias prices in favour of low marginal cost services in order to expand volumes. Italso lessens the bias against participation in demand management programs as an alternativeto network investment.

However, by retaining a link between allowed revenue and output, a hybrid control avoids thedisincentive present under a pure revenue cap to encourage new connections and, potentially,to artificially discourage load growth.

5.4.2. Relationship Between Revenues and Costs

The ‘weighting’ factor between the fixed and variable elements in some forms of hybrid pricecontrols discussed above are intended to reflect the cost drivers on the network business. Forexample, in the case of Northern Ireland it was estimated that around 75% of network costswere fixed: 75% of allowed revenue is therefore fixed under the price control.

The advantage of this type of control is therefore that total revenue tracks total costs moreclosely than under a revenue yield or a revenue cap approach, reducing the risk of persistentlyhigh profits or losses for the regulated firm. Where the variable costs of additional volumesrises in proportion to the increase in allowed revenues under the control, the licensee will bebroadly indifferent to the volumes of units distributed.

The precise formulation of the hybrid control will determine the extent to which the licenseesare able to structure and rebalance tariffs within the overall control.


Under a hybrid approach, the extent to which the allowed revenue of the regulated firm varieswith output is reduced. Licensees are guaranteed a certain level of income, regardless ofvolumes distributed. This level of income can be chosen to reflect the fixed costs ofproviding the distribution service.

Additional volumes earn additional revenue at a level determined by the control. Where thisvariable revenue approximates to the licensees’ variable distribution costs, the licensees’profitability will remain broadly constant as volumes change. To the extent that the variableallowance under the control does not approximate to variable costs, the distribution licenseemay retain some profitability risk, but this will be less than under a revenue yield control.



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5.4.4. Summary

Regulatory thinking and practice is currently moving towards the adoption of ‘hybrid’ formsof price control. Hybrid forms of control have the flexibility to address many of theshortcomings of the traditional price control models.

Under a hybrid form of price control, the link between volume and allowed revenue isweakened but not removed entirely. This has the following implications:

♦ the incentive on the licensee to bias prices in favour of low (marginal) cost services isreduced;

♦ the disincentive to participate in demand management programmes is lowered;

♦ the disincentive to expand distribution services in response to consumer demand islowered;

♦ allowed revenue moves more closely in line with costs; and

♦ the financial risk borne by the distribution licensee is lowered, since profits movemore closely in line with volumes.

It therefore appears that a ‘hybrid’ form of price control has the potential to capture many ofthe benefits of the current revenue yield control on the Victorian distribution licensees, whilstavoiding some of the current disadvantages. However, much depends on the preciseformulation of the hybrid price control.

The Office seeks submissions on the extent to which a hybrid approach offers a betteralternative to the current approach, than the adoption of a form of weighted price cap orpure revenue cap.

In addition, the Office seeks views on the appropriate split between the fixed and variableelements of a hybrid price control.



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6. ISSUES FOR CONSULTATION

This paper has outlined a range of price control approaches which are consistent withincentive-based ‘CPI-X’ regulation. It has noted that the form of price control chosen canhave a significant effect on the incentives of the regulated firms to adopt economicallyefficient behaviour in their pricing and investment decisions, on the relationship betweenallowed revenues and costs and on the appropriate allocation of risk.

The Office believes that the current revenue yield form of price control has significantshortcomings. At this stage of the consultation process the Office is interested in receivingviews as the appropriate general form of price control which should be adopted fordistribution licensees from 2001. The specific formulation of the control, including the rangeand definition of the variables included and the operation of any error correction mechanism,is an issue for more technical analysis, once the appropriate overall form of the control hasbeen determined.

The Office would welcome comments and submissions from interested parties on thefollowing issues:

♦ the appropriateness of the criteria established by the Office to assess different thedifferent forms of price control mechanisms;

♦ the extent to which the current form of control encourages the distribution licensees toadopt pricing structures which encourage increases in volumes distributed;

♦ if the current form of control is retained, whether further regulation of the operationbetween distribution and retail businesses under common ownership should beconsidered;

♦ the appropriateness of the current 2% limit on rebalancing between tariffs;

♦ the impact of the current revenue yield control on the willingness of distributionlicensees to participate in demand management initiatives;

♦ whether it is appropriate for a greater provision for cost pass-through to be madeunder to current form of price control;

♦ the extent to which the allocation of risk under the current revenue yield control isacceptable, and its impact on the cost of capital of the distribution licensees;

♦ the extent to which distribution licensees should be exposed to demand risk;

♦ views on the appropriateness of a tariff basket form of price control;

♦ views on the appropriateness of a pure revenue control on the distribution licensees;



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♦ views on the appropriateness of a hybrid form of price control, including theappropriate balance between fixed and variable revenues.

2001 electricity distribution price review the form of ... · office of the regulator-general...

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