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extraordinary circumstance

extraordinary circumstance

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Published by Core Research

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Published by: Core Research on Jan 09, 2009
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Pricing Principles for Investments Made
Under Extraordinary Circumstances
A Report on behalf of Queensland Competition Authority
Joshua Gans and Stephen King

The analysis here represents the views of CoRE Research Pty Ltd (ACN 096 869 760) and should not be construed as those of the QCA.

10th July, 2003
Executive Summary

We have been asked by the QCA to assist them in considering the relevant issues for a regulator in considering extraordinary circumstances for utility industries. We begin by considering the relevant definition of an extraordinary circumstance (EC). We note that a natural, although na\u00efve, definition is that an EC is a highly unlikely event that involves a prolonged and widespread loss of supply. This definition is na\u00efve in that it (a) ignores the role of parties in determining the risk of a supply interruption and (b) provides no rationale for government involvement in the supply interruption. In our opinion, a better definition focuses on the underlying market failure that calls for government intervention. It is preferable to define an extraordinary circumstance in terms of the severity of (uncompensated) cost of the supply shock to the relevant community. Thus an extraordinary circumstance occurs when there is a supply disruption that leads to highly significant (and uncompensated) harm to the general community served by the regulated utility.

In order to consider the treatment of a regulated firm after an EC has occurred, it is necessary to consider the risk regulation used for that utility prior to any EC. The ex ante approach to precautionary activities by a regulated firm and the ex post treatment of EC costs, such as investment costs, are inextricably linked. Particular ex ante approaches to risk management imply specific ex post treatment of EC costs. If ex ante risk management and ex post treatment of EC costs are not considered together then an inappropriate and socially undesirable regulatory outcome may result.

There are two main approaches dealing with ex ante risk management. The
regulator can respond to the potential risk of an EC by:
Directly regulating actions to mitigate risks; or
Establishing liability rules for outcomes following an EC.

The choice between these alternative policies depends on the particular circumstances facing the regulator, including the information available to the regulator and the regulator\u2019s ability to monitor precautionary activities over time. Further legal, political and commercial limitations undermine sole reliance on liability rules.

In our opinion, an ex ante regulatory response that involves both some mandated standards and some ex post liability is likely to be most desirable for many infrastructure industries. But there is no \u2018one size fits all\u2019 approach.

Compensation for precautionary activities must be consistent with the approach
to regulatory risk. A liability approach is like \u2018self insurance\u2019 with the regulated

firm effectively acting like the insurer for an EC. Under such an approach, the regulated firm needs to be compensated through its operating costs for the implicit self insurance premium. In contrast, a mandated standards approach involves specific set actions for the regulated firm, and the firm can be compensated for these actions using an \u2018efficient firm\u2019 comparator.

Similarly, cost recovery rules following an EC must be consistent with the approach to regulatory risk. A pure liability approach requires that the regulated firm receive no additional compensation for expenditures associated with an EC, whether or not these expenditures involve new capital investment. Effectively the firm has already been compensated for these ex post costs through the ex ante implicit insurance premium. In contrast, a mandated standards approach requires that the regulated firm be fully compensated for any ex post EC expenditures, including any capital investments made by the regulated firm. Under a pure mandated actions approach, the regulated firm bears no residual EC risk so long as it satisfies the minimum regulated standards.

Clearly, these approaches to cost recovery following an EC have very different implications for the ex post regulation of the relevant firm. However, the key point is that this ex post regulation cannot be separated out form the ex ante regulation of risk.

Throughout this report we provide suggestions for questions and issues that can be addressed through the scoping document. In our opinion, the scoping document needs to adopt a systematic framework for considering the relevant issues. The framework presented in section 3 of this report provides one approach to allow participants to consider the relevant issues. It is our view that presenting the issues in a consistent framework that highlights the linkage between ex ante risk regulation and ex post cost recovery is more likely to illicit useful and thoughtful responses from industry participants.

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