The Future of RPI-X/CPI-X

Regulation in Europe

Michael Pollitt
University of Cambridge
http://www.econ.cam.ac.uk/electricity/people/pollitt/index.htm

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 Introduction

• What is RPI-X?
• How is X calculated in the UK and Norway?
• Recent Experiences
• Problems with RPI-X
• Alternative Models: Chile, US, NZ
• Issues for the Future
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 What is RPI-X Regulation?

• Proposed by Littlechild in 1983

– Explicitly to avoid a US style system

• Similar systems exist across Europe

• Average prices or revenue capped by CPI -X
– A temporary measure until ‘competition arrived’.

• 20 years later it is still here!

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 The Theory of RPI-X
• Fixed period for X provides incentives.
– Shleifer formalised theory of yardstick competition
– X equals average cost reduction of comparable firms
– not related to firm’s actual costs in unlinked
benchmarking.
• linking X to actual costs gives rise to perverse
incentives and gaming.

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 The Theory of RPI-X
• Shleifer’s model requires other comparable firms
Otherwise we need to analyse actual costs.
• Therefore we must examine firm-specific factors and
efficiency differences

UK’s system ‘represents an acceptable compromise

between information intensity and the scope for
gaming’ (Bos, 2001).
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Directive 2003/54/EC and regulated tariffs

• Independent Regulator for tariff methodology

• DSO independent of G, T and supply
• Only separate accounts for distribution required
• Settlement of disputes within 2-4 months
• Regulator has duty to consult with companies
• NRAs have duty to co-operate

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 How is X calculated in the UK?

• UK(and Norway) use the building block approach

– Capex and Opex costs are analysed separately
– Capex must be audited ex ante and ex post
– Opex separated: controllable vs. uncontrollable.
– Reasonable WACC calculated.
• Only part of measured inefficiency eliminated.

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 Allowed revenue and X factor
Actual Revenue 2005

X factor 1

X factor 2
Frontier shift

Actual
Opex
Efficient Opex
Depreciation
Efficient
Revenue
WACC x RAB

2005 2010
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 NAO Pipes and Wires Report (4/02)
• Risks and limitations of UK RPI-X approach
– Weak incentives at end of period
– Investment incentives weak
– Regulation introduces risk
– Process viewed as burdensome
• Solutions:
– Standardise efficiency recovery period
– Clear guidelines for assessment of investment
– Develop consistency in cost of capital projections
– Review process ex post (as OFWAT, 2000) 9
Norwegian Distribution Regulation 1997-01
• Composition of Revenue Cap:
– O&M and losses average 1994-95
– Depreciation 1995
– 8.3% return on capital as at 31.12.1995 inc. risk premium of 2%
– Property taxes included
• Annual Adjustments:
– New investment: 50% annual the increase in energy delivered
– CPI
– General X of 1,5%
– Individual X between 0 and 3%
• Allowed Rate of Return:
– 15% and 2%
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Norwegian Distribution Regulation 2002-06
• Composition of Revenue Cap:
– O&M and losses average 1996-99
– Depreciation 1999
– Annual decision on RoR on capital of 31/12/99 inc. risk premium of
2%
– Property tax outside revenue-cap
• Annual Adjustments:
– New investments: Increase in customers and energy delivered
– CPI
– General X of 1,5%
– Individual X between 0 and 5.2%
• Allowed Rate of Return:
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– 20% and 2%
Problems of RPI-X: Discretionary Nature

• OFGEM’s 1999 Distribution Price Control Review

reveals
– Pragmatic rather than rigorous approach
– Results which are not reproducible
– Choices of output weights which are not justified
– Arbitrary combination of regression and judgement
– Reliance on one company (Eastern) to define the frontier
– Benchmarking of Opex not (Capex+Opex)
– No attempt to explain outliers with high costs
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 Problems of RPI-X:non-convergence

• RPI-X meant to be temporary

• Costs should not persistently diverge
• But substantial unexplained differences remain

• NGC:
- no obvious comparator, controllable costs low
(26%), measured efficiency high (97%)
- conventional assessments of efficiency doubtful
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Problems of RPI-X: Incentives to Innovate

• (In)ability to incentivise quality?

• Norway includes value of non-delivered energy into
their benchmarking (not in UK)
• Cost focus
– companies cannot charge more for new products
• Ability to incentivise distributed generation or
isolated energy services questionable

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 Problems of RPI-X: Gaming in Regulation
(Jamasb, Nillesen, Pollitt, 2003)

• The process of determining X can be gamed by:

– Re-allocating competitive to regulated activities
– Allocation of common assets within multi-utilities
– Designation of uncontrollable expenditures
– Outsourcing
– Strategic declarations of inputs or outputs
– Suggested model specifications (method and variables)

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 Problems of RPI-X: Mergers and
information loss
• X calculation requires comparators
• Mergers reduce number of comparators
• UK - only 8 independent Discos
• Reallocations can increase regulated revenue

Efficiency analysis will become statistically more

difficult over time
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 Alternative Models: Chile

• 1982 Law specifies Value Added in Distribution

– for 34 distribution companies
• 2000: model company links supply and demand
• 10% rate of return assumed on model company
• Two consultant reports commissioned
• Excellent incentive properties

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 Alternative Models: Chile
• Problems with the model in Chile:
– Model company has encouraged mergers
– Weighting of reports encourages gaming
– Model lacks transparency

• May work better in UK with similar sized companies

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 Alternative Models: US
• Industry TFP used in regulation of US LECs
• For single firm use comparable industries
• TFP = weighted output growth less input growth
• X factor can be annually updated

• Problems:
– No elimination of initially high profits
– Definition of inputs and outputs

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Table B-12. Summaryof the Components of LECs' Price Cap X-Factor (excludingthe Consumer ProductivityDividend) - 1985-1998

_________________________________________________________________________________________________________________________________________________

Year U.S. LECs' LECs' LECs' TFP U.S. LECs' Input X-factor
Nonfarm Output Input TFP Differential Nonfarm Input Price (%)
Business Growth Growth Growth (%) Business Price Differential
Sector Rate (%) Rate (%) Rate (%) Sector Growth (%)
TFP Input Rate (%)
Growth Price
Rate (%) Growth
Rate (%)

A B C D=B-C E=D-A F G H=F-G I =E+H

_________________________________________________________________________________________________________________________________________________

1998 0.59 5.38 -0.23 5.61 5.01 0.72 0.19 0.53 5.54

_________________________________________________________________________________________________________________________________________________

Source: Uri (1999) inFCC99-345.

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 Alternative Models: New Zealand
• Why regulate monopolies?
• Example: New Zealand 1990s
• Low costs of regulation, no distortion of
investment
• 1994-00 final price stays constant but monopoly
component rises
• In 2000 MoE report recommends CPI-X
• Lack of monitoring
• May work better elsewhere 21
 A Cost-Benefit of RPI-X
• 2000-05 Distribution Price Review costs £9.5m
• What was benefit to society?
• If distributional consequences do not matter then:
– Benefit=value of lost output due to higher price
= ½ Revenue*elasticity of demand*(∆price)2
– If elasticity of demand is 0.3, revenue is £15bn then
– Final Price must rise by more than 7% for benefit>cost

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 Issues which current system of
CPI-X should address
• Need for improved international comparisons
• Quality of service/system robustness inclusion
• Better reporting and consistency of approach
• Improved modelling of the environment
• Joint assessment of capex and opex
• Increasing length of review period
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The Future of RPI-X/CPI-X
Regulation in Europe

Michael Pollitt
University of Cambridge
http://www.econ.cam.ac.uk/electricity/people/pollitt/index.htm

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