Szabo Incentive Regulatio

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Incentive price regulation

László Szabó
Director
REKK
ERRA Online Training | Introduction to Energy Regulation

November 2-December 4, 2020
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• Incentive regulation
•Benchmarking techniques
•Examples of benchmarking
•The Netherlands tariff setting scheme on network
companies
|2|
The problems with classic „cost of service” price regulation
• Weak incentive for improving

cost-efficiency (lack of
competition, almost automatic
O&M cost pass-through)
• „Gold plating” (or Averch-
Johnson effect)
• Incentive for excessive investments if
justified regulated return exceeds
market return
• = high and ever increasing end
customer tariffs
ERRA Training Course: Introduction to Water Utility Regulation 3

November 13-17, 2017, Budapest, Hungary
Incentive price regulatory schemes
• Principal idea: to loosen the relationship between the revenue and the
historic costs of the regulated monopoly
• A simple relationship between classic and incentive price regulation:
TR = (1-b)*(costs)ex-ante + b*(costs)ex-post
where
TR: the revenue of the regulated monopoly (ex-post)
b: 0 ≤ b ≤ 1, a pre-defined coefficient to ensure the acceptance
of justified costs
(costs)ex-ante: forecasted justified costs of the regulated monopoly
(costs)ex-post: actual costs of the of the regulated monopoly
• The incentive power of the regulation is inversely related to the value of b
ERRA Training Course: Introduction to Water Utility Regulation 4 4

Rewarding performance in a price cap scheme
price / cost
regulated price
development
loss
profit
Cost development
4-5 years (pre-defined) 4-5 years (pre-defined)
first period second period
cost reviews year

Pre-determined prices Pt = Pt −1
• Between cost reviews, prices should not change by default

• Unchanging prices provide high-powered incentives to
reduce costs
• Strength of the incentives depend on time left until the next
cost review
• stronger incentives in the beginning of the period, weakening towards
the end
• reason: achieved productivity improvements will translate into lower
prices after the next cost review
• UK Ofwat have a long tradition of using price controls

Cost pass-through Pt = (1 + CPI t ) Pt −1
• The regulated company should only be rewarded or

punished for its own performance
• Many cost elements are mainly outside the company’s
control
• These should largely be passed onto the consumers
(through the regulated prices)
• Pass-through by pre-determined formulae, which the
company cannot manipulate
• e.g.: indexed by consumer price index, instead of company
procurement costs

Sharing the expected Pt = (1 + CPI t − X ) Pt −1
(not the actual!) benefits
• Productivity improvements can be forecast („expected of the

company”) to some extent
• Lower costs  higher profit  allocative inefficiency
• Expected productivity improvements can be built into the prices
beforehand
• X-factor
• Prices decrease regardless of whether the company improves its
productivity
• important difference from profit sharing!
• Incentive power is retained in full, while allocative inefficiency is
mitigated
• Forecasts must be realistic, the firm cannot be squeezed too much
(regulatory commitment is important!)
Service quality regulation Pt = (1 + CPI t − X  Q) Pt −1
• Incentive regulation motivates companies to reduce operating costs

• One easy way of doing so is by degrading service quality
• Service quality regulation must be put in place along with incentives to reduce
costs
• minimum standards, with penalties for non-compliance
• monetary incentives to set the optimal level of quality
• monitor and publish results
• If quality is important and hard to enforce, then cost-cutting incentives should

be weakened
• Instead of aiming for „perfect quality”, find the quality that consumers are
willing to pay for
Correction for unforeseeable costs
Pt = (1 + CPI t − X  Q) Pt −1  Z
• Natural disasters
• Impact of new (e.g. environmental) regulation
• Unexpected tax increases
• Major advantages of price cap regulation for emerging

economies:
➢Reduced information need for the Regulator
➢Applicable under conditions when company accounting isn’t up to
international standards

Revenue cap
Rt = (1 + CPI t − X ) Rt −1  Z
➢Where Rt is the allowed revenue for the regulated monopoly

in year t
• This can be corrected with the change of some major cost

component (e.g. number of customers):
Rt = (1 + CPI t − X )(Rt −1 + CGA  Cust t )  Z
➢CGA: correction factor for change in the number of customers

($/customer)
➢ Cust t : change in the number of customers in year t

Cap-based regulation: overview
Cap Regulation
Price Cap Revenue Cap

(Cap (upper limit) on (Cap (upper limit) on
actual prices) earned revenue)
Individual Price Tariff Basket Fixed Revenue Variable

(Cap on (Cap on weighted (Cap linked only Revenue
one price only) average price) to CPI-X)
(Cap linked to CPI-X
& other variables)
Revenue
Yield Hybrid
(Cap on revenue
per unit of output)
Revenue
(Cap on revenue
and price)

Outline You may add your
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•The Netherlands tariff setting scheme on
network companies
| 13 |
„Peer-determined” prices: benchmarking
(yardstick competition)
• A regulator’s best cost estimate might be whatever the company reports
about its own cost
→weak incentives for efficient operation
• If comparable regional monopolies exist, additional information is available
→e.g. distribution utilities in separate regions of the same country
• A given monopoly’s justified costs may be based on the (reported) average
costs of other (non-competing) monopolies
→strong incentives for efficient operation, since cost savings (relative to benchmark)
are retained
• If all regional monopolies operate under the same benchmarking scheme,
efficiency improvements result
→thus, the benchmark automatically adjusts to redistribute efficiency gains to
customers
→aCourse:
ERRA Training form of competition
Introduction where
to Water Utility real competition
Regulation 14
is infeasible
14
Benchmarking: general remarks
• Statistical methods to compare utilities

• Can be quite data intensive: more data is better than less
• Depends on comparability and competing interests
• The bigger the sample of companies, the bigger the
differences between the utilities
• The smaller the sample of companies, the bigger the
chance of collusion between regulated firms
• Difficulty of defending the methods can limit the
applicability of benchmarking
Price regulation methods – data collection issues
• How to get proper cost data?

– Large company: SAP FI module
– Financial reports
– Data collection process requires huge efforts
• Impose Regulatory obligations: Accounting separation,

regulatory financial reporting

Benchmarking methods
1) Linear programming models – e.g. DEA (Data

Envelopment Analysis
2) Econometric models –e.g. deterministic (OLS, MOLS) or

stochastic (SFA), or panel regression models
3) Index methods – Total Factor Productivity based (TFP),

Partial Productivity Indexes (PPI), Malmquist index
4) Technical cost models – technology based models
Source: Pápai, VÉSZ 2012

Benchmarking techniques
• The comparison of single items is already useful (labour cost of

providing 1MWh of electricity, network loss levels)
• More sophisticated techniques to estimate an „efficient
company”, based on a larger sample of company data
‣ Stochastic Frontier Analysis
‣ Data Envelopment Analysis
• Based on the distance from the ideal state, individual efficiency
improvement factors (X-factors) can be defined for the individual
regulated companies
• Legal background may not permit such comparisons

LOGO here
network companies
| 19 |
Example 1: Efficiency frontier in DEA
Total cost
of service
Efficient frontier
Size
Example 2: Partial Productivity Indexes
• PPI is frequently used by regulators

• E.g. creation of a composite index instead of a single variable
(output), which is then compared to the cost of the various
firms (total or variable costs)
• Corporate activities are grouped to homogeneous activities
• Most important characteristics are connected to these activities
• Examples:
• UK composite index in the early phase (2000):
• Ofgem composite output index = energy served0,25*number of consumers0.25*length of
network0,5

Example 3: Partial productivity indexes
Example of Hungary electricity DSO tariff regulation:

• Hungary – electricity distribution companies (2012-2016):
Activity 1. Factor (weight) 2.Factor (weight)
Operation and maintenance Electricity distributed (1/3) Length of network (2/3)
Management Number of costumers (1/3) Length of network (2/3)
Metering Number of household consumers (1/2) Number of other consumers (1/2)
Consumer service and trade Number of household consumers (1/2) Number of other consumers (1/2
But questions also raised here:

• Measure both capex and opex? But there are trade offs between them!
• Should be a management decision! So the measurement can have
significant bias.
Benchmarking the Q factor

Benchmarking the Q factor – regulatory dynamics

LOGO here
network companies
| 25 |
Example of the Netherlands (1)
• The Netherlands applies a revenue cap/price cap method on the DSOs and
TSOs (both in electricity and gas)
• DSOs above target efficiency levels keep resulting profits
• DSOs at lower efficiency will have losses
• As the efficient cost level is determined not (not only) on the DSO’s own
costs- the regulation gives incentives over the long term as well!
• Regulatory period is typically 3-5 years – methodology does not change in
the period!
• The efficiency improvement factor X is determines for the full 3-5 years
• Tariff decision takes place every year (but no change in the methods!)

Example of the Netherlands - Overview of regulation
ERRA Training Course: Introduction to Water Utility Regulation Source: Autoriteit Consument & Markt 2017 27
Revenue cap yearly determination
Source: Autoriteit Consument & Markt 2017

X factor mechanism
ERRA Training Course: Introduction to Water Utility Regulation Source: Autoriteit Consument & Markt 2017 29
Determining the revenue requirement for the TSO

Conclusions
• Incentive price regulations solves many issues conventional cost +
regulation cannot solve
• But requires additional effort from the regulator
• To collect data (more data is needed in this case)
• Develop and apply sound methodology
• Keep its promises – e.g. if a 5 year tariff period is set, it cannot change
the methodology – otherwise it undermines its operation and the
credibility of the regulation (and the regulator)
• Benchmarking techniques help, but it is very data intensive, and
regulators will always have to keep an eye on the incentives it
cerates!
You may add your
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THANK YOU
FOR YOUR ATTENTION!
László Szabó
laszlo.szabo@rekk.hu
https://erranet.org/

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Incentive price regulation

ERRA Online Training | Introduction to Energy Regulation

• Weak incentive for improving

ERRA Training Course: Introduction to Water Utility Regulation 3

• The incentive power of the regulation is inversely related to the value of b

ERRA Training Course: Introduction to Water Utility Regulation 4 4

4-5 years (pre-defined) 4-5 years (pre-defined)

first period second period

cost reviews year

ERRA Training Course: Introduction to Water Utility Regulation 5 5

• Between cost reviews, prices should not change by default

• UK Ofwat have a long tradition of using price controls

ERRA Training Course: Introduction to Water Utility Regulation 6 6

• The regulated company should only be rewarded or

ERRA Training Course: Introduction to Water Utility Regulation 7 7

• Productivity improvements can be forecast („expected of the

• Incentive regulation motivates companies to reduce operating costs

• If quality is important and hard to enforce, then cost-cutting incentives should

• Major advantages of price cap regulation for emerging

ERRA Training Course: Introduction to Water Utility Regulation 10 10

➢Where Rt is the allowed revenue for the regulated monopoly

• This can be corrected with the change of some major cost

Rt = (1 + CPI t − X )(Rt −1 + CGA  Cust t )  Z

➢CGA: correction factor for change in the number of customers

ERRA Training Course: Introduction to Water Utility Regulation 11 11

Price Cap Revenue Cap

Individual Price Tariff Basket Fixed Revenue Variable

ERRA Training Course: Introduction to Water Utility Regulation 12

• Statistical methods to compare utilities

• How to get proper cost data?

• Impose Regulatory obligations: Accounting separation,

ERRA Training Course: Introduction to Water Utility Regulation 16 16

1) Linear programming models – e.g. DEA (Data

2) Econometric models –e.g. deterministic (OLS, MOLS) or

3) Index methods – Total Factor Productivity based (TFP),

4) Technical cost models – technology based models

Source: Pápai, VÉSZ 2012

• The comparison of single items is already useful (labour cost of

ERRA Training Course: Introduction to Water Utility Regulation 18

• PPI is frequently used by regulators

ERRA Training Course: Introduction to Water Utility Regulation 21

Example of Hungary electricity DSO tariff regulation:

But questions also raised here:

ERRA Training Course: Introduction to Water Utility Regulation 23

ERRA Training Course: Introduction to Water Utility Regulation 24

ERRA Training Course: Introduction to Water Utility Regulation 26

Source: Autoriteit Consument & Markt 2017

ERRA Training Course: Introduction to Water Utility Regulation 30

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