Electricity Lines Regulation Objectives, Issues & Processes January 1999

This presentation is confidential to the intended recipient and may not be divulged to any other parties without the explicit written permission of Utility Consultants.

This presentation is for promotional purposes only. Utility Consultants accepts no liability for any action or inaction arising from its’ use.

This presentation is copyright, and may not be reproduced in whole or in part without explicit written authority from Utility Consultants Ltd.

What is regulation ?? Regulation is the intervention in a business transaction by a third party by way of legislation or rules. In this case it involves a regulator limiting the revenues or profits of an electric utility.

Why regulate ?? Distribution of electricity is a monopoly business, because it is generally economically inefficient to build a competing network. This would permit a utility owner to make unfair profits by inflating prices knowing that customers have no alternative suppliers.

Why regulate ?? Hence the goal of regulation is to prevent unfair profits. This also ensures that at least some value is returned to the customers, and doesn’t all go to the owners.

So how do we regulate ?? Two different regulatory regimes are in common use…. Restricting revenue to costs plus a nominal return on invested capital. Restricting revenue to the rate of inflation less a fixed amount (RPI-X). Cost-plus is used in the US, whilst incentive is used in the UK.

So how do we regulate ?? The cost-plus regime allows a utility to pass on the costs of its inputs such as purchased energy and transmission costs, labor, materials, fuel, depreciation and interest costs, and then add a “profit” to reward the owners for the use of their capital. This method is essentially zero-based.

So how do we regulate ?? The US regulatory regime has the added feature of requiring the owners rather than the customers to bear the costs of any imprudent or unnecessary investments. This means that tariffs cannot be increased simply to make a return on ineffective or inefficient assets.

So how do we regulate ?? The incentive regime requires a utility to vary its revenue in relation to the previous year by the factor RPI-X. Hence for all X>0, the utility must reduce its revenue in real terms with respect to the previous year.

What are the key issues ?? How much is a “fair profit” ?? Underlying cost structure. Providing utilities with the incentive to improve operational efficiencies. Ensuring that sufficient funds are reinvested in the business.

What are the key issues ?? Defining what information the utilities have to disclose. Monitoring the whole process.

How much is a “fair” profit ?? Generally accepted that a “fair” profit is the WACC return on ODV, where…. WACC is the Weighted Average Cost of Capital, which includes the risk premium. ODV is the Optimised Deprival Value of the distribution network.

How much is a “fair” profit ?? Most common measure is the ARP (Accounting Rate of Profit). ARP is defined as... EBIT - cash tax - interest tax shield + revaluations average total funds employed - (0.5* revaluations)

How much is a “fair” profit ?? Sustained ARP’s in excess of the WACC could be regarded as excessive. Only 3 New Zealand utilities had an ARP greater than their WACC during 1996, with 1 of these 3 having an ARP greater than their WACC in 1995.

Underlying cost structure A key driver of a utility’s profit is the underlying cost structure of its’ distribution network. Broadly suggests that rural tariffs will need to be higher than urban tariffs to achieve the same ARP, suggesting that any regulatory regime must consider the cost structure.

Underlying cost structure Some NZ utilities have achieved ARP’s marginally above the likely regulatory “cap” whilst having below average domestic tariffs. Companies with low ARP’s and high tariffs would presumably have either high cost structures or excessive profits.

Operational efficiencies A regulatory regime should encourage a utility to improve operational efficiencies. A “cost-plus” regime allows a utility to pass on costs so there is no obvious drive to improve operating efficiencies (unless their allowable profit is indirectly governed by their operating efficiencies).

Operational efficiencies An incentive regime allows the owners to keep any efficiency gains made within the allowed revenue base, providing a strong driver to improve efficiencies.

Ensuring reinvestment A key measure of value returned to customers (as opposed to owners) is supply reliability - surveys indicate this to be the most important aspect of customer service. Typical measure of supply reliability is System Average Interruption Duration Index (SAIDA).

Ensuring reinvestment SAIDI is defined as…. sum of interruption duration for all interruptions (minutes) average total number of customers SAIDI is measured over one year and usually expressed in minutes, with a low figure being better.

Ensuring reinvestment Investment in supply reliability therefore aims to lower the SAIDI. Reducing SAIDI can be done by the following two methods…. Reducing the duration of supply interruptions. Reducing the number of customers that lose supply.

Ensuring reinvestment Reducing SAIDI will in general require significant network expenditure, as well as expenditure on vehicles, tools and communications. Important to note that SAIDI will depend on many complex factors such as network configuration, customer density and prevailing weather.

Ensuring reinvestment Historical data indicates that dense urban networks with a high percentage of underground cable have low SAIDI’s, and that low-density rural networks in storm- prone locations have high SAIDI’s.

Ensuring reinvestment Necessary to ensure that any regulation based on supply reliability accounts for these factors and provides a measure of what the SAIDI “should be” eg. having a SAIDI of 120 minutes might appear good, but if a robust model suggests it could be 40 minutes, perhaps the utility should be penalised.

Information disclosure Cost of gathering and preparing data must be minimal. Must be provision for detecting incorrect or fraudulent data. Must be presented in a nationally consistent format. Should be collected as raw data, not as numerical results.

Information disclosure Must be penalties for incorrect or incomplete disclosure. Must be normalised before any inter- company comparison occurs.

Monitoring the process Generally requires a regulatory body, possibly as part of a broader agency such as the Ministry of Commerce. Agency should be funded by the industry, not from general tax revenues. Regulator must have “teeth”, and should be able to impose penalties on utilities that are not playing fair.

Monitoring the process Bottom line is that the costs of regulation to the industry must be less than the benefits delivered to consumers in terms of controlled tariffs and improved supply reliability.

Building a regulatory regime Regime should reflect…. Underlying cost structure. Operational efficiencies implemented. Supply reliability. Regulator credibility. Disciplinary action may be invoked for…. Breach of disclosure requirements. Obstructing the monitoring process.

Building a regulatory regime Regulatory regime may need to combine regulation of electricity, gas, water, waste and telecomm’s as multi-utility companies such as Hyder plc and United Utilities plc emerge.

Underlying cost structure Must recognise that low-density rural networks may require higher tariffs to cover O&M costs as well as make a fair profit - high tariffs don’t necessarily indicate excessive profits. Requires normalisation of data before inter-company comparison is valid.

Operational efficiencies Owners should be rewarded when management implement operational efficiencies. Suggests a regime that regulates revenue and allows cost savings within that revenue base to be passed to the owners eg. RPI-X type regime.

Supply reliability Requires an assessment of what SAIDI should be to determine precisely how reliable a network is. Owners should be rewarded in the form of higher profits if their utility has a high SAIDI, and similarly penalised if SAIDI is low.

Supply reliability But limiting revenue in the form of RPI-X may only reduce the funds available for improving SAIDI. Hence the measure of SAIDI needs to reduce the prima facie profit passed to the owners and possibly increase the revenue (to provide additional funding for improving SAIDI).

Supply reliability Need to ensure that comparison of SAIDI between companies includes some normalising process to account for differing contributory factors. Simpler alternative may be to encourage power companies to offer refunds for loss of supply, and then supervise the on- going refunds.

Regulator credibility Need to ensure that the regulator behaves with some degree of predictability to provide stability to industry pricing (and hence capital investment).

References ANZ Securities “The New Zealand Electricity Sector” Ernst & Young “Electric Power Company Analysis” ESAA “Measuring The Efficiency Of The Australian Electricity Supply Industry”, Report 1, 1993.

Cool sites Federal Energy Regulatory Commission (US) Office Of Electricity Regulation (UK) Office Of The Regulator General (Victoria)

For more information... Utility Consultants Web Site with a specific query