1. Sustainable Energy Systems Theory of Regulation PhD, DFA Filomena Garcia and M. Victor M. Martins Semester 2 2011/2012

2. Sustainable Energy Systems Theory of Regulation Slide 2 Yardstick regulation Models of regulation in practice ( cont ) ¡ Yardstick regulation ¡ Partial cost adjustment ¡ Menu of contracts ¡ Performance based regulation ¡ Bibliography ¡ Shleifer, A. 1985, "A Theory of Yardstick Competition," Rand Journal of Economics, Vol. 16, No. 3, pp. 319-327

3. Sustainable Energy Systems Theory of Regulation Slide 3 Yardstick regulation  In the yardstick regulation the performance of a regulated utility is compared against of a group of comparable utilities: for example, the mean of the costs of a peer group of firms can serve as performance benchmark.  Equation: Where: P i = overall price cap for firm i ; = share of firm's own cost information; C i = unit cost of firm; f j revenue or quantity weights for peer group of firms j ; C j = unit cost ( or prices ) for peer group of firms j; n= number of firms in peer group

4. Sustainable Energy Systems Theory of Regulation Slide 4 Yardstick regulation Outline  Yardstick regulation Regulatory framework and benchmarking Benchmarking methods DEA COLS  Yardstick regulation and incentives  Yardstick regulation in practice

5. Sustainable Energy Systems Theory of Regulation Slide 5 Yardstick regulation What is it?  In yardstick regulation the allowed prices or revenues of a company depend on the performance of other companies.  The performance can be regarded in three main aspects: productivity, efficiency and quality  Productive efficiency and in particular cost efficiency are the most commonly used measures in the yardstick regulation of electric sector

6. Sustainable Energy Systems Theory of Regulation Slide 6 Yardstick regulation Value of yardstick competition  Company level Improve technical and cost efficiency  Industry level Detect and follow up technology development  Regulation Incentive system Control of tariffs Structural development

7. Sustainable Energy Systems Theory of Regulation Slide 7 Yardstick regulation  Efficiency measurement methods The methods used for measuring efficiency are referred to as frontier approaches

8. Sustainable Energy Systems Theory of Regulation Slide 8 Yardstick regulation  DEA - In a sample of companies with a k-input-m-output production function with variable returns to scale ( VRS) the measurement of cost efficiency using DEA method reduces to the following minimization problem:  w – vector of input prices ;x - vector of input quantities ; y – vector of output bundle;X and Y are matrices; N and are vectors

9. Sustainable Energy Systems Theory of Regulation Slide 9 Yardstick regulation  Efficiency frontier Example DistributorABCD Operating cost (M€)72.580140120 Deliv power( MWh)1115.5137915001200 Benchmark Cost/MWh655893100  Questions Is D an efficient utility? Who is efficient? Who are the peers to D?

10. Sustainable Energy Systems Theory of Regulation Slide 10 Yardstick regulation  Decomposing efficiency: Technical efficiency  To avoid waste and slack Scale efficiency  To operate at the right scale Cost efficiency  To apply least cost technology

11. Sustainable Energy Systems Theory of Regulation Slide 11 Yardstick regulation Efficiency frontier Technical Eff.: 75/120= 62.5%

12. Sustainable Energy Systems Theory of Regulation Slide 12 Yardstick regulation Efficiency frontier Scale Eff.: 70/75= 93%

13. Sustainable Energy Systems Theory of Regulation Slide 13 Yardstick regulation  Information Technical Efficiency : 62.5% Scale efficiency : 93% Input target - OPEX 75 ( - 45, i.e. 120-75)

14. Sustainable Energy Systems Theory of Regulation Slide 14 Yardstick regulation  The minimization problem can be solved by LP methods. The LP finds a piece-wise linear isoquant in the input space, which corresponds to the minimum costs of producing the given output at any given point.  The solution gives the minimum feasible costs for each company namely, w´ix0i, where xi* is the optimal output bond for firm i. The cost efficiency of each production plan is then estimated as the distance to the envelope. Namely, firm i´s cost efficiency is therefore obtained by:

15. Sustainable Energy Systems Theory of Regulation Slide 15 Yardstick regulation  Example Distribution CompanyABCD Opex (M€)72.580140120 Labor (€/h)877770135 Output( MWh)1200 Totex (M€)9095.4175187.5 Labor/MWh736458113 Opex/MWh6066117100 Cost/MWh7580146156

16. Sustainable Energy Systems Theory of Regulation Slide 16 Yardstick regulation Cost efficiency

17. Sustainable Energy Systems Theory of Regulation Slide 17 Yardstick regulation  Information Cost efficiency : 187M€/63 M€=» 33,5% Cost targets:  Operating costs: 35M€ ( -85)  Labor: 140€/h ( +5)  Total cost: 63m€ (-124M€ )  Yardstick regulation offers: Real targets, norms and peers Cost norms, low information rents Observed technologies Participation

18. Sustainable Energy Systems Theory of Regulation Slide 18 Yardstick regulation  Regression Method- COLS ( corrected ordinary least squares )  Model: ln C i = f( y i,w i )+u i C i – actual cost incurred by the company i f( …) – cost function u i -Stochastic error  After correcting the error term so that all residuals u i become positive the COLS model can be written as: ln C i = f( y i,w i )+min i (u i )+v i with v i =u i -min i (u i ) >0 where v i represents the firm inefficiency.

19. Sustainable Energy Systems Theory of Regulation Slide 19 Yardstick regulation Technique of COLS ( corrected ordinary least squares )

20. Sustainable Energy Systems Theory of Regulation Slide 20 Regulation of utilities in selected countries Countr y Regulati on Method Benchmarking: Method and sample Inputs and outputs From benchmarking to X-factor Great Britain Revenue cap COLS / OPEX 14 Recs in GB I: OPEX O: Composite variable( 50% nº of cust; 25% el dist; 25% length of network High cost utilities must move 75% of the distance to efficient frontier during reg. period NorwayRevenue cap DEA: total controlable costs Regional networks and distribution I: Capital+goods & services +labor O: Nº of customers, en. del. Length lines and cables Utilities revenue cap for 1998-01 is reduced 38.2% Netherl ands Ex-ante tariff regulatio n DEA/RevenueI: Total cost O: Units, demand ( peak) network length, customers OPEX and X: from 8 to -2 for individual companies. SpainRevenueReference network/revenue I: Total costs O: Electricity distributed, demand Customer volume Eff. Requirement: individual+ general 1,5%

21. Sustainable Energy Systems Theory of Regulation Slide 21 Incentive regulation -Partial cost adjustment  Another approach to incentive regulation is to link the price adjustment to changes in utility's own cost observed in a reference year.  The cost minimization is provided by price periodic adjustments that are less than proportional to the actual changes in the cost.  The following equation shows a partial cost adjustment scheme: Where: Pi = adjusted price; C* i = reference cost per unit output ; C i = actual cost and lambda = sharing parameter

22. Sustainable Energy Systems Theory of Regulation Slide 22 Incentive regulation - Menu of contracts  The menu of contracts method is an innovative approach to reduce the information asymmetry between the regulator and the regulated firm  Under this scheme the regulator offers the utility a menu of incentive plans with constant consumer welfare. The utility can choose among the incentives and the flexibility in choosing among the alternatives reveals its welfare-enhancing preferences  For example, a menu of incentives can be designed where the utility's share of profits or some specified reward is a function of the deviation of the X-factor ( or price cap ) chosen by the utility form a base X*:

23. Sustainable Energy Systems Theory of Regulation Slide 23 Incentive regulation - Targeted regulation  Targeted incentive regulation pursue narrower objectives than the broad incentive regulation discussed in the above  The aim of these schemes is to target specific aspects of the operation of the utility and achieve an outcome that would not necessarily result from broad incentive schemes  Targeted incentive regulation may be used to promote environmental standards, technical efficiency and improvement in the quality of service  These schemes have been criticized on the ground that they distort efficient allocation of resources.

24. Sustainable Energy Systems Theory of Regulation Slide 24 Performance based regulation  Performance-Based Regulation ( PBR) has become increasingly popular in many regulated industries in the US and can be defined as the implementation of rules, including financial incentives, that encourage a firm to achieve certain performance goals, while affording the firm significant discretion in how the goals are schived.  An effective PBR regime incorporates mechanisms to overcome information asymmetries and decrease the need for detailed regulatory intervention  A full PBR regime is characterized by two elements: De-linking a utility's own costs with its own allowed prices or revenues, Linking the utility's own allowed prices or revenues with the costs of other, comparable utilities

25. Sustainable Energy Systems Theory of Regulation Slide 25 Performance based regulation ( cont) The advantages of PBR over ROR are the following:  By not linking authorized revenues directly to realized operating costs, PBR plans can provide companies with strong incentives to control costs and increase other aspects of performance  PBR can provide improved rate predictability for customers especially through plans like rate freezes and rate case moratoria  PBR such as earnings sharing plans can secure timely customer participation in a company's improved financial performance thereby making customers “ stakeholders” in the company's operations  PBR plans can reduce administrative and regulatory costs by avoiding regulatory micromanagement of company's operations and by reducing the number of litigated rate cases  By providing an electric utility with incentives similar to those faced by firms in competitive markets, well structured PBR Plans can serve both as a tool to regulate traditional utility operations and as a transitional mechanism to more competitive electricity markets

26. Sustainable Energy Systems Theory of Regulation Slide 26 The evolution pattern of regulation

27. Sustainable Energy Systems Theory of Regulation Slide 27 Method of regulation of utilities in selected countries CountryModel of regulation Great BritainRevenue cap NetherlandsRevenue cap NorwayRevenue cap AustraliaRevenue cap California - Southern Price cap ChileYardstick regulation

28. Sustainable Energy Systems Theory of Regulation Slide 28 Conclusion  Based on the experiences in several European countries, the acceptability of regulatory models among interest groups seems to be an essential part of the development process It has proven to be difficult to implement models that have been unacceptable to the regulated companies  Difficulties in accepting regulatory models may sometimes be due to the fact that they have become very complicated Regulatory models have often been developed piece by piece New adjustments, e. g. efficiency and quality have been added on top of the existing regulatory formulas There are some signs indicating that regulatory models should become more simpler.