How to promote efficiency with water and wastewater price regulation Alexandra Gonçalves da Cunha, Luís Pereira e Eduardo Proença 9.º Congresso Mundial da Água Lisboa, 21-26 de setembro de 2014

1. How to promote efficiency with water and wastewater price regulation
A. Cunha*, L. Pereira**, E. Proença***
* Head of the Economic and Financial Analysis Department at ERSAR, alexandra.cunha@ersar.pt ** Economic Adviser in the Economic and Financial Analysis Department at ERSAR, luis.pereira@ersar.pt *** Economic Adviser in the Economic and Financial Analysis Department at ERSAR, eduardo.proenca@ersar.pt
Choose between models according to risk assessment (the risks should be allocated to the entity best placed to manage them)
Designing the framework
-Regulatory accounting
-Strategic plans for the sector
-Quality of service indicators
-Incentives
Defining operator’s specific constraints
-Investment plan
-Compliance with reference costs
-Ability to meet efficiency goals
-Factor X The regulator should set periodic and triggered reviews of the previous choices, both for the framework and for the operator’s specific constraints, given that the efficient regulation of the sector is marked by the variables of economic regulation.
REGULATOR’S ROLE
inspiring change
References: [1] Alexander, I. and Shugart, C. (1999), Risk, Volatility and Smoothing: Regulatory Options for Controlling Prices. [2] ANACOM (2012), Decisão sobre a proposta de tarifário residencial do serviço telefónico num local fixo, para 2011, apresentada pela PTC em 29/09/2010 e alterada em 22/10/2010. [3] Body of Knowledge on Infrastructure Regulation (2012), http://www.regulationbodyofknowledge.org/?utm_source=Mailinglist&utm_medium=email&utm_campaign=EPostCard [4] Cunha Marques, R. (2005), Regulação de serviços públicos, Edições Sílabo, Lisboa, 402 pp. [5] ERSE (2011), Tarifas e preços para a energia elétrica e outros serviços em 2012 e parâmetros para o período de regulação 2012-2014. [6] Ofwat (2012), http://www.ofwat.gov.uk/. [7] Lopes da Silva, Tiago (2013), Cost Efficiency in the Portuguese Water Sector – The case of multimunicipal systems operating at the bulk level
www.iwahq.org
(source: Lopes da Silva, Tiago (2013), adapted)
The efficiency factor X can be set based only on qualitative data or it can be determined with the help of measuring methodologies. Using the SFA methodology on the Portuguese water sector operators it is possible to rank them according to an efficiency score. Whether the regulator finds that efficiency is time invariant or not will influence the final ranking of the companies and the distance to the frontier. The quality of data is crucial and so, as time goes by, the regression model should incorporate data that is more robust and produce more accurate results.
COST EFFICIENCY AND FACTOR X
Table 2 – Efficiency ranking by average efficiency scores
Factor X cannot be a straightforward application of a formula such as “1-efficiency score”, because greater distances to the efficiency frontier cannot be met in a short period of time. The regulator has then to assume a more long term approach and evaluate for each case the adequate number of years for the required efficiency improvement.
The following chart summarizes the pros and cons of several possible incentive based price regulation methods.
PRICE REGULATION METHODS
Table 1 – Impact of alternative price regulation mechanisms
(source: Alexander, I. and Shugart, C. (1999), adapted)
INTRODUCTION
Practice has shown that the most efficiency enhancing models for water and wastewater services are incentive based models comprising a set of financial incentives to achieve management goals, relying on caps on revenue or price as given by the following formula: 퐴푙푙표푤푒푑 푅푒푣푒푛푢푒 =퐶퐴푃퐸푋+푂푃퐸푋∙1−푋+퐼푛푐푒푛푡푖푣푒푠 In order for the model to be effective it requires mainly:
Substantial risk transfer to the operator
Cost’s forecasts limited by reference costs
Rate of return on a regulatory asset base
Investment plans approved by the regulation authority
Set of goals whose attainment entitles incentives
Incentive models act on three fronts:
CAPEX – by setting the rate of return on the average cost of capital in the sector and subject investment to previous authorization
OPEX – by using a baseline of acceptable cost plus an efficiency inductor, the factor X
Incentives – by rewarding better than expected behaviour This will imply constraints on costs and, given that the operator does not want to loose profitability, it is expected cost reduction to occur.
EXPECTED EFFICIENCY GAINS
MEASURING COST EFFICIENCY
Regardless of the chosen method , it is necessary to determine the operator’s efficiency and thus the improvement need. One possible way is to employ the Stochastic Frontier Analysis (SFA). Figure 1 shows the relation between the output (water produced or wastewater treated) and the cost level as determined by. A cost frontier is outlined applying a regression model using real data from operators.
Figure 1 – Stochastic Frontier Analysis (source: Lopes da Silva, Tiago (2013)
ε is the distance to the frontier, divided between:
-ν – noise term, can be positive or negative
-u – non-negative random variable representing the operator’s own inefficiency
Price cap
Price cap with review triggers
Revenue cap
Hybrid
Volatility
Price
Revenue
Profits









  
Incentives
Cut costs to maximise profits and maximise sales provided MR>MC
Cut costs to maximise profits and maximise sales provided MR>MC, but only within the bounds set by the triggers
Cut costs as route to maximise profits
Cut costs to maximise profits and maximise sales provided MR>MC
Regulatory game
(costs)
Incentive on company to forecast
high costs
Incentive on company to forecast
high costs
Incentive to forecast high cost and high capital expenditure
Incentive to game on the MC of output so as to assure that MR>MC
Forecast demand
(if the actual cost structure is a mixture of fixed and variable)
Incentive to underestimate forecast demand
Incentive to underestimate forecast demand
Incentive to underestimate forecast demand
Incentive depend on the relationship between the actual fixed and variable costs and those assumed in the regulatory regime
Company
Time-invariant inefficiency
Time-varying inefficiency
Efficiency score
Rank
Efficiency score
Rank
A
56.8%
20
55.9%
20
B
87.3%
2
91.9%
2
C
76.9%
7
79.8%
6
D
76.2%
9
75.6%
9
E
84.6%
4
87.7%
4
F
59.4%
19
59.5%
18
G
68.7%
13
70.3%
11
H
67.1%
14
67.9%
14
I
72.5%
11
74.7%
10
J
63.1%
17
64.0%
16
K
76.4%
8
78.8%
8
L
85.7%
3
91.7%
3
M
79.9%
5
84.6%
5
N
64.3%
16
65.4%
15
O
59.7%
18
57.1%
19
P
94.8%
1
95.8%
1
Q
78.2%
6
79.2%
7
R
75.2%
10
63.6%
17
S
69.8%
12
69.0%
12
T
66.2%
15
67.9%
13