Regulatory Design Toolkit for Utilities, Stephen Labson slEconomics

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The Regulatory Design Toolkit (RDT)
The primary role of the RDT is to provide a tool for selecting the form(s) of price regulation appropriate for industry specific application.
The available forms of price regulation span a spectrum of options – with the minutia of detailed application often having a material impact on performance.
It would not be feasible or useful to build an RDT that recommended one unique form for a given application.
The RDT will typically provide a narrowed set of workable options that provide broadly consistent outcomes
The RDT allows the operator to set out in what circumstances one would tend towards specific forms within the sub-set of options
An overly mechanistic approach to price regulation is not generally robust to practical application
The RDT has been built with the understanding that application to industry specific analysis would be further assessed by ESCOSA against a range of less tangible factors not amenable to assessment within the RDT.
The RDT has been designed such that it is robust to the range of industries ESCOSA may have regard to in the foreseeable future.
The RDT has been designed to a level of detail that balances robustness against usefully detailed findings.

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Regulatory Design Toolkit for Utilities, Stephen Labson slEconomics

  1. 1. slEconomics Pty LtdslEconomicsEconomics Consulting in Utilities and Infrastructure Form of Price Regulation Regulatory Design Toolkit For information on this document please contact Contact details Dr Stephen Labson Phone: + 61 412 599 693 Email: slabson@sleconomics.com 1
  2. 2. slEconomics Pty Ltd slEconomics Economics Consulting in Utilities and InfrastructureslEconomics is a boutique economics consulting firm providing specialisedadvice to governments, regulators and corporate clients in the area of utilitiesand infrastructure. We are based in Sydney Australia and have aninternational network of associates to bring global experience to localinitiatives.www.slEconomics.comContact detailsDr Stephen LabsonLevel 32, 101 Miller StreetNorth Sydney NSW 2060Phone: 0412 599 693Email: slabson@sleconomics.com 2
  3. 3. slEconomics Pty LtdIndexSECTION 1.0 – OVERVIEW AND CONCEPTUAL DESIGN 4 1.1 What the Regulatory Design Toolkit is meant to do 6 1.2 Regulatory Design Toolkit architecture and use 10SECTION 2.0 – APPLICATION OF THE REGULATORY DECISION AID 24 2.1 The decision tool 27 - Decision trees for choosing forms of price regulation 31 2.2 Forms of price regulation – key performance characteristics 39 - Price Monitoring 42 - Pricing Principles 45 - Franchise Bidding 48 - Index Approach 52 - Cost Based Approach 56 2.3 Application rules 60 - Choice of target variables (revenue / price caps) 64 - Adjustment factors 66 3
  4. 4. slEconomics Pty LtdSection 1.0Overview and conceptual designOf the Regulatory Design Toolkit 4
  5. 5. slEconomics Pty LtdGuide to Section 1In the first part of this section the basic nature of the Regulatory Design Toolkit (RDT) is explained . The primary nature of the RDT The application space under which the RDT has been constructedThe second part of this section specifies the RDT Architecture and analytical framework, setting out the: Conceptual and analytical framework Data sheets Decision framework 5
  6. 6. slEconomics Pty LtdslEconomicsEconomics Consulting in Utilities and Infrastructure Section 1.1 What the Regulatory Design Toolkit is meant to do Contact: +61 412 599 693 slabson@sleconomics.com www.sleconomics.com 6
  7. 7. slEconomics Pty LtdThe Regulatory Design Toolkit (RDT)The RDT is meant to identify the following as set out in the project TOR  The forms of price regulation available to ESCOSA under the ESC Act  Characteristics, advantages and disadvantages of each form  Relevant market / industry circumstances in which each form would be an appropriate choiceThe RDT is seen as a strategic tool  The logical foundation of the RDT is grounded in both theory and practice, however, for parsimony references to the considerable literature which this work is based on have been placed in a supporting Reference Document.  The RDT does not provide a legalistic or precedent based approach to regulation.The RDT is not a tool for determining if price regulation is warranted.  It will be assumed that that matter would have been resolved prior to use of the RDT, although there would be many common threads to the logic applying to the assessments of forms of price regulation. 7
  8. 8. slEconomics Pty LtdThe Regulatory Design Toolkit (RDT)The primary role of the RDT is to provide a tool for selecting the form(s) of price regulation appropriate forindustry specific application.The available forms of price regulation span a spectrum of options – with the minutia of detailed application oftenhaving a material impact on performance.  It would not be feasible or useful to build an RDT that recommended one unique form for a given application.  The RDT will typically provide a narrowed set of workable options that provide broadly consistent outcomes  The RDT allows the operator to set out in what circumstances one would tend towards specific forms within the sub-set of optionsAn overly mechanistic approach to price regulation is not generally robust to practical application  The RDT has been built with the understanding that application to industry specific analysis would be further assessed by ESCOSA against a range of less tangible factors not amenable to assessment within the RDT.The RDT has been designed such that it is robust to the range of industries ESCOSA may have regard to inthe foreseeable future.  The RDT has been designed to a level of detail that balances robustness against usefully detailed findings. 8
  9. 9. slEconomics Pty LtdThe Regulatory Design Toolkit (RDT) - Reference DocumentThe RDT is supported by a Reference DocumentThe Reference Document provides a summary of how price regulation has been applied in other Australianjurisdictions, as well as a selected set of case studies sourced from domestic and international experience.  The case studies are supplied to highlight innovative approaches and archetypical forms of price regulation.  The Reference Document is to be read in conjunction with the use of the RDT. 9
  10. 10. slEconomics Pty LtdSection 1.2RDT architecture and use 10
  11. 11. slEconomics Pty LtdA conceptual overview of the RDTIdentification of key drivers Forms of price regulation Key characteristics Industry circumstances •The forms of price •Key characteristics of each •The “initial conditions” for regulation defined as form regulatory assessment mutually exclusive •Identifies strengths and •Sets out the circumstances approaches weaknesses of each in unique to that industry which •Spanning the range of terms of stated assessment suggest a particular form of options available to criteria regulation ESCOSA Assessment of preferred formsTo gain an understanding of the conceptual foundation of the RDT it is useful to think in terms of left to right, but theactual assessment will start with the “initial conditions” of the market and industry at hand, and move from right toleft. 11
  12. 12. slEconomics Pty LtdRDT architecture – forms of price regulationCategories of price regulation and application rules Categories of price regulation Application rules The basic forms require specified Describe the practical Description of each form application rules aspects of key operational and key characteristics factors Combinations applied to Application rules can Mutually exclusive forms forms of regulation enhance or diminish key characteristics of Target variables the primary form of Price monitoring regulation (i.e. rev / price cap) Pricing principles Productivity factors Franchise bidding Performance measures Index approach Efficiency carryover Cost based approachThe “pure” forms of price regulation are meant to be mutually exclusive for analytical clarityIn reality, there are only grey areasThe detailed application rules required to operationalise a form of price regulation further complicate matters, and canchange the core characteristics of a particular form of price regulation For example, the choice of revenue or price as the target variable (cap) has clear implications in regard to the regulatory performance of that category of price regulation. 12
  13. 13. slEconomics Pty LtdRDT architecture – assessment criteriaCriteria against which forms are assessed – reduction – and “reduced forms”The assessment criteria have been defined covering the range of factors most relevant to regulatory performance,and that appear to be consistent with the ESCOSA Act . Assessment criteria Reduced form assessment criteria Performance incentives I. Power of incentive mechanism Investment and renewals incentives II. Regulatory risk (Type I & II Error) Allocation of risk III. Information (asymmetry & Benefit sharing revelation) and administrative costs Propensity to allow excess profits IV. Robustness to change and uncertainty  Propensity to allow in-sufficient profits Technological bias (inputs, process, investment choice) Revelation of information / price discovery Predictability of outcomes Robustness to change and uncertainty Facilitate efficient entry Information intensity Cost of administration and compliance 13
  14. 14. slEconomics Pty LtdReduced form criteria explainedThe specified assessment criteria are compactly grouped into reduced form criteria – this sets thefoundation of the RDTReduced form criteriaI. Power of incentive mechanismII. Regulatory risk (Type I & II Error)III. Information (asymmetry & revelation) and administrative costsIV. Robustness to change and uncertaintyThese key concepts are described in the following pages. 14
  15. 15. slEconomics Pty LtdPower of incentive mechanismsA “high powered” incentive mechanism is one in which the firm bears a high proportion of costs at the margin – and likewise captures the benefits from cost reductions  Leads to performance enhancements where better use of inputs, processes and technology leads to lower costs per unit output  Has the potential to lead to performance reductions, when quality of service is a choice variable to the firm and not easily measured, regulated or priced by the market.For example, in the extreme form:  The index approach is a high powered incentive mechanism – where the firm captures cost savings (perhaps benchmarked against an industry average)  The cost based approach (cost pass-through) is low powered – where the firm is largely indifferent to either cost reductions or increases.Practical matters to consider when using a high powered incentive mechanism. Service quality - control and measurement. The regulator may have to set service standards (or payment mechanisms) to off-set the incentive to under provide for quality of service. Not easy to decompose controllable from non-controllable cost shocks – firm probably bears both (force majeure is an example of trying to exclude non-controllable cost shocks from an incentive regime). Probably more appropriate where the two can be separately identified. 15
  16. 16. slEconomics Pty LtdRegulatory risk – Types I & II ErrorThe regulation of firms in the position to exercise market power is in itself subject to considerable uncertainty– with the concomitant risk of either under or over regulating in any given circumstance.Regulatory risk is often considered in terms of risk of over-regulation, where there is the potential for the mis-applicationof price regulation (i.e. from badly designed price controls) to impart net societal costs. The RDT implicitly incorporates the more robust dual framework of regulatory risk which addresses:Type I error - a propensity to ‘under-regulate’ when regulation is warranted – potentially leading to capture of excessprofits by the firm through the exercise of market power.Type II error – a propensity to regulate when regulation is not warranted – potentially leading to insufficient profits tothe firm, and/or net societal costs from regulation.And accordingly:  A form of regulation which has power with respect to Type I error would mitigate against Type I error – thus not as likely to ‘under-regulate’.  A form of regulation which has power with respect to Type II error would mitigate against Type II error – thus not as likely to ‘over-regulate’.There is ultimately a trade-off for the regulator to determine:Forms of price regulation which provide more certainty against the exercise of market power may have the potentialto impart unanticipated net societal costs through poorly designed (inappropriate) regulatory controls.More benign forms of price regulation may have the potential to allow for unanticipated exercise of market powerand capture of excess profits by the firm. 16
  17. 17. slEconomics Pty LtdInformation and administrative costsThe nature of information is crucial to the design of regulationThe preferred form of price regulation will, in part, be determined by information available to the regulator  Asymmetries in information between the regulator and the firm will suggest various forms of price regulation over others.  In some cases, the form of price regulation might reveal market, cost or price information - or similarly - provide more or less incentive to mis-represent information  The costs of information capture for both the firm and the regulator are real and need to be fully considered in the assessment.Examples:Asymmetric informationService quality Revelation of informationAn index based (high power)regime requires ongoing Demand forecasts Administrative costsmeasurement of service quality Revenue caps (or price caps SA ports price caps(where market based based on revenueincentives to supply are requirements) without Based on simple legacydeficient). under/overs adjustment for charges as opposed to a deviations from forecasts can rigorous albeit potentially costly provide incentive to overstate analysis of activity based ports demand forecasts. costs 17
  18. 18. slEconomics Pty LtdRobustness to change and uncertaintyThe various forms of price regulation will have different attributes with regard to change and uncertainty.Anticipated industry and market dynamics might recommend forms of price regulation which better accommodatechanging structural factors. For example:  Anticipated “lumpy” renewals expenditure not closely correlated with increased volumes may suggest implicit or explicit cost pass-through mechanisms.  Anticipated (deemed) productivity enhancements leading to reduced costs may require a concomitant adjustment to price paths.  Anticipated growth in competition which diminishes the risk of long term exercise of market power may suggest more flexible form of price regulation.Uncertain outcomes represent risks that are allocated to the firm or consumers, with some clear and directimplications for the forms of price regulation.  Volume risk is a key factor in regard to uncertainty across the range of forms considered in the RDT – the form of price regulation employed will define the allocation of that risk to the firm or consumers.  Normative analysis typically suggests that risks should be allocated to those that are best placed to manage that risk – identification of controllable and non-controllable risk is the first step in that analysis 18
  19. 19. slEconomics Pty LtdRDT architecture – industry circumstancesIndustry and market circumstances form the “initial conditions” of the assessment.The initial conditions set out the circumstances unique to the industry which suggest particular forms of priceregulation.  The industry circumstances provide a checklist against which the key criteria are assessed.Industry circumstancesIs the industry (or firm) producing at its efficiency frontier? Are there multiple products, services or differentiated customer classes?Is the system at efficient operating capacity? Is substitution in input choice limited by the basic technology?Are there “missing markets” in terms of service quality, Are efficient costs observable by the regulator?and if so, is it feasible to measure and regulate quality ofservice?Is significant capital expenditure or renewals investment Is the data required for a cost build-up easily (cost-in service quality required (expenditure not matched by effectively) accessible?increased sales)?Is there a high degree of concern over the potential to Are service features bundled with competitively suppliedexpropriate consumer surplus through the exercise of services?market power?Is demand responsive to price (high elasticity of demand) Is the market subject to volatility - particularly in regard toand/or the quantum of value significant? volumes or costs?Are there significant spill-overs to other sectors of the Is the market in transition to a more competitiveeconomy? environment with the possibility of new entrants to the market? 19
  20. 20. slEconomics Pty LtdThe decision frameworkUtilising the data sheets, a decision framework maps the relevant industry circumstances to appropriateforms of price regulation.The RDT sets out the key performance characteristics of the regulatory options when applied to a specific industry.It is impossible to determine a unique (or optimal) form of regulation without a pre-defined objective function andformal mapping of relationships.  The RDT is meant to provide a clear set of conditions under which certain forms of price regulation would be appropriate.  A small and workable set of forms will become apparent from the analysis, within which ESCOSA can then consider trade-offs.The RDT provides a compact means of identifying and assessing the advantages and disadvantages stemming fromspecific forms of price regulation when applied to a specific industry setting.ESCOSA will then need to rank close alternatives based on an implicit “regulatory loss function” taking intoconsideration the range of more subjective matters typical to regulatory assessments. 20
  21. 21. Decision tool – overview of designA compact decision tool has been designed which provides a set of four decision trees to be utilised foreach industry evaluation.Power of incentivemechanism Regulatory risk The assessment criteria are grouped by their Information (properties reduced forms - comprising each decision and requirements) tree. Key characteristics of the various forms of Robustness to change price regulation are mapped to industry circumstances. Industry circumstances as inputs Appropriate forms of price regulation are provided as output to the RDT decision tree. Suggested forms of price regulation as outputs 21
  22. 22. Decision tree – the template The decision tree maps the key industry conditions relevant to that particular tree to appropriate forms of price regulation. Reduced form assessment criteria Example - power of incentive mechanismSuggested form(s) Industry condition x (No) Industry condition x (Yes) Suggested form(s)Suggested form(s) Industry condition y (No) Industry condition y (Yes) Suggested form(s)Suggested form(s) Industry condition z (No) Industry condition z (Yes) Suggested form(s) Example - if yes, a high powered incentive mechanism is warranted.Synthesis of forms of price Synthesis of forms of priceregulation suggested by negative regulation suggested by positiveresponses regarding industry responses regarding industrycircumstances circumstancesComments on key factors to Comments on key factors toconsider consider 22
  23. 23. OutputsThe individual decision trees have been grouped such that there would be a tendency to recommend a closerange of forms of price regulation within that grouping of assessment criteria and industry circumstances.However, there may be a tension within or across the major groupings where ESCOSA will have to give a weightingto the various assessment criteria .  For example, in regard to regulatory risk one form might be suggested, whereas in regard to robustness to change a different form might be suggested – ESCOSA will have to determine which factor is of greater importance to resolve this tension.  There could also be conflicting recommendations within a decision tree, where the specific assessment criteria will again need to be given relative weightings to come to a conclusion.The RDT will in these cases provide the key factors that would be considered in such cases – ideally providing clarityto the analysis being undertaken. 23
  24. 24. Section 2.0Application of the Regulatory DesignToolkit 24
  25. 25. User’s guide to application of RDT There are 3 steps in using the RDT (1) Starting with the decision trees that take industry circumstances as inputs to provide a narrowed set options; (2) to be further assessed by reading through the key characteristics sheets; (3) then assessing the choice of key application rules to operationalise the preferred form of price regulation.Step 1 Step 2 Step 3•Work through decision trees in •Read key characteristics sheets in •Work through menu of applicationsection 2.1. section 2.2 for the narrowed set of rules in section 2.3 for the preferred categories of price regulation option obtained in Step 1. suggested in Step 1.•Obtain small (workable) set of •Provides detail on strengths and •Use data sheets in section 2.3 tocategories of price regulation weaknesses of the narrowed set of choose preferred application rules tosuggested by industry circumstances. categories of price regulation be used in conjunction with the suggested in Step 1 – leads to a preferred form of price regulation. preferred option. 25
  26. 26. Guide to Section 2The first part of this section provides a decision tool which suggests appropriate forms of price regulation forgiven industry conditions. Decision trees provide a summary tool which sets out the key industry circumstances to be considered against the assessment criteria – with recommendations for a narrowed set of categories of price regulation as outputs.In the second part of this section, the primary categories of price regulation assessed in the RDT are set outin concise form. A brief description of the form of price regulation is provided The key performance characteristics of each category of price regulation are set out in tabular formThe third part of this section assesses important application rules which have a direct bearing on theperformance of the general categories of price regulation. Critical features of application rules are provided in tabular form, which are to be considered in conjunction with those categories of price regulation in which they might be employed. 26
  27. 27. Section 2.1The decision tool 27
  28. 28. Guide to Section 2.1The first part of this section provides a decision tool which suggests appropriate forms of price regulation forgiven industry conditions. Decision trees provide a summary tool which sets out the key industry circumstances to be considered against the assessment criteriaStep 1•Define the boundaries of the •Work through each decision tree •Where conflicting recommendations areservice being considered for price starting on page 31 of this provided, sort by most relevant criteriaregulation: document – considering the (i.e. if consumer protection is considered assessment criteria for each more important than economic efficiency•Disaggregate the services as industry circumstance factors)required such that industry •Obtain small (workable) set ofcircumstances are are generally categories of price regulationconsistent across the bundled set suggested by industryof services being assessed. circumstances. 28
  29. 29. slEconomics Pty LtdDefining the bundle of services for the purpose of price regulationRelevant industry circumstances may vary between components of the industry or firm which is to beregulated.Where important industry circumstances vary across components of the regulated entity, so would the suggested formof price regulation. For example, the NEC differentiates between “prescribed distribution services” and “excluded distribution services” (i.e. public lighting) whereby excluded services are to be regulated under a more light handed approach. The underlying logic is that industry circumstances (broadly speaking) relevant to the choice of price regulation can and do vary across closely related services.With the above in mind:Workably segmented service bundles must be defined such that it is appropriate to apply a single form of priceregulation to it.Where diverse forms of price regulation are suggested by the RDT, it may be that further disaggregation is requiredfor the purpose of price regulation. 29
  30. 30. slEconomics Pty LtdDecision tool – review of designA compact decision tool has been designed which provides a set of four decision trees to be utilised foreach industry evaluation.Power of incentivemechanism Regulatory risk The assessment criteria are grouped by their reduced forms - comprising each decision Information (properties tree. and requirements) Key characteristics of the various forms of price regulation are mapped to industry Robustness to change circumstances. Industry circumstances Appropriate forms of price regulation are as inputs grouped as output to the RDT decision tree. Suggested forms of price regulation as outputs A comment sheet is provided after each decision tree which further explains the critical factors being assessed. 30
  31. 31. slEconomics Pty Ltd Decision tree – Power of incentive mechanism Power of incentive mechanism Suggested form Industry circumstances Suggested form If no If yesHigh powered forms strongly Is the industry (or firm) producing at Low powered forms of cost basedsuggested to promote cost based its efficiency frontier? regulation can be employed ifproductivity improvements. otherwise warranted.High powered forms strongly Is the system at efficient operating Low powered forms can besuggested to provide incentive to capacity? employed if otherwiseutilise excess capacity. warranted. Are there “missing markets” in termsHigh powered forms appropriate of service quality, and if so, is it Low powered forms limit perversewhere quality is priced or regulated. difficult to measure and regulate incentive to minimise service quality quality of service?High powered forms appropriate Low powered cost pass-throughwhere less need of investment in Is significant capital expenditure or approaches allow for investment innon-revenue generating areas. renewals investment in service non-revenue generating areas (due quality required (expenditure not to missing markets). matched by increased sales)? Price monitoring Pricing principles Cost based approaches Index based approaches Franchise bidding (with targeted cost pass-through clauses) Franchise bidding (without cost pass-through clauses) See next page for additional comments 31
  32. 32. slEconomics Pty LtdExplanatory comments – power of incentive mechanism Power of incentive mechanismIndustry circumstances Explanatory commentsIs the industry (or firm) producing High powered forms provide an internalised incentive for the firm to undertakeat its efficiency frontier? efficient cost reducing initiatives (i.e. in use of inputs, processes, technology and managerial expertise). This factor would be given greater weight where cost reductions are seen as critical. In a rather cost effective and static industry, it might be given less weight.Is the system at efficient The firm captures increased revenue from incremental capacity utilisation underoperating capacity? high powered forms providing an incentive to optimise utilisation of assets. This factor would be given greater weight where there is considerable excess capacity in the system which could be efficiently utilised at appropriate prices.Are there “missing markets” in There can be a perverse incentive to under-provide quality of service under highterms of service quality, and if so, powered forms where it is not either priced into the market, or explicitly regulated.is it difficult to measure and This factor would be given greater weight where it is not feasible to adequatelyregulate quality of service? measure and regulate service standards where there is a willingness to pay for it by consumers.Is significant capital expenditure This matter is closely related to the missing markets matter above. Low poweror renewals investment in service cost pass-through mechanisms may be required where (efficient) renewalsquality required? expenditure is not matched by a concomitant increase in revenue. This factor would be given greater weight where there is the understanding that significant renewals expenditure will be required - and that it is not well funded through increased sales. 32
  33. 33. slEconomics Pty Ltd Decision tree – Regulatory risk Regulatory Risk Suggested form Industry circumstances Suggested form If no If yes Is there a high degree of concernLight-handed over the potential to expropriate Prescriptive price controlsapproaches to price consumer surplus through the suggested.regulation suggested. exercise of market power?Allocative efficiency not Allocative efficiency suggests Is demand responsive to price (highmaterial where demand prescriptive price control. elasticity of demand) and/or theis in-elastic. quantum of value significant? Macroeconomic (generalSuggests light-handed equilibrium) effects may Are there significant spill-overs toapproaches. suggest prescriptive price other sectors of the economy? controls.Flexibility in pricing Are there limited numbers of Prescriptive (uni-dimensional)differentiated goods products, services or differentiated price structures can bepromotes efficient customer classes? considered.(Ramsey type) pricing.Potential for regulatory bias of Regulatory risk in production choice Is substitution in input choice limited is lessened where inputs are limitedproduction choices suggests light- by the basic technology? to fixed proportions .handed approach. Franchise bidding Price monitoring Index based approach Pricing principles See next page for additional comments Cost based approach 33
  34. 34. slEconomics Pty LtdExplanatory comments – regulatory riskIndustry circumstances Explanatory commentsIs there a high degree of concern Prescriptive price controls can provide greater regulatory certainly against theover the potential to expropriate expropriation of consumer surplus through the exercise of market power (orconsumer surplus through the otherwise put – capture of monopoly profits by the firm).exercise of market power? This factor would be given more weight where consumer protection is a primary concern. Economic transfer is the focal point here – not economic efficiency (which is addressed in the next cells of this table)Is demand responsive to price The “dead weight loss” stemming from monopoly prices is directly proportional to(high elasticity of demand) the price responsiveness of demand, and the over-all quantum of value.and/or the quantum of value In terms of simple allocative economic efficiency, the regulatory risk from “undersignificant? regulating” is greater when demand is highly responsive to price.Are there significant spill-overs to Economic efficiency can be considered in either a partial or total analysis. Theother sectors of the economy? total context addresses potential spill-over affects to other services or products. In terms of economic efficiency in a total analysis, the regulatory risk from “under regulating” is greater when there are spill-overs to other sectors.Are there limited numbers of Where there are multiple services or differentiated customer classes differentiatedproducts, services or prices can provide positive efficiency outcomes through “Ramsey oriented” prices.differentiated customer classes? However, the differentiated prices (or cost shifting) implied here has a clear economic impact on individual consumer classes, which may run against the aims of the regulator.Is substitution in input choice Prescriptive price controls can bias optimal input choices where there is thelimited by the basic technology? technical flexibility to do so. For example, a cost-based approach may provide perverse incentive over invest in cap-ex, and under spend on op-ex. This factor is of greater importance t the degree that managers have the ability to make such trade-offs. 34
  35. 35. slEconomics Pty Ltd Decision tree – Information and administrative costs Information and administrative costs Suggested form Industry circumstances Suggested form If no If yesEfficient costs and prices observed by Forms that reveal costs arethe regulator, allowing for non- Is there an asymmetry of information suggested where feasible (franchiseintensive approaches such as on the part of the regulator, and if so, bidding).monitoring or index based price cap. are cost/price comparators difficult to obtain?Low cost / non-intensive forms Informationally intensivesuggested where the cost/benefit of Is the data required for a cost build-up approaches may be warranted (cost-data collection and analysis is not easily (cost-effectively) accessible? based or disclosure rules).otherwise justified.Simple price monitoring or Ring-fencing of accounts may be Are service features bundled withindex will be easy to warranted to separate regulated and competitively supplied services?administer in an effective non-regulated charges.manner. Price monitoring Franchise bidding Pricing principles Cost-based approach Index approach See next page for additional comments 35
  36. 36. slEconomics Pty LtdExplanatory comments – information and administrative costs Information and administrative costsIndustry circumstances Explanatory commentsIs there an asymmetry of If the regulator knows efficient costs and prices (or has valid comparators to use),information on the part of the non-intensive forms such as price monitoring or price caps can be employed.regulator? Alternatively, where the regulator is at a clear disadvantage in regard to information, forms which reveal information (such as franchise bidding) or at least do not provide incentives to mis-represent information are preferred. Forms such as price monitoring or price caps become meaningless or difficult to apply where efficient price are not known and there are no valid cost/price comparators in which to asses monitored prices.Is the data required for a cost Where the regulator suffers from a lack of information, it may be deemedbuild-up easily accessible? necessary to direct the firm to disclose such information, and to asses that against other sources to attain some level of confidence in its accuracy. In this case, the costs of information collection and analysis to both the regulator and the firm should be considered against the benefits stemming from the use of informationally intensive forms of price controls. While a formal cost/benefit analysis would be difficult in itself to undertake, it should be feasible to form a broad (probably qualitative) view of relevant costs and benefits of data collection and analysis.Are service features bundled with Where regulated services are bundled with non-regulated services ring-fencing ofcompetitively supplied services? accounts may be required to mitigate cost-shifting between the two cost pools. Where there is no material bundling, the less informationally intensive forms of price regulation would be easy to administer in an effective manner. 36
  37. 37. slEconomics Pty Ltd slEconomics Pty Ltd Decision tree – Robustness to change and uncertainty Robustness to change and uncertainty Suggested form Industry circumstances Suggested form If no If yesLess flexible forms can be considered Is significant capital expenditure or Robust forms suggested thatthat correspondingly provide greater renewals investment required facilitate investment whereregulatory certainty. (where incremental expenditure is incremental costs are not strongly not matched by increased sales) correlated with incremental sales.Less flexible forms can be considered Is the market subject to volatility -where cost or volume risk is not seen Robust forms suggested that adjust particularly in regard to volumes oras material . to cost and volume risk. costs?Where there is no expectation of Is the market in transition to a Robust forms suggested thatcompetitive entry, franchise bidding more competitive environment facilitate entry by rivals.that excludes entry (ex post) would be with the possibility of new entrantsan option. to the market? Pricing principles Franchise bidding Price monitoring Index approaches Cost-based approaches See next page for additional comments 37
  38. 38. slEconomics Pty LtdExplanatory comments – Robustness to change and uncertainty Robustness to change and uncertaintyIndustry circumstances Explanatory commentsIs significant capital expenditure In many network services, incremental capital expenditure is not stronglyor renewals investment required correlated with increased sales.(where incremental expenditure is • When incremental cap-ex is not closely matched by increased sales, a purenot matched by increased sales) index approach - particularly when based on a price cap – will typically not provide an adequate return on investment, and may require additional side payments or adjustment factors to fund efficient capital expenditure. • When incremental investment does lead to increased sales, the index based price cap will likely provide incentive to invest. In this case, there may be excess returns on investment if scale economies are obtained (which is likely to be the case in network businesses).Is the market subject to volatility - It is important to consider volatility in costs and volumes. For example:particularly in regard to volumes • Price controls do not typically provide the flexibility with regard to cost andor costs? volume volatility that price monitoring and pricing principles would allow for. Price controls will typically allocate windfall gains and losses to the operator. • Further analysis would need to be undertaken to determine if such risk is best placed with the operator or consumers.Is the market in transition to a If there is the expectation that workable competition would develop in the mediummore competitive environment term, transitionary regimes would be put into place. Two key factors to considerwith the possibility of new are:entrants to the market? • Facilitation of entry – ensuring that regulatory structures do not impede competition. • Attention to regulatory risk and administrative costs of more prescriptive and informationally intensive forms of regulation. 38
  39. 39. slEconomics Pty LtdSection 2.2Forms of price regulation – keyperformance characteristics 39
  40. 40. Guide to Section 2.2In the second part of this section, the primary categories of price regulation assessed in the RDT are set outin concise form. A brief description of the form of price regulation is provided. The key performance characteristics of each form of price regulation is set out in tabular form.Step 2•Consider the detailed •Where conflicting •Given the weights (probably subjective andcharacteristics of the narrowed recommendations are obtained qualitative) placed on specific factors,set of categories of price in step 1 – outline those factors determine a preferred category of priceregulation suggested under step which would be given most regulation – setting out the reasons for1. weight in the assessment. choosing between the small set of options considered. 40
  41. 41. slEconomics Pty LtdCategories of price regulation assessed in the RDTThe primary categories of price regulation assessed in the RDT are: Price Monitoring Pricing Principles Franchise Bidding Index Approach Cost Based ApproachThese primary categories are seen as spanning the range of price regulation ESCOSA might consider and have beendefined as a starting basis in which to differentiate key aspects of price regulation.However, in practice, there is more often an overlap between these categories forming hybrids, and the specific detailsin application can have a considerable impact on the key characteristics of the regulatory mechanisms. 41
  42. 42. slEconomics Pty LtdPRICE MONITORINGFor the purpose of the RDT “price monitoring” is more broadly and practically defined as including consideration ofprices, costs or profits of a business or industry, with oversight provision including : Information disclosure – New Zealand’s oversight of electricity wires charges provides an example of the use of information disclosure rules forming the basis of price monitoring (noting that it is currently being augmented by the setting of price thresholds). In that case, distribution businesses are required to provide annual reports on prices, asset valuation and quality of service performance. Monitoring – which could include ad hoc assessments of price adjustments or more formula based trigger mechanism under which a price review would be carried out. Notification of price increases – which allows for light-handed approaches where the proponent develops the framework for reporting, through to rather prescriptive approaches where guidelines are developed under which the proponent is to comply. This form could potentially call for justification on a cost basis - leading in the extreme to a de facto rate of return form of regulation. Setting of prescribed price or profit thresholds – this is the system which New Zealand is apparently moving towards in oversight of electricity wires businesses. Wires charges will be assessed in some form against indexed price paths under which the charges are to sit.Price monitoring can be applied such that it would be an extremely light-handed approach to price regulation, as wellas a rather heavy-handed approach where, for example, prescribed profit thresholds are applied that might lead to ade facto rate-of-return form of regulation. 42
  43. 43. slEconomics Pty LtdKey performance characteristics sheet – PRICE MONITORING (1)Assessment Criteria Transfer mechanism Key performance characteristicsPerformance incentives The more light-handed forms of price High powered incentive mechanism – providing monitoring allow the firm to retain the gains strong incentive for cost minimisation. from efficiency improvements. Profit thresholds would act as a de facto cost Profit thresholds would claw back such based approach – with correspondingly low gains. incentive power.Investment and renewals incentives Flexibility by the firm to charge for capital Appropriate incentives to invest in cost reducing expenditure and renewals where such initiatives. expenditure is aligned with additional Potentially weak incentive for quality of service revenue. related investment and renewals where there is no market for quality of service.Allocation of risk Typically apply an explicit or implicit ceiling Potential for asymmetric allocation of risk. on prices but no support from below in the Wind-fall gains limited from above, but windfall form of a price floor. losses not supported by a floor.Benefit sharing Provides the regulator with the ability to re- Short term benefits captured by the firm – long run align prices to costs where productivity can be clawed back for consumers. gains have been made.Propensity to allow excess or in-sufficient The firm has considerable (short-run) Threat of intervention meant to limit extremeprofits discretion in pricing services. divergence from efficient prices. Requires knowledge by the regulator of If a significant asymmetry of information exists efficient prices. there is greater potential for capture of excess profits by the service provider. 43
  44. 44. slEconomics Pty LtdKey performance characteristics sheet – PRICE MONITORING (2)Assessment Criteria Transfer mechanism Key performance characteristicsTechnological bias (inputs, process, Not prescriptive – does not generally affect Neutral with regard to production choices (inputs,investment choices) the production choice of the firm. process and technology). Facilitates static and dynamic productive efficiency.Predictability of outcomes Flexible form of price regulation. Standard commercial uncertainty – little regulatory uncertainty.Robustness to change and uncertainty Prices typically allowed to vary in relation Can be extremely robust to change and to external events. uncertainty – depending on application rules. For example, petrol prices adjust to real time volatility in market fundamentals allowing for appropriate returns on assets.Revelation of information No internalised revelation of information – Prescribed disclosure of information – but no relies on external disclosure rules. internalised revelation of information through commercial actions of the service provider.Information intensity (requirements) Requires information on efficient prices to An asymmetry of information between the compare against regulator and firm will limit robustness of the monitoring process – typically requires more intensive disclosure rules.Cost of administration and compliance Various levels of disclosure are required Cost of administration and compliance dependent depending on ability of the regulator to on required level of disclosure. assess efficient price levels. 44
  45. 45. slEconomics Pty LtdPRICING PRINCIPLESPricing principles are defined as a form of regulation for the purpose of the RDT and is characteristic of the “light-handed” approach to price regulation, although when cost based reference tariffs are applied becomes more heavy-handed in nature.The use of pricing principles within regulatory structures is well established in Australia, with considerable use underPart IIIA of the Trade Practices Act. Notable applications include gas transport, electricity transmission and distributionnetworks, rail, and telecommunications.In application, pricing principles can and have ranged from truly light-handed approaches in setting out appealsprocesses and dispute resolution mechanisms, to rather prescriptive price setting regimes.An illustrative range of examples includes: Negotiate / arbitrate – possibly under pre-specified guidelines and dispute resolution processes Outcome based – setting out features of pricing, such that it facilitates efficient investment, provides a return on capital, and supports efficient use of the services provided Price bands – such as a floor and ceiling based on stated parameters Reference tariffs – spanning a range from tlight-handed posting of prices, to more heavy-handed application based on pre-specified parameters (for example, recovery of efficient costs)The negotiate/ arbitrate style of this form is most often applied when there a small number of parties purchasingservices, as multiple contracts would usually entail considerable (potentially inefficient) transaction costs. Referencetariffs (or posted prices) can be used where there are a larger number of independent parties to contract with. 45
  46. 46. slEconomics Pty LtdKey performance characteristics sheet – PRICING PRINCIPLES (1)Assessment Criteria Transfer mechanism Key performance characteristicsPerformance incentives Typically price based agreements – with Typically a high power incentive mechanism in no explicit cost pass-through (except for terms of cost minimisation – although cost pass- the extreme form of reference tariffs through limits power for those areas specified. prescribing cost-based approaches). Allowance for rent capture by the operator enhances the incentive to reduce costs though innovation (ie superior use of technology, resources or managerial expertise).Investment and renewals incentives Pricing principles are often used where Pricing principles are amenable to multi- there is a manageable number of parties dimensional price / quality agreements between purchasing services. parties – providing financial incentive to invest in capacity augmentations and quality of service Capacity and quality of service are renewals based investment where there is a parameters that can often be specified in willingness to pay. the contracts between parties.Allocation of risk Risk is usually allocated on a commercial Ideally, risk is priced into the agreements between basis – except for the extreme form of parties and would tend to be allocated on the cost-based reference tariffs, where basis of who can manage it at least cost. demand risk may reside with consumers.Benefit sharing Benefit sharing arrangements are Asymmetry of information may bias the outcome (explicitly or implicitly) agreed to by parties. in the favor of the service provider. Disclosure rules are sometimes employed to mitigate against this - but may fall short of the goal in practice.Propensity to allow excess or in-sufficient Negotiate/arbitrate approach provides the A robust dispute resolution mechanism or use ofprofits potential for workably competitive prescribed price bands or reference tariffs would outcomes in pricing and profits. mitigate against capture of excess profits by the service provider. Prescribed price bands and cost-based reference tariffs used to limit excess Windfall gains are more likely to be captured by profits. the service provider as compared to more prescriptive approaches. 46
  47. 47. slEconomics Pty LtdKey performance characteristics sheet – PRICING PRINCIPLES (2)Assessment Criteria Transfer mechanism Key performance characteristicsTechnological bias (inputs, process, Negotiate / arbitrate provides workably Unlikely to be any technology bias stemming frominvestment choices) competitive foundation for technology this approach – facilitating optimal choice of choices. inputs, processes and technologies.Predictability of outcomes Typically commercial agreements entered Potential for regulatory uncertainty when price into by parties. bands or reference tariffs are applied in a discretionary manner. Prescribed price bands or reference tariffs provide varying levels of discretion to the regulator.Robustness to change and uncertainty Negotiate/arbitrate tailored to market Robustness to change of negotiated contracts circumstances. depends on ability to write complete contracts that anticipate all significant contingencies. Reference tariffs typically set out ex–ante price path. Reference tariffs require review to adjust to changing market fundamentals.Revelation of information No internalised revelation of information – Not relevant. may require external disclosure rules.Information intensity (requirements) Negotiate/ arbitrate typically requires broad Potentially light-handed approach requiring little in procedural guidelines. the way of information. Cost-based reference tariffs can require Application of cost-based reference tariffs can full assessment of firm level expenditures become informationally demanding. and demand forecasts across the regulatory period.Cost of administration, compliance and Negotiate arbitrate typically undertaken for Transaction costs for access seekers / consumerstransaction costs each access seeker / consumer. can be relatively large in the negotiate / arbitrate approach. Reference price typically set price available to any access seeker / consumer Reference tariffs lessen transaction costs to (given ability to provide in a safe manner, individual access seekers / consumers though etc). scale economy in transaction costs. Regulator acts as agent for individuals. 47
  48. 48. slEconomics Pty LtdFRANCHISE BIDDINGFranchise bidding for the provision of services is common within the context of large infrastructure projects thatrequire long term contracts and a high degree of certainty by stakeholders – such as owners, financiers, andgovernments as agents for consumers.Franchise bidding has been employed in the provision of monopoly services such as: Roads Rail Airports Telecommunications Water and wastewater Electricity distributionIn many – if not most cases – end use prices are specified in the supporting concession bids and contracts, which(ideally) facilitates competitive outcomes and revelation of information in the pricing domain. Once assigned, thecontract would prescribe a pricing framework and a dispute resolution mechanism.While there are numerous examples of franchise bidding acting as a substitute for regulation, and entered into bypublic or private parties without any regulatory oversight structure, they have also been extensively used as acomplement to regulation, with oversight by central agencies such as regulators or government ministries. For thisreason, franchise bidding (for the purpose of the RDT) is seen as a form of price regulation.Key considerations in regard to franchise bidding include the ability to design complete contracts that are robust tochanging and uncertain market environments; provide incentives for efficient asset management and renewals; andthat mitigate against the incumbency problem at contract renewal – where it may not be feasible to provide for acompetitively level playing field. 48
  49. 49. slEconomics Pty LtdKey performance characteristics sheet – FRANCHISE BIDDING (1)Assessment Criteria Transfer mechanism Key performance characteristicsPerformance incentives Under franchise bidding, the range of Typically a high power incentive mechanism in service delivery outcomes is specified (to terms of cost minimisation – although cost pass- the degree feasible) in a concession through limits power for those areas specified. contract. Allowance for rent capture by the operator Cost pass-through mechanisms are enhances the incentive to reduce costs though sometimes specified for inputs with innovation (ie superior use of technology, uncertain prices (such as fuel). resources or managerial expertise).Investment and renewals incentives Concession contract may set out Complete contracts difficult to design in regard to investment and renewals profile. investment and renewals. Cost pass-through clauses are sometimes May be a tendency to run down the asset where provided for funding of capital expenditure. the contract tenure is finite, and subject to rebid. Cost pass-through can be utilised as a balancing mechanism to promote investment and renewals expenditure.Allocation of risk Allocation of volume risk usually set out in The concession contract can be designed to the concession contract – typically biased allocate risk in a direct and predictable manner. towards “take-or-pay” provisions or an Volume risk is typically the primary factor to implicit or explicit underwriting of usage. consider – allocated in terms of controllability (ie Cost pass-through provisions can be service provider may be able to increase demand utilised in regard to cost uncertainty. by increasing quality of service).Benefit sharing Contracts set out the nature of benefit As a high powered incentive mechanism, most sharing (or lack of). unanticipated benefits are most often captured by the operator. 49
  50. 50. slEconomics Pty LtdKey performance characteristics sheet – FRANCHISE BIDDING (2)Assessment Criteria Transfer mechanism Key performance characteristicsPropensity to allow excess or in-sufficient Competitive bidding for the franchise Competitive bidding would tend towards an ex-profits provides the potential for workably ante expectation of appropriate levels of profit. competitive outcomes in pricing and Explicit or implicit ex-post adjustments can be profits. used to moderate windfall gains. Contracts typically do not measure or limit Unanticipated or non-controllable outcomes can realised profits – although price levels may drive operator to insolvency. be either pre-set, regulated, or subject to re-evaluation.Technological bias (inputs, process, Contracts can be designed to allow Technology bias can be limited under outputinvestment choices) operator to develop optimal (unbiased) based contract specification. production choices by specifying outputs Cost pass-through mechanisms have the potential rather than inputs. to promote technology bias to those areas covered by such mechanisms.Predictability of outcomes Factors such as service quality and asset While noting the impossibility of specifying management – if measurable – can be complete contracts, predictability of outcomes is specified explicitly in the contract more certain than under the traditional implicit supported by penalty and reward “regulatory contract”. mechanisms.Robustness to change and uncertainty The concession contracts underlying a The long-term fixed nature of concession franchise bidding set out in a detailed but contracts and impossibility of completeness finite set of contingencies . makes them rather inflexible instruments in light of change and uncertainty. For example, technological change or demand volatility can lead to unplanned allocations of windfall gains or losses. 50
  51. 51. Key performance characteristics sheet – FRANCHISE BIDDING (3)Assessment Criteria Transfer mechanism Key performance characteristicsRevelation of information Competitive bids are tendered in securing The competitive nature of the franchise bid has the franchise to provide services . the potential to reveal the workably competitive prices for delivery of the stated service. Service levels, investment and renewals profiles, and design of facilities can be The bidding processes can reveal innovative called for within the bidding environment process designs and management structuresInformation intensity (requirements) The robustness of the contract relies on an The robustness of the concession contract understanding of the nature and materiality requires complete specification of contingencies. of contingencies. The competitive nature of the franchise bid Cost recovery of pass-through items is set mitigates against the need for firm level costs – out in the contract – requiring identification except where costs are passed through. and monitoring of such costs where relevant.Cost of administration and compliance Administrative costs are usually front-end Complex or multiple contingencies will tend to loaded during the bid process for both the increase the cost of contract design and purchaser and provider. monitoring of compliance with prescribed outcomes. Compliance requirements are set out in the contract (ie service quality, availability, Easily identifiable/measurable compliance factors renewals expenditure, etc) lessens the overall costs of compliance. Effective dispute resolution mechanisms are vital to lessening administrative costs 51
  52. 52. INDEX APPROACHThe pure index based approach to price controls aim to provide a light-handed regulatory approach with lowcompliance and regulatory costs through uncoupling allowed prices from the regulated organisation’s costs ofoperation.Importantly, starting prices are assumed to be (reasonably) efficient and taken as given. Allowed price movements arethen typically determined by reference to: general cost index, such as the CPI index measures of efficiency, such as total factor productivity efficient production frontier or best practice benchmarkingUnder the pure approach, if the regulated firm out-performs the external efficiency benchmark, it retains all of theassociated gains and alternatively suffers the consequences of under-performance relative to the benchmark, makingit a very high powered incentive mechanism in its pure form. One consequence is that over time windfall gains orlosses may accrue to either the enterprise or consumers as underlying factors, such as costs or quantities demanded,change.The pure form is most often augmented in practice by either triggers or regulatory review periods which aim to re-alignprices with changing underlying costs and revenue profiles – making it a less powerful incentive mechanism on theone hand, while providing an adjustment mechanism in regard to unanticipated capture of rents by either theenterprise of consumer.The index based approach requires application rules in regard to the target variable – typically applying a form ofrevenue or price caps, with hybrids including revenue yields, and weighted average tariff baskets – each havingsignificant performance characteristics of their own (addressed later in this document).International experience has been that cost de-linked approaches have been adopted within mature regulatoryregimes where the existing price levels and initial cost base are ‘about right’ or in anticipation of transition tocompetitive market environments. In addition, the regulatory regimes included established and effective regulatorydata collection, accounting and decision-making procedures. 52

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