Regulatory Incentives for Investments in Electricity Networks - CRNI ...

etaining these gains. Sharing schemes have been considered in Australia and the UK in the
context of the building blocks approach used in these countries.
The length of the efficiency carry-over reflects the implied benefit sharing between regulated
service provider and network service users. A long term carry-over mechanism provides a
forward looking framework within which the regulated service provider’s actual costs in future
regulatory periods will provide a better indicator of efficient cost levels. On the other hand,
containing the carry-over not only in the following (second) regulatory period but also in the
subsequent (third) one would increase complexity and delay the process of transferring the
benefits to the final consumers.
The carry-over mechanism should provide sufficient incentives for regulated network companies
to pursue efficiency gains. That is, the benefit that regulated network companies retain at the
margin should outweigh the cost of the efficiency improvement. There is no universal formula
for optimal sharing of gains. The optimal relationship between gains retained and efficiencies
achieved depends on the underlying assumptions regarding the responsiveness of the regulated
companies (in terms of cost reduction and innovation) to changes in the share of efficiency gains
they retain.
It could be argued that the greater the share of the benefits regulated network companies are
allowed to retain, the greater their incentive to make efficiency savings and, hence, the greater
the extent of savings to be eventually passed on to consumers. On the other hand, it is evident
that the greater the share that regulated companies are allowed to retain, the longer consumers
will have to wait before the benefits from efficiency savings are passed through to them.
Furthermore, when deciding on the amount of cost reductions to be carried-over, it is difficult for
the regulator to determine which cost reductions are a consequence of management decisions and
which are windfall profits, resulting for example from changes in input prices. 20
20 There are a range of factors that could cause the regulated company to earn a different rate of return from that
forecast at the initial price review. Some of those factors may be within the control of the regulated company, and
others may be external to them. In principle, there are sound reasons to treat unexpected profits differently,
depending on their source. Some profits may result from influences and events external to the regulated company
(i.e. windfall gains) rather than from its direct actions. It follows that they can be shared with customers at the next
review without having any adverse impact on the incentives of the regulated service provider to pursue efficiencies
that are within their control. Conversely, allowing the regulated company to keep the additional profits that arise
from actions under their control (i.e. controllable gains) for a longer period should give them a strong incentive to
continue making such efficiency gains in the future. A typical example of controllable gains is when the regulated
company may have reduced actual expenditure below that forecast via more efficient use of labour, maintenance and
capital expenditure, and/or by introducing more efficient systems for operations.
Additional profits may result from factors that are not within the control of the regulated company. For example,
general economic growth may have been greater than forecast, or market interest rates may have fallen below those
underlying the original forecasts, and this may have increased revenues or reduced financing costs. While the
principle of differentiating between potential sources of increased profitability appears sound, it may be difficult to
distinguish with any precision those different sources in practice. A significant degree of regulatory judgment will
be required in order to distinguish the different reasons for any gap between the returns incorporated at the initial
revenue setting and those now being achieved by the regulated service provider.
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