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

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R t = R t-1 (1 + CPI t - X) where: R t CPI X t is the limit on prices, or on revenue is the growth rate of a general (consumer) price index is a factor that reflects the assumed rate of efficiency increases and other relevant factors is the year index This formula shows that the cap or upper limit on either revenue or prices in the current year, year t is set equal to: • the upper limit in the previous year; • adjusted for general price inflation (the “CPI” term) and the assumed increase in efficiency net of the effect of other factors (the “X” term) This is the essence of cap regulation, though in practice other variables tend to be added to the formula. Often these variables represent costs that are passed through in full to the consumer, usually because they are outside the control of the service provider. They may also represent costs related to a performance target, e.g. the allowance for network losses where the target is a specified percentage of network losses. We provide further details on the application of caps in the next sections. 3.3 Yardstick Regulation The third general category of price control regulation is yardstick regulation. Under this regulation prices or revenues are linked to the average industry performance. Yardstick regulation is not, or at least not completely, based on an assessment of the cost position of individual service providers but upon a comparison of prices or cost positions and cost determinants between firms. 7 For example, under a "yardstick" mechanism based on cost information, service providers are not allowed to charge higher prices than a particular statistical mean that is calculated over costs of all service providers, unless perhaps different prices were justified by their "special operating conditions". Yardstick regulation for electricity distribution is currently applied in Norway and the Netherlands, though in quite different forms. The Norwegian model partially links the allowed revenue to a cost norm. The cost norm is set annually using benchmarking analysis and taking into account any differences in external conditions. The benchmarking for electricity distribution applies a Data Envelopment Analysis (DEA) using a national data sample. 7 For a discussion of the theoretical effects of yardstick regulation see for example Tangerås (2002), Yatchew (2001), Weyman-Jones (1995) or Shleifer (1985). 6
The Dutch model of yardstick regulation is based on the use of a general efficiency factor for all regulated distribution networks. The general efficiency factor is set equal to the average change in productivity of all network operators measured ex-post. The application of yardstick regulation is planned in Sweden and was also discussed in Germany and a number of other countries as a long-term option, after the application of several regulatory periods of revenue-cap regulation. 3.4 Rate-of-Return versus Cap Regulation The key difference between cap and rate-of-return regulation is that with the latter, the upper limit on prices or revenue is normally determined directly from actual costs in the previous year. While in the case of cap regulation, the limit is normally determined from the limit in the previous year. 8 Hence under cap regulation the allowed prices/revenue are determined independently from last year’s actual costs. The service provider is able to keep completely or partially the cost savings it makes in the period between two regulatory price reviews above the assumed efficiency requirements. Compared to rate-of-return regulation, cap regulation provides stronger incentives to reduce costs; it can be argued that the longer the time between reviews, the stronger the cost reduction incentive. Through weakening the relationships between actual costs and regulated prices, cap regulation minimises some of the deficiencies of rate of return regulation. It avoids the need to review prices frequently and can arguably provide greater price stability. However, cost reductions should not be achieved by prohibitive regulatory arrangements that would not allow investors to earn an adequate rate of return. In setting the caps, the regulator will need to ensure that their level is sufficient to cover not only the efficient operation and maintenance costs, but also the capital costs of efficient investments. In economic theory rate-of-return regulation is generally associated with overinvestment and cap regulation with underinvestment. 9 Furthermore, it is also reported in economic literature that cap regulation can result in lower levels of quality of supply. 10 The empirical evidence on the impact of the regulatory regime (rate-of-return versus cap regulation) on investment is however much more mixed. While some empirical papers provide evidence that investments are indeed higher under rate-of-return regulation, other papers provide evidence that investment levels are not affected or are actually higher under models of incentive regulation. 11 What might actually be the case is that regulatory regimes named as rate-of-return or incentive regulation by the respective regulators and regarded as such in these empirical studies, do in fact represent quite different regulatory models in different countries and sectors. Unless the specifics of a regulatory 8 Depending on the types of caps, the limits can be set on the basis of cost projection (linked caps) or automatic formula adjustments (unlinked caps, see further below). It both cases prices / revenues during the regulatory period are decoupled to the actual cost development. 9 See for example Joskow (2008), Armstrong, Cowan, Vickers (1995) and Cabral and Riordan (1989). 10 See for example Kwoka (2009), Elliott (2006) or Liston (1993). 11 See for example Cambini and Rondi (2010), Vogelsang (2002 and 2010), Égert (2009), Ai and Sappington (2002) or Greenstein, McMaster and Spiller (1995). 7
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