Quantitative Techniques for Regulation in Practice Price Control Reviews

Quantitative Techniques for Regulation in Practice

Price Control Reviews

Price control techniques 2

Overview

• Price cap - basic idea

• Key aspects: RPI, X, etc

• The periodic review – Processes, timetables, and consultations

• Approaches to benchmarking


Price cap - basic idea

A basket of goods and services is allowed to rise no faster than the general rate of inflation less a factor X

Rate of inflation is measured by the retail price index:– Well known and understood– Timely


Features of original price cap

• Initially restricted to a “basket” of rentals and local tariffs only

• Much simpler than rate of return.• Incentive for efficiency:

– If firms can cut costs, can keep savings (at least) until the price cap is reviewed in up to five years.


Features of original price cap

• Only temporary for telecoms “until competition arrives”- but possibly permanent in water, gas and

electricity (or parts thereof)


RPI: Expenditure shares formulation

RPI = retail price index (CPI in most other countries)

% change in RPI =(% change in price of item 1

times share of item 1 in retail spending) plus(% change in price of item 2

times share of item 2 in retail spending ) plus(% change in price of item 3

times share of item 3 in retail spending ) plus …etc.


What determines RPI?

1. Input prices e.g. wages, imports, fuel, etc.

2. Share of profit in output• Depends on competition (-), state of demand (+)

3. Productivity growth:• Faster productivity growth => lower RPI

=>higher standard of living (other things equal)• Weighted by importance of each sector• Depends on demand growth as well as

technology


What is X?

• By definition, the amount by which an index of tariffs will be allowed to grow in any year over the next price control period.

• In telecom originally 3% because digitisation was expected to lead to productivity growth 3% faster than the rest of the economy. This was basically a guess, subsequently revised.

• X is sometimes called the productivity factor.


Setting X: the periodic review

Littlechild 1986 on water industry Para 10.20: “In deciding how far to revise X … the economic regulator needs to examine the company’s production methods and investment programme. He must ascertain the scope for cost and price reductions through increased productivity and efficiency and the need for capital expenditure. He needs to predict the consequences of different levels of X on what the company will do, how it will do it, how consumers will be affected and others will react…. So permanent regulation is more complex than temporary regulation.”

• Para 10.21: “It should now be evident that rate of return considerations are necessary implicit in setting and resetting X”.


Key features

• 5 year cycle typically• Consultation on process, and aspects of

detailed work, including draft proposals• Final proposals accepted/rejected by

companies• Competition Commission as appeal tribunal

– (except Airports: integral part of process)

• Based on modelling of cash flows


Main elements of price cap calculations

• Operating costs

• Capital expenditure –maintenance, renewals, growth, quality enhancement

• Return on capital (discount rate)


Overview of Process

• Consultation on framework and processes• Consultation on main issues and how they are to be

dealt with• Submission of business plans by companies• Analysis and response by regulator “draft proposals”• Responses by companies• Final determination• Acceptance or rejection (=> reference to CC)• Implementation and monitoring


Extract from Ofwat web site

For distribution review just completed:• Phase one - Framework and issues • Phase two - Assessment of draft business plans and market research

• Phase three - Decisions and determinations • Phase four - Implementation of price limits and evaluations of periodic review 2004

http://www.ofwat.gov.uk/aptrix/ofwat/publish.nsf/Content/pr04index


Consultations

• Framework and processes– Scope, timetable, methods of working, definitions, possibly

the financial model• Analysis of components:

– Efficiency– Costs of capital– Capital spending

• Draft determination– Prospects for prices

Example:http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/

3939_DPCR_Main%20doc_july03.pdf


Checks and balances

Necessary for confidence building:• Consultations at each stage• Reference to Competition Commission

– On substantive issues

• Judicial review– On procedural issues: Reasonableness e.g. in

recent cases was reason for decision sufficiently well supported by explanation and analysis?


Non controllable components of opex

E.g.:• Rates• NGC exit charges• Costs of work done for other parties e.g. local

authorities


Cost drivers

Electrical system costs: optimal layout given demand patterns

number and distribution of customers

maximum demand at various points

provision for responding to faults, repairs, damage, etc.

deviations of actual from optimalgrowth, churn, etc.

Non system costsBilling, finance, regulation

some fixed elements, other related to customer numbers


The frontier

• Minimum possible costs, given the cost drivers

Cost

Cost driver

Theoretical frontier

Empirical frontier


Investigating the frontier

• Engineering investigation of practices:– intrusive, subjective

• Comparative analysis– limited by paucity of observations

• transco, NGC: no real comparators– but some use of inter-zonal comparisons in gas dist.

• Distribution companies: 14 observations per year

• International benchmarking? Difficulties• (Make deductions about relative importance

of cost drivers from foreign studies?)


Types of comparative data analysis

•Simple cost ratios

•Regression analysis

•Data envelope (DEA) and other frontier techniques

Combination of cross section and time series? (panel

data)

Some scope for international comparisons, limited by

data definition issues.


Movement of the frontier

• Total factor productivity (“TFP”) analysis– compares movements of outputs and of inputs– long term trend– Energy industry plus other “similar” industries– Overseas industries


Example: Distribution costs


Composite output 1999

Component Relative weight

Customers 1.00

kWh 0.25

Network length 0.25


Engineering analysis 1

In order to assess the potential savings available to each PES, a number of techniques were applied as follows:

—a cost per network kilometre benchmark of £575 per km, based on costs from four "top" PESs;

—"engineering cost" based on a profile of its network assets using a best practice cost per asset;

—comparison of historic savings achieved -- four of the top PESs achieved savings in engineering costs of up to 40 per cent from 1994/95 to 1997/98: in addition, the extent of savings in costs from 1990/91 to 1994/95 was also considered;

—a review of each PES’s engineering organisational structures, field efficiency and operating practices;


Engineering analysis 21) methods of cost reduction in past

2) plans for future

Examples:

•new terms and conditions of employment

•increased condition monitoring of assets

•staff multi-skilling

=> range of estimated savings feeding into targets


Key issues for operating costs

•How much productivity gains for the whole sector? •How much weight to put on “efficiency" findings?

–How much of residual is efficiency?–How much of efficiency gap to be made up?

•How quickly should companies approach frontier?•How long should companies keep productivity benefits?

–P0 versus X–five year profile issues

Informed by analysis of past reviewsHow well did companies forecast?How far did they all surpass targets? How well did efficiency scores predict efficiency gains?


Further Reading

1. On the origins of the price capThe UK model of utility regulation. CRI. Papers

by Littlechild and Stern2. Visit Ofwat and Ofgem websitese.g.

http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/5429_Elec_DPCR_second_consult_maindoc_18dec03.pdf

3. For an analysis of Ofwat’s efficiency models one by one: http://www.staff.city.ac.uk/j.s.cubbin/Consulting&Policy/Water%20UK%20Assessing%20Ofwat%20Final140404.pdf

Documents

Quantitative Techniques for Regulation in Practice Price Control Reviews