The Role of the Revenue Requirement

1. The Role of the Revenue Requirement • Revenue Requirement • Operating cost • Capital cost • Firm is allowed to make a return on investment called allowed revenues, valued added of the regulated activity, permissible revenues, rate base, regulated revenues, tariff base, total revenues, revenue requirements • Determining revenue requirements • Investments must be prudent • Used and useful • Known and measurable

2. Factors affecting the revenue requirement • The test year • Used to forecast future costs under normal operations • Past years • Future test years (actual data & projected data) • Vetting costs • Determining what is known and measurable can vary between regulators • Costs • Private vs. social • Original vs. replacement • Short-run vs. long-run

3. Calculating the Revenue Requirements • RR=O&M+A&G+T+D+(WACC*RB) • Operation and maintenance • Administration and general • Depreciation • All taxes • Weighted average cost of capital (represents capital plus rate-of-return and includes income taxes) • O&M+A&G • Deferred (recovered) vs. accrued (not recovered) • Different rate classes (resid, comm, indust) • Direct vs indirect (joint and common costs)

4. Chapter 12 – Alternatives to Traditional Regulation • Public Ownership • Opposite of ‘free market’ • Private vs. public ownership based on efficiency • Meyer (1975) study of electricity utilities • Public ownership has lower AC • Ownership vs regulation? • Pescatrice and Trapani (1980) • Public ownership lower AC • Controls for different techonolgies (public has more hydro and less capital) • Controls for input prices • Caused by regulation • Atkinson and Halvorsen (1986) • Control for competitive vs monopoly market structure • Only examines steam generation • Finds no cost difference between the two • Both are inefficient

5. Franchising • Award one firm an exclusive right to produce and sell the good in a particular market. • The firm that wins the right is one of many bidders. • Competition among bidders should drive the price down. • Production Technologies alone does not justify regulation • Contract must be well-specified. • Consumers must be knowledgeable in price-quality tradeoff • New bidders must have access to existing capital

6. Demsetz (1968) • Similar to example of weak monopoly with no barriers to entry • Contestability Theory • Does not work for strong natural monopoly

7. For Franchising to Work • Determining winner on well-specified criteria • Price • Quality • Reliability vs price • Duration of contract must be specified • Long term contract – more durable • Short term contract – easier to punish for bad quality • Setting price • Ensuring multiple bidders with equal footing • Existing supplier’s capital • Price? Fair-value? Competitive purchase? Depreciation? • Agency to run negotiations • Engineers, legal, accountants, and economic experts

8. Regulating Quality • Create Incentives to promote cost-minimizing behavior • Adopt penalties for inefficient behavior and decreased quality • Difficulties to measure quality • Electricity • Reliability • Average Heat Rate of Baseload Generators • Passenger Trains/Railroad • Punctuality • Car-cleanliness

9. Alternative Regulatory Structures vs COSR • COS regulation and regulatory lag • Performance based regulation (PBR) (reduce costs) • Incentive regulation • Price cap regulation • Sliding Scales • Partial Adjustment Mechanisms • Yardstick competition (reduce asymmetric informations) • All three share a common structure shown but differ in the rules they set. • Revenue Requirementtariff model(rules)prices and conditions for service

10. Incentive Schemes (PBR) • All of these methods provide incentive to reach a specified objective • Vary greatly by industry and objective, but the theoretical model typically used to analyze them are the principal-agent problem. (Joskow and Schmalensee 1986)

11. PBR • Provides incentive to firms to increase operating efficiency • Firms can increase ROR by decreasing their operating costs • Reduces the regulatory lag (time between actual costs occur and the time those changes affect RR and COS) • Firms face a set price

12. Price Caps • CPI-X plan • Regulate firm is constrained so that a weighted average of its prices increase by no more than the CPI less X percent • Pros: • Possible cost reduction, incentives for cost-minimization • Protest core customers from monopoly prices • Reduces regulatory burden • Problems: • CPI vs. other price index • Still need to visit rate of return periodically

13. Yardstick • Best in industries with asymmetric information • Prices are based on the AC in the industry so firms compete and the most efficient firms are rewarded • Problems include • Collusion • Comparability • Commitment

14. Incentive Schemes • 1) Cost-plus mechanisms are rarely optimal. • Regulatory lag, partial adjustment, and using fuel price indices can increase the incentive to search, negotiate, and use forward markets • 2) Scheme should depend on economic conditions • Uncertainty requires more flexibility. Frequent regulatory modification (short vs. long run impacts)

15. Incentive Schemes • 3) Compensation measure should focus on overall measure of performance. • Examples, using CPI as benchmark, or emphasizing the electricity-generating unit availability • 4) Developments not under managerial control should not be rewarded or punished • Examples, risky cost or demand conditions (nuclear plant shut down) should be reflected in the rate of return

16. Incentive Schemes • 5) Long-run viability cannot be jeopardized • If rewards only occur when prices are low, then prices may rise • 6) A firm commitment to stick to incentive mechanism will be difficult • Political feasibility

17. Incentive Schemes • 7)New schemes must be easily compared with traditional regulation • Needed in order to gauge impact • 8) Perfection is not possible with incentive schemes • Some programs can result in greater incentives for cost minimization and should be given priority • Regulation is not a zero-sum game