REGULATION: PURPOSE, HISTORY, AIMS AND MODELS By Ali Nawaz Memon
Need and purpose of regulation • Monopolies must be subject to regulation • Electricity business is a natural monopoly • capital intensity • Minimum required economic scale • Fluctuating demand • Essential product for community • Involves direct connection to consumers
Potential exploitative power by producer • Political and social demand for social control of electricity due to: • The essential nature of the service • The non-storability of the product • The dependence of the consumer upon the supplier
Regulatory Aims • Protect consumers from abuse by firms with substantial market power • Support investment by protecting investors from arbitrary action by public sector • Promote economic efficiency
Regulatory Challenges • Utility prices are political - there are no votes in increasing prices • Investors are aware of political pressures and seek a credible commitment to rules that ensure an opportunity to earn reasonable returns • Long-term nature and large magnitude of required capital require credible commitment, otherwise the cost of capital will be high
Types of regulation • Different types of regulation • economic • technical • safety in nuclear units • waterflow in hydro plants • environment • emissions standards • Riparian issues • Focus on economic regulation • objectives • what is the public interest • approaches • how it is done • structure • how it is organized
Objectives of economic regulation • Competition • promote & facilitate competition • promote increased efficiency • Prices • ensure that suppliers are financially sound • Quality • provide sufficient investment in power system
Regulatory Models • Basic design questions • History of regulatory solutions • Models based on industry coverage • Price regulation
Some Basic Model Designs Questions (1) • Should the regulatory entity have jurisdiction over one industry, one sector or several sectors? • How much discretion/authority to give to the regulator? • What are possible paths towards setting up a regulatory commission? • What will be role of the line minister in comparison to that of the regulator?
Some Basic Model Design Questions (2) • Why “independent regulatory agency”? • What should be the start up strategy? • Should there be a single regulator or a commission? Or what should be decision-making structure? • How do you select regulators? • How do you fund the regulatory commission?
History of regulatory solutions • Focus on balancing interests of producers and consumers. • Historically soutions constrained by politics, history, endowments/ resources, technology, and the state of economy. • USA has gone the way of private ownership and minimum state control (?) • UK with more state control?
Regulation in relation to ownership structures • Entirely publicly owned and hence directly subject to political control and access to funds • Entirely private but regulated • A mixed system in which the private sector is implicitly controlled e.g. by the potential of being taken over by the public sector (case of many developing countries where private sector exists)
Regulatory Approaches developed todate • Independent regulatory agencies • Ministries directly handle most regulatory responsibilities • Ministerial regulatory agencies
Independent regulatory agencies • Independent regulatory agencies separate from the ministry have been established in Australia, Canada, Finland, Ireland, Italy, Portugal, UK, and the US and are planned in Denmark and France. • These agencies often cover both gas and electricity.
Independent regulatory agencies (2) • They are governed by a collegial board, and operate on the basis of public consultation and other transparency enhancing procedures. • In countries with a federal organisation there are often regulators at the federal and state level with the former specialising in wholesale electricity trade and transmission, and the latter concentrating on retail trade and distribution.
Ministries directly handle most regulatory responsibilities • This is the approach currently taken in Austria, Belgium, Germany, Greece, Japan, Luxembourg, New Zealand, Spain, Switzerland, Turkey. • In three of these countries – Belgium, Luxembourg and Spain- an independent advisory agency assists the ministry.
Ministerial regulatory agencies • These are organizations subordinated to the ministry but set to operate autonomously in the day-to-day management of regulatory affairs. The scope of their activity is similar to that of independent agencies. This is the approach adopted in Hungary, The Netherlands, Norway, and Sweden.
Other Regulatory Options • Industry Coverage • Industry specific- separate agency to deal with each sector e.g. power, water, gas, telecommunication (UK and Argentina) • Sector wide—one agency for each broadly defined sector e.g. energy sector to include power, gas (FERC in USA; Hungary ;Columbia) • Multi-sector – single agency for all or most utility industries (electricity, water, gas, telecoms.) e.g. state level regulators (Brazil, USA); national regulators (Jamaica, Costa Rica, Panama)
Price Regulation Approach
Objectives of Price Regulation • Recovery of costs • Fostering climate conducive to investment • Consideration of government policy • subsidies, job growth • External economic considerations • inflation • Costs beyond reasonable technical and commercial standards are not borne by customers
Principles of Rate MakingRate of Return • Traditional US system • Prices based on historic test year • Prices set to allow profits for rate of return • Costs assessed on prudence • Investments assessed on “used and useful” • Profit volatility minimized • Prices stable
Rate-of-return Regulation (USA) • This form of regulation provides full recovery of company’s all reasonably incurred investments through rate application. • The basic structure of rate of return regulation is that the firm’s prices are frequently set, typically each year, to maintain a given rate of return on capital employed.
Price-cap Regulation (UK) • Through this form of economic regulation, the prices are set in relation to movements in some general price indicator. It is further adjusted on the basis of expected productivity improvements of the industry. • RPI-X RPI= Regional Price Index x= Expected productivity improvement
Other Ratemaking Methods • 1) Yard-stick Regulation (tariff adjustment based on results of comparable utilities) • 2)Conduct Regulation (tariff adjustment granted on basis of agreed conduct in relations to operating cost, investments etc) • 3) Revenue caps • 4) Trigger points for incentives