Training course: Economic regulation and electricity tariff setting

Introduction

Economic regulation is needed in areas where no functional competition is possible. For example, electricity networks constitute a natural monopoly and requires regulation to limit monopoly pricing and to set incentives for efficient performance. 

Other activities like generation and supply, which are not natural monopolies, can become de-facto monopolies due to various limitations, and also require regulation. For example, the provision of such services is potentially contestable given the presence of multiple providers in the specific relevant market. 

However, the competitive provision of such services in response to market demand may be limited due to specific legal requirements, limited market size, limited number of companies or existence of operational constraints. 

This training course explores the principles underlying economic regulation including the regulatory fundamentals, price and quality regulation methods, as well as the routines to set revenue and tariff for regulated services. In addition, it describes the role of efficiency analysis and its application in regulation.

Learning Goals

Upon completion of the course, participants will:

• understand the regulatory fundamentals and obtain an enhanced understanding of the price regulation methods.
• become familiar with the technical details used in the regulatory revenue settings, cost of capital, efficiency analysis and quality of supply regulation.
• be trained in the area of electricity pricing including servicing the whole electricity industry. 

The conceptual part of the training will be supported by comprehensive practical exercises throughout the course.

For whom?

This training program is intended for everyone involved in regulated electricity industry e.g. employees of regulated companies, investors, representatives of industry associations, staff of regulatory authorities, officials from policy making institutions.

Course topics

This training course covers six focus areas which touch upon topics related to economic regulation and electricity tariff setting. All modules build up on each other and guide participants step-by-step through the content:

• Regulatory fundamentals (areas, scope & methods)
• Determination of the allowed revenue
• Cost of capital
• Efficiency analysis
• Quality of supply regulation
• Electricity pricing 

Each module is accompanied by examples and practical exercises.

REGULATORY FUNDAMENTALS

This training module addresses first the areas (generation, networks and retail supply) and the scope of regulation (prices, quality of supply, market entry). Furthermore, it explains the economic properties of the different price regulation methods (rate of return, revenue cap, price cap and yardstick) and highlights the advantages and disadvantages of each method. 

Finally, the module addresses selected institutional issues focusing on regulatory independence and regulatory transparency.

DETERMINATION OF THE ALLOWED REVENUE 

Regulators set revenues to allow companies to recover costs necessary to provide the regulated services including a reasonable return to investors. 

This training module explains the major building blocks of the allowed revenue of the regulated activities, namely the operating costs and capital costs including depreciation and return. It also looks at the fuel cost in the context of regulated generation. While in the capital-intensive areas such as networks (and generation) the return is calculated with reference to the allowed rate of return and the value of the regulated assets (regulatory asset base), regulators typically reward electricity retail suppliers through a supply margin (mark-up). This is because electricity retail suppliers tend to have a lower asset base, the value of the tangible assets is relatively small. 

The module draws a special attention on the multi-annual revenue setting for longer regulatory periods in the context of incentive regulation. It explains the design of regulatory formulas to calculate the revenues and the revenue adjustment factors including inflation, efficiency factors, quantity terms, quality incentive terms, loss incentive terms and others. 

COST OF CAPITAL 

The allowed rate of return describes the return the firm is permitted to earn. It aims to adequately reflect the risk of regulated industry and provides return to encourage investments. The allowed rate of return is typically set by using the weighted average of the cost of debt and equity financing (WACC). 

This training module explains the definition and the estimation of the WACC components including cost of equity, cost of debt and capital structure. It addresses the role of inflation and corporate tax for the purposes of WACC setting. For example, WACC may include or exclude corporate taxes (pre-tax or post-tax specification) and can be computed in real or nominal terms, i.e. excluding or including inflation. 

The estimation of WACC is discussed in the context of the application of the capital asset pricing model (CAPM). CAPM calculates the rate of return with reference to risk-free rate (the expected return on an asset which bears no risk at all) and a risk premium that reflects the additional return that investors should require to invest in the regulated assets. In addition to the conceptual part, the participants will carry out several specific exercises that will help them develop understanding the practical WACC estimation. 

EFFICIENCY ANALYSIS 

The purpose of regulatory efficiency analysis is to exploit the efficiency improvement potential of the regulated companies, and to provide them with incentives to improve their efficiency. In regulatory frameworks that apply incentive regulation, the anticipated efficiency improvement targets are incorporated into the allowed revenues set for the duration of the regulatory period. Efficiency analysis is also used by corporate management to set targets for the respective units in the framework of the management strategy. 

In this training module, participants receive insight into the different efficiency analysis methods. The traditional methods for comparative efficiency analysis (benchmarking) include Data Envelopment Analysis (DEA), Corrected Ordinary Least-Squares (COLS) or Stochastic Frontier Analysis (SFA). While DEA is a non-parametric method that uses linear programming, COLS and SFA are parametric methods that apply econometric techniques to calculate relative efficiencies. 

The training module explains the mathematical techniques used by the methods and provides examples of the model specifications (input and output parameters). Furthermore, it outlines the major steps necessary to translate the results of the efficiency analysis (efficiency scores) into efficiency improvement targets (X-factors) and integrate them into the allowed revenue. 

In addition to the conceptual part, the participants will carry out several specific exercises that will help them to develop understanding about the practical application of the benchmarking methods. 

QUALITY OF SUPPLY REGULATION 

Price regulation is typically accompanied by regulation of quality of supply, with the aim of providing orientation of the anticipated (target) quality and preventing from poor quality performance. In line with the classification of the most regulators, this training module groups quality into three general headings: commercial quality, continuity of supply and power (voltage) quality. A range of quality indicators used to characterise the three quality types are provided. 

Finally, the training module describes the methods for quality of supply regulation including requirements to publish quality indicators, setting performance standards or using incentive schemes. The incentive schemes link the quality performance with the allowed revenues and apply reward / penalty provisions reflecting the difference between actual and target quality levels. 

In addition to the conceptual part, the participants will carry out several specific exercises that will help them to develop understanding about the practical use of regulatory quality incentives. 

ELECTRICITY PRICING 

This training module explains the major principles for setting the tariffs of the regulated services and introduces the average cost pricing and marginal cost pricing. The tariffs should reflect the cost caused by the users and enable the regulated companies to recover their allowed revenues. 

The module covers the whole electricity industry chain including generation pricing, transmission pricing, distribution pricing and retail supply pricing (end-user tariffs). It outlines the major approaches and the practical steps for cost allocation in the tariff setting process. This includes aspects related to customer classification, geographical differentiation, time dependency and tariff structure (capacity, energy and/or standing charges). 

In addition to the conceptual part, the participants will carry out several specific exercises that will help them to develop understanding about the practical steps to allocate cost and establish tariffs.

Practical information

For the following items, please refer to the registration form or contact Konstantin Petrov:

• Course dates
• Venue details
• Registration fee
• Payment and cancellation conditions

A few responses from previous participants

• ‘‘After this training I really understand all concepts and methodologies in economic regulation.’’ 
• ‘‘Outstanding presentations and practical excel exercises were very well received.’’ 
• ‘‘The live tutoring and the Q&A session were very helpful.’’