International Experience with Productivity Benchmarking in the Regulation of Public Utilities

Ondřej MACHEK, Jiří HNILICA Katedra podnikové ekonomikyFakulta podnikohospodářskáVysoká škola ekonomická v Praze

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Price Regulation of Public Utilities

Methods of price regulation:

• Cost-of-service regulation (COS)

• Allowed revenues = costs + return on invested capital

• Simple and straightforward

• Firms aren‘t motivated to reduce costs and they can invest too much

• Performance-based regulation (PBR)

• Set a maximum price – RPI-X regulation

• P1 = P0 *(1+ RPI – X)

• P1 = P0 *(1+ inflation – required productivity growth)

• Firms have to reduce costs in order to increase profits

• The idea of benchmarking: calculate the required productivity growth according to other, comparable firms

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How to Measure Productivity

• Productivity = Outputs / Inputs

• Total factor productivity => aggregate all possible outputs and inputs

• Two prevailing approaches: Malmquist and Törnqvist

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International Experience with TFP Benchmarking: USA• Telecommunications

• A long history of TFP-based regulation of local telephony operators (local exchange carriers)

• Electricity and natural gas distribution

• Regulation at the level of individual states

• A large number of states employ the performance-based regulation, but only three of them employ TFP benchmarking: California, Maine and Massachusetts.

• Even if at the firm-level, the data are considered to be accurate, there are disputes over whether it is possible to use a nation-wide sample of firms to bechmarking TFP (different firm structure and operating conditions)

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International Experience with TFP Benchmarking: Canada (Ontario)• Regulation at the level of individual provinces

• In 2001, the retail prices of electricity hve been capped which delayed the introduction of performance-based regulation until 2006.

• In 2007, the “2nd generation incentive regulation mechanism” was adopted (PEG, 2006). This mechanism was intended to be a transitional regime until the “3rd generation incentive regulation mechanism” would be established.

• The third-generation mechanism was created on the basis of a negotiated settlement among consultants, consumers, regulated companies and regulatory agency, and was finished in 2009.

• The methodology is still being developed.

• While the first method was designed by consultants hired by the regulatory agency, the second method was designed by consultants of the regulated companies. The resulting X-factor differed by multiple per cents, even if the calculations were based on similar data.

• Until now, TFP analysis outcomes have not directly been used in tariff setting.

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International Experience with TFP Benchmarking: United Kingdom• The UK belongs to the leading countries in implementing the RPI-X regulation

• In practice, UK always used predictions of cost development in the regulatory period (building-block approach).

• Every regulated firm is required to disclose a detailed plan of its development, which is subsequently analysed by UK experts and becomes the starting point of further regulation.

• This approach, also called bottom-up approach, is combined with the top-bottom approach, which includes the analysis of general trends including the development of productivity and inflation rate in the economy.

• X-factor is determined on the basis of a number of quantitative and qualitative factors and studies

• A price decision has about 60 pages

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International Experience with TFP Benchmarking: New Zealand• Before 1995, there was actually no regulation of energy monopolies at all

• Since 1995, the firms were required to disclose data

• Currently, the regulator is setting a “threshold”, which means a certain required level of prices and quality, after the violation of which an intervention takes place.

• The threshold is based entirely on TFP benchmarking

• Currently, the method is being modified so that it takes into account the aspect of quality. Without the aspect of quality, the firms which invest in quality improvements are likely to be penalised rather than rewarded

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International Experience with TFP Benchmarking: Australia• An example of countries which decided not to apply TFP benchmarking and remained

in the building-block regime

• In 2008, three TFP studies have been elaborated by hired consultants

• These studies emphasize that

• TFP analyses are very sensitive to the parameters: inputs, outputs, time horizon, TFP method calculation

• TFP analyses require large, continuous, uniquely defined data, including monetary and non-monetary indicators

• Heterogeneous conditions result in practical issues in comparing companies

• By the end of 2011, Australia decided not to apply the TFP methodology because the absence of relevant market conditions for an efficient implementation of the TFP approach

• However, companies are required to collect relevant data which could be alternatively used in TFP regulation, and they will have the “opt-in” choice to adopt the TFP regulation as soon as a relevant data base will be available

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International Experience with TFP Benchmarking: Netherlands• Small country with small number of distributors

• The electricity market has been fully liberalised in 2004

• Until 2000, a simple cost-of-service regulation was used

• Nowadays, regulated prices are set according to average costs in the industry and TFP growth

• The method begins in 2000, so the time series are not long enough

• The Dutch regulatory framework has been subject to many legal disputes which led to subsequent corrections of individual X-factors. It is possible that these disputes were partly due to the inability of the regulatory agency to explain the motivation and the way of X-factor setting.

• The regulatory method is a rather mechanical one, since the X-factor has been set directly according to the TFP analysis

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Conclusions

• TFP-based price regulation has been used in Anglo-Saxon countries headed by the UK, USA, Canada and New Zealand.

• Energy regulatory agencies in Europe prefer using frontier-based methods in X-factor setting, except of Netherlands, where the TFP approach is applied thoroughly.

• In those countries where TFP method has been adopted, it has been used mostly as an underlying method to price decisions .

• Further, it seems that TFP analysis and TFP methodology design is an area where regulatory agencies rely on external consulting companies.

• If the analysis becomes too complex, regulated firms may not accept the method. It seems that for a successful adopting of the TFP approach, a broader social consensus in needed

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Conclusions

• Data issues are probably a general obstacle for a successful implementation of the TFP methodology. We may recommend starting the collection of relevant data several years before the anticipated beginning of the first TFP-based regulatory period.

• Even if the TFP method is a simple and straightforward one, the experiences from United Kingdom suggest that even a complex method of regulation can be successful. .

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Thank you for your attention

Ondřej MACHEK