Optimal pricing for sustainability of regulated infrastructure industries

South African Economic Regulators Conference of 2012

Deon Joubert21 August 2012

Main criteria to be analysed

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Full recovery of all prudent costs incurred over life cycle

Price stability

Electricity will be analysed as an example of an infrastructure industry

Costs incurred in generating electricity

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Acquisition cost of asset Operating and maintenance cost (fixed

cost) Fuel cost (variable cost)

Costs incurred in generating electricity(cumulative over life cycle) (illustrative)

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‘Constant’ Rand billion

Costs incurred in generating electricity (cumulative over life cycle, levelised) (illustrative)

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‘Constant’ Rand billion

Levelised Cost of Electricity (or LUEC: Levelised Unit

Electricity Cost)

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‘Constant’ Rand billion

Costs incurred in generating electricity(cumulative over life cycle, discounted) (illustrative)

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Basic regulatory formula for annual electricity revenue determination

AR = PE + O&M + Depreciation + Return on Capital (i.e. %ROA x RAB)

AR/sales volume = ave. tariff

Same as %WACC x total

capital

Note: the actual annual capital expenditure (cash capex) is not directly recovered in the revenue of that year

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Asset related ‘building blocks’

‘Constant’ Rand billion

Basic regulatory formula for annual electricity revenue determination

Revenue

‘building

blocks’

Pays for interest on

capitalPays for

redemption of capital (debt principle or

equity)

Two main regulatory methods* to quantify the asset-related ‘revenue building blocks’ : depreciated historical cost (HC) inflation-indexed or depreciated

replacement cost (DRC)

* in typical cost-of-service type of revenue regulation

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Depreciated historical cost method:

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Illustrative revenue – first operational year of new power station

‘Constant’ Rand billion HC method

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Illustrative revenue – first two operational years of new power station

Note reduction

‘Constant’ Rand billion HC method

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Illustrative revenue – first three operational years of new power station

Note reduction

‘Constant’ Rand billion HC method

Both depr. and ROA

reducing

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Illustrative revenue profile – full operational life of new power station

‘Constant’ Rand billion

Revenue (and tariff)

essentially covering O&M

and PE

PV of life cycle depr. and ROA revenue = initial asset

acquisition cost

HC method

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Severe tariff instability for single asset, at replacement

‘Constant’ Rand billion HC methodReplaceme

nt

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No change in LCOE at

replacement

Tariff instability moderated with multiple assets at regular intervals

‘Constant’ Rand billion HC method

Average revenue /

tariff

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Ave. LCOE

‘Constant’ Rand billion

Significant tariff instability with ‘two assets’* at larger interval

HC method

Average revenue /

tariff

Uncertainty re whether incr. will

happen could cause funding difficulty

* or, two similar groups or ‘batches’ of assets17

Inflation-indexed or depreciated replacement cost method:

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Illustrative revenue profile – full operational life of new power station

‘Constant’ Rand billion DRC method

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Starts lower, ends

higher than on

HC More gradual

reductionPV of life cycle depr. and ROA

revenue = initial asset acquisition cost

Much less tariff instability for single asset, at replacement (vs. HC)

‘Constant’ Rand billion DRC method

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Replacement

vs. HC

Tariff instability well moderated with multiple assets at regular intervals

‘Constant’ Rand billion DRC method

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Average revenue /

tariff

vs. HC

Tariff instability manageable, even with ‘two assets’* at larger interval

‘Constant’ Rand billion DRC method

* or, two similar groups or ‘batches’ of assets22

Average revenue /

tariff

vs. HC

Conclusions Both regulatory revenue methodologies recover all life

cycle costs – an important aspect of sustainability In discounted PV terms the life cycle revenues are equal

to one another (no tariff premium for DRC) and the asset-related revenues are equal to initial asset acquisition cost

HC very vulnerable to significant tariff instability – which could also cause funding difficulty (which could threaten sustainability)

DRC much more stable and robust to large intervals between asset investments (ave. fleet tariff approaches stability of LCOE)

Although both methods only cover cost of existing (not future) assets, the tariff stability of DRC greatly facilitates funding for new assets 23

Thank you

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