Price Level and Tariff Design ^{TEN new FAQs Nov 2010}

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[Response by Sophie Trémolet and Diane Binder, November 2009]

The issue of cost pass-through of bulk tariffs arises largely where utility services are vertically disintegrated and where, therefore, the price at which a distribution company purchases the upstream input (such as electricity or gas) has a substantial impact on the price at which it can then sell its own services to end-customers.¹ For example, the profits of an electricity distribution company can be significantly affected by its ability to pass-through fluctuations in the bulk supply price to end customers.

Rationale for cost pass-throughs. A regulated company may face significant costs that are both uncertain and largely outside its control, such as gas price that are indexed on the world oil markets (which are volatile in essence) or the costs of equipment purchased on international markets, which may be affected by currency devaluation. For example, if retail electricity tariffs are indexed only to a general price index (under price cap regulation or RPI-X), an electricity distribution company would be exposed to significant risk from fluctuations in power purchase costs that are driven by factors outside of its control. Even partial or delayed pass-through of such costs could bankrupt a distribution company because such costs may constitute a substantial percentage of its total costs. This was the situation in Brazil until 2001, where the law prohibited adjusting local currency tariffs in electricity until the next scheduled tariff adjustment (once a year). When the local currency (the real) dropped its value against the dollar, and given that electricity bulk purchase costs constituted between 50% and 80% of the utilities' total costs, distribution companies encountered major losses.

A regulated company may face significant costs that are both uncertain and largely outside its control, such as indexation of gas price on the world oil markets (which are volatile in essence) or devaluation of local currency against the dollar. For example, if an electricity utility were forced to charge prices indexed only to a general price index (under price cap regulation or RPI-X), it would be exposed to a significant risk by not being allowed to recover its purchase costs. Even partial or delayed pass-through of such costs could bankrupt a distribution company because such costs may constitute a substantial percentage of total costs. This was the situation in Brazil until 2001, where the law prohibited adjusting local currency tariffs in electricity until the next scheduled tariff adjustment (once a year). When the real devaluated against the dollar, and because electricity bulk purchase constituted between 50% and 80% of the utilities' total costs, utilities encountered major losses.

Design of cost pass-throughs. Defining an appropriate regulatory regime for cost pass-throughs raises two kinds of challenges, as experienced in the power sector. On the one hand, when a distribution company holds a monopoly over a certain geographical area, its retail customers have no alternative supplier and expect the distribution company to purchase efficiently on their behalf: full cost pass-through may therefore encourage inefficient purchasing. Most regulators believe that the purchases will not be "economical" unless the company bears some risk of non-recovery through some regulatory mechanism. On the other hand, a certain degree of cost pass-through may be needed to encourage distribution companies to enter into long-term power purchase agreements with generation companies, in order to provide them with sufficient foresight to invest in generation capacity (Arizu, Maurer and Tenenbaum, 2004).

Many regulators adopt hybrid incentive schemes to overcome the fact that rate of return regulation (which essentially allows all costs to be passed-through) does not incentivize the utility to be cost-efficient and price cap regulation may disconnect the authorized tariff from underlying costs (i.e. prices are aligned with a price index rather than with movements in the utility's costs between reviews)². As a result, regulatory regimes often combine elements of both. For example, price-cap tariff setting regime may pass certain unexpected bulk supply costs on to the customers (for pre-defined categories of costs that are deemed "uncontrollable").³ Alternative mechanisms for costs pass-throughs include the following:

• Allow for full cost pass through: these are usually allowed when a distribution company has limited discretion to influence volumes, prices, risks allocation or choice in procurement (Arizu, Maurer and Tenenbaum, 2004).
• Differentiate between controllable and non-controllable costs: controllable costs are those which are the responsibility of the operator and can be controlled (such as technical losses or labor costs) whereas non-controllable costs are beyond the control of the company (such as the costs resulting from currency devaluation, a change in bulk tariffs, taxes). The examples of many Latin American countries and India are interesting (Tenebaum, 2003, Alexander, I. and C. Harris, 2001): they include automatic pass-through of uncontrollable cost elements and indexing and efficiency targets for cost elements than can be controlled. In the UK gas sector, the regulator used for British Gas a gas cost index, including producer price index, various energy prices (market price of gas-oil, etc.) and electricity component. Each index was weighted to determine the market costs passed through to customers (Green and Pardina, 1999). Determination of costs pass-through can also be made based on a review of electricity and power contracts (which can be conducted either ex-ante or ex-post) and decided in terms of "reasonableness" of costs (Arizu et al., 2004; Shugart and Alexander, 2008).
• Refer to benchmark values, to define a "reasonable" cost for gas or power purchases. Two methodologies exist for doing so: one is to use administratively established estimates of investments and operating costs to define a reference for performance; the other is to use multi-market benchmarks, used as a baseline to compare a company's purchase costs. If the company is able to buy energy at a price below the benchmark, it retains all or part of the difference as an incentive for good procurement. If it pays more, it bears all the additional cost (it is not allowed to recover these costs through tariffs).
• Mandated Competitive Procurement: a mandated competitive procurement process is introduced for most of the energy needs of a distribution company. In exchange for this commitment, full pass-through of the purchase costs is allowed.
• Allow for more frequent adjustments to avoid the mismatch between cost changes and tariff adjustments. In the US, a monthly adjustment allows bulk electricity tariffs to be passed on to retail electricity customers. This system allows mitigating the bankruptcy risk linked to a sudden increase in bulk tariffs⁴.
• Create a tracking account, as it was done in Brazil after 2001. This involves depositing the differences (both positive and negative) between projected and actual power-purchase costs into a special internal account. At the time of the next annual adjustment, the amount of money in the tracking account is added to or subtracted from the then-current level of power-purchase costs⁵. However, this still represents a significant cash-flow risk for the company if it has to wait one year to get compensated, especially in the case of a sudden and sharp increase in upstream inputs, such as the exponential increase in oil prices in 2008.

Related Questions

• Steps - What are the key steps for designing an effective tariff structure?
• Price Path - How does a regulator or a utility design a tariff structure that will gradually align prices with efficient costs over time?
• Cost pass-throughs - Should bulk tariffs be transferred directly to final consumers through adjustment clauses or comparable pass-through mechanisms?
• Peak-load pricing - How can a regulator develop incentives to reduce peak demands, which would require capacity expansion?
• Challenges of incentive regulation – What are the key challenges that need to be addressed when introducing incentives?
• Promoting efficiency – To what extent do incentives actually lead to improved efficiency?
• Efficiency measures – How do you measure the efficiency of service provision?
• Efficiency targets – What are reasonable efficiency targets?
• Rewards for cost-containment – What incentives should a regulator introduce in order to promote cost-containment?
• Performance incentives – How can regulators encourage improvements in specific dimensions of performance?
• Penalties for non-compliance – What penalties are most effective when the operator is in non-compliance with regulatory rules (e.g. for providing data, setting prices, or meeting targets)?
• Incentives for improved performance – How can a regulator develop incentive to discourage energy / water losses?
• Promoting investments – How can regulatory incentives be introduced to promote investment?
• Coverage – How can regulators establish incentives for service expansion?

Footnotes

1. The issue of cost pass-through may arise when the product is on-sold or where the product is a significant input for production: for example, gas is a substantial input for power generation whilst electricity is a major input for water companies. Back to Content
2. Refer to FAQ question: "Price Path – How does a regulator or a utility designs a tariff structure that will gradually align prices with efficient costs over time?" and Chapter 4 Section D in the BoKIR. Back to Content
3. See Overview Section E.1 in BoKIR. Back to Content
4. Bakovic, Tenenbaum and Woolf 2003. Back to Content
5. Ibid. Back to Content