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

[Response by Sophie Trémolet and Diane Binder, November 2010]

Establishing and enforcing performance requirements is a core task of economic regulation. Sanctions of some kind have to be associated with performance targets in order to make them effective. This is especially important in incentive-based regulation, where the company gains if it can find how to reduce costs. Without effective sanctions, the easiest way to reduce costs might be to skimp on quality. [1]

There are a number of different types of penalties, including[2]:

• Monetary sanctions : the company must pay a specified sum of money to a public authority for each instance of non-compliance with the performance requirements. These payments may be fed back to customers, in general in the form of lower prices, or paid to a fund that can for example be used to provide subsidies to economically disadvantaged people.
• Compensation to customers : the payment of compensation for non-compliance with specific indicators is made by the company directly to the affected customers. Verification of the breach is sometimes difficult to establish and the scheme will be less effective where a large number of customers who are potentially hard to identify are affected. This type of scheme tends to be more successful in relation to customer service issues rather than reliability or technical supply issues. In developing countries, it is rarely recommended as it can create a culture of "applying for penalty payments" (even if the event has not occurred) and it can be difficult to monitor.
• An adjustment is made to the revenue requirement for the next control period to reflect divergences of performance from specified target values. This is the approach used by Ofwat in the water and sewerage sector in England and Wales, with adjustment of +0,5% to -1% made on a three-year rolling period to reflect service levels offered by companies.

In the electricity sector notably, there are also a number of market-based solutions, ranging from allowing recourse to legal remedies. For example, the South Australian Independent Industry Regulator (SAIIR 2002) notes that consumers may have recourse to a number of legal options if they suffer loss or damage as a result of the electricity distributor's poor quality power. Distributors may also be liable for breach of contract provisions (in reality, only large consumers would be willing to go down this course of action). Some states in Australia also have available alternative dispute mechanisms[3] such as an Electricity Ombudsman to reduce the costs of customers complaining about service quality.

Penalties can be one-off or cumulative over a certain period of time. It is the case in the regime of "deficiency points" described by Shugart and Alexander (2009). In such a system, points for failure to comply are accumulated over time, say on an 18-month rolling basis: they are ignored if they are over 18 months old. If the total number of deficiency points reaches a certain value at any time, the regulator is permitted to take action, with each type of action corresponding to a level of points. The purpose of this scheme is to provide a framework for discussion between a utility and the regulator, notably about how to deal with chronic poor performance and to provide a reduced discretion rule for when the company's performance is so deficient that the governing authority can terminate the contract. Actions include: sending warning notices to the company; more intensive monitoring of performance; a requirement for the company to produce a remedial plan; a full technical audit carried out by independent auditors; and, in the most severe case, notice of contract's termination.

The effectiveness of penalties depends on the type of contracts and other legal instruments to frame the activities of the companies. Penalties are frequently included in private sector participation contracts. Penalties for non-compliance are most effective when the operator's remuneration is not directly affected by its performance: for example, in the event of a management contract, the management contractor's remuneration is not affected by the overall company's performance (i.e. the performance of the company it is in charge to manage) except in the case of certain contracts where the management fee is made up of a fixed fee and a performance fee linked to company performance. As a result, to strengthen incentives for improved performance, it is common to rely on penalties for non- performance. These can be for all aspects of performance (including not submitting a report on time or not providing adequate data to the regulator, particularly if one key objective of the contract is to improve the quality of data collection).

In conclusion, penalty payments have the effect of providing relatively strong incentives to meet the specified minimum level of service quality, but provide no incentive for the utility to outperform the minimum standard: it is often better to encourage to do (the nature of incentives) rather than to punish for not doing. Other pitfalls of penalties include that in most cases the magnitude of these payments is set somewhat arbitrarily and usually well below the true cost of the inconvenience suffered by the consumers. Besides, when no regulator is in place, applying penalties can be more difficult and subject to political interference.