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

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

The overall regulatory framework within which a company operates plays a large role in determining this company's incentives for investment. The sunk nature of many investments by utilities means that investors are vulnerable to governments or regulators changing the rules of the game. Regulators should therefore strive to develop a stable environment and can adopt specific approaches to incentivize utilities to invest sufficiently to expand the network while promoting efficiency and equity[1]. In developing countries specifically, the need for new infrastructure development is vast and regulators, while encouraging investments, must not encourage gold-plating [2] and inefficiencies.

Regulatory decisions that can promote (or discourage) investments include setting the allowed return on capital, the definition of the asset base and the link between cost allocation and tariff structures. These elements are examined below.

Determining the allowed revenue, i.e. the allowance for operating costs and the remuneration on the capital invested.

• Operating and maintenance costs may be divided between controllable costs on one side, for which the company may be allowed to keep efficiency savings for a determined period, and non-controllable costs , which are driven by external factors, and can be subject to cost pass-through[3]. The regulatory lag as well as the set target for cost-containment [4], and the level of cost pass-through are all substantial factors in determining the incentives of the company to further invest in the network.
• Investors must be remunerated based on the opportunity cost of the capital employed (which is proxied by the allowed rate of return and reflects the cost of both debt and equity financing) plus the cost of depreciation. The former must be estimated close to the actual cost of capital: if the allowed rate of return is above the cost of capital, the operator will have an incentive to over-invest (this is referred to as the Averch-Johnson effect [5]); if the allowed rate of return is below the cost of capital, the operator will be earning less than it needs to be financially sustainable. The estimation of the allowed rate of return is therefore one of the critical issues that must be settled by regulators[6]. In some situations, regulators have allowed differential rates of return on new investments as an incentive for companies to promote network extension. For example, when investment in Terminal 5 at Heathrow Airport was being reviewed at the 2002 price determination for London airports companies (owned by BAA), the regulator (the Civil Aviation Authority) proposed that the project should be handled separately and that a higher rate of return be allowed. They reached that conclusion as they estimated that T5 faced higher risks than the rest of the airport operator which meant that a higher rate of return should be allowed. The Competition Commission, which also reviews pricing determinations for airports recommended instead to deal with all investments together and to allow a higher cost of capital overall (Alexander and Harris, 2005).

Inclusion of assets in the regulatory asset base : Issues surrounding controllability and predictability of investments are important in infrastructure investment and have prompted regulators to develop a range of approaches to identify those assets that can be included in the regulatory asset base and at what price, the most common approach being estimating the needed investment made at the time of the price determination (ex-ante) and adjusted with the out-turn figures when the ex-post review occurs. This approach is used in most of the regulated UK industries, the Manila water concessions and most of the regulated Australian industries. Several implementation issues arise from such an approach, for instance the timing of the switch from ex-ante to ex-post figures (options include at the next price control determination or on a rolling basis) and the level of intrusiveness that should be used in estimating ex-post figures with, for example, issues about whether to include costs according to the concept of "used and useful", current utilization of assets or the outcome of investment decisions.

Cost allocation and revenue recovery issues : The design of the tariff structure is an important element of regulatory treatment of investment and can have a significant impact on incentives for investment and the risk allocation. The tariff structure can have a substantial impact on the incentives to invest in specific areas, such as for coverage extension.[7]This includes connection charging (up-front or ongoing payment, whether the risk of investment is shifted to the consumers or stays with the operator), the extent to which investment costs associated with a specific user will be reflected in the charges that the user pays (deep vs. shallow pricing[8]), replacement expenditure (whether they are considered as capital or operating expenditure) and pre-payment (whether some existing users should meet some of the costs associated with long-term investment, i.e. whether assets in course of construction should be included in the regulatory asset base).