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

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

Definition. A tariff structure is a set of rules and procedures that determines how to charge different categories of consumers (Brocklehurst, 2002). Typical tariff structures include: i) flat-rate tariff¹, ii) volumetric tariff based on actual metered consumption (with different variables: constant volumetric tariff², increasing block tariff³, linear progressive tariff⁴ and peak-load pricing) and iii) multi-part tariffs, (including two-part tariffs, where users pay both a monthly fee for access and a usage fee for consumption such as in the water and electricity sectors, and optional tariffs where customers are offered a menu of pricing plans)⁵. Tariff structures depend on many factors, including the network's characteristics and the objectives pursued via pricing policy. The charges may differ between customer classes (such as residential, commercial and industrial).

The tariff structure is either regulated or defined by the operators themselves with minimal regulatory oversight, depending on the degree of competition in the sector and whether the government and the operator have similar objectives⁶. In the water sector in England & Wales, the water utilities have some flexibility in defining tariff structures, as long as they stay within the overall price control and meet a series of principles set by the regulator, including non-discrimination, i.e. a principle according to which there should be no unnecessary cross-subsidy between different types of customers (Ofwat, 2006). An effective tariff structure needs to take into account the following elements: financial viability (ensuring that the maximum allowed revenue is recovered), cost-reflectiveness (charging the customers in a way that reflects the costs plus a reasonable return on investment), efficiency (setting prices at marginal costs) and social acceptability (ensuring that charges are "reasonable" so that all customers receive at least basic services and that subsidies are efficiently targeted⁷) (Groom, Halpern et al., 2006). These criteria may be conflicting and require evaluating potential trade-offs between those principles⁸.

Where a tariff regulation regime exists, tariff structures can be modified either in the context of a periodic tariff review or at a separate time when current tariff structure is found not to be effective and prices need rebalancing. For example, the latter can happen when competition is introduced in a sector where the existing tariff structure would have the incumbent vulnerable to "cream-skimming entry" (Green and Pardina, 1999). For example in the telecommunications sector, a tariff structure implying cross-subsidies among call categories has often been implemented, where high-rate long-distance calls are used to pay for low line-rentals charges to reduce the bill paid by poor consumers. A new company that does not have to serve domestic customers could undercut the incumbent's price for business consumers (using long-distance calls) even if it is less efficient, only because it does not have to pay the cross-subsidy.

Designing an efficient tariff structure can be done through a step-wise approach: i) gathering information about operator's activity and demand forecasts, ii) evaluating the effectiveness of the current tariff structure and the need for reform; iii) announcing the reform and iv) implementing the proposed reform (Green and Pardina, 1999). When the regulator is responsible for tariff setting, it has first to address the inherent information asymmetry by gathering information from the operator. These four steps are set out below:

Step One: Gather information

When starting a review of the tariff structure, the operator or regulator needs to gather information about the current activity of the utility (present and projected operating costs, assets, and investment plans), the demand forecasts (trend analysis, statistical analysis⁹) and feedback from consumers on the actual service and price. Consumers' inputs can be gathered through consultation (UK), public hearings (Argentina), focus groups, appointment of a consumer representative to the regulatory agency board (Senegal), or consumers' associations (Jakarta Consumer and Community Communication Forum) (Green and Pardina, 1999; Muzzini, 2005).

Step Two: Evaluate the effectiveness of the existing tariff structure and the need for reform

• Assess whether the operator is predicting an excessive level of operating costs and investments and estimate the corrected cost of service, covering all justified costs and accounting for all inefficiencies.
• Evaluate economic efficiency: the volumetric charge should be set in alignment to the short-run marginal costs¹⁰ of bringing an additional unit of service¹¹.
• Calculate the revenue requirements: even though there are several definitions, revenues from tariffs are generally expected to cover operating and maintenance costs, depreciation and a return on capital (World Bank, 2006; Shugart and Alexander, 2009).
• Evaluate whether current tariffs are sufficient to cover costs or whether there needs to be an overall tariff increase or decrease in order to move towards cost-covering tariffs. If so in a regulated sector, the regulating entity needs to implement some form of price control¹². In all cases, the operator / regulator need to evaluate whether an equal tariff increase should be implemented across tariff categories or whether an overall rebalancing is needed between services or customer groups.
• If revenues from tariffs do not cover the full cost of service, then subsidies have to cover the difference. Existing subsidies should be identified and their targeting performance evaluated (based on an evaluation of the underlying error of inclusion and error of exclusion.¹³ These should then be adjusted accordingly.

Step Three: Publish tariff decisions (allowing for possible appeals on these decisions)

• Present the results of this evaluation to a broad range of stakeholders so as to build support for reform, with built-in participation mechanisms. For example, the regulator may publish draft determinations first, then organize a formal consultation process on these with sector stakeholders before publishing final determinations. Such an approach allows for better consensus building along the way.
• Provide opportunities for an appeal if the operator disagrees with the price determinations.

Step Four: Implement the proposed tariff reforms

• Identify potential winners and losers from proposed reforms and potentially design compensation or transitional measures (for example, phasing in changes in tariff structure, leaving time for people to adjust their consumption, especially for poor consumers).
• Monitor the impact of tariff reform over time so as to be able to carry out potential adjustments over time.

Particular attention should be paid to poor and unconnected customers, who are most likely to suffer the most from an ineffective tariff structure¹⁴. It is worth mentioning the option of additional or new services, in particular pre-paid meters to mitigate negative impacts.

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. Independent of actual consumption and reflecting the fixed costs of distribution. It is the only possible structure in the absence of metering. It is widely used in industrialized countries such as Canada, Norway and the UK (Whittington, 2002). Back to Content
2. Tariff structure where the bill is purely proportional to the volume consumed (Mathys, undated). Back to Content
3. A price is defined for each consumption block. The block rate and volume are generally different for the different user categories. This strategy is designed to provide minimal amounts of water at low prices to households (lifeline rates), with higher blocks carrying increasing per-volume prices (Mathys, undated). Back to Content
4. The unit price rises linearly with consumption (Mathys, undated) Back to Content
5. See Chapter 5 Section B and all related sub-sections for more details about various tariff designs. Refer also to PPIAF and World Bank Institute studies on water tariffs in South Asia (2002). Back to Content
6. Refer to FAQ on Social Pricing and Rural issues: "when and why the regulator choose not to regulate the price structure, leaving the task to the operating company?", and to Chapter 5 Section B.1 in the BoKIR. Back to Content
7. to FAQ, question: "Do higher income customers benefit more from subsidies than do poorer customers?" Back to Content
8. Refer to FAQ on social pricing: "what procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)?" Back to Content
9. Chapter 5 Section E describes various methods of demand forecasting. Back to Content
10. This term means the incremental change in the cost of providing a good over a "short time horizon" for an incremental change in output. Over a short time period some costs are not escapable; such costs are thus not part of the "short run marginal costs" over this planning horizon. From an economic perspective, the only costs that are relevant to decisions are those that are escapable. Ideally, the volumetric portion of the tariff should reflect the short-run marginal cost. (Brocklehurst, 2002) Back to Content
11. See Chapter 5 Section B.2 and B.3 respectively about Ramsey pricing and multipart prices as solutions towards economic efficiency in a monopolistic sector. Back to Content
12. Price level regulation is described in details in Chapter 4 of the BoKIR. Back to Content
13. Refer to FAQ question: "Do higher income customers benefit more from subsidies than do poorer customers?" Subsidy delivery mechanism should be targeted, transparent and triggered by household indication of demand (Brocklehurst, 2002). Back to Content
14. Refer to FAQ about social pricing. Back to Content