The purpose of Day 1 is to give an introduction into the traditional monopoly price regulatory issues and practices. The following topics will be discussed (lecture times are indicated for each topic).

Introduction; The role and objectives of tariff planning

Overview of the course. Introduction of basic economic concepts: demand, supply, costs, social welfare. Competition and monopoly. Problems with monopoly structure, necessary solution in energy markets: regulation. Role and objectives of tariff planning. We arrive at the conclusion that regulated prices should provide utilities to cover their “justified” costs. Basics on corporate finance and the structure of financial reports.

We have provided arguments that regulation should provide to fulfill the following requirement for regulated utilities: TR = TC, that is, regulated revenue / prices should cover the justified cost of utility operations for a given period. To arrive to that end, we have to make the following steps:

1st step: Assessing historical costs

TR = RB*WACC + Opex + d + T

• RB- rate base. The amount of capital or assets the utility dedicates for providing its regulated service
• WACC- allowed rate of return. The cost the utility incurs to finance its rate base. Include both debt and equity.
• Opex- operating expenses. Costs such as supplies, labor, other items for resale consumed in a short period of time (less than 1 year)
• d- annual depreciation expense
• T- taxes

Issues for discussion:

• RB: capital structure: equity or assets? Book value or re-valued? – and their incentive on investments
• Methods to assess WACC
• Depreciation: actual or estimated. The effect of depreciation policy on the utility’s actual profitability
• Handling taxation by price regulation

2nd step: deciding on whether the audited historical cost is justified: a move away from historic data and the use of benchmarking (simple)

• Network losses: incentives to decrease it
• Judging operating efficiency and its effect on allowed return
• Does legislation allows to use comparative data / benchmarking?

3rd step: Inflating historic cost data

The historic data collected through e.g. a cost audit in order to set a regulated price /tariff is mostly based on audited past data. How to inflate those figures to set present tariffs?

• Qt
• Pt = (RB*WACC + Opex + d + T)/Qt

Issues for discussion:

• Demand characteristics: elasticity, temperature-dependence
• Methods to forecast Qt (e.g. gas)
• Introduction to the tariff day: how to divide TR and Qt across consumer groups?

Until now we assumed that we have the required data for doing the price regulatory job. This section removes this assumption and enters into the practical details of data collection, cost monitoring, economic performance auditing, etc. The process of a rate case.

This section will discuss basic tools of financial analysis that might be used to get a feedback on the effects of regulatory decisions. An overview of risk assessment connected to utility operations is also provided.

Issues for discussion:

• What can we see from financial ratios and what is hidden?
  • Cross-financing within holding companies and their effect on financial statements
• Effects of changes in accounting policy on financial performance (e.g. depreciation)
• Effects of company efforts vs. exogenous shocks (e.g. fuel price changes, financial market developments, product market price developments) on company performance

Case presentation and discussion I.

The purpose of Day 2 is to familiarize students with the concepts and main recommendations of normative economic theory regarding price regulation, and to demonstrate how these ideas should (and sometimes do) come through in practice. The general idea is to start with the most abstract representation of the market and increase realism and complexity gradually towards practical applications.

Introduction

Basic concepts introduced in some depth: demand, supply, natural monopoly, welfare, efficiency (depending on details of Day 1). Inefficiency resulting from unregulated monopoly may be discussed (again).

Basics

Initial assumptions: omniscient and benevolent regulator (no information asymmetries), single product natural monopoly, single time period, no uncertainty. Marginal cost pricing, need for (and problems with) lump-sum transfers to regulated firms. Second best alternative: average cost pricing (= covering justified costs), resulting inefficiency. More complex pricing schemes to reduce inefficiency: price discrimination, non-linear pricing, two-part tariffs. Distributional effects of non-linear pricing.

Multiproduct monopoly. The problem of fixed cost allocation. FDC pricing: inefficiency, arbitrariness. Minimizing inefficiency with linear prices: Ramsey-pricing (information requirements stressed). Non-linear (two-part) tariffs, just as before. Special case for electricity: peak load pricing (the role of capacity constraints).

Information asymmetries. Information and objectives of regulators and firms. (Assumption: no lump-sum transfers to regulated firms, multiproduct monopoly.) Infeasibility of Ramsey-pricing. The regulator is no longer the most appropriate party to set individual prices, but it still needs to control profit levels and inefficiency. Single period price caps. Choice of weights for the price cap (fixed, average revenue, tariff basket). Real world examples of price cap weighting, effects of alternative weighting methods. Yardstick competition and benchmarking.

Dynamic (multiperiod) setting. Revision of concepts: productive and allocative efficiency. The effect of regulatory lag. Cost-plus (rate of return) and price cap (RPI-X, CPI-X) regulation. Pros and cons of each. Real world examples of their application. Dynamic price cap weighting methods, examples. (More on alternative incentive regulation methods on Day 3.)

Other dynamic issues (optional). Commitment problems, regulatory opportunism, resulting underinvestment. Regulatory capture.

Access to essential facilities. Theory of access pricing with vertically integrated firms and a competitive production sector. The problem of cross-subsidization and foreclosure (anti-competitive behavior by incumbents).

Access to networks. General criteria (non-discrimination, transparency). Cost-causality? Congestion and physical laws in electricity transmission. Efficient short term pricing of network access: nodal (locational marginal) pricing. Real world applications, problems and practical alternatives. Postal stamp and zonal pricing, market-splitting, flow-based market-coupling, auctions, coordinated auctions. Examples and expected future developments in Europe (Regulation 1228).

Long-term issues. Incentives for investment in networks, conflicts with efficient short-term pricing.

The presentation should aim for discussing practical issues related to the following topics. Cost structure of network operators (through an example). Connection, capacity and usage charges for consumers. Charges dependent on voltage level. Regional variation or uniformity in access charges, regional cross-subsidization. Inclusion of tariff elements that serve alternative goals (green certificates, stranded cost coverage – more on this on Day 4).

Demonstration of network tariff setting as it happened in a country. Invited presentation on the process of network tariff setting in a given country (primarily the starting price in year 1. dynamic issues – choice of regulatory regime, efficiency factor, etc. – reserved for Day 3). Real numbers and issues. Reflection on Day 1’s and Day 2’s material from a practitioner’s viewpoint. What could and could not be implemented from the normative recommendations. Additional considerations in tariff setting (social, political, historic, etc.)

Case presentation and discussion II.

Exercise

Group work: Designing a network tariff from scratch. Details to be worked out.

The objective of Day 3 is to familiarize students with alternative methods of incentive regulation, mostly its practical side. Lectures should build and reflect on the basics of price cap regulation introduced on Day 2. As opposed to the previous days, the focus should shift towards dynamic issues in regulation, such as encouraging investment, controlling profit levels over time, and designing and implementing the methods that form the long-term basis of a country’s regulatory regime in a given industry.

Two lectures based on topics in incentive regulation (price and revenue caps, yardstick competition, sliding scale regulation). As the theory of price/revenue caps is introduced on Day 2, the focus should be more on questions likely to arise in practice, such as the determination of the efficiency factor or the appropriate degree of cost pass-through. Issues related to service quality may also be discussed here, as it is often alleged that incentive regulation may have adverse effects on service quality.

Incentive regulation in a specific country.

Regulators’ game as played in the ERRA Monitoring Course in December 2005 (with refinements). Discussion of lessons/optimal strategies.

Lunch, sight-seeing tour in Budapest, group work in the evening

The purpose of Day 4 is the discussion of topics that are important extensions of a standard price regulation curriculum: social tariffs and environmental issues. The social impacts of energy policy decisions are especially emphasized, as they often precede or override economic efficiency considerations in price setting.

The following topics are suggested for discussion in these two presentations:

• Special characteristics of energy consumption.
• The evolution of consumption in Central and Eastern Europe, effects of transition to the free market system.
• Effects of different price structures on consumption, selecting the appropriate ratio of cost elements, incentive effects on consumption.
• Questions of affordability, different ways of subsidizing low-income consumers. Political and economic issues involved in subsidizing energy consumption.
• 2 types of differentiated subsidies: 1) subsidizing tariffs 2) direct compensation. Their advantages and disadvantages.
• Cross-subsidization and its consequences.

Final presentations I. 

Environmental issues related to tariffs

The lecture offers a coverage of major environmental liabilities within the price regulated activities in the energy sectors. A theoretical background is provided to distinguish economic efficiency of environmental objectives from cost efficiency of environmental instruments. Neoclassical concepts of environmental economics are going to be presented to understand the social optimum of pollution, the company optimum of pollution, the role of state authorities, the cost effectiveness of instrument design, the welfare effect and scope of regulatory mistake under uncertainty of information.

Final presentations II. 

Final test, evaluation of the course, and good-bye