cerc discussion paper (june 2003) it is time to say goodbye

1
CERC DISCUSSION PAPER (JUNE 2003)  

• IT IS TIME TO SAY GOODBYE TO
• AVAILABILITY BASED TARIFF
• PRESENTATION BY
• DR. M. R. BHAT
• AND DR. AJIT KARNIK
•  
• WELCOME OPTIMAL TARIFF
• HEARING AT NEW DELHI
• November 12, 2003

2
WHAT IS THE PROBLEM?

• Problem lies in structure and application
  of Availability Based Tariff.
• Mandatory Plant Availability Factor poses serious
  limitations.
• Availability Based Tariff does not motivate
  investment and facilitate objective Optimization
  of Capital Investment.
• Other limitations of Availability Based Tariff
  are forwarded to CERC.

3
WHAT IS THE SOLUTION?

• Solution to Problem is to
• Discard mandatory Plant Availability Factor, as
  is done in limitation-free Optimal Tariff.
• Adopt Optimal Tariff (based on holistic
  application of optimizing principles of
  economics), on an imperative basis, in lieu of
  Availability Based Tariff.
• Solution offers several advantages.

4

WHY THIS SOLUTION?

• Over-investment - inevitable under Availability
  Based Tariff - is negated in Optimal Tariff,
  based on new concept of Optimizer - which is the
  unique optimal value of Risk Premium for given
  values of its associated variables.
• Optimal Tariff maximizes social welfare and
  motivates investment, in an economy facing
  shortage of funds and risks.
• Power Producer, Consumer and Regulator are
  treated equitably.

5
SECTION 1 OF 4APPROACH TO FORMULATION
OFOPTIMAL TARIFF
6
Optimal Tariff Components

•  
• Method 1.
• Theory of Behavioral Patterns.
• Performance Incentive.
• 4. Optimization Strategy.

7
Optimal Tariff Features

• Optimal Tariff lets Power Producers to  
• Respond to needs of society and also power
  system.
• Earn fair Profit plus Performance Incentive for
  good performance.
• Avoid conflicts on who is to generate what, when
  and why, regardless of ownership of plants.
• Optimal Tariff is based on conventions/
  simplifications (available with CERC), which do
  not distort its practical application in power
  generation industry.

8
Rate of Return in Optimal Tariff Elements

• Risk Free Return.
• Normal Rate of Profit, when risks are minimal.
• Risk Premium, in addition to Normal Rate of
  Profit when risks and shortage of funds prevail.
• Sum of three elements equals Rate of Return,
  which has no more its regulatory role.
• Normal Rate of Profit and Risk Premium have - for
  given units generated, cost of fuel per unit
  generated, optimal value of capital investment
  and Risk Free Return - distinct and unique
  optimal values, which serve different purposes in
  Optimal Tariff.

9
Rate of Return in Optimal Tariff Basics

• Risk Free Return is assumed as weighted average
  Reserve Bank Rate.
• Refer Report (1991) - India, Long Term
  Issues in the Power Sector, by London Economics,
  Indira Gandhi Institute of Development Research
  and others.
• Reserve Bank Rate reflects macro economic
  considerations relating to state of countrys
  economy.
• Unique optimal values of Normal Rate of Profit
  and Risk Premium reflect microeconomic
  considerations, which drive investment in power
  sector.

10
Amount of Return

• Amount of Return
• Rate of Return ? Capital Investment.
• Government, as Bulk Purchaser, pays Amount of
  Return to Power Producer.
• Amount of Return not affected by changes in (Risk
  Free Return Reserve Bank Rate), since Rate of
  Return is based on mutual agreement.
• Amount of Return excludes Performance Incentive.

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Objectives of Optimal Tariff
Distinctly defined Objectives form a package,
achieved collectively and completely through
application of four Components of Optimal Tariff.
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Motivation

• Power Producer (Regulator) is motivated to
  increase (decrease) Amount of Return, calculated
  from Capital Investment and Rate of Return.
• Power Producer expects to increase Profit.
• Regulator wants to optimize Capital Investment.
  Power Producer extends support, provided Profit
  is safeguarded.
• Power Producer and Regulator desire to
  increase generation, the former to increase
  Profit, the latter to decrease Unit Fixed Cost.

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SECTION 2 OF 4STRUCTURE AND APPLICATION
OFOPTIMAL TARIFF
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Method 1 Definition

•   Method 1 is the procedure wherein Capital
  Investment and Rate of Return are mutually agreed
  between Power Producer and Regulator.

15
Theory of Behavioral Patterns Definition and
Classification

• Theory of Behavioral Patterns is developed
  from behavior of three variables, Capital
  Investment, Profit and Amount of Return, with
  respect to changes in Rate of Return.
• Behavioral patterns are classified as
• Standard (Non-standard)
• Conditional Standard (Conditional Non-standard)
• In Standard (Non-standard) Patterns, as Rate
  of Return increases
• Capital Investment and Amount of Return always
  decrease (increase).
• Profit always increases (decreases).

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Theory of Behavioral Patterns Attributes

• Both standard and non-standard patterns are
  always valid, but their characteristics are
  opposite in nature.
• Conditional Standard (Conditional Non-standard)
  Patterns are those that are Standard
  (Non-standard), provided that specified condition
  applicable to Pattern concerned is satisfied.

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Theory of Behavioral Patterns Features

• Standard and conditional standard patterns - but
  not non-standard and conditional non-standard -
  form the basis of Theory of Behavioral Patterns.
• Conditional patterns have to satisfy Conditions,
  which are variable-specific for
  optimal/non-optimal values and derived through
  theory.
• Under Method 1, Behavioral patterns of
• Capital Investment is inherently standard.
• Profit and Amount of Return are conditional
  standards, for which conditions are easily
  satisfied.

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Theory of Behavioral Patterns Application

• Power Producer desires to maximize Amount of
  Return and Profit through increases in both
  Capital Investment and Rate of Return.
• Regulator desires to decrease their values,
  to minimize Amount of Return.
• Conflict is resolved through application of
  Step-by-Step Approach (Forwarded to CERC),
  utilizing collectively all four Components of
  Optimal Tariff.

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Theory of Behavioral Patterns Advantages

• Risk-free procedure in application of Theory
  of Behavioural Patterns provides built-in
  motivation for Power Producer and Regulator to
• Increase Rate of Return, if Capital Investment
  decreases.
• 2. Minimize Capital Investment and Amount of
  Return.
• 3. Maximize Rate of Return and Profit.

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Theory of Behavioural Patterns Highlights

• Power Producer and Regulator agree to
• Decrease Capital Investment, though not sought by
  Power Producer, whose interest is to increase
  Profit.
• Increase Rate of Return, though not favoured by
  Regulator, whose interest is to decrease Amount
  of Return.
• Paradoxically, there is no conflict between
  increasing Profit and reducing Amount of Return.
• The interests Power Producer, Regulator and
  consumers get balanced, while promoting Capital
  Investment, in a win-win scenario.

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Performance Incentive Definition

• Performance Incentive is a financial
  instrument of recognition and reward for good
  performance, in the absence of quantifiable
  mandatory Plant Availability Factor and/or Plant
  Load Factor.
• Performance Incentive Rate is equal to
  Performance Incentive per unit of Capital
  Investment.

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Performance Incentive Characteristics

• Performance Incentive is an add-on to Profit.
• Performance Incentive Rate is an add-on to Rate
  of Return.
• For given values of other variables, Performance
  Incentive/Performance Incentive Rate
• Increase as Capital Investment decreases.
• Increase as generation increases, but under
  progressive restraint.
• Are independent of the value of
• (Risk Free Return Reserve Bank Rate).
• Performance Incentive is subject to regulatory
  ceiling.

23
Performance Incentive and Performance Incentive
Rate Application

• The principle of Performance Incentive is that
  Power Producer, who is not only ready to perform,
  but also actually performs by generating energy
  to meet system needs, is compensated
  additionally.
• Performance Incentive is not paid to another
  Power Producer who is only ready to perform, but
  is not called upon to generate on demand.
• The ability of Power Producer to generate on
  demand depends on his maintaining high Plant
  Availability Factor.
• Power Producer may not comply with generation
  schedule of Load Dispatch to ensure grid
  discipline. Nevertheless, he is likely to do so
  willingly and achieve high Plant Load Factor,
  since Performance Incentive increases as
  generation increases.

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Performance Incentive and Performance Incentive
Rate Features

• Performance Incentive
• Fosters grid discipline, augmenting Method 1.
• Improves internal efficiency, which is its
  primary role and depends on total costs for
  producing given bundles of outputs (Vickers and
  Yarrow).
• Suitable formula secures the features of
  Performance Incentive/Incentive Rate.

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Optimal Tariff Accomplishments

• Optimal Tariff, through its first three
  Components
• Sets road map to achieve Objective 1, through
  Optimization Strategy (Fourth Component).
• Achieves Objective 2, to ensure grid discipline.
• Encourages Power Producer voluntarily to
• Maintain high values of Plant Availability/Load
  Factors without mandatory compulsions.
• Accept Load Dispatchs exclusive control over
  grid discipline, if Producers Profit is secured.
  
• Promote allocative efficiency, based on output
  level with given cost structure (Vickers and
  Yarrow).
• Agree to Performance Incentive to improve grid
  discipline and internal efficiency.

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SECTION 3 OF 4APPLICATION OF OPTIMIZATION
STRATEGY FOROPTIMAL TARIFF
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Optimization Strategy Scope

• Optimal Tariff, through its four Components -
  particularly Optimization Strategy including
  application of Optimizer
• Optimizes/Near-optimizes Capital Investment,
  Amount of Return and Profit.
• Achieves/Near-achieves Objectives 1 and 3.
• Maximizes/Near-maximizes
• Allocative efficiency through Theory of
  Behavioral Patterns and Method 1, with
  Performance Incentive playing a secondary role.
• Internal efficiency through Performance
  Incentive, which is its primary role.

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Optimization Strategy Theory

• Theoretical analysis leads to conclusions
  that
• Marginal and average consumptions of coal (or
  other fuel) in a thermal power plant are equal.
• Partial derivative of output with respect to
  input (fuel) is a constant in given time period,
  without disturbing constraints.
• Optimal/Near-optimal allocation of resources is
  achievable.
• Normal Rate of Profit and Risk Premium are two
  distinct optimized values, assigned different
  roles.
• The latter, which has technical advantages, is
  termed as Optimizer and used to achieve Optimal/
  Near-optimal allocation of resources

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Optimization Strategy Features

• Maximization/Near-maximization achieved by
  Optimal Tariff, aided by Optimization Strategy,
  makes no distinction between Public and
  Independent Power Producers.
• The former produces more units of generation
  and makes more cost-saving effort to achieve
  higher level of social welfare than the latter -
  who may rectify the imbalance, if improved
  incentive systems are introduced (Vickers and
  Yarrow).
• Optimal Tariff addresses itself to incentive
  systems and encourages Power Producers to
  implement Optimization Strategy.

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Optimization Strategy Fixed Unit Cost

• Optimal Tariff, through four Components,
  particularly - Optimization Strategy - optimally
  reduces (enhances) Amount of Return (Profit).
• For given units generated, between Unit Fixed
  Cost (excluding/including Performance Incentive
  Rate), the latter is higher than the former, but
  moderately, due to ceiling on Rate.
• Higher Cost is acceptable, since Incentive Rate
  is Power Producers reward for internal
  efficiency.
• Comparison between Unit Fixed Cost (excluding/
  including Incentive Rate) is however not
  meaningful.
• Significant comparison is between two values of
  the latter, corresponding respectively to
  optimal/near-optimal and non-optimal values of
  Capital Investment.

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Optimization Strategy Phases

• Optimization Strategy - a Component of Optimal
  Tariff - consists of two distinct phases Phase 1
  and Phase 2.
• Phase 1 relates to Capital Investment, incurred
  until plant is ready for commercial operation.
• Phase 2 covers continuing optimization

32
Optimization Strategy (Phase 1) Application

• Optimal values of Capital Investment, Rate of
  Return, Performance Incentive and Profit are
  determined by collective application of four
  Components of Optimal Tariff, using Step-by-Step
  Approach, referred to earlier.
• It defines mutually agreed and frozen values of
  variables, when plant steps into Year 1 of its
  life.
• Corresponding formula based optimal values
  equalize/near-equalize themselves to their
  mutually agreed and frozen values and not
  vice-versa, due to inherent flexibility of value
  of Optimizer. The latter are then
  optimal/near-optimal.

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Optimization Strategy (Phase 1) Conclusion

• In Year 1, values of Capital Investment, Rate of
  Return, Performance Incentive, Profit and Unit
  Fixed Cost (Performance Incentive Rate included)
  for given units generated are optimal/near-optimal
  .
• Optimization Strategy (Phase 1) stands
  formulated, achieving Objectives 1 and 3 in Year
  1.
• Key components of Optimal Tariff are defined.
• Next Step Optimization Strategy (Phase 2), again
  based on Optimizer.

34
Optimization Strategy (Phase 2)

• Optimization Strategy (Phase 2) ensures
  Optimality/Near-optimality, based on specific
  value of Optimizer for each year.
• Value of Optimizer is calculated from actual
  weighted average values of variables at
  conclusion of each year.
• In each Year, values of Capital Investment, Rate
  of Return, Performance Incentive Rate and Unit
  Fixed Cost (including Performance Incentive Rate)
  are optimal/near-optimal.
• Optimization Strategy (Phase 2) stands
  formulated, achieving Objectives 1 and 3 from
  Year to Year.

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Optimization Strategy Overview

• Optimal Tariff, through its four Components -
  particularly Optimization Strategy, including
  application of Optimizer
• Assures that fear of over-investment
  (Averch-Johnson effect) would almost fade away.
• Implies that traditional concepts of regulatory
  Rate of Return are abandoned and structural
  changes in regulatory practice introduced.
• Maximizes/Near-maximizes the sum of producers
  and consumers surpluses or social welfare and
  achieves Objectives 1 and 3, with Objective 2
  having been earlier achieved.
• In this context, four issues involved call
  for discussion.

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Optimization Strategy Issue 1

• Use of mathematical technique in design of
  Optimization Strategy appears contrived and not
  in order.
• This is not sustainable, since Common sense
  recognizes itself only in the searchlight of
  mathematics (Samuelson).
• Nevertheless, one may agree with Bailey and
  Malone that theory based on static analysis is
  not in tune with the dynamic real world.

37
Optimization Strategy Issue 2

• Optimization may not be achieved unless discrete
  time period for optimization is short, say one
  day or one hour.
• Performance Incentive may be calculated on a
  daily/hourly basis and its values incorporated on
  a cumulative basis up to month-end to determine
  unit Fixed Cost (including Performance Incentive
  Rate) for the month.
• The monthly energy bill is prepared
  accordingly for payment.

38
Optimization Strategy Issue 3

• Theory of Optimality is valid under a
  competitive situation and cannot be a measure of
  efficiency - - under other situations according
  to the second best theorem. (Takayama)
• Theorem It is not necessarily worse for
  society if a large number of optimality
  conditions are violated than only if a few are
  violated. (Baumol).
• Near-optimization may not necessarily
  indicate that social welfare is substantially
  maximized.

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Optimization Strategy Issue 4

• Any isolated optimization restricted to power
  plants may not necessarily be valid, because of
  other distortions in society.
• Piecemeal interventions by Government would
  however eliminate some distortions and reduce the
  impact of some others and increase social
  welfare. (Henderson and Quandt).
• It is particularly so, where the distortions are
  not directly related to power generation.
• Realistically, what is therefore achieved in
  practice is Near-Maximization of social welfare
  or the sum of the producers and consumers
  surpluses.
•  

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SECTION 4 OF 4 CONCLUSIONSOPTIMAL TARIFF
meets expectations of Power Producers,
Consumers, Government and Regulatorin full and
even measure.From a totality of
considerationsIT IS TIME TO SAY GOODBYE TO
AVAILABILITY BASED TARIFF ANDWELCOME OPTIMAL
TARIFF
41
IT IS TIME TO SAY GOODBYE TOAVAILABILITY BASED
TARIFF
PRESENTATION BY DR. M. R. BHAT AND DR. AJIT
KARNIK    WELCOME OPTIMAL TARIFF HEARING AT
NEW DELHI November 12, 2003