Direct regulation in practice

1
Direct regulation in practice
2
Overview

• Rate-of-return regulation
• Price cap regulation
• The TXU case

3
Rate-of-return regulation

• Formulaic approach
• Determine allowed rate of return (WACC) r
• Determine capital base K
• Work out depreciation (d) and operating costs
  (OM)
• Then, set REVENUE so that
• pQ OM d rK
• If need to set prices, use last years output to
  estimate Q

4
Effect of rate-of-return regulation

• Represents an attempt to set price equal to
  average cost.
• Offers a high level of insurance to the
  regulated firm.
• If regulator errs on side of firm to guarantee
  that firm will not make losses, then often get r
  gt true cost of capital. In this situation, get
  inefficient production due to over-capitalisation.
  

5
Over-capitalisation under rate-of-return
regulation

• Suppose your allowed return is 10 but real cost
  of capital is 8. If current capital base is
  100m then you can earn (10m - 8m) 2m
  economic profit.
• Suppose you can spend another 100m on a
  completely useless asset. If you do so then you
  can raise your capital base to 200m and can earn
  (20m - 16m) 4m economic profit
• So tend to artificially expand your capital base.
• Result under rate-of-return regulation the
  regulator has to check and approve new investment
  and determine if old assets with positive value
  are still needed (a used and useful test).

6
Practical problems under rate-of-return regulation

• How to determine r ?
• Mix of debt and equity.
• Risk of business.
• Extra adjustment due to regulatory risk (increase
  r) or due to regulatory insurance (decrease r).
• What is the relevant benchmark for a regulated
  firm (real option adjustment)

7

• How to determine K ?
• Depreciated historic cost?
• Replacement cost?
• Current replacement or green fields replacement
• Depreciated replacement cost?
• Scrap value?
• Deprival value?
• Some mix of these?
• How to determine d ?
• Straight line depreciation?
• Economic depreciation?
• Some other form of depreciation?

8
Result 1

• Most regulation in Australia today is closely
  related to rate-of-return regulation.

9
Price caps or CPI X regulation

• Idea
• Set initial price of product at p0
• Adjust each year by inflation (CPI) and predicted
  productivity improvements in relevant industry
  (X)
• So p1 p0 CPI X.
• Leave this formula to run for 3 to 5 years.
• Can set initial price on basis of current prices
  under old regime.

10
Effects of CPI X regulation

• Gives strong incentives to reduce costs in early
  years.
• Provides low insurance for firm
• But may need to allow for pass through of
  important costs that are outside regulated
  firms control.
• Can be adjusted for multiple products and baskets
  of goods (responsive to changing customer tastes).

11
Problems with CPI X

• After 3-5 years, when it is time to re-set the
  starting price, how do we do it?
• Rate-of-return calculation?
• Benchmarking?

12
Result 2

• In Australia, price caps are reset in general by
  rate-of-return calculation
• Tends to turn price cap into rate-of-return
  regulation with a long lag.

13
Case study the TXU case

• The Office of the Regulator General (ORG) sets
  the price for electricity generation.
• By law it is required to use price based
  regulation adopting a CPI-X approach and not
  rate-of-return regulation.
• Look through the discussion of the process the
  ORG used for resetting the price cap
• Has the ORG broken the law?
• Did it have any alternative?
• Could it have done something differently or
  better?