INCENTIVE PRICE REGULATION

Transcription

1 INCENTIVE PRICE REGULATION dr. Péter Kaderják Director, REKK NARUC Training on Tariff Development and Utility Regulation May 7-11, 2007, Baku, Azerbaijan

2 COST-PLUS REGULATION AND SOFT BUDGET CONSTRAINT Cost-plus regulation: regulated rates are set to cover reported (justified) costs plus rate of return on assets Soft budget constraint: spending of the regulated company is covered by tariff revenues and subsidies Compare the two! Discuss the incentives provided by the regimes! Discuss the local situation! 2

3 THE FALLACIES OF COST-PLUS REGULATION Motivation for over-investment (increased rate base) golden plating No motivation to increase productive efficiency Continuous pressure for price increase (rare example of price decreases) No real pressure for selection Major source of fallacy: information asymmetry at the regulator s side: no up-to-date operating cost information, no data on future business plans (investments, costreduction etc.), obscure picture on consumer demand characteristics. 3

4 EFFICIENCY CONCEPTS Productive (X-) efficiency production costs can be influenced by the company over time technological improvements, managerial and organizational skills we would like the company to produce with an efficient cost structure at all times if production costs are lower, the pie to share between the consumers and producers becomes larger cost reduction requires effort from the firm, which must have its rewards, otherwise it will not be undertaken part of the per period profit increase resulting from more efficient operation must be left at the company for some time Allocative efficiency (reminder) we would like to set the price of the service equal to its (marginal) cost for efficient allocation of the total surplus between the producer and the consumers this is related to (but not quite the same!) as not leaving economic rents (profits) at the firm 4

5 STRIVING TOWARDS PRODUCTIVE EFFICIENCY Productive efficiency cannot be mandated because of informational asymmetry, the regulator is unaware of the cost-reducing capabilities of the monopolist Productive efficiency can be encouraged by letting the firm keep the additional profits that result from the cost-savings this is accomplished by setting a fixed regulated price for an extended (and fixed!) period of time long and exogenous regulatory lag high-powered incentives to reduce costs 5

6 STRIVING TOWARDS ALLOCATIVE EFFICIENCY Allocative efficiency is easier to mandate the actual cost level might be determined by a cost review (informational asymmetry is less serious) to reach allocative efficiency, prices should be set equal to costs on a regular (frequent) basis ( costplus contracts) short and endogenous regulatory lag low-powered incentives to reduce costs 6

7 CONFLICT BETWEEN THE EFFICIENCY CONCEPTS Productive efficiency requires a fixed price Allocative efficiency requires a price that varies with costs (and frequent cost reviews) Practical regulation tries to balance between the two extremes Cost-plus vs. incentive regulation differences are not absolute, more a question of degree 7

8 EXAMPLE 1 FIXED PRICE CONTRACT I. Poor, badly-paid (civil servant) regulator goes abroad A) and gets a fixed per diem, all costs inclusive; no expost accounting is required (savings can be reatained by him/her). Result? our regulator uses public transport eats sandwiches stays at an inexpensive hotel and keeps the rest of the daily allowance. 8

9 EXAMPLE 1 COST-PLUS CONTRACT I. Poor, badly-paid (civil servant) regulator goes abroad B) and gets a fixed, reduced per diem (daily salary); all direct costs are refunded ex post. Result? our regulator takes taxi eats in a restaurant stays at an expensive hotel, so he retains less money, but taxpayers pay more for this journey. 9

10 EXAMPLE 2 FIXED PRICE CONTRACT II. Government orders a public works project, A) and signs a fixed price contract with the contractor. Result? contractor keeps money that it saves on its costs the fixed price may be overestimated 10

11 EXAMPLE 2 COST-PLUS CONTRACT II. Government orders a public works project, B) and signs a cost-plus contract with the contractor. Result? negative profit (loss) is impossible for the contractor there is no incentive to reduce project costs 11

12 LESSONS FROM THE EXAMPLES 1. Fixed price contracts provide sufficient incentives to reduce operating costs and increase productive efficiency - high-powered incentive scheme 2. Fixed price contracts might result in too high profits and distributive concerns may arise - might hurt allocative efficiency and fair welfare distribution 3. Cost-plus contract provides no incentive to improve productive efficiency - low-powered incenctive scheme 4. The profit provided by the cost plus contract will not be too high - does not hurt allocative efficiency 12

13 INCENTIVE PRICE REGULATION: FEATURE 1 Rewarding (penalizing) regulated firms for betterthan-expected (worse-than-expected) (economic) performance. 13

14 THE SCHEME OF PRICE CAP REGULATION price cost price - π π cost 4-5 years (fixed!) Cost reviews years 14

15 PRICE CAP REGULATION: SINGLE PRODUCT Pre-defined regulatory period (4-5 years) and pricing rule: p t =p t-1 *(1+CPI-X) CPI: consumer price index (other price index is possible) X: efficiency improvement requirement Transparency Credibility is needed Sharing of benefits from efficiency improvement among industry and consumers Trade-off between incentive property and flexibility E.g. what to do in times of sharply decreasing oil prices? 15

16 PRICE CAP: REGULATED versus ACTUAL RATE OF RETURN Return on equity in the Hungarian Distribution Industry ,00% 14,00% 12,00% 10,00% 8,00% 6,00% 4,00% 2,00% 0,00% Distridution and public supply 8 percent Problem: to explain when actual return is >> proposed regulated return 16

17 IMPROVED PROFIT SHARING (SLIDING SCALE REGULATION ) A system that shares the difference between proposed and actual return among producers and consumers: s a = s t + h(s * -s t ) s a : rate of return built into the regulated price s * : proposed (regulated) rate of return s t : actual rate of return produced by the company before rate adjustment by the regulator The value of h falls between 0 and 1 Consider the case when h = 0 Consider the case when h = 1 17

18 PRICE CAPS: ISSUES Pros Simple, clear incentives Balance between company and consumer interests under incomplete information Moderate resource and info needs for the regulator Extremely useful when company auditing systems are not well developed Cons Starting price cost review How to define X? Choice of inflation index Provides for inflation inertia in times of high inflation Political problems when real return deviates from regulated return Unfair profit sharing within the regulatory period Incentive for degrading service quality: CPI-X+Q 18

19 INCENTIVE PRICE REGULATION: FEATURE 2 Giving regulated firms partial freedom in setting tariffs 19

20 PRICE CAP REGULATION: MULTIPRODUCT CASE Multiproduct monopoly, but exact cost structure is unknown to the regulator Demand information available to the regulator may also be limited Under these conditions, it seems reasonable to delegate some pricing decisions to the firm itself However, pricing behavior still needs to be controlled to restrict market power abuse These controls typically come in the form of constraints on weighted average price levels 20

21 PRICE CAP REGULATION: MULTIPRODUCT CASE N regulated product markets Prices: P n [n = 1,, N] Weights in the scheme: w n (one for each product) The cap is a value: P * Price cap constraint: w 1 P 1 + w 2 P w N P N P* What effect does the choice of weights have on the goodness of the cap scheme? 21

22 PRICE CAPS: EXAMPLE WITH FIXED WEIGHTS Suppose it is known historically by the regulator, that prices P 1 *,, P N * yield demand levels Q 1 *,, Q N * and acceptably low profits for the monopoly Let us weight the prices in the cap scheme by the (historically known) demand quantities: w n = Q n * Let us set the cap equal to the historic revenue (R*) of the firm: P* = P 1 * Q 1 * + + P N * Q N * R* Thus, the monopolist can choose any prices it likes as long as the following holds: P 1 Q 1 * + + P N Q N * R* Consequences: under the new set of prices, consumers (on aggregate) will still be able to maintain their old consumption level by spending an equal amount of (or less) money as before as a result, they will be at least as well-off, and most likely better-off than historically the firm can also increase its profits without harming the customers (on aggregate) the regulator needs little information about either demand or cost conditions On the other hand: some consumer classes may lose from the price cap scheme, while others will benefit from it 22

23 CAP-BASED REGULATION: AN OVERVIEW Cap Regulation Price Cap (Cap (upper limit) on actual prices) Revenue Cap (Cap (upper limit) on earned revenue) Individual Price (Cap on one price only) Revenue Yield (Cap on revenue per unit of output) Tariff Basket (Cap on weighted average price) Fixed Revenue (Cap linked only to CPI-X) Hybrid Revenue (Cap on revenue and price) Variable Revenue (Cap linked to CPI-X & other variables) 23

24 PRICE CAPS: LESSONS Pros Less than full cost and demand information needed for the regulator Utilize private information by firms to increase welfare Provide pricing flexibility in the face of uncertainties regarding cost structure Cons Depending on the weighting methods, some consumer groups may suffer this can be limited by combining price caps with limits on individual price increases If some product markets are (partially) liberalized, price caps may distort competition opportunities for crosssubsidization 24

25 SIMPLE BENCHMARKING Historic costs versus benchmarking Simple, single variable benchmarks (labour cost per kwh output, revenue / km line, etc.) Strong regulatory tool when a company wishes to hide performance results Has to be employed by much care only for simple comparisons Legal background is to be taken into account Dte example 25

26 MEDIUM VOLTAGE DISTRIBUTION TARIFFS, EURO/MWH Spain Sweden Portugal typical factory typical shopping mall Austria Finland France Germany Hungary Ireland Netherlands Norway

27 YARDSTICK COMPETITION AND BENCHMARKING A regulator s best cost estimate might be whatever the company reports about its own cost weak incentives for efficient operation If comparable regional monopolies exist, additional information is available A given monopoly s justified costs may be based on the (reported) average costs of other (non-competing) monopolies strong incentives for efficient operation, since cost savings (relative to benchmark) are retained If all regional monopolies operate under the same benchmarking scheme, efficiency improvements result thus, the benchmark automatically adjusts to redistribute efficiency gains to customers a form of competition where real competition is infeasible 27

28 YARDSTICK COMPETITION More sophisticated techniques to estimate an efficient company, based on a larger sample of company data Stochastic Frontier Analysis Data Envelopment Analysis Based on the distance from the ideal state, individual efficiency improvement factors (X-factors) can be defined for the individual regulated companies Again: legal background 28

29 STOCHASTIC FRONTIER ANALYSIS Product 1 Inefficiency Product 2 29

30 SUMMARY Productive and allocative efficiency Fixed-price (high powered) and cost-plus (low powered) contracts Price cap regulation Revenue cap regulation Sliding scale regulation Simple benchmarking Yardstick competition 30