Tariff Setting Principles and Methodologies EMP LUMS Sep

Tariff Setting Principles and Methodologies EMP @ LUMS Sep 16 -20, 2019

Contents An overview of ratemaking principles and approaches adopted by governments and regulators for (i) end consumers, and (ii) for sector entities and investors. The session will also highlight the role of the government and regulator in promoting investment in the sector, maintain performance standards, and ensure that consumer tariffs remain affordable for all categories of customers. § Principles for Price Regulation § Types of Price Regulations § Rate of Return Based Regulations § Performance Based Regulations § Calculation of Revenue Requirement § Typical Pricing Basis for Generation, Transmission and Distribution § Cost of Electricity Supply Chain § RPI-X Price Regulation § Consumer Tariff Design

Price Regulation in Public Sector Vertically Integrated Utility § Government provide equity funds for investment to build assets of the utility to meet its obligation to provide ‘service’ to the people of the country. § Government takes the ownership of all liabilities and performance of the utility that usually operates in inefficient manner. § Tariffs are set to meet the social and political objectives of the government resulting in high level of subsidies and cross subsidies to cover the operational cost of the utility.

Price Regulation in Autonomous or Investor Owned Utilities § In autonomous or privately owned utilities, however, the role of regulation is critical in ensuring that consumers are provided electricity in the most economical manner at a satisfactory service quality while protecting the interest of investor. § Tariff setting is a primary instrument of economic regulation. Tariff provides economic signals, which determine the volume and nature of demand supply.

Principles for Price Regulation Equity Additivity Economic Efficiency Regulatory Principles Consistency Sustainability Simplicity Stability Transparency

Principles for Price Regulation Economic Efficiency § Tariffs must send economic signals that promote efficiency operation and investment. This requires that costs should be assigned to those who are responsible for them. § Productive: Produces the service at minimum cost and meeting prescribed quality standards. § Allocative Efficiency: Promotes efficiency in consumption of electricity in the short and long term. Sustainability § Guarantee of recovery of all regulated costs so that the electrical power sector is economically viable. Continues…

Principles for Price Regulation …Continued Equity § Non discrimination in the allocation of costs to consumers meaning same charge should apply to the same provision of services, regardless of the end use of the electricity. Transparency § In the tariff determination methodology, so that all employed criteria and procedures are made public. Stability § In the adopted methodology, so that the concerned agents have the least possible regulatory uncertainties. Simplicity § In the tariff determination methodology and its implementation to the extent possible. Continues…

Principles for Price Regulation …Continued Additivity § Derived from the principles of efficiency and sustainability. End user tariff must be the outcome of adding all applicable cost concepts. Consistency § With the specific regulatory process in the country. Other Principles § Universal service: Everybody must have access to electricity § Protection of low income consumers § Protection of environment

Types of Price Regulation § Tariff or electricity prices are designed to enable a utility to earn the total amount of revenue it would need to provide a reasonable opportunity to earn a fair rate of return on its investment, given specified assumptions about sales and costs. § In autonomous or privately owned utilities, a part of the revenue is reinvested to expand infrastructure to meet the growing demand of the utility, important to maintain sustainable operations. § The major approaches used by regulators to determine the basis of revenue allowed to utilities are: Rate of Return Regulation (Ro. R) Performance or Incentive-based Regulation (PBR)

Rate of Return Regulation § The Ro. R, also known as cost of service (Co. S) regulation, is based on cost plus regulation. § The Ro. R regulation is most common method used to regulate the rates in electrical and other regulated business or industry. § The purpose of regulation is to ensure that the utility / licensee recovers all costs that are prudently incurred including a fair rate of return on prudent investment. § In Ro. R regulation, the rates are set to allow the utility / licensee to raise certain amount of gross revenues known as Revenue Requirement.

Rate of Return Regulation Rate of Return Formula RR = Expenses + (Ro. R x NFA) Where RR - Revenue Requirement Ro. R - Rate of Return NFA - Net Fixed Assets

Rate of Return Regulation Advantages of ROR § Is based on an allowed rate of return. Therefore, the prices for the year are fixed and are unchangeable until next tariff revision. § Lowers the risk of utilities / licensees and would encourage them to invest in plant and machinery to ensure efficient and reliable power supply. § The method is conceptually simple and unambiguous in making use of historic accounting data. § The utilities are familiar with the data requirement for filing the data etc.

Rate of Return Regulation Disadvantages of ROR § Since the utility’s earnings are linked to the amount of invested capital, utilities tend to over invest. § The cost plus nature of Ro. R regulation reduces the incentive for the utilities to minimize costs and perform efficiently in the long run. § Historic book values may not provide sufficient revenues for future investment and may result in inadequate investments for future needs. § The regulatory process under Ro. R is long, litigious and costly.

Performance Based Regulation § The performance based regulation is also called incentive regulation (IR) and is an alternative to Ro. R regulation. § The performance based regulation focuses on utility incentives to attain particular results and its product performance (price and service quality) rather than costs, so help improve operational efficiency. § PBR regulates prices or revenues, rather than profits § Many regulatory systems, especially where competition is being introduced, have shifted or are planning to shift to PBR as it has gained wide acceptance. § Primarily, there are two types of the PBR: Price Cap Revenue Cap

Performance Based Regulation Key Features of PBR § Rates are initially established on a bench mark cost of service and performance standards. § Performance could include quality of service: Operating standards such as plant load factor, T&D losses management, O&M expenses per customer etc. Quality of service indices such as duration of outage both brownouts and blackouts. § Performance of these factors is periodically (annually) reviewed and the tariff adjusted for lower or higher performance than the benchmark. § The method allows sharing the benefit of cost saving between consumers and stake holders on predetermined basis. § Since the method rewards or penalizes the utility based on its performance therefore this is not strictly a cost based regulation.

Performance Based Regulation Types of PBR § Primarily, there are two types of the PBR: Price Cap Revenue Cap § The price or revenue caps do not constrain profitability of the utility as such as long as the service standards are maintained at or above the benchmarks set by regulator.

Performance Based Regulation Price Cap Regulation § Prices are fixed for longer period of time (4 to 5 years) and are intended to provide incentive to reduce costs. § A price cap scheme begins by setting the initial rates for each class based on appropriate allocations of costs. § The price cap then allows for an increase from year to year for inflation. § However, the entire increase in input price is normally not compensated as improvements in productivity are also factored in while determining the prices.

Performance Based Regulation Price Cap Formula Pmax < Pt [1 + (I -X)] + Z Where Pmax is the cap of price for the current period to be charged from different classes of consumers. Pt - is the average price charged to the same class during the previous year excluding the fuel component price. I - is the inflation factor. X - is the productivity factor and Z - represents any incremental costs that are not subject to the cap such as change in fuel expenses, tax laws, accounting procedures etc.

Performance Based Regulation Revenue Cap Regulation § Revenue caps are based on same principle as price caps, where cap in a particular year is based on the revenue earned in the previous year with adjustments for inflation, customer growth adjustment and productivity. § Also referred as ‘decoupling’, as revenues are independent of sales volumes. Rates are adjusted periodically to ensure that the utility is actually collecting the allowed amount of revenue even if sales have varied from the assumptions used when the previous general rate case was decided. § This method places an upper limit on revenues thereby constraining the price indirectly. § Revenue cap regulation is preferred for utilities that face high fixed costs. § Revenue cap is relatively easy to determine and monitor than price cap.

Performance Based Regulation Disadvantage of PBR § Estimates of more parameters are needed for proper implementation which could lead to significantly distorted price. § Substantial data requirements to set the base line tariffs and formulae for adjustment particularly as they relate to the assumed capital expansion plan. § If the final tariffs are to be achieved by the application of price adjustment formulae, the regulator must be satisfied that base line tariffs are appropriate. § Unless performance system is carefully designed, there may be an incentive for the regulated utility to lower service quality while pursuing monetary incentives in other areas. § There is less public input to the tariff process under this system because full tariff hearings are not held as frequently as Ro. R regulation.

Calculation of Revenue Requirement under Ro. R § Rate of return regulation combines a company’s costs and allowed rate of return to develop the revenue requirement. § This revenue requirement then becomes the target revenue for setting prices. § The basic formula for determining the revenue requirement is: R=Bxr+E+D+T Continues…

Calculation of Revenue Requirement under Ro. R …Continued R=Bxr+E+D+T Where: R -revenue requirement B -rate base, which is the amount of capital or assets the utility dedicates to providing its regulated services r - allowed rate of return, which is the cost the utility incurs to finance its rate base, including both debt and equity E - prudently operating expenses, which are the costs of items such as supplies, salaries and wages, and items that are consumed by the business in a short period of time (less than one year) D -annual depreciation expense, which is the annual accounting charge for wear, tear, and obsolescence of plant T - all taxes not counted as operating expenses and not directly charged to customers.

Calculation of Revenue Requirement under Ro. R Rate Base § Rate base is the total of all long-lived investments made by the utility to serve consumers, net of accumulated depreciation, also referred as Regulatory Asset Value (RAV). § In some systems, the net Working Capital is also included in the rate base calculations. § In systems with capital intensive projects with long gestation period, construction work in progress (CWIP) is also included in the rate base. § Consumer contributions or long term security charges are deducted from the rate base to provide credit to customers against their deposits.

Calculation of Revenue Requirement under Ro. R Rate of Return § Utilities are allowed a regulated return on their rate base § Rate should be sufficient to allow utility to attract additional capital under prudent management, given the level of risk that the utility business faces § There are two variants of the way rate of return is applied: Return on Assets: Rate of Return = Weighted Average Cost of Capital (WACC) Return on Equity: Rate of Return = Return on Equity (ROE) plus actual interest paid on all debts

Calculation of Revenue Requirement under Ro. R Requirements for inclusion of costs in revenue requirement § Costs must be just and reasonable § Costs must be prudently incurred § Cost adjustments must be known and measurable Examples of costs disallowed by regulator § An expenditure for legislative advocacy such as lobbying § Funds expended in support of political or religious causes § Any expenditure that the regulatory authority finds to be unreasonable, unnecessary or not in public interest, such as: Salary levels Advertising expenses Legal expenses Civil penalty Fines

Calculation of Revenue Requirement under Ro. R Revenue Imputation § Other Income deducted from revenue requirement of the utility Many utilities have additional income or receive funds in addition to the revenue collected from sale of electricity to its customers. First calculate the revenue requirement. Subtract the revenue imputation amount from the revenue requirement.

Approaches for Calculation of Revenue Requirement § Embedded costs or actual historical accounting cost Based on a specific 12 month period in recent past as the historic test year data. § Estimation of future accounting cost Based on forecast of future cost and future load expected in a specific 12 month period. In some cases, the required return on assets is calculated by periodically (yearly) revaluing the fixed assets based on current replacement costs (net of accumulated depreciation). § Estimation of marginal cost Based on cost of expanding system (efficiently) to satisfy the forecasted load over along term horizon.

CHAIN OF COST COMPONENTS

Costs of Electricity Supply Chain

Typical Pricing Basis § Generation Rate of return based pricing for public sector plants - Return on net fixed assets (NFA) - Depreciation - Operating and maintenance (O&M) Cost - Fuel cost (based on thermal efficiency and fuel price) - Taxes Power Purchase Agreements for IPPs - Long-term (over the project’s economic life) - Cost Plus based on O&M costs, fuel costs and return on assets with pass through for fuel Prices and indexation to cover inflation) Competition - Bilateral contracts (short- to long-term) - Trading on the basis of bid prices Continues…

Typical Pricing Basis …Continued § Transmission and Distribution Performance based pricing formulas based on revenue or price caps. - 1 years to 3 -5 year (multi-year) control period - Revenue or Price Cap with (I-X) indexation to cover inflation (I) after accounting for productivity factor (X) - RPI - X formula for transmission and distribution revenue calculation Revenue requirements are based on benchmark transmission and distribution (T&D) losses and assuming 100% collection of billed amount.

Consumer Tariff Design § Assignment of total revenue requirements to various classes of service and fixing tariff with in those classes based on electricity sales to each class. § Typical approaches include: Embedded cost-based allocation Marginal cost-based allocation Social tariff making

Embedded Cost-based Allocation for Consumer Tariffs § Allocation of the total revenue requirement to various categories of consumers based on the embedded or historic costs of the utility. § The revenue requirement is allocated to classes of service to fix tariff based on various allocation factors, such as: Peak demand Share of energy purchased by each class in the total sales Number of consumers in the class etc. § Advantage: The embedded costs and allocation factors can be measured from the data recorded in the books of the utility. § Disadvantage: The embedded cost based tariffs do not reflect the economic costs (cost to serve) that consumers impose on the utility through their electricity consumption as the historic costs of supply tend to significantly differ from the economic costs. Continues…

Embedded Cost-based Allocation for Consumer Tariffs …Continued § For determination of economic costs (cost to serve) incurred in delivering electricity to each class of consumers, the following factors have to be taken into consideration in working out the actual cost incurred to serve each class of consumers. Voltage at which the class of consumers is served T&D losses at each voltage level The contribution of the class to the coincident peak demand/non-coincident peak demand/energy Energy consumed by the class Nature of load

Marginal Cost-based Allocation for Consumer Tariffs § Marginal cost represents the economic value that the utility has to incur in order to provide consumers with an additional unit of electricity. § It is considered the most efficient approach to allocate total revenue requirements for class revenues. § The revenue requirement is allocated by: Determining the level of revenue realization if marginal costs were charged as prices to each class. Comparing the total to the revenue requirement of the utility Closing any gap in a way that minimizes the distortions in consumption resulting in any necessary price deviations from marginal cost. Continues…

Marginal Cost-based Allocation for Consumer Tariffs …Continued § The main disadvantage of the marginal cost approach is that it does not ensure appropriate cost for the utility, which is caused by the fact that the marginal cost tends to be lower or higher than the average cost of supply.

Social Tariff § In social tariff approach, social policy objectives of the government determine the level of revenues from each class § There is no relationship between the costs a consumer imposes in the system and the price consumer pays. § Low income groups and agricultural consumers usually benefit from this approach. § The cost of this measure, however, would have to be recovered from other sources such as: External source - Government subsidies (direct or indirect) Internal source - Cross subsidy from other classes of consumers or across geographical boundaries

Consumer Tariff Structure § Residential Customers Slab system for providing relief to low income groups Consumers pay more with increasing consumptions to encourage energy conservation § Industrial and Commercial Consumers Two Part Tariff to encourage higher utilization against the demand - Fixed Charge based on the peak load (k. W) demanded - Variable charge based on units of energy (k. Wh) consumed § Time-of-the-Day-Use Tariffs for large customers § Two Part Tariff to shift consumption during off-peak hours - Peak time charges - Off-Peak time charges

Contents Regulations relevant to the Transmission Use of Service (TUOS) with relevant examples from different countries, and a comparison with the regulations adopted by ECRA. § Institutional Structure § Institutions § Operational Entities

What is Transmission Open Access? § Transmission Access The use of electric power lines and other power transmitting facilities by parties other than the owners of the lines. Also known as common carriage. § Transmission Open Access Enables all participants in the wholesale market equal access to transmission service, as long as capacity is available, with the objective of creating a competitive wholesale power market.

What is Power Wheeling? § Simultaneous purchase and sale of electricity of non-adjoining parties through the transmission lines of a third party. § Change in actual power flows in transmission lines owned by other parties, when a seller sells to a buyer. § Use of utility’s transmission facilities to transmit power for any buyers and sellers.

Prerequisites of Power Wheeling § § § Separation of transmission from generation Open access rules Determination of Transmission Use of Service Charges (TUo. SC) Transmission service agreement Ancillary service management Balancing market operations

Transmission Use of Service Charge § Major approaches used by regulators to determine the basis of revenue allowed to transmission utilities are: Rate of Return (Ro. R) based pricing Performance or Incentive-based pricing also referred to as price control mechanisms § Main components of the allowed revenue are: Depreciation of regulated assets Return on equity and cost of debt Operation and maintenance (O&M) costs Performance against incentives Timing differences Continues…

Transmission Use of Service Charge …Continued § Examples of other components of the TUo. SC are: System operation charge Metering service provider charge Connection charges Residual sub-transmission charge Technical services charge Ancillary service charge

Approaches for Calculation of TUo. SC § Embedded costs or actual historical accounting cost Based on a specific 12 month period in recent past as the historic test year data. § Estimation of future accounting cost Based on forecast of future cost and future load expected in a specific 12 month period. In some cases, the required return on assets is calculated by periodically (yearly) revaluing the fixed assets based on current replacement costs (net of accumulated depreciation). § Estimation of marginal cost Based on cost of expanding system (efficiently) to satisfy the forecasted load over along term horizon.

Basis of Wheeling Rates Wheeling rates are the prices which are charged for the use of transmission networks and are payments made by the sellers and/or buyers to compensate the wheeling utility(ies) for the cost incurred. Wheeling rates Include: § Existing system cost The allocation of cost of existing transmission facilities used by the transmission transaction. § Operating cost Production (fuels) costs due to generation re-dispatch and rescheduling resulting from the transmission transactions. Continues…

Basis of Wheeling Rates …Continued § Opportunity cost: Benefits of all transactions that the utility forgoes due to operating constraints that are caused by the transmission transaction § Reinforcement cost: Capital cost of new transmission facilities needed to accommodate the transmission transaction.

Methods for Charging Wheeling Rates § Flat fee or linense plate pricing Same price for all customers based on transmission cost per customer, usually within specified zones. § Postage stamp method Price based on amount of power moved and the duration of use. § Zonal rates to manage congestion Price based on amount of power moved and the duration of use across specific zones to manage transmission congestion. § Pro forma transmission tariffs Price based on a capacity fee, based on the installed cost of transmission system as a whole, allocated on per k. W basis. Plus the variable operating cost incurred at the time of use. Continues…

Methods for Charging Wheeling Rates …Continued § MW-Km method A wholesale wheeling price proportional to both the amount of power moved and distance. § Contract path method Price based on the cost of a single identified path from point A to point B. § Rated system path Price based on the cost on a computed set of parallel paths for a particular path identified by load flow or other system studies of the grid.

Transmission Congestion When the producers and consumers of the electrical energy desire to produce and consume an amounts that would cause the transmission system to operate at or beyond one or more transfer limit, the system is said to be congested. § Ways to tackle congestion Price area congestion management Available transfer capability (ATC) based congestion management Optimal power flow (OPF) based congestion management

Ancillary Service Management Activities on the interconnected grid that are necessary to support the transmission of power while maintaining reliable operation and ensuring the required degree of quality and safety. § Main ancillary services include: Regulation Energy Imbalance Operating Reserve- Spinning Operating Reserve- Supplemental Backup Supply System Control Continues…

Ancillary Service Management …Continued Dynamic Scheduling Reactive Power and Voltage Control from Generator Sources Real Power Transmission Loss Network Stability Services from Generation Sources System Black Start Capability

Transmission Losses § Transmission Losses Loss of power in the form of wasted heat, associated with transmitting electrical current over transmission line. - Losses are directly proportional to the mathematical square of the current. - Losses are also directly proportional to the transmission distance. - Need to benchmark Losses (average or Incremental) § Treatment of Losses in Transmission Service Agreement Borne by the Seller: Seller inject additional power in to the transmission network to meet the contracted load requirement of buyer Borne by the Buyer: Buyer draws lesser power from the transmission network against the contracted supply from seller In some countries, value of losses is charged from customers by the transmission operator