Providing Incentives for Regulated Infrastructure Companies to Deliver Investment Ian Alexander November 8th, 2005 International Consulting Economists’ Assoc

Presentation Outline Why are incentives for investment important Review main approaches taken to treatment of investment in regulated utilities Investment obviously influenced by broad parameters of regulatory regime (cost of capital allowed etc) Based upon the World Bank paper “The Regulation of Investment in Utilities: Concepts and Applications”, co-authored with Clive Harris

Investment is an important issue Concern that regulatory approaches have not provided adequate incentives for investment Cost structure means efficiency of capital expenditure is important; concerns to avoid gold-plating In network utilities, can be difficult to predict investment very far ahead

Types of investment Replacement investment: assets are repaired to ensure continued provision of an existing service at present quality levels New investment: assets are provided for: Quality: improve quality of service e.g. reliability Expand output: increased sales of units of service Balance may vary (World Bank estimates 50:50 split to 2010) Individual investments may address quality, replacement and expansion issues together

Characteristics of investment When considering investments it is important to consider: Predictability: is it easy to forecast the need for that type of investment Controllability: can be divided into: Volume Unit cost

Details are important: Predictability Rehabilitation – in general should be easier to predict, but not in utilities with very poor information on quality of existing assets Quality – can be driven by mandates from sector regulator or from outside (E.U. for UK water) Expansion – in some situations easy (e.g. transmission investment to connect new power plant); in others not

Details are important: Controllability Rehabilitation – in general would expect more control over this, with flexibility in timing Quality – parameters outside the control of the utility Expansion – planning consent often required and can introduce additional uncertainties

Characteristics of different types of investment - summary

Determining allowed revenue

Key regulatory issues Efficiency gains (important principle of incentive regulation): how are these distributed between investors and consumers? Opportunities for gaming – overstating expected demand and investment plans Regulators may find it easier to benchmark operating costs, pass through investment => bias towards capitalization

Treatment of investment within regulatory process Regulation of investment Decisions on the need for assets and their cost Cost allocation issues

Inclusion of assets in rate base Decisions on the need for assets and their cost Ex-ante ex-post Ex-post including logging-up Interim determination Contracting out Error-Correction Mechanisms

Ex-ante/ex-post Estimate of investment at start of price control used to determine prices At next price determination, out-turn figures on investment replace assumptions Key issues: Timing/pace of switch from actual to estimated Intrusiveness/scope of ex-post review

Rebasing ex ante to ex post Three main options for rebasing: At the next price determination (option 1) At the price determination after the next (option 2) Five years after the investment is undertaken – a rolling basis (option 3) Implications for length of period during which the company retains the efficiency savings

Impact of the choice of when to rebase

The firm Ex-Ante Cap ACCC in Australia intends to shift to a forward-looking ex-ante cap for energy. Key features will be: At start of price period forecast of investment made At end of period, lesser of actual investment or cap rolled into asset base No assessment of individual investments as long as at or below cap

Ex-post Assessment at end of price control period Prudency (Australia) vs. used and useful (Brazil) Logging-up: formal and specific rules laid down at the start of the price determination that set out rules with regard to carrying-costs of investment, types of investments eligible, depreciation Used for some investments in Manila and UK water; all investments in Abu Dhabi utilities

Logging-up: Abu Dhabi water and power Lack of confidence in utility’s ability to forecast investment, and in costs incurred in past 1999-2002: no allowance for forecast investment Plan: at 2002 review, capex to be included if it was required for expansion/quality reasons and if at efficient costs At 2002 audit data on capex still poor – provisional allowance of 75% of submitted figures Utility is government-owned: the risks in this for private utility would be very high

Interim Determination Review of investment and prices within period of price control Several options: Asymmetric (only company can request) or symmetric (both regulator and company) Event or impact specific (materiality thresholds) Investment specific or company wide (e.g. does it become full price review looking at efficiency savings etc.)

Interim Determination – UK Water Not mini-price reviews, but used for specific issues where unanticipated expenditures had arisen Allowed for in 4 types of defined situations (change in legal requirement; land disposal value changes; failure to meet agreed output; movements in construction price index) plus notified items (items that could not have been forecast with much certainty at time of price review) Price limits reset if these exceed threshold of 10% of turnover in last reported financial year or if impacts > 20% (P.V. of capital, opex, revenue changes)

Error- Correction Mechanisms and Volume Adjustments Mechanistic formula for updating regulatory asset base UK NGC: regulator allowed adjustment of GBP 23mn for every 1GW of new generating capacity connected above or below forecast levels Rationale: NGC had no control over pace of connections

Contracting-out Agree to asset, but have utility pass on responsibility for cost and delivery of investment to 3rd party Competitive process for this replaces regulatory approach of estimating prudent cost In some cases, if BOT or similar structures used, capital charge is replaced by operating charge Examples: Power transmission in Australia, water in Scotland Attractive but there are limits to contracting-out

Cost allocation and revenue recovery issues Are costs of investment recovered from specific users or all users? Are they spread over time or recovered in one go? Is quality of service linked explicitly to revenue? Are costs of investment recovered from new or existing users?

Cost allocation and revenue issues Cost allocation issues Connection charging Deep versus shallow Replacement expenditure Pre-payment of assets Triggers

Connection charging Alternatives: Up-front payments On-going payments that amortize cost of investment Higher upfront payment reduces regulatory risk But can be problematic, as was seen in water and sanitation in Buenos Aires, particularly for low income consumers

Deep versus shallow pricing For specific connection, are costs reflected in charges that user pays (deep), or averaged across all users (shallow) Issues of risk (consumer could leave system, go bankrupt) versus ideal of allocating costs to those benefiting from assets UK power transmission: move to make transmission pricing more shallow

Pre-payment Major investments can take several years to complete: should assets in course of construction be included in RAB? Trigger values – UK airports: revenue allowed increases if certain investments made by specified dates

Replacement expenditure/ pay-as-you-go UK gas: need to replace many of pipes in distribution network, but uncertainty over costs because different diameters of pipes involved Out-turn costs compared to estimated for each year, ⅓ of underspend kept by company, ½ of overspend Correction is made through adjustment to required operating expenditure

Assessing different approaches Risk allocation Impact on profitability, cash flow and other incentives Direct and indirect costs of regulatory approach Ability to handle different types of investment

Risk allocation: investment approaches Cost risks Demand risks within the price control period Inclusion Over-runs Below 100% Obsolescence Ex ante ex post Consumer Operator Mixed Interim determination Ex post Logging-up Prudency test Contracting out Contractor Triggers

Compliance costs: investment approaches Direct costs for the regulator Operator compliance costs Ex ante ex post Low Interim determinations Medium/High Medium Ex post

Ability to handle different types of investment Approach Predictable Not predictable Ex ante ex post Well placed to address this type of investment given the forecastability of this type. Where it is possible to forecast the quality and expansion investments then this approach is well suited. Interim determinations This approach is not well suited for this type of investment and is not needed. Where these types of investment cannot be forecast and are significant when they occur, this approach is well suited. Ex post Not well placed to handle this type of investment owing to the amount that would have to be handled Logging-up type approaches can be well placed to handle these types of investments.

Summary: Choice of Charging Options

Summary: Choice of Inclusion Approach

Thank You Ian_alexander_1967@yahoo.com.sg