BSc Economics and related programmes Economics of Competition and Regulation EC 3015 Week 9: Costs in Price Cap Regulation

Main question How do we work out financing requirement for a regulated natural monopoly? => we look at : cost components and basics cost drivers efficiency analysis 2Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

BASICS Costs in RPI-X regulation3

“Building blocks” of cash flow model Operating expenditures –Maintenance, repairs, operation, customer transactions, central operations Capital expenditures Initial and closing regulatory asset value Future values discounted at cost of capital, avoiding accounting rates of return These are forward-looking costs, so costs need to be modelled 4Costs in RPI-X regulation Cost components and basics Cost driversEfficiency analysis

Modelling costs Starting point is existing costs. –Are they “correct”? –Are they temporarily high or low for specific reasons? => initial adjustments Future costs depend on future events –Need for forecasting elements –Especially “cost drivers” 5Costs in RPI-X regulation Cost components and basics Cost driversEfficiency analysis

If the average costs of delivering letters falls when more letters are delivered to each address this reflects... Market Investigations6 1.An economy of network scale 2.An economy of scope 3.An economy of density 4.None of the above

The difference between cost of service and price cap is... Market Investigations7 1.Price cap adjusts for inflation 2.Price cap has a longer regulatory lag 3.Cost of service uses accounting rate of return, but price cap uses DCF 4.All of the above 5.None of the above

THE FACTORS THAT DRIVE COSTS Costs in RPI-X regulation8

Cost drivers: generic Capital ExpendituresOperating Expenditures Revenue requirement Cost of capital Demand growth Efficiency improvements Improved quality Risk Financial environment Environmental regulation Arrows to show main effects 9Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

So let’s look at: Demand growth Quality and environmental regulation Efficiency Costs in RPI-X regulation10 Cost components Cost driversEfficiency analysis

Demand growth Assumptions based on: –Econometric analysis esp. income elasticities –Surveys –Other forecasts Impact on: –New Capital expenditure –Fixed operating cost –Variable operating cost 11Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Specific cost drivers: electricity distribution – impact of growth Electrical system costs: Optimal layout given demand patterns: –number and distribution of customers –maximum demand at various points –provision for responding to faults, repairs, damage, etc. – deviations of actual from optimal: »growth, churn, etc. Non system costs: Billing, finance, regulation: –some fixed elements, other related to customer numbers Some of the above are related to number of customers, some to demand or network complexity/length, some to overheads 12Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Quality The produce itself: –Water purity, –compliance of electricity with standards –Gas calorific value (Wobbe Index), water content, etc. The quality of service: –Response times Problems, billing, etc –Interruptions to service Frequency, length, warnings, compensation Some related to environmental considerations: 13Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Environmental regulation Examples: –CO 2 and SO 2 from power stations –Water discharged from sewage treatment stations –Pesticide and nitrates in drinking water 14Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Which of the following is not a building block in RPI-X? Costs in RPI-X regulation15 1.Operating cost 2.Capital expenditure 3.Allowed return on RAV 4.Annual depreciation 5.All of the above 6.None of the above

Which of the following is not a building block in cost-of-service regulation? Costs in RPI-X regulation16 1.Operating cost 2.Capital expenditure 3.Allowed return on RAB 4.Annual depreciation 5.All of the above 6.None of the above

The Averch-Johnson effect Market Investigations17 1.is designed to ensure that firms earn a fair and reasonable return 2.means that opex is above the optimal level 3.does not apply to one- shot price caps 4.all of the above 5.none of the above

EFFICIENCY OF COSTS Costs in RPI-X regulation18

Efficiency Requirement is usually to allow an efficient firm to finance its activities What if a firm is inefficient? (and what do we mean by this anyway?) 19 Costs in RPI-X regulation Cost components Cost driversEfficiency analysis => need concept of frontier Productive Efficiency =(Output/input) actual ( Output/input) potential

The frontier Minimum possible costs, given the cost drivers Cost Cost driver Theoretical frontier Empirical frontier 20Costs in RPI-X regulation Cost components Cost driversEfficiency analysis (The position of the frontier depends on the level of prices. Technical change may move the frontier down.)

Investigating the frontier Engineering (bottom up) investigation of practices: –intrusive, subjective Comparative analysis –limited by paucity of observations Transco, NGC: no real comparators –but some use of inter-zonal comparisons in gas distribution. Electricity distribution companies: 14 observations per year International benchmarking? Difficulties (Make deductions about relative importance of cost drivers from foreign studies?) 21Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Types of comparative data analysis Simple cost ratios Regression analysis Data envelope (DEA) and other frontier techniques such a stochastic frontier analysis Combination of cross section and time series? (panel data) Some scope for international comparisons, limited by data definition issues. 22Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Dep var = log(delivery costs)OLS Stochastic Frontier (Half- normal) Variable (in logs usually)Coefft-ratioCoefft-ratio Constant Wage rate paid Local Wage level Volume/Delivery point No delivery points (log) Road length per delivery point DELZONE DELZONE DELZONE DELZONE Business delivery points REDIRECTIONS FRAMES Example of econometric analysis of costs: postal delivery services 23Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Postal services findings Delivery costs: savings of £220m or 10.9% of relevant costs Mail Centre costs savings of around £100m or 14% of relevant costs Costs in RPI-X regulation24 Cost components Cost driversEfficiency analysis

Example 2: Distribution costs 25Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Composite output 1999 Component Relative weight Customers  1.00 kWh  0.25 Network length  Costs in RPI-X regulation Cost components Cost driversEfficiency analysis (Arrived at through a process of consultation, not econometrics: too few observations)

Engineering analysis 1 In order to assess the potential savings available to each PES, a number of techniques were applied as follows: —  a cost per network kilometre benchmark of £575 per km, based on costs from four "top" PESs; —"engineering cost" based on a profile of its network assets using a best practice cost per asset; —comparison of historic savings achieved -- four of the top PESs achieved savings in engineering costs of up to 40 per cent from 1994/95 to 1997/98: in addition, the extent of savings in costs from 1990/91 to 1994/95 was also considered; —a review of each PES’s engineering organisational structures, field efficiency and operating practices; 27Costs in RPI-X regulation Electricity example of “bottom up” approach: Cost components Cost driversEfficiency analysis

Engineering analysis 2 1) methods of cost reduction in past 2) plans for future Examples: new terms and conditions of employment increased condition monitoring of assets staff multi-skilling => range of estimated savings feeding into targets 28Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Movement of the frontier Total factor productivity analysis –compares movements of outputs and of inputs –long term trend –Energy industry plus other “similar” industries –Overseas industries 29Costs in RPI-X regulation Cost components Cost driversEfficiency analysis TFP = Δlog (Q-M) - Δαlog K - Δβlog L Q-M = Value added K =capital input, α = share of capital in output L = labour input, β = share of labour in output

Key issues for operating costs in RPI –X (1) How much productivity gains for the whole sector? How much weight to put on “efficiency" findings? –How much of efficiency gap to be made up? How quickly should companies approach frontier? 30Costs in RPI-X regulation Cost components Cost driversEfficiency analysis

Key issues for operating costs (2) How long should companies be allowed to keep efficiency gains? –P 0 versus X –five year profile issues Informed by analysis of past reviews How well did companies forecast? How far did they all surpass targets? How well did efficiency scores predict efficiency gains? 31Costs in RPI-X regulation Cost components Cost driversEfficiency analysis p0p0 X

Summary As with so many aspects of competition and regulation, the key to cost modelling is finding an objective basis for decisions Economics has many tools that are used in order to help Costs in RPI-X regulation32 Cost components Cost driversEfficiency analysis