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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Characteristics of different types of investment - summary

9. Determining allowed revenue

10. 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

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

12. 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

13. 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

14. 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

15. Impact of the choice of when to rebase

16. 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

17. 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

18. Logging-up: Abu Dhabi water and power
Lack of confidence in utility’s ability to forecast investment, and in costs incurred in past
: 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

19. 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.)

20. 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)

21. 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

22. 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

23. 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?

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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. 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.

33. Summary: Choice of Charging Options

34. Summary: Choice of Inclusion Approach

35. Thank You