Case Study of Regulation of Water in California Michael A. Crew - - PowerPoint PPT Presentation

Guaranteed Return Regulation: a Case Study of Regulation of Water in California

Michael A. Crew Rutgers Business School Rami Kahlon California Public Utilities Commission

Outline

• 1. Motivation, Background and Introduction
• 2. Regulation of Monopoly Rents
• 3. Case: California Water
• 4. Conclusions and Implications

Motivation

• Regulation and consumers
• Simple monopoly graph
• Unregulated monopoly - OE
• Regulation cannot provide efficiency of

competition

• OF’ with consumer getting all the rents at

second best optimum

P E A F B” F’ B’ C’ AC B C MC MR AR Q

Figure 1: Monopoly Rents

Rents attract

• Replication of competitive P = MC not feasible

because of dominant scale economies

• Second best optimality a less clear concept
• Determination of Average Cost – OF’
• Regulator’s ability to estimate cost limited by

asymmetric information

Dissipation of Rents

• Labor and the firm
• Politicians, consumers and regulators
• Environmental policies
• Public utility commissions (PUCs) determine

the distribution of rents

• Effective vehicle to enforce state

environmental policies

• State conservation mandates

Regulation cannot eliminate rents

• Mechanism for redistribution
• Opaque more effective way than taxes
• Politicians oppose a tax to support

environmental projects

• Use utility rates
• Partial immunization for legislators

Regulatory Institutions

• Regulation originated in the US over a century

ago

• Specialist “Independent” Commissions
• Cost of Service (CoS) or Rate of Return (RoR)

dominant form

• Process ostensibly simple – protect from

monopoly exploitation and financial viability

Cos/RoR

• Regulated firm typically makes its case in

administrative law tribunal

• RR = O + s(V-D)
• O = Operating Expenses
• s = Allowed Rate of Return
• V = Gross value of its property (rate base)
• D = Accumulated Depreciation

Asymmetric Information

• Firm’s superior information on its costs
• Firm’s incentive to pad costs because
• RR increases as revealed costs increase
• Weakness of COS in cost control ->
• Price cap regulation (PCR)

• UK’s extensive privatization and adoption of

PCR

• Except for telecom PCR not employed

significantly in the US

• Took different form – Crew and Kleindorfer

(1996)

• Littlechild’s (1983 and 1986) influential papers
• 1983 paper sees PCR is transition

What is PCR?

Definitions

• CPI = Consumer Price Index or similar inflation

measure

• X = X factor or real price decrease
• Y = Exogenous factors, e.g. taxes
• T = Term of the price cap

PCR Deceptively Simple

• Provides incentives for X-efficiency
• But at a price
• Laffont and Tirole demonstrate that efficiency
• Requires commitment by regulator
• Firm retaining information rents

Rents contested

• PCR X-efficiency with rents to firm
• CoS incentives for X-inefficiency
• Consumer faces other contenders for rents
• Notably government employing regulation to

promote its social and environmental policies

• PCR difficult to fund renewables and conservation
• PCR drives the firm to maximize profits
• Conservation contrary to this

PCR, CoS and rents

• PCR Firm retains rents
• Commission discretion reduced
• Contrast cost of service regulation
• With considerable discretion to regulator
• But COS limited in ability to implement certain

policies

Regulation to Implement Policy

• E.g. conservation and increasing block rates
• Policies ostensibly motivated by fairness
• PCR provides little scope to implement such

policies

• The reverse - PCR promotes sales
• CoS offers more but not sufficient scope

Evolving form of regulation

• New form of regulation providing

implementation possibilities

• Decouple revenue requirements from output

e.g. conservation and weather

• Permits implementing policies through

regulation

• Appeals to notions of fairness – unjust

enrichment

Guaranteed Return Regulation (GRR)

• Energy efficiency programs
• Separation of distribution and generation
• Including conservation programs in CoS
• Cross subsidies of renewables in CoS
• Attempt to “guarantee” returns
• Traditionally opportunity to earn return was

guaranteed

The Guarantee in GRR

• Guarantee return comes at a price
• Firm faces more regulation
• Loses ability to earn on increased sales in

return for compensation if sales fall short

• Further disincentives for X-efficiency
• Lower costs normally mean greater profit not

with GRR

2005 CPUC Water Action Plan

• 1. Maintain Highest Standards of Water Quality
• 2. Strengthen Water Conservation Programs to a
• Level Comparable to those of Energy Utilities
• 3. Promote Water Infrastructure Investment
• 4. Assist Low Income Ratepayers
• 5. Streamline CPUC Regulatory Decision-making
• 6. Set Rates that Balance Investment,

Conservation, and Affordability

Achieving Objectives

• Less than successful but arguably unattainable

under PCR

• Guarantee Elusive

Year Adopted Revenue Requirement in Aggregate Net aggregate WRAM Under collection Average WRAM Under collection Percentage Median WRAM Under collection Percentage 2012 $795,204,287. $53,853,477. 6.77% 8.09% 2011 $806,482,389. 56,786,925. 7.04% 8.60% 2010 $630,115,859. $37,174,377. 5.90% 5.18%

Explaining Shortfall

• Incentive for DRA to over-forecast volume – a

partial explanation

• Recession
• Weather
• Despite objectives GRR limited in ability to

guarantee a return

• Forecasting distortions and accuracy problems

Conclusions and Implications

• More accurate forecasts limited by exogenous

factors and rent seeking for consumers by public advocates

• Ex post adjustments for exogenous factors –

weather!

• Snow cap exogenous variable in rate setting
• Potential future paper