[PPT] - Is cost-of-service plus incentives the best that we can do? David PowerPoint Presentation

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Is ‘cost-of-service plus incentives’ the best that we can do?

David Newbery 12th ACCC Regulatory Conference Brisbane 28th July 2011

http://www.eprg.group.cam.ac. uk

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D Newbery ACCC 2011 2

Outline

Regulation is inevitable for grids & distribution

– Legacy of under-pricing state assets

need for increased investment => pricing problems

– raises questions about efficacy of regulation

natural monopolies in power networks

– What have we learned? What remains the same? – How to set the X-factor?

Future possibilities

– Making networks contestable?

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D Newbery ACCC 2011 3

Classic network utilities

e.g. electricity grids

network is natural monopoly

– competition from rival networks uneconomic

capital-intensive
provides essential services
connected to consumer/voter

Regulation inevitable, state ownership likely

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D Newbery ACCC 2011 4

Capital Investment ESI 1948-1989

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 1948/9 1953/4 1958/9 1963/4 1968/9 1973/4 1978/9 1983/4 1988/9 £ billion (reflated to 1985) 10 20 30 40 50 60 70

percent of revenue

Total Central/CEGB Area Boards % of revenue

Emerging spare capacity cuts investment demand But stores up future investment need

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D Newbery ACCC 2011 5

Investment in Water in England and Wales

Industry actual total capital expenditure from 1920 to 2002 with Ofwat's latest assumptions for 2003 to 2005

1 2 3 4 5

1920- 21 1940- 41 1960- 61 1980- 81 2000- 01

Financial year

Notes

1. Original data for the period 1920 to 1980 was for water and sewerage companies only. These figures have been increased by 8% (based on a long term average
f actual spend since 1980), to allow for expenditure by the water supply companies over this period.
2. Projected expenditure from 2002-03 to 2004-05 is that assumed in Ofwat's 1999 price limits but with a) the underspend in investment from 2000-01 and 2001-02

included and b) an estimated efficiency saving of 7% removed.

£ billion (2001-02 prices using RPI)

IMF imposes budget cuts Privatisation

WW2

Source: Byatt

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D Newbery ACCC 2011 6

GB infrastructure needs

Source; Buchanan, 10/2/11

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D Newbery ACCC 2011 7

Dynamic efficiency

main determinant of prosperity is quantity

and quality of investment

Investment: hazard current $ for uncertain

future gain

private investors require:

– secure title to future returns – commercial not political risks

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D Newbery ACCC 2011 8

Regulatory credibility

Public (regulator) and utility both want

investment ⇒ cooperate

both want rents ⇒ conflict

=> Sunk investment risks regulatory opportunism

easier to privatise and restructure if prices fall

Regulation/public ownership evolves to finance investment and distribute rent

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D Newbery ACCC 2011 9

Regulation

Transfer efficiency gains to consumer

p ≤ bp + (1-b)c p = efficient price, c is unit cost b is power of incentive

conflict between incentives and transfers
high power=strong efficiency incentive
low power for rent transfer

Applies to public ownership and regulation

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10

Retail prices after privatisation

UK real domestic utility prices

20 40 60 80 100 120 140 160 180

1 9 8 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 2 1 2 2

Index 1987=100 water rail electricity gas telephones

Rail privatised Electricity privatised water privatised gas privatised BT privatised

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D Newbery ACCC 2011 11 Newbery IIB 1 11

Basic trade-offs

Efficiency vs equity
Increase credibility => reduces required return

– longer-term guarantees vs flexibility – contracts vs market support/subsidies

Reduce cost of capital to lower price (rises)

– delivering investment efficiently => allocate risk – reduce risk => reduce WACC but increase cost?

reduce informational asymmetries

eases equity-efficiency trade-off

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D Newbery ACCC 2011 12

Setting Price-caps

Initial P0, X set at privatisation

– P0 for smooth transition, X for good sale

Price controls reset every 5 years

– but how to reset and still preserve incentives? – P0 to claw back some efficiency gains – X: catch up frontier, then industry prod growth?

=> benchmark where possible

– fine for distribution companies, hard for grids

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D Newbery ACCC 2011 13

Incentives for investment

benchmarking used for opex, hard for capital
Investment plans ⇒ RABt+i ⇒ price path

⇒ Utility overstates investment plans

– delay investment until end of price control period – if RAB updated ⇒ rate-of-return regulation? – If RAB based on benchmarks ⇒ under-invest?

How judge if investment is good value?

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D Newbery ACCC 2011 14

British Electricity Distribution Investment

200 400 600 800 1000 1200 1400 1600 1800 2000

8 9 / 9 9 / 1 9 1 / 2 9 2 / 3 9 3 / 4 9 4 / 5 9 5 / 6 9 6 / 7 9 7 / 8 9 8 / 9 9 9 / / 1 ' 1 / 2 ' 2 / 3 ' 3 / 4 ' 4 / 5 £ millions (2003/4 prices)

Company forecast Regulator's allowance Actual investment

Source: Green

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D Newbery ACCC 2011 15

Transmission investment pre-privatization

Transmission investment England and Wales 1978-2011

£0 £100 £200 £300 £400 £500 £600 £700 £800 £900 £1,000

7 8 / 7 9 7 9 / 8 8 / 8 1 8 1 / 8 2 8 2 / 8 3 8 3 / 8 4 8 4 / 8 5 8 5 / 8 6 8 6 / 8 7 8 7 / 8 8 8 8 / 8 9 8 9 / 9 9 / 9 1 9 1 / 9 2 9 2 / 9 3 9 3 / 9 4 9 4 / 9 5 9 5 / 9 6 9 6 / 9 7 9 7 / 9 8 9 8 / 9 9 9 9 / / 1 1 / 2 2 / 3 3 / 4 4 / 5 5 / 6 6 / 7 7 / 8 8 / 9 9 / 1

£ million (2007/8)

NGC NGET

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D Newbery ACCC 2011 16

Transmission investment is increasing rapidly

Transmission investment England and Wales 1978-2011

£0 £100 £200 £300 £400 £500 £600 £700 £800 £900 £1,000

7 8 / 7 9 7 9 / 8 8 / 8 1 8 1 / 8 2 8 2 / 8 3 8 3 / 8 4 8 4 / 8 5 8 5 / 8 6 8 6 / 8 7 8 7 / 8 8 8 8 / 8 9 8 9 / 9 9 / 9 1 9 1 / 9 2 9 2 / 9 3 9 3 / 9 4 9 4 / 9 5 9 5 / 9 6 9 6 / 9 7 9 7 / 9 8 9 8 / 9 9 9 9 / / 1 1 / 2 2 / 3 3 / 4 4 / 5 5 / 6 6 / 7 7 / 8 8 / 9 9 / 1

£ million (2007/8)

NGC NGET

Post -privatisation

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D Newbery ACCC 2011 17

Capex, Allowances & Constraints

£0 £100 £200 £300 £400 £500 £600 £700 £800 £900 £1,000

90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 08/09 09/10

Capex £m 07/08 £0 £50 £100 £150 £200 £250 £300 £350 £400 £450 £500 Constraints £m 07/08

Allowance TO Investment E&W Constraints GB constraints

GB transmission investment

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D Newbery ACCC 2011 18

Capex, Allowances & Constraints

£0 £100 £200 £300 £400 £500 £600 £700 £800 £900 £1,000

90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 08/09 09/10

Capex £m 07/08 £0 £50 £100 £150 £200 £250 £300 £350 £400 £450 £500 Constraints £m 07/08

Allowance TO Investment E&W Constraints GB constraints

Regulatory gaming or smarter investment? Investment runs ahead of regulation

in pursuit of returns?

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D Newbery ACCC 2011 19 Newbery IIB 1 19

Reforming regulation

Reduce informational asymmetry

– standardized accounting no-brainer (free-ish lunch?) – allows benchmarking

menu regulation => incentive compatible

efficiency revelation

– higher b for lower P0

Most regulatory choices address power b

– longer periods, glide paths, marking up capex, …

is P0, X for PDV of planned I or future incentives?

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D Newbery ACCC 2011 20 Newbery IIB 1 20

Ofgem’s RIIO

Revenue=Incentives+Innovation+Outputs
Intended to be more output-oriented

– Utility specifies outcomes – Remove capital bias -look at total operating budget – 8-year price control, longer depreciation periods (lowers initial cost, charge future customers more) – Contestable investment; customer engagement

Competition for innovation trials - LCNF

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D Newbery ACCC 2011 21 Newbery IIB 1 21

Contestable networks

Aim – to deliver low-C at least cost
Problem – grid proposes expensive solution

– Lengthy assessment, misaligned incentives

Solution: invite proposals – choose best value

– Encourages customer engagement – Upgrades, relocate wind, different quality – Encourage local partners for planning applications – Bid on payment stream from regulated revenues

Risk: entrants overoptimistic on planning => greater delay

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D Newbery ACCC 2011 22 Newbery IIB 1 22

Conclusions

Regulation is inevitably inefficient: conflict between

efficiency and rent extraction

– least bad option if competition not possible

but there are ways of making networks contestable
and reducing informational asymmetries
Main problems - predicting future:

– setting X; financing investment

Regulatory reforms aim to remove distortions

– between capex and opex, over life of price control

but the change in incremental, not radical

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23

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D Newbery ACCC 2011 24

Planned and realised CEGB

utput

*assuming 10% planning margin Electricity Council

ACS Demand (GW) (log scale)

1948/49 1958/59 1968/69 1978/79 1988/89 10 Out-turn (at ACS) Planning Forecast Available capacity*

Forecasts and outturns CEGB 1950-88

20 30 50 60

High demand for investment Investment demand falls dramatically

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D Newbery ACCC 2011 25 Newbery IIB 1 25

Capital under-valuation

CEGB 1947-90 earned 2.7% real
GB water industry sold for £6bn, MEA>£100bn
Railtrack sold for £2.5bn, WCML costs £10bn
Eskom value = US$8.5 bn, HC = US$18.5 bn

inflation adjusted, ODV > US$47 bn

– Economic return < 2.3% on ODV

=> underpricing when investment falls

– difficult to fund investment without price rises

privatize and take asset write-down? if private, revisit regulation?

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D Newbery ACCC 2011 26 Newbery IIB 1 26

Why undervalue assets?

Writing down existing assets rapidly

– companies want fast depreciation (tax, cash-flow) – public sector bad at current cost accounting

HC < ODV (unless rapid obsolescence)

– flatters return on assets, justifies equity premium? => lower prices when demand, investment low => higher prices when demand, investment high – OK in competitive markets – politically difficult for regulated assets