Transcript Chapter 3 – The Role of the Revenue Requirement

Chapter 3 – The Role of the Revenue
Requirement
• Revenue Requirement
– Operating cost
– Capital cost
• Firm is allowed to make a return on investment called
allowed revenues, valued added of the regulated activity,
permissible revenues, rate base, regulated revenues, tariff
base, total revenues, revenue requirements
• Determining revenue requirements
– Investments must be prudent
– Used and useful
– Known and measurable
The regulatory compact
• Grants monopoly power
• Allows firm to make a just and reasonable
return on capital
• Allows government to regulate firm
Factors affecting the revenue
requirement
• The test year
– Used to forecast future costs under normal operations
• Vetting costs
– Determining what is known and measurable can vary
between regulators
• Costs
– Private vs. social
– Original vs. replacement
– Short-run vs. long-run
Calculating the Revenue Requirements
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RR=O&M+A&G+T+D+(WACC*RB)
Operation and maintenance
Administration and general
Depreciation
All taxes
Weighted average cost of capital (represents
capital plus rate-of-return and includes income
taxes)
• O&M+A&G
– Deferred vs. accrued
– Different rate classes (resid, comm, indust)
– Direct vs indirect (joint and common costs)
Chapter 5 – Cost Management
• Transforming Cost to Price
– Firms allowed to make a return on capital
expenses
– Firms can only make a return of operating
expenses
– Regulatory accounting requires three sets of
books
• Statutory books (How are we doing? Were we
profitable?)
• Tax books (What must we pay?)
• Regulatory books (What may we charge?)
Steps for Calculating Regulated Prices
• Determine the Revenue Requirement
• Functionalize Costs depending on the different
activities of the utility
• Classify Costs (variable, fixed, customer)
• Allocate costs to different customer groups
• Establish rates and tariffs for the different
customers
Chapter 6 – Cost Allocation
• Functionalization – breaking down into
production, transmission, distribution, retailing,
and other activities
• Classification
– Demand (fixed)
– Energy (variable)
– Customer categories
• Allocating costs across the three customer groups
(most difficult step)
– Residual
– Industrial
– Commercial
Chapter 7 – Rate Setting
• Billing determinants (therms, kilowatts of
demand, kwh)
– Forecasting demand
– Forecasting peak demand
– Normalizing for weather
• Multiple policy goals
– Ensure “just and reasonable” rates
– Prevent excessive (monopoly) profits
– Prevent unreasonable (inequitable) price
discrimination among customers and places
– Provide regulated firms with “adequate” earnings
– Provide service to the most customers possible
– Promote “economic development” and employment
The Pricing Dilemma
P
PM
PAC
AC*
DWL
AC
P*
D
QM
QAC Q*
MR
Q
MC
Alternative Design Structures
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One-part tariff
Two-part tariff
Multi-block tariffs
Incentive rate structures
Entry-exit tariffs
Interruptible rates
Time-of-use rates
Seasonal rates
Two-Part Tariff Pricing
P
Customers pay marginal
cost (P*) for energy, and a
fixed charge per customer
such that total fixed
charges collected equal the
shaded area
PM
AC
PAC
P*
D
QM
QAC Q*
MR
Q
MC
Block Rate Design
P
Intra-block prices set such that
excess cost recovered equals
fixed costs
P1
P2
AC
P3
D
Q1
Q2
Q3
Q
MC
Block Rate Design Increasing Marginal
Costs
P
P1
The first Q1 units are sold at price P1, which is
below the firm’s cost. The remaining Q2-Q1 units
are sold at price P2=MC above average cost. The
two shaded areas are equivalent. Overall
revenues for all Q2 units equal AC.
P2
AC
P1
D
Q1 Q2
QAC
Q
MC
Other rate structures
• Entry/exit – fixed fees and variable charges
• Interruptible rates – uncertainty of service but
get a lower rate
• Incentive rate – usually paired with economic
development, like job creation
• Seasonal rate – peak vs. non-peak
– Expensive to meter
– Seems unfair to customers (i.e. price gouging)
Rate Changes
• Tariff Levelization
• Revenue checks to make sure they are covering
costs
– Deals with time value of money and multi-year tariffs
– Discount to present values future revenues and billing
• Embedded and MC methods
• Alternative approaches
– DCF approach
– Model company approach
– Benchmarking methods
Pricing and Social Policy
• One social question is whether multi-part
pricing should be increasing or decreasing?
• Tariff setting not always about economic
efficiency. Sometimes they try to meet some
social agenda as well: energy consumption,
energy conservation, making sure everyone
has enough access.
Chapter 8 – Rate and Tariff Adjustment
Mechanisms
• Rate Adjustments
– Pass through mechanisms are meant to encourage
efficiency.
– Reducing regulatory lag by implementing an
automatic price adjustment mechanism, which
allow for rate changes without too much of a
bureaucratic process
– Common for changes in the price of fuels
Inflation Adjustments
• Most common adjustment mechanism is RPI-X
where RPI is the retail price inflation index and
X is an efficiency factor that encourages
efficiency
• This measure reduces price volatility that is
common with a producer specific index
Other factor adjustments
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X Factor – for productivity
K Factor – for capital investment
Q Factor – service quality
Z Factors – factors that affect financial
accounting standards, taxes, or environmental
or other laws
Chapter 9 – Market Power
• Because a deregulated industry cannot be reregulated most electricity transmission
operators have a market monitor to ensure
competitveness in the market.
• FERC oversees mergers & acquisitions to
ensure competition
Defining Market Power
• A firm is able to affect market prices
• Other ways to affect market power is through
product quality, service, or technological
innovation
• Market power does create welfare losses, but it’s
not all bad because of the nature of energy firms.
With high upfront costs and low marginal costs,
the firm may need to charge a price greater than
MC to recover some of its investments
• Market power requires barriers to entry, i.e. costs
borne by new market entrants that are not borne
by incumbent firms
Dominant Firms
• When one firm in the market is far larger than
all others
• The dominant firm has market power and sets
price off the residual demand curve (that is,
the demand left-over after the “fringe” firms
have satisfied their demand)
Horizontal and Vertical Market Power
• Horizontal
– Firm’s ability to influence price in a single market
– Market share or market concentration represent
horizontal market power
• Vertical
– Firm with “upstream” market power
– Market foreclosure – firms use upstream power to
raise prices downstream
Other factors
• Chapter 10 – uncertainty
• Chapter 11 – environmental regulation
• Chapter 12 - reliability