Transcript test remunerated consumption

Lecture 2
Price regulation
Rate of Return Regulation
Tariff structure
Basic Accounting Equation
In practice average cost pricing is often the
easiest and less costly solution relative to mg.
cost pricing and external financing of loss;
n
∑ p i q i = Expenses+ sB
i= 1
p’s = price of the i-th service
q’s = quantity of the i-th service
n= number of services
s= allowed or “fair rate of return”
B= rate base
Tasks of Regulator
• Set allowed ‘normal’ profits, s and B;
• Given profit levels, set prices to earn that
profit;
• Given one product this means average
cost pricing;
• For more than one product, there are sets
of prices that satisfy equation (structure of
prices);
• Then Regulator needs to know demand
elasticities
WACC: setting the s
• What is the appropriate rate of return?
It will change depending on the type of business
and the form of finance. In general is a form of
WACC/ Weighted Average Cost of Capital:
E
D
WACC  rk
 rd (1  t )
DE
DE
Where rk is usually evaluated through CAPM, E
and D are the amounts of Equity and Debt capital,
rd is the rate of return on debt, t is the corporate
tax rate
WACC: setting the s
E
D
WACC  rk
 rd (1  t )
DE
DE
Some issues:
• rd is the return on debt. Should we take the interest arte
paid by the firm? Not necessarily as this would
eliminate the incentive of firms to save on interests; The
regulator may compute a ‘normal’ rate.
• Why (1-t)? Because debt finance usually grants tax
advantage in the form od deductibility from corporate
taxation. So the real cost for firm is (1-t)rd ;
• Capital Asset Pricing Model is a method for pricing
capital assets and their appropriate return.
Regulatory Asset Base
- In USA the most part of the regulatory review is
devoted to discussion on approriate rate of
return; in UK and Europe the focus is on
Regulatory Asset Base (ES: dispute OFGAS-BG
valuations differed by 65%);
- Regulatory opportunism,the possibility that the
regulator takes advantage of firms after they
invested by not allowing some (capital) costs in
the tariff calculation, may find an easy way of
expression in the calculation of RAB;
Regulatory Asset Base
The ‘used and useful’ doctrine: Capital expenditure
is recognized in RAB for regulatory purposes only
iff used and useful
Why was it proposed?
- Method to control the incentive to over-investment
(Averch-Johnson); When any capital expenditure is
recognized firms can invest more capital than
useful;
- But with demand uncertainty it may cause
underinvestment
- Under Price Cap is not very relevant
Valuation methods for Rate Base
• Original cost; indexation
• Reproduction cost: replacing capacity with
old technology
• Replacement costs: replacing capacity
with newest technology
• Value of outstanding stocks and bonds;
circularity
• Discounting of the revenue flow
Regulatory Asset Base
Discounting of revenues: Circularity
-Expected Revenues are de facto the regulated
tariffs. So expectations determine the RAB
which in turn determines the actual flow of
revenues;
-Need an anchor for the system; Must be based
on some notion of efficient use of resources of
society
-Note that the problem of circularity is that any
level of capital may be legitimated ex post;
-Mistakes in RAB evaluation canot be corrected
ex-post;
Regulatory Asset Base
Indicative Value (water privat. in UK)
uses the discounted revenue flow at
‘current regulatory practices’.
That meant usually before privatization
and reform;
Regulatory Asset Base
Market value (equity e debt):
-The value of a firm is (broadly speaking) the discounted
value of its revenue flow;
-delegates to markets the task of forming expectations on
regulated revenues; Circularity again is a problem;
- Mistakes in the allowed rate of return are amplified by the
discounting method (eg. low rate leads to low RAB) and
lower overall remuneration;
-May cause low RAB when there is regulatory risk;
- Difficult to implement when the firm has both regulated
and non-regulated business;
- Nonetheless has been widely used at privatization in UK;
-Good point: no windfall;
Regulatory Asset Base
Mkt value:
Company
Market to CCA value
BT
97%
BG
42%
Water Comp.
3,6%
Electric.
40-60%
Railtrack
68%
Regulatory Asset Base
Replacement cost: Pros
- Tariffs should ideally reflect the real cost of the
resources we are consuming;
- It allows the firm to build capital for replacement
in time;
Replacement Cost: Cons
- Difficult to estimate; No secondary market for
assets (investiments are sunk); Discretionality
- May generate large windfall (gains or losses)
Regulatory Asset Base
Reproduction/Original cost :
- easy;
- equitable;
- less discretionary/less chances for regulatory
opportunism;
- but may be not-reliable at all in times of
privatization (it depends on system of
accounting adopted by public firms before)
Regulatory Lag
• Prices remain fixed between rate cases; a revision
of tariffs occurs every time the regulator or the firm
think costs are not in line with tariffs any more;
• Implies incentive for cost efficiency due to the
regulatory lag as the firm can make profits by
efficiency in the lag before the price revision
• Infact rate cases are opened as soon as the
regulator or the firm think that some threshold
(profit or losses) has been passed and therefore
incentives are very mild
Averch-Johnson Effect
• RoR regulated firm choose too much
capital relative to other inputs; inefficiency
• Profit maximisation problem of the
monopolist becomes:
Maximise =R(K,L)-wL-rK
subject to
[R(K,L)-wL]/K=s
Notation
•
•
•
•
•
•
 = profit
R( ) = revenue
K = quantity of capital
L = quantity of labour
w = wage rate
r = cost of capital
s = allowed rate of return
Assumptions
• RoR restricts rate of return to s
• s > r, regulator allows the firm to earn a
higher rate of return than its true cost of
capital
• This is the interesting case, otherwise
there’s default and exit
Solution
• MPk / MPl = (r- λs)/w(1- λ)= r/w - α
where
 = λ (s – r)/w(1– λ) > 0
MP = marginal product of capital (or labour)
λ = Lagrangean multiplier between 0 and 1
→the equilibrium MPk/MPL will be lower than the
optimal; hence more capital than optimal is used
(from decreasing marginal productivity of factors)
Graphically
Graphical Solution
• Averch-Johnson point F: solution under rateof-return regulation
• E, Efficient, cost minimising point: solution of
unregulated firm
• Averch Johnson effect: Regulated firm uses
more capital and less labour than optimal -bias
towards capital
• Excess costs measured in units of labour:
distance on labour axis between iso-costline
through efficient point and iso-costline through
Averch-Johnson Point (MN)
Averch-Johnson Effect
• Bias towards capital
• excess costs measured in units of labour:
distance on labour axis between isocostline through efficient point and isocostline through Averch Johnson Point
• Capital intensive industries: stimulation of
innovation, long distance phone calls
• Retard innovations because of other effects
Incentive Regulation
• The main problem of RoR is the lack of
incentives to cost efficiency (and innovation)
• Performance standards
• Earnings share or sliding scale regulation
encouraging cost reductions and efficiency
enhancing strategies
• Excess earnings are shared between the
regulated firm and consumers. Year by year
a fraction the excess profit is returned to
consumers
Class of Earnings sharings
• Let r be the gross rate of return of the firm.
The regulator fixes two threshold rates: r and r
The net rate of return to the firm is given by
r
if r ≤ r
r + θ (r – r) if r ≤ r ≤ r
r + θ (r – r) if r ≥ r
• Assume that r ≤ r and 0 ≤ θ ≤ 1
Remarks
• When the gross rate of return is in the band
between r and r the regulated firm keeps a
fraction θ of excess profits
• After r is reached the firm has to rebate all
excess profits
• The higher θ, the higher the incentives
Yardstick regulation
• Information of performance of other regulated firms
can be used as a yardstick or benchmark to
regulate a firm.
• Example: water and sewage. Several firms
operating in different geographical regions; Their
costs can be compared and used to set a common
tariff based on best practices
• Difficulty in finding comparable utilities
• Useful where:
– Cost structure is similar across producers;
– Shocks to costs and market conditions are correlated;
Rate Structure
• How to vary prices among customer classes and
products?
• Economically efficient prices, marginal cost
prices; with multiproduct monopoly particularly
with sub-additivity that is inapplicable;
• Main (traditional) alternative: Fully distributed cost
(FDC) pricing
Fully Distributed Cost
• Allocate common (fixed sunk) cost on the
basis of some common physical measure
of utilisation, in proportion to costs that can
be directly assigned (eg variable costs),
quantity sold, etc
Problems:
• Arbitrary
• May have unwanted distributional
implications.
Example FDC
•Two products, electricity for residential customers X,
electricity for industrial customers Y
• Costs
X alone: C(X) = 700 + 20X
Y alone C(Y) = 600 + 20Y
Joint Production Function, C(X,Y) = 1050 +20X + 20Y
• Subadditive Cost function: Least cost required to produce
both: fixed cost 1050 versus 1300, MC the same
FDC example
• Distribution of common costs of 1050,
based for ex. on common measure of final
consumption
• 75 % on product X, 25 % on Y
75 % of 1050 is 787.5 (on X)
25 % of 1050 is 262.5 (on Y)
• FDC average costs are
AC(X) = 787.5/X + 20
AC(Y) = 262.5/Y +20
FDC example: Demand
• Demand for X: P(X) = 100 – X
• Demand for Y: P(Y) = 60 – 0.5Y
• Set Demand equal to Average cost, so that
revenues are equal to costs
P(X) = AC(X) and P(Y) = AC(Y)
100 – X = 787.5/X +20 and
60 – 0.5Y = 262.5/Y +20
Solution
P(X) = 31.5, X = 68.5
P(Y) = 23.6, Y = 72.8
• Prices satisfy revenues equal to costs.
There's a Deadweight Loss
• Note that the efficient prices (RamseyBoiteux prices) are
P(X) = 30, X = 70
P(Y) = 25, Y= 70
FDC prices, problems
• Arguments among consumer classes
• Equity; One consumer group may
“subsidise” implicitly other consumer
groups; Cross-subsidisation
• Check:
– Stand alone average cost test
– Average incremental cost test
Stand alone average cost test
Question: Does it pay off to consumers (some
class) to break away and produce X alone?
FDC: X = 68.5, P(X) = 31.5
• Stand alone average cost
C(X)/X=700/X +20 when X = 68.5 gives C=30.219
• Therefore, consumers for X can break away,
produce X themselves and reduce the prices from
31.5 to 30.219.
→these FDC are not subsidy free, there is crosssubsidisation
Cross subsidisation
• Ramsey-Boiteux prices: P(X)=30 with X=70
• Stand alone average cost C(X)/X=700/X
+20
• When X=70, stand alone average cost are
given by 10 + 20 = 30.
• stand alone average cost are equal to the
Ramsey-Boiteux prices in this case, there is
no incentive to break away
→No cross-subsidisation, subsidy free prices
Average Incremental Cost test
Question: Does the product contributes to
total revenues an amount that at least
covers the extra cost it causes, WHEN
added to the production of the other
products?
• Average incremental cost of X is the cost of
producing X and Y jointly minus the cost of
producing Y alone, divided by the
production of X
AIC(X) = [C(X,Y) – C(Y) ]/X
AIC(Y) = [C(X,Y) – C(X) ]/Y
AIC
• The average incremental cost of X are the
costs that X causes when added to the
production in the joint cost function.
• Intuitively, the price for X should be larger
than AIC(X) in order to be subsidy free.
• That's the average incremental cost test
• Note that the average incremental cost test
and the stand alone average cost test give
the same answer and are equivalent (under
some assumptions)
AIC, Example
• FDC: Y = 72.8 , P(Y) = 23.6
• The average incremental cost of Y is given
by (1050+20X+20Y-700-20X)/Y.
• At Y=72.8 this gives AIC of Y of 24.8
• The average incremental cost of Y (24.8)
are larger than the FDC price of 23.6.
• Therefore, there exist cross-subsidisation
because the cost of adding the production
of Y “causes more cost than adds to
revenues’.