Is ‘cost-of-service plus incentives’ the best that we can do? David Newbery 12 th ACCC Regulatory Conference Brisbane 28 th July 2011 http://www.eprg.group.cam.ac. uk
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? D Newbery ACCC 2011 2
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 D Newbery ACCC 2011 3
Capital Investment ESI 1948-1989 4.50 70 4.00 Emerging spare capacity 60 £ billion (reflated to 1985) 3.50 cuts investment demand 50 3.00 percent of revenue But stores up 40 2.50 future investment 2.00 30 need 1.50 20 1.00 10 0.50 0.00 0 1948/9 1953/4 1958/9 1963/4 1968/9 1973/4 1978/9 1983/4 1988/9 Total Central/CEGB Area Boards % of revenue D Newbery ACCC 2011 4
Investment in Water in England and Wales Industry actual total capital expenditure from 1920 to 2002 with £ billion Ofwat's latest assumptions for 2003 to 2005 (2001-02 prices using RPI) 5 Privatisation IMF imposes budget cuts 4 3 2 WW2 1 0 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 of 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. D Newbery ACCC 2011 5 Source: Byatt
GB infrastructure needs D Newbery ACCC 2011 6 Source; Buchanan, 10/2/11
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 D Newbery ACCC 2011 7
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 D Newbery ACCC 2011 8
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 D Newbery ACCC 2011 9
Retail prices after privatisation UK real domestic utility prices 180 water 160 rail electricity 140 gas telephones 120 Index 1987=100 100 80 60 gas water privatised privatised Rail 40 privatised BT Electricity privatised privatised 20 0 10 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2
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 Newbery IIB 1 D Newbery ACCC 2011 11 11
Setting Price-caps • Initial P 0 , X set at privatisation – P 0 for smooth transition, X for good sale • Price controls reset every 5 years – but how to reset and still preserve incentives? – P 0 to claw back some efficiency gains – X : catch up frontier, then industry prod growth? => benchmark where possible – fine for distribution companies, hard for grids D Newbery ACCC 2011 12
Incentives for investment • benchmarking used for opex, hard for capital • Investment plans ⇒ RAB t+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? D Newbery ACCC 2011 13
British Electricity Distribution Investment 2000 1800 1600 £ millions (2003/4 prices) 1400 1200 1000 Company forecast 800 Regulator's allowance 600 Actual investment 400 200 0 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 9 / / / / / / / / / 0 / / / / / 0 1 2 3 4 5 6 7 8 0 1 2 3 4 / / 9 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 8 9 ' ' ' ' Source: Green D Newbery ACCC 2011 14
Transmission investment pre-privatization Transmission investment England and Wales 1978-2011 £1,000 £900 £800 NGC NGET £700 £ million (2007/8) £600 £500 £400 £300 £200 £100 £0 9 0 1 2 3 4 5 6 7 8 9 0 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 7 8 8 8 8 8 8 8 9 9 9 9 9 9 0 0 0 0 0 1 8 8 8 9 9 9 9 0 0 0 0 0 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 D Newbery ACCC 2011 15
Transmission investment is increasing rapidly Transmission investment England and Wales 1978-2011 £1,000 £900 Post -privatisation £800 NGC NGET £700 £ million (2007/8) £600 £500 £400 £300 £200 £100 £0 9 0 1 2 3 4 5 6 7 8 9 0 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 7 8 8 8 8 8 8 8 9 9 9 9 9 9 0 0 0 0 0 1 8 8 8 9 9 9 9 0 0 0 0 0 / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 D Newbery ACCC 2011 16
GB transmission investment Capex, Allowances & Constraints £1,000 £500 £900 £450 £800 £400 £700 £350 Constraints £m 07/08 Capex £m 07/08 £600 £300 £500 £250 £400 £200 £300 £150 £200 £100 £100 £50 £0 £0 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 Allowance TO Investment E&W Constraints GB constraints D Newbery ACCC 2011 17
Capex, Allowances & Constraints £1,000 £500 Investment runs £900 £450 ahead of regulation £800 £400 - in pursuit of returns? Regulatory gaming or £700 £350 smarter investment? Constraints £m 07/08 Capex £m 07/08 £600 £300 £500 £250 £400 £200 £300 £150 £200 £100 £100 £50 £0 £0 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 Allowance TO Investment E&W Constraints GB constraints D Newbery ACCC 2011 18
Reforming regulation • Reduce informational asymmetry – standardized accounting no-brainer (free-ish lunch?) – allows benchmarking • menu regulation => incentive compatible efficiency revelation – higher b for lower P 0 • Most regulatory choices address power b – longer periods, glide paths, marking up capex, … is P 0 , X for PDV of planned I or future incentives? Newbery IIB 1 D Newbery ACCC 2011 19 19
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 Newbery IIB 1 D Newbery ACCC 2011 20 20
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 Newbery IIB 1 D Newbery ACCC 2011 21 21
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