Lec+23-Tariff+Setting+Principles+nad+Methodologiesf EE556+ 1

Syed Babar Ali
School of Science and Engineering
EE 556 Power System Planning – Fall 2019
Instructor: Fiaz A. Chaudhry, Ph.D., P.Eng.

Lecture 23 – Electricity Tariff Setting
Principles and Methodologies
Electricity Tariff Setting
The lecture introduces major ratemaking principles and
approaches generally adopted by governments and regulators for:
• end consumers, such as cost-of-service, historical basis pricing,

replacement cost basis pricing, and marginal cost-based pricing, and
• for sector entities and investors, including cost-plus approaches

vs competitive pricing.
We will also highlight role of the government and how it may

potentially intervene in promoting investment in the sector,
maintain performance standards, and ensure that consumer tariffs
remain affordable for all categories of customers.
Vertically Integrated Utilities
• Government provide equity funds for investment to build assets of
the utility to meet its obligation to provide ‘service’ to the people of
the country
• Government takes the ownership of all liabilities and performance of
the utility that usually operates in inefficient manner
• Tariffs are set to meet the social and political objectives of the
government resulting in high level of subsidies and cross subsidies to
cover the operational cost of the utility
Principles for Price Regulation
Economic
Efficiency
Equity Sustainability
Regulatory
Additivity Simplicity
Principles
Consistency Stability
Transparency
Economic Efficiency
 Tariffs must send economic signals that promote efficiency operation
and investment. This requires that costs should be assigned to those
who are responsible for them.
 Productive: Produces the service at minimum cost and meeting
prescribed quality standards
 Allocative Efficiency: Promotes efficiency in consumption of electricity
in the short and long term.
Sustainability
 Guarantee of recovery of all regulated costs so that the electrical
power sector is economically viable.
…Continued
Equity
 Non discrimination in the allocation of costs to consumers meaning
same charge should apply to the same provision of services, regardless
of the end use of the electricity.
Transparency
 In the tariff determination methodology, so that all employed criteria
and procedures are made public.
Stability
 In the adopted methodology, so that the concerned agents have the
least possible regulatory uncertainties.
Simplicity
 In the tariff determination methodology and its implementation to the
extent possible.
Continues…
…Continued
Additivity
 Derived from the principles of efficiency and sustainability. End user
tariff must be the outcome of adding all applicable cost concepts.
Consistency
 With the specific regulatory process in the country.
Other Principles
 Universal service: Everybody must have access to electricity
 Protection of low income consumers
 Protection of environment
Price Regulation
 Tariff setting is a primary instrument of economic regulation. Tariff
provides economic signals, which determine the volume and nature of
demand and supply
 Tariff or electricity prices are designed to enable a utility to earn the
total amount of revenue it would need to provide a reasonable
opportunity to earn a fair rate of return on its investment, given
specified assumptions about sales and costs
 The major approaches used by regulators to determine the basis of
revenue allowed to utilities are:
 Rate of Return Regulation (RoR)
 Performance or Incentive-based Regulation (PBR)
Rate of Return Regulation (RoR)
 The RoR, also known as cost of service (CoS) regulation, is based on
cost plus regulation
 The RoR regulation is most common method used to regulate the
rates in electrical and other regulated business or industry
 The purpose of regulation is to ensure that the utility / licensee
recovers all costs that are prudently incurred including a fair rate of
return on prudent investment
 In RoR regulation, the rates are set to allow the utility / licensee to
raise certain amount of gross revenues known as Revenue
Requirement.
Rate of Return Formula
R R = Expenses + (RoR x NFA)
Where
R R - Revenue Requirement
RoR - Rate of Return
NFA - Net Fixed Assets (Rate Base)
Advantages of RoR
 Is based on an allowed rate of return. Therefore, the prices for
the year are fixed and are unchangeable until next tariff revision
 Lowers the risk of utilities / licensees and would encourage them
to invest in tools, plant and machinery to ensure efficient and
reliable power supply
 The method is conceptually simple and unambiguous in making use
of historic accounting data
 The utilities are familiar with the data requirement for filing the
data etc.
Disadvantages of RoR
 Since the utility’s earnings are linked to the amount of invested
capital, utilities tend to over invest.
 The cost plus nature of RoR regulation reduces the incentive for
the utilities to minimize costs and perform efficiently in the long run
 Historic book values may not provide sufficient revenues for future
investment and may result in inadequate investments for future
needs
 The regulatory process under RoR is long, litigious and costly.
Performance Based Regulation (FBR)
 The performance based regulation is also called incentive regulation
(IR) and is an alternative to RoR regulation
 The performance based regulation focuses on utility incentives to
attain particular results and its product performance (price and
service quality) rather than costs
 Many regulatory systems, especially where competition is being
introduced, have shifted or are planning to shift to PBR as it has
gained wide acceptance.
 Primarily, there are two types of the PBR:
 Price Cap
 Revenue Cap
Key Features of PBR
 Rates are initially established on a bench mark cost of service and
performance standards
 Performance could include quality of service:
 Operating standards such as plant load factor, T&D losses
management, O&M expenses per customer etc.
 Quality of service indices (Reliability) such as duration and
frequency of outage both brownouts and blackouts.
 Performance of these factors is periodically (annually) reviewed and
the tariff adjusted for lower or higher performance than the
benchmark
 The method allows sharing the benefit of cost saving between
consumers and stake holders on predetermined basis
 Since the method rewards or penalizes the utility based on its
performance therefore this is not strictly a cost based regulation.
 Primarily, there are two types of the PBR:
 Price Cap Regulation
 Revenue Cap Regulation
 The price or revenue caps do not constrain profitability of the
utility as such, as long as the service standards are maintained at or
above the benchmarks set by regulator.
Price Cap Regulation
 Prices are fixed for longer period of time (4 to 5 years) and are
intended to provide incentive to reduce costs
 A price cap scheme begins by setting the initial rates for each class
based on appropriate allocations of costs
 The price cap then allows for an increase from year to year for
inflation
 However, the entire increase in input price is normally not
compensated as improvements in productivity are also factored in
while determining the prices.
Price Cap Formula
Pmax < Pt [1 + (I -X)] + Z
Where Pmax is the cap of price for the current period to be charged from
different classes of consumers.
Pt - is the average price charged to the same class during the previous
year excluding the fuel component price.
I - is the inflation factor.
X - is the productivity factor and
Z - represents any incremental costs that are not subject to the cap such
as change in fuel expenses, tax laws, accounting procedures etc.
Revenue Cap Regulation
 Revenue caps are based on same principle as price caps, where cap in a
particular year is based on the revenue earned in the previous year with
adjustments for inflation, customer growth adjustment and productivity.
 Also referred as ‘decoupling’, as revenues are independent of sales
volumes. Rates are adjusted periodically to ensure that the utility is
actually collecting the allowed amount of revenue even if sales have
varied from the assumptions used when the previous general rate case
was decided.
 This method places an upper limit on revenues thereby constraining the
price indirectly.
 Revenue cap regulation is preferred for utilities that face high fixed
costs.
 Revenue cap is relatively easy to determine and monitor than price cap.
Disadvantage of PBR
 Estimates of more parameters are needed for proper implementation
which could lead to significantly distorted price.
 Substantial data requirements to set the base line tariffs and formulae
for adjustment particularly as they relate to the assumed capital
expansion plan.
 If the final tariffs are to be achieved by the application of price
adjustment formulae, the regulator must be satisfied that base line
tariffs are appropriate.
 Unless performance system is carefully designed, there may be an
incentive for the regulated utility to lower service quality while
pursuing monetary incentives in other areas.
 There is less public input to the tariff process under this system
because full tariff hearings are not held as frequently as RoR
regulation.
Calculation of Revenue Requirement Under RoR
 Rate of return regulation combines a company’s costs and allowed
rate of return to develop the revenue requirement.
 This revenue requirement then becomes the target revenue for
setting prices.
 The basic formula for determining the revenue requirement is:
R≡Bxr+E+D+T
Continues…
…Continued
R≡Bxr+E+D+T
Where:
R - revenue requirement
B - rate base, which is the amount of capital or assets the utility dedicates
to providing its regulated services
r - allowed rate of return, which is the cost the utility incurs to finance its
rate base, including both debt and equity
E - prudently operating expenses, which are the costs of items such as
supplies, salaries and wages, and items that are consumed by the
business in a short period of time (less than one year)
d - annual depreciation expense, which is the annual accounting charge for
wear, tear, and obsolescence of plant
T - all taxes not counted as operating expenses and not directly charged to
customers.
Some variants on allowed rate of return
 Return on Assets
 Rate of Return = Weighted Average Cost of Capital (WACC)
 Return on Equity
 Rate of Return = Return on equity plus actual interest paid
Requirements for inclusion of costs in revenue requirement
 Costs must be just and reasonable
 Costs must be prudently incurred
 Cost adjustments must be known and measurable
Examples of Costs disallowed by Regulator
 An expenditure for legislative advocacy such as lobbying
 Funds expended in support of political or religious causes
 Any expenditure that the regulatory authority finds to be
unreasonable, unnecessary or not in public interest such as
 salary levels
 advertising expenses
 legal expenses
 Civil penalty
 Fines
Approaches for Calculation of Revenue Requirement
 Embedded costs or actual historical accounting cost
 Based on a specific 12 month period in recent past as the historic
test year data
 Estimation of future accounting cost
 Based on forecast of future cost and future load expected in a
specific 12 month period
 In some cases, the required return on assets is calculated by
periodically (yearly) revaluing the fixed assets based on current
replacement costs (net of accumulated depreciation)
 Estimation of marginal cost
 Based on cost of expanding system (efficiently) to satisfy the
forecasted load over along term horizon
Principles and Methodologies: Typical Pricing Basis
 Generation
 Rate of return based pricing for public sector plants
 Power Purchase Agreements for IPPs (long-term)
- Long-term (over the project economic life)
- Cost Plus based on O&M costs, fuel costs and return on
assets with pass through for fuel Prices and indexation to
cover inflation)
 Competition
- Bilateral contracts
- Trading on the basis of bid prices
 Transmission and Distribution
 Performance based pricing formulas
- 1 year to 3-5 years control period (multi-year)
- Revenue Cap based on O&M costs and return on assets with
(I-X) indexation to cover inflation (I) after accounting for
productivity factor (X)
Costs of Electricity Supply Chain
Consumer Tariff Design
 Assignment of total revenue requirements to various classes of
service and fixing tariff with in those classes based on electricity
sales to each class.
 Typical approaches include:
 Embedded cost-based allocation
 Marginal cost-based allocation
 Social tariff making
Embedded cost-based allocation for Consumer Tariff
 Allocation of the total revenue requirement to various categories of
consumers based on the embedded or historic costs of the utility.
 The revenue requirement is allocated to classes of service to fix
tariff based on various allocation factors, such as:
 the peak demand
 the share of energy purchased by each class in the total sales
 the number of consumers in the class etc.
 Advantage: The embedded costs and allocation factors can be
measured from the data recorded in the books of the utility.
 Disadvantage: The embedded cost based tariffs do not reflect the
economic costs (cost to serve) that consumers impose on the utility
through their electricity consumption as the historic costs of supply
tend to significantly differ from the economic costs.
Continues…
Embedded cost-based allocation for Consumer Tariff
…Continued
 For determination of economic costs (cost to serve) incurred in
delivering electricity to each class of consumers, the following
factors have to be taken into consideration in working out the
actual cost incurred to serve each class of consumers.
 Voltage at which the class of consumers is served
 T&D losses at each voltage level
 The contribution of the class to the coincident peak
demand/non-coincident peak demand demand/energy
 Energy consumed by the class
 Nature of load
Marginal cost-based allocation for Consumer Tariff
 Marginal cost represents the economic value that the utility has to
incur in order to provide consumers with an additional unit of
electricity.
 It is considered the most efficient approach to allocate total
revenue requirements for class revenues.
 The revenue requirement is allocated by:
 Determining the level of revenue realization if marginal costs
were charged as prices to each class.
 Comparing the total to the revenue requirement of the utility
 Closing any gap in a way that minimizes the distortions in
consumption resulting in any necessary price deviations from
marginal cost.
Continues…
Marginal cost-based allocation for Consumer Tariff
…Continued
 The main disadvantage of the marginal cost approach is that it does
not ensure appropriate cost for the utility, which is caused by the
fact that the marginal cost tends to be lower or higher than the
average cost of supply.
Social Tariff
 In social tariff approach, social policy objectives of the government
determine the level of revenues from each class
 There is no relationship between the costs a consumer imposes in
the system and the price consumer pays.
 Low income groups and agricultural consumers usually benefit from
this approach.
 The cost of this measure, however, would have to be recovered
from external source such as:
 Government subsidies (direct or indirect).
 From other classes of consumers as cross subsidy.
Common Tariff Setting Approach
1. Estimate Company 2. Allocate Revenue to 3. Design End-User
Revenue Requirement Companies Tariff
Allocate revenue Design tariff to ensure
Estimate revenue required requirement to that level and
to cover utility’s operating customer classes (e.g. components (fixed,
and capital costs determine how much variable, customer) of
revenue must be tariffs for each
collected from each customer class recover
class) allocated revenue
Linked to how requirement
costs are incurred
(“cost causation”)
• Objectives of Tariff Setting Process:

• Supply adequacy
• Better cost recovery leads to better service
• Efficient costs
• Tariffs provide both consumers and utilities incentive to make
economically efficient decisions
Cost Allocation (per unit analysis)
Variable Cost
PPP
Competition Cost
Fixed Cost
CSS
Cost applied to all
NTDC UoSC,
MoF
including BPC
DM leaving DISCO
Costs / kWh
• PPP: Power Purchase Price

• CSS: Cross Subsidy
• DM: Distribution Margin
Thank you
Fiaz.Chaudhry@lums.edu.pk
+92 321 999-0780

Estimating the Revenue Requirement: Summary of two approaches
 “Revenue requirement” is an aggregation of the 1. Revenue 2. Revenue 3.Tariff
Requireme Allocation Design
total costs incurred to provide service nt
 Two different approaches to calculate revenue

Revenue Requirements
requirement: under Different Approaches
Cash- Rate of
◦ Rate-of-return (RoR) approach: Needs Return
 Revenue Requirement = O&M expense X X
Operating and maintenance expenses
Debt service X
Capital
+ Depreciation X
Improvements
+ (Rate Base (Net Assets) x Allowed Return) Depreciation
X
Return on Expense
◦ Cash-Needs Approach: Return on
invested X
 Revenue Requirement =
capital investment
Operating and maintenance expenses Other
X X
Revenue
+ Actual cost of debt service
+ Actual cost of capital improvements Principal +
interest debt
payments
Estimating the Revenue Requirement: General Comments
1. Revenue 2. Revenue 3.Tariff
Requireme Allocation Design
nt
 Short-term: Cash-Needs approach
◦ Overall more straightforward and
transparent than RoR
◦ Does not require evaluation of assets
◦ Avoids the complications of determining
a “fair” rate of return on assets What about depreciation?
Depreciation costs and
◦ Improves governance and transparency return on assets are used in
the Rate of Return approach
in the sector by removing perception as an approximation for
that profits are included in tariffs capital improvement and
debt service costs…these
 Long-term: Rate of return actual costs are included in
the cash-needs approach
◦ NEPRA follows this approach

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Syed Babar Ali

School of Science and Engineering

EE 556 Power System Planning – Fall 2019

Instructor: Fiaz A. Chaudhry, Ph.D., P.Eng.

• end consumers, such as cost-of-service, historical basis pricing,

• for sector entities and investors, including cost-plus approaches

We will also highlight role of the government and how it may

R R = Expenses + (RoR x NFA)

Pmax < Pt [1 + (I -X)] + Z

• Objectives of Tariff Setting Process:

• PPP: Power Purchase Price

+92 321 999-0780

 Two different approaches to calculate revenue

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