PROJECT FINANCE

CHARACTERISTICS OF ALTERNATIVE PRICE

CONTROL FRAMEWORKS

Group 8
Harsha | Deepak | Paarth | Saransh | Yash | Aritra
 INTRODUCTION

• Overview of different approaches to price regulation

• Present basic outline of different features of alternative price control
frameworks
• There is substantial variety of price control arrangements applied across
different jurisdictions and within different regulated sectors.
• No single or dominant approach can be observed across sector
 RATE OF RETURN REGULATION

• It allows regulated supplier to recover total costs of regulated services

including allowable rate of return on regulated asset base

• Determining costs and regulated prices through following 3 stages

1. the set of products or services to be supplied is determined, ranges are
estimated for the likely volumes of supply
2. Given these expected volumes, the costs of supply are estimated. These costs
include a reasonable return on capital within the category of capital costs
3. prices for the provision of the regulated services are set in such a way such
that prices and costs are closely aligned
 RATE OF RETURN REGULATION
• Advantages
i. It ensures prices are always lose
to a given level of costs
ii. More effective than other
approaches in attracting capital
investment in regulated sector
iii. It ensures guaranteed recovery
of operating and investing costs
iv. Effectively shifts capital risk to
consumers
• Disadvantages
i. Indirectly discourages firms to
reduce costs, be efficient and
innovate
ii. Cases where regulators have
limited information, supplier
might misrepresent resulting in
high prices and work against
allocate efficiency gains
iii. Traditional rate of return
regulation can, it is argued, lead
to incentives to over-invest in
assets and facilities
ISSUES TO CONSIDER
Traditional rate of return regulation is unlikely to be as effective as other
forms of price control arrangements in
i. the existing suppliers are not considered to be fully efficient
ii. where, the industry being regulated is itself dynamic and is subject
to rapid or significant change, such as demand or technological
change.

In practice, variants of rate of return regulation have been employed.

For example, in the United States, prices are not typically continuously
and automatically linked to a firm‘s costs. Rather, the prices are set in
hearings on the basis of audited estimates of the capital and operating
costs and an estimate of the cost of capital
 PRICE CAP REGULATION
Price cap regulation involves the regulator setting a maximum allowable average price (or
revenue) path for a set of relevant services for a specified period, which to some degree is
independent of the actual costs associated with the provision of those services.

Depends upon 2 Factors:

• Movements in general inflation (RPI)
• Assumed rate of productive efficiency growth (X)

Key Difference compared to Traditional Rate of Return: Average prices are set so as to be
independent of the controllable costs of the supplier for a significant period of time. Regulator may make
an adjustment to initial prices to reflect any changes in underlying costs (a so-called Po adjustment) and
will also reset X .

Value X is set at, including

• Past efficiency performance
• The need to finance future investments
• Expected changes in growth and earnings
TYPES OF PRICE CAP REGULATIONS

The type used can have

important effects on the
incentives of a supplier to: Total Average
Revenue Revenue
• Reduce costs
• Set efficient tariff structures
• Expand demand
• Improve the quality of supply Hybrid or Weighted
Mixed Average
TYPES OF PRICE CAPS REGULATIONS
Suppliers Total Revenue
• Capped ex ante such that the revenue that may be
earned is constant, and is independent of
fluctuations in the quantity supplied
• Consequently, under this approach, the risks
associated with demand volatility fall largely on
consumers, and suppliers with significant fixed costs
are effectively protected from demand volatility risk
• prices tend to rise when demand is falling and
decrease when demand is rising
• In addition, in order to induce a reduction in demand, a
supplier may have incentives to set inefficient
price structures by setting prices above
marginal cost on the most elastic services.
• supplier may have perverse incentives to reduce the
volume of sales and degrade the quality of services
Average Revenue
• An alternative approach is to cap the average revenue
of a supplier by setting an allowable revenue per
unit of -output. ex ante
• The (positive and negative) risks associated with
demand volatility fall on the supplier
• If demand is lower than expected when the average unit
price is set some fraction of fixed costs will not be
recovered by the firms, conversely, where demand is
higher than expected, the supplier will over-recover relative
to its fixed costs
• Under this approach a supplier therefore has clear
incentives to expand demand beyond that forecast
by the regulator at the time the price cap is set.
• the supplier may have incentives to increase the quality of
services offered to high-demand customers only, or
similarly, may have incentives to set tariffs in such a way
so as to encourage greater usage by high-demand
customers
TYPES OF PRICE CAPS REGULATIONS
Mixed or Hybrid
• The third type of price-cap combines the total
revenue and average revenue approaches into a
‘mixed‘ or ‘hybrid‘ cap which allows for both fixed
and variable revenue constraints
• A function of a few important fixed and variable
revenue drivers, including the total quantity of output,
but also other factors
• It follows that under this approach the incentives to
expand demand, increase the quality of services
and set efficient tariffs will depend on how the
marginal revenue is determined, and in particular,
the difference it creates between the marginal revenue
and marginal cost for the services supplied.
Weighted Average Price
• Under a weighted average price cap approach the
allowed price increases are ‘capped‘ on the basis of a
weighted average price for the supply of a basket
of services
• Under this approach the amount of allowable revenue is
typically calculated by applying the quantities of
services supplied in the previous year to an
expected demand for that service in the current
period
• It establishes a link between the marginal revenue from a
particular service and the price of that service.
• On this basis it is argued that, in principle, a weighted
average price cap approach will result in efficient
price structures emerging as suppliers will have
incentives to set prices at close to marginal cost
for elastic services, and charge higher prices for
inelastic services.
ADVANTAGES
• Cuts in real prices help households and
industrial consumers. Prices are lower, so
there is greater consumer welfare, alongside
lower production costs.
• Useful for controlling consumer price
inflation. Inflation can arise from increased
costs for firms.
• In the early stages of competition price cap
regulation protects consumers and competitors
by preventing the regulated firm from
increasing the prices of its monopoly services
• price cap regulation gives the regulator the
option of setting prices based on the costs
of an efficient firm or on costs based on an
international benchmark reflecting best
practice.
DISADVANTAGES
• Job losses. Lower prices can mean lower profits for
firms, so firms may have to fire workers in order to
cut costs and increase profits.
• Distortion of price mechanism. Price sends signals
within markets as to the balance of demand and
supply. Artificially altering the price can send the
wrong signals to the market.
• Setting the Price Cap too tightly or loosely
• Implementation Costs- The firm incurs compliance
costs, as it has to devote managerial and analytical
resources to meeting the informational and pricing
requirements set out by the regulator. The regulator
also incurs the costs of developing and operating the
regulatory regime.
ISSUES TO CONSIDER

• How to set initial rates – Too high or too low can cause problems
• How often to update the regulation - Short lags allow for a greater
fraction of the surplus to be transferred to customers. Longer lags will
entice the firm to strive for Longer lags will entice the firm to strive for
productive efficiency.
• What constitutes an appropriate index - A general price index carries
with it the advantage and disadvantage of imperfectly matching actual
costs
 HYBRID APPROACHES
COST OF
PRICE CAP
CAPITAL
REGULATION
REGULATION

• Finding this middle ground requires trade-offs regarding different

factors

• Some specific adaptations have been made to the standard

approaches:
• Benchmark (Full and Partial Yardstick)
• Profit Sharing
• Error Correcting
• Sliding scale
• LRIC-type

BENCHMARK
( F U L L YA R D S T I C K )
APPROACH
• Benchmarking is done by linking prices
of the supplier to other similar suppliers
• According to full yardstick, suppliers
don’t have control over the prices
• It is solely based on an index
• Actual productivity difference is taken
into account at the end of regulatory
period
• The changes in prices is reflected in the
subsequent regulatory period
• It mimics the operation of competitive
market
BENCHMARK
( PA RT I A L
YA R D S T I C K )
APPROACH
• Suppliers have partial control over
their prices
• Maximum price is set by the
regulator
• Determination of future path of
prices is done by the regulator
• This encourages improvement in
cost efficiency and performance
 P R O F I T- S H A R I N G A P P R O A C H
• Rate of return is bounded

• Price is reduced if rate of return is higher than upper bound

• Price is increased if rate of return is lower than lower bound
• Profit is shared between supplier and consumers
• Intermediate option between traditional rate of return and price-cap option
• Advantages:
- Price can be adjusted in the same regulatory period
- Less analysis required
• Disadvantages:
- Increasing the prices if rate of return is lower than expected usually does not have the
intended effect
• Example – Power sector in UK, 3 distributing companies, 16 power producing companies (
Reference)
 ERROR-CORRECTION MECHANISMS

• These correction mechanisms is ideal for automatic within period

adjustments to prices which would reflect changes in the value of
the underlying exogenous variables.
• If it is found that if Variations against expectation exceeded a
defined threshold, there would be an automatic adjustment.
• Such a mechanism would mean that it allows for these
exogenous changes to be passed-through to final prices
within the regulatory period.
• The time period of error correction and the incentives to suppliers to
solve them should be given due consideration.
 SLIDING SCALE APPROACHES TO CAPEX

• Information asymmetry could be addressed by presenting each suppliers with a

menu of a allowable regulatory contracts with different profit sharing provisions
contained within the contract.
• Sliding Scale Mechanism also known as information quality mechanism is
intended to induce companies to reveal expectations about future
expenditure requirements and overcome the issue of asymmetric
information.
• It was designed to allow:
a) Allow for more flexible CAPEX
b) Retain the incentives to minimize costs
c) Reward companies for delivering reasonable cost forecasts
d) Restrain companies from over-investing or under-investing.
LRIC – TYPE APPROACHES
• In regulated industries subject to rapid and
significant technological change, the price
control framework has allowed for prices to
periodically adjust to reflect the costs
associated with a hypothetical efficient
supplier
• This approach is most common in the
regulation of telecommunications services
and is based around the notion of some
variant of forward looking, or total,
incremental cost of providing a set of
services.
ADVANTAGES
• This approach is most common in the
regulation of telecommunications services and
is based around the notion of some variant of
forward looking, or total, incremental cost of
providing a set of services.
• This approach is most common in the
regulation of telecommunications services and
is based around the notion of some variant of
forward looking, or total, incremental cost of
providing a set of services.
APPENDIX
 BENCHMARK APPROACH

• Economic settings
• Suppliers are sufficiently similar
• Similar cost and demand conditions
• Suitable adjustments needed to be made if difference in conditions
• High quality information is available for analysis

• Advantages
• Strong incentives for efficient performance
• Practical approach in real world
• Disadvantages
• High quality information usually not available
• Suppliers have very little autonomy