Chapter 8 Rate and Tariff Adjustment Mechanisms

1. Chapter 8 Rate and Tariff Adjustment Mechanisms

2. 8.2 Inflation Adjustments • RPI-X Adjustment (most common) RPI--- retail (consumer) price inflation index X---efficiency factor, to encourage firms to improve productivity efficiency • Drawbacks: consumer retail price index may not accurately estimate changes to industry factor costs.

3. Comparison: producer-specific measures of inflation • More accurate than retail price measures. • Subject to greater volatility contravene the goal of rate stability; hard to optimize production Therefore, RPI is more commonly used.

4. 8.4 An Alphabet Soup of Adjustment Factors • The Productivity (X) Factor: ---the expected change in industry productivity that will be passed through to consumers in prices. • Why is X factors positive in practice? ---improved productivity results in lower prices to consumers. ---regulators ensure that firms cannot raise prices more than inflation rate.

5. Productivity trend should be based on the relevant industry, rather than specific company itself. • Accurate and objective measures of underlying productivity growth in the subject industry are crucial to developing effective incentive regulation plans • Formula containing X factor provides short-term incentives. But setting X must incorporate long-term incentives.

6. Setting X should: • Use publicly available data that are expected to be available at subsequent reviews • Use an understandable and transparent methodology that will not be continually challenged or changed • Ensure that any judgmental adjustments are consistent with defined principles or productivity measurement • Provide a reasonably reliable measure of likely future productivity growth of the industry compared to the productivity of the economy as a whole.

7. Methods to Calculate the X Factor: • most popular: TFP (total factor productivity) ---historical induces for the major inputs into the production process are analyzed in precise ways. • Forecasting ---X factor is used together with a base price (P0), to ensure that a price cap will allow an NPV earning. Problem: use one model to determine both initial prices and X factor not reasonable in basic algebra.

8. Subjective Add-Ons to the X Factor: ---regulators made X factors slightly larger than the TFP productivity factor alone. Rationale: industry productivity should grow at a faster rate in future. Typically add a “stretch factor” or a “consumer dividend” to the productivity offset.

9. The Investment (K) Factor Rationale: the cost of investments that cannot be made under existing tariffs, can be incorporated into the rate base by increasing the current tariff by the K factor. ---rolling the costs associated with a larger rate base into tariffs.

10. The Service Quality (Q) Factor ----A solution to regulated companies reducing costs by reducing product or service quality. Two questions: How to monitor quality of service? What is required to ensure that quality of service is preserved?

11. First question: ---service quality can be compared to benchmarks established in advance rewarded where appropriate and penalized where inadequate. • Second question: ---more a policy matter to establish measurable service standards.

12. Q factor has been applied under both price-cap and revenue-cap schemes. • Mostly rely on multiple indicators, which are mostly technical. • Standards of indicators are set using historical data, projected improvement, negotiation, and values from other jurisdictions and/or companies.

13. The Exclusion (Z) factor ---exogenous adjustment factor ---specific items that are wholly or partly excluded from price and revenue adjustment formulae. • Z factor isolates the risk from the regulated company and passed through the incurred costs to ratepayers. • Exogenous cost changes represent any changes in the company’s costs that are beyond the company’s control.

14. Changes in these costs should: • Be passed directly through to customers (what would occur in a competitive industry) • Be passed through to customers w/o affecting the company’s incentive to reduce costs. • Exogenous events that adversely affect just the regulated firm, are good candidates for Z factors. • Z are established: types of events; set of criteria