Optimal pricing for sustainability of regulated infrastructure industries

1. Optimal pricing for sustainability of regulated infrastructure industries South African Economic Regulators Conference of 2012 Deon Joubert 21 August 2012

2. Main criteria to be analysed • Full recovery of all prudent costs incurred over life cycle • Price stability • Electricity will be analysed as an example • of an infrastructure industry 2

3. Costs incurred in generating electricity • Acquisition cost of asset • Operating and maintenance cost (fixed cost) • Fuel cost (variable cost) 3

4. Costs incurred in generating electricity(cumulative over life cycle) (illustrative) ‘Constant’ Rand billion 4

5. Costs incurred in generating electricity (cumulative over life cycle, levelised) (illustrative) ‘Constant’ Rand billion Levelised Cost of Electricity (or LUEC: Levelised Unit Electricity Cost) 5

6. Costs incurred in generating electricity(cumulative over life cycle, discounted) (illustrative) ‘Constant’ Rand billion 6

7. Basic regulatory formula for annual electricity revenue determination AR = PE + O&M + Depreciation + Return on Capital (i.e. %ROA x RAB) AR/sales volume = ave. tariff Same as %WACC x total capital Note: the actual annual capital expenditure (cash capex) is not directly recovered in the revenue of that year 7

8. Basic regulatory formula for annual electricity revenue determination ‘Constant’ Rand billion Asset related ‘building blocks’ Revenue ‘building blocks’ Pays for interest on capital Pays for redemption of capital (debt principle or equity) 8

9. Two main regulatory methods* to quantify the asset-related ‘revenue building blocks’ : • depreciated historical cost (HC) • inflation-indexed or depreciated replacement cost (DRC) * in typical cost-of-service type of revenue regulation 9

10. Depreciated historical cost method: 10

11. Illustrative revenue – first operational year of new power station ‘Constant’ Rand billion HC method 11

12. Illustrative revenue – first two operational years of new power station ‘Constant’ Rand billion HC method Note reduction 12

13. Illustrative revenue – first three operational years of new power station ‘Constant’ Rand billion HC method Note reduction Both depr. and ROA reducing 13

14. Illustrative revenue profile – full operational life of new power station ‘Constant’ Rand billion HC method PV of life cycle depr. and ROA revenue = initial asset acquisition cost Revenue (and tariff) essentially covering O&M and PE 14

15. Severe tariff instability for single asset, at replacement ‘Constant’ Rand billion HC method Replacement No change in LCOE at replacement 15

16. Tariff instability moderated with multiple assets at regular intervals ‘Constant’ Rand billion HC method Average revenue / tariff Ave. LCOE 16

17. Significant tariff instability with ‘two assets’* at larger interval ‘Constant’ Rand billion HC method Average revenue / tariff Uncertainty re whether incr. will happen could cause funding difficulty * or, two similar groups or ‘batches’ of assets 17

18. Inflation-indexed or depreciated replacement cost method: 18

19. Illustrative revenue profile – full operational life of new power station ‘Constant’ Rand billion DRC method Starts lower, ends higher than on HC More gradual reduction PV of life cycle depr. and ROA revenue = initial asset acquisition cost 19

20. Much less tariff instability for single asset, at replacement (vs. HC) ‘Constant’ Rand billion DRC method vs. HC Replacement 20

21. Tariff instability well moderated with multiple assets at regular intervals ‘Constant’ Rand billion DRC method vs. HC Average revenue / tariff 21

22. Tariff instability manageable, even with ‘two assets’* at larger interval ‘Constant’ Rand billion DRC method vs. HC Average revenue / tariff * or, two similar groups or ‘batches’ of assets 22

23. Conclusions • Both regulatory revenue methodologies recover all life cycle costs – an important aspect of sustainability • In discounted PV terms the life cycle revenues are equal to one another (no tariff premium for DRC) and the asset-related revenues are equal to initial asset acquisition cost • HC very vulnerable to significant tariff instability – which could also cause funding difficulty (which could threaten sustainability) • DRC much more stable and robust to large intervals between asset investments (ave. fleet tariff approaches stability of LCOE) • Although both methods only cover cost of existing (not future) assets, the tariff stability of DRC greatly facilitates funding for new assets 23

24. Thank you 24