Model B: Stand-alone and outsourced + modified rate base

It is important to recognise, as Oxera does, that some of the benefits of the price cap

approach could be achieved with less fundamental changes to the existing regime. However, model B would still require modifications to existing Ordinance and regulations, and

agreement on the status on the takeover arrangements.

Oxera understands that model B would include the following institutional features: – the creation of an independent economic regulator (while recognising that full

independence in a small-island context is difficult to achieve), but with regulatory activity that would involve extensive outsourcing during the periods when this input is needed (eg, every three years);

– a rules-based approach prescribed in the Ordinance, or in regulations, setting out the criteria for assessing the RAB, allowed return and CAPEX, and the information required by the regulator (external advisers would also need to pay regard to this);

– the provision of input by the companies into the tariff-setting framework (eg, business planning, engagement, CAPEX, OPEX, KPIs);

– tariffs would be decided every three years by an independent party on behalf of the regulator, and these would be binding (and not subject to further review by the

Governor, except perhaps in pre-specified exceptional circumstances, such as following a severe hurricane event).

Specifically in relation to outsourcing, it is envisaged that external advisers would provide advice mainly as follows:

– financial/regulatory advisers would provide advice on RAB and WACC issues; – engineering experts would provide advice on engineering issues, including CAPEX

efficiency (this would probably also require site visits);

– external regulatory experts would provide some further advice on efficiency issues using higher-level data.

Key features of Model B are described in Table 7.2 below. In setting rates for three years, it would be necessary to keep base rates flat or apply a notional index (weighing up future potential inflation against potential efficiencies relative to inflation) in the three-year forecasts of allowed revenues.

Some of the analysis required to make model B operational is also required for model A, once model B moves away from just accepting all expenditure by the firm as being remunerated.

Model B seems to be a hybrid between a price cap (ie, model A) and a pure rate of return regime. Nominal base rates would remain fixed for three years and there could be some check on efficiency. However, the setting of base rates would be more rules-based, using past experience. It would be inherently less forward-looking than under a price cap approach, and, to the extent that mistakes were made in matching revenue to costs in the price control period, these would be corrected in the next period.

Advantages of model B include the following:

– it avoids the need to calculate an explicit RPI or CPI, but may still need to factor in an implicit inflation contingency in nominal base rates (weighed against implicit real efficiencies); otherwise, base rates will be more volatile when future rate reviews occur and, in periods of high inflation, holding base rates fixed could also pose financial risks; – fuel cost incentives are more or less the same as under model A;

– while it would still require changes to the Ordinance and regulations (it is not just an extension of the existing regime), these would be less extensive than under model A;

– the institutional set-up could be lower-cost than model A, probably requiring few (if any) additional staff compared with the status quo, albeit with some additional external advisory support being used to conduct rate reviews;

– there would probably be a less onerous information requirement in between rate reviews than would be the case for model A;

– it could still potentially tackle the overcapitalisation incentive if the regulatory powers exist to question historical and prospective CAPEX, or if the regulator had powers to review ‘large’ CAPEX programmes before they are implemented. (However, this makes the regulation more complex and requires significant analysis to establish whether expenditure has been inefficient);

– setting out allowed return and asset based measurement criteria can improve regulatory certainty for companies, but may generate some inflexibility over time;

– as noted, it is not clear that the companies are necessarily inefficient on OPEX (although this is a possibility), and volume growth going forward looks more limited than in the past (a source of savings through scale economies). It is inherently uncertain whether price caps (ie, model A) would generate significant additional efficiencies over and above B (which in any case captures a number of the price cap/building block features); and – provided that it tackles the key issues of the appropriate level of return and CAPEX accumulation (in future), model B may be a good compromise—that is, it has some features of a price cap, but may be better suited to the context in TCI.

Potential concerns with model B are as follows:

– the existing rules-based approach is too legalistic and process-driven, and has resulted in disagreements between the TCI Government and the companies in relation to its implementation. For example, arguments persist over the interpretation of the

Ordinance, regulations and takeover agreements. It would be necessary to get the rules and criteria correct under a rules-based approach (as opposed to one that involves more discretion). The risk is that any set of rules would eventually (perhaps too quickly)

become outdated, and updating the legislation too frequently could then increase perceptions of political risk;

– there is less scope for the regulator to demand information, or make decisions based on the merits of a particular case, except where these are not captured by the rules;

– a ‘reasonable’ standard needs to be reflected in the rules, rather than the assessment of what is reasonable being based on the regulator’s general duties;

– it is not clear just how ‘forward-looking’ rate-base assessments would be, or whether the approach reveals efficient costs in the same way as a price cap. It would still be a rate- base approach to target a given return (although there is debate in recent rate cases over what the existing legislation allows on efficiency assessment—eg, the recent TCU review). What is clear, however, is that the incentives and checks implied under model B fall short of a price cap regime such as model A, and that model B leans towards being a cost of service contract;

– related to the above point, there are no explicit ongoing efficiency incentives or targets built into model B as there are under model A;

– the rules risk being incomplete, and the regulator and/or external consultants would still

need to look at issues in setting rates that go beyond the specific issues covered in the rules. There could be disagreement on the level of discretion available to the regulator in areas not completely covered by the rules;

– sporadic use of external consultants may mean less scope for the regulator to retain skills internally, thereby foregoing the potential benefits associated with regulating other sectors more carefully and to a higher standard of evidence than has traditionally been the case in TCI.

Table 7.2 Model B features

Features Observations on viability

Certain changes to the existing Ordinance and regulations, and clarity on status of takeover agreements

Certain legal and contractual issues

Independent economic regulator with final say on tariffs

True independence is difficult in a small-island context, but more independence is possible than is currently the case

Single regulator with extensive outsourcing when rate reviews occur

Lower-cost than multi-sector regulator and price cap; but less skills retention and ongoing monitoring capability

Ordinance or regulations set out criteria for assessment of rate cases

If Ordinance prescribes the approach, this may be difficult to adjust over time; as might be any regulations that are legally prescribed by the Ordinance

Planned and periodic adjustments (eg, taking place every 3 years) to base-rate tariffs and the fuel cost adjustment mechanism

More limited assessment than price cap, especially if all expenditure by the firm is automatically recoverable through prices

Mainly backward and current assessment of costs in rate cases (with some forward-looking

assessment)

More limited assessment than price cap, but can easily involve issues of judgement around whether past expenditure was efficient, and should therefore be included in the future price limits

Pre-specified rules and criteria (set out in the Ordinance or regulations) for calculating an appropriate rate of return

These reduce regulatory discretion, and can steer external consultants. Care is required in the design of the framework. The framework also requires external financial/regulatory experts. It requires a WACC calculation at each tariff-setting point unless the rate of return is set once for a long time period

Rules and criteria (pre-specified in the Ordinance or regulations) for calculating a utility’s asset base

Reduces regulatory discretion. Steers external

consultants. Care required in design. Requires external financial/regulatory experts

Pre-specified rules and criteria for assessing the ‘prudence’ and efficiency of CAPEX undertaken to date (or in the course of the past regulatory period), and in future, at rate reviews

Reduces regulatory discretion. Steers external

consultants. Care required in design. Requires external engineering experts. The more the regulator can adjust prices to take account of a firm’s efficiency, the more analysis and judgement are required and the more complex the analysis will be

Separate fuel base cost allowance taking account best estimate of fuel costs (T2)

Quite simple for this to be constructed. Requires monitoring (as at present)

Improved fuel cost adjustment mechanism (T3) (eg, up-to-date fuel efficiency factor, economic purchasing obligation, smoothing requirement)

Quite simple for this to be constructed. Requires monitoring (as at present)

Source: Oxera.

Some final observations on Option B are as follows:

– standard of evidence—to meet the standard of evidence referred to in section 7.2, it is

envisaged that guidelines would be needed on the methodologies for assessing key parameters of the tariff review. As a guide, regulatory authorities in the Netherlands and New Zealand could provide a model for how to measure parameters such as the

allowed return and RAB, and how costs should be allocated to inform these

assessments. Such criteria should perhaps not be included in the TCI Ordinance, but rather contained in secondary regulations referred to by the Ordinance.

– CAPEX criteria—it is difficult to be prescriptive on these, given the myriad of technical

issues involved in assessing the costs (eg, over the short and long term, especially given uncertain demand growth) and benefits (eg, perceptions of quality of service by customers) of a particular asset that is part of an integrated electricity system. However,

general criteria can be set out for appraising CAPEX, which cover issues such as the following.

– What is the quality of the company’s business plan? – Has the company clearly explained its strategy?

– What is the quality of the company’s forecast of CAPEX drivers in future (eg, demand)?

– Has the company engaged with its customers and listened to their needs (what evidence is there of this)? Has the company considered an adequate mixture of options for meeting future drivers of CAPEX at least cost?

– What level of risk (and reliability) has been assumed by the business in doing so (is this appropriate)?

– To what extent has the business relied on quantitative modelling versus anecdotal evidence in forecasting CAPEX?

– How does the planning process compare with best practice?

– What evidence has the company put forward on its CAPEX efficiency?

– resourcing strategy—section 6.5 listed strategies for a small-island economy in terms

of resourcing regulation at least cost. Model B would involve more outsourcing, as and when the above types of input are required. However, for continuity, it would still require an ongoing presence, with many activities still performed in-house.