Tariff Setting Priciple

7/30/2019 Tariff Setting Priciple

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Chapter 2

Principles of Tariff Fixation

2.1 In exercise of powers conferred on it by Section 22 & 29 of the Electricity

Regulatory Commissions Act 1998, and regulation 3 (1) of the Punjab State

Electricity Regulatory Commission Tariff Regulations 2002, the Commission for

fixation of tariff shall be guided by the following;

a. The principles and their applications provided in Sections 46, 57 and 57(A) of the Electricity (Supply) Act 1948 and the sixth schedule thereto.

b. In the case of Board or its successor entities, the principles under Section

59 of the Electricity (Supply) Act 1948.

c. That the Tariff progressively reflects the cost of supply of electricity at an

adequate and improving level of efficiency.

d. The factors which would encourage efficiency, economical use of

resources, good performance, optimum investments and other matters which

the State Commission considers appropriate for the purpose of this Act.

e. The interests of the consumers are safeguarded and at the same time the

consumers pay for the use of electricity in a reasonable manner based on the

average cost of supply of energy.

f. The electricity generation, transmission, distribution and supply are

conducted on commercial principles

and

g. National Power Plans formulated by the Central Government.

2.2 Section 59 (1) of The Electricity (Supply) Act 1948 reads as under -

General Principles for Board's Finance.


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The Board shall, after taking credit for any subvention from the State Government

under section 63, carry on its operations under this Act and adjust its tariffs so as

to ensure that the total revenue in any year of account shall, after meeting all

expenses properly chargeable to revenue, including operating, maintenance and

management expenses, taxes (if any) on income and profits, depreciation and

interest payable on all debentures, bonds and loans, leave such surplus as is not

less than three percent, or such higher percentage, as the State Government

may, by notification in the Official Gazette, specify in this behalf, of the value of

the fixed assets of the Board in service at the beginning of such year.

Explanation - For the purposes of this sub-section, value of the fixed assets of

the Board in service at the beginning of the year means the original cost of such

fixed assets as reduced by the aggregate of the cumulative depreciation inrespect of such assets calculated in accordance with the provisions of this Act

and consumers' contributions for service lines.

The principles under section 59 of ES Act 1948 have been followed by the

Commission in determination of tariffs for PSEB for the year 2002-03 in line

with regulation 3 (1)(b) of the Punjab State Electricity Regulatory

Commission Tariff Regulations, 2002.

2.3 The principles of tariff determination and methodology proposed to be adopted

by the Commission are discussed below:

2.3.1 Price Regulation

There are different methods for regulation of electricity pricing (tariff) in a

regulatory regime. The methods normally used are:

Rate of return Regulation (RoR)

Performance or incentive based regulation (PBR)

2.3.1.1 Rate of Return Regulation

The Rate of Return Regulation known also as cost of service (COS) Regulation

is based on cost plus regulation. 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


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utility / licensee to raise certain amount of gross revenues known as Revenue

Requirement. The revenue requirement is usually determined by

Revenue Requirement (RR) = Expenses + (RoR X CB or NFA)

Where RoR = Rate of return.CB = Capital base.NFA = Net fixed assets.

The expenses include fuel costs, purchase of power cost, operation and

maintenance expenses including employees cost, Administration and

General expenses, depreciation expenses, interest on loans and taxes etc.

The rate of return (RoR) is on the capital base defined in the Sixth Schedule in

Electricity (Supply) Act 1948 in the case of licensee and on net fixed assets as

per Section 59 of Electricity (Supply) Act 1948 in the case of State Electricity

Board.

Under RoR regulation the utility has to provide all the required data to arrive at

the revenue requirement to the satisfaction of the Commission. The onus is on

the utility to prove to the Commissions satisfaction that the proposed revenue

requirements include only prudently incurred costs and the sales and revenues

are reasonably estimated.

The advantages of RoR regulation are:

(i) it is based on an allowed rate of return. Therefore, the prices for the year

are fixed and are unchangeable until next tariff revision.

(ii) lowers the risk of utilities / licensees and would encourage them to invest

in plant and machinery to ensure efficient and reliable power supply.

(iii) the method is conceptually simple and unambiguous in making use of

historic accounting data and

(iv) the utilities are familiar with the data requirement for filing the data etc.

The disadvantages are:

(i) since the utilitys earnings are linked to the amount of invested capital,

utilities tend to over invest.

(ii) the cost plus nature of RoR regulation reduces the incentive for the

utilities to minimize costs and perform efficiently in the long run


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(iii) historic book values may not provide sufficient revenues for future

investment and may result in inadequate investments for future needs

and

(iv) the regulatory process under RoR is long, litigious and costly.

The RoR regulation is most common method used to regulate the rates in

electrical and other regulated business or industry.

2.3.1.2 Performance Based Regulation (PBR)

The performance based regulation is also called incentive regulation (IR) and is

an alternative to RoR regulation. The performance based regulation focuses on

utility


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incentives to attain particular results and its product performance (price and

service quality) rather than costs. Many regulatory systems have shifted or are

planning to shift to PBR as it has gained wide acceptance. Moreover it is

considered that RoR regulation generates inefficiency and is unsuitable when

competition is to be introduced.Performance based regulation encompasses the following features: 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. as well as quality of service indices such as duration ofoutage both brownouts and blackouts. Performance of these factors is then

periodically reviewed and the tariff adjusted for lower or higher

performance than the benchmark. This method rewards or penalizes the

utility based on its performance. This is not strictly cost based.- Tariff filing is not frequent as in the case of RoR but there is

periodical (annual) review of the performance and tariffs are adjusted

accordingly.- The method allows sharing the benefit of cost saving between

consumers and stake holders on predetermined basis.The performance based regulations are:a) Price Cap

The most commonly discussed PBR is price cap. Prices are fixed for

longer period of time (4 to 5 years) and are intended to provide incentive

to reduce costs. A well designed 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 as given below:


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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.


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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

suchas change in fuel expenses, tax laws, accounting procedures etc.

b) Revenue CapPBR mechanism can also be designed using revenue cap instead of price

cap (tariff per unit or kWh terms)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.

This method places an upper limit on revenues thereby constraining the

price indirectly. As in the case of price caps, revenue caps do not constrain

profitability. Revenue cap regulation is preferred for utilities that face

high fixed costs. Its advantage is that it is easy to determine and monitorthan price cap. The disadvantage of this regulation is that estimates of

more parameters are needed for proper implementation and it could lead to

significantly distorted price. Some of the other shortcomings of the system

are:- 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.


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- 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.

Conclusion

For proper design of a good PBR system comprehensive, reliable and

verifiable data is an essential requirement. Having considered the

pros and cons of the two forms of regulation and their

implementability immediately, it is considered appropriate now to

adopt RoR regulation with some modifications by introducing certain

performance targets such as reduction of T&D losses, better metering,

billing and revenue realisation and other quantifiable items.

2.3.2 Determination of Revenue Requirement

An utility, in order to be viable, must be given the opportunity to recover its

prudently incurred total cost of providing electricity services to its consumers.

The allowed revenue must be equal to the revenue requirement to enable theutility to recover its costs and a reasonable return on the investment. To

determine the overall revenue requirement of the utility, it is essential to arrive at

the total cost of providing the service by using accounting, financial and operating

data for the utility system as a whole. The total revenue requirement of the utility

can be worked out by the following formula.

R R = Expenses + (RoR x NFA)

Where

R R - Revenue Requirement

RoR - Rate of Return

NFA - Net Fixed Assets


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The expenses include fuel and power purchase costs, operation and maintenance

costs, wages and salaries, depreciation, interest on loans, taxes etc. NFA is net

fixed assets on which the utility (SEB) is expected to earn a minimum of 3

percent rate of return according to ES Act 1948.

There are three approaches to determine overall revenue requirement.

Actual historical accounting cost.

Estimation of future accounting cost.

Estimation of marginal cost.In actual historic accounting approach the regulator defines a specific 12 months

period in recent past as the historic test year data. The future accounting

approach uses a forecast of future costs and future load expected in a specific 12

months period. The utility may not be able to produce forecasts with sufficient

degree of reliability. The marginal cost approach reflect the cost of expanding

the system efficiently to satisfy the load forecast over a long time horizon.

Estimation of long-term marginal cost is difficult and sensitive to many subjective

assumptions that must be made during the estimation process.

The approach based on historic accounting cost is being traditionally used in the

Indian power sector. There is very little experience with the other two

approaches. The Commission has adopted the historical cost approach for

determining the total revenue requirement.

2.3.3 Consumer Tariff designAfter the total revenue requirement of the utility / licensee is determined, it is

necessary to assign the total requirement to various class of services and to fix

tariff within those classes. The typical approaches include:- embedded cost-based allocation.

- marginal cost-based allocation.

- social tariff making.

a) embedded cost based allocation.


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The embedded cost based approach allocates the total revenue requirement

to various categories of consumers based on an analysis of the embedded

or historic costs of the utility. In such an analysis, the revenue requirement

is allocated to classes of service to fix tariff based on various allocation

factors. The factors can be the contribution of classes to the peak demand,

the energy purchased by each class as a percentage of total sales, the

number of consumers in the class etc.

The advantage of the embedded cost approach is that embedded costs and

allocation factors can be measured based on data that is recorded in the

books of the utility.

The main disadvantage of the embedded cost approach is that the

embedded cost based tariffs do not reflect the economic costs (cost to

serve) that consumers impose on the utility through their electricity

consumption. Embedded cost-based tariffs reflect the average historic

costs of supply which


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tend to significantly differ from the economic costs. For determination of

economic costs (cost to serve) incurred in delivering electricity or service

to each class of consumers a number of factors have to be taken into

consideration in working out the actual cost incurred to serve each class

of consumers. The main factors are: 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 etc.

The data has not been built up by the SEBs in India including PSEB to

arrive at the actual cost incurred in delivering electricity to each class of

consumers. Attempt has to be made to get the data in these aspects over

the next few years to adopt tariffs based on cost of service / cost to serve.

b) Marginal cost based Allocation

According to economic theory, the most efficient assignment of the utility

revenue requirement results from the use of marginal costs on the basis for

class revenue development. This is done by:

i) determining the level of revenue realisation if marginal costs were

charged as prices to each class.

ii) comparing the total to the revenue requirement of the utility and

iii) closing any gap in a way that minimizes the distortions in consumption

resulting in any necessary price deviations from marginal cost.

Marginal cost represents the economic value that the utility has to incur

in order to provide consumers with an additional unit of electricity. As a

result, marginal cost based tariffs provide efficient price signals to

consumers.

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


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c) Social Tariff

In social tariff approach, social policy objectives determine the level of

revenues from each class and there is no relationship between the costs a

consumer imposes in the system and the price consumer pays. For

example the objective to provide highly subsidised power to agriculture

and other classes would lead to very low price to the consumer. The cost

of this measure however, would have to be recovered from external

source, such as governments budget or from other classes of consumers.

If subsidized by other consumers the resulting cross subsidies have a

negative consequence.

ConclusionConsidering the different approaches discussed above, the embedded

cost approach which leads to charging the average cost of supply (as

against consumer class-wise cost of supply) with suitable modification

to allow for some socio economic factors is most appropriate in the

initial years till required data is built up on the pattern of

consumption for each class and categories of consumers.

Inverted block energy charge which leads to higher charge for

increased usage may result in incorporating the marginal cost

approach to some extent.2.3.4 Subsidies & Cross Subsidies

Cross subsidy takes place when one consumer group pays a part of or all of the

cost imposed on the system of another consumer group. The current levels of

electricity tariffs in Punjab contain a large degree of cross subsidisation with

some categories of consumers like large industry, commercial and Railways

paying well above the average cost of supply as compared to other consumers

like agriculture and domestic. The task before the commission is to promote

efficiency, economical use of resources so as to improve the financial health of

the power sector and efficient utilisation of capital, etc.


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The subsidy is the difference between cost of service and tariff charged to a

consumer class. In order to determine the amount of subsidy one must first

estimate the cost of providing service to the customer class. With a large number

of

un-metered users this becomes most difficult. In this context long term tariff

policy will target:- Determining the cross subsidies and shortfall in revenue caused by not

charging subsidised consumer their cost based tariff.- Developing a plan to reduce cross subsidies in electricity tariffFor the Commissions Policy on tariff setting it is important for the State

government to clarify its stand on subsidy amount that it proposes to transfer for

compensating the gap between average cost of service to subsidised categories

and tariff charged to them.

The Commission will in any case, attempt to minimize cross subsidies over

a period of time.

2.3.5 Multi Year Tariff

The tariff filing ideally needs to be a long term multiyear regime to providestability to the market structure. Long-term tariff principles give indication to the

utilities/Licensees and also to investors of how the regulators work and provide a

long term view of their returns. However such a long term tariff determination

and implementation is possible only in a stable demand and supply framework,

not in a shortage situation and growth of 7 to 9 percent every year, where the

investments and costs have yearly fluctuations. Hence to accommodate the

dynamic nature of the Indian Power sector and the State, a yearly tariff filing will

be necessary in the initial years with a transition to multiyear only when the

market conditions stabilize. The Commission proposes to go in for yearly tariff

filings. However, the desirable pace of reduction of T&D losses would be

inducted in a multiyear basis.


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2.3.6 Commissions Approach

In view of several advantages and disadvantages of various options

discussed above, the Commission proposes:

- to adopt the Rate of Return Regulation (ROR) for determining the

revenue requirement with certain performance targets for better

performance of the utility.

- to adopt average cost of supply approach in determination of tariff to

different class of consumers.

- to develop a plan to reduce cross subsidization gradually with improved

efficiency of the utility.

- to suggest that tariff filings should be on yearly basis in the initial years till

demand and supply conditions as well as costs become stable.

Tariff Setting Priciple

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