Price Path – How does a regulator or a utility design a tariff structure that will gradually align prices with efficient costs over time?

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[Response by Sophie Trémolet and Diane Binder, November 2009] In many developing countries, utilities services are deficient, often due to the fact that they are chronically under-funded (price is based on political considerations rather than on underlying costs), and that government-operating subsidies are unreliable (Brocklehurst, 2002). However, when public money has become scarce and markets have opened to competition, utilities have had to rebalance prices in order to better align them to their marginal costs. To do so, utilities can either reduce costs and/or increase tariffs. Both actions are a gradual process: while increasing tariffs to a level that covers reasonable costs is socially and politically challenging, phasing-out inefficiencies requires long-term incentives and capacity building. A transition period may therefore be needed where inefficient costs would be passed on to customers in the form of a tariff increase with no immediate change in service quality1. The utility would then gradually improve its efficiency and align service to price levels while reducing its costs.

How does a regulator or a utility convince citizens to pay higher prices?2 In most developing countries, prices need to be increased, so that revenues from tariffs can cover sustainable service delivery and coverage expansion, and promote water, electricity or gas conservation by efficient consumption. In order to do so, the regulator or utility needs to engage in an effective consultation with stakeholders and in a change in tariff structure.

  • A demand-responsive approach is instrumental to adapt service to consumer preferences by offering various cost-quality options3 (Dinar, 2000).
  • Tariff reform often involves changing tariff levels, but not tariff structure4. If the latter is not taken into consideration, it can be the case that poorly targeted consumption subsidies (which often simply benefit high volume users with private connection5) persist and service is not in line with the way people use the service (Brocklehurst, 2002). The change in tariff structure6 may include the phasing-out of subsidies, preferably coordinated with an improvement in targeting so that the poorest continue to benefit from lifeline rates7. The introduction of prepaid meters could be an option to facilitate paying access for the poor by simplifying budgeting issues at household’s level and reducing the risks of non-payment for utilities.

How does a utility reduce costs? An effort-less way for utilities to reduce their costs is to either limit quality and coverage expansion. This is obviously not a good option in view of improving overall economic development, or increase efficiency. Making sure that cost reduction happens in a manner beneficial for consumers and the economy at large is the purpose of incentive regulation. The regulator must design a rule that relates the operator’s prices to its costs and will give the firm a trade-off between risk and incentives: if the price does not vary with the costs, the utility has much stronger incentives to keep costs down, but is exposed to much greater risks if it cannot do so. There are several methodologies:

  • Price-cap regulation8, where tariffs are decoupled from costs between price reviews and linked to a price index. Price limits should give companies the incentive to increase efficiency and stimulate them to reduce costs without reducing the level of service to customers. If such tariffs remain unchanged for a relatively long time (as a general rule, 4-5 years seem to be the most frequent interval chosen between reviews), the operator is motivated to improve efficiency since between adjustments, revenues from a gain in efficiency are retained in the utility.
  • Benchmarking, as done for the water and electricity industries in England and Wales where it is possible to get industry-wide performance information. When comparative information is missing, it is also possible to use a virtual company approach9 in which analysts build a simulation model of the operator and estimate the cost level of an efficient operator (the “empresa modelo” to regulate water utilities in Chile for instance).
  • Earning sharing10 (or profit-sharing regulation), which is an approach that allows to share the benefits of cost reductions between the operator, who would keep some portion of its earnings, and consumers, who would get the rest in the form of price reductions, refunds or increased investments in facilities. For instance, the British water regulator Ofwat introduced a rolling incentive allowance for gains in efficiency on both operating and capital expenditures.
  • Another way to motivate operators to reduce costs is to set in the contract explicit targets and penalize the operator if it fails to achieve them (Shirley and Ménard, 2002).

In practice, utilities are often encouraged to increase efficiency and improve the quality of service in order to justify charging higher prices. Customers should be involved, at least informed, about the process, so that tariff reform can smoothly be implemented over time. In many developing countries, tariff reform can be made more palatable to consumers if a credible commitment to quality increase accompanies it.

 

Resources

Resetting Price Controls for Privatized Utilities: A Manual for Regulators
 Washington, D.C.: World Bank, 1999.
Green, Richard, and Martin Rodriguez Pardina

Basics of Rate Design – Pricing Principles and Self-Selecting Two-Part Tariffs
in Infrastructure Regulation and Market Reform: Principles and Practice, edited by Margaret Arblaster and Mark Jamison. Canberra, Australia: ACCC and PURC, 1998, pp. 74-90.
Berg, S.

Tariff Setting Guidelines: A Reduced Discretion Approach for Regulators of Water and Sanitation Services
Public-Private Infrastructure Advisory Facility (PPIAF), Working Paper no. 8, 2009.
Shugart, Chris and Ian Alexander

The Political Economy of Water Pricing Reforms
Oxford, U.K.: Oxford University Press for the World Bank, 2000.
Dinar, A., ed.

Explanatory Notes on Key Topics in the Regulation of Water and Sanitation Services
Water Supply and Sanitation Sector Board Discussion Paper Series, Paper No. 6, June, 2006, Note no. 5: Cost of Service and Tariffs for Water Utilities.
Groom, Eric, Jonathan Halpern, and David Ehrhardt

Profit Sharing Regulation: An Economic Appraisal
Fiscal Studies, 17(2): 83-101, 1996.
Mayer, Colin and John Vickers

Utility Benchmarking
Viewpoint, Note No. 229. Washington, D.C.: World Bank Group, March 2001.
Kingdom, Bill, Vijay Jagannathan

The Case for International Coordination of Electricity Regulation: Evidence from the Measurement of Efficiency in South America.
World Bank Policy Research Working Paper 2907, Washington, D.C., October 2002.
Estache, Antonio, Martin A. Rossi, and Christian A. Ruzzier

Cities Awash: A Synthesis of the Country Cases
in Thirsting for Efficiency, edited by Mary M. Shirley. Washington, D.C.: The World Bank, 2002.
Shirley, Mary M., and Claude Ménard

Definición de la Empresa Modelo en Regulación de Monopolios en Chile
Instituto de economía Pontifica Universidad Católica de Chile, 2003.
J., J.M. Sánchez

Final Determinations. Future Water and Sewerage Charges 2000-05: Periodic Review 1999
November 1999.
OFWAT

Footnotes

  1. Refer to FAQ, question: “Since rates in the water sector seldom reflect cost recovery, how can you convince citizens to accept higher prices (given their willingness to pay?“
  2. Ibid.
  3. See FAQ, question: “To what extent does service quality need to be the same in high and low cost areas?“
  4. See definition of “Price structure” in the glossary.
  5. See FAQ, question: “Do higher income customers benefit more from subsidies than do poorer customers?“
  6. Refer to FAQ, question: “What are the key steps for designing an effective tariff structure?“
  7. Refer to FAQ, question: “What are the strengths and limitations of lifeline rates?“
  8. See Features of Price Cap and Revenue Cap Regulation for more details about price-cap regulation.
  9. Refer to Basic Forms of Regulation.
  10. Ibid.