xmlns="http://www.w3.org/TR/REC-html40" xmlns:v = "urn:schemas-microsoft-com:vml" xmlns:o = "urn:schemas-microsoft-com:office:office" xmlns:w = "urn:schemas-microsoft-com:office:word">APERC Consultative Paper

 

 

 

 

 


CONSULTATIVE PAPER

ON

LONG TERM TARIFF PRINCIPLES

 

 

 

 

Andhra Pradesh Electricity Regulatory Commission

February 2002

 

 

 

 


 

Table of Contents

A1:       Review of Tariff Principles..................................................................................................................... 3

Background................................................................................................................................................................... 3

Concerns expressed in present tariff regulations............................................................................. 4

Experience from other countries and states......................................................................................... 7

What do long term tariff principles regulation mean?................................................................. 9

A2:       Proposals for LOng Term Tariff Principles............................................................................ 11

Present tariff regulation................................................................................................................................. 11

Proposals for modifying tariff regulation.......................................................................................... 13

Overview....................................................................................................................................................................... 13

Process at the Beginning of Control Period:........................................................................................................ 14

Process During the Control Period:....................................................................................................................... 27

Process at the End of Control Period:.................................................................................................................... 32

Implementation Issues.......................................................................................................................................... 34

A3:       Frequently asked questions................................................................................................................ 36

A4:       Consultation Process............................................................................................................................. 39

A5:       Annexes............................................................................................................................................................... 40

Annex 1: International Experience............................................................................................................... 40

Annex 2: Distribution Losses in Andhra Pradesh................................................................................. 44

 

 

 

 

A1:          Review of Tariff Principles

1.1              The Andhra Pradesh Electricity Regulatory Commission (APERC) is presenting this Consultative Paper discussing the application of Long Term Tariff Principles for Distribution and Retail Supply licensees in the state. These principles are intended to determine annual revenue requirement of the said licensees (Discoms).

Background

1.2              The Andhra Pradesh Electricity Reform Act (Reform Act) was enacted on October 29, 1998. The Reform Act provided for reorganisation of the electricity industry, constitution of the Andhra Pradesh Electricity Regulatory Commission etc. Following this, the Commission (APERC) was constituted on March 31, 1999.

Section 11 of the Reform Act details the functions that it entrusts to the Commission. Among them are following functions:

·                    to aid and advise, in matters concerning electricity generation, transmission, distribution and supply in the State

·                    to regulate the working of the licensees and to promote their working in an efficient, economical and equitable manner including laying down standards of performance for the licensees in regard to services to consumers

·                    to promote efficiency, economy and safety in the use of the electricity in the State including and in particular in regard to quality, continuity and reliability of service and enable to meet all such reasonable demands for electricity

·                    to regulate the purchase, distribution, supply and utilisation of electricity, the quality of service, the tariff and charges payable keeping in view both the interest of the consumer as well as the consideration that the supply and distribution cannot be maintained unless the charges for the electricity supplied are adequately levied and duly collected

·                    to promote competitiveness and progressively involve the participation of private sector, while ensuring fair deal to the customers

·                    Others, including – to collect data and forecast on demand and use of electricity, require licensees to formulate perspective plans, lay down a uniform system of accounts and all incidental activities, etc.

1.3              The Reform Act (and other provided legislation) guides the Commission’s approach to regulation. The Reform Act mandates the Commission to take measures conducive to the development and management of the electricity industry in an efficient, economic and competitive manner.

1.4              Section 26 of the Reform Act entitles the Commission to prescribe the terms and conditions for the determination of the licensee’s revenue and tariffs by regulations published in the Official Gazette.

Further, licensees are required to observe the methodologies and procedures specified by the Commission in calculating the expected revenue from charges (viz. Annual Revenue Requirement) and in designing tariffs.

1.5              The section also lays down the following principles for determination of licensees’ revenues and tariffs:

                         the financial principles and their applications provided in the Sixth Schedule to the Electricity (Supply) Act,1948

                         the factors which would encourage efficiency, economic use of the resources, good performance, optimum investments, performance of license conditions

                         the interest of the consumers

In following these principles, the Commission may depart from factors specified in the Sixth Schedule of the Electricity (Supply) Act, 1948 in determining the licensees’ revenues as well as tariffs by recording the reasons therefor in writing.

The overriding expectation is that the Commission will pursue factors that encourage efficiency, efficient use of resources etc., and in the process depart, if necessary, from the strict application of Sixth Schedule. The long-term tariff principles proposed in the consultative paper are wholly consistent and supportive of the expectations of the Reform Act.

Concerns expressed in present tariff regulations

1.6              Present tariff methodology involves an annual review of licensees’ costs and revenues. This review is conducted using well-established regulations and guidelines and follows a clearly stated tariff policy. Licensees, however, will desire:

                         a more quantitative description of tariff policy and standards of performance to avoid different interpretations

                         a stated policy on how risks that are beyond their reasonable control will be dealt, and

                         a regulatory regime that gives them more flexibility in managing their operations and investments

These measures are intended to help mitigate licensee’s business uncertainty and financial risk. The cost of uncertainty and risk, otherwise, falls on both licensees and consumers.

Further, electricity business has certain characteristics that require these concerns to be addressed to make it viable.

                         Electricity distribution system is a capital-intensive infrastructure requiring large investments made in anticipation of demand. Licensees need to raise large funds to build / renovate network and contract generation, which becomes difficult if future income is risky and unpredictable.

                         Electricity generation and consumption happen together. There is no storage – so licensees have to build or contract capacity to meet peak demand (used only for a short period) of consumers, maintain a reserve for system reliability, and import from other states if availability at any instance is insufficient to meet requirements.

                         Licensees are subject to universal service obligation, which mandates them to supply to all consumers irrespective of market conditions. Also, licensees cannot directly control how much or when electricity will be consumed.

In a regulated business such as electricity distribution and retail supply, the regulatory principles are expected to address these characteristics of the electricity industry. .

1.7              Specifically, there are some concerns arising from application of the Sixth Schedule of Electricity (Supply) Act, 1948, which is used for tariff setting, especially for licensees formed from erstwhile State Electricity Boards. The concerns of the Sixth Schedule, and the modifications for consideration are summarised in following table:

 

Table 1

Concern

Provisions in the Sixth Schedule

Modifications for consideration

Quantification and treatment of Sixth Schedule provisions

These are financial principles and not quantified in terms of norms / standards

Norms / standards for costs under reasonable control will be defined. Quantification helps licensees plan better, brings some predictability to its revenues, lowers risk, etc.

Incentive for performance improvement

There is no reward for any improvement in performance

Given the present state of distribution business, well directed incentives can help improve performance faster

Protection against financial losses, which can harm the licensees’ viability

Special appropriation permits recovery of all previous loss as allowed by the regulator

Losses from non-controllable costs alone are permitted for recovery in tariffs

Flexibility to the licensees in managing operations and investments

Flexibility is limited by the annual process for review of all costs and revenues

Licensee is given principles for quantifying tariff (revenue requirement) & quality standards set for certain years, in which period they have freedom to manage their business

Treatment of multiple distribution & retail supply licensees in a region

It deals with a single licensee

Need to deal with more than one distribution licensee in the state, to address regional differences

Linking supply quality and customer service to regulated profits / tariffs

There is no specific provision for quality and service levels

Regulations will link licensee’s profitability to quality of supply and customer service in a phased manner

Addressing transition period issues of licensees formed from unbundling SEBs

Transition period issues are not addressed, although the Commission has expressed its willingness to deviate to meet transition requirements

Transition period issues are clearly quantified and the path for coming out of this transition is also specified

 

1.8              Following its tariff policy, the Commission permitted licensees to recover certain costs deemed beyond their reasonable control such as correcting for shortfall in hydro generation and shortfall in non-tariff income on account of court order. Further, the Commission suggested that losses incurred in taking actions at the instance of the Government (such as extended supply to agriculture) be borne by the Government.

The present process leaves the decision on how uncontrollable risks / losses are borne until the next tariff review. This leaves the licensees in some uncertainty of whether, and how, these risks / losses will be addressed by the Commission.

1.9              To address these concerns, the Commission expressed its intention in its March 24, 2001 Tariff Order, to debate and to prescribe long-term tariff principles for the licensees.

The Commission observed in this Order that it was “inclined to prescribe long term tariff principles on specific aspects such as loss reduction, efficiency gain, incentives and disincentives and such other aspects as the Commission may consider appropriate.  This can be done to provide certainty to the Licensees and facilitate long term planning by the licensee to aggressively deal with loss reduction and otherwise achieve efficiency in the working. The Commission recognises the need for incentivising good performance by the Licensee and the further need to motivate the Licensee through appropriate financial gains”.

Experience from other countries and states

1.10          In the countries the Commission studied, successful electricity sector reform was accompanied by tariff reforms, involving some form or other of long-term tariff principles. Indeed, long-term tariff principles are now seen as sine qua non for performance improvement.

1.11          In UK (England and Wales), the distribution tariff principles are set for five years at a time – the initial control period was 1990-95, the second control period 1995-2000, and the present control period lasts up to 2005. The regulator undertakes a detailed review at the end of these control periods.

In all the periods, power purchase (through a competitive pool, bilateral contracts, etc) is a pass-through and not directly regulated. However, distribution tariffs are directly regulated and are pegged to inflation viz. retail price index (RPI).

In the first control period (1990-1995), distribution income was permitted to cover RPI plus an additional amount (thus RPI+X, where X varied between licensees) to fund additional investments etc. At the end of this first period, a major price cut of about 25% was effected.

The second control period (1995-2000) again pegged distribution income to inflation but was reduced by an amount that was to be met through productivity gains (thus, it was RPI-3%). At the end of the second period, again, a major price cut of about 25% was effected. The third control period, now in operation continues with RPI-3%, and will last until 2005 (summary is presented in Annex 1).

1.12          In Argentina, which had many similarities with our power sector at its restructuring in 1992, the initial tariff control period was 10 years (1992-2002) for the problems were thought to be more acute requiring a longer time to resolve. In the event, the turnaround was achieved much sooner.

Distribution network costs are pegged to inflation, while distribution system losses are pass-through only to the extent of 10%. The licensees were permitted to retain all efficiency gains over these targets for the ten-year control period. Power purchase (which is from various sources including a competitive pool and bilateral contracts) is smoothened through a system of seasonal tariffs and is a pass-through. The results of Argentine experience, in terms of viability of licensees, loss reduction, improvement in customer service etc, are presented in Annex 1.

1.13          The Commission is aware of the regulatory experience in other states through its interactions. In Orissa, the licensees have expressed concerns, among other things, of the regulatory risk. A number of experts have advocated the need to allay these concerns. In Uttar Pradesh, certain proposals were made to reduce perceived regulatory uncertainty and provide incentives to encourage better performance. The Government of Delhi notified its policy directions for similar purposes in the Delhi Gazette dated November 22, 2001.

1.14          The Commission recognises that in Andhra Pradesh, the successful experience and principles from elsewhere need to be adapted to the conditions in the state. These are well-known and briefly discussed below:

                         At present, licensees’ revenues from tariffs do not cover their costs. In FY2001, APTRANSCO expected Rs 6239 crores as revenue from tariffs and Rs 500 crores from efficiency gains with the balance Rs 1626 crores to be met through Government subsidy. In the event, it incurred a loss of Rs 1024 crores because expected outcomes did not materialise and additional power purchases made for supply to subsidised categories. A process of tariff rationalisation to cover the gap between expenditure and revenue, reduce distortions arising from cross subsidies and reduce Government subsidy is inevitable, which may cause tariffs to initially rise but reduce later as efficiency gains are achieved.

                         Ground conditions are more difficult in Andhra Pradesh, due to larger population and area than many other countries, poor network and asset conditions, etc., requiring larger investment and more effort (and thus time) to effect efficiency improvements.

                         Large cross-subsidy poses a supply risk to licensees today. In FY2002, apart from the Government subsidy of Rs 1561 crores, certain customer categories (e.g. industrial and commercial) provided cross-subsidy of Rs 2028 crores to, mainly, agriculture and domestic consumers. Cross-subsidy causes a financial loss if less than expected is sold to subsidising consumers (such as industrial and commercial users). Indeed, this problem tends to snowball, for due to high cross-subsidy, many industries have switched over to cheaper alternatives.

                         Licensees have little information on supply quality and customer service. It is evident, though, that large difference persists across licensees and, for a licensee, between different (rural / urban) areas.

These concerns are real, and have to be addressed, irrespective of the choices that may be made on the future tariff policy.

What do long term tariff principles regulation mean?

1.15          Long-term tariff principles do not mean tariffs will be set for many years to come. Indeed, it is not possible to set tariffs for a long time because input costs change all the time. Power costs change with fuel prices, salaries and wages with inflation, finance cost with interest rates, cost of investment and repairs with equipment cost and so on, none of which are in the licensees’ control or prior knowledge. Finally, changes in consumer mix also impact the viability of licensees because some consumers are subsidised by others.

1.16          Long-term tariff principles give indication to licensees (and also to others) of how the regulator works. It unambiguously lays down the tariff methodologies, which can be understood by all, and gives a fair idea of future upon making certain assumptions. In this way, all stakeholders are made aware of the outcome of various actions / events, and at least for the defined future time period, and are able to plan accordingly. In simple words, the rules of the game are agreed up-front and then adhered to by all.

1.17          For the licensees, the principles provide clarity in rules applied over a long-term, and help finance growth and operations better, and facilitate improvement in supply quality and customer service.

Secondly, the design of incentives should help promote efficiency. Since efficiency improvements need time to take effect, these incentives should be applicable for a reasonably long period of time. 

Thirdly, the principles help licensees mitigate risks in electricity supply. A feature that is peculiar to SEBs and licensees formed of them is the large risk in supply (due to high cross-subsidy), which is mostly beyond their control.

1.18          For consumers, improvement in efficiency translates into more cost-effective tariffs. And viable licensees alone can provide better supply and service.

The long-term tariff principles regulation is expected to evolve towards managing by outcomes (such as supply quality, customer service, retail tariffs etc) rather than by regulating discrete cost elements and actions. This emphasis on retail outcomes will help bring in time better attention to customer care.

1.19          The Commission believes all proposals made in this consultative paper on long-term tariff principles regulation, are consistent with the provisions of law. The proposals complement the Sixth Schedule and fully support the principles laid in the Reform Act for determination of tariffs. The Commission believes that implementation of these principles is essential for achievement of the objectives (efficient, economic and competitive development and management of the electricity industry) by the Reform Act.

 

 

A2:          Proposals for LOng Term Tariff Principles

Present tariff regulation

2.1              To help gain better understanding, following simplified description of the tariff regulation has been adopted by the Commission in its past tariff reviews. The important elements of the review are:

·                    Review of annual revenue requirement and Tariff proposals

·                    Cost of service and Fully allocated costs

·                    Tariff design and Full cost tariffs

2.2              Annual Review of Revenue Requirement and Tariff Proposals:

In terms of Section 26 (5) of the Reform Act and subsequent APERC regulations[i], licensees are required to file effectively by December 31st of every year, the following details for the ensuing financial year:

                         its expected aggregate revenue from charges under current tariffs

                         its expected cost of service, and

                         its expected revenue gap and explanation on how it proposes to deal with the revenue gap (if any)

In this process, the Commission examines all other relevant financial and operating results of the licensee, using latest available estimates for the ongoing year. In the detail, the review supports a number of actions:

                         whether the proposed costs and revenue projections are prudent

                         how past performance compares with the previous Order, the reasons for variation in out-turn from that expected, and how to address it

                         assess efficacy of incentives (load factor, metering, etc), changes in supply conditions etc., and consider changes required

2.3              Cost of Service and Fully Allocated Costs:

The Cost of Service computation help understand, on a more scientific basis than  mere average cost, the actual costs involved in supply to each category of consumers, and thus the actual quantum of cross subsidy and subsidy. Using this approach, costs are assessed for each category of consumers, and the Fully Allocated Cost (FAC) for each category of customers is determined after reducing respective cost by the proposed overall efficiency gains.

2.4              Tariff Design and Full Cost Tariffs

The Commission determines how much of this FAC is to be met by cross-subsidy from subsidising consumers such as industries. Accordingly, the revised tariffs of categories of subsidising consumers are fixed. This is a discretionary decision, but guided by the twin objectives of reducing the onerous level of cross-subsidy today and a gradual tariff rationalisation.

To the extent that revenue from current charges and expected cross-subsidy available falls short of FAC, the tariffs are revised for each category of subsidised consumers. This schedule, called the Full Cost Tariff, is released to the Government, which in accordance with Section 12(3) of the Reform Act may propose an alternate tariff and extend a subsidy to cover the shortfall.

The concept of Full Cost Tariffs is important – it ensures that the licensees obtain an income sufficient to cover their expenditure. It is a separate matter how this income is generated viz. through tariffs and the balance by way of subsidy. 

2.5              The concerns of present tariff regulation were discussed in the previous chapter. To recap, the main concerns were:

                         annual review, lack of quantification in tariff policy and insufficient guidance on risk mitigation were seen as causing uncertainty

                         insufficient consideration for transition problems, and lack of incentive to eliminate large inefficiencies prevailing today

To address these concerns, certain proposals are made in this paper, in the form of Long Term Tariff Principles. The key features of these proposals were discussed in the previous chapter, and for a quick recap, they are:

                         tariff principles will be quantified and fixed for a control period of 3 to 5 years

                         performance and quality standards will be set and improvements will be incentivised

The third chapter of this consultative paper discusses the benefits and safeguards provided in the proposed tariff regulation.

Proposals for modifying tariff regulation

Overview

2.6              Long Term Tariff Principles are sought to be fixed for a certain period (viz. control period). This involves three different stages of process:

                         process at beginning of the first control period

                         process during the control period, and

                         process at the end of the control period

The Commission will present the proposals, for each of the above stages, explaining how they will operate, discuss pros and cons, identify implementation issues and provide safeguards. The descriptions are reasonably detailed, to the extent demanded by the nature of this paper/process, and are stated in a simple form to facilitate wider participation.

2.7              The process at the beginning of the first control period has to determine the form these principles should take, and the period for which they should apply. In discussing the form, the questions asked will be:

·                    which performance factors need to be incentivised and in what form should incentives and penalties be structured, and how the targets should be set

·                    how will the variance between the actual performance and the targets should be dealt

2.8              During the control period, the annual review will be conducted as specified in the Long Term Tariff Principles that were agreed at the commencement of the control period. The questions asked will be:

·                    how are the principles applied during control period, and how to make the corrections needed

·                    what are the principles to be applied in determination of bulk supply tariffs

2.9              At the end of the control period, the principles and process will be comprehensively reviewed. The review is intended:

·                    to take stock – whether the regulations have achieved objectives sought, to assess changes needed before proceeding to the next control period, etc

·                    to propose the way forward – includes revising targets/incentives or other provisions and sharing gains with consumers at the time of resetting new control period, etc

2.10          The reviews at the beginning/end of the control period are extensive requiring longer time say, 12 to 18 months. The annual (viz. during the control period) reviews will be shorter and, as required under the Reform Act, will be completed within 90 days.

 

Process at the Beginning of Control Period:

2.11          The first step viz. to determine the form these principles should take, is the most important one. For this, it is useful to understand the nature of the licensees’ business and what control it has on the outcomes. It is characterised by following features:

                         Volume of energy sales is not in its control as individual consumers decide how much & when to consume, and influenced by weather conditions, industrial activity, etc. It follows that the mix of consumers whom licensee sells to (and, thus, the net sum of cross-subsidy) is also outside its control[ii].

                         Bulk Supply Cost constituting about four-fifths of licensees’ costs is well beyond their control. In fact, the cost movement here is outside the power sector and arises due to fuel price changes, forex variation, failure of rainfall and thus the shortfall of cheaper hydro generation, inflation, etc.

                         System Losses: Part of power purchased dissipated in technical loss and theft, is deemed as within licensees’ control. It is evident that certain losses can be tackled sooner. System loss reduction, however, may not be considered controllable if the control period is short.

                         Operating costs are considered within the control of licensees. It may have lesser discretion in incurring some of these costs, but should be able to manage on the whole.

Following table helps us understand the relative magnitude of these costs (taken from the Distribution Tariff Orders for FY02).

 

Component

Cost (paise/kWh)

Percentage

Bulk Supply Cost

 

 

·        Cost of Power Purchase (purchased units for sale)

196

63%

·        Distribution System Losses (purchased units to cover losses)

58

19%

Operating Costs

 

 

·        Network Costs

44

14%

·        Financing Costs

12

4%

Average Cost of Supply

310

100%

 

This characterisation of licensees’ business provides a useful basis for shaping the long-term tariff principles. Thus,

·                    Licensees could be made responsible for controllable factors. Incentives and penalties, hence, should apply only to such factors that it influences – in our case, it will be system losses and operating costs

·                    Licensees should be fully compensated for factors not in their control. Thus, changes in non-controllable factors are appropriately corrected, and no incentive or penalty is applied.

2.12          The Commission will first discuss controllable factors, which are defined as those, broadly, in licensees’ control. Before discussion on the specific factors, two questions arise:

(a)                On what factors should the incentives and penalties be structured?

The controllable factors, System Losses and Operating Costs, are clearly distinct and need to be dealt with separately. Operating Costs, in turn, can be treated as one element, or can be split into:

                         Network Costs, which consist of salaries and wages, repairs and maintenance, administrative and general costs

                         Financing Costs, which consist of interest, return on capital base (or equity), banking charges etc

The answer to whether these should be treated separately or together depends on the context. If large investments are needed, which are not evenly spread over time, and future interest rates are uncertain, it may help to deal with network and financing costs separately.

(b)               In what manner should the incentives and penalties be structured?

How the incentive/penalty is structured is important - Will it be attractive enough for the licensees? Are they capable of taking on the attendant risks? There are two ways of structuring this incentive/penalty:

·                    Set a target. Any better performance (i.e., all savings on this target) is retained by the licensee as incentive, and under-performance (i.e., all losses from inability to meet target) is retained with the licensee as penalty.

·                    Accept the cost as filed by licensees. Thus, cost increases or decreases are passthrough into tariffs. Better performance (in comparison with previous year, or vis-à-vis a benchmark, or relative to other Discoms) earns a predetermined incentive and under-performance a predetermined penalty.

Clearly, the former method offers more incentive but is more risky as well. Relatively, the latter has less incentive but is less risky. Which is the preferred method is a question for debate. In the description of long-term tariff proposals, the Commission has presented elements of both methods.

2.13          System Losses:

For distribution licensees in Andhra Pradesh, the largest economically desirable and most practicable improvement is in reduction of system losses (Annex 2). There is ample evidence now from here and other states, that loss reduction is a hard and time-consuming process, requiring investment, good management systems, vigilance, proper legislation and regulation, effective public communication and support.

In the following paragraphs, the proposals made for treatment of system losses under long-term tariff principles are discussed.

(a)                How should rewards be structured to encourage reduction in system losses? Sometimes, the question put is – what is the level of losses? The Commission discusses below three alternate proposals, which are successfully in use elsewhere.

Option 1: Accept system losses as declared, and provide a predetermined incentive for improvements or a penalty for non-achievement: If L% is the expected distribution system loss for ensuing year, the same is accepted in full for computing revenue requirement. At the end of the year, if the actual system loss is:

·        higher; then the licensee is permitted to claim the deficit in next year’s revenue requirement, but a penalty proportionate to underachievement but limited to say, its regulated return (i.e., profit) for the year is imposed

·        lower; then the licensee is required to deduct the excess from next year’s revenue requirement, but claim an incentive (say, equal to half of savings i.e., kWh saved at rate of 50% BST)

In this method, one needs to know the actual system losses every year. To ensure correctness of the licensees’ report on system losses, a previously agreed measurement procedure will be used.


 

Option 2: Accept targeted system loss level, and any improvement/shortfall i.e., target less actual constitutes incentive (and if vice versa, a penalty). The target is set, at the beginning of the control period, for the entire period, and is called a loss curve.

If T1%, T2%, T3%, etc are pre-set distribution system loss targets for each year of the control period, revenue requirement will use the target for the year (and not the actual). If the actual system loss is:

·        lesser than target; the licensees gain the entire difference as incentives, without any cap. Thus any performance better than the set target contributes to the licensees’ financial profit.

·        higher than target; the licensees bear the entire difference as penalty, without any safety-net. Thus, any performance below the set target is borne by the licensees as a financial loss.

In this method, licensees can make large gains or incur large losses. It is expected that the financial loss in the initial years will be made good by the profit in subsequent years. A suggestion is to impose a cap (or safety net) on incentive  (or penalty), but it has the disadvantage of diluting the very strength of this method. The target loss is set at a reachable, but well-below present day level causing licensees to bear deficits initially but sufficient surplus later to recover it. In setting target below present day level, consumers gain immediately but “repay” it later by permitting licensees a higher income than otherwise. Given the diverse uncertainties inherent to licensees business, this method will succeed only when sufficiently long time (viz. long control period) is provided.

Option 3: Accept system loss level equal to a moving average of say, past 3 years’ actual loss level as the target, and any improvement/shortfall i.e., target less actual is an incentive (and if vice versa, a penalty). The target is not set upfront, as it was for the first two options, but evolves with time.

If T0%, T-1% and T-2% are actual system losses of past three years, for revenue requirement moving average of these three is considered. The interpretation of outcomes is same as for (ii) above.

In the method, the licensee earns incentive if its performance improves, and suffers penalty when performance worsens. The incentive / penalty arise from the natural lag of a moving average. Thus, the pace of change (improvement or deterioration) determines the degree of incentive and risk incident on the licensees.

Another method proposes to fix system losses, for deriving revenue requirement, at present level for the entire control period. Thereafter, if assured by evidence of reducing system losses, tighter targets could be written in for the next control period.

(b)               How do these methods compare with each other in terms of, immediate as well as long-term, benefits to consumers?

The end of control period process applies similarly to all. This may involve consumers sharing efficiency gains achieved over the just completed control period, followed by possibly stricter performance targets for the next control period.

(c)                Is the concern of insufficient or incorrect information valid? And how are the licensees and consumers protected against its consequences?

If all consumers were metered, measurement of system losses would have been possible. As about 10,000 MU sales are not metered, level of system loss has come to depend on the assumptions made for measuring agriculture usage, on which different opinions have been expressed.

Method (ii) using loss curve avoids need for annual loss estimation, but is exposed to the risk of a wrong starting point. A number of studies are underway, with different methodologies, to estimate the starting point. For further comfort it can be provided that if licensees later discover, using an agreed methodology, significant deviations from initial estimates, the Commission is open to revising the initial estimate.

For all methods, a commonly agreed methodology for loss estimation is vital for the proposed principles to work.

(d)               How are changes in consumer demand addressed in the proposals made?

System losses on EHT/HT network are far different from that on LT. And the licensees have little control over load evolution. A single measure of aggregate system losses poses them risk of sales mix. This is addressed by separate loss incentive methods for EHT/HT and for LT connections.

With regard to load growth, one will expect that new supply will have better protection (say, to help control pilferage) and hence help decrease aggregate system loss. For reasons of simplicity, it may be desirable to treat demand growth in same fashion as present sales, while dealing with system losses.

2.14          Network Costs:

Network costs comprise Wages and Salaries, Repair & Maintenance (R&M) costs, Administrative & General (A&G) expenses, etc. Effectively, it covers all costs of operating a distribution business other than financing.

The present practice involves review and approval of these costs forecasted by the licensees. In this traditional review there are considerable limitations: first, network costs comprise a large number of diverse items and in the short time available there is a limit to effectiveness of this review. On the other hand, it may be desirable to give more flexibility to licensees in managing their operations and to set economic signals through a performance based regulation.

For dealing with network costs, and determining what is acceptable for its revenue requirement, the Commission proposes below two methods of regulation:

(a)                Option 1: Indicate the permissible cost. And any improvement / under-performance is by itself an award of incentive / penalty respectively. The process is:

·                    undertake a detailed review of present network costs and assess the trends forecast for next 3-5 years, concluding with an approved initial cost (this can be a more rigorous, and hence an effective exercise, as more time is available to conduct it)

·                    permit an annual revision of the approved initial cost by pegging to an external predetermined index (such as the consumer price index as published by the Labour Bureau)

This assures licensees recovery of cost increases up to inflation. Further, it doubly encourages economy - first, by forcing licensee to limit its expenditure within means; and second, by means of an incentive that permits it to retain any savings over adjusted approved cost. Finally, the benefit of regulatory scrutiny is not lost (it comprehensively reviews at start of control period) even as the freedom of licensees to manage its business in not compromised.

 

(b)               Option 2: Accept the full declared network costs of licensees. Better performance (in comparison with previous year, or vis-à-vis a benchmark, or relative to other Discoms) earns a predetermined incentive and under-performance a predetermined penalty.

The support for this method arises from a concern that most constituents that make up network costs may elude control of licensees. These apprehensions were expressed:

                         distribution operating costs in the past (1993-1998) increased at an average 16% per annum whereas Consumer Price Index rose at 10%

                         it is suggested that licensees historically under-spent on repairs and maintenance for budgetary constraints, and that in future this deficit has to be made up and probably more for improving quality standards

                         certain cost rise such as salary and wage revision that, historically, was undertaken once every five years, and not be predictable today

Not digressing into the merits of these apprehensions, it should be mentioned that these concerns could be addressed in method (i) proposed above as well. For instance, rather than a simple peg to inflation, network costs can be set to inflation plus an X offset, where the X can be designed to cover costs that are structurally in excess of inflation, or provide for additional maintenance costs and so on.

2.15          In the following paragraphs, proposals for tariff regulation are discussed separately for the regulatory asset base and the rate (of interest, and of return on capital). The discussion on regulatory asset base is essentially that of future capital investments, as past will continue to be assessed as per present practice viz. historical net book value basis. Thus, the discussion is under the heads of:

                         capital investments

                         interest /financing charges and return on capital

2.16          Capital Investments:

How should investments be approved? Should actual investments be reviewed every year vis-à-vis the approved plan or licensees permitted a longer time to capitalise?

License conditions require distribution licensees to seek the Commission’s approval for any capital expenditure over Rs 5 crores. The filing is expected to inter alia show that the investment is needed and in consonance with the power system plan, and that it is satisfied with economic, technical, environmental etc., feasibility of the project. The first option is to continue with the present process of annual investment plan review and monitoring.

The second option seeks to give licensees flexibility in planning and implementation of capital works in response to field conditions. This also helps the regulators perform a more discerning economic appraisal as it is for a package of capital works rather than for numerous separate works posed at different times.

In the second option, the approach for capital investment approval is as follows:

·                    at beginning of the control period, undertake a detailed review of investment plan, addressing needs in the next 3-5 years for load growth, refurbishment, loss reduction, supply quality and reliability, metering and communication etc. concluding with an approved long term investment plan

·                    during the control period, the investment plan implementation is monitored but no adjustments are made for observed differences in revenue requirement as long as physical parameters agreed earlier are being met

This allows licensees to implement investments in closer response to customer needs. It also rewards a licensee that is able to procure capital goods cost-effectively, manage project execution better and has higher asset utilisation.

For the initial control period, considering relative inexperience in long-term planning of investments, it may be prudent to provide for a mid-term review. The scope of the review can be defined up-front and may include looking at new demands, revised priorities, delays outside control, changes in industry structure or technology or any significant issues on which licensees desire a review.

Depreciation charge for purpose of revenue requirement will be initially as forecast but later corrected to that provided in audited accounts.

2.17          Interest /Financing Charges and Return on Capital:

Interest/ financing charges and Return on Capital under the Sixth Schedule provisions are permitted at actuals, which give licensees no motivation to economise on costs, and does not distinguish a better performing licensee from another. There are different ways of modifying the present approach:

                         Based on cost of capital, a single rate combining the interest rate and rate of return, applied over total capital employed (debt + equity)

                         Based on separate norms for interest and rate of return, applied separately to debt and to equity

In either case, the Commission reviews all aspects of financing in detail at the beginning of the control period. The difference between the two approaches lies in flexibility given to licensees to change their financing mix depending on which is cheaper.

The questions that may be discussed are:

(a)                What should be the permissible level of debt and equity?

All capital investment is funded through equity or debt (could be any form). Approved investment plan indicates total fund requirement – the manner of financing may be left to the licensee.

Debt for working capital is separately addressed later. Debts raised earlier for deficit funding will have to be included for interest computation. If there were debts beyond this, say funding a non-regulated business like a telecom, it would stand excluded.

(b)               What is the permissible cost of debt?

To give prior indication of costs that licensees can incur on future investments, and provide incentive to lower effective cost, the options are to peg the cost of debt to a Bank Rate or a Prime Lending Rate (PLR) plus a predefined margin that depends on licensee credit rating, market conditions etc., at beginning of control period.

Thus, any saving achieved in raising funds more cost-effectively rewards the licensee. This may also have some scope for misuse – for instance, licensees can defer interest payments out of control period, or defer principal repayments causing cash shortfall later. For this reason, a good safeguard in form of mandatory regulatory accounting standards and policies are important.

(c)                Is the working capital provision under the Sixth Schedule adequate to licensee requirement? How is working capital requirement better met?

The Sixth Schedule provides working capital support for stores and cash but not for receivables from consumers. Presently, collections from both current billing and arrears fall short of average billing, resulting in licensees eventually defaulting to generators. Licensees are making efforts to improve collection performance. To extend working capital during this transition period, it is necessary to modify the treatment of Sixth Schedule. The options for working capital are:

                         Option 1: set a target for collection % over the control period and permit charges for working capital cost to that extent

                         Option 2: permit recovery of entire working capital cost as filed but provide incentives inversely proportionate to quantum of working capital

Shareholders invest capital that funds licensees’ capital expenditure and operations in small part but helps in borrowing the rest (often 70-80%). Shareholders expect a reasonable security and return on their capital necessary to invest any and lack of shareholders financial support can snowball into a severe financial crisis. Experience from other states bears this out.

This leads to the following questions:

(d)               What is the appropriate base for determining licensees’ returns?

Sixth Schedule of Electricity (Supply) Act, 1948 does not provide a direct return on shareholders funds (viz. net-worth) but indirectly on what it defines as Capital Base (broadly, assets less non-shareholder liabilities). Ideally, capital base equals net-worth but licensees formed of erstwhile SEBs inherit their operational problems and are, for the moment, loss-making. Now,

                         a licensee that bridges revenue loss with additional shareholder funds gets no compensation for it, since no corresponding asset is created

                         and if licensee funds revenue loss through debt, which if not permitted renders the entire corresponding interest cost non-recoverable

Companies in process of turnaround need money, and shareholders’ continued interest is important. The Sixth Schedule provisions do not support this need. The proposal suggested is to substitute computation of Returns from Capital Base to Net Worth. 

(e)                What is the appropriate Rate of Return?

Conceptually, there is no difference between capital base and the proposed net-worth. Thus, the rate of return could remain unchanged at 16%. 

(f)                 Is there a cap on profits that licensees may earn beyond 16%? Is this shared with the consumer?

The Sixth Schedule permits licensees to retain profits up to 1.2 times above the 16% norm and thereafter retain one-third (limited to a maximum of 5% of reasonable return) of excess and redistribute the rest equally into a reserve and as a rebate to consumers. The proposed tariff regulation retains this clause for sharing gains with consumers, with two modifications:

·                    The limitation of 5% could be done away with, as profits beyond 16% can come only through better performance, and a better incentive can be permitted if it encourages a correspondingly better outcome.

Thus, there is no cap on profits, although beyond the limit specified under the Sixth Schedule, profits are equally shared between the licensee, its shareholders and consumers, which means a gain of 1/3rd to each.

In sharing the efficiency gains, the two options to discuss are whether to distribute every year, or to retain it till the end of control period before they are shared.

·                    The reserves can be more broad-based than that specified in the Sixth Schedule (i.e., Tariff and Dividend Control Reserve), and this relaxation is to permit end-use suggested above and to encourage licensees utilise reserves for investments.

Furthermore, a part of this amount can be provided for distribution to employees as performance incentive.

Licensees are required to follow accounting standards and policies as laid down by the Commission and are expected to take specific approval for any change in basis. This is meant to safeguard integrity of profit information from creative use of accounting provisions.

2.18          Standards of Performance

The Commission has initiated certain steps to improve supply quality and customer service. This includes:

                         Regulations on Standards of Performance, which inter alia deal with normative time for restoration of supply, information to consumers on scheduled outages, time to attend metering / billing complaints, time taken by licensees to connect new applicants and so on.

                         Regulations on Consumers’ Right to Information, which inter alia deal with the rights of consumers such as notice to be served before disconnection, notice prior to entry into any consumers premises, reclassification of consumer categories and so on.

Evolution of regulation in other countries shows that quality and customer service grow gradually to become pivotal for all regulation. Licensees enjoy considerable freedom in operations, maintenance and investments, and increasingly reviewed only against achievement of quality and service standards. As the market becomes more competitive, and price controls gradually dismantled, quality & service are the only regulatory measures – it is left to the market to deal with pricing aspects.

However, even in developed economies, the transition came about gradually. Measurement of quality and service is difficult, more so in large dispersed networks as in Andhra Pradesh.

(a)                What are the constraints in linking quality and service aspects to tariffs today, and how can this be addressed in future?

Licensees have little information on supply quality and customer service obtaining today, and will have even less conception of how much improvement is possible. This is not an unusual starting point, and elsewhere also, the regulators had to overcome similar constraints.

The Commission believes that further initiatives are needed to bring better attention to quality and service aspects:

                         after an initial moratorium period, a phased implementation of penalties for under-par supply quality and customer service

                         an early statement of principles and expectations to help the licensees prepare with measurement systems, investment plans etc

(b)               How are supply quality and customer service issues addressed in the proposed tariff regulations?

Our immediate step is to develop a mechanism to quantitatively measure and record supply quality and customer service. An early start can help ready the system sufficiently to gradually implement more effective service measures.

2.19          This concludes the discussion on proposals confirmed at the beginning of the control period. The subsequent steps i.e., review during the control period, and at the end of control period, also have to be declared up-front. These are discussed below.

 

 

Process During the Control Period:

2.20          In this section, the Commission will discuss the process during the control period. The annual process will involve:

·                    Filing of Expected Revenue from Charges / ARR

·                    Filing of Tariff Proposals

·                    Determination of Bulk Supply Tariffs

Following paragraphs discuss the treatment for these annual processes under long-term tariff principles.

2.21          Filing of Revenue Requirement:

The licensees will file their Expected Aggregate Revenue from Charges (ERC, better known as the Annual Revenue Requirement – ARR) as required under the Reform Act at least 3 months before the ensuing financial year.

2.22          Filing for Proposed Tariffs:

In filing its proposals for tariffs, licensees are required to observe the methodologies & procedures specified by the Commission for calculating the ERC and for designing tariffs. The methodologies & procedures prescribed in the present regulations may be amended based on the decisions taken by the Commission in the matter of long-term tariff principles, the subject of this consultative paper.

The annual tariff filing will contain:

                         description of costs, at actual for past and current year, and worked as provided under long-term tariff principles for the ensuing year

                         forecast other elements, such as expected sales, inflation, interest rates, etc., as required

                         correction factors (discussed below)

                         supply quality and customer service actual and anticipated (for aspects that will be linked, in phased manner, to licensee returns and thus, tariffs)

These details will help us assess the adjusted fully allocated costs (adjusted, because, it is based on use of long-term tariff principles). Based on this, and other process that the Commission discussed in this paper, the final full-cost tariffs are determined.

2.23          Correction Factors:

In the tariff filing, licensees will claim controllable costs as provided under long-term tariff principles. There is no correction for controllable costs other than to revise for actual values of external variables such as inflation etc., that may be used to peg some of these costs. However, for non-controllable costs and for items that are forecasted, every year a correction is needed to reconcile the actual vis-à-vis the forecast. This is simple in concept but complex in implementation. The readers may have the following queries:

(a)                Why is a correction factor required?

Tariffs, it may be recalled, are set on the basis of forecast costs and sales for the ensuing year. Licensees, while filing tariff proposals, thus make a few assumptions for the ensuing year such as likely sales to each consumer category, power purchase mix from various sources, inflation, interest rates etc. These assumptions are compared with actual, when the actual becomes known at the year-end, and the difference (positive or negative) is the correction factor.

Sometimes, a correction factor may require a further “correction” in the next period because some data takes longer time to get finalised. The chain of correction factors concludes with audited accounts or its equivalent. This is analogous to revising budget estimates, later revisions to provisional estimates, etc before finalisation.

Correction factors operative today, such as Fuel Price Adjustment Clause, will continue, though processes may be streamlined for convenience.

(b)               How is the correction factor applied?

The correction factor (positive or negative) is taken as a special appropriation and added to other expenditure to arrive at revenue requirement.

Correction for external variables such as for inflation will be adjusted in revenue requirement of distribution licensees directly. Correction factors relating to all non-controllable costs are adjusted in revenue requirement of – either the distribution licensees evenly, or in the bulk supply tariffs (this aspect is discussed later). In either case, the correction will eventually be reflected in full cost tariffs.

(c)                How should the extraordinary or large correction factors be dealt?

Routine correction factors, discussed till now, should be small. However, licensees could face a large unanticipated change from external events – for example, a rise in global fuel prices or severe industrial downturn or climatic factors such as a persistent monsoon failure or a cyclone etc.

These costs are non-controllable, qualifying for recovery in tariff. However, as these are exceptional items, it is possible (and, desirable from consumer and economic perspective) to spread their recovery over a few years, reimbursing the interest costs in the meantime.

2.24          Bulk Supply Tariffs (BST):

In present industry structure, APTRANSCO is the single buyer / seller of grid power. All distribution licensees purchase electricity from APTRANSCO at a Bulk Supply Tariff. As BST is regulated, it is an entirely valid cost to distribution licensees. This is straightforward; the complexity of setting BST comes from other aspects that are discussed shortly:

(a)                How does the Commission determine the BST at present?

In its 24th March 2001 Tariff Order, the Commission adopted a differential BST recording its reasons. The Commission has observed that:

                         The principle of level playing field suggests the need for the Transmission Company, especially since it is a natural monopoly, to charge uniform bulk supply tariffs to all who purchase power

                         In the transition period, the historical factors which have shaped the Discoms stand in the way of simple uniform bulk supply tariff and uniform retail tariff

                         Section 26 (8) of the Reform Act directs the Commission to endeavour to fix tariff in such a manner that as far as possible similarly placed consumers in different areas pay similar tariff

                         To implement this mandate, the Commission has to re-balance the surplus and deficit in cross-subsidy available with Discoms, to ensure that the retail tariff is the same

                         In future, the extent of differential in the bulk supply tariffs charged to Discoms will gradually reduce in tune with the reduction in extent of cross-subsidy between various classes of consumers

                         However, it is important to have an in-built mechanism of monitoring performance and providing performance based incentives to the individual Discoms.

The Commission opined that in the process of determining BST, efficiency gains achieved by a licensee should be recognised and not lost in the ensuing year’s BST setting. This is extremely important, as otherwise a bad performer will come to be subsidised by the good performer, who in turn would have lost all motivation to perform any better.

(b)               How is BST computed under proposed long-term tariff principles in future?

The methodology to compute ensuing year’s BST depends on the nature of long-term tariff principles adopted at the end of this consultative process. In other words, this question is best answered at the conclusion of this exercise. It is important, nonetheless, to discuss the principles on which BST will be structured. This is the single biggest cost element for Discoms, and the Commission recognises the need to design it robustly.

In future, until transition conditions discussed earlier prevail, BST may have to be set on a differential basis. The differential will be derived in following manner:

(i)                       Transmission and Bulk Supply (T&BS) Costs: All changes in power purchase and transmission costs filed by APTRANSCO will apply evenly to BST of all distribution licensees; but any directly entered approved PPAs, will apply to that licensee alone as provided in its PPA.

(ii)                     Distribution and Retail Supply (D&RS) Costs: Not all cost changes will be taken back to adjust in the BST, as is done in a residual method. But depending on the methodology:

·                    If a target-based system is adopted: such costs / items that are not covered by the targets are adjusted in BST. In other words, all non-controllable costs are adjusted back in BST thus sharing it among all Discoms.

And for such costs / items that are covered by the targets, there is no external change, but the predetermined evolution of targets (say, difference in slopes of loss curve) will be adjusted in BST. Clearly, if licensees’ BST is “subsidised” then, the target evolution should first reduce this burden of higher BST on others. If its BST is “subsidising” then, the evolution should benefit its direct consumers by reducing its BST. In the long run, when cross-subsidy and subsidy are tapered off, the BST of all Discoms should converge to a cost reflective basis.

·                    If a cost-based system is adopted: all costs / items are adjusted in BST. The reason is that, profits are regulated on which incentives / penalties are provided – so the relative level of BST is not a concern here.

(iii)                    Correction factors: For external variables such as inflation, BST is not impacted in relative terms. However, all non-controllable factors such as sales mix changes are adjusted in the BST.

(iv)                   Forecast elements: These, such as ensuing year category-wise sales, inflation, etc., are taken at a standard level for all licensees and thus will apply similarly to the BST of all distribution licensees.

If above principles are adopted, BST differential is predictable (in relative terms), during the control period, addressing a serious concern of licensees. It also seems the most effective manner to keep retail tariffs as far as possible uniform.

2.25          Implication on Retail Tariffs:

The long-term tariff principles, and this consultative paper, mainly deal with revenue requirement of licensees.

How these charges are allocated between consumer categories, is an important but separate matter of tariff design, and is beyond the scope of this paper to discuss. The Commission would, however, make a limited observation concerning uniformity of retail tariff following from earlier discussion in this paper. It should be noted that irrespective of the choice of tariff regulation methodology, correct application of economic principles would result in the following outcomes:

·                    While it is possible to design, at the beginning of the control period, for retail tariffs to be uniform across the state for a consumer category, it will gradually differentiate in succeeding years due to valid reasons such as, differences in performance etc. For instance:

                         A licensee that comes to share profits with its consumers (as provided in Sixth Schedule etc), does it through a rebate in retail tariffs

                         A licensee that is subject to a more aggressive performance target, will pass that “savings” to its consumers in lower distribution charges

                         Direct power purchase, if any, by distribution licensees, if contracted at rates different from BST (more likely than not, the rate will be different), such differences will be applied to its costs

·                    At the end of the control period, further changes will inevitably drive some differentiation in retail tariffs. For example, these are:

                         Actual investments will be reflected in regulatory capital base at the end of the control period; and investments capitalised will differ between licensees

                         Licensees will propose, and the Commission may accept, different targets and different starting points for each licensee area, keeping in view its local conditions (and the scope for it depends on actual performance)

For all these reasons, retail tariffs will gradually come to reflect the conditions specific to the licensee area and the performance of the licensees.

In our view, this differentiation in retail tariffs arising mainly due to performance should be encouraged. Indeed, the formation of four independent Discoms is intended to foster this competition.

 

Process at the End of Control Period:

2.26          Towards, and at the end, of the control period, the Commission will seek to review if the implementation of long-term tariff principles has achieved its intended objectives.

If the regulations demonstrate having reasonably met expectations, the Commission will amend them suitably to adopt for the next control period. In amending them, the Commission will take into account, among other things, the sector reality, consumer and other stakeholder expectations and licensees’ requirements at that point in time.

This review will be comprehensive, taking anything from 12 to 18 months. It will thus have to commence sufficiently early to avoid a gap between two control periods. It will be undertaken separately but simultaneously for all the distribution and retail supply licensees. The process will be consultative and the Commission will publish for public discussion a paper laying out its observations on outcomes of the first control period and its proposals for the next.

(a)                Review of Performance / Outcomes of control period that is just concluding:

The review of performance / outcomes should be as close to the end of the control period as possible, so that the latest information is studied and fair time is given to licensees to perform.

This review is quite different, and more detailed in scope, from the regular monitoring and review undertaken by the Commission, which incidentally is a separate mandate and will continue as before. The end of period review seeks to assess:

                         How far has the regulation of long-term tariff principles succeeded in achieving planned objectives?

                         Are there any unexpected, favourable or unfavourable, outcomes that can be hedged in future?

                         Take into account conditions prevailing in power sector (financial, supply adequacy, efficiency, quality standards and customer service etc) and likely future trends.

                         Seek the views of licensees, consumers, the Government and other interested parties.

The observations of this review will be presented in a paper (Review of First Control Period) for public knowledge and discussion.

(b)               Review of Proposals for the next control period that is to commence:

The licensees will make proposals for the next control period, which will be reviewed by the Staff and presented to public for discussion and decided by the Commission taking into account all the deliberations.

The licensees’ and the Commission’s Staff proposals towards the succeeding control period will cover:

                         The base or initial values for various parameters. Towards this end, the Commission will indicate its guiding principles, which will emphasise efficiency, economic use of the resources, good performance, optimum investments, etc.

It will also take into account the actual outcomes – for instance, if loss reduction achieved differs from (exceeds or falls short of) that expected, the actual will be considered for setting next targets in the next control period. Similarly, if actual investments made in the control period differ from (exceeds or falls short of) that approved for the control period, the actual will be considered as asset base at commencement of that period.

                         The targets over control period for performance, and corresponding incentives / penalties (again, incentives / penalties can be structured as additional amounts, or as performance savings / shortfall on pre-set targets).

                         Reduction in distribution operating charges, at the beginning of the next control period, thus sharing all performance efficiency achieved during the just concluded control period with consumers.

These can be defined with more clarity when deliberations on these long-term tariff principles by consultative process are concluded.

Implementation Issues

2.27          Implementation of this regulation of long-term tariff principles needs preparedness and involvement of all participants. In following paragraphs, the requirement for implementation of these proposals is discussed.

2.28          Availability of reliable information:

A frequent concern expressed is want of reliable information to structure a good regulation; and such concerns are expressed elsewhere too. The nature of reforms is such that the industry is now studied in far more depth and in separate segments, not required earlier, placing greater demand on information.

Regulatory process cannot wait for perfect information, which given its external position, it can never obtain. Critics of cost-based method suggest that information, and hence review of cost, are always unsatisfactory and argue for a performance linked regulation, which addresses outcomes (easier to measure, and certainly more relevant to consumers) rather than input costs.

Reliable and timely information is an imperative, and all steps should be taken to achieve this. Experience from elsewhere shows that regulatory developments induce better information to become available. The Commission proposes to further improve the regulatory information systems during this period, even as long-term tariff principles, subject to the deliberations of this process, are implemented.

2.29          Differences between Discoms:

The Commission is conscious of the differences between Discoms, not just in terms of electricity business (financial position, consumer base, operating parameters, age of assets, staffing profile etc) but also in structural form such as demographics and area spread, terrain and weather conditions, physical connectivity, water-tables and farming patterns, industrial climate, potential for development, etc. In different ways, all these factors have a bearing in determining the performance reasonably expected of a licensee. It is important that the differences between licensees are well understood and sufficiently addressed in their respective revenue determining provisions in the long-term tariff principles regulation.

2.30          Metering:

Agricultural consumers, about 2 million in number and using about 10 billion kWh annually, are not metered. Without meters, agricultural consumption is estimated (in a recent public hearing, objectors contested these estimates and claimed very different figures), and that renders distribution system losses an equally uncertain figure.

Complete metering at the consumer level is the sole solution to eliminate uncertainty in level of system losses or un-metered sales. The Commission directed complete metering of all users by March 31, 2003, and initiated a number of studies to secure a better guidance on estimates in the meantime.

2.31          Industry Structure:

Long-term tariff principles discussed in this consultative paper recognise today’s industry structure. Any change in industry structure will require us to revisit these principles and make needed amendments to ensure this regulation works as intended.

2.32          Government Subsidy

The State Government, under the provisions of Section 12 (3) of the Reform Act, can inter alia direct a subsidised tariff to any class provided it compensates the licensees to the extent of subsidy granted. It is expected that the need for Government subsidy will be phased out over a period of time as the licensees improve viability.

In FY2002, Government subsidy provided was Rs 1561 crores, which is about 19% of the sector’s revenue requirement. In its monthly review of licensees’ performance, the Commission also monitors receipt of subsidy. The Commission has committed that in the event of non-receipt of subsidy, it would revert to the Full Cost Tariffs to ensure the licensees’ operations remain unaffected.

2.33          For how many years should the control period be set? What are the implications?

Ideally, the control period should be long enough for a licensee to turnaround and recover past losses. This option suggests that the first control period should be at least of 5 to 7 years.

Another view proposes a short first control period to learn from the experience and thereafter implement a longer control period as required. However, if the control period is too short, licensees may decide to wait for a more opportune time to act, causing loss of time for no gain (because nothing will be learnt, when licensees are not responsive).

The third option proposes a moderate path. This involves an initial medium-term control period (say of 3 years), followed by a longer control period provided a commitment can be made to adopt realistic base values and targets at the end of this initial control period.

 

A3:          Frequently asked questions

3.1              Two frequent questions, viz. what are the benefits of long-term tariff principles’ regulation and what are the safeguards provided, were discussed alongside the proposals made in the consultative paper. These observations are compiled from various specialist discussions on this subject in India and elsewhere. It may be useful to bring all these together in the form of a few commonly asked questions:

3.2              Why are these new regulations needed? Are the existing provisions not sufficient?

Licensees have huge potential to improve efficiency. If they do not improve, the sector will suffer high costs, large subsidies, and supply will deteriorate, causing distress to both households and all economic activity (industry, agriculture, services, etc) that depends on it. The Sixth Schedule methodology contains no incentive to reward efficiency gains. Further, the Sixth Schedule does not address other transition period concerns of the licensees.

The licensees express concerns on subjectivity involved in interpretation of the Sixth Schedule and seek better quantification. Further, they seek protection against factors beyond their reasonable control.

Further, licensees seek more flexibility in operations and investment than an annual process provides them. And consumers seek that price they pay for electricity should have some link to the supply quality and customer service of licensees.

The Commission believes that given all these requirements, certain modifications are required to the Sixth Schedule methodology. This is the genesis of proposed regulation of long-term tariff principles.

3.3              Has this form of regulation demonstrated successful results elsewhere? And what results can be expected here?

This form of regulation, the Commission understands, is widely used and has been successful in lowering costs, improving efficiency and service quality. The Commission studied the experiences of the UK, Argentina, and a few other countries in detail and find merit in the concepts used.

The results expected are – sustainable loss reduction, stricter control of distribution costs, better quality of supply and customer service, improvement in licensees’ credit rating, and such other. These will help control or reduce both, power purchase and distribution costs, as well as the Government subsidy. The Government, which today incurs a high outlay on power sector, can use savings for more critical needs such as education, health, civic amenities etc.

3.4              Will this regulation fix the electricity tariffs for many years? Why not? And if not, how does it mitigate regulatory risk and improve predictability of the licensees’ revenue? Does this benefit the system?

This regulation does not fix tariffs, but gives guidelines of how revenue requirement must be determined in future years. Unless fuel prices, inflation, equipment costs, interest rates, demand growth of all consumers etc, are known, tariffs cannot be set for more than a year. In fact, licensees can seek compensation for fuel cost escalation mid-year.

Revenue predictability refers to the confidence a licensee has that its income will be sufficient to meet costs, provided it has met certain expectations and obligations that are pre-defined. In a regulated business, this comes from a consistent application of clearly defined principles determined up-front for an agreed period. This is what the long-term tariff principles seek to achieve.

Revenue predictability is useful and important. Licensees are able to assure their lenders and long-term suppliers of their capacity to pay and honour contracts, which otherwise they cannot. With this improvement in credit worthiness comes ability to borrow at better terms or say, contract power purchases on less onerous guarantees.

Consumers also prefer a predictable, rather than a sudden (no change for a while, followed by a large accumulated revision) evolution in tariffs. Especially, the large industrial consumers, who make large investment decisions seek an assurance that the future electricity prices will not erode competitiveness of their products.

3.5              Will this new regulation cause electricity tariffs to shoot-up?

Licensees’ revenues cover only about 75% of costs, and the balance comes as subsidy. This is not a sustainable position – and indeed, the deficit may grow for many reasons, for example, when consumers use more electricity that the licensees purchase from new costly generators. Then, inflation, fuel & transport prices, exchange rate depreciation etc., add to the burden. With all this, there will be pressure on tariffs to increase at least until efficiency improvement gives respite. This is a fact and equally valid in almost all states in India and cannot be ignored. It applies irrespective of tariff policy used. The proposed long-term tariff principles regulation is designed to motivate licensees accelerate efficiency improvements, and help overcome the present crisis sooner. 

3.6              Will the proposed regulation cause an under-investment or under-maintenance, even though the licensees are approved full cost of such investment & maintenance?

Given the flexibility, it is possible that licensees will spend less, on capital works and maintenance than that approved. But this should not cause concern, as long as the corresponding physical achievements such as, new sub-stations commissioned, transformation capacity added, new network expanded, meters installed, new customer service and quality initiatives undertaken, etc. are fully satisfied.

It is the intention of the proposed regulation to give licensees more freedom in developing their expenditure plans and its implementation. A licensee, who by better contract negotiations and project management is able to save on capital cost, is thus rewarded. Conversely, cost-over run from project delays is disallowed, and acts as the penalty. In either case, with asset base adjusted for actual at the end of control period, the incentive/penalty is limited to a short duration and is automatically moderated.

The freedom given to licensees also can help innovate to the benefit of the system. For instance, a licensee may invest more in new technologies and save on repair and operating costs, while another licensee may chose the opposite to take advantage of lower labour costs in its area.

3.7              Should there be a concern that licensees may earn excess rewards?

The reward and penalty structure will be based on a rigorous simulation and adequate care will be taken to avoid super-profits. Second, incentives proposed in this paper are earned upon (either demonstrated or pre-determined) efficiency improvements, in areas that are in control of licensees. Finally, all incentives earned by a licensee, because they show up in profit, have an inherent restraint for they are obliged to share it between consumers, reserves and shareholder. 

3.8              How are licensees protected for financial viability?

Licensees’ equity base, and profit set on it, is small compared to its business size. The present equity base of all licensees together is Rs 1297 crores, which at say, 16% gives an allowed profit of Rs 207 crores. The total expenditure of all licensees is about Rs 8000 crores, which means a variation in costs of as small as 3% can wipe out entire profit and push it to bankruptcy. For this reason, it is important that some safeguards are provided:

                         Specific penalties in the proposed regulation would limit levy on all such accounts in a year to say, a maximum of 8% on net-worth.

                         Where targets are used as means of incentives and penalty, safeguard requires us to recognise the ground reality and practicability.

The long-term tariff principles, in recognising transition period and risk mitigation needs of licensees, also help protect their viability.

 

A4:          Consultation Process

4.1              This Consultative Paper presents the Commission’s proposals on Long Term Tariff Principles. The Commission invites the members of public, including consumers, the media, licensees, industry / farmers / consumer associations, lenders and potential investors, industry experts, the Government and any other persons interested in it, to involve in this process. In this process, the Commission seeks:

·                    public representations, airing their views or concerns or objections or suggestions for improvement etc to the questions and suggestions discussed in this paper

·                    public participation in the public hearings will be held on a date to be separately notified by the Commission

4.2              The views, suggestions, etc presented in this paper are a refined compilation from a number of recent deliberations and workshops on this subject in Andhra Pradesh and other states in India.

4.3              The Commission has tried to address all aspects in as much detail as possible in this paper, but kept it simple to facilitate easy understanding.

4.4              At the conclusion of these proceedings, the Commission will issue its Order on Long Term Tariff Principles for the Distribution and Retail Supply Licensees. The Order will also define the next steps to be taken, which could include determination of performance and quality targets for licensees, design of detailed regulations, etc.

 

A5:          Annexes

Annex 1: International Experience

5.1              UK Experience (Distribution Price Control 1999):

(a)                Distribution Prices

The final proposal involves RPI-3% for period up to 2004-05. This follows an initial one-off price cut Po. Following table shows:

                         The one-off price cut for all licensees arising from 1999 Review

                         Average distribution system charge for all licensees and the change over the previous year.

Source: OFGEM papers.

Licensee

One-off Price Cut

Impact of total Price Control

Proposed in 1999 Review

Average Distribution Rate[iii] (pence/kWh)

Reduction on 1999-00

1999-00

2000-01

Eastern

28%

1.91

1.43

25%

East Midland

23%

2.20

1.67

24%

London

27%

2.30

1.66

28%

Manweb

21%

2.68

2.05

23%

Midlands

23%

2.14

1.69

21%

Northern

24%

2.45

1.88

23%

NORWEB

27%

2.47

1.64

34%

SEEBOARD

33%

2.04

1.36

33%

Southern

19%

2.19

1.81

18%

SWALEC

26%

3.22

2.56

21%

South Western

20%

2.52

2.02

20%

Yorkshire

23%

2.26

1.74

23%

Scottish Power

13%

2.94

2.41

18%

Hydro Electric

4%

2.38

2.25

5%

 


(b)               Distribution Losses: Following are the total distribution system losses, average for all companies. Although the initial system losses are not high, a reduction was achieved since restructuring.

Year

Average

1991

7.6%

1992

7.2%

1993

7.1%

1994

7.0%

1995

6.9%

1996

6.7%

1997

6.9%

1998

6.8%

 

(c)                Following are two measures of improvement in quality of service, which shows a significant improvement since restructuring.

Year

Interruption per 100 customers

Minutes lost per customer

1989-90

96

184

1992-93

95

133

1997-98

89

92

2000-01

77

75

 


 

5.2              Argentina Experience (Distribution Price Controls)

The achievements of Argentine electricity industry restructuring are briefly presented in following tables. The results are for the federal companies, which include the two largest distribution companies EDENOR and EDESUR that operate in Buenos Aires. The two companies serve 22.2 lakhs and 20.9 lakhs consumers respectively.

Source: Information compiled from ENRE (regulator), licensees, published reports.

(a)                Reduction in Distribution System Losses. The licensees were able to achieve the benchmark 10% distribution system loss level by fifth to seventh year, averaging a reduction of 2.3% to 2.6% per annum.

Year

EDENOR

EDESUR

1992

29.2%

24.0%

1993

26.1%

22.1%

1994

20.2%

16.2%

1995

17.0%

12.0%

1996

14.4%

10.1%

1997

11.9%

8.3%

1998

10.7%

8.1%

 

(b)               Improved financial performance of distribution companies, which achieved breakeven within 2-3 years post-privatisation.

Year

Net Profit in $ Million

EDENOR

EDESUR

1992

(58.0)

(30.7)

1993

(73.0)

(65.0)

1994

1.4

(16.5)

1995

46.5

74.5

1996

70.7

82.7

1997

100.3

66.9

1998

81.8

93.2

 


 

(c)                Retail Tariffs reduced on the average.

Year

Cents per MWh

EDENOR

EDESUR

1992

9.07

8.91

1993

9.13

8.51

1994

8.49

8.94

1995

7.77

8.51

1996

7.49

8.30

1997

7.11

7.79

1998

6.82

7.40

 

(d)               Improvement in quality of supply and customer service. One of the indexes (showing system downtime) is presented below.

Year

Average System Interruption Duration Index (hours per year)

EDENOR

EDESUR

1992

19

21

1993

14

14

1994

7

5

1995

6

5

1996

8

6

1997

7

4

1998

6

9

 


 

Annex 2: Distribution Losses in Andhra Pradesh

5.3              Following table shows technical and non-technical losses for each Discom. For the total system loss, add Transmission Loss of 8.5% (source: Tariff Order March 24, 2001).

Licensee

Distribution System Losses

Technical Loss

Non-Technical Loss

Total Loss

EPDCL

13.1%

4.4%

17.5%

SPDCL

15.1%

8.1%

23.2%

CPDCL

16.9%

13.8%

30.7%

NPDCL

14.6%

9.8%

24.4%

All Discoms

15.9%

10.1%

26.0%

 

 



[i] Amendment to APERC (Conduct of Business) Regulations 2000 (Regulation No. 8) and the Guidelines for Revenue and Tariff Filings.

[ii] There may be a few exceptions – licensees can arguably restrict supply to regulated levels for subsidised classes, attract subsidising industrial consumers through better service, etc.

[iii] Applicable for Standard Domestic customers.