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A feasible reform for the electricity supply industry in Hong Kong
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Energy Policy 34 (2006) 2881–2890 www.elsevier.com/locate/enpol
A feasible reform for the electricity supply industry in Hong Kong H.W. Ngana,, J.H. Wanga, W. Engriwana, K.L. Lob a
Department of Electrical Engineering, The Hong Kong Polytechnic University, Hong Kong b Department of Electronic and Electrical Engineering, University of Strathclyde, UK Available online 23 June 2005
Abstract With the current scheme of control regulation for the Hong Kong electricity supply industry expiring in 2008, the Government has sent out a consultation paper seeking views from the general public on its reform and possible future development. This paper investigates the characteristics of the current agreement and the rationale for feasible reform of the Hong Kong ESI. It leads to a discussion on a proposed feasible reform using performance-based regulation approach modeling and the associated implementation issues related to price capping, risk analysis, performance indices, quality monitoring and governance. r 2005 Elsevier Ltd. All rights reserved. Keywords: PBR; Scheme of control; ESI Reform
1. Introduction Reform of electricity supply industry (ESI) has been a major concern in the energy sector throughout the world in the past two decades (Joskow and Schmalensee, 1983). It leads to changes in structure, ownership and market operation of power enterprises in different forms such as unbundling privatization, deregulation and the introduction of direct competition into the industry. A motive of the changes is to move away from the paradigm in which regulation may have been too responsive to protect benefits of certain interest groups and inherent information asymmetry between regulators and those that are to be regulated may also lead to distortions such as under or over investment (Murry, 2001). In Hong Kong, electricity needs are served by privately owned utilities with vertically integrated operation and financially regulated through a Scheme of Control (SOC) Agreement which will be outlined in more detail in the next section. The SOC was designed in the 1960s and is now considered insufficient to cope with Corresponding author. Tel.: +852 2766 6181; fax: +852 2330 1544.
E-mail address: [email protected] (H.W. Ngan). 0301-4215/$ - see front matter r 2005 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2005.05.007
the changing environment when investment is no longer the only main concern. One allegation is that the present SOC (expiring by 2008) cannot provide sufficient motivation for better performance. It is further postulated that the simple rate-of-return regulation (Ngan and Chow, 2000) is a cause of uneconomical deployment of resources due to lack of market arbitration and competition mechanisms, and insufficient incentive to optimize the use of scarce infra-structure resources. Introducing market competition is poised to be a typical feature of Electricity Industry (EI) reform worldwide including in our vicinity, Mainland China. Any possible reform of the ESI in Hong Kong is more than likely to follow the worldwide trend (Leung and Ngan, 2001) and, in fact, it aligns with one of the Government’s principal policies in enhancing economic efficiency and free flow of trade. The Government considers it be best nurtured and sustained by allowing a free play of market forces and by keeping intervention to a minimum (EDLB, 2003). Since electric utilities in Hong Kong have been privatized right from their inception, the regulatory reform of the ESI in Hong Kong aims more specifically to correct inefficiencies caused by the SOC rather than on relaxation of ownership. It is viewed as
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complementary to the success of existing operation in terms of incentives for investment and system reliability. The proposed reform of any sort is to broaden trade and to facilitate competition. Establishing a credible regulatory framework is an essential element of the overall reform because it has to create a stable and predictable operating environment that is conducive for long-term participation and investment. In this paper, a framework is proposed which ensures sufficient rules and regulations be set in place in such a way that reform of the regulation not only improves the status quo but also leads the way to an even more competitive future.
2. Scheme of control agreement The SOC was first proposed by CLP in 1964. HEC did not join the SOC until 1979, the year CLP renewed its Scheme with the Government. It lays down rules for governing financial affairs of their electricity-related activities and consists of the following main points: (i) The duration of the regulatory contract is fixed at 15 years, with a 5-year review clause. (ii) The Scheme requires each company to set up a development fund. The main purpose of the fund is to assist the company in financing its acquisition of fixed assets. In addition, any difference between the actual profit after taxation and the permitted return will be transferred to or from the fund. In other words, the company is not allowed to keep any excess profits above the permitted level. Any excess profits have to be put into the fund. The development fund does not form part of distributable shareholders’ funds and is, in effect, a liability owing to customers carried in the company’s books. (iii) The permitted rate of return on equity-financed asset is 15%, while the permitted rate on asset financed by debt or the development fund is 13.5%. That extra 1.5% is aimed at ‘‘encouraging shareholders to increase investment’’. (iv) From the permitted return, interest deductions must be made in order to obtain the figure of net return. These interest deductions are: interest payable on long-term financing up to a maximum of 8% per annum; and a charge of 8% per annum on the average balance of the development fund, which is to be credited to the rate reduction reserve. The purpose of the rate reduction reserve is to give rebates to consumers. After making all necessary transfers, the net return is what the shareholders of the company would ultimately obtain.
2.1. Deficiencies By nature, the SOC agreement can be regarded as a sort of ESI regulation which works on a guaranteed rate of return on investment type of model. It has proven to be a successful model particularly during the early stages of development in Hong Kong, for the power utilities in securing investment for expanding their infrastructure. When referring to evaluation on its effectiveness as a regulatory scheme, Littlechild (1983) proposed a number of criteria which can mainly be grouped into the following aspects:
Protection against monopoly Encouragement of efficiency and innovation Minimization of the burden of regulation Promotion of competition Proceeds and prospects of the firm.
Judging from these criteria, the following deficiencies inherently exist in the current version of the SOC:
It confines return of investment to a fixed rate to be derived only based on financial investment. There is no financial incentive for power trading with/from outside parties and no motivation to enhance their interconnection infrastructure for this purpose. The regulation serves as a financial mechanism to safeguard interests biasing on the investment side but it provides insufficient provision to look after customers’ wishes on having choice of services. No provision for competition. The permitted rate of return mechanism has no bearing to the level of performance of the service providers. Market sensitivity is playing neither a role for inducing new technology nor innovation into the industry. The SOC as a form of regulatory framework does not align with trends of development in the vicinity areas including Mainland China that is poised to move to a more market-oriented reform in her ESI.
2.2. Regulation or competition Consumers, utilities, and regulators have different objectives to achieve in a regulatory system. Consumers want a reliable supply with low price while utilities would like to have better return on their investment and secure ways to off-load their cost centers. As a key member among various stake holders, a regulator is to ensure that balanced interest be maintained on the environmental and social concerns. In an economic
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sense, optimal performance is obtained by pricing the services near marginal costs. How to achieve it depends on different views: whether electricity can be treated as a competitive commodity or not. Conventional view: Electricity is essential for modern life and hence ESI must serve all its customers reliably and without discrimination. Electricity Supply cannot be put at risk; and in exchange for the obligation to serve, electric companies are given the right or provided with conditions to serve a specific region as what is happening in Hong Kong. Open market view: Electricity should be treated like any commodity and be subject to competitive markets. Competition suppliers provide any other essentials and there are means to ensure system reliability and security of supply in competitive electricity markets. 2.2.1. Competition In the case of Hong Kong, with its high population density and lifestyle concentrated in high-rise buildings, we have a high reliance on electricity for lifts and air-conditioning, etc. A reliable electricity supply is vital to the success in Hong Kong’s business operation and economic activities. Under the current regulatory regime, utilities have been able to provide a stable infrastructure for supplying electricity with a high reliability and affordable tariff. Hence, it would be risky to go for a full scale of competitive market structure without due consideration on resulting consequences that follow, such as higher compliance costs and lessening incentives for investment, and imposing extra burden to setup an independent regulator for monitoring the market operation regularly. 2.2.2. Regulation By considering the costs and perceived risks associated with a complex framework needed for introducing competition into Hong Kong’s electricity market, it is obvious that a refined regulation framework may be an alternative consideration. In principle, a simple regulation framework provides operational merits such as simpler management structure with lower overhead cost, better deterministic outcome and clearer signal to attract investment, effective planning and monitoring functions. However, the current regulatory regime in Hong Kong also attracts criticism such as the risks associated with fuel price variation and financing capital investment are totally borne by consumers. Suggestions for improvement to prevent over-investment and to further improve the operational efficiency emerge in various occasions. In line with it, a performance-based regulation (PBR) is envisaged as described in the following context.
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3. Performance-based regulation One major critic of the present model based on costof-service for determining the rate-of-return (COS/ ROR) is a lack of mechanism to link return to performance. PBR appears to be a logical outcome which provides a framework for incorporating performance-based factors into the formula and can be regarded as a penalty/reward mechanism that provides strong incentives for utilities to perform efficiently. The utilities can employ its superior knowledge of their businesses to achieve certain performance goals. In this respect, PBR differs from COS/ROR by relying more on explicit financial incentives and by affording greater discretion to the utilities than on a more strictly permitted rate-of-return on investment as with COS/ ROR. In other monopolistic utilities like water and gas services, PBR can also bring in benefits of having competition and reducing shortcomings of the traditional COS/ROR type of models (OEBS, 1999), e.g. information asymmetry followed by the so-called Averch–Johnson effect (refers to effect of a public regulation that creates incentive for firms to over-invest in tangible assets). Other shortcomings of COS/ROR include its cost-plus nature that blunts the incentive for the utility to minimize cost in the long run since if the allowed rate-of-return is less than the actual cost of capital then there will be a disincentive for the utility to make further investments. Though PBR is a modification of ROR regulation, under a PBR system, PBR seeks to eliminate some of the regulatory command and control aspects of ROR regulation and substitute for it a system of incentives or penalties for performance by the regulated entity outside of a ‘‘normal’’ band and its regulatory lag is stretched out at pre-set intervals (often 5–10 years). With the longer regulatory lag, PBR seeks to reduce a need for frequent tariff filings by utilities, which would lead to reduced administrative costs. For the regulator, a longer regulatory lag means there is ample opportunity in the regulatory review process to monitor the rate, cost and distributional effects of the PBR incentives, and to modify the PBR, or to terminate it if necessary. Thus, when designing the PBR model, special attention is paid to avoid these shortcomings. More focusing effort is to address on the innovative functions of regulation so as to achieve the following objectives:
Cutting cost and prices consequently while ensuring other dimensions of financial performance—increasing the incentives for utilities to reduce their cost and operate at the most efficient level while keeping or improving other dimensions of their financial performance by creating a competitive environment for the regulated utilities.
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Streamlining regulation by simplifying the process of regulation and decreasing the costs involved. Restructuring risk exposure—allowing a more thoughtful allocation of risk between utilities and customers in respect of the proposed changes. Ensuring a good non-financial performance—acquiring a clean, diverse resource mix; at least maintaining or improving the current service quality standards and reliability of supply; new products (service) and technology innovation and application; diverse resource acquisition; demand side management (DSM) application. Keeping a reasonable investment under the principle of sustainable development—PBR should by no means aim at particular objectives at the expense of environmental impacts.
Broad-based PBR mechanisms—focusing on the broader dimensions of the performance of the regulated utilities and providing them with a greater freedom to carry through their own micro-management.
The scope of regulation should be neither too targeted nor too broadly based. Excessive broad regulation will not control the performance of utilities effectively while a strictly targeted PBR will restrict the micro-management of the utilities. From the available experience in the global environment, broad-based PBRs accompanied with appropriate quality monitor measures appears more prevalent for reforming the SOC in Hong Kong’s ESI. 4.2. PBR implementation
These objectives should be balanced in the design of a PBR mechanism while attention should be paid to the differences between traditional COS/ROR and PBR. While COS/ROR offers its own standardized functions of regulation, it would appear that a successful PBR mechanism should include its own functions and unique innovations resulted from negotiations that provide various stakeholders with tangible benefits. Any policy on PBR must recognize that a contractual arrangement between regulator, utility, and consumer groups must be upheld. And it is up to the regulator to control the amount of regulatory risk any utility faces. In addition to the arrangements agreed upon by the different parties, special precaution should be taken when designing a PBR mechanism. Some objectives of PBR may under certain circumstances contradict with each other. For example, if prices are to reduce significantly, the ability and incentive for utilities to invest in new facilities can be jeopardized. Otherwise it goes to the other extreme in the traditional COS/ROR regimes where utilities tend to over-invest so as to benefit from the guaranteed rate-of-return on investment. Thus, a PBR mechanism designed to achieve any one of the objectives can create incentives that might conflict with other objectives. These conflicting objectives will be discussed further in the following sections.
4. Various forms of PBR 4.1. Feasible PBR models According to the designed scope of regulation, PBR can be grouped into two categories:
Targeted PBR mechanisms—designed with rewards or penalties for utilities’ specific aspects of behavior, such as their performance in acquiring cost-effective DSM.
PBR can be implemented in several dimensions. According to its working principle, PBR mechanism can be designed in many ways such as price cap, yardstick/benchmarking, and earnings sharing. Depending on the objectives of the regulation, every mechanism of PBR can bring about the overall regulating effect on the utilities. Take the case of a price cap, it can be designed to encourage regulated utilities to operate more efficiently and to lower prices over time. On the other hand, some particularly targeted PBRs are designed to monitor one or several special characteristics of the utilities with rewards or penalties. But their operating rationales stay close to broad-based PBR as mentioned earlier. Whether using price cap or yardstick or earnings sharing, a PBR mechanism has to be tailored to suit the unique industry structure in Hong Kong. In a vertically integrated electric industry, the emphasis would usually shift away from the generation-related objectives such as improving power plant performance and reducing purchased power costs towards applying PBR to transmission (T)- and distribution (D)-related objectives, such as quality of service and T&D development since the generation business has yet to be deregulated to be competitive. However, it may be appropriate to consider the unique characteristics of Hong Kong, the current SOC, and the geographic monopolies by the existing electric power companies. The aim of PBR is not just to decrease the relevant companies’ revenue although that could well be one of the objectives. PBR should provide incentives for private, regulated companies to behave in ways to promote the public interest but not necessary to the sole detriment of monopolies. By aligning the incentives to utilities with the interests of the consumers, a regulator seeks to encourage economic efficiency through innovative services, increased quality of services and decreased prices over time. The majority of PBR mechanisms may
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provide utilities with a fixed price or a fixed level of revenues, as opposed to a pre-determined level of profits as in COS/ROR.
profits in excess of return on capital costs (Comnes et al., 1996).’’
4.2.1. Yardstick competition In the yardstick competition model, the profitability of a company depends on the behavior of a similar group of companies. It is to encourage companies to make optimal investments oriented to the reduction of their costs. Yardstick competition approach works well in Chile’s electricity distribution industry since there are a number of distribution utilities that can provide a good base for comparison following their successful reform in the early 1980s. However, unlike Chile, there are only two electric utilities in Hong Kong and thus a yardstick competition model is inapplicable to Hong Kong’s ESI. In Chilean regulatory scheme (Rudnick and Donoso, 2000), there is an absence of mathematical models to deal with the calculation of optimal management cost. Additionally, collusion is the biggest potential threat to the application of yardstick competition. The inferior company tends to look for some kind of ‘‘cooperation’’ with the superior company to maintain profits while a ‘‘model’’ company has limited incentive to further improve its performance. Another way is to build a ‘‘Model Company’’ which is more similar to the model company under regulation (Saenz et al., 2001). There are controversies related to the way the model comxcpany determines its operating costs. The lack of a reliable methodology could affect the correct signals of efficiency. Hence such an ideal and independent model which requires plenty of relevant data may be unrealistic for the real companies to achieve. Many external and internal factors may hinder the realization of its assumed objectives.
4.2.3. Price cap regulation Price cap regulation differs from traditional ratemaking regulation in two fundamental ways. First, prices are put in place for longer periods of time (3–5 years) with the intention to maintain price stability and reduce costs in some cases relative to inflation. Second, utilities are allowed to lower their prices as long as all prices stay within the cap. This flexibility allows utilities to provide competitive price discounts. Under the price cap regulation, customer class may be divided into four sub-classes, mainly, residential, government, industry, and business. The initial rates are set for each customer sub-class fairly depending on an appropriate allocation of costs, determined separately by the power companies. As to prevent cost shifting between sub-classes, it is advisable to apply different price caps for different customer sub-classes. Even so, price caps can be applied to customers as a whole or to an individual customer sub-class. Furthermore, price cap is allowed to adjust on regular intervals to allow for inflation but it is also required to decline over time to encourage increased productivity. The stipulated limit can be calculated using the following equation:
4.2.2. Revenue cap regulation Revenue cap regulation aims to limit the revenue of the utilities by setting an allowed level of revenues which is based on actual costs for a test year and can be adjusted to account for inflation and productivity over time. However, the regulation on profits is more complicated to operate than the price cap regulation since the allowed level of revenues may change to reflect changes in sales levels. If there is any deviation in the collected revenues from those allowed, the difference will be returned to, or recovered from, customers through periodic adjustments. Thus, under the revenue cap regulation, the incentives for utilities to invest, innovate, enhance efficiency are reduced. The potential lost revenues from successful DSM programs, for example, will not affect utilities’ revenues. And any inclination to diversify in services is diluted. Also, ‘‘The regulated companies under this kind of regime have strong incentives to act like monopolists. The companies have a will to raise prices, reduce output, and receive
Pt ¼ Pt1 ð1 þ I X Þ Z,
(1)
where Pt is the maximum price that can be charged to a customer class or classes for the current time t, Pt1 is the average price charged to the same class or classes during the previous period, ‘‘I’’ is the inflation factor, ‘‘X’’ is the productivity factor, and ‘‘Z’’ represents any incremental costs such as taxation, accounting methods which are not subjected to the cap. Obviously, the challenge for a regulator is to properly assess the X and I factors. If the X factor is too high in lowering Pt , it will act as a penalty which will reduce the utility incentive to provide services more efficiently. If I is higher than the rate of increase in input costs, the utility will earn too high a return and may not focus on improving service efficiency. Another factor that is worth much attention in a price cap regulation is the set of duration in which the initialized plan will be effective until the next price review is conducted. In the intervals of reviews, utilities have greater freedom to operate as they wish. They could try to enlarge the differences between their costs and the capped price to earn more profit. Under the price cap, utilities can grasp all the profit they earn to compensate their costs and take the risk of losing some when the price is too low. External factors such as increased tax rates are completely uncontrollable by the utilities themselves. So, price cap regulation provides incentive for them to operate at the least
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profitable level while reducing their costs with a strong rigor.
5. Incorporate price cap to reform of the SOC 5.1. General lessons In the United States, many States have replaced their traditional regulations with broad-based PBR plans. One major scheme they took is price cap regulation. Although the experience with PBR in the EI in US is presently too limited to draw a general conclusion, the advantage of PBR over cost of return regulation are expected based on their successful applications in the telecommunications industry (Sappington et al., 2001). For an effective comparison to the traditional COS/ ROR, PBR’s experiences against economic, cost, and weather conditions should be tested in order to fully determine whether or not the PBR mechanism has met its objectives. Additionally, in the United Kingdom price cap regulation has brought about productivity increases and customer bill decreases for electricity distribution, and for the water and sewerage services. In fact, after the 1994–1999 regulatory period, some companies in UK achieved costs savings up to 20% in operational cost and 15% in capital expenditure (Rudnick and Donoso, 2000). Broad experience in other European countries has also reflected the benefit that price cap regulation scheme has introduced (Bell, 2002). The price cap scheme has been applied to regulate the transmission and distribution in the ESI in the United States and the UK where mature wholesale markets have been established in their domestic electricity supply. On the other hand, regulation in their generation markets is to monitor the market power and keep the market operating fairly. Although price cap regulation has been applied widely in transmission and distribution, the uniqueness of electricity network makes it impossible to introduce real competition in the operation of utilities. A regulation of any kind is only to simulate a competitive environment under which the regulated utilities can perform effectively. As far as the situation in Hong Kong is concerned, the two investor-owned utilities have their own power plants and grids. No competition in the generation and retail markets exists between the two firms. Thus, price cap(s) should be placed on the retail electricity price of both companies where different price caps may be applied for different customer sub-classes as described previously. Alternatively, a single price cap from either CLP or HEC on the retail electricity price is also acceptable for a single customer class. These ultimate cap(s) can encourage the companies to decrease their power supply cost from production to the retail side of the operation.
5.2. Setting the X factor Given differences on the operating costs by both CLP and HEC, a benchmarking exercise is found suitable in revealing the operation efficiency of both companies. Data envelopment analysis (DEA) (Bell, 2002) provides a powerful tool to describe an efficient front–end analysis or frontier for both companies. DEA can find the relative efficiency of the targeted companies through finding the firms’ individual distance to the envelopment surface or efficient frontier. It follows that both the regulated utilities must be subjected to similar expected efficiency improvements, the X factors. Although an appropriate level of improved productivity is not easily definable, the DEA analysis can be used to reveal any potential for improving efficiency. Note that a productivity adjustment or X may not be necessary if the price cap is used to tie the input costs incurred or output prices charged by the utilities. The lesser efficient companies will be spurred to catch up with the better ones. However, the more efficient companies should get corresponding rewards even if they get a smaller improvement because their maneuver area is comparatively more restricted than the other ones. Another factor that should be paid attention to is the possible coalition as mentioned before. If the two companies united to hide their real costs from others, the determination effects of X factor could be abnormally small. And the two companies can enjoy their monopolistic status longer. So the regulator should take the responsibility to monitor the occurrence of such kind of conducts. The level of X factor should ensure the possibility of efficiency improvement. Also, the methods and procedures for setting the X factor should be kept transparent since it would have important implications for utility cost recovery and the rate at which prices are allowed to increase. 5.3. Earnings sharing mechanism An earnings-sharing mechanism provides some level of insurance for the utility and consumers against the risk that something in the PBR will go awry. Certain earnings sharing mechanisms often accompany the price cap regulation and takes effect only if earnings fall outside a given range. In the sample (Sappington et al., 2001) ‘‘Of the 28 active PBR plans, 21 of them contain earnings sharing provisions or simple ‘‘deadbands,’’ which specify a range of authorized earnings for the utility, rather than sharing bands.’’ In the application of earnings sharing mechanisms, how to allocate the extra benefit varies according to the different plans:
Some plans or ‘‘sharing bands’’ suggest the extra earnings that exceed the earning target, say +10%,
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be allocated with certain sharing proportions between the utilities and customers. Other ‘‘sharing bands’’ plans focus on the benefits of customers where the first +5% beyond the earning target will be transferred to customers’ account and the remaining percentage will be awarded to the utilities or shared between them and customers. With the ‘‘deadbands’’ approach, the earnings sharing mechanism has no effect inside the earning range and should be applied only if earnings fall outside a very wide range, for example outside +20% range from the earning target.
Theoretically, the earnings sharing mechanism tends to discourage the incentive to cut costs, a main goal for considering the use of PBR But, if it is managed properly, the earnings sharing mechanism can generate confidence in the utility and consumers. One important consideration is that any earnings-based sharing mechanism is inherently biased because earnings can be manipulated. The ability to change earnings by utility management in the form of spending on discretionary items, for example, reduces the amount of sharing required. Thus, price cap regulation with earnings sharing mechanism is preferable so the extent of earnings can be ‘‘managed’’. Additionally, the earnings sharing mechanism should include some forms of quality regulation. If the quality of service cannot attain certain standards, the share of the utilities in extra earnings can be decreased as a way of punishment. Moreover, an earning sharing mechanism does not reduce the liabilities for the customers and utilities to share the loss in case earnings fall below the pre-set target. The allocation of any earnings loss should be considered when designing the earnings sharing mechanism as well. The choice of earning target and the proportion of sharing are very crucial in the design of the earnings sharing mechanism. A very high earning target is unrealistic for the utilities to attain and no benefits for the customers are possible. Therefore, broad ‘‘deadbands’’ are preferable since it can provide greater incentive for the companies to reduce their costs. With earnings way outside the range as in ‘‘deadbands’’, the PBR probably looses its effectiveness anyway and a kind of revenue stabilizing mechanism is called for. 5.4. Risk analysis Another important PBR goal is to determine who can bear particular risks more efficiently and then evaluate how investment decisions are influenced by various risk allocations. It is difficult to determine the effect of a PBR without considering the differing market conditions, politics, and personalities. Market conditions such as cooler weather, could affect the utilities’ revenue as customers might use less electricity for air-conditioning.
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A sudden price hike in fuel prices, another market condition, may trigger higher electricity price charged to consumers. Unstable political situation may influence shareholders’ confidence for continuing investment in utilities’ infrastructure. And of course, personalities determine where PBR stands in the priority list set by the utilities against other cost pressures, for example, the competitive changes taking place in the industry and the organizational restructuring efforts could take senior priority. These factors affect the success of PBR given that the same PBR applied to both utilities may have very different results. Among different approaches to risk allocation, Z factors are the primary mechanisms used to allocate risks. The Z factor, as described in Section 3.2.3, means a cost or a risk which are excluded from the operation of PBR that the utilities will not bear. Any cost due to a change in accounting methods as in the case of income tax rate changes, for example, could permit the utilities to pass the effects of this Z factor to the customers. Alternatively, the use of Z factor in adjusting the revenue to minimize risk as in earnings sharing mechanism has attracted much attention. In this respect, the PBR could set a limit at a specified level before these Z factors become effective and thus creating a fairer sharing of the risk. 5.5. Indexing methods to evaluate the performance of utilities PBR is considered as a better method to improve the social efficiency than the traditional (COS/ROR) regulation. In what way the PBR should be evaluated and consequently developed is the focus of interest. In this respect, some indices can be designed to measure the various effect of the PBR. The principle of PBR is that good utility performance should lead to higher profits, and poor performance should lead to lower profits. In implementing the price cap formula, there should be agreements between regulator, utilities, and customer groups to identify what is considered good quality performance and how should the formula be designed to link performance to profits. In the gaming of regulation, the regulator (probably the government), the customers and the utilities represent the interests of the shareholders, so the developed standards or indices should consider the participants’ need and social benefit maximization. These indices designed for the PBR plans can be categorized as in Table 1. Table 1 prescribes the criteria for evaluation standards. The above criteria can be represented by an engineering and economic indexing method. More detailed indices are described in Davis (2000), however, the author neglected the reasonable benefit of the
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Table 1 Evaluation standards for performance-based regulation Participants
Evaluation standards for performance-based regulation
Regulators
Reliability Safety Environmental consideration and sustainable development Efficiency improvement Technology innovation
Customers
Call center service Satisfaction for billing and metering Field service quality Continuity of supply
Utilities
Financial integrity and future development Regulatory commitment
regulated firms in the actual PBR. A regulation plan which considers only benefit transferred to customers and ignoring possible financial losses for the utilities is by no means a good regulation scheme. Acceptable level of returns for the shareholders can guarantee the future development of the firms, which in turn guarantee the reliability of electricity supply and other long-term benefits to consumers. Similarly, the corresponding accounting indices can reveal the financial integrity and future development for the utilities. If the financial performance of the utilities is deteriorated because of the application of certain PBR, some reasonable modification for the plan must be made. Any regulatory commitment through the government’s policies should create an economic environment suitable for investment. Policy volatility will affect the regulated firms’ confidence for investing and thus reduce their capital injection. Moreover, a convincing regulatory commitment can encourage new competitors to enter the electricity market and a chance for more benefits transfer to the customers, a foundation of a fair electricity market, is becoming more apparent. With the development of the EI, measures for environmental protection are receiving more attention. PBR must have a thorough consideration on the sustainable development and coordination with the development of the whole society. Evaluation for the generation of resources diversification, pollution emission, adequacy for the whole society’s electricity consumption or supply reliability, and demand side management should all be included in a PBR plan. In accordance with the evaluation standards, the baseline and the corresponding rewards/penalty mechanism for quality should be constructed where a socalled dead zone should be set such that if the quality performance of the utilities falls outside the stipulated
band of standards for quality, the dead zone, a corresponding reward/penalty will take effect. Such a mechanism should be constructed before a PBR is implemented. When setting standards of service quality, a cost-benefit analysis should be conducted to determine whether or not any cost saving exercises can ultimately maintain and even improve service quality. Obviously, the cost-benefit analysis should directly link the sharing of cost savings to the maintenance of quality standards. Cost savings may not necessarily mean higher rates for increased quality standards and the maintenance of quality standards should be closely monitored especially in the early implementation of PBR. Close monitoring and evaluation are necessary to make sure quality is maintained where reasonable customer desires and expectations are met. The excessive reserve margin under the SOC provides utilities with redundant protection that can be used to improve service quality while under PBR, utilities may be tempted to achieve false cost savings by deferring necessary maintenance and coupled with a possible reduction in service personnel, some measures of performance may be affected. It is up to the regulator to monitor these activities and if the earnings sharing mechanism is to be used, it should not give rewards that could be achieved at the expense of quality of services. Finally, efficient evaluation and technology innovations are also important criteria for the performance of the utilities. Efficient evaluation can be measured with the maturely developed engineering indices. Technology can be observed directly in the operation of the regulated utilities as utilities are willing to report their technology improvement in order to get extra awards and correspondingly compensated for their investments.
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5.6. Investment incentives and sustainable development How to provide incentives for reasonable investments is one focus in designing the PBR. One of the basic objectives of PBR is to share the benefit from the utilities with the customers. Traditional COS/ROR regulation may result in over investment by the utilities while any decreased earnings in the application of certain PBR will probably limit the regulated firms’ discretion on investment. For example, in the price cap regulation, when the review for the regulation is approaching, utilities will be reluctant to invest more in the productivity improvement measure because all the efforts they have made could result in more stringent requests for further productivity improvement. Furthermore, during the periodic regulation, they would rather maintain the current service quality or technology standards than pay more for technology innovation, which will certainly influence their ability for sustainable development and betray their responsibility for supporting social development. Moreover, if the index for regulation is not properly designed, the PBR plans will affect the regulated firm’s and the social long-term development. For example, price cap-based regulation may produce a disincentive for utilities to take demand side management measures. So in price cap regulation, requests for DSM should be demonstrated clearly. In total, the rewards for the utilities should cover all the cost for taking DSM measures and deliver an exciting return for them. Special items in the regulation schemes must be set to ensure investments in DSM, technology innovation, etc. ‘‘The regulator, in resetting X, would need to have regard to the fact that investors had other options available and would therefore need to ensure that the level of X offered a rate of return at least comparable to what investors could get elsewhere (for a comparable risk and requirement to be efficient and innovate, etc.)’’ (Littlechild, 2003). Other similar PBRs that focus on the resource acquisition are referred to as portfolio PBR. Portfolio PBR is aiming at mixing resources for generating electricity, which can monitor the pollution of the ESI. Portfolio PBR can provide incentive for the utilities to maintain a clean environment and improve the sustainable ability for themselves. Further resource mix can bring more choices to the customers and can decrease the exertion of the market power in the competitive power market.
6. Conclusions This paper reviews the current Scheme of Control (SOC) on Hong Kong electricity supply industry (ESI) and analyzes its characteristics. It describes a possible
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framework of using price cap regulation for reforming the SOC on Hong Kong ESI. Creating a competitive electricity market at reduced costs is a very challenging task. Only through financial incentives can utilities lower electricity costs and of course, a flexible marketbased PBR can be a guide for utilities to achieve the efficient use of the ever scarce electricity infrastructure resources. Price cap regulation model offers flexibility and fairness in providing competitive electricity price for the consumers. In this paper, PBR has discussed how performance can be measured and high profits at reduced costs and improved service quality are all possible. In this competitive electricity market environment, utilities are encouraged to perform more efficiently, as never before. The design of PBR plans for Hong Kong should be based on the long-term strategic development of Hong Kong ESI. Some measures aiming to enhance the benefit of customers such as the investment on basic facilities need a comparatively longer time to become effective while dynamic adjustments on PBR plans should be done from time to time. Moreover, some regulatory objectives cannot be met through PBR mechanisms alone, but need to be promoted through a combination of PBR and other policies. In evaluating the performance of utilities, it is recommended that indices should be set to provide an economic incentive at a reasonable cost. These indices should be accompanied by some kind of penalty indices to ensure utilities deliver acceptable performance. A customer rebate program can be part of these indices where a price rebate to customers can be the substitute (alternative) for the diminishing value of the service quality received. A complaint index can be used as a measurement for customer satisfaction. However, a complaint index without clear objective may measure all complaints from customers including those unrelated to the service quality. Careful categorization on the type of complaints received can produce a positive measurement. Meanwhile, the category for a particular service element (performance) should include a wide variety of service elements since utilities may neglect other service elements at the cost of achieving good performance on measured factors. The success of PBR depends on the availability of sufficient data for the evaluation. A regular and comprehensive reporting process is needed to provide the data and a regulator should monitor the rate, cost and other affects of the PBR incentives. Moreover, the reporting process should be made simple and consume less resources of utilities. Lastly, reliability must continue to be the most important consideration in any reform, including PBR. The Hong Kong ESI has maintained a high reliability standard of 99.99%. Consumers want reliable services at low costs. With careful planning, PBR can ensure
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reliability and other tangible benefits to consumers and utilities.
Acknowledgements The authors would like to thank the Research Committee of the Hong Kong Polytechnic University for the financial support given to this project. Also, the authors would like to express a gratitude to Mr. Andrew C.Y. Tam, Industry Advisor of the project, for his advice and assistance in reviewing the paper. References Bell, M., 2002. Performance-based regulation: a view from the other side of the pond. The Electricity Journal 15 (1), 66–73. Comnes, G.A., Nathanael, S.S., Hill, L., 1996. Six useful observations for designers of PBR plans. The Electricity Journal 9 (3), 16–23. Davis, R., 2000. Acting on performance-based regulation. The Electricity Journal 13 (4), 13–23. EDLB, 2003. http://www.edlb.gov.hk/edb/eng/resp/promote.htm Joskow, P.L., Schmalensee, R., 1983. Markets for Power: an analysis of electric utility deregulation. MIT Press.
Leung, T.P., Ngan, H.W., 2001. Lessons for the electricity supply industry in Hong Kong. Hong Kong Engineers, 19–23. Littlechild, S., 1983. Regulation of British Telecommunications’ Profitability: Report to the Secretary of State. Department of Industry, London. Littlechild, S., 2003. The birth of RPI-X and other observations. Comments at Conference on The UK Model of Utility Regulation, London. Murry, D., 2001. Electric energy deregulation experiences and some lesions for Oklahoma. State Policy & Economic Development: 2001 Okalahoma City, 81–94. Ngan, H.W., Chow, K.F., 2000. A feasible model of open electricity supply industry in Hong Kong. International Conference on Electric Utility Deregulation and Restructuring and Power Technologies 2000. London,, 632–635. Ontario Energy Board Staff (OEBS), 1999. Electric Distribution Handbook, Section 2.1.1. Objectives of PBR. Rudnick, H., Donoso, J., 2000. Integration of price cap and yardstick competition schemes in electrical distribution regulation. IEEE Transactions on Power Systems 15 (4). Saenz, J.R., Arceluz, J., Marin, J., Fernandez, E., Torres, E., Equia, P., 2001. Effects of deregulation on electricity distribution: a review of distribution remuneration schemes. Electricity Distribution, Part 1: Contributions. CIRED, IEE Conference Publication 482 (6). Sappington, D.E.M., Pfeifenberger, P., Hanser, P., Basheda, G.N., 2001. The state of performance-based regulation in the US Electric Utility Industry. The Electricity Journal 14 (8), 71–79.
Energy Policy 34 (2006) 2881–2890 www.elsevier.com/locate/enpol
A feasible reform for the electricity supply industry in Hong Kong H.W. Ngana,, J.H. Wanga, W. Engriwana, K.L. Lob a
Department of Electrical Engineering, The Hong Kong Polytechnic University, Hong Kong b Department of Electronic and Electrical Engineering, University of Strathclyde, UK Available online 23 June 2005
Abstract With the current scheme of control regulation for the Hong Kong electricity supply industry expiring in 2008, the Government has sent out a consultation paper seeking views from the general public on its reform and possible future development. This paper investigates the characteristics of the current agreement and the rationale for feasible reform of the Hong Kong ESI. It leads to a discussion on a proposed feasible reform using performance-based regulation approach modeling and the associated implementation issues related to price capping, risk analysis, performance indices, quality monitoring and governance. r 2005 Elsevier Ltd. All rights reserved. Keywords: PBR; Scheme of control; ESI Reform
1. Introduction Reform of electricity supply industry (ESI) has been a major concern in the energy sector throughout the world in the past two decades (Joskow and Schmalensee, 1983). It leads to changes in structure, ownership and market operation of power enterprises in different forms such as unbundling privatization, deregulation and the introduction of direct competition into the industry. A motive of the changes is to move away from the paradigm in which regulation may have been too responsive to protect benefits of certain interest groups and inherent information asymmetry between regulators and those that are to be regulated may also lead to distortions such as under or over investment (Murry, 2001). In Hong Kong, electricity needs are served by privately owned utilities with vertically integrated operation and financially regulated through a Scheme of Control (SOC) Agreement which will be outlined in more detail in the next section. The SOC was designed in the 1960s and is now considered insufficient to cope with Corresponding author. Tel.: +852 2766 6181; fax: +852 2330 1544.
E-mail address: [email protected] (H.W. Ngan). 0301-4215/$ - see front matter r 2005 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2005.05.007
the changing environment when investment is no longer the only main concern. One allegation is that the present SOC (expiring by 2008) cannot provide sufficient motivation for better performance. It is further postulated that the simple rate-of-return regulation (Ngan and Chow, 2000) is a cause of uneconomical deployment of resources due to lack of market arbitration and competition mechanisms, and insufficient incentive to optimize the use of scarce infra-structure resources. Introducing market competition is poised to be a typical feature of Electricity Industry (EI) reform worldwide including in our vicinity, Mainland China. Any possible reform of the ESI in Hong Kong is more than likely to follow the worldwide trend (Leung and Ngan, 2001) and, in fact, it aligns with one of the Government’s principal policies in enhancing economic efficiency and free flow of trade. The Government considers it be best nurtured and sustained by allowing a free play of market forces and by keeping intervention to a minimum (EDLB, 2003). Since electric utilities in Hong Kong have been privatized right from their inception, the regulatory reform of the ESI in Hong Kong aims more specifically to correct inefficiencies caused by the SOC rather than on relaxation of ownership. It is viewed as
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complementary to the success of existing operation in terms of incentives for investment and system reliability. The proposed reform of any sort is to broaden trade and to facilitate competition. Establishing a credible regulatory framework is an essential element of the overall reform because it has to create a stable and predictable operating environment that is conducive for long-term participation and investment. In this paper, a framework is proposed which ensures sufficient rules and regulations be set in place in such a way that reform of the regulation not only improves the status quo but also leads the way to an even more competitive future.
2. Scheme of control agreement The SOC was first proposed by CLP in 1964. HEC did not join the SOC until 1979, the year CLP renewed its Scheme with the Government. It lays down rules for governing financial affairs of their electricity-related activities and consists of the following main points: (i) The duration of the regulatory contract is fixed at 15 years, with a 5-year review clause. (ii) The Scheme requires each company to set up a development fund. The main purpose of the fund is to assist the company in financing its acquisition of fixed assets. In addition, any difference between the actual profit after taxation and the permitted return will be transferred to or from the fund. In other words, the company is not allowed to keep any excess profits above the permitted level. Any excess profits have to be put into the fund. The development fund does not form part of distributable shareholders’ funds and is, in effect, a liability owing to customers carried in the company’s books. (iii) The permitted rate of return on equity-financed asset is 15%, while the permitted rate on asset financed by debt or the development fund is 13.5%. That extra 1.5% is aimed at ‘‘encouraging shareholders to increase investment’’. (iv) From the permitted return, interest deductions must be made in order to obtain the figure of net return. These interest deductions are: interest payable on long-term financing up to a maximum of 8% per annum; and a charge of 8% per annum on the average balance of the development fund, which is to be credited to the rate reduction reserve. The purpose of the rate reduction reserve is to give rebates to consumers. After making all necessary transfers, the net return is what the shareholders of the company would ultimately obtain.
2.1. Deficiencies By nature, the SOC agreement can be regarded as a sort of ESI regulation which works on a guaranteed rate of return on investment type of model. It has proven to be a successful model particularly during the early stages of development in Hong Kong, for the power utilities in securing investment for expanding their infrastructure. When referring to evaluation on its effectiveness as a regulatory scheme, Littlechild (1983) proposed a number of criteria which can mainly be grouped into the following aspects:
Protection against monopoly Encouragement of efficiency and innovation Minimization of the burden of regulation Promotion of competition Proceeds and prospects of the firm.
Judging from these criteria, the following deficiencies inherently exist in the current version of the SOC:
It confines return of investment to a fixed rate to be derived only based on financial investment. There is no financial incentive for power trading with/from outside parties and no motivation to enhance their interconnection infrastructure for this purpose. The regulation serves as a financial mechanism to safeguard interests biasing on the investment side but it provides insufficient provision to look after customers’ wishes on having choice of services. No provision for competition. The permitted rate of return mechanism has no bearing to the level of performance of the service providers. Market sensitivity is playing neither a role for inducing new technology nor innovation into the industry. The SOC as a form of regulatory framework does not align with trends of development in the vicinity areas including Mainland China that is poised to move to a more market-oriented reform in her ESI.
2.2. Regulation or competition Consumers, utilities, and regulators have different objectives to achieve in a regulatory system. Consumers want a reliable supply with low price while utilities would like to have better return on their investment and secure ways to off-load their cost centers. As a key member among various stake holders, a regulator is to ensure that balanced interest be maintained on the environmental and social concerns. In an economic
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sense, optimal performance is obtained by pricing the services near marginal costs. How to achieve it depends on different views: whether electricity can be treated as a competitive commodity or not. Conventional view: Electricity is essential for modern life and hence ESI must serve all its customers reliably and without discrimination. Electricity Supply cannot be put at risk; and in exchange for the obligation to serve, electric companies are given the right or provided with conditions to serve a specific region as what is happening in Hong Kong. Open market view: Electricity should be treated like any commodity and be subject to competitive markets. Competition suppliers provide any other essentials and there are means to ensure system reliability and security of supply in competitive electricity markets. 2.2.1. Competition In the case of Hong Kong, with its high population density and lifestyle concentrated in high-rise buildings, we have a high reliance on electricity for lifts and air-conditioning, etc. A reliable electricity supply is vital to the success in Hong Kong’s business operation and economic activities. Under the current regulatory regime, utilities have been able to provide a stable infrastructure for supplying electricity with a high reliability and affordable tariff. Hence, it would be risky to go for a full scale of competitive market structure without due consideration on resulting consequences that follow, such as higher compliance costs and lessening incentives for investment, and imposing extra burden to setup an independent regulator for monitoring the market operation regularly. 2.2.2. Regulation By considering the costs and perceived risks associated with a complex framework needed for introducing competition into Hong Kong’s electricity market, it is obvious that a refined regulation framework may be an alternative consideration. In principle, a simple regulation framework provides operational merits such as simpler management structure with lower overhead cost, better deterministic outcome and clearer signal to attract investment, effective planning and monitoring functions. However, the current regulatory regime in Hong Kong also attracts criticism such as the risks associated with fuel price variation and financing capital investment are totally borne by consumers. Suggestions for improvement to prevent over-investment and to further improve the operational efficiency emerge in various occasions. In line with it, a performance-based regulation (PBR) is envisaged as described in the following context.
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3. Performance-based regulation One major critic of the present model based on costof-service for determining the rate-of-return (COS/ ROR) is a lack of mechanism to link return to performance. PBR appears to be a logical outcome which provides a framework for incorporating performance-based factors into the formula and can be regarded as a penalty/reward mechanism that provides strong incentives for utilities to perform efficiently. The utilities can employ its superior knowledge of their businesses to achieve certain performance goals. In this respect, PBR differs from COS/ROR by relying more on explicit financial incentives and by affording greater discretion to the utilities than on a more strictly permitted rate-of-return on investment as with COS/ ROR. In other monopolistic utilities like water and gas services, PBR can also bring in benefits of having competition and reducing shortcomings of the traditional COS/ROR type of models (OEBS, 1999), e.g. information asymmetry followed by the so-called Averch–Johnson effect (refers to effect of a public regulation that creates incentive for firms to over-invest in tangible assets). Other shortcomings of COS/ROR include its cost-plus nature that blunts the incentive for the utility to minimize cost in the long run since if the allowed rate-of-return is less than the actual cost of capital then there will be a disincentive for the utility to make further investments. Though PBR is a modification of ROR regulation, under a PBR system, PBR seeks to eliminate some of the regulatory command and control aspects of ROR regulation and substitute for it a system of incentives or penalties for performance by the regulated entity outside of a ‘‘normal’’ band and its regulatory lag is stretched out at pre-set intervals (often 5–10 years). With the longer regulatory lag, PBR seeks to reduce a need for frequent tariff filings by utilities, which would lead to reduced administrative costs. For the regulator, a longer regulatory lag means there is ample opportunity in the regulatory review process to monitor the rate, cost and distributional effects of the PBR incentives, and to modify the PBR, or to terminate it if necessary. Thus, when designing the PBR model, special attention is paid to avoid these shortcomings. More focusing effort is to address on the innovative functions of regulation so as to achieve the following objectives:
Cutting cost and prices consequently while ensuring other dimensions of financial performance—increasing the incentives for utilities to reduce their cost and operate at the most efficient level while keeping or improving other dimensions of their financial performance by creating a competitive environment for the regulated utilities.
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Streamlining regulation by simplifying the process of regulation and decreasing the costs involved. Restructuring risk exposure—allowing a more thoughtful allocation of risk between utilities and customers in respect of the proposed changes. Ensuring a good non-financial performance—acquiring a clean, diverse resource mix; at least maintaining or improving the current service quality standards and reliability of supply; new products (service) and technology innovation and application; diverse resource acquisition; demand side management (DSM) application. Keeping a reasonable investment under the principle of sustainable development—PBR should by no means aim at particular objectives at the expense of environmental impacts.
Broad-based PBR mechanisms—focusing on the broader dimensions of the performance of the regulated utilities and providing them with a greater freedom to carry through their own micro-management.
The scope of regulation should be neither too targeted nor too broadly based. Excessive broad regulation will not control the performance of utilities effectively while a strictly targeted PBR will restrict the micro-management of the utilities. From the available experience in the global environment, broad-based PBRs accompanied with appropriate quality monitor measures appears more prevalent for reforming the SOC in Hong Kong’s ESI. 4.2. PBR implementation
These objectives should be balanced in the design of a PBR mechanism while attention should be paid to the differences between traditional COS/ROR and PBR. While COS/ROR offers its own standardized functions of regulation, it would appear that a successful PBR mechanism should include its own functions and unique innovations resulted from negotiations that provide various stakeholders with tangible benefits. Any policy on PBR must recognize that a contractual arrangement between regulator, utility, and consumer groups must be upheld. And it is up to the regulator to control the amount of regulatory risk any utility faces. In addition to the arrangements agreed upon by the different parties, special precaution should be taken when designing a PBR mechanism. Some objectives of PBR may under certain circumstances contradict with each other. For example, if prices are to reduce significantly, the ability and incentive for utilities to invest in new facilities can be jeopardized. Otherwise it goes to the other extreme in the traditional COS/ROR regimes where utilities tend to over-invest so as to benefit from the guaranteed rate-of-return on investment. Thus, a PBR mechanism designed to achieve any one of the objectives can create incentives that might conflict with other objectives. These conflicting objectives will be discussed further in the following sections.
4. Various forms of PBR 4.1. Feasible PBR models According to the designed scope of regulation, PBR can be grouped into two categories:
Targeted PBR mechanisms—designed with rewards or penalties for utilities’ specific aspects of behavior, such as their performance in acquiring cost-effective DSM.
PBR can be implemented in several dimensions. According to its working principle, PBR mechanism can be designed in many ways such as price cap, yardstick/benchmarking, and earnings sharing. Depending on the objectives of the regulation, every mechanism of PBR can bring about the overall regulating effect on the utilities. Take the case of a price cap, it can be designed to encourage regulated utilities to operate more efficiently and to lower prices over time. On the other hand, some particularly targeted PBRs are designed to monitor one or several special characteristics of the utilities with rewards or penalties. But their operating rationales stay close to broad-based PBR as mentioned earlier. Whether using price cap or yardstick or earnings sharing, a PBR mechanism has to be tailored to suit the unique industry structure in Hong Kong. In a vertically integrated electric industry, the emphasis would usually shift away from the generation-related objectives such as improving power plant performance and reducing purchased power costs towards applying PBR to transmission (T)- and distribution (D)-related objectives, such as quality of service and T&D development since the generation business has yet to be deregulated to be competitive. However, it may be appropriate to consider the unique characteristics of Hong Kong, the current SOC, and the geographic monopolies by the existing electric power companies. The aim of PBR is not just to decrease the relevant companies’ revenue although that could well be one of the objectives. PBR should provide incentives for private, regulated companies to behave in ways to promote the public interest but not necessary to the sole detriment of monopolies. By aligning the incentives to utilities with the interests of the consumers, a regulator seeks to encourage economic efficiency through innovative services, increased quality of services and decreased prices over time. The majority of PBR mechanisms may
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provide utilities with a fixed price or a fixed level of revenues, as opposed to a pre-determined level of profits as in COS/ROR.
profits in excess of return on capital costs (Comnes et al., 1996).’’
4.2.1. Yardstick competition In the yardstick competition model, the profitability of a company depends on the behavior of a similar group of companies. It is to encourage companies to make optimal investments oriented to the reduction of their costs. Yardstick competition approach works well in Chile’s electricity distribution industry since there are a number of distribution utilities that can provide a good base for comparison following their successful reform in the early 1980s. However, unlike Chile, there are only two electric utilities in Hong Kong and thus a yardstick competition model is inapplicable to Hong Kong’s ESI. In Chilean regulatory scheme (Rudnick and Donoso, 2000), there is an absence of mathematical models to deal with the calculation of optimal management cost. Additionally, collusion is the biggest potential threat to the application of yardstick competition. The inferior company tends to look for some kind of ‘‘cooperation’’ with the superior company to maintain profits while a ‘‘model’’ company has limited incentive to further improve its performance. Another way is to build a ‘‘Model Company’’ which is more similar to the model company under regulation (Saenz et al., 2001). There are controversies related to the way the model comxcpany determines its operating costs. The lack of a reliable methodology could affect the correct signals of efficiency. Hence such an ideal and independent model which requires plenty of relevant data may be unrealistic for the real companies to achieve. Many external and internal factors may hinder the realization of its assumed objectives.
4.2.3. Price cap regulation Price cap regulation differs from traditional ratemaking regulation in two fundamental ways. First, prices are put in place for longer periods of time (3–5 years) with the intention to maintain price stability and reduce costs in some cases relative to inflation. Second, utilities are allowed to lower their prices as long as all prices stay within the cap. This flexibility allows utilities to provide competitive price discounts. Under the price cap regulation, customer class may be divided into four sub-classes, mainly, residential, government, industry, and business. The initial rates are set for each customer sub-class fairly depending on an appropriate allocation of costs, determined separately by the power companies. As to prevent cost shifting between sub-classes, it is advisable to apply different price caps for different customer sub-classes. Even so, price caps can be applied to customers as a whole or to an individual customer sub-class. Furthermore, price cap is allowed to adjust on regular intervals to allow for inflation but it is also required to decline over time to encourage increased productivity. The stipulated limit can be calculated using the following equation:
4.2.2. Revenue cap regulation Revenue cap regulation aims to limit the revenue of the utilities by setting an allowed level of revenues which is based on actual costs for a test year and can be adjusted to account for inflation and productivity over time. However, the regulation on profits is more complicated to operate than the price cap regulation since the allowed level of revenues may change to reflect changes in sales levels. If there is any deviation in the collected revenues from those allowed, the difference will be returned to, or recovered from, customers through periodic adjustments. Thus, under the revenue cap regulation, the incentives for utilities to invest, innovate, enhance efficiency are reduced. The potential lost revenues from successful DSM programs, for example, will not affect utilities’ revenues. And any inclination to diversify in services is diluted. Also, ‘‘The regulated companies under this kind of regime have strong incentives to act like monopolists. The companies have a will to raise prices, reduce output, and receive
Pt ¼ Pt1 ð1 þ I X Þ Z,
(1)
where Pt is the maximum price that can be charged to a customer class or classes for the current time t, Pt1 is the average price charged to the same class or classes during the previous period, ‘‘I’’ is the inflation factor, ‘‘X’’ is the productivity factor, and ‘‘Z’’ represents any incremental costs such as taxation, accounting methods which are not subjected to the cap. Obviously, the challenge for a regulator is to properly assess the X and I factors. If the X factor is too high in lowering Pt , it will act as a penalty which will reduce the utility incentive to provide services more efficiently. If I is higher than the rate of increase in input costs, the utility will earn too high a return and may not focus on improving service efficiency. Another factor that is worth much attention in a price cap regulation is the set of duration in which the initialized plan will be effective until the next price review is conducted. In the intervals of reviews, utilities have greater freedom to operate as they wish. They could try to enlarge the differences between their costs and the capped price to earn more profit. Under the price cap, utilities can grasp all the profit they earn to compensate their costs and take the risk of losing some when the price is too low. External factors such as increased tax rates are completely uncontrollable by the utilities themselves. So, price cap regulation provides incentive for them to operate at the least
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profitable level while reducing their costs with a strong rigor.
5. Incorporate price cap to reform of the SOC 5.1. General lessons In the United States, many States have replaced their traditional regulations with broad-based PBR plans. One major scheme they took is price cap regulation. Although the experience with PBR in the EI in US is presently too limited to draw a general conclusion, the advantage of PBR over cost of return regulation are expected based on their successful applications in the telecommunications industry (Sappington et al., 2001). For an effective comparison to the traditional COS/ ROR, PBR’s experiences against economic, cost, and weather conditions should be tested in order to fully determine whether or not the PBR mechanism has met its objectives. Additionally, in the United Kingdom price cap regulation has brought about productivity increases and customer bill decreases for electricity distribution, and for the water and sewerage services. In fact, after the 1994–1999 regulatory period, some companies in UK achieved costs savings up to 20% in operational cost and 15% in capital expenditure (Rudnick and Donoso, 2000). Broad experience in other European countries has also reflected the benefit that price cap regulation scheme has introduced (Bell, 2002). The price cap scheme has been applied to regulate the transmission and distribution in the ESI in the United States and the UK where mature wholesale markets have been established in their domestic electricity supply. On the other hand, regulation in their generation markets is to monitor the market power and keep the market operating fairly. Although price cap regulation has been applied widely in transmission and distribution, the uniqueness of electricity network makes it impossible to introduce real competition in the operation of utilities. A regulation of any kind is only to simulate a competitive environment under which the regulated utilities can perform effectively. As far as the situation in Hong Kong is concerned, the two investor-owned utilities have their own power plants and grids. No competition in the generation and retail markets exists between the two firms. Thus, price cap(s) should be placed on the retail electricity price of both companies where different price caps may be applied for different customer sub-classes as described previously. Alternatively, a single price cap from either CLP or HEC on the retail electricity price is also acceptable for a single customer class. These ultimate cap(s) can encourage the companies to decrease their power supply cost from production to the retail side of the operation.
5.2. Setting the X factor Given differences on the operating costs by both CLP and HEC, a benchmarking exercise is found suitable in revealing the operation efficiency of both companies. Data envelopment analysis (DEA) (Bell, 2002) provides a powerful tool to describe an efficient front–end analysis or frontier for both companies. DEA can find the relative efficiency of the targeted companies through finding the firms’ individual distance to the envelopment surface or efficient frontier. It follows that both the regulated utilities must be subjected to similar expected efficiency improvements, the X factors. Although an appropriate level of improved productivity is not easily definable, the DEA analysis can be used to reveal any potential for improving efficiency. Note that a productivity adjustment or X may not be necessary if the price cap is used to tie the input costs incurred or output prices charged by the utilities. The lesser efficient companies will be spurred to catch up with the better ones. However, the more efficient companies should get corresponding rewards even if they get a smaller improvement because their maneuver area is comparatively more restricted than the other ones. Another factor that should be paid attention to is the possible coalition as mentioned before. If the two companies united to hide their real costs from others, the determination effects of X factor could be abnormally small. And the two companies can enjoy their monopolistic status longer. So the regulator should take the responsibility to monitor the occurrence of such kind of conducts. The level of X factor should ensure the possibility of efficiency improvement. Also, the methods and procedures for setting the X factor should be kept transparent since it would have important implications for utility cost recovery and the rate at which prices are allowed to increase. 5.3. Earnings sharing mechanism An earnings-sharing mechanism provides some level of insurance for the utility and consumers against the risk that something in the PBR will go awry. Certain earnings sharing mechanisms often accompany the price cap regulation and takes effect only if earnings fall outside a given range. In the sample (Sappington et al., 2001) ‘‘Of the 28 active PBR plans, 21 of them contain earnings sharing provisions or simple ‘‘deadbands,’’ which specify a range of authorized earnings for the utility, rather than sharing bands.’’ In the application of earnings sharing mechanisms, how to allocate the extra benefit varies according to the different plans:
Some plans or ‘‘sharing bands’’ suggest the extra earnings that exceed the earning target, say +10%,
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be allocated with certain sharing proportions between the utilities and customers. Other ‘‘sharing bands’’ plans focus on the benefits of customers where the first +5% beyond the earning target will be transferred to customers’ account and the remaining percentage will be awarded to the utilities or shared between them and customers. With the ‘‘deadbands’’ approach, the earnings sharing mechanism has no effect inside the earning range and should be applied only if earnings fall outside a very wide range, for example outside +20% range from the earning target.
Theoretically, the earnings sharing mechanism tends to discourage the incentive to cut costs, a main goal for considering the use of PBR But, if it is managed properly, the earnings sharing mechanism can generate confidence in the utility and consumers. One important consideration is that any earnings-based sharing mechanism is inherently biased because earnings can be manipulated. The ability to change earnings by utility management in the form of spending on discretionary items, for example, reduces the amount of sharing required. Thus, price cap regulation with earnings sharing mechanism is preferable so the extent of earnings can be ‘‘managed’’. Additionally, the earnings sharing mechanism should include some forms of quality regulation. If the quality of service cannot attain certain standards, the share of the utilities in extra earnings can be decreased as a way of punishment. Moreover, an earning sharing mechanism does not reduce the liabilities for the customers and utilities to share the loss in case earnings fall below the pre-set target. The allocation of any earnings loss should be considered when designing the earnings sharing mechanism as well. The choice of earning target and the proportion of sharing are very crucial in the design of the earnings sharing mechanism. A very high earning target is unrealistic for the utilities to attain and no benefits for the customers are possible. Therefore, broad ‘‘deadbands’’ are preferable since it can provide greater incentive for the companies to reduce their costs. With earnings way outside the range as in ‘‘deadbands’’, the PBR probably looses its effectiveness anyway and a kind of revenue stabilizing mechanism is called for. 5.4. Risk analysis Another important PBR goal is to determine who can bear particular risks more efficiently and then evaluate how investment decisions are influenced by various risk allocations. It is difficult to determine the effect of a PBR without considering the differing market conditions, politics, and personalities. Market conditions such as cooler weather, could affect the utilities’ revenue as customers might use less electricity for air-conditioning.
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A sudden price hike in fuel prices, another market condition, may trigger higher electricity price charged to consumers. Unstable political situation may influence shareholders’ confidence for continuing investment in utilities’ infrastructure. And of course, personalities determine where PBR stands in the priority list set by the utilities against other cost pressures, for example, the competitive changes taking place in the industry and the organizational restructuring efforts could take senior priority. These factors affect the success of PBR given that the same PBR applied to both utilities may have very different results. Among different approaches to risk allocation, Z factors are the primary mechanisms used to allocate risks. The Z factor, as described in Section 3.2.3, means a cost or a risk which are excluded from the operation of PBR that the utilities will not bear. Any cost due to a change in accounting methods as in the case of income tax rate changes, for example, could permit the utilities to pass the effects of this Z factor to the customers. Alternatively, the use of Z factor in adjusting the revenue to minimize risk as in earnings sharing mechanism has attracted much attention. In this respect, the PBR could set a limit at a specified level before these Z factors become effective and thus creating a fairer sharing of the risk. 5.5. Indexing methods to evaluate the performance of utilities PBR is considered as a better method to improve the social efficiency than the traditional (COS/ROR) regulation. In what way the PBR should be evaluated and consequently developed is the focus of interest. In this respect, some indices can be designed to measure the various effect of the PBR. The principle of PBR is that good utility performance should lead to higher profits, and poor performance should lead to lower profits. In implementing the price cap formula, there should be agreements between regulator, utilities, and customer groups to identify what is considered good quality performance and how should the formula be designed to link performance to profits. In the gaming of regulation, the regulator (probably the government), the customers and the utilities represent the interests of the shareholders, so the developed standards or indices should consider the participants’ need and social benefit maximization. These indices designed for the PBR plans can be categorized as in Table 1. Table 1 prescribes the criteria for evaluation standards. The above criteria can be represented by an engineering and economic indexing method. More detailed indices are described in Davis (2000), however, the author neglected the reasonable benefit of the
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Table 1 Evaluation standards for performance-based regulation Participants
Evaluation standards for performance-based regulation
Regulators
Reliability Safety Environmental consideration and sustainable development Efficiency improvement Technology innovation
Customers
Call center service Satisfaction for billing and metering Field service quality Continuity of supply
Utilities
Financial integrity and future development Regulatory commitment
regulated firms in the actual PBR. A regulation plan which considers only benefit transferred to customers and ignoring possible financial losses for the utilities is by no means a good regulation scheme. Acceptable level of returns for the shareholders can guarantee the future development of the firms, which in turn guarantee the reliability of electricity supply and other long-term benefits to consumers. Similarly, the corresponding accounting indices can reveal the financial integrity and future development for the utilities. If the financial performance of the utilities is deteriorated because of the application of certain PBR, some reasonable modification for the plan must be made. Any regulatory commitment through the government’s policies should create an economic environment suitable for investment. Policy volatility will affect the regulated firms’ confidence for investing and thus reduce their capital injection. Moreover, a convincing regulatory commitment can encourage new competitors to enter the electricity market and a chance for more benefits transfer to the customers, a foundation of a fair electricity market, is becoming more apparent. With the development of the EI, measures for environmental protection are receiving more attention. PBR must have a thorough consideration on the sustainable development and coordination with the development of the whole society. Evaluation for the generation of resources diversification, pollution emission, adequacy for the whole society’s electricity consumption or supply reliability, and demand side management should all be included in a PBR plan. In accordance with the evaluation standards, the baseline and the corresponding rewards/penalty mechanism for quality should be constructed where a socalled dead zone should be set such that if the quality performance of the utilities falls outside the stipulated
band of standards for quality, the dead zone, a corresponding reward/penalty will take effect. Such a mechanism should be constructed before a PBR is implemented. When setting standards of service quality, a cost-benefit analysis should be conducted to determine whether or not any cost saving exercises can ultimately maintain and even improve service quality. Obviously, the cost-benefit analysis should directly link the sharing of cost savings to the maintenance of quality standards. Cost savings may not necessarily mean higher rates for increased quality standards and the maintenance of quality standards should be closely monitored especially in the early implementation of PBR. Close monitoring and evaluation are necessary to make sure quality is maintained where reasonable customer desires and expectations are met. The excessive reserve margin under the SOC provides utilities with redundant protection that can be used to improve service quality while under PBR, utilities may be tempted to achieve false cost savings by deferring necessary maintenance and coupled with a possible reduction in service personnel, some measures of performance may be affected. It is up to the regulator to monitor these activities and if the earnings sharing mechanism is to be used, it should not give rewards that could be achieved at the expense of quality of services. Finally, efficient evaluation and technology innovations are also important criteria for the performance of the utilities. Efficient evaluation can be measured with the maturely developed engineering indices. Technology can be observed directly in the operation of the regulated utilities as utilities are willing to report their technology improvement in order to get extra awards and correspondingly compensated for their investments.
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5.6. Investment incentives and sustainable development How to provide incentives for reasonable investments is one focus in designing the PBR. One of the basic objectives of PBR is to share the benefit from the utilities with the customers. Traditional COS/ROR regulation may result in over investment by the utilities while any decreased earnings in the application of certain PBR will probably limit the regulated firms’ discretion on investment. For example, in the price cap regulation, when the review for the regulation is approaching, utilities will be reluctant to invest more in the productivity improvement measure because all the efforts they have made could result in more stringent requests for further productivity improvement. Furthermore, during the periodic regulation, they would rather maintain the current service quality or technology standards than pay more for technology innovation, which will certainly influence their ability for sustainable development and betray their responsibility for supporting social development. Moreover, if the index for regulation is not properly designed, the PBR plans will affect the regulated firm’s and the social long-term development. For example, price cap-based regulation may produce a disincentive for utilities to take demand side management measures. So in price cap regulation, requests for DSM should be demonstrated clearly. In total, the rewards for the utilities should cover all the cost for taking DSM measures and deliver an exciting return for them. Special items in the regulation schemes must be set to ensure investments in DSM, technology innovation, etc. ‘‘The regulator, in resetting X, would need to have regard to the fact that investors had other options available and would therefore need to ensure that the level of X offered a rate of return at least comparable to what investors could get elsewhere (for a comparable risk and requirement to be efficient and innovate, etc.)’’ (Littlechild, 2003). Other similar PBRs that focus on the resource acquisition are referred to as portfolio PBR. Portfolio PBR is aiming at mixing resources for generating electricity, which can monitor the pollution of the ESI. Portfolio PBR can provide incentive for the utilities to maintain a clean environment and improve the sustainable ability for themselves. Further resource mix can bring more choices to the customers and can decrease the exertion of the market power in the competitive power market.
6. Conclusions This paper reviews the current Scheme of Control (SOC) on Hong Kong electricity supply industry (ESI) and analyzes its characteristics. It describes a possible
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framework of using price cap regulation for reforming the SOC on Hong Kong ESI. Creating a competitive electricity market at reduced costs is a very challenging task. Only through financial incentives can utilities lower electricity costs and of course, a flexible marketbased PBR can be a guide for utilities to achieve the efficient use of the ever scarce electricity infrastructure resources. Price cap regulation model offers flexibility and fairness in providing competitive electricity price for the consumers. In this paper, PBR has discussed how performance can be measured and high profits at reduced costs and improved service quality are all possible. In this competitive electricity market environment, utilities are encouraged to perform more efficiently, as never before. The design of PBR plans for Hong Kong should be based on the long-term strategic development of Hong Kong ESI. Some measures aiming to enhance the benefit of customers such as the investment on basic facilities need a comparatively longer time to become effective while dynamic adjustments on PBR plans should be done from time to time. Moreover, some regulatory objectives cannot be met through PBR mechanisms alone, but need to be promoted through a combination of PBR and other policies. In evaluating the performance of utilities, it is recommended that indices should be set to provide an economic incentive at a reasonable cost. These indices should be accompanied by some kind of penalty indices to ensure utilities deliver acceptable performance. A customer rebate program can be part of these indices where a price rebate to customers can be the substitute (alternative) for the diminishing value of the service quality received. A complaint index can be used as a measurement for customer satisfaction. However, a complaint index without clear objective may measure all complaints from customers including those unrelated to the service quality. Careful categorization on the type of complaints received can produce a positive measurement. Meanwhile, the category for a particular service element (performance) should include a wide variety of service elements since utilities may neglect other service elements at the cost of achieving good performance on measured factors. The success of PBR depends on the availability of sufficient data for the evaluation. A regular and comprehensive reporting process is needed to provide the data and a regulator should monitor the rate, cost and other affects of the PBR incentives. Moreover, the reporting process should be made simple and consume less resources of utilities. Lastly, reliability must continue to be the most important consideration in any reform, including PBR. The Hong Kong ESI has maintained a high reliability standard of 99.99%. Consumers want reliable services at low costs. With careful planning, PBR can ensure
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reliability and other tangible benefits to consumers and utilities.
Acknowledgements The authors would like to thank the Research Committee of the Hong Kong Polytechnic University for the financial support given to this project. Also, the authors would like to express a gratitude to Mr. Andrew C.Y. Tam, Industry Advisor of the project, for his advice and assistance in reviewing the paper. References Bell, M., 2002. Performance-based regulation: a view from the other side of the pond. The Electricity Journal 15 (1), 66–73. Comnes, G.A., Nathanael, S.S., Hill, L., 1996. Six useful observations for designers of PBR plans. The Electricity Journal 9 (3), 16–23. Davis, R., 2000. Acting on performance-based regulation. The Electricity Journal 13 (4), 13–23. EDLB, 2003. http://www.edlb.gov.hk/edb/eng/resp/promote.htm Joskow, P.L., Schmalensee, R., 1983. Markets for Power: an analysis of electric utility deregulation. MIT Press.
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