Cap prices or cap revenues? The dilemma of electric utility networks

2018·0.45 MB·English

by  Alrick Campbell

EnergyEconomics74(2018)802–812
ContentslistsavailableatScienceDirect
Energy Economics
journal homepage: www.elsevier.com/locate/eneco
Cap prices or cap revenues? The dilemma of electric utility networks
AlrickCampbell
CrawfordSchoolofPublicPolicy,TheAustralianNationalUniversity,132LennoxCrossing,Acton,ACT2601,Australia
DepartmentofEconomics,TheUniversityoftheWestIndies,MonaCampus,Kingston7,Jamaica
A R T I C L E I N F O A B S T R A C T
Articlehistory: InthispaperIanalysethebehaviourofamonopolyelectricityproviderthatservesthreedistinctmarkets
Received3February2017 underapricecaporrevenuecapplan.Imakecomparisonsintermsoftheireffectsonpricesetting,energy
Receivedinrevisedform18July2018 conservation,andsocialwelfare.
Accepted27July2018 InadditiontocontraveningtheRamseypricingrule,Ifindthatunderconditionsofinformationasymmetry,
Availableonline2August2018
whendemandbecomesmoreelasticormarginalcostincreases,revenuecappriceincreasesarelargerrel-
ativetopricecapregulation.Inthisspecificsetting,revenuecappriceincreasescanencourageenergy
JELclassification: conservationbutislesslikelytodosowhenmarginalcostislargeinamarketthatismoreelasticrel-
D42 ativetoothers.Incontrasttoapricecapplan,theseoverallresultsshowthatrevenuecapschemesare
I30
welfare-reducing.
L51
Forpublicpolicydecision-makingpurposes,pricecapregulationismoredesirableespeciallyindeveloping
L94
economiesthatoftenexperiencesubstantialinflationarypressuresfromglobaloilmarketdevelopments
Keywords: butislesssuitablethanrevenuecapregulationwhenelectricitysupplyconstraintsandclimatechangeare
Electricity majorpolicyconcerns.
Pricecap ©2018ElsevierB.V.Allrightsreserved.
Ramsey
Revenuecap
Welfare
1. Introduction is widely discussed in the literature (see, for example, Wirl, 1995;
Sappington and Weisman, 2010). However, proponents of price
Public network industries such as electricity markets were cap regulation argue that in contrast to price cap regimes, rev-
traditionallygovernedbyrate-of-return(ROR)regulation.However, enuecapregulationincentivisespriceincreasesthatdepartfromthe
thisregulatoryapproachwasoftencriticisedforitslackofincentives Ramsey pricing rule, creates output restrictions, and may lead to
in minimising costs and tendency to encourage too much invest- major reductionsinsocial welfare(Comnes etal., 1995;Crew and
mentincapital(AverchandJohnson,1962;LaffontandTirole,1993; Kleindorfer,1996b;Decker,2009).OtherssuchasDutraetal.(2015)
Sappington, 1994). As electricity sectors underwent major market find that price cap regulation induces incentives for supply-side
reforms, ROR was eventually replaced with incentive regulation energyefficiencybyreducingnetworklosseswhilebothschemescan
schemes to constrain the market power of privatised utilities and beimplementedtoachievethesamelevelofwelfare.
encourageefficiency. Theargumentsinsupportofaparticularincentivepricingplan
In light of the many incentive schemes that exist, advocates have evolved from a theoretical framework without knowledge of
liketheAustralianEnergyRegulator(2013)andtheJamaicaPublic behaviouraldifferencesinpractice.Therefore,Iaimtoreconcilethese
Service (2014) claim that replacing price caps with revenue cap arguments by using actual industry parameters to quantitatively
regulation will provide greater incentives for cost recovery and assessdifferencesinrevenueandpricecapschemesintermsofprices,
investment in energy efficiency and promote energy conservation energy conservation, and welfare. This represents the first known
inelectricitymarkets.Theineffectivenessofpricecapregulationin attemptatperformingacomparativeanalysisofbothschemesusing
encouraging energy conservation from a demand-side perspective parameterscalibratedwithindustrydata.Itakeademand-sideman-
agementfocusanduseafirmoperatingunderaverticallyseparated
electricity market structure with a monopoly in the downstream
(distributionandretail)segment.Tocapturetheregulator’sproblem
E-mail addresses: [email protected], [email protected]. ofinformationasymmetriesrecognisedbyLaffontandTirole(1993),
jm. Ialsoaddresscostanddemanduncertainties.
https://doi.org/10.1016/j.eneco.2018.07.029
0140-9883/©2018ElsevierB.V.Allrightsreserved.
A.Campbell/EnergyEconomics74(2018)802–812 803
Understandingdifferencesbetweeneitherschemehasimportant BasedontheEuropeanBankforReconstructionandDevelopment
policy implications. For example, developing countries that gener- (EBRD) definition of sector transition which has five levels, rang-
ate a substantial portion of their electricity from imported fuels ing from extensive government control (Level 1) to large-scale
are more prone to price instability, and may show a preference privateinvolvement(Level4+),electricityreformmeasuresunder-
for price cap regulation to ease inflationary pressures on the local taken in many developing countries can be categorised according
economy. This is of particular significance when there is substan- toLevel4.Thisinvolvestheseparationoftheindustryintogener-
tialpass-throughtodomesticinflation.However,iftheargumentfor ation,transmission,anddistribution;settingupofanindependent
energyconservationholdsforarevenuecap,heightenedsecurityof regulatorwithrulesforcost-effectivetariff-settingformulatedand
supplyandclimatechangeconcernsmaynecessitatetheuseofrev- implemented;andsomedegreeofliberalisation(TheEuropeanBank
enuecapregulationwhichfavourspriceincreases.Thisisimportant for Reconstructionand Development,n.d.). Thiscouldalso include
sinceaclimate-inducedincreaseinelectricitydemandcangiverise separationofthedistributionandretailsegmentsasisthecasein
tohigheremissionsduringpeakdemandhours(Chenetal.,2015). manydevelopedcountriessuchasNordicstates.
Theseemissionscouldbereducedthroughdemandflexibilityarising
fromhigherrenewableenergypenetration,butKroezeetal.(2004) 2.1. Incentiveregulationplans
arguethatend-useefficiencyalsohasthepotentialtocreatesubstan-
tialreductionsingreenhousegasemissionsindevelopingcountries. Traditionally, rate of return regulation has been the primary
Inthisparticularcase,cautionshouldbeexercisedsinceincreased meansofregulatingutilities,wheretheutilityisallowedtorecover
pricescouldresultinthesubstitutionofoilandgas-firedgenerat- itscostsandaguaranteedrateofreturn.Thispricingmethodology
ingunitsforcheaperandmorecarbon-intensivetechnologiessuch hasbeencriticisedonanumberofgrounds,mostnotablyofwhich
ascoal(Xieetal.,2014).Ingeneral,choiceofaspecificschemewill istheincentiveitgivestofirmstoover-investincapitalaswasfirst
involvetrade-offsandisdependentonthegoalsofgovernmentand pointedoutbyAverchandJohnson(1962).Thishasledtothedevel-
regulators. opmentofvariousincentiveregulationschemes.Commonformsof
To test the theoretical arguments about price setting, energy theseschemesthatexistinpracticeincludepricecapregulation,rev-
conservation,andsocialwelfareforbothschemes,Iuseaconstrained enuecapregulation,sliding-scaleregulation,yardstickcompetition,
optimisation problem similar to Brennan (1989)and De Villemeur andmenuofcontractsregulation.RelativetoRORwhereconsumers
et al. (2003), and apply it to the electricity network in Jamaica. I bearalltherisks,sinceoperatingandinvestmentcostsarereflected
findthatundercertainconditions,relativetopricecapregulation, inpriceincreases,differencesamongincentiveschemesarelargely
revenue cap regulation creates conditions for higher and ineffi- explainedbyriskallocationandincentives.
cientpricesetting,encouragesenergyconservation,andiswelfare- IntheUnitedKingdomandmanyLatinAmericancountries,price
reducing. The remainder of the paper is organised as follows: cap regulation is the preferred form of regulation used to incen-
Section2providesabriefoverviewofmarketreformsandvarious tivisecostreductionsandconstrainthemarketpowerofprivatised
incentiveregulationschemes.Section3presentsthemainelectric- utilities. Under a price cap, constraints are placed on the path of
itypricingmodelsused.InSections4and5,Icalibrateeachpricing pricesforservicesprovidedbyaregulatedfirmduringafixedperiod
modelwithparametervaluesthatapproximatethekeycharacteris- oftime.Withpricesconstrained,firmsincreaseprofitsbyreducing
ticsoftheregulatedentity,discussthedataused,performanalyses, costorincreasingsales.Therefore,unexpectedcostchangesandvol-
and report their results. Section 6 highlightsthe main conclusions umetric risk are borne mostly by the firm. This reduces the moral
andpolicyimplicationsofthestudy. hazardproblempresentinmanagerialeffort,butifregulatorshave
limitedknowledgeofthefirm’sabilitytoreducecoststhiscanpoten-
tially allow the firm to extract significant rent from consumers or
2. Marketreformsandincentiveregulation it can lead to the firm’s detriment (Joskow, 2007). Another draw-
back of price caps is the potentialto deterinvestmentand reduce
Policymakers inbothdevelopedanddevelopingcountrieshave service quality (Sappington, 2002) as effort is expended at min-
long believed that it is most efficient for electricity to be supplied imising cost, though Banerjee (2003) does not find any evidence
byasinglefirm.Itisthisthinkingthatgaverisetothecreationof that price cap causes deterioration in service quality. Despite its
anaturalmonopolycharactersisedbycommonownershipandsole shortcomings,ArmstrongandVickers(2012)showthatsocialwel-
responsibility for electricity generation, transmission and distribu- farecanincreasewhenregulatedfirmsoperateunderapricecapby
tionservices.Joskow(1997)postulatesthatutilitieshavemaintained limitingcross-subsidizingpricingbehaviour.
this vertically integrated structure because of significant operat- In order to overcome volumetric risk, European countries such
ing and investment complementarities that allowed them to ben- asNorwayandSwedenshowapreferenceforrevenuecapregula-
efit from economies of scale and scope. However, this traditional tion(Jarvis,2011).Initssimplestform,constraintsareplacedonthe
belief is increasingly being challenged. Indeed, many developed regulatedfirm’srevenuesratherthanprices.Hirstetal.(1994)advo-
and developing countries have implemented major structural and catedfortheuseofrevenuecapsbasedontheideathattheyprovide
regulatory reforms to promote competition within the electricity greaterincentivesfordemand-sidemanagementcomparedtoprice
sector. cap regulation. Though both schemes encourage cost reduction, a
Large-scalereformmeasuresinelectricitysectorsacrossdevel- price cap encourages higher sales while a revenue cap promotes
oped countries dates back to as early as the 1980s. These reform energysavingsthroughflexiblepriceadjustments.Underabinding
measureswerelargelyaimedatintroducingprivatesectorpartici- revenuecap,thefirmcanincreaseprofitbyreducingcoststhrough
pationandthepromotionofcompetitionthrougheconomicdereg- reductions in output or increasing price. Revenue caps are more
ulation. In contrast, the introduction of substantial reforms in the suitableinsituationswherethepositivecovariancebetweencosts
electricity sectors of developing countries has been a more recent and sales is low. If tariffs are reflective of the utility’s costs and
phenomenon.Itwasnotuntiltheearly1990sand2000sthatsuch demandisinelastic,apricerisewillreducethequantityofelectric-
reformswereinitiated.BaconandBesant-Jones(2001)theorizethat ity demanded and total costs, while increasing revenue. With the
comparatively,introducingelectricityreformmeasuresindevelop- revenuesoftheutilitycapped,thereductionincostswilltranslate
ingcountriesismorechallengingthanindevelopedcountriesand directly into profits. This incentivises price increases for the least
everyeffortshouldbemadetoensurethatsuchmeasuresareboth inelasticmarketsegmentsservedbyutilities.Thisideawasadvanced
desirableandpoliticallyfeasiblebeforeimplementation. byJamison(2007)andwassimilarlysupportedbyLantz(2008)who
804 A.Campbell/EnergyEconomics74(2018)802–812
emphasizedthatuseofrevenuecapsisa‘badidea’whendetailed deliver.FurtherempiricalevidencebyKopsakangas-Savolainenand
information about the firm’s cost function is not available. A rev- Svento (2010) show that menu of contracts regulation provide
enue cap may also lead to substantial reductions in social welfare sufficient incentives to solve moral hazard and adverse selection
sincetheregulatedfirmislikelytodeviatefromRamseypricingby problems.
charginghigherpricestoconsumersasdemandbecomesmoreelas- The preceding discussion provides a comparison of the many
tic (Comnes et al., 1995; Crew and Kleindorfer, 1996b). Crew and incentiveregulationschemesthatexistinpractice,butinthisstudy
Kleindorfer(1996b)alsoclaimthatrevenuecapsprovideincentives Ionlyanalysedifferencesbetweenpriceandrevenuecapregulation
forpriceincreasesthatcouldexceedtheunregulatedmonopolylevel toreconcileargumentsputforwardbyproponentsandopponentsof
resultinginsubstantialreductionsinsocialwelfare. bothschemes.However,sinceJamaica’selectricitysectorisusedin
Pricecapsarebadatextractinginformationaboutthefirm’sabil- theapplication,Idiscusskeytenetsoftheindustryinmoredetailin
itytoreducecostsandcanleadtosupernormalprofits,butprovide thenextsection.
goodincentivesformanagerstominimiseproductioncosts–alim-
itation of ROR schemes. As a result, sliding-scale regulation serves
2.2. PriceregulationinJamaica
asacompromisebetweenpricecapandRORschemes(Lyon,1996).
Manyincentiveregulationschemesarehybridinnature,butthegen- Theinitialmotivationbehindstructuralreformmeasuresimple-
eral rule is that sliding-scale regulation allows for provisions that mentedinJamaicalargelyresultedfromtheneedtoimprovefinan-
redistribute extra rents to customers if the company earns profits cial performance and operational efficiency of government-owned
inexcessoftheallowedrateofreturn.Theycanalsobesymmetric enterprises.Thiswasprimarilyseenasanopportunitytorelievetax-
– allowing for price increases when the firm is exposed to losses payerburdenandtoimprovetheoperationalefficiencyoftheutility
beyondacertainlimit(ParkerandKirkpatrick,2005).Ineithercase, ratherthanagenuinemeanstointroducecompetition.Theprocess
downside and upside risks are shared by consumers and the firm. of reform measures undertaken can be broadly divided into three
However, information requirements can be substantial relative to categories: (1) private sector participation; (2) structural reforms
otherschemes(ParkerandKirkpatrick,2005)andtheutilitymaynot to address the vertical separation of electricity supply functions
bemotivatedtopursueefficiencyasstronglywhenexcessprofitsare suchasgeneration,transmissionanddistribution;and(3)regulatory
shared(CrewandKleindorfer,1996a). reformsthatcodifybehaviourandprovideincentivesforutilitiesto
In terms of yardstick competition, this entails comparing firms operateefficiently.
engaged in the same line of business with each other. To infer In 2001, the Government of Jamaica sold 80% of its stake in
the efficient cost level, the regulator uses the costs of comparable theJamaicaPublicService–thesoleelectricitysupplierinJamaica.
firmsasabenchmark(Shleifer,1985).Asthefirm’spriceandown Majority share ownership is held jointly between Marubeni
cost drivers are delinked, this regulatory mechanism provides the Caribbean and Korea East-West Power Company Limited (Jamaica
regulated firm with robust incentives to employ optimal effort in Public Service, 2013b). The government of Jamaica retained 19%
reducingcostsbelowtheindustryaveragesinceitisthesoleben- whilethefinal1%wasownedbyminorityshareholders.Underthe
eficiary of these cost reductions. Some limitations of this model OfficeofUtilitiesRegulation(OUR)Actof1995,regulationandover-
include possible collusive behaviour among firms (Potters et al., sight of the sector remains the responsibility of the OUR which
2004) and the difficulty in inferring the efficient cost level when was established in 1997 by an Act of Parliament. Its responsibili-
regulatedentitiesoperateinanheterogeneousenvironment(Jarvis, tiesincludetheissuanceandreviewoflicences,reviewoffive-year
2011).Forinstance,itwouldbemisleadingorimpracticaltocom- tariffapplicationsandrequestsforannualincreases,andtheinvesti-
parefirmsthatdifferintermsofgeographicallocationandcustomer gationofbreachesbytheelectricityprovider.Inadditiontothis,the
base.However,theproblemrelatedtodifferencesinenvironmental OUR issues and reviewsRequests for Proposals (RFPs) for capacity
operatingconditionscanbeminimisedbyusingtechniquessuchas additiontotheelectricitygrid(OfficeofUtilitiesRegulation,2004).
randomparametersstochasticfrontieranalysis(SFA)andstochastic Jamaica’s electricity generation sector was fully liberalised in
non-parametricenvelopmentofdata(StoNED)whichcombinesfea- 2004butmostoftheapproximately820MWofelectricityneeded
turesofSFAanddataenvelopmentanalysis(DEA).1 Thisregulatory to meet demand in the country is still generated by the JPS. The
approachistypicallyusedalongsideotherschemesandisgenerally majorityofJPS’electricityisgeneratedfromimportedfossilfuel,but
applicableindevelopedcountriesthatoftenhaveunbundledmarket it also owns eight hydro-electric plants with capacity of approxi-
structures.Norway’sincentiveregulationschemealsohaselements mately25MW.Ofthetotalrequiredcapacityofthecountry,215MW
ofyardstickregulation(seeAppendixA). ofcapacityisavailabletothedistributorunderlong-term(20years)
LaffontandTirole(1993)arguethatoptimalincentiveschemes power purchase agreements (PPAs) with the four independent
shouldbedesignedtoaddresstheprincipal-agentproblemassoci- powerproducers(IPPs).
atedwithasymmetricinformation.Theprincipal(regulator)hasfar Eventhoughcompetitionhasbeenintroducedintothegeneration
lessinformationabouttheutility’s(agent)operations.Forinstance, segmentandregulatoryentrybarriershavebeeneliminated,theJPS
regulatedfirmsarebetterinformedaboutthecostofprovidingelec- retaineditsverticalstructureandcontinuestoperformthefunctions
tricity and consumer demand behaviour. Given the positive and ofgeneration,transmission,anddistribution.Onthegenerationside,
negativeattributesofthevariousschemesdiscussedpreviously,the anumberofprivateentitiesoperatealongsidethestate-ownedgen-
regulator can do even better by presenting firms with a choice of eratortosupplyelectricitytothenationalgridownedandoperated
regulatorycontracts(LaffontandTirole,1986,1993).Thisiscalled bythemonopolydistributor(JamaicaPublicService,2013b).
‘menu of contracts’ regulation and induces the optimal behaviour During the 2001 period in which the electricity company was
of firms. Such contracts are often complex and require substantial privatised, the OUR introduced price cap regulation to incentivise
information,butRogerson(2003)showedthatinareal-worldcon- improvementsinoperationalefficiency.Thespecificformofthecap
text, a menu consisting of two simple regulatory contracts (fixed usedis
priceorcostofservice)iseasytounderstandandisoftenenoughto
capturethemajorityofsurplusthatamorecomplexcontractwould
pt=pt−1(1+dI+X+Q+Z) (1)
where pt−1 is the non-fuel tariff at the beginning of the price cap
1 Foradetailedexpositionofthesetechniques,seeKuosmanenetal.(2013). period, dI accounts for inflation and exchange rate devaluation, X
A.Campbell/EnergyEconomics74(2018)802–812 805
cishaanngeeffisicnietnhceyqtuaarlgietyt,oQfsiesrtvhiceeapllroowvieddedprtiocethaedcjuussttmomenetrst,oanredflZecist where4i =−∂∂pqii,,tt.pqii,,tt istheelasticityofdemandforelectricitywith
respecttoelectricitytariffs.Thisfunctionalformassumesthatthere
theallowedrateofpriceadjustmentforspecialreasonsnotcaptured
willbesomedemandforelectricityirrespectiveofthepriceifk >0.
bytheotherelementsoftheformula(OfficeofUtilitiesRegulation, i
ThisdemandfunctionisdiscussedinmoredetailinSection4.1.
2004). Under this regime, the non-fuel tariff accounts for all costs
Usingtheinversedemandfunctionp (q ),totalvalueVtocon-
exceptfuelwhichispassedonfullytocustomers(irrespectiveofthe i,t i,t
sumersofconsumptionquantityq istheareaunderthedemand
priceoffuel)andissubjecttoheatrateandelectricitydistribution i,t
curvegivenas
lossadjustments.Itwasoriginallyimplementedforthreeyearswith
XandQsettozero.Theideawastoallowtheutilitysometimeto
improveefficiencyandgivetheregulatortimetodevelopappropri- (cid:2)n q(cid:3)i,t
atemeasuresofXandQbeforetheregimewasfullyimplementedin V(q1,t,...,qn,t)= pi,t(qi,t)dqi,t. (4)
June2004andthepricecapperiodextendedtofiveyears. i=1 0
In2014theJPSrequestedthattheOfficeofUtilitiesRegulation
changetheexistingpricecapplantoarevenuecap(JamaicaPublic WecanthendetermineconsumersurplusCSbyevaluatingEq.(4)
Service, 2014). Without any empirical justification, the electricity overtherange(0,qi,t)andsubstitutingEq.(3)intoitssolutionsuch
providerarguedthatarevenuecapwillensurethatsufficientrev- that
enuesareearnedtocoverallprudentcostsinadditiontothereturn
(cid:2)n
oninvestment.Additionally,itadvocatedforarevenuecaponthe CS(p1,t,...,pn,t)=V(q1,t(p1,t),...,qn,t(pn,t))− pi,tqi,t(pi,t) (5)
basis that it encourages energy conservation and efficiency. After
i=1
ninemonthsofdeliberations,theregulatorrejectedtheproposalin
January2015usingtheoreticalargumentssimilartothatofComnes Ontheotherhand,thevalueofproducersurplusPSiscalculated
etal.(1995)andCrewandKleindorfer(1996b)eventhoughitwas as
recentlyapprovedinJanuary2016.Inlightofthissituation,thereg-
ulated electric utility in Jamaica serves as a natural case study to (cid:2)n
empiricallytestfordifferencesinpricesetting,energyconservation, PS(p1,t,...,pn,t)= [pi,t−ci,t]qi,t(pi,t) (6)
andwelfaresinceithadanestablishedpricecapregulatoryregime i=1
that has been in operation since 2001 and now operates under a
revenuecapscheme.2
3.1. Ramseypricing
3. Optimisationmodels Thefirst-bestsolutionforpricingelectricityismarginalcostpric-
ing because it maximises social welfare. However, marginal cost
To examine how price cap regulation compares with revenue pricingwillresultintheregulatedfirmmakingaloss,thusrequir-
capregulation,Ifirstpresentabasicmodelofaregulatedfirmthat ingtheregulatortooptforthesecond-bestRamsey(1927)pricing
operatesunderaverticallyseparatedmarketstructure.Thisisthen rulewhichmaximisessocialwelfaresubjecttotheconstraintthat
followedbythespecificset-upoftheRamsey(1927)pricing,price thefirmbreakeven.Underthispricingrule,thefirmwillincrease
cap,andrevenuecapconstrainedoptimisationproblems. prices, above marginal cost, for goods with inelastic demand. In
The basic model consists of a regulated firm that has a natural contrast,goodswithhigherelasticitiesofdemandwillhavelower
monopolyindownstreamelectricityoperationswhereitisrespon- prices. Ramsey pricing therefore serves as natural benchmark for
sibleforretailanddistributionservices.Theregulatedfirmmayor analysing the differences between price and revenue cap schemes
may not operate in the upstream segment (electricitygeneration), andisdiscussedfirst.
butthisisimmaterialasthefocusisonhowtheregulatorypolicy Formally,aregulatorthatiswell-informedaboutthefirm’scost
optioninfluencesfirmbehaviourindownstreamoperations. anddemandstructurewillaimtomaximisesocialwelfaredefined
Theregulatednaturalmonopolysuppliesahomogeneousgood– as the sum of consumer surplus CS and producer surplus PS, sub-
electricity–toi=1...ndistinctmarkets:residential,commercial, jecttothebreak-evenconstraint.Thus,Ramseypricesmaximisethe
andindustrial.Ifc ismarginalcostformarketi,q istheelectricity followingLagrangian:
i i
soldineachmarket,pi istheretailpriceofelectricityinmarketi, (cid:4) (cid:5)
andFiscommonfixedcost;thefirmseekstomaximisetheprofit (cid:2)n
functionattimetsuchthat maxL=CS+PS−k [pi,t−ci,t]qi,t(pi,t)−Ft (7)
pi,t,k i=1
(cid:2)n
pt= [pi,t−ci,t]qi,t(pi,t)−Ft (2) Thefirstorderconditionwithrespecttopriceis
i=1 (cid:6) (cid:7)
∂L ∂q ∂q ∂q ∂q
To simplify the model, I assume that demand in each market ∂p =pi,t∂pi,t −ci,t∂pi,t −k qi,t+pi,t∂pi,t −ci,t∂pi,t =0 (8)
i,t i,t i,t i,t i,t
segmentisindependentofeachothersothatthecross-priceelastic-
itiesarezero.Residentialconsumers,forinstance,donotusemore SolvingEq.(8)resultsin
electricityinresponsetoanincreaseinthepriceofcommercialor (cid:8) (cid:9)
industrialelectricitytariffs. k 1
I also assume a constant-elasticity demand function for each li=− 1−k 4i i=1,...,n (9)
marketsegmentoftheform
qi,t(pi,t)=kipi,t−4i, 0≤4i<1 (3) wsohceiarlewleil=farepiw,tp−i,itclil,tinacnrdeakseiswthheenshpardoofiwtsaprreicreedinudciecdatbinygonheowdomllaurc.h
WithRamseyprices,themark-upofpriceovercostisinversely
proportionaltothepriceelasticityofdemandineachmarket.This
2 Examplesofothercountriesthatusepriceandrevenuecapregulationschemes impliesthatpricesandmark-upsarehigherinmarketsegmentswith
areprovidedinAppendixA. lowerpriceelasticityofdemand(BaumolandBradford,1970).Under
806 A.Campbell/EnergyEconomics74(2018)802–812
theassumptionthatpriceisgreaterthanmarginalcost,wehavethat sinceinefficientproductionpracticeswillonlyreduceprofitswithout
k<0.However,ifk = 0,thebreak-evenconstraintisnotbinding generatinganyadditionalwelfare(Brennan,1989).
andEq.(9)reducestofirst-bestpricingwherepriceequalsmarginal
cost,thatisp = c . 3.3. Revenuecap
i,t i,t
3.2. Pricecap If the firm maximises profit in accordance with Eq. (2), the
Lagrangianforaregulatedfirmthatissubjecttoarevenuecapis
In light of information asymmetries that usually exist between
⎛ ⎞
the regulator and the regulated entity; Laffont et al. (1996) and (cid:2)n (cid:10) (cid:11) (cid:12) (cid:13) (cid:2)n (cid:12) (cid:13) (cid:2)n (cid:12) (cid:13)
De Villemeur et al. (2003) argue that the regulator can decentral- L= pi,t−ci,t qi,t pi,t −Ft−k⎝ pi,tqi,t pi,t − pi,t−1qi,t−1 pi,t−1 ⎠
ize Ramsey prices using a global price cap formula that allows i=1 i=1 i=1
(15)
the utility to choose its prices when there is uncertainty about
thefirm’sdemandandcoststructure.TomovedirectlytoRamsey
prices, quantity weights under the price cap must be proportional Differentiatingwithrespecttopi,tgivesthefirstorderconditions
toactualquantitiesgeneratedfromtheRamseypricingequationin (cid:8) (cid:9)
SecTtioonill3u.1st.ratethemechanicsofthisprocess,IfollowNeu(1993) ∂∂pL =qi,t+pi,t∂∂pqi,t −ci,t∂∂pqi,t −k qi,t+pi,t∂∂pqi,t =0 (16)
i,t i,t i,t i,t
and assume that the regulated firm maximises profit subject to a
global price-cap constraint where the weighted average of price whichcanberewrittenas
changes of the n regulated market segments between t − 1 and t
1
mustnotexceedzeroshownby li=(1−k)4i +k i=1,...,n (17)
(cid:2)n
(pi,t−pi,t−1)wi≤0 (10) whereli= pi,tp−i,tci,t.
i=1 Aslongas4i<1,whichisusuallythecasefortheutilityindustry,
kwillbegreaterthan1andtherevenuecapdeliverspricesthatsat-
wherew istheweightofserviceiintheconsumptionbasket.Note
i isfyaninteriorsolution,butdeviatefromtheRamseypricingrule.
thattheJamaicancaseinEq.(1)issimilartoEq.(10)exceptthatdI,X,
ThiscanbeeasilyseenbyrearrangingEq.(16)sothat
Q,andZsettozerotoallowforeaseofcomparisonwiththerevenue
cap. p = ci,t4i i=1,...,n (18)
CombiningEqs.(2)and(10)givesthefirm’sobjectivefunctionas i,t (1−k)(4i−1)
(cid:4) (cid:5)
(cid:2)n (cid:2)n Thismeansthatpricesarehigherinmarketswithmoreelastic
L= [pi,t−ci,t]qi,t(pi,t)−Ft−k (pi,t−pi,t−1)wi (11) demandandlowerininelasticmarketsastherevenuecapbecomes
i=1 i=1 morebinding.
where k is the Lagrange multiplier so that differentiating with
respecttop givesthefirstorderconditions 4. Calibrationofmodelparameters
i,t
∂L ∂q ∂q Tosolvetheconstrainedoptimisationmodels,demandandcost
∂p =qi,t+pi,t∂pi,t −ci,t∂pi,t −kwi=0 (12) parametersareneeded.Inthissection,Idiscusshowthesedemand
i,t i,t i,t andcostparametersareestimatedandprovideabriefdescriptionof
theinitialdataused.
By setting w = q , it is easy to see why the global price cap
i i,t
satisfiestheinverseelasticityrulewhere
4.1. Estimatingthedemandfunction
1
li=(1−k)4i i=1,...,n. (13) utilFitoyr,eIaacshsuomfethaectohnresteanmta-erklaesttisceitgymdeenmtsasnedrvfuedncbtiyonthoefrtehgeulfaotremd
similar to Eq. (3), qi,t(pi,t) = kipi,t−4i. This functional form follows
Ingeneral,Eq.(13)isdifferentfromEq.(9)becausethefirmis
thespecificationoutlinedinCampbell(2018)whereqisalsoafunc-
allowed to earn a profit under a price cap, but if the exogenous
tionofincome(y)andtheurbanshareofthepopulation(u).Since
weights are proportional to each market’s electricity consumption
pisthevariableofinterest,fixedvaluesofyanduareassumedand
lveevreifileresatlhisaetdthuendLaegrrRaanmgesemyuplrtiipcilniegrsoufcthhethparticweic=apqc∗i,ot,nosntreairnetadanildy incorporatedintoaconstantki suchthatki = aiyib,tieciui,t.3 Anesti-
mate of k is obtained after calibrating the demand function with
Ramseyequationarerelatedasfollows: i
theknownparametersqi,t,pi,t,and4i.Forsimplification,zerotrans-
mission and distribution losses are assumed so that output q of
1 i,t
k= i=1,...,n. (14) electricitygeneratedisalsoextractedbyconsumers.
(1−k∗)
4.2. Costparameters
∗
wherek istheLagrangemultipliergivenbythesolutiontoEq.(7)
andq∗i,t isRamseyquantityweight.Thus,thepricesinducedbythe Up-to-datemarginalcostdataarenotpubliclyavailable,butthe
globalpricecapareoptimalandarethesameasthosegivenbythe JamaicaPublicService(2014)publishesdataontotalvariablecost
RamseysolutiontoEq.(7). exclusive of the fuel component. Since the original data does not
With 0 < k < 1, the global price cap moves towards Ramsey
pricesaskincreasesandtheconstraintbecomesmorebinding.Thus,
thepricesandquantitiesderivedmaximisewelfaresubjecttoprices 3 Theconstanttermisaiwhilebiandciaretherespectivecoefficientsofincome
notexceedingthecap.Thisencouragescost-minimisingbehaviour andtheurbansharevariableforeachmarket.
A.Campbell/EnergyEconomics74(2018)802–812 807
give any information about the variable cost attributable to each Marginalcost,measuredinUS$perkWh,is0.2710,0.2735,and
customerclass,themarginalcostforelectricityinmarketiattimet 0.2413 for the residential, commercial, and industrial segments,
isapproximatedas respectively.The fixed cost estimatefor JPS is US$413millionand
is also obtained from Jamaica Public Service (2014). It represents
(cid:18)
ci,t= ni=1VqNsFi,ti,t×vi,t +FQCtt (19) ampapirnolyxiimncaltuedlyes89d%eporfecthiaeticoonm,cpoasntyo’sfctoatpailtanl,oann-fdueplucrochstass.eTdhpisocwoesrt
fromindependentpowerproducers.
whereVNFi,tisthevariablenon-fuelcost,FCtisthetotalfuelcost,Qt
istheaggregateelectricitysold,qs istheamountofelectricitysold 5. Analysisanddiscussion
i,t
tocustomerblocki,andvi,tistheallocationfactorforeachblock.
FollowingasimilarapproachbyJamaicaPublicService(2014),a Using the solution and functions provided in the previous
uniformfuelchargeFCt/Qtisascribedtoeachcustomerblock.Tocal- sections,pricesandquantitiesarecalculatedforthepricecapand
culatetheallocationfactorforeachblock,Iassumethatthevariable revenue cap schemes for the three markets served by the utility
non-fuelcostcanbeallocatedbasedontheshareoftotalenergyand provider.Recallthatinthecaseofthepricecap,theweightsapplied
demandchargeforeachblock.Marginalcostswerecomputedacross to Eq. (10) are based on the quantities obtained from maximizing
thetwelveblocksofconsumersandsimpleaveragestakenforthe Eq. (7). I also calculate the social welfare changes associated with
threemaincustomersegments. eachschemeusing2013tariffsasthebenchmarkcase.
4.3. Data 5.1. Prices,output,andwelfarechanges
Iuse2013datafortheJPSwhichcurrentlyservestwelveblocksof The price estimates of the constrained optimisation problems
customers.Theseblockshavebeenreclassifiedintothreemaincus- are reported in Table 2 for both regulatory options. For compari-
tomersegments:residential(Rate10),commercial(Rate20/40),and sonpurposes,Ialsoincludethemarginalcostestimatesandoriginal
industrial (Rate 50). Each rate class has different customer blocks. tariffsfor2013.
For example, Rate 10 may include customers that consume below ThreekeyfindingsemergefromTable2.Firstly,prevailingtariffs
100kWhpermonthandthosethatconsumeabovethatlimit.Except foreachcustomersegmentinJamaicacontravenetheinverseelas-
forthedemandelasticitiesobtainedfromCampbell(2018),themain ticityrulewhichrequiresthemark-upofpriceovermarginalcostto
sourceofthedatausedisJamaicaPublicService(2013a). beinverselyproportionaltotheelasticitiesofdemand.Forexample,
Table1showstheinitialdataonelectricityprices(tariffs),quanti- residential consumers are most responsive to price changes, but
ties,priceelasticitiesofdemand,andmarginalcostsfortheregulated paidthehighestrateforelectricityin2013whencomparedtothe
firm attributable to each customer segment, as well as total fixed othercustomergroups.Inasimilarapplicationtoutilitynetworks
costs. The average unit price of electricity is denominated in US$ inFinland,Kopsakangas-Savolainen(2004)alsofoundthatprevail-
andcalculatedastotalrevenueattributabletoeachcustomerclass ingelectricitypriceswerenotefficientlyset.Secondly,optimalprice
divided by their respective sales volume. In 2013, residential cus- setting–apricecapbasedonRamseyweights–wouldrequirean
tomersconsumedapproximately996GWhofelectricityatanaver- increaseinpriceforthecommercialandindustrialcustomersof37%
agepriceofUS$0.3891perkWh.Commercialcustomerswerebilled and12%,respectively;andadropinpriceforresidentialcustomers
for1366 GWhatUS$0.3640perkWhwhilethesmallestcustomer (27%).Inthissituationtheinverseelasticityruleissatisfiedsincethe
class, industrial customers, was billed 605GWh at US$0.3030 per pricemark-upislowestintheleastinelasticresidentialmarket.This
kWh. alsoimpliesthatexistingconsumersinthecommercialandindus-
The absolute value of the price elasticity of demand for each trial markets are being cross-subsidized by residential consumers.
customer segment is 0.82, 0.15, and 0.25, respectively. Campbell Finally,pricesunderarevenuecapcontravenetheinverseelastic-
(2018)derivedtheselong-runpriceelasticityofdemandestimates ity rule. Specifically, residential prices would be approximately 13
over the period 1970 to 2014 using the bounds testing approach timeslargerthanexistingtariffswitha43%declineand13%increase
tocointegration.Themodelheestimatedwastestedforparameter observedinthecommercialandindustrialmarkets,respectively.For
constancy and passed a range of diagnostics tests covering serial thecommercialsegment,pricealsofallbelowmarginalcostunder
correlation,normality,functionalform,andheteroscedasticity. therevenuecap.
Table1
Initialdatausedinconstrainedoptimisationmodelsa.
Variables Coefficient Residential Commercial Industrial
Constant(inmillions) ki 459 1174 449
Originaltariff(US¢/kWh) pi,t 38.91 36.40 30.30
Originalquantity(GWh) qi,t 996 1366 605
Demandelasticity 4i 0.82 0.15 0.25
Marginalcost(US¢/kWh) ci,t 25.83 26.05 24.82
Commonfixedcost(US$,inmillions) Ft 413
a Datafor2013areusedfortariff,quantity,marginalcost,andfixedcost.
Table2
Tariffcomparisonundertheoptimalpricecapandrevenuecapschemesa.
Markets Demandelasticities Marginalcosts Originaltariffs Optimalpricecaptariffs Optimalpricecap(%D) Revenuecaptariffs Revenuecap(%D)
Residential 0.82 25.83 38.9 28.3532 −27.1126 500.2171 1185.905
Commercial 0.15 26.05 36.4 50.7287 36.83469 19.5422 −43.3364
Industrial 0.25 24.82 30.3 35.0512 12.21385 35.1699 12.51907
a Marginalcosts,originaltariffs,optimalpricecaptariffs,andrevenuecaptariffsareinUScentsperkWh.Tariffchangesarebasedoncomparisonwith2013tariffs.
808 A.Campbell/EnergyEconomics74(2018)802–812
The preceding evidence aligns with the views of Crew and thesensitivityofthepricecapandrevenuecapmodelstochangesin
Kleindorfer(1996b)whosupportpricecapsandbelievethatdemand- thedemandelasticityandmarginalcostparameters.Ialsoexamine
side management policies based on revenue caps are inefficient. differencesbetweenapricecapbasedonRamseyquantityweights
Underarevenuecap,largeincreasesinpricewillleadtoareduction andtheuseofpastquantitieswhentheregulatorcannotpredictthe
inelectricitysoldtothemorepricesensitiveresidentialcustomers. Ramseyquantitieswithcertainty.
Aselectricityusefalls,totalcostsfallmorethanthedeclineinrev-
enues.Thisleadstoanoverallincreaseintheutility’sprofits.Infact,
5.2.1. Impactofdemandelasticitychanges
theutilitymaybemoreinclinedtomovetowardspeak-loadpricing
Thesizeofdemandelasticitiescanhavevariedeffectsonrelative
to induce residential consumers to shift their consumption to the
prices,quantities,andwelfareundereachscheme.Todemonstrate,
off-peakperiodwheremarginalcostislower.Inthiscase,itisableto
I decrease residential demand elasticity threefold and show the
generatethemajorityoftherevenuefromcommercialandindustrial
impact of 100 linearly-spaced values over the range of 0.27 and
customersthatcontinuetoconsumeinthepeakperiod.Ingeneral,
0.82,whileholdingallothervariablesconstant.Fig.1showsthatas
theutilityhasanincentivetominimiseitsfixedcharges,soitisnot
demandbecomesmoreelasticforresidentialcustomers,pricefalls
hardtounderstandwhysuchaschemeislikelytounderminenew
slowlyforthatcustomersegmentunderapricecapbutrisesmore
investmentincapacity.Withoutadditionalinvestments,thiscould
sharplyunderarevenuecap.Thistrendisreversedforthecommer-
alsoreducetheincentivefortheutilitytomoveto100%electricity
cialandindustrialsegments,butpricesstarttoriseunderarevenue
coverage(MinistryofEnergyandMining,2009),thusconflictingwith
capwhenelasticityincreasesbeyondacertainpoint.
Jamaica’s2030NationalDevelopmentPlan.
The sub-plot in Fig. 1 for electricity sold shows strong sup-
Thepricechangesassociatedwiththetwoschemesalsohavesig-
port for the energy conservation view under a revenue cap since
nificant implications for energy conservation and societal welfare.
totalelectricitysalesdeclineasresidentialconsumersbecomemore
Table3showsthattotalelectricityconsumptionrisesby7%under
responsivetopricechanges.Incontrast,salesincreaseunderaprice
thepricecapscheme,butfallsbyabout26%underarevenuecap.
capsincetheutilityhasagreaterincentivetoencourageelectricity
Thissupportstheconservationistsviewofarevenuecap.However,
consumption.Thisshowsthatalthougharevenuecaptransfersvol-
this ignores the possible price shock consumers are exposed to if
umeriskawayfromtheutilitytoconsumers,itcomesattheexpense
actualdemandislessthanforecasted,andtheutilitylosesrevenue.
ofmajorpriceshocksandlargereductionsinsocialwelfare.
Under a price cap, the utility would be forced to make the neces-
Ingeneral,welfarepercustomerundertherevenuecapisalways
saryinvestmenttoreducelossesandincreasesales,butthereisno
negativeanddeclinesovertheentirerangeofelasticityvalues.These
guaranteeunderarevenuecapsincenewinvestmentssendsignals
overallresultsshowastrongpreferenceforpricecapregulationwith
ofhigherX-factorefficiencyrequirementsinthefuture.Underarev-
atendencyforwelfaretoincrease.
enuecap,theutilitywouldsimplyrecoverthelossesinthenextprice
reviewbycharginghigherprices.Indevelopingcountries,transmis-
sionanddistributionlossesareamajorsourceofinefficiencymaking 5.2.2. Impactofcostchanges
demandtargetsmoredifficulttoachieve.Forexample,databythe The generation and distribution of electricity requires large
USEnergyInformationAdministration(2016)showedthattransmis- investmentsininfrastructuresuchaspoles,transformers,distribu-
sionanddistributionlossesin2013was26%forJamaicacompared tionlines,andsystemupgradestominimiselosses.Asaresult,the
to2%,8%,and8%incountrieslikeTrinidadandTobago,Norway,and marginal cost of supplying electricity to residential communities
theUK,respectively. with low population density could be quite high relative to other
Theimpactonsocialwelfare,calculatedasthesumofthechanges sectors,butregulatorsdonothavepreciseinformation.Inthiscase,
inconsumerandproducersurpluses,isalsodepictedinTable3.With the utility could exploit the limited knowledge of the regulator.
0.6millioncustomeraccountsin2013,thedeclineinsocialwelfare Giventhecomparativelylargerdemandelasticityoftheresidential
underarevenuecapwouldapproximatetoUS$1328percustomer market,itisusefultodemonstratethebehaviouraldifferencesofthe
peryearwhileUS$14wouldbegainedunderapricecap.Thisresult priceandrevenuecapschemeswhenitbecomesmoreexpensiveto
is supported by Raineri and Giaconi (2005), who find evidence of supplyelectricitytothatparticularmarket.
highersocialwelfareintheChileanelectricitydistributionnetwork To undertake the numerical analysis, I simulate marginal cost
when optimal Ramsey weights are used with the price cap. These changesbyanalysingtheeffectsofalinearthreefoldincreasefromits
general findings suggest that the revenue cap scheme is welfare- currentlevelof25.83US¢to77.49US¢fortheresidentialcustomer
reducing and presents the price cap scheme as a better option for segmentonly,whileholdingallotherparametersfixed.Theresults
regulators. arepresentedinFig.2.
Asitbecomesmoreexpensivetosupplyelectricitytoresidential
5.2. Behaviouraldifferencesunderasymmetricinformation customers,thetariffincreasesunderbothschemes,butataslower
rateunderthepricecapplan.Forcommercialandindustrialtariffs,
LaffontandTirole(1993)arguedthatthepresenceofinformation asteadydeclineisobservedunderbothschemes,butthepricecap
asymmetries mean that regulators generally have limited knowl- planhasthefasterrateofdeclineforcommercialcustomerswhen
edge about a regulated firm’s operations. In this section, I explore marginalcostincreasesbeyondacertainpoint.
Bylookingatthesheermagnitudeoftotalelectricitysold,arev-
enuecapseemslikethebetterregulatoryoptionintermsofenergy
conservation since the total amount of electricity sold is lower at
Table3
Output,consumersurplus,producersurplus,andtotalwelfarechangesunderthe everymarginalcostpointunderarevenuecap.However,astheslope
optimalpricecapandrevenuecapschemes.a ofthecurvesinFig.2demonstrate,totaloutputincreasesundera
Variables Optimalpricecap Revenuecap revenue cap and decreases under a price cap suggesting that the
argumentforenergyconservationislessconvincingathigherlevels
Totaloutputsold(%D) 6.971 −25.6751
DCS(US$/customer) −164.677 −1723.94 ofmarginalcost.Ifhighermarginalcostsarereflectiveofadditional
DPS(US$/customer) 178.6976 395.7574 investments that target improvements in the energy efficiency of
DW(US$/customer) 14.02057 −1328.18 generatingunits,thisisconsistentwiththeviewofDutraetal.(2015)
a Thechangeineachvariableisthedifferencebetweenvaluesattheoriginalprices whofindsthatpricecapsincentivisesupply-sideenergyefficiencyby
andthenewpricescalculatedforeachscheme. minimisingnetworklosses.However,inmyparticularsetting,itis
A.Campbell/EnergyEconomics74(2018)802–812 809
Residential tariff - US$/kWh 109 Total output sold - kWh 109
0.36 6 3.2 3
0.34 2.8
4 3.1
0.32 2.6
2 3
0.3 2.4
0.28 0 2.9 2.2
0 20 40 60 80 100 0 20 40 60 80 100
Commercial tariff - US$/kWh Welfare - US$/customer
0.52 0.3 20 0
0.5 0.25 10 -500
0.48 0.2 0 -1000
0.46 0.15 -10 -1500
0 20 40 60 80 100 0 20 40 60 80 100
Industrial tariff - US$/kWh
0.355 0.5
0.35 0.45
0.345 0.4
0.34 0.35
0.335 0.3
0 20 40 60 80 100
Fig.1. Impactofresidentialelasticityofdemandchanges.Dashedlinerepresentspricecap(leftaxis)andsolidlineisrevenuecap(rightaxis).Plotsarebasedonresidential
demandelasticitychanges(holdingallothervariablesconstant)with100pointslinearlyspacedbetweenandincluding0.27and0.82.
thecostpass-throughtohigherend-userpricesthatforceconsumers it is possible to improve welfare when a two-part tariff scheme is
toconserveenergy. applied.Theinclusionoftheaccessfeeallowstheusagechargeto
Thewelfaresub-plotinFig.2providestwointerestinginsights. besetequaltothefirm’smarginalcost.Therefore,theaccessfeefor
First,overtherangeofmarginalcostvalues,thecurvesforwelfare eachcustomerclassshouldbesettoreflectthedifferencebetween
percustomerareconvexinshape.Second,welfareisalwayslarger price and marginal cost. This approach is justified as long as high
underthepricecapandpositiveinmostcases,butisalwaysnegative access fees do not prevent some customers from participating in
undertherevenuecap. the market (Sappington and Sibley, 1992). However, the inelastic
natureofelectricitydemandissuchthatallcustomersarelikelyto
participate.
5.2.3. Demanduncertainty
Laffontetal.(1996)demonstratethattomovedirectlytoRamsey
prices,quantityweightsunderthepricecapmustbeproportionalto 6. Conclusionandpolicyimplications
actualquantitiesgeneratedunderRamseypricing,givenconditions
of information symmetry. However, if the regulator cannot accu- In this paper I have used actual data for a monopoly distribu-
ratelypredicttheRamseyquantityweights,itmayopttowait,and torofelectricityinJamaicatoexploreperformanceunderpricecap
set wi = qi,t−1 in Eq. (10) so that the weights are based on the andrevenuecapregulationandmakecomparisonsintermsoftheir
consumptionbasketinthepreviousperiod. effectsonpricesetting,energyconservation,andsocialwelfare.In
TheresultsofthisexercisearedetailedinTable4andshowsthat themajorityofsituationsanalysed,theresultsrevealapreference
ifthegivenelasticityestimatesrepresentprecisedemandinforma- forpricecapregulation.
tion,whichtheutilityislikelytohave,socialwelfarepercustomer Ifoundthatincontrasttoapricecapplan,arevenuecapscheme
wouldincrease.Specifically,thethirdcolumnofTable4showsthat generates prices that depart from the Ramsey pricing rule with
if demand is known with certainty, social welfare per customer striking differences in magnitudes observed. A revenue cap sup-
improves to US$17.71 when compared to the US$14.02 generated ports the views of energy conservationists, but is less convincing
under the Ramsey optimal price cap. If welfare improvement is of whenresidentialdemandbecomesmoreelasticsincetotalelectric-
primary interest to regulators, this result implies that it would be ityconsumptionincreasesatafasterratecomparedtothepricecap.
morebeneficialtosocietyifthepricecapregimeismaintainedand The conservation argument also loses support at higher levels of
demand elasticities are used to discriminate among the different marginal cost becauseof thetendencyfor totaloutputtoincrease
customersegments. ataslowerrateunderarevenuecapanddecreaseatafasterrate
Two-part tariffs can be easily incorporated into this particular under a price cap. This means that a price cap could potentially
scenariobyallowingtheelectricutilitytodiscriminatewithincus- encourage energy conservation at relatively higher marginal cost
tomerclassesbyusingafixedaccessfeeandausagecharge,instead becauseofadditionalutilityinvestmentsthatarereflectedinend-
ofusinguniformprices.Kopsakangas-Savolainen(2004)showsthat userprices.Furthermore,Ialsofindthatincontrasttothepricecap,
810 A.Campbell/EnergyEconomics74(2018)802–812
Residential tariff - US$/kWh 109 Total output sold - kWh 109
1 12 3.2 2.26
0.8 10 3
2.24
0.6 8 2.8
2.22
0.4 6 2.6
0.2 4 2.4 2.2
0 20 40 60 80 100 0 20 40 60 80 100
Commercial tariff - US$/kWh Welfare - US$/customer
0.508 0.2 150 -1250
100
0.506 0.18 -1300
50
0.504 0.16 -1350
0
0.502 0.14 -50 -1400
0 20 40 60 80 100 0 20 40 60 80 100
Industrial tariff - US$/kWh
0.351 0.4
0.3505
0.35
0.35
0.3
0.3495
0.349 0.25
0 20 40 60 80 100
Fig.2. Impactofresidentialmarginalcostchanges.Dashedlinerepresentspricecap(leftaxis)andsolidlineisrevenuecap(rightaxis).Plotsarebasedonresidentialmarginal
costchanges(holdingallothervariablesconstant)with100pointslinearlyspacedbetweenandincluding25.83and77.49UScents.
theinefficientpricesettingencouragedunderarevenuecapscheme rates of inflation than developed countries, an electricity provider
reducessocialwelfareorgeneratesrelativelylargerwelfarelosses. thatincursfuelcoststhataresensitivetooilpricesdeterminedin
Therefore, when information asymmetries are present, a revenue worldmarketswillpassthesecostsontocustomers.Thepricecap
capschemeislikelytoresultinmoredevastatingeffectsonsocial isnotimmunetothisproblem,butasbothschemesreflectchanges
welfare. Since demand uncertainty generally poses a problem for in input costs, nominal prices will rise faster under a revenue cap
regulators,furthergainsinwelfareareachievableunderapricecap scheme.Therefore,arevenuecapcanhavemoredamagingeffectson
ifquantityweightsfromthepreviousyearareusedintheregulatory theoveralleconomysincehigherelectricitypricesfeedthroughto
process. furtherinflation.Althoughtheultimateperformanceofanyscheme
From a policy perspective there are certain situations that dependsonthequalityofinformationandthepotentialforwelfare
arguablyfavourtheuseofaparticularscheme,especiallyindevel- gains,thedecisiontoimplementshouldalsoconsiderthepotential
opingcountries.Forinstance,ifthereareclimatechangeconcerns, trade-offsamongthegoalsofpolicymakers.
thehigherpriceelasticityofresidentialelectricitydemandimplies Despite the intuitive nature of these results, there are a few
thatthereisthepotentialtousethepriceinstrumentunderarev- shortcomings.Iassumedanenvironmentofzerotransmissionand
enuecaptoreduceelectricityconsumption,thoughthismaybeless distributionlosses,butlossescanbesubstantial,especiallyindevel-
effectivewhenmarginalcostishigh.Furthermore,iftheelectricity opingcountries.Likewise,thestaticsettingexaminedassumesthat
network is supply-constrained then a revenue cap is more con- thefirm’stechnologyrequirementsarefixedandthereisnodynamic
ducivetousingpricestobalancesupplywithdemandandavoiding interplaybetweentheregulatorandthefirm.Nonetheless,oneofthe
poweroutages.Asdevelopingcountriesgenerallysufferfromhigher benefitsofincentiveregulationschemesisthatovertimeregulators
learnmoreaboutthefirm’sabilitytoreducecosts.Itisalsodifficultto
determineiftheseresultscanbegeneralisedtounbundledmarkets
Table4 especiallywherecompetitionexistsinwholesaleandretailmarket
Demanduncertaintyandpricecapregulationa. segments.However,integrationoftheseissuesintofutureresearch
Variables Optimalpricecap Pricecap(knowndemand) wouldrevealmoreevidenceaboutaparticularscheme’sdesirability.
Residentialtariff(%D) −27.1126 −15.7037
Commercialtariff(%D) 36.8347 13.2751 Acknowledgments
Industrialtariff(%D) 12.2139 4.7144
Totaloutputsold(%D) 6.9719 3.8426
IwishtoexpressmysinceregratitudetoDavidStern,PaulBurke,
DWelfare/customer(US$) 14.0206 17.7125
andanonymousrefereesfortheirusefulandinsightfulcomments.I
a Pricecap(knowndemand)usesquantityweightsfromthepreviousperiod(2012)
wouldalsoliketothanktheparticipantsatthe2015International
insteadoftheRamseyquantityweightswhichareusedfortheoptimalpricecap.The
Association of Energy Economists (IAAE) Conference in Turkey for
changeineachvariableisthedifferencebetweenvaluesattheoriginalpricesandthe
newpricescalculatedforeachscheme. theirvaluablefeedbackandcomments.
A.Campbell/EnergyEconomics74(2018)802–812 811
AppendixA. Casestudiesofpriceandrevenuecapschemes where pt−1 is the price of electricity at the beginning of the price
cap period, CPI is the annual rate of inflation and X is the off-
Inthefollowingsection,Iprovidethreecasestudyexamplesof set to inflation (annual real price increase or decrease) result-
other countries that have applied cap regulation to their electric- ing from productivity changes in the electricity industry. This
itynetworks.Ifocusonissuesrelatedtoprivatization,structureof ‘RPI − X(cid:4) formula was applied to electric utilities in five-year reg-
theindustry,andthespecificpartoftheindustrytowhichincentive ulatory periods in which Ofgem specified the maximum rates a
schemesareapplied. utility could charge for its services. The UK currently uses the
RIIO(Revenue=Incentives+Innovation+Outputs)modelwhichis
seenasanextensionofpricecapregulation.
A.1. TrinidadandTobago
TheTrinidadandTobagoElectricityCommission(T&TEC)isthe A.3. Norway
soleretailerofelectricityinTrinidadandTobagoandhasfullrespon-
sibilityforthedesign,construction,operation,andmaintenanceof LiketheUK,competitioninNorway’selectricitysectorhasbeen
thecountry’selectricaltransmissionanddistributionnetwork,but encouraged through vertical separation. In 2012, installed capac-
the ownership structure differs in the sense that T&TEC is wholly itywasapproximately32,283MWwithapproximately35%coming
ownedbythegovernmentofTrinidadandTobago(McGuire,2007). from hydro power (US Energy Information Administration, 2016).
EventhoughTrinidadandTobago’selectricitysectorwasopened Statnett–Norway’stransmissionsystemoperator,anditsover155
up to competition in 1993 to attract foreign investment, the net- electricitydistributioncompaniesoperateunderarevenuecapintro-
workisstillverticallyintegrated.Variouslegislationswereamended duced by the Norwegian Water Resources and Energy Directorate
whichallowedT&TECtoformcompanies,holdshares,andoperate (NVE)in1997(NorwegianWaterResourcesandEnergyDirectorate,
itsgenerationandtransmissionanddistributionsegmentsindepen- 2014).Itsetsanupperlimitforrevenuesintendedtocoverthenet-
dently (Ministry of Energy and Energy Affairs, 2013). The state- work’scostssuchasoperationandmaintenanceofthegrid,andearn
ownedT&TECretainsmajorityownershipinPowerGen–thelargest areasonablereturnoncapitalinvested.Theannualcapisbasedon
generator, while Trinity Power and Trinidad Generation Unlimited 40%costrecoveryanda60%costnorm.Asimplifiedversionofthe
(TGU)areprivatelyowned.Together,allthreeIPPshaveaninstalled revenuecapformulais
capacityofapproximately2289 MW.Ofthistotal,PowerGenpro-
dTGucUe.s 1344 MW and the rest is produced by Trinity Power and Rt=0.4Ct−2+0.6Ct∗−2 (A.3)
The Regulated Industries Commission (RIC) was established in
2001 to supervise the operations of the two generators – Trinity where Rt is the revenue cap in year t and Ct−2 is the two-year lag
PowerandPowerGen;andT&TEC.IncentiveregulationinTrinidad on the cost base for each network operator. C∗ is the cost norm
t−2
andTobagoisintheformofarevenuecap: foreachnetworkcompanyderivedthroughbenchmarkingwithlocal
andregionalutilities,andotherinternationaltransmissionoperators
inthecaseofStatnett.Statnett’scostnormisderivedfromthe2012
Rt=Rt−1[1+(CGA×CUST)+(RPI−X)]+Z (A.1) e3GRIDstudywhichanalysedthecostefficiencyof22transmission
systemoperatorsinEurope.
where Rt−1 is the authorised revenue for time t − 1, RPI is the
annualchangeinprices,Xisthereductioninpricesimposedbythe
regulator,Zisacostpass-throughvariable,CUSTistheannualchange
References
inthenumberofcustomers(ortheannualchangeinoutput),and
CGAisacustomergrowthfactorwhichcanbeexpressedinpercent-
Armstrong,M.,Vickers,J.,2012.Consumerprotectionandcontingentcharges.J.Econ.
age terms. In Trinidad and Tobago, this fixed revenue cap regime
Lit.50(2),477–493.
tookeffectinJune2006andcoveredafive-yearregulatoryperiod Regulator,AustralianEnergy,2013.AERResponsetoProductivityCommissionFur-
(RegulatedIndustriesCommission,2006). ther Information Request. Australian Energy Regulator. Retrieved from URL
https://www.aer.gov.au/system/files/AER%20response%20to%20Productivity%
20Commission%20further%20information%20request%20-%2022%20February%2-
A.2. UnitedKingdom 02013.pdf.
Averch,H.,Johnson,L.L.,1962.Behaviorofthefirmunderregulatoryconstraint.Am.
Econ.Rev.52(5),1052–1069.
Prior to 2010, the United Kingdom pioneered the use of price Bacon, R., Besant-Jones, J., 2001. Global electric power reform, privatization, and
capregulationandapplieditforover20yearsafterwide-scalepri- liberalizationoftheelectricpowerindustryindevelopingcountries.Annu.Rev.
EnergyEnviron.26(1),331–359.
vatization and decoupling of state-owned network utilities in the
Banerjee,A.,2003.Doesincentiveregulation‘cause’degradationofretailtelephone
late1980sandearly1990s.In1999,theOfficeofGasandElectric- servicequality?Inf.Econ.Policy15(2),243–269.
ityMarkets(Ofgem)wasestablishedasthekeyoversightbodyfor Baumol,W.J.,Bradford,D.F.,1970.Optimaldeparturesfrommarginalcostpricing.Am.
Econ.Rev.60(3),265–283.
theindustryafteramergerbetweentheOfficeofEnergyRegulation
Brennan,T.J.,1989.Regulatingbycappingprices.J.Regul.Econ.1(2),133–147.
(Offer)andtheOfficeofGasRegulation(Ofgas).Theindustryconsists Campbell,A.,2018.Priceandincomeelasticitiesofelectricitydemand:evidencefrom
ofover436generatingfacilitiesandover70electricityretailerswith Jamaica.EnergyEcon.69, 19–32.
Chen,Y.,Hobbs,B.F.,Ellis,J.H.,Crowley,C.,Joutz,F.,2015.Impactsofclimatechangeon
establishedcompetitioninbothsegments(Mandel,2014).Installed
powersectorNOxemissions:along-runanalysisoftheUSmid-Atlanticregion.
capacity was estimated at approximately 93,784MW in 2012 (US EnergyPolicy84, 11–21.
EnergyInformationAdministration,2016).Thetransmissionsystem Comnes,G.,Stoft,S.,Greene,N.,Hill,L.,1995.Performance-basedRatemakingfor
operator–NationalGridCompany(NGC),andthedistributionseg- Electric Utilities: Review of Plans and Analysis of Economic and Resource
Planning Issues. Vol. I. Oak Ridge National Laboratory, Oak Ridge, TN, and
ment are regulated as natural monopolies and both are subject to UniversityofCalifornia,Berkeley.
pricecapregulationunderOfgemoversight.Thepricecapsetsthe Crew,M.A.,Kleindorfer,P.R.,1996a.IncentiveregulationintheUnitedKingdomand
maximumbaserevenuetheregulatedbusinessescanearnforeach theUnitedStates:somelessons.J.Regul.Econ.9(3),211–225.
Crew,M.A.,Kleindorfer,P.R.,1996b.Pricecapsandrevenuecaps:incentivesanddis-
yearoftheregulatoryperiod.Thepricecaptakestheform
incentivesforefficiency. In:Crew,M.A.(Ed.),PricingandRegulatoryInnovations
UnderIncreasingCompetition. Springer.,pp.39–52.
DeVillemeur,E.B.,Cremer,H.,Roy,B.,Toledano,J.,2003.Optimalpricingandprice-cap
pt=pt−1(1+RPI−X) (A.2) regulationinthepostalsector.J.Regul.Econ.24(1),49–62.