Service Pricing models

Question 1

Which service price models exist?

Answer 1

1. Traditional cost-of-service regulation
2. Incentive-based regulation
3. Market competition

Question 2

Which are the characteristics of the traditional cost-of-service regulation / rate of return regulation?

Answer 2

= Tariffs are calculated every year based on recognised costs

1. The state requires quality of supply standards and pays the cost of service
2. Investments must be approved by the regulator and are built into the tariff
3. Remuneration is set periodically

Question 3

Disadvantages of traditional COS regulation?

Answer 3

Costs can easily be manipulated by the companies to increase them

(Averch-Johnson effect –>
This type of regulation requires the regulator to accurately calculate the utility’s real cost of capital)

Question 4

What’s the Averch Johnson Effect?

Answer 4

It’s the tendency of regulated companies to engage in excessive amounts of capital accumulation in order to expand the volume of their profits.

A company allowed a rate of return higher than the true cost of capital has an incentive to over-invest, giving rise to economic inefficiency.

Conversely, if the rate of return is lower than the cost of capital, the utility will invest very little and its operating costs will rise, likewise generating economic inefficiencies.

This type of regulation requires the regulator to accurately calculate the utility’s real cost of capital

Question 5

What’s the advantage of Cost-of-Service incentive?

Answer 5

Regulatory stability, if the regulator has accurately calculated the real costs.

Because consumers do not overpay and investors are not undercompensated

Question 6

What are the characteristics of incentive-based regulation?

Answer 6

1. allows utilities to make a profit when they are able to lower costs
2. tariffs aren’t calculated once a year, but for longer periods
3. Companies can make investment decisions

Question 7

What are the disadvantages of incentive-based regulation?

Answer 7

1. The ratchet effect

2. Instability (of price)

Question 8

What is the ratchet effect?

Answer 8

High short-term profit when costs are significantly lower than expected, but lower mid-term profits because allowed earnings will decrease

Question 9

What are the characteristics of market competition?

Answer 9

1. Introduced in pursuit of higher efficiency
   2 Investment and operation decisions are left to market agents
2. No tariff is calculated, remuneration set in the market, cost recovery is not guaranteed
3. Well-functioning markets require design and supervision

Question 10

What are the disadvantages of market competition?

Answer 10

1. Lack of sufficient elastic demand: non-storability may result in very volatile prices (much wind → lower prices sometimes below 0 because of merit-order) which would require a real-time reaction from consumers. But they are not able to react to such rapidly-changing price signals

Efficient markets need active demand that reacts to price signals

2. Too-large-to-fail effect: the government forced to intervene in case of bankruptcy
3. demand unconcerned about power shortages and therefore no (very) long term demand
4. Possibility of investment cycles (?)