A public utility is essentially an organisation that offers an infrastructural service. As such, public utilities encompass activities like the provision of electricity, gas, water, sewage treatment, solid waste disposal, transport, telecommunications, and postal delivery services. Well-developed public utility systems encourage the social and economic development of a country through the improvement of rural and urban environmental quality, while increasing the overall quality of life of citizens.
Even though public utility organisations have been traditionally government-owned, today they follow a different ownership model and can be government-owned, privately-owned, customer-owned or jointly owned through public-private partnerships (PPPs). In several cases, public utilities are inherently natural monopolies due to the nature of the market and the cost of construction and maintenance of the infrastructures that produce and deliver products such as water and electricity.
There are essentially two schools of thought when it comes to public utility service provision. On the one hand, there is a standard economic efficiency argument that in this industry, a single, cost-minimising firm is the best way to serve the overall level of demand. This means that the most efficient market structure is a sole producer, acquirer, seller and distributor of the service rather than multiple competing firms. These can be either government monopolies or alternatively, private monopolies regulated by a public utilities commission that control the rates and service of the public service. The single firm can, in most cases, ensure that the current level of demand is served at the lowest possible cost. However, if future levels of demands rise due to increases in the number of customers and to growth in their purchasing power, this may cease to be the most effective market structure.
On the other hand, there is the diametrically opposed view that public utilities are best opened to fair market competition forces because only non-abusive market competition can guarantee good quality of service at the cheapest possible cost to the consumer. This school of thought is essentially premised on competition policy and the fair market doctrine from the Western world, which is in turn informed by the economic tenet that markets, as long as they can be kept competitive and free from abusive market behaviour, are better than any of the known alternatives in bringing about socially-beneficial outcomes.
Public utility economics strives to improve the provision and distribution of public utilities subject to demand, resources and geography. Public utility economics, in conjunction with industrial and environmental economics, is the basis for the implementation of recent public utility infrastructures such as: Waste-To-Energy projects, renewable energy sources, desalination plants, storm-water relief projects, sewerage networks, road networks and telecommunications projects.
The pricing of public utility services is a subject deriving from price theory and aims to determine the principles that should guide the pricing of utilities. In the 1930’s and 1940’s, the prevalent doctrine was to make public utility prices equal to marginal cost. This policy was adhered to even when the marginal cost was less than average cost and a government subsidy was required to maintain the sustainable production of utilities. This policy had a very weak basis as it was neither rational, nor supported by evidence. People did not limit their consumption and this had severe environmental effects through misallocation of resources and market failures. Today’s economics techniques, while still imperfect, allow us to determine economically-efficient prices that maximise social welfare through valuation techniques such as the average willingness to pay (WTP) of public utilities.
Public utility pricing can refer to either wholesale (or upstream) pricing or retail (or downstream) pricing.
The availability of Regulatory Accounting statements is in most cases necessary to be able to regulate public utility service pricing. Most of the price-setting regulatory mechanisms (except for retail-minus explained below) require some form of detailed accounting statements to implement.
An overview of the more widely-used price-setting mechanisms (this is by no means exhaustive) may be found below.
As its name implies, marginal cost pricing policies set prices equal to their marginal cost of production. Marginal cost pricing can be used for both retail and wholesale pricing policies. The proposal for pricing utility services at marginal cost merits an explanation of how the losses that may arise are to be financed, as marginal cost pricing does not always ensure that total costs are recovered. The inclusion of overhead charges as a form of charge or taxation can be used. Other types of taxes, such as pollution taxes and lump sum taxes, are preferred from an allocative perspective due to their effect on the distribution of national income and the incentives they give rise to. If such taxes were employed, and public utility prices were equated with marginal cost, then desirable welfare conditions can be achieved.
Under certain circumstances, a two-part tariff avoids the shortcomings of marginal-cost pricing. This is due to the fact that it is designed to meet the optimum welfare conditions and also raises enough revenues to cover all outlays. The essence of the proposal is that the price to be charged should be the sum of two parts:
- a ‘marginal-cost’ element determined by the increase in costs necessarily incurred in providing further consumption for an individual consumer; and
- a ‘fixed charge’ to cover costs which do not vary with consumption but which must be incurred if the consumer in question is to be enabled to consume at all.
In this way, total costs are covered and the payments made for additional consumption are kept equal to the extra costs of provision marginal cost alone. The problem appears to be solved, since the ‘welfare’ conditions are satisfied and no income redistribution seems to be implied.
Retail-minus pricing solutions, as the name suggests, take the retail price, which is directly observable in the market as given and deduct a percentage from that retail price to allow for a ‘fair return’ on the operations of another operator or new entrant. Retail-minus is therefore a wholesale pricing mechanism and does not require complex regulatory accounts to establish.
The incumbent’s or the new entrant’s WACC is commonly used to approximate this ‘fair return’, although at times the results from industry benchmarking exercises form the basis for such valuations.
A variant of the retail-minus mechanism that is commonly referred to as the ‘Efficient Component Pricing Rule’ (ECPR) is also worth mentioning on account of its interesting property that tries to ensure that a rival producer of the complementary component can provide service only if that producer is at least as efficient as the existing industry in the production of the complementary component; i.e., the ECPR ensures that production will not be diverted to an inefficient producer.
Cost-plus pricing solutions usually define a cost-base that can be reasonably justified in a particular situation, and subsequently apply a ‘fair’ mark-up thereto. Given the multitude of methods that exist to build a cost base and to compute a ‘fair return’ on that cost base, as well as the numerous bases on which costs may be apportioned, it is reasonable to say that cost-plus pricing heavily relies on a thorough appraisal of costs. It is thus very common for bottom-up, top-down or hybrid models to be built to simulate public utility service provision components used in the provision of particular services in this respect. Some of the issues that need to be sorted out before a cost-plus regulatory pricing method is implemented include whether the incumbent’s (or incumbents’) actual costs or whether hypothetical costs are to be taken as the relevant cost base. The issue as to what constitutes a fair return on infrastructural investment, and whether Fully Distributed Costs (FDC), Depreciated Actual Cost (DAC), Depreciated Optimised Replacement Cost (DORC), Stand-Alone-Cost (SAC), Weighted Average Cost of Capital (WACC), or any compatible combination of the foregoing methods will be adopted in determining costs in a way that will foster competition while still incentivising, or at least not disincentivising, infrastructural investment, will also be important.
Hypothetical costs might include the costs of a so-called ‘efficient’ operator, the Marginal Costs of the incumbent(s), the Average Total Costs of the incumbent(s), the Long-Run Incremental Costs (LRIC) of the incumbent(s), the Long-Run Average Incremental Costs (LRAIC) of the incumbent(s), the Total Service Long Run Incremental Cost (TSLRIC) of the incumbent(s), and the Total Element Long-Run Incremental Cost (TELRIC) of the incumbent(s). A pricing glidepath might also be adopted where efficiency gains are expected of the incumbent(s) over time rather than abruptly, but this would usually also entail the use of some efficiency benchmark.
The LRIC model is a model that revolves around the long-term additional costs of providing public utility services and a ‘fair’ or ‘reasonable’ surcharge for overhead and finance costs, inasmuch as these costs are necessary for service provision.
Long Run Incremental Costs refer to the incremental costs corresponding to a time horizon where all factors of production, including capital, are variable in response to changes in demand. Therefore, all investment costs are considered to be variable.
As such, LRIC models require very detailed regulatory accounts and economic models to implement.
LRIC+, a variant of LRIC, is a methodology that is based on the LRIC modelling approach but which additionally provides for a mark-up for the recovery of common costs.
LRAIC is similar in approach to LRIC but takes average incremental costs rather than the simple incremental costs.
Given certain initial conditions, LRAIC endeavours to calculate the average cost of providing an incremental unit of the public utility service. Simply put, therefore LRAIC poses the question of what cost would be incurred in the long-run by adding a product or service to an existing portfolio of products or services.
LRAIC is path-dependent in that initial conditions matter for the result(s) to be obtained. They determine what shared costs are taken into account, if any, when calculating incremental cost. When faced with situations where additional shared costs are required for producing the increment, an allocation method to attribute these costs to the constituent products of the group needs to be established.
The main difference between LRIC and LRAIC is that whereas the LRAIC approach identifies allocation measures that allocate a part of the shared costs to all products / services of the increment, calculating an average price for the various products / services, the LRIC method allocates shared costs to the product / service that is constitutes the first increment.
Bottom-up pricing estimation methodologies can be used for both retail and wholesale pubic utility pricing regulation, although in practice they are used more widely in wholesale pricing. BUCM refers to the calculation of overall costs by adding together the individual costs of various components comprising it. The costing figures are built upwards by modelling the public utility service setup (i.e. the technical components involved in providing the product / service), and by picking up the elements at the lowest level and consequently adding them up and apportioning shared costs to arrive at aggregates for successive upper layers of the product / service and ultimately to the product / service being priced.
The bottom-up approach provides the greatest level of granularity possible and results in more accurate estimations than the top-down approach, although it is much more laborious as an approach. It involves identifying all of the resources utilised to provide a product / service and to assigning an apportionment value to each of those resources that are shared. Such values are then summed and linked to an activity driver to derive a total unit cost, providing a basis for assessment of which costs can be avoided as a result of reduced demand.
The top-down pricing estimation methodologies can be used for both retail and wholesale public utility pricing regulation. The top-down approach is based on a simple calculation: divide total expenditure for a given product or service cost centre by the total activity units to derive a unit cost. The units of activity are specific to the product or service that is being costed. Typically, this approach uses aggregate, financial accounting data to estimate unit costs. Despite not being as rigorous as the BUCM approach, top-down is still amply used due to the lower cost involved in establishing top-down models in relation to bottom-up models.
The top-down approach, however, makes for two major limitations. Firstly, it fails to identify what drives costs, and therefore has a tendency to obfuscate the factors determining why unit costs vary. Secondly, the top-down approach cannot be used to reliably forecast how costs will evolve as a result of changes in the way people use services or how costs might change with improvements in the product or service.
Average Avoidable Costs include all costs that could have been avoided if a certain quantity of output had not been produced or a certain action (e.g. redundancy investment) had not been undertaken. The relevant volume of output over which AAC is calculated is usually the amount of (incremental) output considered for the exercise. Avoidable costs include both variable and fixed costs incurred as a result of the decision to produce additional output.
As a methodology, the AAC approach is used for both wholesale and retail pricing regulation.
The team at Equinox Advisory can support your public utility consultancy and advisory needs through:
- Support in public-private partnership decision making for both governments and private entities;
- Wholesale and retail price regulation in the realm of public utilities;
- Public utility cost and price modelling;
- Tariff structure and design to ensure fair and efficient recovery of operations cost and to generate a return on investment;
- Regulatory accounting advice;
- Aiding developing countries in preparing a structural public utilities plan to facilitate economic growth and socio-economic development;
- The valuation of specific public utilities and their economic and financial welfare benefits;
- Determining the demand and supply trends of a service and by forecasting the demand trends of a proposed public utility investment to mitigate the risk of the project being unnecessary;
- Public utility market assessments that help determine the most effective tailor made strategy;
- Feasibility studies for the construction of new public utility infrastructure and the feasibility of private-ownership or PPPs;
- Public policy development and analysis;
- Regulatory advice to ensure equal access and proper market structures;
- WTP calculations through Revealed Preference and Stated Preference techniques such as Contingent Valuations; and
- The provision of training.