TARIFF PHILOSOPHY PAPER OF M.P.E.R.C.

METHODOLOGY FOR PRICE REGULATION

1. The section 29(2)(a) and (b) of the Act lays down that the Commission, while deciding tariffs will be guided by sections 57 and 57-A of the Electricity (Supply) Act, 1948 and its Sixth Schedule for licensees and its section 59 for the Electricity Board. Section 30 of the Act also confers discretion on the Commission to depart from the above provisions, by recording reasons.
2. Electricity pricing has ultimately to be in line with the market forces. As the electricity industry at present, works as a natural monopoly, there is need for a regulatory framework to achieve efficiency in the industry.
3. The traditional framework for setting electricity prices is governed by the principle of Rate-of-Return (RoR). The Sixth Schedule or section 59 of Electricity (Supply) Act, 1948 specifies the methodology thereof. It is sometimes referred to as cost-plus pricing because the regulated entity is able to collect all its cost, plus a regulated return on its investment from consumers. In general this method permits the total revenues allowed to the utility, under the following formula:

   RR = [RB x RoR] + ED + EO&M + I + T

   Where:

Under this general framework, the utility has the responsibility of proving to the regulatory body’s satisfaction that each proposed element of the revenue requirement is prudent. Every component of revenue requirement has to be carefully ascertained, in order to ensure the justification for its inclusion in the cost of service to be provided.

4. The revenue requirement of the regulated entity is fixed and based upon the values of the terms used in the formula during a Test Year and usually adjusted for known and measurable changes so as to reflect these during the time the proposed tariff will be in effect. Each term of revenue requirement formula is usually subjected to intense regulatory scrutiny.
5. There are several advantages of RoR regulation. Firstly, the system limits prices based upon a test year and they are unchangeable until the next tariff order. Secondly, as a result of the above, there is some incentive for the utility to minimize costs until the next tariff order. Thirdly, non-economic goals such as price relief for some sections of consumers are easier to achieve using this system. Lastly, the hearings on tariff changes provide consumers a forum to present their views regarding the tariffs as also the performance of the regulated utility.
6. However, the main drawback of the system is its cost-plus approach which reduces the incentive for the utility to minimize cost, in the long run.
7. An alternative methodology is Performance Based Regulation (PBR) which is a development over rate-of-return/rate base regulation. Performance Based Regulation seeks to eliminate some of the regulator command and control aspects of RoR regulation and substitutes it by a system of incentives (or penalties) for performance by the regulated entity outside a ‘normal’ range. A good PBR system of price regulation has both advantages and disadvantages. The advantages are much the same as those listed for the RoR method with two important additions, namely, a definite incentive for cost minimization built into the system, and reduction of the need for annual tariff filings by the entity. The first disadvantage of a PBR system is that unless the system is carefully designed, it may result in lowering service quality by the regulated utility, while pursuing monetary incentives in other areas. Secondly, there is less regulatory scrutiny in a well-designed PBR system. Thirdly, there is less public input to the tariff process under this system because hearings are not required to be held as frequently as under a RoR system.
8. For proper design of a good PBR system, comprehensive and reliable data are essential requirements. These data are also required to be amenable to independent verification.
9. After careful consideration of the advantages and disadvantages of the two basic forms of price regulation, the Commission is inclined to continue to utilize the methodology in the Sixth Schedule or section 59 of the Electricity (Supply) Act,1948 which is a form of RoR regulation until such time as data become available to apply a comprehensive form of PBR.