THEORETICAL CONSIDERATIONS OF ELECTRICITY TARIFF
4.1 Rate-of-return (ROR)
Rate-of-return (ROR) is also known as revenue requirement. According to Jamison (2001) this type of pricing mechanism is used for the following:
• To constantly monitor the utility earnings and allow price adjustment to keep the realised rate of return in line with what is allowed;
• To adjust price levels in a rate case setting;
• To review past efficiency assumptions during a price review;
• To set initial price for price cap regulation; and,
• To set net present value (NPV) of cash flows earning a particular rate of return.
The prices are set to enable the utility to generate an allowed rate of return on all capital investments used and useful in delivering service and its operating costs including depreciation and other taxes. The following formula is used to determine the total revenue requirement necessary to meet demand for service:
RR = [(V-D)*r] + E + d + T ---(4.1) (USAID, undated: 32)
• RR =Revenue requirement;
• V-D =Book value of the useful fixed asset (rate base);
• V = original book value of plant in service;
• D =accumulated depreciation;
• r =allowed rate of return (weighted average cost of capital);
• E =operating expenditure;
• d = annual depreciation expenses; and,
• T =taxes.
Fixed assets are the useful assets used by the utility in generating and delivering electricity. They include generating plant, buildings, vehicles, poles, wires, computers, etc. There are various methods to value the rate base. Methods such as historical cost, replacement cost and concession bid are most commonly used. The choice of method will depend on the regulatory regime. Operating costs include production and delivery costs, wages, salaries, maintenance, billing, administration and general expenses.
Depreciation is the annual accounting charge for wear, tear and the obsolescence of the plant. It is an expense though non-cash. Different methods can be used to estimate depreciation but straight-line method is always used, by accounting conventions, to calculate book-depreciated expenses in the income statement. This method assumes the value of an asset to decrease at a constant rate and the depreciation at any year is given as:
Where:
D = --1
P-F
n ---(4.2)
• Dt = the depreciation charge in year t;
• P = original cost of asset;
• F = salvage value; and,
• n =estimated life.
(Thuesen and Fabrycky, © 1998)
Generally, the value of a plant decreases more rapidly in the first few years in service. So, other accounting methods that depreciate the assets rapidly can also be used. These are sum-of-the-year's digits and declining balance. Sum-of-the year's digit depreciation assumes the asset value decreases at a decreasing rate and the depreciation at any year tis given as:
n-t+l
D,
=
(P- F) ---(4.3)n(n + 1)/2 (Thuesen and Fabrycky, © 1998)
Where P, F and n have the same meaning as above.
Declining-balance method depreciates the asset based on the net book value, which decreases over . time. The general expression for the depreciated charge for any point in time is given as:
D, =a(!-a)'-1
*
P ---(4.4) (Thuesen and Fabrycky, © 1998) Where a= fixed depreciation rate.The allowed rate of return (r) is determined based on weighted average cost of capital (WACC). This is due to the fact that the asset of a utility, in most cases, is financed by both equity and debt capitals. The choice of the allowed rate is very crucial as this can cause over investment for allowed rates greater than the cost of capital and vice versa. The actual average tariff is given by:
. Revenue Requirement
Ave.pnce
=
---(4.5) Tota!SaleVolume(kW I h)The ammmt obtained will reflect recent changes in the market condition and future tariffs are updated on a regular basis. ROR pricing mechanism guards against excessive earnings by the utility. It provides limited incentive for operational and financial efficiencies, because all costs are passed on to the end- user. Thus, the customer bears the market risk and not the utility when using ROR to set tariffs.
4.1.2 Performance based (PB)
Performance based (PB) pricing methods are more appropriate for price increases in successive years.
This method provides strong incentives for efficiency improvements (cost containment or reduction, innovations, encourages increased energy efficiency in supply and end-use, and increase service quality). The crucial issue is to get the numbers used in the computation to be right. If these are wrong, then the utility will be enriched or jeopardised. Prices are set arbitrarily for a relatively long period and then allow the regulated utility to reveals its true cost.
Price Cap (PC)
This type of pricing is based on LRMC or average cost. Price caps are often set using the same formula as in rate-of-return, but the difference is that the regulatory body has a target rate of return; r. Future prices are adjusted according to the formula given below:
---(4.6) (Sapington D, undated)
Where:
• %~PR = average % change in the regulated price;
• I = Inflation index; and,
• X= Productivity factor.
Productivity factor measures the extent to which the utility's costs are rising faster or slower than the inflation. Its choice in calculations is very crucial: too small factor will earn the utility excessive profit while too large factor will threaten its financial position. Wars and storms can affect or damage useful capital assets of the utility. Such exogenous factors are outside the control of the utility expense, but have to be incurred for smooth running. When these are considered, the PC adjusting factor is given as:
%~PR =I+ X± Z ---(4.7) (Sapington D, undated)
Where Z =cost items that falls outside the scope of normal operation.
Future prices are given as:
PC!t = PCJ(t-1l [1 + Jt- Xt] ---(4.8) (Sapington D, undated) Where:
• PC!t =future price cap in year t;
• PCI (t-1) = price cap in year t-1;
• It= inflation index in year t; and,
• Xt =productivity factor for year t.
Revenue Cap (RC)
This is a type of tariff setting that gives incentive for a utility to improve on its productivity efficiency. It is set using the same formula as ROR and PC such that the revenue capped equals rate of return plus cost, and it allows a fixed amount of revenue. The basic formula for future revenue cap changes is given as:
Cap1 = Cap2 (I- X)± Z ---(4.9) (USAID, undated: 53) Where
• Cap1 = future revenue cap; and,
• Cap2 =existing revenue cap.
RC and PC are identical for the fact that they are incentives regulatory mechanisms. Their main difference is that with RC there is a room to invest in energy efficiency while PC encourages increased volume sales and hence discourages end-use energy efficiency.
Sliding scale (SS)
This is a type of tariff set in which excessive profit or abnormal loss by the utility is shared between the utility and the tariff payer in the form of either a decrease or increase in tariff.
There are two types of electricity supply industries (ESI) namely, vertically integrated and unbundled industries. The tariff setting in these industries can be different and are discussed below.