Chapter 8 Rate and Tariff Adjustment Mechanisms

Chapter 8 Rate and Tariff
Adjustment Mechanisms
8.2 Inflation Adjustments
RPI-X Adjustment (most common)
RPI--- retail (consumer) price inflation index
X---efficiency factor, to encourage firms to improve
productivity efficiency
consumer retail price index may not accurately estimate
changes to industry factor costs.
Comparison: producer-specific measures of inflation
More accurate than retail price measures.
Subject to greater volatility contravene the goal of
rate stability; hard to optimize production
Therefore, RPI is more commonly used.
8.4 An Alphabet Soup of
Adjustment Factors
 The Productivity (X) Factor:
---the expected change in industry productivity that will be
passed through to consumers in prices.
• Why is X factors positive in practice?
---improved productivity results in lower prices to
---regulators ensure that firms cannot raise prices more
than inflation rate.
• Productivity trend should be based on the relevant
industry, rather than specific company itself.
• Accurate and objective measures of underlying
productivity growth in the subject industry are crucial to
developing effective incentive regulation plans
• Formula containing X factor provides short-term
incentives. But setting X must incorporate long-term
Setting X should:
Use publicly available data that are expected to be
available at subsequent reviews
Use an understandable and transparent methodology
that will not be continually challenged or changed
Ensure that any judgmental adjustments are consistent
with defined principles or productivity measurement
Provide a reasonably reliable measure of likely future
productivity growth of the industry compared to the
productivity of the economy as a whole.
Methods to Calculate the X Factor:
most popular: TFP (total factor productivity)
---historical induces for the major inputs into the
production process are analyzed in precise ways.
2) Forecasting
---X factor is used together with a base price (P0), to
ensure that a price cap will allow an NPV earning.
use one model to determine both initial prices and X
factor not reasonable in basic algebra.
 Subjective Add-Ons to the X Factor:
---regulators made X factors slightly larger than the TFP
productivity factor alone.
Rationale: industry productivity should grow at a faster rate
in future.
Typically add a “stretch factor” or a “consumer dividend” to
the productivity offset.
 The Investment (K) Factor
Rationale: the cost of investments that cannot be made
under existing tariffs, can be incorporated into the rate
base by increasing the current tariff by the K factor.
---rolling the costs associated with a larger rate base into
 The Service Quality (Q) Factor
----A solution to regulated companies reducing costs by
reducing product or service quality.
Two questions:
How to monitor quality of service?
What is required to ensure that quality of service is
• First question:
---service quality can be compared to benchmarks
established in advance
rewarded where appropriate and penalized where
• Second question:
---more a policy matter to establish measurable service
• Q factor has been applied under both price-cap and
revenue-cap schemes.
• Mostly rely on multiple indicators, which are mostly
• Standards of indicators are set using historical data,
projected improvement, negotiation, and values from
other jurisdictions and/or companies.
 The Exclusion (Z) factor
---exogenous adjustment factor
---specific items that are wholly or partly excluded from
price and revenue adjustment formulae.
• Z factor isolates the risk from the regulated company and
passed through the incurred costs to ratepayers.
• Exogenous cost changes represent any changes in the
company’s costs that are beyond the company’s control.
Changes in these costs should:
Be passed directly through to customers (what would
occur in a competitive industry)
Be passed through to customers w/o affecting the
company’s incentive to reduce costs.
Exogenous events that adversely affect just the
regulated firm, are good candidates for Z factors.
Z are established: types of events; set of criteria

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