Electricity networks, like water services and rail services are a natural monopoly. The significant cost of extensive networks of electricity poles and wires means that network services in a particular region can be most efficiently provided by a single (monopoly) supplier.

The National Electricity Rules (NER) governing the economic regulation frameworks for the electricity sector enable the Australian Energy Regulator (AER) to set the maximum revenues that electricity network businesses can charge for the services they provide.

Regulation helps consumers by managing the potential risks of monopoly pricing (such as overcharging or poor service).

Prices are usually set every five years. The five-year regulatory cycle was established to help encourage a stable investment environment.

Regulation of natural monopolies is beneficial to users of this infrastructure, however there are risks and problems. Any regulatory regime has to take account of :

• information asymmetry
• cost of regulating
• regulatory risks.

There are two main types of regulatory approaches to natural monopolies:

1. Cost of service regulation - where prices are set to cover the business’s actual expenditures, including a return on investment.
2. Incentive regulation - where revenue or prices are capped prior to the beginning of the regulatory period and with that set the business knows that if it can reduce costs below the cap it can retain the savings for the remainder of that regulatory period. This is the approach used in Australia.

Cost of service regulation

Cost of service regulation is used by some energy networks in the USA.

It is relatively simple to regulate in this way. Businesses provide cost information. The regulator only needs to determine a “fair” rate of return.

However there is little incentive for the businesses to minimise costs as all costs are passed on, and further there is an incentive to “gold plate” (over-invest in its assets) since the profit is set according to the return on the asset base.

Incentive regulation applied to electricity networks

Incentive regulation is widely used in Europe and Australia.

From a business perspective:

• over the course of the regulatory period, the business receives the revenue as determined at the beginning of the process by the regulator
• this amount may be different from the actual costs the business will incur in the process of undertaking its role
• if the business can operate more efficiently than the regulator forecasts i.e. at lower cost, it keeps the difference and thereby retains those savings.

From a consumer perspective:

• the regulator sets the allowed revenue required over a regulatory period. Consumers will be required to pay enough to meet this requirement.
• the regulator uses the revealed behaviour of the business in one regulatory period in determining the cap for the next regulatory period – the lower allowed revenue results in lower prices for consumers.

Setting the cap

In Australia, using incentive regulation for electricity networks, the revenue is set by splitting up costs into three sources and estimating these at the start of the regulatory period. This estimation uses a combination of benchmarking, forecasting and revealed costs.

Once the allowed revenue is determined the regulator must decide how it will be translated into actual prices to be charged to customers in each year of the regulatory period. There are two approaches to setting the cap:

1. Revenue cap – based on the overall revenue for the regulated period.
2. Weighted average price cap – based on the average price level.

The type of cap chosen has implications for the businesses’ expenditure and pricing incentives.

Revenue Cap

Under a revenue cap:

• total revenue is locked in over the regulatory period at the cap
• the business is free to adjust individual prices as it sees fit subject to meeting the cap
• prices change annually to ensure revenue recovery at the cap
• because revenue is locked in, any additional profit is purely determined by cost.

The advantages of a revenue cap system include:

• strong incentive to reduce costs
• incentive to use demand side management to reduce costs
• incentive to set peak demand prices to reduce costs
• guaranteed allowed revenue recovery (lower risk could result in a lower rate of return).

However there are also disadvantages:

• a disincentive to provide more services
• a disincentive to increase the quality of quality services
• a disincentive to set prices efficiently
• average prices have to adjust each year to ensure allowed revenue recovery – price volatility i.e. consumers bear the revenue risk.

Weighted average price cap

Under a weighted average price cap:

• revenue is not fixed at the cap.
• combining the cap with forecast demand for energy and customer numbers the regulator caps average price increases at the start of the regulatory period
• the business is able to adjust individual prices above or below the average
• changes in demand above forecast result in higher revenue recovery
• changes in demand below forecast result in lower revenue recovery
• revenue above the cap is kept by the business
• revenue below the cap is lost by the business.

Advantages of a weighted average price cap include:

• incentive to price efficiently when demand is stable
• incentive to provide more services and higher quality services where revenue is greater than cost.

However there are also disadvantages including:

• price volatility as the business seeks to earn revenue above the cap
• likely over recovery of revenue – resulting in higher prices on average for all consumers
• disincentive for demand side management
• potentially higher rate of return required as the business bears revenue and cost risk.