Walking a tightrope : the perils of electricity tariff setting
The electricity sector needs to attract investors to build and maintain the energy infrastructures required to green the World economy. Indeed, in the wake of the energy transition, electricity is intended to play a major part in the energy mix. According to the IEA, electricity could represent up to 26% of the world’s final energy consumption in 2030 and 49% in 2050[1].
The price of electricity has always been a complicated issue, in theoretical and practical matters. Why one needs to regulate the electricity market? With which tools? How does it work in practice? More generally, why is regulation a complex issue?
Why and when one needs to regulate the electricity market?
Why regulation
According to classical economic theory, a market needs to be regulated when the competition is not perfect, that is when there is a market failure. On the electricity market, market failures arise due to high entry costs, eventually leading to the creation of natural monopolies. This means that some stakeholders in the electricity sector hold market power, and therefore can impose high price levels on the final consumers. These monopolies exist naturally at the level of transmission and distribution of electricity, but can also appear – as a result of history and the legal framework, at all levels in the sector.
In this context, regulation is necessary, first to protect customers and to ensure them access to electricity at a fair price. Second, public authorities might also be interested in overcoming information asymmetries with the operator in order to align the latter’s interest with theirs[2], for example to ensure universal access to electricity.
Who regulates
Regulation is assured by a regulatory authority, whose role is to put in place rules and mechanisms favourable to the sustainable development of the sector. The authority promotes continuous improvement of the electricity service, in line with public policies, and often plays an important role in opening up to competition.
As an independent authority, guarantor of the sector's long-term technical and financial health, the regulator has to arbitrate between sector development, financial viability of sector operators and affordability constraints.
Financial viability – a cornerstone of economic regulation
Sector development requires investments in grid extensions, reinforcements and maintenance; in mini-grid development and in new power generation and in rehabilitation of existing assets. It also requires continuous improvements to system operations thanks to dispatching, control centres and other advanced control systems (smart grids) for example. All this requires adequate funding.
The regulator plays a central role in attracting the required funding to the sector by setting tariffs at an appropriate level and by ensuring regulatory stability. Both are key in attracting the long term investors on which the sector depends.
Tariffs can not be too high though. Affordability is important to sector and economic development. The regulator thus strives to ensure that tariffs cover only efficiently incurred costs. To ensure efficient use of resources, the regulator defines differentiated tariffs for differentiated consumer profiles, ensuring that each consumer pays the costs they impose on the system.
What not to do : example of the situation in Chad
The electricity sector has deteriorated in Chad over the years, as a result of the socio-economic situation in the country. In the absence of an independent regulator, the alarm was not raised loud enough to be heard and acted upon. Since 2015, no new electricity installation has been made due to a lack of funding[3]. The financial situation of the operator, Société Nationale d’Electricité (SNE), is worrying due to a lack of efficiency and the dependence to fuel according to the Ministry of Energy. The company also suffers from tariffs lower than costs and low bill collection rates; driven by non-payment by their public sector clients.
Since the beginning of the year 2022, the number of power cuts increased, especially in the capital. The partnership between SNE and the electricity provider Aggreko was broken in April, worsening the situation[4]. A regulator has been recently put in place. It has yet to obtain the appropriate resources and capabilities needed to tackle the situation.
Theoretical approach to tariff setting
General principle: cost-revenue balance
Tariff structure and level should reflect revenue needs, applying the rule that users should pay for the costs that they impose to the system. The electricity tariff should be set by the regulator such that there is a balance between costs and revenues for the operators of the electricity system. Regulators generally define a tariff framework applicable for a multi-annual period. In Dominica, the tariff is set for 3 years, for 4 years in France and for 5 years in Mali.
Costs include production costs (construction and operation, fuel, return on capital), transport and distribution costs (construction, maintenance and operation of the power grid, technical losses, return on capital), and commercialisation costs (agency costs, billing, commercial losses and sales margin).
All these costs should be covered by what is sometimes called the ‘authorised revenue’ of the operator. It includes tariff revenues and sometimes an operating subsidy given by the Government to the operator.
Different methodologies to figure out costs and revenues
There are two different approaches to calculate costs. The first one is the top-down approach, where the regulator defines costs according to either costs observed among a large number of operators (benchmarking), or the theoretical costs of a model power system. The former methodology has been used by the Dutch regulator and the latter one by the Malian regulator. The second approach is called bottom-up, where it is the operator that forecasts its costs and builds its business plan based on its strategic and business decisions. These forecasted costs are then presented to the regulator who may audit them. This approach has been adopted in France and in the United Kingdom.
Regarding authorized revenues, there are three approaches to consider: economic-based, accounting-based and cash flow-based. All these approaches consist is a summation of operational expenditures, licence fees, taxes, and capital charges. The main difference results in the calculation of the capital charges. In the economic-based approach, one has to compute the weighted average cost of capital and apply it to a regulated asset base to calculate capital costs. Capital charges also cover amortization of regulated assets. In the two other approaches cost of debt is calculated directly from the operator’s books while cost of equity is calculated in reference to the economic theory, usually using the capital asset pricing model. In the accounting-based approach, capital charges also include amortization of the operators’ assets based on their book value. In the cash-flow based approach, capital charges include debt repayment and a share of investment costs.
Political sensibility of electricity tariffs and the need to tailor regulation to each country’s specific contexts
We now have to consider our homo oeconomicus in a broader social and political context. Indeed, the optimal tariff set by theory is not always accepted by the consumers or political authorities, especially when economics direct that the tariff needs to be increased and when the regulator is not sufficiently established to impose its point of view.
Tariff processes dictate that sector stakeholders align on the cost-revenu balance
Tariff setting results from a process lasting several months that involves different stakeholders. Usually, the operator, the regulator, Ministries of Finance and Energy, and consumer associations are involved. First, the operator establishes its business plan, including demand, cost and investment forecasts, that is presented to and discussed with the other stakeholders. When they all agree on the operator’s business plan, the regulator calculates the adequate tariff, sometimes also the subsidy required to cover costs when tariff increases are not in order. This is also presented to and discussed with the other stakeholders. In the end, when everybody agrees on a trajectory, a tariff is published.
Sometimes it is difficult to reach an agreement
Most of the time, a rise in electricity tariffs is not welcomed. In 2014, the French Minister of Ecology Ségolène Royal refused to increase end-user electricity tariffs, whereas the regulator (Commission de Régulation de l’Energie) was of the opinion that increasing tariffs is necessary in order to face the increase in EDF’s charges and to finance the maintenance of nuclear power plants as well as the development of renewable energies[5]. Several electricity suppliers referred to the Council of State to stop the freezing of electricity tariffs[6]. In Senegal, it is the consumers who protested against the rise in tariffs in 2020. Several demonstrations were organised in Dakar and other cities following a tariff increase by the utility, the Senelec[7].
More generally, Jean Tirole reminds that the choice of the appropriate regulation for a market depends on the context in which it is considered.
His ability to take into consideration the peculiarities of different markets was one of the reasons for which he was attributed the Nobel Price in Economics in 2014[8].
The main take away
Regulation of the electricity market is necessary to maintain the sector healthy, inaction has to be avoided. Economic theory provides room for manoeuvre to regulate the electricity market, with a wide range of methodology options.
In practice, regulators need a strong institutional setting to impose an electricity tariff to political authorities or consumers. Therefore, the tariff setting methodology has to be chosen carefully, to ensure that it is tailored to the country specificities, especially regarding its social and political context.
[1] International Energy Agency, Net Zero by 2050, 2021, https://www.iea.org/reports/net-zero-by-2050 [2] “Theories of Regulation”, Body of Knowledge on Instrastructure Regulation, https://regulationbodyofknowledge.org/general-concepts/theories-of-regulation/ [3] A. Bazzara-Kibangula, « Tchad: l’ingéniosité des habitants face aux pénuries d’électricité », TV5 Monde, 11 mai 2022, https://information.tv5monde.com/video/tchad-l-ingeniosite-des-habitants-face-aux-penuries-d-electricite [4] Sabre Na-ideyam, « Pour justifier le manque d’électricité à N’Djamena, la SNE accuse son partenaire Aggreko », TchadInfos, 20 avril 2022, https://tchadinfos.com/politique/pour-justifier-le-manque-delectricite-a-ndjamena-la-sne-accuse-son-partenaire-aggreko/ [5] Franceinfo, « Il n’y aura pas d’augmentation des tarifs EDF au 1er août, annonce Ségolène Royal », franceinfo, 19 juin 2014, https://www.francetvinfo.fr/economie/il-n-y-aura-pas-d-augmentation-des-tarifs-edf-au-1er-aout-annonce-segolene-royal_626495.html [6] Joseph Martin, « Tarifs de l’électricité, Victoire de Ségolène Royal au Conseil d’Etat », RSE Magazine, 12 septembre 2014, https://www.rse-magazine.com/Tarifs-de-l-electricite-Victoire-de-Segolene-Royal-au-Conseil-d-Etat_a819.html [7] RFI, « Sénégal : nouvelle manifestation contre la hausse du prix de l’électricité », RFI, 11 janvier 2020, https://www.rfi.fr/fr/afrique/20200111-senegal-manifestation-hausse-prix-electricite-noo-lank-senelec [8] The Royal Swedish Academy of Sciences, “The Prize in Economic Sciences 2014”, Press release, 2014, initially available here Jean Tirole - Kungl. Vetenskapsakademien (kva.se), but deleted and can be found here Popular economicsciences2014 (slideshare.net)