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Volume 29 Number 1 September 2011

Tuition fees Can universities use price discrimination?

f o s c i m o n o The ec Key economic xt concepts in conte

Making sense of

opportunity cost

Behavioural economics Why do people make bad decisions? www.philipallan.co.uk/magazines

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In this issue

Editorial board

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Editor Peter Smith Managing Editor Jackline Wahba Consultant editors John Aldrich Max Kwiek Carmine Ornaghi Geoff Stewart Mirco Tonin Economics Division School of Social Sciences University of Southampton Southampton SO17 1BJ

Understanding the economics of running a health service

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Use your personal access details on the back page Published by Philip Allan, an imprint of Hodder Education, an Hachette UK company, Market Place, Deddington, Oxfordshire OX15 0SE www.philipallan.co.uk Cover image: Fotolia © PHILIP ALLAN UPDATES 2011 ISSN 0265-0290 Publishing editor: Cathy Harrison Artwork: White-Thomson Publishing Printing: Ian Allan Printing Ltd, Hersham The paper on which Economic Review is printed is sourced from managed, sustainable forests.

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University tuition fees Up-to-date information linked to the article in this issue

Weblinks Websites to expand your knowledge and aid your revision

Development profile solution Did you work out the identity of Country X? Find out here

Question and answer extension Further commentary to improve your understanding

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Volume 29

Number 1

September 2011

2 Economics of the health sector Maksymilian Kwiek

5 Getting started Opportunity cost Peter Smith

8 Price discrimination: university tuition fees William Bohanna

12 Question and answer Questions on economic concepts Peter Smith

Exam questions to practise, with commen ts and answers

14 Who’s who in economics James Tobin John Aldrich

16 Fiscal policy Why do people make bad decisions?

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Wenchao Jin

19 The history of the public debt Helen Julia Paul

22 The energy industry: new regulation for new challenges Chris Watts

28 Question and answer Answers Peter Smith

Behavioural economics: how do we make decisions?

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32 Student’s corner A student’s view Ben Sorrell

34 Development profile Country X Peter Smith

The energy industry

Chris Watts provides an insight into the regulation of the gas and electricity industries and the new challenges facing the energy sector

E

nsuring reliable and sustainable delivery of energy to business and households is crucial for the economy.

However, the gas and electricity transmission networks are seen to be natural monopolies, so there is a need for regulation to avoid the potential market failure that could hamper the efficient allocation of resources in the sector.

Gas and electricity businesses were privatised in 1986 and 1989 respectively, and a regulatory framework was put in place under the aegis of Ofgem. This agency has applied price control regulation to the networks, and provided incentives for firms, initially to improve cost efficiency, but later encompassing other objectives covering aspects of service standards.

The RPI-X framework has been successful in delivering benefits to consumers.

Since privatisation, the cost to consumers for network services has fallen by around 60% in electricity distribution and 30% in electricity transmission. It fell by around 41% for the gas networks between 1995 and 2007 but has been increasing more recently, reflecting increased investment.

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The framework has delivered a better quality of service and over ÂŁ35 billion in network investment.

The energy industry now faces major new challenges and Ofgem needs to make sure that the regulatory framework steps up to support these, while continuing to protect consumers. The sector plays a key role in moving to a low-carbon economy. The government has set a target of an 80% reduction in greenhouse gas emissions by 2050 and decarbonised electricity generation by 2030, while maintaining security of supply. The networks need to adapt to connect new energy sources such as onshore and offshore wind generation, biofuel generation and fossil fuels with carbon capture.

It is estimated that the networks will need to invest in excess of ÂŁ30 billion leading up to 2020, at least doubling the rate of investment.

Ofgem has put in place a new regulatory framework to support this. This is the RIIO model — Revenue set to deliver strong Incentives, Innovation and Outputs.

It builds on the existing RPI-X regulatory framework, refining the approach and

TebNad/Fotolia

New regulation for new challenges

building in a number of exciting new elements. It focuses on two key outcomes: delivering a sustainable energy sector in a timely manner and value for money for consumers. Ofgem is carrying out the current transmission and gas distribution reviews using this approach (RIIO-T1 and GD1).

This article provides an insight into the energy networks, the RPI-X framework, the changes facing the industry and the new regulatory regime, and also provides some examples of new developments.

Structure of the energy industry Figure 1 shows the structure of the gas industry in Britain. Gas is brought into Britain through several sources, including production on the UK Continental Shelf, imports from Europe and liquefied natural gas (LNG) brought in by tanker. This is a competitive activity. Gas is then transported from the relevant entry terminal to the network across the country through high-pressure pipes on the National Transmission System (NTS). It is distributed to the majority of end consumers by the eight local Gas Distribution Networks Economic Review

Production from the UK Continental Shelf (UKCS)

Imports from Europe through interconnectors

Worldwide imports of liquefied natural gas (LNG)

Transportation on high pressure National Transmission System (NTS) by National Grid Gas (NGG) Shippers arrange for delivery of gas on the transmission system and from distribution companies to suppliers

Transportation of gas on medium pressure distribution networks

Metering

Transport of gas via Independent Gas Transporters (IGTs)

Gas storage (not possible in electricity)

= Competitive = Monopoly

Metering

Source: Ofgem

Transport of gas to consumers by suppliers

Figure 1 The structure of the gas industry in Britain

Generation from coal

Generation from gas

SHETL owns the high voltage pylons and wires in the Scottish Hydro area

Nuclear generation

NGET owns the high voltage pylons and wires in England and Wales

Renewable generation

Combined heat and power

SPTL owns the high voltage pylons and wires in the Scottish Power area

Electricity imports

Distributed generation

NGET operates the system of high voltage pylons and wires in Great Britain

Metering

Distribution companies operate the medium voltage regional electricity distribution networks

Transport of electricity via Independent Distribution Network Operators (IDNOs)

= Competitive = Monopoly

Metering

Suppliers transport the electricity to final consumers

Source: Ofgem

Figure 2 The structure of the electricity industry in Britain

(GDNs), which operate at lower pressures.

These networks are owned by four companies and are regional natural monopolies.

The shippers and suppliers that arrange for the delivery and sale of gas to end customers September 2011

are competitive businesses. There is a similar structure for electricity (Figure 2).

The networks have the key characteristics of natural monopolies. They have high levels of sunk costs, provide essential

services, serve large markets and have large economies of scale, which means a large minimum efficient scale.

In the absence of regulation, profit-maximising network companies would look to

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underperform. At the end of the period, the companies’ actual performance has revealed additional information about their costs, which can be used to set lower prices in the next period and pass on benefits to customers.

Scottish and Southern Electricity

Building blocks

Maintaining the electricity distribution network

set prices and quantities at a point at which marginal revenues are equal to marginal costs, significantly pushing up prices and reducing consumer welfare. Ofgem applies price controls to protect the interests of consumers.

RPI-X framework Since privatisation, Ofgem has applied RPI-X incentives to the networks. This sets allowed revenue that the companies can charge for a fixed period (typically 5 years).

It is adjusted for inflation, which is captured by the Retail Price Index (RPI) less a specified ‘X-factor’. The idea was originally developed by Stephen Littlechild in the context of the regulation of British Telecom. The

X-factor was intended to represent improvements in productivity over and above the economy as a whole.

As price controls have developed further, the RPI-X framework has become more focused on the key building blocks of companies’ costs and the X-factor represents the profile of those costs over time including efficiency improvements, but capturing other factors such as changes in input prices.

Ofgem sets allowed revenue based on an estimate of efficient costs for the 5-year period (Figure 3). Companies have a strong incentive to outperform. If they can achieve lower costs, they retain the benefit until the end of the 5-year period and earn a higher return. If they have higher costs, they Lower costs for consumers

Additional profits for company

Challenges facing the sector

Allowed revenues Company’s actual cost First price control review

Y1

Figure 3 Price control reviews

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Y2

Y3

Y4

Y5

There are a number of building blocks that Ofgem assesses for a price control. These are as follows: 1 Operating expenditure The day-to-day costs of running a network. Examples of these include staff salaries, costs of carrying out repairs to the network and tree cutting.

2 Capital expenditure This covers investments in assets such as overhead lines and pipes. The benefits of these assets are realised over time and costs are recovered gradually through an allowance for depreciation and financing costs.

3 Regulatory asset value (RAV) The RAV is calculated by determining the opening value of the companies’ assets at the start of the price control and rolling this forward for capital expenditure minus depreciation.

4 Depreciation A depreciation charge is calculated by making an assumption on the average life of an asset and then applying this to the RAV. For example, under straight line depreciation, based on an asset life of 40 years, the depreciation charge for a RAV of £800 million would be £20 million.

5 Allowed return Investors require a return that reflects the opportunity costs of holding network assets rather than other forms of investment. This is based on an estimate of the weighted average cost of capital (WACC), which is the average cost of debt and equity finance with an assumed (or notional) level of gearing. This is applied to the RAV. The overall revenue allowances are calculated by bringing together operating expenditure, depreciation and the allowed return and making allowance for other incentive income and costs outside the companies’ control.

Second price control review

After a stable period of around 20 years since privatisation, the energy sector faces significant new challenges in responding to a low-carbon economy. In December 2008, the Climate Change Committee (CCC) recommended that UK greenhouse gas emissions should be reduced by 26% by 2020 and 80% by 2050. To deliver this target, the Economic Review

RIIO regulation Ofgem has developed the RIIO model of price control regulation to address these challenges. The price controls will now be output rather than input led. To assess the efficiency of companies and set an appropriate regulatory settlement, it is essential to understand what they are proposing to deliver as well as the costs associated with this (Figure 4).

This puts customers, network users and other stakeholders at the heart of the price control process. Ofgem has identified a number of key types of outputs that must be targeted: ■■ Environmental impact both in terms of their contribution to broader government environmental targets and networks’ efforts to reduce their own carbon emissions.

September 2011

Specification of outputs to be delivered

Expected efficient expenditure Allowance for taxation RAV carried forward from previous price control period

Upfront efficiency incentives

Indexation Other uncertainty mechanisms (e.g. volume drivers, revenue triggers)

Rewards/penalties for delivery of outputs

RAV, capitalisation and depreciation WACC

Revenue commitment under price control

Source: Ofgem

=

Baseline revenue allowance £m (including financing costs)

+

Rules to adjust revenues in light of company’s performance

+

Rules to adjust revenues for other factors (uncertainty mechanisms)

Combined effect determines financial risks faced under price control

Figure 4 Building blocks of output-led price controls

Safety — networks should be maintained and operated in a safe manner with regard to both staff and members of the public.

■■ Customer satisfaction for a wide range of network users, including domestic customers, small and large businesses, generators, and suppliers.

■■ Reliability of supply — customers expect to have a reliable energy supply and for issues to be dealt with rapidly when there are problems with the networks.

■■ New connections — there should be a timely and high quality process for new connections to the networks, both for smaller scale and larger users.

■■ Social obligations — these include provisions of services to vulnerable customers and the fuel poor.

Ofgem is putting into place enhanced incentives for the delivery of these outputs.

■■

For example, in transmission ±1% of allowed revenue will depend on a survey of customer satisfaction and companies’ performance in engaging stakeholders. Ofgem is applying a marginal incentive on companies’ performance in managing the level of energy not supplied due to supply interruptions. It is also introducing a reputational incentive and considering a financial incentive on transmission companies’ performance in promoting low-carbon energy flows.

A key element of the new price control process is placing greater focus on the longer term. Companies will be required to produce their plans in the context of how they will contribute to longer-term environmental objectives. Ofgem has decided to lengthen price controls from 5 to 8 years, giving companies greater certainty over their

Alex Yeung/Fotolia

CCC recommends that electricity should be almost completely decarbonised by 2030.

The move to a low-carbon economy could see some significant changes in the use of the gas network, as a large proportion of carbon dioxide (CO2) emissions come from domestic premises and gas central heating, and there is a large proportion of gas turbine generation.

The electricity networks need to adapt to a range of challenges including connection of increased volumes of offshore generation, greater renewable generation onshore, more generation connected to the distribution networks, use of electric vehicles and increased use of electric space heating. This will have a significant impact in terms of how the electricity networks are managed, requiring more active management to deal with changing energy flows and smarter grids to deal with changing patterns of supply and demand. There will need to be greater focus on energy efficiency and demand-side management to address peaks in demand. For the gas networks there will be significant uncertainties over demand with a greater variety of gas sources, including the use of LNG and opportunities for connection of renewable gas.

All of this points to significant changes in the use of the networks, the need to invest in new assets and operating solutions to meet the challenges of changing customer requirements and the energy mix.

It is important to consider new technical and commercial solutions and to focus on the longer term to meet the 2030 and 2050 targets.

Customers expect a reliable energy supply

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loading. Category 5 indicates that the level of demand is exceeding capacity of the substation and that additional capacity is needed. By setting output measures tied to the investment on the network, it can be established whether a company is efficiently deferring expenditure or causing the network to deteriorate, and ensure that only efficient improvements in costs and outputs are rewarded.

BP plc

Equalised incentives

Some gas is brought into the UK from the North Sea

future allowances but placing the onus on them to look further into the future and consider how to manage uncertainties.

Ofgem is encouraging companies to work with partners to develop innovative ways of meeting future challenges. It is also applying a proportionate approach for assessing the companies’ price control forecasts with the level of analysis dependent on the justification within the companies’ plans, their track record for delivery and benchmarking across companies. Below are three examples of how Ofgem is developing this approach.

Network output measures In the past, Ofgem has set allowances for capital investment based on its view of efficient expenditure but has not defined associated outputs. It has been difficult to distinguish between a company that has acted efficiently in terms of deferring investment without impacting on the network and another company that has simply chosen not to invest to improve its returns at the expense of the robustness of the network. In

this case the economic incentives to manage costs potentially lead to perverse outcomes.

It is not always easy to observe the network deterioration in terms of how the networks are performing on a day-to-day basis. This is why Ofgem is introducing network output measures for the gas distribution and transmission businesses, which provide leading indicators of asset condition and loading.

The output measures capture the condition of the companies’ assets and their criticality in terms of safety, environmental and reliability consequences. For example, an asset may be considered to be high criticality if failure would pose a danger of injury to staff or to the public. These two factors are combined to determine a replacement priority. Ofgem is capturing similar information on the loading of the networks and how this changes over time.

Figure 5 illustrates the distribution of how substations are loaded on an electricity distribution network. For example, load-category 1 indicates a low level of

In past price controls there have been significant differences in the strength of incentives between operating and capital expenditure.

For example, if companies made a £100 one-off saving in operating costs they would have received the full benefit of this. By contrast, if they saved £100 worth of capital expenditure they would have retained the benefit in terms of lower depreciation and financing costs until the end of the price control period. There was a 100% incentive strength on operating costs but a much lower incentive strength for capital expenditure.

This provided incentives for companies to focus on more capital solutions and to look to reclassify costs as capital expenditure.

Ofgem has now addressed this by ensuring that companies face the same incentive strength for all activities and there is a level playing field. This is important in the context of a low-carbon economy, as the costs of innovative operating solutions such as demand-side management are treated equivalently to the costs of building new assets to meet growth in demand.

Innovation One of the difficulties that Ofgem faces in setting price controls and mimicking how a competitive market works is encouraging appropriate levels of research and Year 5 percentage of customers supplied split by load index — with investment

Number of substations

Year 5 load index profile — with investment 120 100

10%

80 20%

60 40 20 0

70% 1

Figure 5 Load index

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2

3

4

5 Load index

LI1–3

LI4

LI5 Source: Ofgem

Economic Review

development and trialling. Ofgem looks to pass through efficiencies to customers when a price control is reset and this potentially puts companies off speculative research and trials. Ofgem has introduced a number of elements as part of the RIIO model to encourage innovation.

Ofgem will be providing innovation funding of £240 million over the price control period for electricity transmission and £160 million for gas transmission and

gas distribution. Ofgem is setting longer price controls over 8 years rather than 5 years, which gives companies greater certainty and potentially greater retention of benefits from innovation. There is a greater focus on outputs, which gives companies an incentive to seek innovative ways of meeting a change in the demand and supply balance, delivering capacity and new connections to the network. Companies will be given the opportunity to present the case for new

Review notes 1 The gas and electricity industries have the key characteristics of natural monopolies. They have high levels of sunk costs, provide essential services, serve large markets and have large economies of scale, which means a large minimum efficient scale.

2 In the absence of regulation, profit-maximising network companies would look to set prices and quantities at a point at which marginal revenues are equal to marginal costs, significantly pushing up prices and reducing consumer welfare.

3 Ofgem, the regulatory agency covering both the gas and electricity industries, applies price controls to protect the interests of consumers. It has applied RPI-X price controls, which set the revenue that the companies can earn for a fixed period and provide incentives to improve cost efficiency.

4 The energy sector is facing significant new challenges in responding to a low-carbon economy. Ofgem has developed the RIIO model to address these challenges. RIIO stands for Revenue set to deliver strong Incentives, Innovation and Outputs. It builds on the existing RPI-X regulatory framework, refining the approach and building in a number of exciting new elements such as more emphasis on the longer term, outputs that stakeholders want and providing funding for new innovation.

technology that only pays off in the longer term, up front in their business plans.

Conclusion After years of stability, the energy industry and energy networks are facing major new challenges with the move to a low-carbon economy, needing to facilitate the connection of a new generation, manage changing demand and supply patterns and innovate to offer new solutions. Ofgem’s RIIO framework for price controls provides stronger incentives and opportunities to address this with a focus on sustainability, outputs and value for money. The price controls focus more on the longer term and on outputs that stakeholders want, and provide funding for new innovation. £

Further information For further information, see: www.ofgem.gov.uk

Some explanation of the problems caused by a natural monopoly can be found on EconomicReviewOnline.

Dr Chris Watts is head of networks, costs and outputs at Ofgem.

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