The Regulatory Design Toolkit (RDT) The primary role of the RDT is to provide a tool for selecting the form(s) of price regulation appropriate for industry specific application. The available forms of price regulation span a spectrum of options – with the minutia of detailed application often having a material impact on performance. It would not be feasible or useful to build an RDT that recommended one unique form for a given application. The RDT will typically provide a narrowed set of workable options that provide broadly consistent outcomes The RDT allows the operator to set out in what circumstances one would tend towards specific forms within the sub-set of options An overly mechanistic approach to price regulation is not generally robust to practical application The RDT has been built with the understanding that application to industry specific analysis would be further assessed by ESCOSA against a range of less tangible factors not amenable to assessment within the RDT. The RDT has been designed such that it is robust to the range of industries ESCOSA may have regard to in the foreseeable future. The RDT has been designed to a level of detail that balances robustness against usefully detailed findings.

1. slEconomics Pty Ltd
slEconomics
Economics Consulting in Utilities and Infrastructure
Form of Price Regulation
Regulatory Design Toolkit
For information on this document
please contact
Contact details
Dr Stephen Labson
Phone: + 61 412 599 693
Email: slabson@sleconomics.com
1

2. slEconomics Pty Ltd
slEconomics
Economics Consulting in Utilities and Infrastructure
slEconomics is a boutique economics consulting firm providing specialised
advice to governments, regulators and corporate clients in the area of utilities
and infrastructure. We are based in Sydney Australia and have an
international network of associates to bring global experience to local
initiatives.
www.slEconomics.com
Contact details
Dr Stephen Labson
Level 32, 101 Miller Street
North Sydney NSW 2060
Phone: 0412 599 693
Email: slabson@sleconomics.com
2

3. slEconomics Pty Ltd
Index
SECTION 1.0 – OVERVIEW AND CONCEPTUAL DESIGN 4
1.1 What the Regulatory Design Toolkit is meant to do 6
1.2 Regulatory Design Toolkit architecture and use 10
SECTION 2.0 – APPLICATION OF THE REGULATORY DECISION AID 24
2.1 The decision tool 27
- Decision trees for choosing forms of price regulation 31
2.2 Forms of price regulation – key performance characteristics 39
- Price Monitoring 42
- Pricing Principles 45
- Franchise Bidding 48
- Index Approach 52
- Cost Based Approach 56
2.3 Application rules 60
- Choice of target variables (revenue / price caps) 64
- Adjustment factors 66
3

4. slEconomics Pty Ltd
Section 1.0
Overview and conceptual design
Of the Regulatory Design Toolkit
4

5. slEconomics Pty Ltd
Guide to Section 1
In the first part of this section the basic nature of the Regulatory Design Toolkit (RDT) is explained .
The primary nature of the RDT
The application space under which the RDT has been constructed
The second part of this section specifies the RDT Architecture and analytical framework, setting out the:
Conceptual and analytical framework
Data sheets
Decision framework
5

6. slEconomics Pty Ltd
slEconomics
Economics Consulting in Utilities and Infrastructure
Section 1.1
What the Regulatory Design
Toolkit is meant to do
Contact:
+61 412 599 693
slabson@sleconomics.com
www.sleconomics.com
6

7. slEconomics Pty Ltd
The Regulatory Design Toolkit (RDT)
The RDT is meant to identify the following as set out in the project TOR
 The forms of price regulation available to ESCOSA under the ESC Act
 Characteristics, advantages and disadvantages of each form
 Relevant market / industry circumstances in which each form would be an appropriate choice
The RDT is seen as a strategic tool
 The logical foundation of the RDT is grounded in both theory and practice, however, for parsimony
references to the considerable literature which this work is based on have been placed in a supporting
Reference Document.
 The RDT does not provide a legalistic or precedent based approach to regulation.
The RDT is not a tool for determining if price regulation is warranted.
 It will be assumed that that matter would have been resolved prior to use of the RDT, although there would
be many common threads to the logic applying to the assessments of forms of price regulation.
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8. slEconomics Pty Ltd
The Regulatory Design Toolkit (RDT)
The primary role of the RDT is to provide a tool for selecting the form(s) of price regulation appropriate for
industry specific application.
The available forms of price regulation span a spectrum of options – with the minutia of detailed application often
having a material impact on performance.
 It would not be feasible or useful to build an RDT that recommended one unique form for a given
application.
 The RDT will typically provide a narrowed set of workable options that provide broadly consistent
outcomes
 The RDT allows the operator to set out in what circumstances one would tend towards specific forms
within the sub-set of options
An overly mechanistic approach to price regulation is not generally robust to practical application
 The RDT has been built with the understanding that application to industry specific analysis would be
further assessed by ESCOSA against a range of less tangible factors not amenable to assessment within
the RDT.
The RDT has been designed such that it is robust to the range of industries ESCOSA may have regard to in
the foreseeable future.
 The RDT has been designed to a level of detail that balances robustness against usefully detailed
findings.
8

9. slEconomics Pty Ltd
The Regulatory Design Toolkit (RDT) - Reference Document
The RDT is supported by a Reference Document
The Reference Document provides a summary of how price regulation has been applied in other Australian
jurisdictions, as well as a selected set of case studies sourced from domestic and international experience.
 The case studies are supplied to highlight innovative approaches and archetypical forms of price
regulation.
 The Reference Document is to be read in conjunction with the use of the RDT.
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10. slEconomics Pty Ltd
Section 1.2
RDT architecture and use
10

11. slEconomics Pty Ltd
A conceptual overview of the RDT
Identification of key drivers
Forms of price regulation Key characteristics Industry circumstances
•The forms of price •Key characteristics of each •The “initial conditions” for
regulation defined as form regulatory assessment
mutually exclusive
•Identifies strengths and •Sets out the circumstances
approaches
weaknesses of each in unique to that industry which
•Spanning the range of terms of stated assessment suggest a particular form of
options available to criteria regulation
ESCOSA
Assessment of preferred forms
To gain an understanding of the conceptual foundation of the RDT it is useful to think in terms of left to right, but the
actual assessment will start with the “initial conditions” of the market and industry at hand, and move from right to
left.
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12. slEconomics Pty Ltd
RDT architecture – forms of price regulation
Categories of price regulation and application rules
Categories of price
regulation Application rules
The basic forms
require specified Describe the practical
Description of each form application rules aspects of key operational
and key characteristics factors
Combinations applied to
Application rules can
Mutually exclusive forms forms of regulation
enhance or diminish
key characteristics of
Target variables
the primary form of
Price monitoring regulation (i.e. rev / price cap)
Pricing principles Productivity factors
Franchise bidding Performance measures
Index approach Efficiency carryover
Cost based approach
The “pure” forms of price regulation are meant to be mutually exclusive for analytical clarity
In reality, there are only grey areas
The detailed application rules required to operationalise a form of price regulation further complicate matters, and can
change the core characteristics of a particular form of price regulation
For example, the choice of revenue or price as the target variable (cap) has clear implications in regard to
the regulatory performance of that category of price regulation.
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13. slEconomics Pty Ltd
RDT architecture – assessment criteria
Criteria against which forms are assessed – reduction – and “reduced forms”
The assessment criteria have been defined covering the range of factors most relevant to regulatory performance,
and that appear to be consistent with the ESCOSA Act .
Assessment criteria
Reduced form assessment criteria
Performance incentives
I. Power of incentive mechanism
Investment and renewals incentives
II. Regulatory risk (Type I & II Error)
Allocation of risk
III. Information (asymmetry &
Benefit sharing revelation) and administrative costs
Propensity to allow excess profits IV. Robustness to change and
uncertainty
 Propensity to allow in-sufficient profits
Technological bias (inputs, process,
investment choice)
Revelation of information / price discovery
Predictability of outcomes
Robustness to change and uncertainty
Facilitate efficient entry
Information intensity
Cost of administration and compliance 13

14. slEconomics Pty Ltd
Reduced form criteria explained
The specified assessment criteria are compactly grouped into reduced form criteria – this sets the
foundation of the RDT
Reduced form criteria
I. Power of incentive mechanism
II. Regulatory risk (Type I & II Error)
III. Information (asymmetry &
revelation) and administrative costs
IV. Robustness to change and
uncertainty
These key concepts are described in the following pages.
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15. slEconomics Pty Ltd
Power of incentive mechanisms
A “high powered” incentive mechanism is one in which the firm bears a high proportion of costs at the
margin – and likewise captures the benefits from cost reductions
 Leads to performance enhancements where better use of inputs, processes and technology leads to lower
costs per unit output
 Has the potential to lead to performance reductions, when quality of service is a choice variable to the firm
and not easily measured, regulated or priced by the market.
For example, in the extreme form:
 The index approach is a high powered incentive mechanism – where the firm captures cost savings
(perhaps benchmarked against an industry average)
 The cost based approach (cost pass-through) is low powered – where the firm is largely indifferent to
either cost reductions or increases.
Practical matters to consider when using a high powered incentive mechanism.
 Service quality - control and measurement. The regulator may have to set service standards (or payment
mechanisms) to off-set the incentive to under provide for quality of service.
 Not easy to decompose controllable from non-controllable cost shocks – firm probably bears both (force
majeure is an example of trying to exclude non-controllable cost shocks from an incentive regime). Probably
more appropriate where the two can be separately identified.
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16. slEconomics Pty Ltd
Regulatory risk – Types I & II Error
The regulation of firms in the position to exercise market power is in itself subject to considerable uncertainty
– with the concomitant risk of either under or over regulating in any given circumstance.
Regulatory risk is often considered in terms of risk of over-regulation, where there is the potential for the mis-application
of price regulation (i.e. from badly designed price controls) to impart net societal costs.
The RDT implicitly incorporates the more robust dual framework of regulatory risk which addresses:
Type I error - a propensity to ‘under-regulate’ when regulation is warranted – potentially leading to capture of excess
profits by the firm through the exercise of market power.
Type II error – a propensity to regulate when regulation is not warranted – potentially leading to insufficient profits to
the firm, and/or net societal costs from regulation.
And accordingly:
 A form of regulation which has power with respect to Type I error would mitigate against Type I error
– thus not as likely to ‘under-regulate’.
 A form of regulation which has power with respect to Type II error would mitigate against Type II error
– thus not as likely to ‘over-regulate’.
There is ultimately a trade-off for the regulator to determine:
Forms of price regulation which provide more certainty against the exercise of market power may have the potential
to impart unanticipated net societal costs through poorly designed (inappropriate) regulatory controls.
More benign forms of price regulation may have the potential to allow for unanticipated exercise of market power
and capture of excess profits by the firm.
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17. slEconomics Pty Ltd
Information and administrative costs
The nature of information is crucial to the design of regulation
The preferred form of price regulation will, in part, be determined by information available to the regulator
 Asymmetries in information between the regulator and the firm will suggest various forms of price
regulation over others.
 In some cases, the form of price regulation might reveal market, cost or price information - or similarly -
provide more or less incentive to mis-represent information
 The costs of information capture for both the firm and the regulator are real and need to be fully
considered in the assessment.
Examples:
Asymmetric information
Service quality
Revelation of information
An index based (high power)
regime requires ongoing Demand forecasts Administrative costs
measurement of service quality Revenue caps (or price caps SA ports price caps
(where market based based on revenue
incentives to supply are requirements) without Based on simple legacy
deficient). under/overs adjustment for charges as opposed to a
deviations from forecasts can rigorous albeit potentially costly
provide incentive to overstate analysis of activity based ports
demand forecasts. costs
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18. slEconomics Pty Ltd
Robustness to change and uncertainty
The various forms of price regulation will have different attributes with regard to change and uncertainty.
Anticipated industry and market dynamics might recommend forms of price regulation which better accommodate
changing structural factors. For example:
 Anticipated “lumpy” renewals expenditure not closely correlated with increased volumes may suggest
implicit or explicit cost pass-through mechanisms.
 Anticipated (deemed) productivity enhancements leading to reduced costs may require a concomitant
adjustment to price paths.
 Anticipated growth in competition which diminishes the risk of long term exercise of market power may
suggest more flexible form of price regulation.
Uncertain outcomes represent risks that are allocated to the firm or consumers, with some clear and direct
implications for the forms of price regulation.
 Volume risk is a key factor in regard to uncertainty across the range of forms considered in the RDT – the
form of price regulation employed will define the allocation of that risk to the firm or consumers.
 Normative analysis typically suggests that risks should be allocated to those that are best placed to
manage that risk – identification of controllable and non-controllable risk is the first step in that analysis
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19. slEconomics Pty Ltd
RDT architecture – industry circumstances
Industry and market circumstances form the “initial conditions” of the assessment.
The initial conditions set out the circumstances unique to the industry which suggest particular forms of price
regulation.
 The industry circumstances provide a checklist against which the key criteria are assessed.
Industry circumstances
Is the industry (or firm) producing at its efficiency frontier? Are there multiple products, services or differentiated
customer classes?
Is the system at efficient operating capacity? Is substitution in input choice limited by the basic
technology?
Are there “missing markets” in terms of service quality, Are efficient costs observable by the regulator?
and if so, is it feasible to measure and regulate quality of
service?
Is significant capital expenditure or renewals investment Is the data required for a cost build-up easily (cost-
in service quality required (expenditure not matched by effectively) accessible?
increased sales)?
Is there a high degree of concern over the potential to Are service features bundled with competitively supplied
expropriate consumer surplus through the exercise of services?
market power?
Is demand responsive to price (high elasticity of demand) Is the market subject to volatility - particularly in regard to
and/or the quantum of value significant? volumes or costs?
Are there significant spill-overs to other sectors of the Is the market in transition to a more competitive
economy? environment with the possibility of new entrants to the
market?
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20. slEconomics Pty Ltd
The decision framework
Utilising the data sheets, a decision framework maps the relevant industry circumstances to appropriate
forms of price regulation.
The RDT sets out the key performance characteristics of the regulatory options when applied to a specific industry.
It is impossible to determine a unique (or optimal) form of regulation without a pre-defined objective function and
formal mapping of relationships.
 The RDT is meant to provide a clear set of conditions under which certain forms of price regulation would
be appropriate.
 A small and workable set of forms will become apparent from the analysis, within which ESCOSA can
then consider trade-offs.
The RDT provides a compact means of identifying and assessing the advantages and disadvantages stemming from
specific forms of price regulation when applied to a specific industry setting.
ESCOSA will then need to rank close alternatives based on an implicit “regulatory loss function” taking into
consideration the range of more subjective matters typical to regulatory assessments.
20

21. Decision tool – overview of design
A compact decision tool has been designed which provides a set of four decision trees to be utilised for
each industry evaluation.
Power of incentive
mechanism
Regulatory risk
The assessment criteria are grouped by their
Information (properties reduced forms - comprising each decision
and requirements) tree.
Key characteristics of the various forms of
Robustness to change price regulation are mapped to industry
circumstances.
Industry circumstances
as inputs Appropriate forms of price regulation are
provided as output to the RDT decision tree.
Suggested forms of
price regulation as
outputs
21

22. Decision tree – the template
The decision tree maps the key industry conditions relevant to that particular tree to appropriate forms of
price regulation.
Reduced form assessment criteria
Example - power of incentive mechanism
Suggested form(s) Industry condition x (No) Industry condition x (Yes) Suggested form(s)
Suggested form(s) Industry condition y (No) Industry condition y (Yes) Suggested form(s)
Suggested form(s) Industry condition z (No) Industry condition z (Yes) Suggested form(s)
Example - if yes, a high powered
incentive mechanism is warranted.
Synthesis of forms of price Synthesis of forms of price
regulation suggested by negative regulation suggested by positive
responses regarding industry responses regarding industry
circumstances circumstances
Comments on key factors to Comments on key factors to
consider consider
22

23. Outputs
The individual decision trees have been grouped such that there would be a tendency to recommend a close
range of forms of price regulation within that grouping of assessment criteria and industry circumstances.
However, there may be a tension within or across the major groupings where ESCOSA will have to give a weighting
to the various assessment criteria .
 For example, in regard to regulatory risk one form might be suggested, whereas in regard to robustness
to change a different form might be suggested – ESCOSA will have to determine which factor is of
greater importance to resolve this tension.
 There could also be conflicting recommendations within a decision tree, where the specific assessment
criteria will again need to be given relative weightings to come to a conclusion.
The RDT will in these cases provide the key factors that would be considered in such cases – ideally providing clarity
to the analysis being undertaken.
23

24. Section 2.0
Application of the Regulatory Design
Toolkit
24

25. User’s guide to application of RDT
There are 3 steps in using the RDT
(1) Starting with the decision trees that take industry circumstances as inputs to provide a narrowed set options; (2) to
be further assessed by reading through the key characteristics sheets; (3) then assessing the choice of key
application rules to operationalise the preferred form of price regulation.
Step 1 Step 2 Step 3
•Work through decision trees in •Read key characteristics sheets in •Work through menu of application
section 2.1. section 2.2 for the narrowed set of rules in section 2.3 for the preferred
categories of price regulation option obtained in Step 1.
suggested in Step 1.
•Obtain small (workable) set of •Provides detail on strengths and •Use data sheets in section 2.3 to
categories of price regulation weaknesses of the narrowed set of choose preferred application rules to
suggested by industry circumstances. categories of price regulation be used in conjunction with the
suggested in Step 1 – leads to a preferred form of price regulation.
preferred option.
25

26. Guide to Section 2
The first part of this section provides a decision tool which suggests appropriate forms of price regulation for
given industry conditions.
Decision trees provide a summary tool which sets out the key industry circumstances to be considered
against the assessment criteria – with recommendations for a narrowed set of categories of price regulation
as outputs.
In the second part of this section, the primary categories of price regulation assessed in the RDT are set out
in concise form.
A brief description of the form of price regulation is provided
The key performance characteristics of each category of price regulation are set out in tabular form
The third part of this section assesses important application rules which have a direct bearing on the
performance of the general categories of price regulation.
Critical features of application rules are provided in tabular form, which are to be considered in conjunction
with those categories of price regulation in which they might be employed.
26

27. Section 2.1
The decision tool
27

28. Guide to Section 2.1
The first part of this section provides a decision tool which suggests appropriate forms of price regulation for
given industry conditions.
Decision trees provide a summary tool which sets out the key industry circumstances to be considered
against the assessment criteria
Step 1
•Define the boundaries of the •Work through each decision tree •Where conflicting recommendations are
service being considered for price starting on page 31 of this provided, sort by most relevant criteria
regulation: document – considering the (i.e. if consumer protection is considered
assessment criteria for each more important than economic efficiency
•Disaggregate the services as industry circumstance factors)
required such that industry
•Obtain small (workable) set of
circumstances are are generally
categories of price regulation
consistent across the bundled set
suggested by industry
of services being assessed.
circumstances.
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29. slEconomics Pty Ltd
Defining the bundle of services for the purpose of price regulation
Relevant industry circumstances may vary between components of the industry or firm which is to be
regulated.
Where important industry circumstances vary across components of the regulated entity, so would the suggested form
of price regulation.
For example, the NEC differentiates between “prescribed distribution
services” and “excluded distribution services” (i.e. public lighting) whereby
excluded services are to be regulated under a more light handed approach.
The underlying logic is that industry circumstances (broadly
speaking) relevant to the choice of price regulation can and do vary
across closely related services.
With the above in mind:
Workably segmented service bundles must be defined such that it is appropriate to apply a single form of price
regulation to it.
Where diverse forms of price regulation are suggested by the RDT, it may be that further disaggregation is required
for the purpose of price regulation.
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30. slEconomics Pty Ltd
Decision tool – review of design
A compact decision tool has been designed which provides a set of four decision trees to be utilised for
each industry evaluation.
Power of incentive
mechanism
Regulatory risk
The assessment criteria are grouped by their
reduced forms - comprising each decision
Information (properties tree.
and requirements)
Key characteristics of the various forms of
price regulation are mapped to industry
Robustness to change circumstances.
Industry circumstances Appropriate forms of price regulation are
as inputs grouped as output to the RDT decision tree.
Suggested forms of
price regulation as
outputs
A comment sheet is provided after
each decision tree which further
explains the critical factors being
assessed.
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31. slEconomics Pty Ltd
Decision tree – Power of incentive mechanism
Power of incentive mechanism
Suggested form Industry circumstances Suggested form
If no If yes
High powered forms strongly Is the industry (or firm) producing at Low powered forms of cost based
suggested to promote cost based its efficiency frontier? regulation can be employed if
productivity improvements. otherwise warranted.
High powered forms strongly Is the system at efficient operating Low powered forms can be
suggested to provide incentive to capacity? employed if otherwise
utilise excess capacity. warranted.
Are there “missing markets” in terms
High powered forms appropriate of service quality, and if so, is it Low powered forms limit perverse
where quality is priced or regulated. difficult to measure and regulate incentive to minimise service quality
quality of service?
High powered forms appropriate Low powered cost pass-through
where less need of investment in Is significant capital expenditure or approaches allow for investment in
non-revenue generating areas. renewals investment in service non-revenue generating areas (due
quality required (expenditure not to missing markets).
matched by increased sales)?
Price monitoring
Pricing principles Cost based approaches
Index based approaches Franchise bidding (with targeted
cost pass-through clauses)
Franchise bidding (without cost
pass-through clauses) See next page for additional comments
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32. slEconomics Pty Ltd
Explanatory comments – power of incentive mechanism
Power of incentive mechanism
Industry circumstances Explanatory comments
Is the industry (or firm) producing High powered forms provide an internalised incentive for the firm to undertake
at its efficiency frontier? efficient cost reducing initiatives (i.e. in use of inputs, processes, technology and
managerial expertise).
This factor would be given greater weight where cost reductions are seen as
critical. In a rather cost effective and static industry, it might be given less weight.
Is the system at efficient The firm captures increased revenue from incremental capacity utilisation under
operating capacity? high powered forms providing an incentive to optimise utilisation of assets.
This factor would be given greater weight where there is considerable excess
capacity in the system which could be efficiently utilised at appropriate prices.
Are there “missing markets” in There can be a perverse incentive to under-provide quality of service under high
terms of service quality, and if so, powered forms where it is not either priced into the market, or explicitly regulated.
is it difficult to measure and This factor would be given greater weight where it is not feasible to adequately
regulate quality of service? measure and regulate service standards where there is a willingness to pay for it
by consumers.
Is significant capital expenditure This matter is closely related to the missing markets matter above. Low power
or renewals investment in service cost pass-through mechanisms may be required where (efficient) renewals
quality required? expenditure is not matched by a concomitant increase in revenue.
This factor would be given greater weight where there is the understanding that
significant renewals expenditure will be required - and that it is not well funded
through increased sales.
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33. slEconomics Pty Ltd
Decision tree – Regulatory risk
Regulatory Risk
Suggested form Industry circumstances Suggested form
If no If yes
Is there a high degree of concern
Light-handed over the potential to expropriate Prescriptive price controls
approaches to price consumer surplus through the suggested.
regulation suggested. exercise of market power?
Allocative efficiency not Allocative efficiency suggests
Is demand responsive to price (high
material where demand prescriptive price control.
elasticity of demand) and/or the
is in-elastic. quantum of value significant?
Macroeconomic (general
Suggests light-handed equilibrium) effects may
Are there significant spill-overs to
approaches. suggest prescriptive price
other sectors of the economy?
controls.
Flexibility in pricing
Are there limited numbers of Prescriptive (uni-dimensional)
differentiated goods
products, services or differentiated price structures can be
promotes efficient
customer classes? considered.
(Ramsey type) pricing.
Potential for regulatory bias of Regulatory risk in production choice
Is substitution in input choice limited is lessened where inputs are limited
production choices suggests light-
by the basic technology? to fixed proportions .
handed approach.
Franchise bidding
Price monitoring Index based approach
Pricing principles See next page for additional comments
Cost based approach 33

34. slEconomics Pty Ltd
Explanatory comments – regulatory risk
Industry circumstances Explanatory comments
Is there a high degree of concern Prescriptive price controls can provide greater regulatory certainly against the
over the potential to expropriate expropriation of consumer surplus through the exercise of market power (or
consumer surplus through the otherwise put – capture of monopoly profits by the firm).
exercise of market power? This factor would be given more weight where consumer protection is a primary
concern. Economic transfer is the focal point here – not economic efficiency
(which is addressed in the next cells of this table)
Is demand responsive to price The “dead weight loss” stemming from monopoly prices is directly proportional to
(high elasticity of demand) the price responsiveness of demand, and the over-all quantum of value.
and/or the quantum of value In terms of simple allocative economic efficiency, the regulatory risk from “under
significant? regulating” is greater when demand is highly responsive to price.
Are there significant spill-overs to Economic efficiency can be considered in either a partial or total analysis. The
other sectors of the economy? total context addresses potential spill-over affects to other services or products.
In terms of economic efficiency in a total analysis, the regulatory risk from “under
regulating” is greater when there are spill-overs to other sectors.
Are there limited numbers of Where there are multiple services or differentiated customer classes differentiated
products, services or prices can provide positive efficiency outcomes through “Ramsey oriented” prices.
differentiated customer classes? However, the differentiated prices (or cost shifting) implied here has a clear
economic impact on individual consumer classes, which may run against the aims
of the regulator.
Is substitution in input choice Prescriptive price controls can bias optimal input choices where there is the
limited by the basic technology? technical flexibility to do so.
For example, a cost-based approach may provide perverse incentive over invest
in cap-ex, and under spend on op-ex. This factor is of greater importance t the
degree that managers have the ability to make such trade-offs. 34

35. slEconomics Pty Ltd
Decision tree – Information and administrative costs
Information and administrative costs
Suggested form Industry circumstances Suggested form
If no If yes
Efficient costs and prices observed by Forms that reveal costs are
the regulator, allowing for non- Is there an asymmetry of information
suggested where feasible (franchise
intensive approaches such as on the part of the regulator, and if so,
bidding).
monitoring or index based price cap. are cost/price comparators difficult to
obtain?
Low cost / non-intensive forms Informationally intensive
suggested where the cost/benefit of Is the data required for a cost build-up approaches may be warranted (cost-
data collection and analysis is not easily (cost-effectively) accessible? based or disclosure rules).
otherwise justified.
Simple price monitoring or Ring-fencing of accounts may be
Are service features bundled with
index will be easy to warranted to separate regulated and
competitively supplied services?
administer in an effective non-regulated charges.
manner.
Price monitoring Franchise bidding
Pricing principles Cost-based approach
Index approach
See next page for additional comments
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36. slEconomics Pty Ltd
Explanatory comments – information and administrative costs
Information and administrative costs
Industry circumstances Explanatory comments
Is there an asymmetry of If the regulator knows efficient costs and prices (or has valid comparators to use),
information on the part of the non-intensive forms such as price monitoring or price caps can be employed.
regulator? Alternatively, where the regulator is at a clear disadvantage in regard to
information, forms which reveal information (such as franchise bidding) or at least
do not provide incentives to mis-represent information are preferred.
Forms such as price monitoring or price caps become meaningless or difficult to
apply where efficient price are not known and there are no valid cost/price
comparators in which to asses monitored prices.
Is the data required for a cost Where the regulator suffers from a lack of information, it may be deemed
build-up easily accessible? necessary to direct the firm to disclose such information, and to asses that against
other sources to attain some level of confidence in its accuracy.
In this case, the costs of information collection and analysis to both the regulator
and the firm should be considered against the benefits stemming from the use of
informationally intensive forms of price controls.
While a formal cost/benefit analysis would be difficult in itself to undertake, it
should be feasible to form a broad (probably qualitative) view of relevant costs
and benefits of data collection and analysis.
Are service features bundled with Where regulated services are bundled with non-regulated services ring-fencing of
competitively supplied services? accounts may be required to mitigate cost-shifting between the two cost pools.
Where there is no material bundling, the less informationally intensive forms of
price regulation would be easy to administer in an effective manner.
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37. slEconomics Pty Ltd
slEconomics Pty Ltd
Decision tree – Robustness to change and uncertainty
Robustness to change and uncertainty
Suggested form Industry circumstances Suggested form
If no If yes
Less flexible forms can be considered Is significant capital expenditure or Robust forms suggested that
that correspondingly provide greater renewals investment required facilitate investment where
regulatory certainty. (where incremental expenditure is incremental costs are not strongly
not matched by increased sales) correlated with incremental sales.
Less flexible forms can be considered Is the market subject to volatility -
where cost or volume risk is not seen Robust forms suggested that adjust
particularly in regard to volumes or
as material . to cost and volume risk.
costs?
Where there is no expectation of Is the market in transition to a Robust forms suggested that
competitive entry, franchise bidding more competitive environment facilitate entry by rivals.
that excludes entry (ex post) would be with the possibility of new entrants
an option. to the market?
Pricing principles
Franchise bidding
Price monitoring
Index approaches
Cost-based approaches
See next page for additional comments
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38. slEconomics Pty Ltd
Explanatory comments – Robustness to change and uncertainty
Robustness to change and uncertainty
Industry circumstances Explanatory comments
Is significant capital expenditure In many network services, incremental capital expenditure is not strongly
or renewals investment required correlated with increased sales.
(where incremental expenditure is • When incremental cap-ex is not closely matched by increased sales, a pure
not matched by increased sales) index approach - particularly when based on a price cap – will typically not
provide an adequate return on investment, and may require additional side
payments or adjustment factors to fund efficient capital expenditure.
• When incremental investment does lead to increased sales, the index based
price cap will likely provide incentive to invest. In this case, there may be excess
returns on investment if scale economies are obtained (which is likely to be the
case in network businesses).
Is the market subject to volatility - It is important to consider volatility in costs and volumes. For example:
particularly in regard to volumes • Price controls do not typically provide the flexibility with regard to cost and
or costs? volume volatility that price monitoring and pricing principles would allow for.
Price controls will typically allocate windfall gains and losses to the operator.
• Further analysis would need to be undertaken to determine if such risk is best
placed with the operator or consumers.
Is the market in transition to a If there is the expectation that workable competition would develop in the medium
more competitive environment term, transitionary regimes would be put into place. Two key factors to consider
with the possibility of new are:
entrants to the market? • Facilitation of entry – ensuring that regulatory structures do not impede
competition.
• Attention to regulatory risk and administrative costs of more prescriptive and
informationally intensive forms of regulation. 38

39. slEconomics Pty Ltd
Section 2.2
Forms of price regulation – key
performance characteristics
39

40. Guide to Section 2.2
In the second part of this section, the primary categories of price regulation assessed in the RDT are set out
in concise form.
A brief description of the form of price regulation is provided.
The key performance characteristics of each form of price regulation is set out in tabular form.
Step 2
•Consider the detailed •Where conflicting •Given the weights (probably subjective and
characteristics of the narrowed recommendations are obtained qualitative) placed on specific factors,
set of categories of price in step 1 – outline those factors determine a preferred category of price
regulation suggested under step which would be given most regulation – setting out the reasons for
1. weight in the assessment. choosing between the small set of options
considered.
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41. slEconomics Pty Ltd
Categories of price regulation assessed in the RDT
The primary categories of price regulation assessed in the RDT are:
Price Monitoring
Pricing Principles
Franchise Bidding
Index Approach
Cost Based Approach
These primary categories are seen as spanning the range of price regulation ESCOSA might consider and have been
defined as a starting basis in which to differentiate key aspects of price regulation.
However, in practice, there is more often an overlap between these categories forming hybrids, and the specific details
in application can have a considerable impact on the key characteristics of the regulatory mechanisms.
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42. slEconomics Pty Ltd
PRICE MONITORING
For the purpose of the RDT “price monitoring” is more broadly and practically defined as including consideration of
prices, costs or profits of a business or industry, with oversight provision including :
Information disclosure – New Zealand’s oversight of electricity wires charges provides an example of the
use of information disclosure rules forming the basis of price monitoring (noting that it is currently being
augmented by the setting of price thresholds). In that case, distribution businesses are required to provide
annual reports on prices, asset valuation and quality of service performance.
Monitoring – which could include ad hoc assessments of price adjustments or more formula based trigger
mechanism under which a price review would be carried out.
Notification of price increases – which allows for light-handed approaches where the proponent develops the
framework for reporting, through to rather prescriptive approaches where guidelines are developed under
which the proponent is to comply. This form could potentially call for justification on a cost basis - leading in
the extreme to a de facto rate of return form of regulation.
Setting of prescribed price or profit thresholds – this is the system which New Zealand is apparently moving
towards in oversight of electricity wires businesses. Wires charges will be assessed in some form against
indexed price paths under which the charges are to sit.
Price monitoring can be applied such that it would be an extremely light-handed approach to price regulation, as well
as a rather heavy-handed approach where, for example, prescribed profit thresholds are applied that might lead to a
de facto rate-of-return form of regulation.
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43. slEconomics Pty Ltd
Key performance characteristics sheet – PRICE MONITORING (1)
Assessment Criteria Transfer mechanism Key performance characteristics
Performance incentives The more light-handed forms of price High powered incentive mechanism – providing
monitoring allow the firm to retain the gains strong incentive for cost minimisation.
from efficiency improvements.
Profit thresholds would act as a de facto cost
Profit thresholds would claw back such based approach – with correspondingly low
gains. incentive power.
Investment and renewals incentives Flexibility by the firm to charge for capital Appropriate incentives to invest in cost reducing
expenditure and renewals where such initiatives.
expenditure is aligned with additional
Potentially weak incentive for quality of service
revenue.
related investment and renewals where there is
no market for quality of service.
Allocation of risk Typically apply an explicit or implicit ceiling Potential for asymmetric allocation of risk.
on prices but no support from below in the
Wind-fall gains limited from above, but windfall
form of a price floor.
losses not supported by a floor.
Benefit sharing Provides the regulator with the ability to re- Short term benefits captured by the firm – long run
align prices to costs where productivity can be clawed back for consumers.
gains have been made.
Propensity to allow excess or in-sufficient The firm has considerable (short-run) Threat of intervention meant to limit extreme
profits discretion in pricing services. divergence from efficient prices.
Requires knowledge by the regulator of If a significant asymmetry of information exists
efficient prices. there is greater potential for capture of excess
profits by the service provider.
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44. slEconomics Pty Ltd
Key performance characteristics sheet – PRICE MONITORING (2)
Assessment Criteria Transfer mechanism Key performance characteristics
Technological bias (inputs, process, Not prescriptive – does not generally affect Neutral with regard to production choices (inputs,
investment choices) the production choice of the firm. process and technology).
Facilitates static and dynamic productive
efficiency.
Predictability of outcomes Flexible form of price regulation. Standard commercial uncertainty – little regulatory
uncertainty.
Robustness to change and uncertainty Prices typically allowed to vary in relation Can be extremely robust to change and
to external events. uncertainty – depending on application rules.
For example, petrol prices adjust to real time
volatility in market fundamentals allowing for
appropriate returns on assets.
Revelation of information No internalised revelation of information – Prescribed disclosure of information – but no
relies on external disclosure rules. internalised revelation of information through
commercial actions of the service provider.
Information intensity (requirements) Requires information on efficient prices to An asymmetry of information between the
compare against regulator and firm will limit robustness of the
monitoring process – typically requires more
intensive disclosure rules.
Cost of administration and compliance Various levels of disclosure are required Cost of administration and compliance dependent
depending on ability of the regulator to on required level of disclosure.
assess efficient price levels.
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45. slEconomics Pty Ltd
PRICING PRINCIPLES
Pricing principles are defined as a form of regulation for the purpose of the RDT and is characteristic of the “light-
handed” approach to price regulation, although when cost based reference tariffs are applied becomes more heavy-
handed in nature.
The use of pricing principles within regulatory structures is well established in Australia, with considerable use under
Part IIIA of the Trade Practices Act. Notable applications include gas transport, electricity transmission and distribution
networks, rail, and telecommunications.
In application, pricing principles can and have ranged from truly light-handed approaches in setting out appeals
processes and dispute resolution mechanisms, to rather prescriptive price setting regimes.
An illustrative range of examples includes:
Negotiate / arbitrate – possibly under pre-specified guidelines and dispute resolution processes
Outcome based – setting out features of pricing, such that it facilitates efficient investment, provides a return
on capital, and supports efficient use of the services provided
Price bands – such as a floor and ceiling based on stated parameters
Reference tariffs – spanning a range from tlight-handed posting of prices, to more heavy-handed application
based on pre-specified parameters (for example, recovery of efficient costs)
The negotiate/ arbitrate style of this form is most often applied when there a small number of parties purchasing
services, as multiple contracts would usually entail considerable (potentially inefficient) transaction costs. Reference
tariffs (or posted prices) can be used where there are a larger number of independent parties to contract with.
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46. slEconomics Pty Ltd
Key performance characteristics sheet – PRICING PRINCIPLES (1)
Assessment Criteria Transfer mechanism Key performance characteristics
Performance incentives Typically price based agreements – with Typically a high power incentive mechanism in
no explicit cost pass-through (except for terms of cost minimisation – although cost pass-
the extreme form of reference tariffs through limits power for those areas specified.
prescribing cost-based approaches).
Allowance for rent capture by the operator
enhances the incentive to reduce costs though
innovation (ie superior use of technology,
resources or managerial expertise).
Investment and renewals incentives Pricing principles are often used where Pricing principles are amenable to multi-
there is a manageable number of parties dimensional price / quality agreements between
purchasing services. parties – providing financial incentive to invest in
capacity augmentations and quality of service
Capacity and quality of service are
renewals based investment where there is a
parameters that can often be specified in
willingness to pay.
the contracts between parties.
Allocation of risk Risk is usually allocated on a commercial Ideally, risk is priced into the agreements between
basis – except for the extreme form of parties and would tend to be allocated on the
cost-based reference tariffs, where basis of who can manage it at least cost.
demand risk may reside with consumers.
Benefit sharing Benefit sharing arrangements are Asymmetry of information may bias the outcome
(explicitly or implicitly) agreed to by parties. in the favor of the service provider. Disclosure
rules are sometimes employed to mitigate against
this - but may fall short of the goal in practice.
Propensity to allow excess or in-sufficient Negotiate/arbitrate approach provides the A robust dispute resolution mechanism or use of
profits potential for workably competitive prescribed price bands or reference tariffs would
outcomes in pricing and profits. mitigate against capture of excess profits by the
service provider.
Prescribed price bands and cost-based
reference tariffs used to limit excess Windfall gains are more likely to be captured by
profits. the service provider as compared to more
prescriptive approaches.
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47. slEconomics Pty Ltd
Key performance characteristics sheet – PRICING PRINCIPLES (2)
Assessment Criteria Transfer mechanism Key performance characteristics
Technological bias (inputs, process, Negotiate / arbitrate provides workably Unlikely to be any technology bias stemming from
investment choices) competitive foundation for technology this approach – facilitating optimal choice of
choices. inputs, processes and technologies.
Predictability of outcomes Typically commercial agreements entered Potential for regulatory uncertainty when price
into by parties. bands or reference tariffs are applied in a
discretionary manner.
Prescribed price bands or reference tariffs
provide varying levels of discretion to the
regulator.
Robustness to change and uncertainty Negotiate/arbitrate tailored to market Robustness to change of negotiated contracts
circumstances. depends on ability to write complete contracts that
anticipate all significant contingencies.
Reference tariffs typically set out ex–ante
price path. Reference tariffs require review to adjust to
changing market fundamentals.
Revelation of information No internalised revelation of information – Not relevant.
may require external disclosure rules.
Information intensity (requirements) Negotiate/ arbitrate typically requires broad Potentially light-handed approach requiring little in
procedural guidelines. the way of information.
Cost-based reference tariffs can require Application of cost-based reference tariffs can
full assessment of firm level expenditures become informationally demanding.
and demand forecasts across the
regulatory period.
Cost of administration, compliance and Negotiate arbitrate typically undertaken for Transaction costs for access seekers / consumers
transaction costs each access seeker / consumer. can be relatively large in the negotiate / arbitrate
approach.
Reference price typically set price
available to any access seeker / consumer Reference tariffs lessen transaction costs to
(given ability to provide in a safe manner, individual access seekers / consumers though
etc). scale economy in transaction costs. Regulator
acts as agent for individuals.
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48. slEconomics Pty Ltd
FRANCHISE BIDDING
Franchise bidding for the provision of services is common within the context of large infrastructure projects that
require long term contracts and a high degree of certainty by stakeholders – such as owners, financiers, and
governments as agents for consumers.
Franchise bidding has been employed in the provision of monopoly services such as:
Roads
Rail
Airports
Telecommunications
Water and wastewater
Electricity distribution
In many – if not most cases – end use prices are specified in the supporting concession bids and contracts, which
(ideally) facilitates competitive outcomes and revelation of information in the pricing domain. Once assigned, the
contract would prescribe a pricing framework and a dispute resolution mechanism.
While there are numerous examples of franchise bidding acting as a substitute for regulation, and entered into by
public or private parties without any regulatory oversight structure, they have also been extensively used as a
complement to regulation, with oversight by central agencies such as regulators or government ministries. For this
reason, franchise bidding (for the purpose of the RDT) is seen as a form of price regulation.
Key considerations in regard to franchise bidding include the ability to design complete contracts that are robust to
changing and uncertain market environments; provide incentives for efficient asset management and renewals; and
that mitigate against the incumbency problem at contract renewal – where it may not be feasible to provide for a
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49. slEconomics Pty Ltd
Key performance characteristics sheet – FRANCHISE BIDDING (1)
Assessment Criteria Transfer mechanism Key performance characteristics
Performance incentives Under franchise bidding, the range of Typically a high power incentive mechanism in
service delivery outcomes is specified (to terms of cost minimisation – although cost pass-
the degree feasible) in a concession through limits power for those areas specified.
contract.
Allowance for rent capture by the operator
Cost pass-through mechanisms are enhances the incentive to reduce costs though
sometimes specified for inputs with innovation (ie superior use of technology,
uncertain prices (such as fuel). resources or managerial expertise).
Investment and renewals incentives Concession contract may set out Complete contracts difficult to design in regard to
investment and renewals profile. investment and renewals.
Cost pass-through clauses are sometimes May be a tendency to run down the asset where
provided for funding of capital expenditure. the contract tenure is finite, and subject to rebid.
Cost pass-through can be utilised as a balancing
mechanism to promote investment and renewals
expenditure.
Allocation of risk Allocation of volume risk usually set out in The concession contract can be designed to
the concession contract – typically biased allocate risk in a direct and predictable manner.
towards “take-or-pay” provisions or an
Volume risk is typically the primary factor to
implicit or explicit underwriting of usage.
consider – allocated in terms of controllability (ie
Cost pass-through provisions can be service provider may be able to increase demand
utilised in regard to cost uncertainty. by increasing quality of service).
Benefit sharing Contracts set out the nature of benefit As a high powered incentive mechanism, most
sharing (or lack of). unanticipated benefits are most often captured by
the operator.
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50. slEconomics Pty Ltd
Key performance characteristics sheet – FRANCHISE BIDDING (2)
Assessment Criteria Transfer mechanism Key performance characteristics
Propensity to allow excess or in-sufficient Competitive bidding for the franchise Competitive bidding would tend towards an ex-
profits provides the potential for workably ante expectation of appropriate levels of profit.
competitive outcomes in pricing and
Explicit or implicit ex-post adjustments can be
profits.
used to moderate windfall gains.
Contracts typically do not measure or limit
Unanticipated or non-controllable outcomes can
realised profits – although price levels may
drive operator to insolvency.
be either pre-set, regulated, or subject to
re-evaluation.
Technological bias (inputs, process, Contracts can be designed to allow Technology bias can be limited under output
investment choices) operator to develop optimal (unbiased) based contract specification.
production choices by specifying outputs
Cost pass-through mechanisms have the potential
rather than inputs.
to promote technology bias to those areas
covered by such mechanisms.
Predictability of outcomes Factors such as service quality and asset While noting the impossibility of specifying
management – if measurable – can be complete contracts, predictability of outcomes is
specified explicitly in the contract more certain than under the traditional implicit
supported by penalty and reward “regulatory contract”.
mechanisms.
Robustness to change and uncertainty The concession contracts underlying a The long-term fixed nature of concession
franchise bidding set out in a detailed but contracts and impossibility of completeness
finite set of contingencies . makes them rather inflexible instruments in light of
change and uncertainty.
For example, technological change or demand
volatility can lead to unplanned allocations of
windfall gains or losses.
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51. Key performance characteristics sheet – FRANCHISE BIDDING (3)
Assessment Criteria Transfer mechanism Key performance characteristics
Revelation of information Competitive bids are tendered in securing The competitive nature of the franchise bid has
the franchise to provide services . the potential to reveal the workably competitive
prices for delivery of the stated service.
Service levels, investment and renewals
profiles, and design of facilities can be The bidding processes can reveal innovative
called for within the bidding environment process designs and management structures
Information intensity (requirements) The robustness of the contract relies on an The robustness of the concession contract
understanding of the nature and materiality requires complete specification of contingencies.
of contingencies.
The competitive nature of the franchise bid
Cost recovery of pass-through items is set mitigates against the need for firm level costs –
out in the contract – requiring identification except where costs are passed through.
and monitoring of such costs where
relevant.
Cost of administration and compliance Administrative costs are usually front-end Complex or multiple contingencies will tend to
loaded during the bid process for both the increase the cost of contract design and
purchaser and provider. monitoring of compliance with prescribed
outcomes.
Compliance requirements are set out in the
contract (ie service quality, availability, Easily identifiable/measurable compliance factors
renewals expenditure, etc) lessens the overall costs of compliance.
Effective dispute resolution mechanisms are vital
to lessening administrative costs
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52. INDEX APPROACH
The pure index based approach to price controls aim to provide a light-handed regulatory approach with low
compliance and regulatory costs through uncoupling allowed prices from the regulated organisation’s costs of
operation.
Importantly, starting prices are assumed to be (reasonably) efficient and taken as given. Allowed price movements are
then typically determined by reference to:
general cost index, such as the CPI
index measures of efficiency, such as total factor productivity
efficient production frontier or best practice benchmarking
Under the pure approach, if the regulated firm out-performs the external efficiency benchmark, it retains all of the
associated gains and alternatively suffers the consequences of under-performance relative to the benchmark, making
it a very high powered incentive mechanism in its pure form. One consequence is that over time windfall gains or
losses may accrue to either the enterprise or consumers as underlying factors, such as costs or quantities demanded,
change.
The pure form is most often augmented in practice by either triggers or regulatory review periods which aim to re-align
prices with changing underlying costs and revenue profiles – making it a less powerful incentive mechanism on the
one hand, while providing an adjustment mechanism in regard to unanticipated capture of rents by either the
enterprise of consumer.
The index based approach requires application rules in regard to the target variable – typically applying a form of
revenue or price caps, with hybrids including revenue yields, and weighted average tariff baskets – each having
significant performance characteristics of their own (addressed later in this document).
International experience has been that cost de-linked approaches have been adopted within mature regulatory
regimes where the existing price levels and initial cost base are ‘about right’ or in anticipation of transition to
competitive market environments. In addition, the regulatory regimes included established and effective regulatory
data collection, accounting and decision-making procedures.
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