Meghraj Capital Advisors Private Limited

MYT-Features and Status of ImplementationNagpur- 25th February 2011

Infrastructure Advisory I Mergers & Acquisitions I Syndication I Capital Markets

Vivek Mishra

Structure

I. Introduction to MYT Conventional Tariff Setting Process and its Limitations

Concept of MYT

Rationale and Benefits

II. Framework and Options Legal and Policy Framework

Current Status – India and International

Key Elements of MYT Framework Design

Options for MYT Framework Design

III. MYT Options in Detail Cost plus Regulation

Targeted Incentive Regulation

Performance based Regulation – Price and Revenue Cap

Risk and Return Framework of various Options

IV. MYT Options and Regulatory Objectives 2

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I. Introduction to Multi Year TariffsI. Introduction to Multi Year TariffsI. Introduction to Multi Year Tariffs

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I. Introduction to Multi Year TariffsI. Introduction to Multi Year Tariffs

● Till recently, most of the State Electricity Regulatory Commission in India have followed the annual process of tariff determination

● The mechanism involves: Establishing of Prudent costs each year by the Regulator Limited but assured return allowed in cost estimates (Concept Cost Plus

Regulation) Cost variations (above or below the approved figures) eligible for true-up at the

end of each year Limited or no incentive to outperform regulatory awards

Conventional Process of Tariff Setting

Key Limitations of Conventional Tariff Setting Process

• Mechanism is not sufficiently stable to provide the certainty required to

undertake long term investments

Principles are not clearly set and tendency to pad up costs

Annual evaluation and determination of “reasonable” costs

Possibility of change in regulatory principles from year to year

• The annual framework does not provide the requisite incentive

Any savings on account of better performance taken away next year

Any cost on account of under-performance is subject to regulatory discretion,

bringing in uncertainty

• Process is very long leading to high cost of regulation

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MYT is an answer to make the tariff setting exercise more predictable, and to ensure that costs are recovered in a more mechanistic manner

MYT – The Concept

“ A new system where the tariff setting exercise is done for a

multiple years in one go, is termed as MYT”

• Concept of MYT can mean several things: Prescribing values/numbers on a multi-year basis for various elements of

cost/ARR

Adherence to prescribed benchmarks

Instead of prescribing numbers/values principles governing the input costs

and output prices for the multi year period can be done

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Key Benefits of MYT

• Predictability

Leads to regulatory certainty

Simplification of regulatory process

• Innovation and Cost Reduction

Encourages utility to find innovative ways to reduce costs and improve

efficiency

Accompanied by a transparent and stable system of incentives

• Improvement in Customer service and satisfaction

There is a provision of reward/penalty to encourage achievement of the

prescribed customer service and satisfaction levels

• Risk allocation Determines the best entity to bear a particular risk

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II. Multi Year Tariffs – Framework and Options

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Legal and Policy Framework

• As of 31st March 2009, 14 states have notified

MYT regulations

Of the above 8 of them have issued one or

more tariff orders

A no. of other SERCs are in process of

development of MYT regulations

• Internationally, MYT has been implemented in

several countries

Latin America – Chile, Argentina, Brazil

Europe – UK, Spain

USA

Asia – Pakistan, Vietnam (in process), India

State MYT Regulations

MYT Orders

Andhra Pradesh √ √

Assam √ ×

Bihar √ ×

Chhattisgarh √ ×

Delhi √ √

Gujarat √ √

Himachal Pradesh √ √

Jharkhand √ ×

Karnataka √ √

Kerala √ ×

Madhya Pradesh √ √

Maharashtra √ √

Rajasthan √ √

Tamil Nadu √ ×

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● Section 61(f) of the Electricity Act, 2003 requires the Appropriate Commission to be guided by the principles of MYT in tariff determination

● The National Tariff Policy notified by the Govt. of India in 2006 also provides for development of MYT framework by the States

Key Elements of MYT Framework Design

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Measurability Materiality Controllability Predictability

Measurability of the element

around which incentivization

will be planned is important for design and

correct implementation

Risk Mitigation mechanisms

become necessary around those elements that have the potential to significantly impact the

performance of the utility

Measurability of the element

around which incentivization

will be planned is important for design and

correct implementation

The element will need to be

controllable to the utility to

enable them to beat regulatory

targets

The element will need to be predictable because the

ability to determine a

prudent level of regulatory target is crucial for the incentivization

process

Options in MYT Regulatory Framework Design

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• Prudent costs established by Regulator

• Limited but assured return allowed in cost estimates

• Cost variations eligible for true-up

• Limited or no incentive to outperform regulatory awards

• Also called “Benchmark Regulation”

• Works on the basic cost plus framework but overlays incentives on cost plus

• Identifies cost pass through and risk mitigation elements clearly

• Having elements of TI and PBR (few elements on Multi-year basis)

• Uses the basic PBR and TI concepts

• Incentivizes better metering and loss reduction

Cost PlusRegulation

Targeted Incentive

Hybrid option

• Regulates by outcome and not by cost behaviour

• Utility at liberty to

manage costs and

enhance profits

• Initial rate setting

based on cost of

service

• Two basic variants -

price cap and

revenue cap

Performance Based Regulation

Choice of framework will depend on implementation capabilities of the sector entities

Conventional Options for MYT Framework

III. MYT Framework Design – Options in Detail

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Cost Plus Regulation or Rate of Return

• Is the traditional form of US regulation and has been extensively used in

India

In India, the approved costs are reviewed every year against the historic costs

• Prices are set to allow the recovery of allowed costs and the required rate

of return

• Perceived as relatively less risky, the capital costs of the company is lower

than under other approaches

• Regulation becomes intrusive:

costs are assessed for their prudency

investments are assessed as to their ‘used-and-useful’ status

• Company has the incentive to Gold-Plate Investments and has no

compulsion to achieve efficiency savings

• Profit volatility should be minimized but price and revenue volatility may be

high

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Targeted Incentive based Regulation

• Specific targets set for some important operating elements for the

duration of the control period

Losses

Collection Efficiency

Operating Expenditure

Quality of Service parameters etc

• All other cost elements subject to normal cost-plus regulation

• Improvements over and above the targets to the account of utility or

shared with consumers and vice-versa

• Most of the SERCs in India have adopted the Targeted Incentive

approach

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Performance Based Regulation (PBR)

• Under PBR, rules of the road are better known up front

Reduced risk of prudence disallowance and greater flexibility for utilities, utilities prefer

such regulatory structure

The frequency of rate cases is reduced and there are reduced administrative costs

• Helps in reduction of overall cost of service to the customers and improve

system reliability and quality of service to customers

• In order to achieve public policy goals, the Regulator can set specific

goals for utility management to focus on, such as promoting Demand Side

Management, and supply diversity

• Characterised by RPI-X+Y formula

Base cost set at beginning of control period based on historical cost data

Efficiency gains/losses to account of utility

Pass through of external costs (Y) allowed

• Variants of PBR include “Price Cap” and “Revenue Cap”

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Price-Cap

• Price path established for a set price control period (in the extreme, to the end of the useful life of the asset, but normally for 3 to 5 years)

Price path is based on forecast of operating and capital costs

• Provides the company with an opportunity, if it outperforms the forecasts, of earning a rate of return higher than required

• Incentives are, however, linked with a higher required return, owing to the greater risk faced by the company

• Regulation is, in theory, less intrusive and the more detailed price review only happens once every 3 to 5 years

• Company has the incentive to game - especially by under estimating demand

• No price volatility but revenue and profits may be volatile

• Has been used in England, Chile, Brazil, Australia

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Revenue-Cap

• Rather than setting a price-path, revenue-cap regulation establishes a fixed revenue profile

Removes incentive to under-forecast demand

Limits the upside potential to the company to those cost aspects actually under the

control of the company

• Most useful for industries where the fixed costs dominate the cost base

• Requires a correction factor in the formula so that any under or over-recovery of revenue can be corrected within the life of the price control

• Can lead to moderate price and profit volatility

• Has been used in Spain, Norway, Netherlands, Denmark

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Risk and Return Framework of various Options

 FeatureAnnual CoS

Regulation

Targeted Incentive / Benchmark Regulation

Performance Based Regulation

Risk Mitigation High Moderate to High Moderate to High

Regulatory Involvement

High Moderate to High Low

Incentive Low Moderate to High High

Benefit sharing To Consumers Shared To Utilities

Information Requirement

Moderate Moderate High

Measurement Requirement

High Moderate Low

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Choice largely depends on the level of data availability, stability in the current regulatory framework, socio-economic and political considerations etc. An option

could also be to gradually move from Annual CoS Regulation to more advance form of Performance based Regulation

III. Building blocks of MYT

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Control Period

• Implies the period for which the principles for determination of allowable revenue and the applicable norms remain unchanged

Provides regulatory certainty

Length of the control period determines the incentives available as the surplus available

consequent to superior performance can be retained for the length of the control period

Converse is also true as losses too have to be retained for the control period

• Several aspects need to be considered while deciding the length of the control period

Should be sufficiently long so that utilities have the incentive to investment as the probability

for costs recovery is higher. Also the benefits accrue for a longer period

Should not be very long as this would result in inflexible MYT framework

Could lead to excess profits or losses for the utilities

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Control Period contd..

• Commission determines the control period by taking into account: licensees proposal

data regime in the state

preparedness of the licensees to implement the proposed changes

• Involves periodic reviews by Regulator from time to time, and

• Review at the end of the control period to factor in the “learning” for the next control period

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MYT Control Period duration across states in India

States Control Period First Year of Control Period

Andhra Pradesh First control period = 3 years and subsequent control period = 5 years

FY 2006-07

Assam Generation = First control period, 5 years from 1st April 2006; Transmission = First control period, 3 years from 1st April 2006; Distribution = First control period, 3 years from 1st April 2006

FY 2006-07

Delhi First control period = 4 years and subsequent control period = 5 years

FY 2007-08

Jharkhand First control period = 3 years and subsequent control period = 5 years

Not specified

Kerala First control period = 3 years and subsequent control period = 5 years

FY 2007-08

Madhya Pradesh First control period = 3 years FY 2006-07

Maharashtra First control period = 3 years and subsequent control period = 5 years

FY 2006-07

West Bengal First control period = 1 year; Second control period = 3 years; Subsequent control periods = 5 years

FY 2007-08

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To start with the control period may be on the shorter side

Controllable Elements

• Sales

• System Losses – Transmission and Distribution

• Power Purchase Cost (except variation in fuel cost & GCV)

• Operating Parameters

• Debt Equity Ratio

• Operating Expenditure

Employee Cost

Administrative and General Expenses

Repair and Maintenance Expenses

• Working Capital Requirement

• Interest Cost and Interest Rate

• Capital Expenditure

• Quality of Supply

• Collection Efficiency

• Bad Debts

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There are divergent views on Sales & Transmission losses some consider these to be uncontrollable

Un-Controllable Elements

• Price of Fuel – Coal or Oil

• Gross Calorific Value of Coal/Oil

• Terminal benefits of the employees

• Force Majeure Events

• Changes in law, judicial pronouncements and orders of the Central and State Government or the Commission

• Economy-wide fluctuations like changes in inflation rates, market rates, taxes and statutory levies etc.

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Elements of cost and other parameters which are beyond the reasonable control of the Utility are considered uncontrollable

IV. Prerequisites for implementing MYT

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Implementation Pre-requisites

• Good baseline data for reasonable estimation of future costs and performance (and hence efficiency gains)

System losses, power demand, power purchase costs, operating expenditures, un-metered

consumption etc.

All the should be estimated through actual measurement or scientific studies

• Nevertheless, Regulatory process should not wait for perfect information to be first available

Process and mechanism can be introduced that improve the data regime in due course

However, reliable and timely information is an imperative, and all steps should be taken to

achieve this

• Strong and robust measurement and monitoring mechanisms through the control period For approval of incentive/disincentive linked to actual performance

For incorporating the feedback in the subsequent control period

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Key Imperatives for MYT Implementation (Prior to the control period)

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Load Forecasting Study

Generation Planning (Supply Side Analysis)

System and Network Planning Study

Study for estimation of un-metered

consumption`

Determination of Power Purchase Requirement

and Optimization

Opex Efficiency Targets and Verification Framework

Collection Efficiency

Assessment

ARR Projections

Development of Regulations (Including

incentive and monitoring framework)

Study on Actual Loss Estimation

Realistic Capex Estimation and

Evaluation Framework

Tariff Determination and Rationalization

Preparation of Business Plans/Account Separation

Dissemination Workshops for Stakeholders

Plan for Meaningful Consumer Participation

Revenue and Billing Analysis

Monitoring and Verification Framework

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Key Imperatives for MYT Implementation (During the control period)

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Establishment of Robust MIS

System

Monitoring of Controllable parameters

Capex Monitoring

Regular monitoring

and generation of

reports

Data collection process and system audit

Assessment of Performance & Validation of

Computations

Monitoring of uncontrollable

parameters

Compliance of Directions

Corrective Actions –

Implementation timelines

Overall System Audit

Thank You