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         DR. M. R. BHAT

          November 12, 2003

   Problem lies in structure and
   application of Availability Based
1. Mandatory Plant Availability Factor
   poses serious limitations.
2. Availability Based Tariff does not
   motivate investment and facilitate
   objective Optimization of Capital
3. Other limitations of Availability
   Based Tariff are forwarded to CERC.

  Solution to Problem is to:
1. Discard mandatory Plant Availability
   Factor, as is done in limitation-free
   Optimal Tariff.
2. Adopt Optimal Tariff (based on holistic
   application of optimizing principles of
   economics), on an imperative basis, in
   lieu of Availability Based Tariff.

  Solution offers several advantages.
1. Over-investment - inevitable under
   Availability Based Tariff - is negated in
   Optimal Tariff, based on new concept of
   Optimizer - which is the unique optimal
   value of Risk Premium for given values of
   its associated variables.
2. Optimal Tariff maximizes social welfare
   and motivates investment, in an
   economy facing shortage of funds and
3. Power       Producer,    Consumer    and
   Regulator are treated equitably.
      SECTION 1 OF 4


      Optimal Tariff: Components

1. Method 1.

2. Theory of Behavioral Patterns.

3. Performance Incentive.

4. Optimization Strategy.

         Optimal Tariff: Features
   Optimal Tariff lets Power Producers to:
1. Respond to needs of society and also
   power system.
2. Earn fair Profit plus Performance
   Incentive for good performance.
3. Avoid conflicts on who is to generate
   what, when and why, regardless of
   ownership of plants.

  Optimal Tariff is based on conventions/
  simplifications (available with CERC), which
  do not distort its practical application in power
  generation industry.
Rate of Return in Optimal Tariff: Elements
1. Risk Free Return.
2. Normal Rate of Profit, when risks are minimal.
3. Risk Premium, in addition to Normal Rate of
   Profit when risks and shortage of funds
     Sum of three elements equals Rate of Return,
     which has no more its regulatory role.
     Normal Rate of Profit and Risk Premium have -
     for given units generated, cost of fuel per unit
     generated, optimal value of capital investment
     and Risk Free Return - distinct and unique
     optimal values, which serve different purposes
     in Optimal Tariff.
Rate of Return in Optimal Tariff: Basics
1. Risk Free Return is assumed as weighted
   average Reserve Bank Rate.
   Refer Report (1991) - India, Long Term Issues in the
   Power Sector, by London Economics, Indira Gandhi
   Institute of Development Research and others.
   Reserve Bank Rate reflects macro economic
   considerations relating to state of country’s
2. Unique optimal values of Normal Rate of
   Profit   and     Risk     Premium     reflect
   microeconomic considerations, which drive
   investment in power sector.
            Amount of Return
1. Amount of Return =
   [Rate of Return  Capital Investment].
2. Government, as Bulk Purchaser, pays
   Amount of Return to Power Producer.
3. Amount of Return not affected by changes in
   (Risk Free Return = Reserve Bank Rate),
   since Rate of Return is based on mutual
4. Amount of Return excludes Performance
         Objectives of Optimal Tariff

Objective 1: Minimize Amount of Return
             earned by Power Producer,
             while striking a balance with his
             objective of maximizing Profit.
Objective 2: Ensure grid discipline.
Objective 3: Optimize Capital Investment.
Distinctly defined Objectives form a package,
achieved collectively and completely through
application of four Components of Optimal Tariff.

1. Power Producer (Regulator) is motivated to
   increase (decrease) Amount of Return,
   calculated from Capital Investment and Rate
   of Return.
2. Power Producer expects to increase Profit.
3. Regulator wants to optimize Capital
   Investment. Power Producer extends support,
   provided Profit is safeguarded.
4. Power Producer and Regulator desire to
   increase generation, the former to increase
   Profit, the latter to decrease Unit Fixed Cost.
       SECTION 2 OF 4


       Method 1: Definition

Method 1 is the procedure wherein
Capital Investment and Rate of
Return    are   mutually   agreed
between Power Producer and

         Theory of Behavioral Patterns:
          Definition and Classification
  Theory of Behavioral Patterns is developed
  from behavior of three variables, Capital
  Investment, Profit and Amount of Return, with
  respect to changes in Rate of Return.
  Behavioral patterns are classified as:
1. Standard (Non-standard)
2. Conditional Standard (Conditional Non-standard)
   In Standard (Non-standard) Patterns, as Rate of
   Return increases:
       Capital Investment and Amount of
       Return always decrease (increase).
       Profit always increases (decreases).
Theory of Behavioral Patterns: Attributes

1. Both standard and non-standard
   patterns are always valid, but their
   characteristics are opposite in nature.

2. Conditional Standard (Conditional Non-
   standard) Patterns are those that are
   Standard (Non-standard), provided that
   specified condition applicable to Pattern
   concerned is satisfied.
Theory of Behavioral Patterns: Features
1. Standard and conditional standard patterns -
   but not non-standard and conditional non-
   standard - form the basis of Theory of
   Behavioral Patterns.
2. Conditional patterns have to satisfy Conditions,
   which are variable-specific for optimal/non-
   optimal values and derived through theory.
3. Under Method 1, Behavioral patterns of:
      Capital Investment is inherently standard.
      Profit and Amount of Return are conditional
      standards, for which conditions are easily
Theory of Behavioral Patterns: Application

1. Power Producer desires to maximize
   Amount of Return and Profit through
   increases in both Capital Investment and
   Rate of Return.
   Regulator desires to decrease their values,
   to minimize Amount of Return.

2. Conflict is resolved through application of
   Step-by-Step Approach (Forwarded to
   CERC), utilizing collectively all four
   Components of Optimal Tariff.
Theory of Behavioral Patterns: Advantages

   Risk-free procedure in application of
   Theory of Behavioural Patterns provides
   built-in motivation for Power Producer
   and Regulator to:
1. Increase Rate of Return, if Capital
   Investment decreases.
2. Minimize Capital Investment and
   Amount of Return.
3. Maximize Rate of Return and Profit.
   Theory of Behavioural Patterns: Highlights

1. Power Producer and Regulator agree to:
       Decrease Capital Investment, though not
       sought by Power Producer, whose interest
       is to increase Profit.
       Increase Rate of Return, though not
       favoured by Regulator, whose interest is
       to decrease Amount of Return.
2. Paradoxically, there is no conflict between
   increasing Profit and reducing Amount of
3. The interests Power Producer, Regulator
   and consumers get balanced, while
   promoting Capital Investment, in a win-
   win scenario.
  Performance Incentive: Definition

Performance Incentive is a financial
instrument of recognition and reward for
good performance, in the absence of
quantifiable mandatory Plant Availability
Factor and/or Plant Load Factor.

Performance Incentive Rate is equal to
Performance Incentive per unit of
Capital Investment.
 Performance Incentive: Characteristics
1. Performance Incentive is an add-on to Profit.
2. Performance Incentive Rate is an add-on to
   Rate of Return.
3. For given values of other variables,
   Performance Incentive/Performance Incentive
     Increase as Capital Investment decreases.
     Increase as generation increases, but under
     progressive restraint.
     Are independent of the value of:
     (Risk Free Return = Reserve Bank Rate).
4. Performance Incentive is subject to regulatory
          Performance Incentive and
    Performance Incentive Rate: Application
1. The principle of Performance Incentive is that Power
   Producer, who is not only ready to perform, but also
   actually performs by generating energy to meet
   system needs, is compensated additionally.
2. Performance Incentive is not paid to another Power
   Producer who is only ready to perform, but is not
   called upon to generate on demand.
3. The ability of Power Producer to generate on demand
   depends on his maintaining high Plant Availability
4. Power Producer may not comply with generation
   schedule of Load Dispatch to ensure grid discipline.
   Nevertheless, he is likely to do so willingly and
   achieve high Plant Load Factor, since Performance
   Incentive increases as generation increases.
          Performance Incentive and
     Performance Incentive Rate: Features
1. Performance Incentive:
       Fosters grid discipline, augmenting
       Method 1.
       Improves internal efficiency, which is its
       primary role and depends on total costs
       for producing given bundles of outputs
       (Vickers and Yarrow).

2. Suitable formula secures the features of
   Performance Incentive/Incentive Rate.

    Optimal Tariff: Accomplishments
   Optimal Tariff, through its first three Components:
1. Sets road map to achieve Objective 1, through
   Optimization Strategy (Fourth Component).
2. Achieves Objective 2, to ensure grid discipline.
3. Encourages Power Producer voluntarily to:
       Maintain high values of Plant Availability/Load
       Factors without mandatory compulsions.
       Accept Load Dispatch’s exclusive control over
       grid discipline, if Producer’s Profit is secured.
       Promote allocative efficiency, based on output
       level with given cost structure (Vickers and
       Agree to Performance Incentive to improve grid
       discipline and internal efficiency.
    SECTION 3 OF 4


      Optimization Strategy: Scope
   Optimal Tariff, through its four Components -
   particularly Optimization Strategy including
   application of Optimizer:
1. Optimizes/Near-optimizes Capital Investment,
   Amount of Return and Profit.
2. Achieves/Near-achieves Objectives 1 and 3.
3. Maximizes/Near-maximizes:
      Allocative efficiency through Theory of
      Behavioral Patterns and Method 1, with
      Performance Incentive playing a secondary
      Internal efficiency through Performance
      Incentive, which is its primary role.
       Optimization Strategy: Theory
   Theoretical analysis leads to conclusions that:
1. Marginal and average consumptions of coal (or
   other fuel) in a thermal power plant are equal.
2. Partial derivative of output with respect to input
   (fuel) is a constant in given time period, without
   disturbing constraints.
3. Optimal/Near-optimal allocation of resources
   is achievable.
4. Normal Rate of Profit and Risk Premium are two
   distinct optimized values, assigned different roles.
5. The latter, which has technical advantages, is
   termed as Optimizer and used to achieve
   Optimal/ Near-optimal allocation of resources
       Optimization Strategy: Features

1. Maximization/Near-maximization achieved by
   Optimal Tariff, aided by Optimization Strategy,
   makes no distinction between Public and
   Independent Power Producers.
   The former produces more units of generation and
   makes more cost-saving effort to achieve higher level
   of social welfare than the latter - who may rectify the
   imbalance, if improved incentive systems are
   introduced (Vickers and Yarrow).
2. Optimal Tariff addresses itself to incentive
   systems and encourages Power Producers to
   implement Optimization Strategy.
 Optimization Strategy: Fixed Unit Cost
1. Optimal Tariff, through four Components,
   particularly - Optimization Strategy - optimally
   reduces (enhances) Amount of Return (Profit).
2. For given units generated, between Unit Fixed Cost
   (excluding/including Performance Incentive Rate), the
   latter is higher than the former, but moderately, due
   to ceiling on Rate.
3. Higher Cost is acceptable, since Incentive Rate is
   Power Producer’s reward for internal efficiency.
4. Comparison between Unit Fixed Cost (excluding/
   including Incentive Rate) is however not meaningful.
5. Significant comparison is between two values of
   the latter, corresponding respectively to
   optimal/near-optimal and non-optimal values of
   Capital Investment.                         -30-
     Optimization Strategy: Phases
1. Optimization Strategy - a Component of
   Optimal Tariff - consists of two distinct
   phases: Phase 1 and Phase 2.

2. Phase 1 relates to Capital Investment,
   incurred until plant is ready for
   commercial operation.

3. Phase 2 covers continuing optimization
  Optimization Strategy (Phase 1): Application

1. Optimal values of Capital Investment, Rate of
   Return, Performance Incentive and Profit are
   determined by collective application of four
   Components of Optimal Tariff, using Step-by-
   Step Approach, referred to earlier.
2. It defines mutually agreed and frozen values of
   variables, when plant steps into Year 1 of its
3. Corresponding formula based optimal values
   equalize/near-equalize themselves to their
   mutually agreed and frozen values and not
   vice-versa, due to inherent flexibility of value
   of Optimizer. The latter are then optimal/near-
   optimal.                                      -32-
Optimization Strategy (Phase 1): Conclusion
1. In Year 1, values of Capital Investment, Rate
   of Return, Performance Incentive, Profit and
   Unit Fixed Cost (Performance Incentive Rate
   included) for given units generated are
2. Optimization Strategy (Phase 1) stands
   formulated, achieving Objectives 1 and 3 in
   Year 1.
3. Key components of Optimal Tariff are defined.
4. Next Step: Optimization Strategy (Phase 2),
   again based on Optimizer.
      Optimization Strategy (Phase 2)

1. Optimization Strategy (Phase 2) ensures
   Optimality/Near-optimality,     based     on
   specific value of Optimizer for each year.
2. Value of Optimizer is calculated from actual
   weighted average values of variables at
   conclusion of each year.
3. In each Year, values of Capital Investment,
   Rate of Return, Performance Incentive Rate
   and Unit Fixed Cost (including Performance
   Incentive Rate) are optimal/near-optimal.
4. Optimization Strategy (Phase 2) stands
   formulated, achieving Objectives 1 and 3
   from Year to Year.                    -34-
      Optimization Strategy: Overview
   Optimal Tariff, through its four Components -
   particularly Optimization Strategy, including
   application of Optimizer:
1. Assures that fear of over-investment (Averch-
   Johnson effect) would almost fade away.
2. Implies that traditional concepts of regulatory Rate
   of Return are abandoned and structural changes
   in regulatory practice introduced.
3. Maximizes/Near-maximizes the sum of producers’
   and consumers’ surpluses or social welfare and
   achieves Objectives 1 and 3, with Objective 2
   having been earlier achieved.
   In this context, four issues involved call for
   Optimization Strategy: Issue 1

Use of mathematical technique in design of
Optimization Strategy appears contrived and
not in order.

This is not sustainable, since “Common sense
recognizes itself only in the searchlight of
mathematics” (Samuelson).

Nevertheless, one may agree with Bailey and
Malone that theory based on static analysis is
not in tune with the dynamic real world.
    Optimization Strategy: Issue 2
Optimization may not be achieved unless
discrete time period for optimization is short,
say one day or one hour.

Performance Incentive may be calculated on a
daily/hourly basis and its values incorporated
on a cumulative basis up to month-end to
determine unit Fixed Cost (including
Performance Incentive Rate) for the month.

The monthly energy         bill   is   prepared
accordingly for payment.
    Optimization Strategy: Issue 3

Theory of Optimality is valid under a
competitive situation and cannot be “a
measure of efficiency - - under other situations
according to the second best theorem”.
Theorem: “It is not necessarily worse for
society if a large number of optimality
conditions are violated than only if a few are
violated.” (Baumol).
Near-optimization    may     not    necessarily
indicate that social welfare is substantially
   Optimization Strategy: Issue 4
Any isolated optimization restricted to power
plants may not necessarily be valid, because of
other distortions in society.

Piecemeal interventions by Government would
however eliminate some distortions and reduce
the impact of some others and increase social
welfare. (Henderson and Quandt).
It is particularly so, where the distortions are not
directly related to power generation.

Realistically, what is therefore achieved in
practice is Near-Maximization of social
welfare or the sum of the producers’ and
consumers’ surpluses.

meets expectations of Power Producers,
Consumers, Government and Regulator
       in full and even measure.

   From a totality of considerations:
          IT IS TIME TO SAY
            GOODBYE TO
     WELCOME OPTIMAL TARIFF             -40-

                  PRESENTATION BY
                   DR. M. R. BHAT
                 AND DR. AJIT KARNIK


               HEARING AT NEW DELHI
                 November 12, 2003
Dr. M. R. Bhat                               3 Homeworth,
Senior Consultant (Power)
(Formerly:                      Gulmohar Cross Road No. 7,
Chief Executive, BSES Ltd.)
Telephone: 022-26201960;                     JVPD Scheme
E-Mail: sbhat@hotmail.com                 Mumbai 400 049


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