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CERC DISCUSSION PAPER (JUNE 2003) IT IS TIME TO SAY GOODBYE TO AVAILABILITY BASED TARIFF PRESENTATION BY DR. M. R. BHAT AND DR. AJIT KARNIK WELCOME OPTIMAL TARIFF HEARING AT NEW DELHI November 12, 2003 -1- WHAT IS THE PROBLEM? Problem lies in structure and application of Availability Based Tariff. 1. Mandatory Plant Availability Factor poses serious limitations. 2. Availability Based Tariff does not motivate investment and facilitate objective Optimization of Capital Investment. 3. Other limitations of Availability Based Tariff are forwarded to CERC. -2- WHAT IS THE SOLUTION? 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. -3- WHY THIS SOLUTION? 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 risks. 3. Power Producer, Consumer and Regulator are treated equitably. -4- SECTION 1 OF 4 APPROACH TO FORMULATION OF OPTIMAL TARIFF -5- Optimal Tariff: Components 1. Method 1. 2. Theory of Behavioral Patterns. 3. Performance Incentive. 4. Optimization Strategy. -6- 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. -7- 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 prevail. 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. -8- 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 economy. 2. Unique optimal values of Normal Rate of Profit and Risk Premium reflect microeconomic considerations, which drive investment in power sector. -9- 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 agreement. 4. Amount of Return excludes Performance Incentive. -10- 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. -11- Motivation 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. -12- SECTION 2 OF 4 STRUCTURE AND APPLICATION OF OPTIMAL TARIFF -13- Method 1: Definition Method 1 is the procedure wherein Capital Investment and Rate of Return are mutually agreed between Power Producer and Regulator. -14- 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). -15- 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. -16- 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 satisfied. -17- 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. -18- 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. -19- 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 Return. 3. The interests Power Producer, Regulator and consumers get balanced, while promoting Capital Investment, in a win- win scenario. -20- 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. -21- 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 Rate: 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 ceiling. -22- 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 Factor. 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. -23- 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. -24- 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 Yarrow). Agree to Performance Incentive to improve grid discipline and internal efficiency. -25- SECTION 3 OF 4 APPLICATION OF OPTIMIZATION STRATEGY FOR OPTIMAL TARIFF -26- 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 role. Internal efficiency through Performance Incentive, which is its primary role. -27- 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 -28- 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. -29- 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 -31- 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 life. 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 optimal/near-optimal. 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. -33- 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 discussion. -35- 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. -36- 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. -37- 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”. (Takayama) 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 maximized. -38- 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. -39- SECTION 4 OF 4: CONCLUSIONS OPTIMAL TARIFF 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 AVAILABILITY BASED TARIFF AND WELCOME OPTIMAL TARIFF -40- IT IS TIME TO SAY GOODBYE TO AVAILABILITY BASED TARIFF PRESENTATION BY DR. M. R. BHAT AND DR. AJIT KARNIK WELCOME OPTIMAL TARIFF 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 022-26235105 E-Mail: sbhat@hotmail.com Mumbai 400 049 -41-