Regulatory Regimes

Regulatory regimes have intrinsic biases in their effects on the firms being regulated. To overcome these effects, regulators and other stakeholders need to carefully manage the process to avoid imposing perverse incentives on the companies. There are two broad methods for regulation - "Internal Rate of Return capping" (IRR) and "Retail Price Index - X" (IPR-X).

• With IRR regulation, the firms that own transmission systems are allowed a given internal rate of return on their investments. Without checks and balances, this could incentivise companies to invest heavily to increase absolute levels of financial returns. If checks are insufficient, firms may be tempted to gold plate projects, maximizing invested capital whilst not necessarily giving the most efficient and cost effective infrastructure. Value for money guidelines are required to manage this.
• With RPI-X, firms are regulated on their transmission service charges, which are allowed to rise with inflation minus a factor of "X". This regulatory method is very effective for controlling prices, but may incentivise firms to underinvest in order to control their costs. This means, for example, that cheaper inefficient equipment may be procured, as the cost of losses is bourne by generators and customers. Controlling this issue requires enforcement of quality standards.

Another issue for regulators is that in certain circumstances, it may be advantageous for firms to maximize their allowable annual operating expenditure within their regulatory regime, as these yearly expenditure allowances can offer a useful cashflow boost if the measures they are intended for can be delivered for less cost than originally agreed. When this underspend becomes apparent, the regulator will usually demand a transmission tariff adjustment to compensate consumers for the higher than required up-front payment. However this recovery may take place in the next control period, giving a useful cashflow advantage to the operator. There are reputational risks for operators who make a habit of over-estimating opex for this purpose, and regulators are very sensitive to requests of this type.