4.8.1 There are a variety of methods for tariff regulation as reviewed below. The choice of the method will be dictated by factors like effectiveness of the method in achieving tariff objectives, appropriateness, in the light of the existing methods being used for the purpose and administrative convenience given the existing infrastructure and information systems.

Rate of Return + Cost of Service;
Marginal Cost based Price;
Performance Based Regulation (PBR);
RPI-X;
Competitive Bidding;

4.8.2.1 The rate of return approach requires the determination of allowable costs, a rate base and the rate of return to be allowed on the rate base. The rate base is the capital amount on which a return is allowed. Typically the rate base represents the historic cost of the assets employed, less the accumulated depreciation of the asset³. The data requirements for carrying out RoR regulation are the historic costs of investments (in the Indian system the gross block) together with the variable costs incurred in the test year. The test year is generally taken as the latest financial year for which complete data is available.

4.8.2.2 This form of regulation has a number of distinct advantages:

a) It provides predictable, steady returns for the utility, which is conducive to making further investments.
b) The method is conceptually simple and unambiguous, generally making use of historic accounting data.
c) It is perceived to be fair. The cost of the electricity service is related directly to the actual asset base, with the end user paying for the facilities used. Today's user pays for the system built to date.
d) It is a traditional approach, used over many years, and is familiar to electric utilities, users and regulatory agencies.

4.8.2.3 The strengths of this form of regulation like its simplicity and predictability, also create its limitations.

a) Once an investment is made it tends to remain in the rate base and earns a return, even if the investment becomes non productive due to future developments, resulting in "stranded costs".
b) Since the rate of return and the rate base are the two main variables in the determination of the return to the utility. There is a tendency to over invest. Higher the investment, higher the rate base and hence the return to the investor.
c) The process is backward looking. The end user pays the historic cost and there are no price signals regarding future costs. This is not conducive to the efficient use of energy.
d) Historic book values may not provide sufficient revenue for future investments and may result in inadequate investment for future needs.
e) This is an intrusive form of regulation. It provides little incentive for the supplier to reduce costs and make efficiency gains. Since the net return to the utility is fixed any reduction in costs or increase in revenue are passed through to consumers.
f) Due to its intrusive nature the transaction costs are high The period of tariff review tends to be short. The nature of review is detailed as regulators have to overcome the inherent problem of information asymmetry between the regulated and the regulator

4.8.3.1 Recent trends have been towards more "light handed" regulation i.e. least interference by the regulators. PBR moves away from the RoR method by providing incentives for the utility to improve efficiency and reduce costs. Rather than prescribe a return, the utility is given a set of performance criteria to follow. Performance criteria⁵ may include both operational and financial criteria. The return to the utility depends upon performance. Over achievement of the performance criteria can increase returns for the utility while underachievement will decrease returns. Performance targets are set using historic data, trends of system costs and operational characteristics. The establishment of an extensive data base for benchmarking performance criteria on the basis of industry best practice is an essential component for effective regulation under this method. A form of PBR is in actual use in India, where tariffs are based on normative parameters. With minor adaptation and reformulation of the normative values to

2 This method has been used extensively in the US but there is a movement away as in California
³ In some jurisdictions the rate of return is allowed on revalued assets. This tends to push up tariffs and is not widely used.
4 This method is being used in England and Wales and is being considered elsewhere, e.g. Ontario and Alberta, Canada
5 Performance criteria might include such items as, number of hours of system degradation (down time) losses expressed as a % of energy produced, expenditure on O&M, number of employees per 1000 consumers, lost time due to accidents, etc.