4.8.4.1 The hybrid method of PBR combines some of the best features of ROR and PBR. The hybrid approach combines elements of both the methods to suit local conditions. For some elements of tariff, performance bench marking could be applied, whereas with respect to other elements, the historic cost and rate of return may be applied. This would be effectively a refinement of the existing norm based ROR system.

4.8.4.2 This is a variation of the PBR method under which the performance criteria do not remain fixed but change over time. The purpose is to allow time to the utility to take the appropriate corrective steps before a tightening of the performance criteria.

4.8.5 RPI-X

This is the least intrusive form of regulation which has been extensively applied in the UK. It imposes a price cap which, over the tariff period, can be crossed only to the extent of the retail price inflation (RPI). This inflation rate is not fully available as an add-on to the price cap for the utility. It is reduced by a pre-determined efficiency gain (X). The strength of the scheme derives from the flexibility it affords to the utility to incur costs and take actions as is commercially feasible so long as the objectives of good quality supply are met within the capped price. The problem is how to retain this simplicity in design, while at the same time ensuring that an appropriate price (sufficient for financial viability without being generous), is allowed, for generating stations of different fuel types, ages, technology and siting. In transmission the issue would be to price transmission of energy irrespective of the age of the line, the capacity and technology. The ROR type of approach would try and establish a unique price for these classes of generators. The RPI minus X approach is more aggregative and prices services rather than technologies or fuel usage. It leaves these choices to the utility. Hence, under this system, old stations may lose on operational parameters but gain on total cost due to depreciated rate bases. For the application of this method the following critical decisions have to be taken by the regulator.

(a) How should the price cap be determined? Determination of the base year price can be complex since the regulator must decide to what extent current inefficiencies should be allowed. However the decision is no different than that required under a PBR regime while setting performance criteria.
(b) Which indices are to be used for inflation? In India, there are the wholesale price index (WPI), the consumer price indices (CPI) for agricultural labour, and the CPI for industrial workers. The latter has historically been higher than the former. Which of these is appropriate? There is also the problem of continuity and representativeness of the indices. If the basket of goods, measured for calculating the index changes, the continuity of application of the indices is lost. In the light of these factors would it be more appropriate to use a specially devised inflation formula rather than an existing index?
(c) Determination of the X factor, the proxy for efficiency improvements, is similarly complex. Time series data for the actual costs and efficiencies of a range of stations and transmission lines would be required to devise the X factor. Decisions would also be required on the sharing of efficiency gains between the utility and consumers.

4.8.6 Competitive Bidding

This is an alternative to tariff determination. Under the mega-project-policy, government has specified that this method would be followed for the determination of tariffs. This is a market based approach and hence avoids scrutiny of costs, revenues, etc. which is necessary in other methods of tariff determination. Successful adoption of this method presupposes the existence of competitive forces at the bidding stage.

4.8.7.1 From a theoretical perspective, marginal cost pricing methods provide the most appropriate signals for the pricing of electricity. Marginal pricing sends out a clear signal to the supplier and end user regarding the true value of the power being consumed. Marginal cost pricing emphasises future economic signals rather than relying on financial signals based on today's performance and historic financial costs. Long run Marginal Cost is the future cost of power which takes account of additional investments, consequent capacities, and projected variable costs. Short run Marginal Cost is the variable cost of incremental production. The data requirements for the determination of the LRMC are the energy production and capital costs of all future plants included in the long-term expansion plan. To determine the LRMC, the system expansion plan needs to be defined in terms of investment costs, variable costs and power and energy production. This is generally carried out with an investment horizon of 20 to 25 years.

4.8.7.2 The calculation of long run Marginal Cost Pricing is a necessary tool for estimating the efficiency of current tariffs. If the current price being paid to suppliers is lower than the LRMC, then a careful evaluation of the revenues being earned by them is necessary, to ensure that the utilities are being left with sufficient investible resources. Conversely, if the LRMC is less than the current prices paid to suppliers they are probably being over compensated. Short-run Marginal Cost captures only the operating cost and ignores fixed cost which are 'sunk' and cannot be changed in the short-term. Hence it provides appropriate signals to system operators for the despatch of energy and to users for the use of energy. The rational user will always ensure that the incremental value added or the incremental "utility" of the use of energy is higher than the short run marginal cost of energy.

4.8.7.3 While providing a good theoretical basis for the determination of tariffs, there are a number of disadvantages⁷ to the marginal costing approach, most of the disadvantages relate to the practicality of the method. A number of assumptions used in the least cost expansion plan may be controversial and contestable. Some examples are uncertainties inherent in the energy and demand forecasts, system planning assumptions, unit costs used to establish the investment plan, size of the system or the discount rate. Marginal cost based tariff may be difficult to reconcile with the actual costs encountered in the system. The method uses economic, rather than financial concepts and so may overstate or understate financial requirements. In periods of falling capital costs the LRMC will decrease which may become lower than the costs required to recoup historic costs. Similarly in periods of escalating costs LRMC will tend to overstate the price required to recoup historic costs.

7 This does not apply where the marginal price is determined through a bidding system, such as in the power pool in UK.