There are a variety of issues regarding tariff setting on which the Commission would like to get the responses of all concerned. Some of these issues are listed below :

4.9.1.1 The return to a utility, expressed in monetary terms, is calculated using two variables. The Rate of Return which is a proportion or percentage and the Rate Base which is also expressed in monetary terms.

The rate of return, approved for a utility, consists of two principal components. A risk free⁸ cost of capital and an element representing adequate compensation for taking on the perceived risk associated with the investment. Broadly two alternative formulations may be followed. Either the utility may be approved a Return on Equity (ROE) or a Return on Capital Employed (ROCE). In India, the ROE is set at 16%⁹ for all investments, regardless of actual cost of capital or associated risk, the rate itself, which includes a risk component, and

The ROE or ROCE is applied to a rate base to determine the return of the utility. Where ROE is used it will be applied to the funds of the owners or shareholders equity. In such cases interest cost on outstanding debt is a pass through. Alternatively, if a Return on Capital Employed (ROCE) is being used, the rate base will be the capital base, which represents prudent investments made by the promoter on which the return is calculated and provided in the tariff. The capital base consists of both debt and equity. A strength of this method for allowing return is the flexibility it allows to the utility to optimise financial costs by varying the debt equity ratio inline with market trends.

4.9.1.2 There can be several determinants and classifications of risk. Some are listed below.

country, political, regulatory risk,
financial, cost overrun, foreign exchange, interest rate risk,
project size and type (Hydro power versus thermal, transmission), pre or post construction, fuel supply and price risk.

Risk may vary also with the nature of ownership; public vs. private, foreign vs. local.

4.9.1.3 Of the two components of rate of return the risk free cost of capital is constant for all investments. However the risk premium will vary for different categories of investments. This implies that the appropriate rate of return will vary with the characteristics of the investment. Should not such variations be reflected in the rate of return allowed by the Commission?

The determination of allowable costs and the rate base require significant amounts of information to be filed by the utility. The various elements of costs are already discussed in Annexure II. Costs can be collected at the time of the tariff submission or annually, based on the audited financial statements of the utility. The Commission intends to prescribe both annual filings as well as those, specific to tariff petitions. The intention is to develop a database over time for assessing the performance of individual plants. This type of date is required for implementing any performance based regulatory regime

Tariffs can be determined at different levels of disaggregation. The choice can vary between a unit, station, region or company in generation, and at line, region or company in transmission, are issues to be addressed. The decision depends on the availability of data to support such unbundling and the anticipated efficiency improvements.

How should common costs be allocated? At what stage and on what basis should they be allowed to be recovered through tariff. Infrastructure projects have significant levels of common costs. Since projects are implemented in modules or stages, a common cost like a gas import terminal may be incurred in a lump sum, because of the economies of scale, even though the generation capacity may be added in stages. Hence till the full generation capacity is added, only a part of the common facility may be in beneficial use. Currently the extent of common cost allowed is not linked, to the proportion of final output or capacity of the station or transmission line, actually made commercially available. Can alternative allocation methods avoid unnecessary lags between the creation of common assets and their beneficial use?

4.9.5 Periodicity of Tariff Setting

The period between tariff revisions could vary from one to five years. Currently tariffs are effective for five years, once the tariff has been established and the construction of a station¹⁰ is complete. The argument in favour of frequent reviews is that tariffs can be adjusted regularly and the rate of return to the utility controlled. However this removes any incentive for the utility to make efficiency improvements. Under a PBR system the utility must be allowed a sufficiently long period over which the tariff will remain effective. This enables it to make efficiency improvements and capture the efficiency before the review is required. Shortening the period between tariff review also adds costs to the tariff setting process and increases the burden of regulation. What is the appropriate period between tariff reviews in the Indian context?

4.9.6 Dealing with Change between Tariff Filing Periods

In between normal tariff review periods, additional adjustments may be required. How should these be dealt with? What should be the scope for automatic adjustment? Clearly the method of adjustment will vary with the method of regulation. Under an ROR system all changes have to be considered and approved specifically. Under RPI minus X adjustments are built into the formula. Under competitive bidding the formulas are prescribed in the contract. Can the area of certainty regarding the pass through of unavoidable costs be enlarged for the supplier? How can the consumer be simultaneously assured that only reasonable cost escalations will be passed through? How can costly and time-consuming proceedings be avoided? Where a consumer wishes to challenge the cost escalations passed through by the utility, should it be necessary for the consumer to pay under protest, before it is taken up for consideration by the Commission?

4.9.7 Retrospective Adjustment of Tariffs

Retrospective adjustments arise on various counts including delays in finalisation of project cost, which is approved post-construction for public sector projects. This approach is unusual in the sense that costs may be added to a project after its original approval. Consideration may be given as to whether this method should be continued. This is in contrast to IPP projects, where costs are contractually decided in advance. Post commissioning adjustments in tariff are not in the best interest of the buyer as it may insulate the supplier from the risks associated with plant construction. A clear definition of what may be reviewed retrospectively is required. The concept of allocation of risk needs to be considered. Should the buyer be responsible for all unforeseeable risk, or should the risk be shared between buyer and seller? A principle that might be adopted is that tariffs, once set, remain in place for that transaction. This implies that retrospective revision of bills would not be allowed other than for accounting errors. Any approved adjustment in tariff due to new investments could then be applied only to future years.

8 The risk free interest rate is usually taken as the rate payable on long term government bonds.
⁹ The 16% return on equity is allowed on achieving 68.5% availability / deemed PLF for Thermal generation, 85% availability for Hydro Stations and 90% availability in transmission. In the case of central Thermal Stations in existence prior to 1992 the 16% return on equity is allowed on a notional equity of 50% of the capital cost. Generators who achieve higher than targeted availability can earn higher returns.
¹⁰ A station constructed in stages with considerable time lapse between stages or with stages employing different technology may be regarded as two separate stations in terms of tariff filing