In the fourth article in Economic Insight’s series on financeability, Chris Pickard and Sam Williams consider the importance of getting a reliable view of companies’ efficient costs.
As we set out in the preceding article in this series (see links below), to avoid customers paying for inefficiently incurred costs, regulators typically determine revenue allowances and assess financeability based on a notional, efficient firm. Financeability assessments therefore seek to determine whether such a firm has sufficient financial headroom, over and above its efficient costs. As such, a critical part of assessing financeability accurately is a reliable view of companies’ efficient costs.
It is impossible, however, to know the level of efficient costs with certainty, because we can only ever observe the costs that companies actually incur, which may not be fully efficient. Efficient costs must instead be estimated using available data. While comparisons can be made between low- and high-cost companies, it can be challenging to disentangle inefficiency from other factors that drive costs, including service quality. Furthermore, technological progress means that the efficient level of costs is a moving target that constantly changes over time.
This means that there are material risks of both overestimating efficient costs, leading to customers paying for company inefficiency, and underestimating them. In the latter case, revenue allowances will be insufficient even for efficient companies. Assessing financeability using inappropriately low cost estimates will give an unrealistically optimistic view of the notional company’s financial position. Taking a rigorous approach to the estimation of efficient costs is therefore vital to ensuring financeability is accurately assessed. In our view, a rigorous approach to estimating efficient costs has four key components.
In the first place, a balanced approach to evidence is needed to avoid bias in estimates of efficient costs. While efficient costs cannot be observed directly, multiple sources of evidence are often available to inform regulators’ estimate of them. By way of example, statistical modelling is often used to benchmark the efficiency of companies’ operating and capital maintenance expenditure and provide a view of their comparative efficiency. Statistical tests will often indicate that several models perform equally well. Similarly, both government and AAA-rated corporate bonds may be used as evidence on risk-free asset returns when estimating the cost of equity.
Although different sources of evidence sometimes point in the same direction, there will often be some degree of divergence between them. Regulators need to take account of their strengths and weaknesses, and should only favour one source of evidence over other contradictory sources if there are compelling reasons to believe that it genuinely provides a more accurate estimate. If they choose to rely on a single piece of evidence, regulators must be confident that it is not biased in one direction or another. They should also bear in mind that pooling different sources of evidence can help to avoid overreliance on a single erroneous piece of data.
Secondly, a robust approach to dealing with uncertainty is required to understand the risk of under- or over-estimating efficient costs. Because no single piece of evidence will ever be conclusive, some uncertainty will remain over the true level of efficient costs even with a balanced approach. As such, while a balanced approach can help to ensure there is no more reason to expect an estimate of efficient costs to be biased upwards than downwards, the possibility of a mistake in one direction or another remains. It will therefore be important for regulators to consider the implications of the true level of efficient costs being different to their best estimate thereof. Regulators will need to pay particular attention to their financeability duties in this context, and consider the implications of these duties for how uncertainty over efficient costs should be addressed.
In this context, it is essential to be clear as to the extent of any remaining uncertainty and the plausible range as to where the true level of efficient costs may lie. In practice, once all of the underlying sources of uncertainty have been identified and analysed, the overall range of uncertainty may be significant, and it is important for regulators to be frank about this. Once identified, uncertainty can be accounted for when assessing the level of risk in the price control and when conducting financeability analysis. For example, this could involve determining whether the notional company would be financeable in the event that efficient costs were, in fact, at the higher end of the range of uncertainty.
Thirdly, internal consistency across all elements of the price control framework is required, including cost assessment and financeability assessment. Price controls are usually complex and combine many different inputs and pieces of analysis to determine revenue allowances and/or price limits. It is a challenging, but necessary, task to ensure internal consistency across these different inputs and analyses, in addition to consistency with the approach to assessing financeability. Failure to do so, however, will lead to inaccurate conclusions being drawn about the efficient level of costs.
By way of example, the cost of debt is typically estimated by analysing the debt costs of appropriate comparators for the regulated company in question. This analysis needs to ensure consistency with the target credit rating used to determine the financial headroom required as part of the financeability assessment. If, for example, the cost of debt was determined based on evidence from low risk A-rated bonds, but financeability assessed at a target rating of BBB, this would lead to an underestimation of efficient costs and an overestimation of the notional company’s financial headroom.
Finally and relatedly, clarity as to the level of service that is funded is needed to ensure that cost estimates are consistent with what companies need to deliver within the price control.
In addition to controls on revenues and/or prices, the level of service that companies provide to customers is also subject to regulation. This typically takes the form of performance monitoring with associated financial rewards or punishments. These rewards and punishments are triggered when company performance deviates from a target level.
It is essential that the level of service companies are required to deliver through these targets is set on a consistent basis with the estimate of the notional company’s efficient costs. Higher levels of service are more costly for companies to achieve, meaning that if targets are disconnected from the level that is achievable within the regulator’s estimate of efficient costs, revenue allowances may be too low or too high. Similarly, the assessment of financeability will be conducted on the basis of a different level of service to the one that companies are in fact required to deliver.
In summary, because financeability assessments analyse the notional company’s financial headroom over and above efficient costs, taking a rigorous approach to the estimation of efficient costs is vital. This requires a balanced approach to evidence, a robust approach to dealing with uncertainty, internal consistency across the price control, and clarity as to the level of service that companies are funded to provide.
This is the fourth in a series of articles from Economic Insight for Utility Week. The first explored the vision of a financeability blueprint, the second looked at the role of finaceability duties in a stagnating economy and the third focussed on finaceability assessment.