What is the rate reset process?

By Elyssa Lopez

Philippine Center for Investigative Journalism

Under its concession deal, the National Grid Corporation of the Philippines (NGCP) is obliged to “provide transmission service… and to bill and collect from transmission customers for its account such charge as the Regulated Entity may lawfully demand.”

The agreement is also clear that the Energy Regulatory Commission (ERC) shall regulate NGCP under applicable laws, including the Electric Power Industry Reform Act or “any successor legislation.”

In 2009, the ERC introduced a regulatory methodology and a process to reset rates for power distribution utilities and the NGCP that follows a “performance-based regulation” (PBR) framework. Today, distribution utilities and the transmission operator follow the same framework in applying for their revenue requirements, or during the rate reset process.

In principle, the framework incentivizes a regulated entity, including a monopoly like the NGCP, to perform competitively and run operations efficiently.

“It puts an incentive on the utility firm to be efficient and effective,” former UA&P School of Economics dean Peter Lee U told the Philippine Center for Investigative Journalism (PCIJ).

The regulators’ judgment of the utility’s performance determines the rates that can be charged to consumers over a certain period.

This also serves as an avenue for the utility to apply for a new budget to finance its operations and investments.

The PBR is “forward-looking” so both the regulators and the regulated entity work on capital and operating budgets based on forecasts, which can be a contentious process.

“The principle behind that is to give NGCP more incentive to save on cost and to be more efficient [in their operations]. Because anything that is below the expenses that were approved [by ERC] that they can recover, that’s going to be their profit. The firm becomes the residual claimant of any savings,” former socioeconomic planning undersecretary Adoracion Navarro said in an interview.

Under the rate reset process, the NGCP seeks approval for its annual revenue requirement (ARR), which it can recover from consumers.

The ARR is computed using a formula that sums up operating and maintenance expenses, taxes other than income tax, and return on capital.

Regulators also approve any savings, which are labeled as “net efficiency adjustment.”

To check which items to include in operating and capital expenditures for a certain period, regulators need to pore over a “voluminous” amount of data and documents, said Maria Corazon Gines, director of ERC’s legal services unit, during the hearings for the fourth regulatory period.

The ERC, for example, had to study transaction receipts dating back to 2013. The regulator also needed to undertake a “field inspection of the land and land-related CAPEX of NGCP as part of the “prudency review process.”

Regulators are expected to conduct three to four months of hearings for the rate reset process. In the fourth (2016-2022) and fifth (2023-2027) regulatory periods, however, the process has taken at least a year.

What is the WACC?

Another hot topic during the rate reset process is the WACC or the weighted average cost of capital (WACC), which is part of the formula that determines the ARR.

This is the guaranteed rate of return that the NGCP gets from its capital spending on the country’s power grid.

“The economic principle is to ask: what is the opportunity cost of capital? For example, as a businessman, you put in capital for a business. You won’t be able to use that capital anywhere. WACC is that cost, it’s what you could have earned in the next best use of your capital,” Lee U explained.

He said the WACC may be compared to inflation and the rate of return on treasury bonds.

Since a business would have earned, for example, a certain rate of return on treasury bonds, which are considered risk-free, the natural thing would be to allow a regulated entity to earn at least more than that and inflation, he said.

“The floor [of that rate] should be what has been the historical rate of return on government securities. Then you have to add on the risk any business has to take,” he said.

Navarro said the risk-free rate on investments and the market risk premium are determined by studying a pool of financial data.

Regulatory period

The duration of the regulatory period has also been a point of conflict between the NGCP and the ERC.

Under the 2009 rules, the regulatory period should be every five years. The reset process should begin at least 18 months before another regulatory period.

However, a tumultuous time in the ERC, between 2015 and 2017 in particular, delayed the fourth regulatory review process.

New rules issued by the ERC changed the regulatory period to seven years from five, setting the fourth regulatory period to between 2016 and 2022.

Now that the fourth regulatory period has passed, regulators need to consider actual expenditures, instead of forecasts.

The ERC, however, decided to simulate a forecast for the WACC based on financial data from 2011 to 2015.

The process is all too technical, but translates to real costs that ordinary Filipino consumers will bear for the next few years.