How did the Jamaica Public Service Company's (JPS) new pricing policy get the approval of the Office of Utilities Regulation (OUR) after being initially rejected? In its last Tariff Application 2014-2019, the JPS requested that its price cap scheme be changed to a revenue cap on the grounds that it would provide better opportunities for revenue recovery and energy conservation.
After nine months of deliberation, that proposal was rightly rejected by the OUR. In support of its decision, the OUR used arguments similar to those published in a 1995 paper by Comnes, Stoft, Greene and Hill and a 1996 article by Crew and Kleindorfer. One year later, in January 2016, Schedule 3 of the New Electricity Licence states clearly that the JPS's tariff schedule will be based on a revenue cap scheme. This implies one of two things: either the OUR was not involved in these deliberations, as Section A of the Licence wants us to believe, or some external pressure may have been applied to the OUR to endorse the licence, perhaps from the Ministry of Science, Technology, Energy and Mining. This would mean that the OUR would not be an independent body. What else could possibly explain such a sharp U-turn by the OUR?
The JPS tariff application is a complicated manual, and even an interested reader would have difficulty comprehending its contents and interpreting how such a scheme could potentially affect them. Over the last seven years and while employed at the Jamaica Productivity Centre, I have taken a keen interest in price cap regulation, and that drove me to design aspects of my research around this type of regulatory structure by comparing it to a revenue cap scheme.
Preliminary results from my study show that it would be misguided to think that a revenue cap scheme would be better for Jamaica. My results concur with the initial stance of the OUR and other researchers. It all comes down to basic economics. If revenues are capped, any reduction in the quantity of electricity demanded can only be met by raising prices to ensure that the revenue target is met.
Using 2013 data available in the JPS submission, I show that average residential electricity prices could be almost three times what they were in 2013. Over the last few years, the JPS has found it rather difficult to reduce its system losses, which currently hover at around 25 per cent. By moving to a revenue cap, this essentially means that the company is trying to protect itself against volumetric risk associated with high systems losses.
However, in contrast to a price cap scheme, the JPS would have no real incentive to invest in loss-reduction methods, since it could simply recover any lost revenue in its next annual tariff submission. Therefore, the consumer is likely to experience sharp jumps in electricity prices from year to year.
A key point made by other researchers, which I also discovered in my study, is the potential for the revenue cap scheme to exploit differences in consumer demand behaviour. This is done through the price elasticity of demand which measures consumer responsiveness to price changes. For example, if a consumer could easily leave the grid by powering their house with solar panels, that consumer would have a larger absolute elasticity value and is considered more responsive to price changes.
Certainly, the JPS would have better information on elasticities of demand for different customer segments, but if the estimates published in the OUR Electricity Peak and Energy Demand Forecast 2010-2030 are anything to go by, residential customers in Jamaica should be very worried given their larger elasticity estimates.
Generally, the higher elasticity of demand means that prices should be lower for residential customers compared to other customer groups, but a revenue cap results in precisely the opposite - prices will be higher for the more elastic residential customer group. The way to understand this perverse behaviour is by analysing JPS's profit-maximisation objective and the cost side of utility. The higher price results in a significant reduction in quantity of electricity consumed either from consumers conserving or leaving the grid.
Recall that revenues are capped, which means that the only way the utility can increase profits is by reducing costs. Therefore, by getting rid of some of these customers, the utility is able to significantly reduce the overall cost of supplying electricity to them, especially if the utility's overall generation and distribution costs move closely and in the same direction as costs attributable to this customer group. The energy-conservation argument for a revenue cap is also weak, since it is a direct result of charging higher prices to more elastic customer groups.
At the macro level, the price shocks that are likely to originate under a revenue cap can easily translate into higher inflationary expectations and associated wage-price spirals, and eventually an unstable economic environment.
A revenue cap is not just an inefficient regulatory scheme, it actually promotes inefficiency. For the utility it is a cheap and easy way out of the problem of high system losses, but an expensive lesson that consumers and the country will eventually learn.
- Alrick K. Campbell is a final-year PhD economics student studying at the Australian National University. Email feedback to firstname.lastname@example.org