The General Efficiency Assumptions: Setting X in RPI-X
1 October 2002
By Dr. William Baker with Brian Williamson and Helen Lay Jung
Water UK asked NERA to examine the process for setting the general efficiency target X for the determination of price caps at Periodic Reviews -- giving particular consideration to studies since 1999 and the efficiency target for operating expenditure. The authors approached this task by first studying the available economic literature on setting efficiency factors, and then reviewing the experiences of regulated companies both in the UK and internationally.
In NERA's report to Water UK, the authors consider all of the factors that can affect the pre-RPI price cap level, such as anticipated changes in the volume and quantity of outputs to be delivered, and any incentive rewards and penalties for past company performance against targets. The report also discusses setting X so that anticipated output prices track the anticipated costs of delivering outputs, after adjustment for anticipated input price and productivity movements. The authors found that a wide range of methods for determining X have been employed in both the UK and internationally -- some of which are more sound than others -- and that no single method has been endorsed for use in Periodic Reviews. The authors contend that as long as there is a need to rely on disparate data and judgments in setting X, these elements should be employed within an explicit and transparent framework which ensures that X is based on internally consistent positions consistent with the evidence.
This report offers a review of the literature considered by the authors, as well as explanations and a discussion on the various methods for setting X employed internationally. The authors then formulate a series of proposals for defining X and recommending how the factor should be set during price cap reviews. Both the full report submitted to Water UK and the executive summary are available for download below.
