Utility Tariff Setting for Economic Efficiency and Financial Sustainability - A Review

Abstract

This paper reviews the literature on utility tariff setting with an emphasis on economic efficiency and financial sustainability. The paper first discusses the merits as well as practical limitations in applying marginal cost pricing. It then presents details on estimation of revenue requirements of utilities under two regulatory regimes: rate of return regulation; and performance-based regulation. Finally, the paper discusses how to set tariffs when an enabling environment for achieving both financial sustainability and economic efficiency is lacking. Under such circumstances, the paper argues that initial focus should be on cost recovery. As the enabling environment improves, goals of tariff setting can include broader objectives. The success of such a gradual approach depends on: (i) participatory and rigorous analytical work to assess the feasibility of the type of tariff; and (ii) policy and institutional reforms, regulatory enhancements, and performance improvements of the utility to create an enabling environment for implementing advanced types of tariffs.