Tariff Structure

A tariff structure is a set of rules and procedures that determines how to charge different categories of consumers (Brocklehurst, 2002). Typical tariff structures include:

(i) Flat-rate tariff

(ii) Volumetric tariff based on actual metered consumption (with different variables: constant volumetric tariff, increasing block tariff, linear progressive tariff and peak-load pricing).

(iii) Multi-part tariffs, (including two-part tariffs, where users pay both a monthly fee for access and a usage fee for consumption such as in the water and electricity sectors, and optional tariffs where customers are offered a menu of pricing plans)5. Tariff structures depend on many factors, including the network’s characteristics and the objectives pursued via pricing policy. The charges may differ between customer classes (such as residential, commercial and industrial)

The tariff structure is either regulated or defined by the operators themselves with minimal regulatory oversight, depending on the degree of competition in the sector and whether the government and the operator have similar objectives. In the water sector in England & Wales, the water utilities have some flexibility in defining tariff structures, as long as they stay within the overall price control and meet a series of principles set by the regulator, including non-discrimination, i.e. a principle according to which there should be no unnecessary cross-subsidy between different types of customers (Ofwat, 2006). An effective tariff structure needs to take into account the following elements: financial viability (ensuring that the maximum allowed revenue is recovered), cost-reflectiveness (charging the customers in a way that reflects the costs plus a reasonable return on investment), efficiency (setting prices at marginal costs) and social acceptability (ensuring that charges are “reasonable” so that all customers receive at least basic services and that subsidies are efficiently targeted7) (Groom, Halpern et al., 2006). These criteria may be conflicting and require evaluating potential trade-offs between those principles.

Where a tariff regulation regime exists, tariff structures can be modified either in the context of a periodic tariff review or at a separate time when current tariff structure is found not to be effective and prices need rebalancing. For example, the latter can happen when competition is introduced in a sector where the existing tariff structure would have the incumbent vulnerable to “cream-skimming entry” (Green and Pardina, 1999). For example in the telecommunications sector, a tariff structure implying cross-subsidies among call categories has often been implemented, where high-rate long-distance calls are used to pay for low line-rentals charges to reduce the bill paid by poor consumers. A new company that does not have to serve domestic customers could undercut the incumbent’s price for business consumers (using long-distance calls) even if it is less efficient, only because it does not have to pay the cross-subsidy.

Designing an efficient tariff structure can be done through a step-wise approach:

(i) Gathering information about operator’s activity and demand forecasts,

(ii) Evaluating the effectiveness of the current tariff structure and the need for reform;

(iii) Announcing the reform and

(iv) Implementing the proposed reform (Green and Pardina, 1999). When the regulator is responsible for tariff setting, it has first to address the inherent information asymmetry by gathering information from the operator.