Regulatory Strategies for Concessional Finance

Regulators in emerging markets sometimes struggle with how to let utilities handle concessionary financing (e.g., grants and low-interest loans). Regulators allow utilities to place their capital investment amounts in what is called the “rate base” or “regulatory asset base (RAB).” Utilities are then allowed to earn an appropriate return on these investments. Customers pay for that return on capital through the tariff. The investment principal is also returned to the utilities through repaid depreciation, which also comes from customers through the tariff (called the return of capital). 

But, when a utility receives a grant or low interest loan, should ratepayers be forced to pay the utilities a return on money the utilities did not invest? Further, should the utilities receive that money back through a depreciation allowance when it was not their investment in the first place? After all, the grant or low-cost loan is usually being offered specifically to keep the tariff as low as possible.

It might not seem fair for customers to pay so the utility can earn a return on donated money, nor for them to return that money to the utility when the utility did not provide it. However, this “disallowance” may not serve the customer well in the long run, as it increases the cost of capital for the utility and may lead to declines in service quality. 
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If utilities cannot earn a return on concessional finance, they lack an incentive to pursue it. This keeps the utility’s cost of capital high and limits its sources of funding. Furthermore, if utilities cannot receive a portion of donated capital back, they may not be able to replace the equipment that was purchased with donated money, at the end of its useful life.

To incentivize utilities to pursue concessional financing, and leverage it toward capital improvements, the National Association of Regulated Utility Commissioners (NARUC) suggests the following as three strategies for the regulator [1]:

1. Allow partial capital recovery. This action permits shareholders to earn a return on a portion of an asset funded with concessional finance and reclaim that portion through depreciation. This way utilities are incentivized to pursue concessional finance to improve or expand generation, transmission, and distribution infrastructure. Consumers benefit from improved service, and they do so at lower electricity rates than if the projects were financed entirely with risk-adjusted returns. 
2. Adjust calculations for costs of capital. Rather than full removal of the cost of the asset from the rate base, regulators can allow a lower return that reflects the concessional finance. This would especially apply in cases where financing is a concessional loan, with a lower-than-market interest rate. That rate should be passed on to ratepayers (as suggested above, a partial return could also be applied to grants where the cost of capital to the utility is zero).
3. Allow recovery of costs to secure concessional finance. The process to apply for and secure concessional finance can be expensive for a utility. Resources must be allocated toward identifying funding sources, applying for funding, and tracking relevant metrics. One possibility is that the regulator allows for the costs of securing grants to be passed to ratepayers through an operations expense for the utility. 

Some combination of these approaches to concessionary finance can keep capital costs lower, which means lower long-term utility rates. It can also incentivize utilities to access a broader range of financing sources. Finally, it can help to ensure there are sufficient funds to maintain and replace assets that are originally funded with low-cost capital.

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[1] NARUC. 2021. Primer on the Impact and Treatment of Grants, Donor Assistance, and Concessional Financing. ​