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Electricity distribution investments: no country for old rules?

A critical overview of the British and the Italian regulation

Simona Benedettini, Clara Poletti, and Federico Pontoni

IEFE SeminarMilano – April 13, 2012

Outline of the research

Aim

how the regulation of electricity distribution networkinvestments is evolging or … should evolve

perform a critical overview of the British and Italian regulation

Motivations

Ofgem’s regulatory review beginning of a new regulatory period in Italy distribution network investments in Italy are declining innovation in grids’ management calls for innovative

regulation

Methodology

definition of the relevant (evolving) drivers of distributionnetwork investment regulation

Introduction

The new environment …

rapid increase of DG: e.g. in Italy, the numbers of connectiongrew from 35,000 units (6.6 GW in 2008) to 75,000 in 2009(7.5 GW). PV represents the fast growing DG: they went upfrom 71,000 units (1.1 GW) in 2009 to 155,000 units in 2010(3.5 GW);

the installation of smart meters;

the launch of many smart grid projects.

… requires DSOs to invest and to become managers ofactive grids (EnergyLab, 2011); but to do so…

for instance, OFGEM foresees infrastructural investments formore than £ 35 billion in the next 10 years.

Introduction

... Regulators have to adapt the regulatory framework, toguarantee that DSO will play a proactive role in thetransition to a low carbon electricity sector. This means thatRegulators have to:

remove all possible distortions; and

stimulate investments and innovation.

but also guarantee:

high performance levels; and

a fair tariff for network users.

Drivers of distribution network investment

regulation - 1

Cost minimization (e.g. Joskow, 2008)

drives productive efficiency (generally in the short term)

from low powered (rate of return) to high powered (caps)

Innovation

mixed effects of price-cap and rate of return regulation onthe incentive to innovate (Bailey, 1974; Armstrong et al.,1994; Littlechild, 2006; Bauknecht, 2010)

cost savings

risk - bearing

Drivers of distribution network investment

regulation - 2

Timing implementation of some specific investments

input-based regulation

wrong technological pattern

reduces the risk-bearing of innovation (Baucknecht 2010)

Performance

output-based regulation

make the innovation outputs more attractive for distributors (Baucknecht 2010)

Implications for investments and possible sources of bias

how to treat costs

to regulate differently OPEX and CAPEX?

effects on innovation (Holt 2005, Mayo and Flynn 1988)

how to shape incentives

risk of an “overlapping effect”

how to remunerate the investments

setting correctly the financial issues

Drivers of distribution network investment

regulation - 3

The evolution of the British regulation - 1

2008: OFGEM began the review process of the electricity sectorregulation

2010: the RIIO model was adopted

investment regulation is about performance and costs and requires aconsistent interaction between OFGEM and the DSOs

The evolution of the British regulation - 2

Main features of the British regulation

the clear link between investment/action and output:

DSOs will have to justify the option they think optimizes output deliveryminimizing long term costs. For instance, if there are different optionsavailable, OFGEM expects that a well justified business plan shoulddiscuss all of them “ by comparing the net present value cost andchoices in terms of impact on, and risk to, delivery of primary outputs”.Moreover the DSO “ will separately need to show how its choice isaffected by the degree of uncertainty in its volume forecasts”.

the reward/penalty system set up to remunerate/penalize theover/under performance with respect to a specific target;

the forward looking approach.

The evolution of the British regulation - 3

Main features of the British regulation

the TOTEX approach, which introduces a unified efficiency-based mechanism for costs

in order not to distort DSOs’ investment decision, OFGEM has decidedto treat OPEX and CAPEX in a unified manner.

equal treatment means that they are summed up and they are added tothe RAV (to be more precise, only 85% of TOTEX enters the RAV, the

remaining 15% is recovered the same year of the expenditure).

the low carbon fund

big money (£ 500 million); big competition (money are collected from allfinal users and then handed out to project winners).

The evolution of the British regulation - 4

What we

the focus on DSO’s performance;

the forward looking approach;

the TOTEX approach; and

What is challenging (but can only be verified in 2015)

setting the output targets right;

setting rewards and penalties in a way not to punish orremunerate DSOs for situations which are not under their control

The question mark

financial issues (as we shall see later)

Network investments. Average for any regulatory period in £ billions.

Distribution network investments in the UK

1.2 1.3

1.7

0

1

2

2000-05 2005-2010 2010-2015

The Italian regulation - 1

Main features of the Italian regulation

it focuses on the cost driver, where OPEX and CAPEX aretreated differently (that’s the law): price cap for the former andrate of return for the latter; all this, at least in principle, shouldfavor investment, if financial issues are right;

DSOs do not have to present business plans to the Regulator,who can only check ex post that investments included in the RAVhave been really performed;

there are minor elements of input-based regulation, throughthe promotion of certain investments by granting an extraremuneration;

there are also some elements of performance-basedregulation, confined in the quality (continuity) of service;

Distribution network investments in Italy – 1

Network investments in the distributionand metering sector in Italy

Network investments performed by Enel Distribuzione S.p.A. (Mln € )Annual average values over different regulatory periods

Distribution network investments in Italy – 2

The Italian regulation - 2

the figures show that there is a slightly decreasing trend ininvestments, notwithstanding the rate of return regulation;

given that, at present, there are no major input nor outputincentives, investment regulation in Italy is all about financialissues.

Financial issues in bothCountries

Italy

cost of debt: 4.1% in real terms;

cost of equity: 6.0%, again in real terms,

gearing: 55.6%.

RFR: 5.24% (nominal), which is a one year trailing average of the Italian 10-year bond.

UK

cost of debt: 3.6% in real terms;

cost of equity: 6.7%, again in real terms,

gearing: 65%.

RFR: 1.5% (nominal), which is a five year trailing average index-linked gilts.

Italian distortions

n n+1 n+2

Opening RAB 0 0 1,000

CAPEX additions 1,000 0 0

allowed depreciation 0 0 50

RAB for tariff (Closing RAB) 0 0 950

2-year regulatory lag (introduction of an extra remuneration of +1%) Wrong RAB used for capital remuneration As such, the present value of the investment < up-front value of the investment IRR < Real WACC Vanilla (Cambini and Rondi, 2010) Under-estimation of the RFR by AEEG

UK distorsions

n n+1

Opening RAB 0 1,000

CAPEX additions 1,000 0

allowed depreciation 0 50

RAB for tariff (Opening RAB) 0 1,000

Over-estimation of the RFR by OFGEM Is this driving investments more than the brand new output-based regulation?

Conclusions

The transition to a low-carbon electricity sectors calls for:

a different role of DSOs an active network management more and innovative investments in distribution networks

Wide but not conclusive policy debate among Europeanregulators (ERGEG, 2010; CEER, 2011; EC, 2011)

Comprehensive British regulatory reform … but still to betested TOTEX approach Forward looking approach to investment decisions Output-based approach

Building – block approach of the Italian regulation, withattempts to move toward a stronger output-based approach

Policy suggestions for Italy

Promoting a “learning” regulatory period aimed at:

experimenting the progressive adoption of a forward lookingapproach to investment decisions

adopting as a general rule a performance - based regulation toremunerate investments

asymmetric regulation

overcoming the distinction, by law, between OPEX and CAPEXregulation