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This session explains the nature of economic regulation. It discusses the central question why some parts of the electricity value chain remain regulated and are not subject to competition. Furthermore, four main issues regarding an adequate regulatory regime are addressed: · Areas: Where should be regulated? · Scope: What should be regulated? · Type: How should be regulated? · Institutions: Who should regulate? Special emphasis is put on the types of regulation respectively the different forms of price control and their effects (advantages / disadvantages) – including incentive regulation. A short overview on the current legislation and application of price control in the EU completes the session.
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Dr. Konstantin Petrov, DNV KEMA
28 October 2013
Introduction to Network Regulation Module 1: Principles of Price Regulation
Introduction to Network Regulation
14 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Regulatory Institutions
6. Regulation in the EU
Introduction to Network Regulation
28 October 2013
Introduction to Electricity Regulation
Competition provides the best service to customers in terms of price and quality of
service. But competition is not feasible in all segments of the power sector.
In areas where competition does not work (e.g. natural monopoly such as
electricity networks) or is legally excluded (exclusive rights given by the law),
regulation is needed.
The major regulatory objectives are to:
- protect consumer interests and eliminate monopoly inefficiency
- ensure financial viability of industry participants (efficient cost coverage)
- ensure equal conditions and non-discrimination of all sector participants
- improve conditions for competition where possible
Regulation is defined as a state intervention that is applied to various company
specific (e.g. prices, revenues, quality of supply) or integral parameters (e.g. market
entry / market design).
Why regulate?
3
Introduction to Network Regulation
28 October 2013
Introduction to Electricity Regulation
Characteristics of Electricity (Networks)
Economies
of Scale and Scope
Load flow from generator to consumer uncontrollable
and unpredictable
Investments are capital
intensive
Production needs to equal
demand plus reserve
margin at every point of
time Transmission network
capacity should be able to
accommodate peak load
Network capacity depends
on the location of
generation and load within
the network
Sunk costs
Characteristics of
Electricity (Networks)
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Introduction to Network Regulation
28 October 2013
Introduction to Electricity Regulation
Regulation must balance obligations to both customers and regulated companies
and also the costs and benefits of the regulatory system itself.
Balancing Interests
Costs and Benefit of Regulatory System
Distortions to
industry structure
Costs of operating
regulation
Prevention of
monopoly abuse
Efficiency savings
and lower costs
Customer and Company Interests
Price reductions
Protection against
monopoly abuse
Fair return
Profit
opportunities
5
Introduction to Network Regulation
28 October 2013
Introduction to Electricity Regulation
The choice of an adequate regulatory regime requires a definition of the area, scope
and type of regulation, as well as the establishment or assignment of an institution
responsible for regulatory issues.
Choice of Regulatory Regime
Areas of Regulation
Scope of Regulation
Type of Regulation
Regulatory Institutions
Where should be regulated?
What should be regulated?
How should be regulated?
Who regulates?
Choice of
Regulatory
Regime
6
Introduction to Network Regulation
28 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Regulatory Institutions
6. Regulation in the EU
7
Introduction to Network Regulation
28 October 2013
Areas of Regulation – Which areas should be regulated?
Ancillary
Services
Wholesale
Supply
Power
Generation
System
Dispatch
Power
Transmission Power
Distribution
Retail
Supply
Metering
and Billing
Services subject to
regulatory control
Competitive services
Potentially competitive
services
Regulated and Competitive Elements
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Introduction to Network Regulation
28 October 2013
Areas of Regulation – Which areas should be regulated?
Traditionally, all business areas in network industries (such as the electricity sector)
had naturally been regarded as monopolies not subject to competition.
However, only the network business is characterised by large sunk costs and
economies of scale and scope, which generate stable market power for incumbent
network owners.
Other business areas of the sector (such as production, wholesale and retail) can be
provided in a competitive process.
A fair and non-discriminatory regulation framework for the transmission and
distribution networks has important implications for supporting wholesale
competition (electricity generation) and retail competition (end-user supply)
Regulation should focus on the network segment
9
Introduction to Network Regulation
28 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Regulatory Institutions
6. Regulation in the EU
10
Introduction to Network Regulation
28 October 2013
Scope of Regulation – What should be regulated?
Regulatory Controls
Regulation should ensure: functional market design, reasonable prices
and reasonable quality of supply for regulated services.
Market Functioning
Market design / market
rules
System / network
rules
Market monitoring
Market integration
Other
Unbundling
Security of supply
Innovation
Price Control
Revenue / tariff setting
Efficiency incentives
Investment sufficiency
Innovation
Commercial quality
Continuity of supply
(reliability)
Technical quality
Quality of Supply
Regulatory Controls
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Introduction to Network Regulation
28 October 2013
Scope of Regulation – What should be regulated?
Elements of Price Control
Setting Revenue
Requirements
Price / Revenue
Adjustments
Efficiency
Assessment
Tariff Design
– Setting an allowance for operation and maintenance cost
– Setting capital cost allowance (including provisions for asset valuation and
depreciation methods, regulatory asset base, cost of capital)
– Setting a price control formula
– Application of adjustment factors: productivity increases, price and volume
adjustment
– Defining length of price control period
– Tariff structures: e.g. use of network charges / connection charges, demand
charges / energy charges / standing charges
– Cost allocation: differentiation for voltage level, location, time of use, energy
use / peak demand
– Assessment of inefficiency of regulated service providers (Benchmarking)
– Techniques: non-parametric models (Data Envelopment Analysis), parametric
models (Corrected Ordinary Least Square, Stochastic Frontier Analysis),
engineering models
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Introduction to Network Regulation
28 October 2013
Scope of Regulation – What should be regulated?
Elements of Quality of Supply
Continuity of
Supply
Technical Quality
Commercial
Quality
– Reliability of electricity supply
– Performance indicators (number and frequency of interruptions)
– Physical properties of electricity
– Performance indicators (voltage variation, dips, flickers)
– Customer service quality
– Performance indicators (complaints from consumers, response time to
consumer complaints, appointments with consumers)
13
Introduction to Network Regulation
28 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Regulatory Institutions
6. Regulation in the EU
14
Introduction to Network Regulation
28 October 2013
Type of Regulation – How should be regulated?
Theory vs. practice:
- Differences between regimes in practice less strong.
- Depending on the details of the regulatory regime, differences might only exist in the name of the regime.
- Hybrid forms (combinations of regimes) frequently applied in practice.
- Almost all regimes require a calculation of the company’s cost and price levels.
Forms of Regulatory Price Control
Cap
Regulation
Incentive
Regulation
Rate-of-return
Cost-based
Regulation
Regulatory price
controls
Revenue
Cap Price Cap
Revenue
Sharing
Profit
Sharing
Sliding Scale
Regulation
Yardstick
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Introduction to Network Regulation
28 October 2013
Type of Regulation – How should be regulated?
Principle:
Prices / revenues based on operating costs plus “fair” rate
of return on capital (cost recovery principle)
Application:
- Frequent (yearly) regulatory reviews
- Price setting theoretically by the companies, but in
practice regulator often determines prices directly
- Traditional form of regulation (USA)
Primary Objective:
limit profits, prevent companies from pricing above costs
Cost-based Regulation – Rate of Return
Rate-of-Return regulation
Return on Capital
Operating cost + Depreciation
Price
time
Influenced by company
Determined by regulator
Incentives for Efficiency Increase weak
Practicability and Information Requirement medium – high
Regulatory Capture / Gaming high / low
Potential for Over-/Underinvestment overinvestment
Regulatory Risk low
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Introduction to Network Regulation
28 October 2013
Type of Regulation – How should be regulated?
Principle:
Establishes upper limit on prices or revenue
Application:
- Longer regulatory lag and regulatory period (3-5 years)
- Requires explicitly productivity increase via the price
formulas (X factor)
- Allows retention of efficiency gains; should address
quality of supply
Major Forms:
- linked caps (based on projection of capex and opex)
- unlinked caps (formula for adjustment of initial cost
base rather than projection)
Incentive Regulation – Cap Regulation
Incentives for Efficiency Increase medium – strong
Practicability and Information Requirement low - medium
Regulatory Capture / Gaming low / high
Potential for Over-/Underinvestment underinvestment
Regulatory Risk medium
Cap regulation
Actual Cost
Current revenue level
Current revenue + Inflation
Current revenue + Inflation – productivity growth
Efficiency gains
time
Influenced by company
Influenced by company
Set by regulator
Base level
for next
regulatory
period
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Introduction to Network Regulation
28 October 2013
Type of Regulation – How should be regulated?
Principle:
Regulator sets target level of revenues the
company is permitted to keep; sharing scheme for
profits and losses
Application:
- Often together with cap regulation
- Sharing is usually done by adjusting the
allowed revenue for the next regulatory period
Main Objective:
“fair” sharing of profits and risks between
company and customer
Incentive Regulation – Sliding Scale and Yardstick
Incentives for Efficiency Increase medium
Practicability and Information Requirement medium
Regulatory Capture / Gaming medium
Potential for Over-/Underinvestment not clear
Regulatory Risk not clear
Sliding Scale
Principle:
Prices or revenues linked to the costs of a peer
group of companies
Application:
- Companies not allowed to charge higher prices
than the mean of the costs of peer group
- Few cases of practical application (Norway, the
Netherlands)
- Decouples allowed revenue from actual costs
Yardstick
Incentives for Efficiency Increase strong
Practicability and Information Requirement medium - high
Regulatory Capture / Gaming low
Potential for Over-/Underinvestment underinvestment
Regulatory Risk medium
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Introduction to Network Regulation
28 October 2013
Type of Regulation – How should be regulated?
Depending on the degree of coupling between costs and revenues the models using
incentive regulation can be divided into two major groups.
Linked caps (building blocks): UK, Australia, Central and Eastern Europe (Slovenia,
Macedonia, Romania etc.)
- Allowed revenues based on explicit cost projections for the upcoming regulatory period
- Focus on operating cost efficiency and separate checks of capex plans
- Often supported by supplementary schemes: efficiency carry over, sliding scale
Unlinked (decoupled) caps (often yardstick): Germany, Norway, the Netherlands,
Austria
- Allowed revenues based on regulatory formula (no explicit cost projections)
- Hindsight efficiency analysis using benchmarking on total costs including capital costs
- Often supported by supplementary schemes: quantity terms (pre-specified cost drivers)
incorporated in price control formulas, explicit investment allowances and caps on
inefficiency / floors on efficiency
Incentive Regulation – Linked and Unlinked Approaches
19
Introduction to Network Regulation
28 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Regulatory Institutions
6. Regulation in the EU
20
Introduction to Network Regulation
28 October 2013
Regulatory Institutions – Who regulates?
Roles in the Regulatory Process
Primary and Secondary
Legislation
Regulatory Determinations
Licenses (e.g. generation)
Rules (e.g. market rules)
Consultation and Position
Papers
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Introduction to Network Regulation
28 October 2013
Regulatory Institutions – Who regulates?
Key tasks of the regulator:
- Transparent, consistent, predictable regulatory decisions (crucial for regulatory credibility)
- Consultation with stakeholders and communication with interested public
- Collection and conversion of data into regulatory decisions
- Identification of possible problems and solutions
Key prerequisites:
- Clear transparent rules and procedures for the regulator in the legislation
- Legal basis for regulatory independence (in terms of appointment, decision making and
funding) from government and regulated firms
Role of the Regulator
In order to ensure a transparent, consistent and predictable regulatory
framework without lobbying or governmental interventions, the law
must define rules and rights of the regulator and empower him.
22
Introduction to Network Regulation
28 October 2013
Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Institutional Questions
6. Regulation in the EU
23
Introduction to Network Regulation
28 October 2013
Regulation in the EU
Status Quo of the European Electricity Industry
Customer Generator
Generator
Generator
Transmission
Customer
Customer
System
operation
Supplier
Supplier
Supplier
Distribution
Retail
market
Whole-
sale
market
Since 1996 the European Union has been
promoting the establishment of functional
competitive electricity markets.
EU policy objectives: competitive markets,
secure supply and clean environment
Competitive wholesale and retail electricity
supply
Strict unbundling requirements
Regulated network infrastructure, non-
discriminatory network access
Market integration policy
National RES support schemes and
European ETS
Independent national regulators
Regional coordination policy and
institutional framework (framework
guidelines and codes)
24
Introduction to Network Regulation
28 October 2013
Regulation in the EU
Timeline of the EU Electricity Legislation
1998 2003
› Directives 2003/54/EC (Electricity) and Directive 2003/55/EC (Gas)
› Complete market opening (full retail competition – 100% until July 2007)
› Regulated network access (only)
› Legal, functional and informational unbundling
› Creation of independent regulatory agencies
2nd Internal Market Directive 2003
› Directive 96/92/EC (Electricity) and Directive 98/30/EC (Gas)
› Negotiated or regulated third party access (to networks)
› Accounting unbundling
› Market opening – retail competition (first steps – 25% until 1999)
1st Internal Market Directive 1996/1998
1988
› EU Commission working paper
› Aim: Creation of a single European energy market:
– Cross-border transmission and trading
– Liberalisation
– Removal of distortions of competition
Concept of an Internal Market for Energy
› Directive 2009/72/EC (Electricity) and Directive 2009/73/EC (Gas)
› Switching of supplier within 3 weeks
› Roll-out of Smart Metering until 2020 for 80% of household customers
› Tightening of unbundling
3rd Internal Market Directive 2009
1996 2009
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Introduction to Network Regulation
28 October 2013
Regulation in the EU
Revenue cap is the currently the most used price control method; selected countries using
revenue cap: Austria, Denmark, Germany, Great Britain, Ireland, Spain and Sweden
Only a few countries use yardstick regulation: The Netherlands, Norway
Although the general method applied is similar, regulatory regimes may be highly different due
to the concrete features and specification of details
The design of regulatory models have been driven by several factors such as national and
regional energy policy, investment requirements, need for efficiency increase incentives, price
levels in the country, political and social factors and many more.
Also, regulatory regimes in different countries exhibit different degree of maturity:
- UK: 20 years history of price control, cap regulation, regulatory periods of 5 years
- Norway: regulation since 1997, moved from cap to yardstick regulation in 2007
- Netherlands: revenue caps 2001 to 2006, moved to yardstick regulation in 2007
- Germany: started applying revenue caps in 2009
- Austria: since 2006, revenue caps for electricity distribution and rate-of-return for electricity transmission
- Several countries in Central and Eastern Europe: moved to cap regulation in the last few years
Regulatory Price Control in the EU
26
Introduction to Network Regulation
28 October 2013
End of Session 1.
Dr. Konstantin Petrov
Service Line Leader Markets & Regulation / Business Line Director Gas Consulting Services
DNV KEMA Energy & Sustainability
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8
53113 Bonn
Tel: +49 228 44690 56
Fax: +49 228 4469099
Mobile: +49 173 515 1946
E-mail: konstantin.petrov@dnvkema.com
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Introduction to Network Regulation
28 October 2013
www.dnvkema.com
28
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