Consultation on ESB PES’s Price Control 2011-12Consultation on ESB PES’s Supply Price Control 2011-2012 CER/10/130 - 13 Aug 2010 3 Executive Summary This paper examines the internal

Consultation on ESB PES’s Price Control 2011-12

DOCUMENT TYPE:

Consultation Paper

REFERENCE:

CER 10/130

DATE PUBLISHED:

13th August 2010

CLOSING DATE:

10th September 2010

RESPONSES TO:

[email protected]

The Commission for Energy Regulation,

The Exchange, Belgard Square North, Tallaght, Dublin 24. www.cer.ie

CER – Information Page Abstract: The document outlines ESB Customer Supply’s submission for allowed revenue for the period 2011-12. It also sets out the CER’s proposals for the form of price control to be implemented along with the level of allowed revenue to be passed through in regulated tariffs.

Target Audience: This paper is for the attention of members of the public, the energy industry, customers and all interested parties. Related Documents:

• Decision on ESB PES Revenue Regulation Framework - CER10067 • Direction to ESB PES on Allowable Costs 2006 – 2010 - CER05164 • ESB PES Allowable costs for the period 1st October 2009 - 30th

September 2010 - CER09152 Responses to this consultation should be returned by email, post or fax and marked for the attention of Fergus O’Toole ([email protected]) at the CER. The CER intends to publish all submissions received. Respondents who do not wish part of their submission to be published should mark this area clearly and separately or enclose it in an Appendix, stating the rationale for not publishing this part of their comments.

Consultation on ESB PES’s Supply Price Control 2011-2012 CER/10/130 - 13 Aug 2010

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Executive Summary This paper examines the internal supply costs that ESB PES has submitted for the 2011-12 period. The paper sets out how the CER intends to review these costs and what reasonable and efficient costs will be allowed to be passed on to domestic customers through the regulated tariffs. PES submitted to the CER proposed internal supply costs of €115.93 million for 2011 and €111.09 million for 2012 (in 2010 monies) which covers the supply costs for both domestic and business customers. These compare to CER-approved supply costs of €159.8 million for 2010 and €160.32 million for 2009 (in 2009 monies). Since the PES’ business customer segment will become deregulated upon 1st October 2010, the CER must also approve an allocation of the total PES supply costs to its deregulated and regulated customer segments. Of the proposed internal supply costs of €115.93 million for 2011 and €111.09 million for 2012, PES propose to include in regulated domestic tariffs €94.38 million for 2011 and €91.01 million for 2012. The CER has reviewed PES’ proposed allocation of costs between domestic and business segments and finds it to be reasonable. The methodology is consistent with Tariff Methodology Statements previously approved by the CER, and with international practice in tariff setting. The CER has identified no evidence to suggest that regulated domestic customers will be cross-subsidising the newly-deregulated business customers. Based on a detailed review and analysis of the PES submission, the CER finds the majority of the applied for supply costs to be reasonable, efficient and necessary for the fulfilment of the role of Public Electricity Supplier and compliance with the associated licence conditions. The CER further finds these levels of cost to be reasonable when compared to those observed in a fully competitive market such as Great Britain, where a study of supply cost was recently performed by Ofgem, taking into account the differences between the two regulatory regimes. The CER does not, however, accept that all elements of the PES proposal contain reasonable, efficient and necessary levels of cost. In particular, the CER will make every effort to ensure that, in the difficult economic circumstances, efficiencies are being made and passed along to consumers. Specifically, the CER is proposing to reduce the allowed level of cost in the following areas:

• Capital expenditures associated with IT investments expected to be made by ESB Customer Supply as part of its transition to a deregulated supply company which impacts the level of depreciation allowed over the period; (Reduction of; €0.44 million)


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• Payrolls in excess of existing levels. The CER proposes to reduce payroll costs in line with ESRI forecast nominal wage decreases and in line with expected productivity gains. (Reduction of; €3.21 million)

• Sales and advertising costs. The CER proposes to disallow an increase in sales and advertising cost which has been applied for and to allow costs at pre-2010 levels. (Reduction of; €1.11 million)

• Bad debts. In order to incentivise PES to reduce the level of bad debt the CER is proposing to allow PES to recover bad debts at 1% of forecast turnover and not the 1.6% applied for. (Reduction of; €7.38 million)

• ESB Corporate Centre, SLAs & Inter Business Unit Costs. The CER proposing that an incentive should be incorporated into the allowance based on a productivity increase of 2.5% per annum. (Reduction €2.04million)

Once these cost elements are excluded, the CER proposes to approve internal supply costs of €87.81 million in 2011 and €83.78 million in 2012 for inclusion in the Maximum Allowed Revenue (CER 10/0671). As in prior controls, the CER will approve these for a base year (2010) and thereafter will link changes in allowed costs to inflation. Further, in prior controls PES has been allowed to track “uncertain costs” (i.e., costs outside the control of PES such as the CER levy or SEM-related investments) and has been allowed to recover these at levels deemed reasonable and efficient by the CER. For this price control, the CER will not allow uncertain costs for the 2011 allowed revenue. For 2012, the CER will consider any submission made by PES in advance of setting the 2012 allowed revenue, for costs arising outside of its control. The CER is proposing to continue the incentive payments and penalties associated with the performance at the National Customer Contact Centre (NCCC). However the total reward or penalty will be allocated between regulated and deregulated customers in a manner consistent with other cost areas, ensuring that costs relating to deregulated customers are not attributed to the regulated customer base. In previous reviews, revenue under or over recoveries were allowed for in the regulated supply costs through a correction or K-factor. Revenue surpluses were refunded to customers and revenue shortfalls recovered through tariffs. However in an increasingly competitive market, the allocation of K-factors becomes increasingly complex, potentially having negative consequences for consumers and impacting on competition. Recognising this, the CER issued a decision in 2008 which stated that K-factors should not be included in tariffs where they have a negative impact on competition2. In 2009 the CER also consulted on the future

1 Decision on ESB PES Revenue Regulation Framework - CER10067 2 Treatment of K-factors in Retail Tariffs-Letter to ESB CS – CER08049


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application of K-factors in regulated tariffs3. Further to that consultation the CER has largely eliminated the mechanism from the regulatory framework that will be applied to PES during 2011/12, moving to an ex-post review of revenue that requires in year adjustments to avoid the accumulation of K-factors. PES has projected a significant accumulated K-factor to 30th September 2010. Much of this under recovery has accrued due to a general reduction in overall electricity demand, but a significant proportion is attributable to PES losses due to increased customer switching. As a regulated supplier, PES is allowed to recover its reasonably incurred costs. Regulatory controls are intended to provide the correct package of incentives to drive efficiencies in the regulated company, to reflect how an efficient supplier would behave in a competitive market, to the benefit of consumers. The CER is mindful that the application of the carryover from the current price control does not create unintended consequences, such as electricity prices being artificially raised above an efficient level, due to a fall in demand or increased competition. The CER considers that this would constitute a perverse economic logic, and notes that all businesses have had to react to this difficult economic climate, cutting costs to address reductions in consumer demand. The application of the accumulated K-factors to a diminished regulated customer base would present a disproportionate burden on consumers at this time. Therefore the CER proposes not to include any K-factors in the 2010/11 regulated tariffs. Recognising that a proportion of the costs may have been legitimately incurred in the context of the prevailing regulatory framework, the CER will give further consideration to potential recovery mechanisms to ensure that ESBCS is not unduly disadvantaged in an increasingly competitive market. In its Decision on ESB PES Revenue Regulation Framework, the CER determined that a supply margin of 1.3% continues to be appropriate for 2011 and 2012. As in prior controls, this supply margin will be considered part of PES’ “allowed revenue” and will be calculated based on outturn costs on an ex post basis. At the conclusion of the 12 month MAR review period, the CER will perform a detailed ex post review of PES’ tariff revenues and the MAR formula. The margin for the 2010/11 period will be included as part of this consultation. Insofar as PES remains regulated for the 2011/12 tariff period, the CER will also perform a detailed ex post review of PES’ tariff revenues and the MAR formula for that period and a review of the margin will be incorporated into this. The CER will not publish consultations on Internal Supply Costs for the 2010/11 and 2011/12 periods. Instead, the CER will conduct a detailed ex post review of PES’ tariff revenues and the application of the MAR formula.

3 Information Note - Review of K Factors and Supply Margins and Tariff Structures - CER09203


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Table of Contents Executive Summary .............................................................................................. 3 1.0 Introduction ..................................................................................................... 8

1.1 The Commission for Energy Regulation ...................................................... 8 1.2 Purpose of this paper ................................................................................... 8 1.3 Background Information ............................................................................... 8 1.4 Structure of this paper ............................................................................... 10 1.5 Responding to this paper ........................................................................... 10

2.0 Regulatory Background ................................................................................ 11 2.1 Introduction ................................................................................................ 11 2.2PES Supply Price Control 2006 - 2010 ....................................................... 12 2.3 Elements of Revenue Regulation Framework for 2011-2012 .................... 13 2.4 PES Allowed Revenue Review for the 2011-12 Period ............................. 13

3.0 Form of Price Control .................................................................................... 15 3.1 Introduction ................................................................................................ 15 3.2 Ex ante Approval of Supply Costs ............................................................. 15 3.3 Formula for Adjusting Supply Costs from Year to Year ............................. 15 3.4 Inflation ...................................................................................................... 16 3.5 Incentive Mechanisms ............................................................................... 18

3.5.1 Continuation of Incentive Mechanisms ................................................ 19 3.6 Uncertain Costs ......................................................................................... 19 3.7 Margin ........................................................................................................ 20 3.8 Treatment of 2010 Allowed Revenue ......................................................... 20 3. 9 Treatment of Accrued K-factor .................................................................. 20

3.9.1 Accumulation of K-factors .................................................................... 21 3.9.2 Treatment of Accumulated K-factors ................................................... 22

4.0 CER Review of PES Supply Costs ............................................................... 24 4.1 Approach ................................................................................................... 24 4.2 Scope of the Review .................................................................................. 24 4.3 Conduct of the Review Process ................................................................. 25

5.0 Underlying Assumptions ............................................................................... 26 5.1 Customer Numbers .................................................................................... 26 5.2 Projected Efficiency Gains ......................................................................... 27 5.3 Regulated/Unregulated Costs Separation ................................................. 28

6.0 Operational Expenditure ............................................................................... 30 6.1 Proposed OPEX ........................................................................................ 30 6.2 Review of OPEX ........................................................................................ 31 6.3 Historic OPEX review ................................................................................ 32 6.4 Payroll ........................................................................................................ 33 6.5 Contractors ................................................................................................ 35 6.6 Materials for Goods and Service ................................................................ 35 6.7 Transport & Communications .................................................................... 35 6.8 Establishment ............................................................................................ 36 6.9 Computer ................................................................................................... 36 6.10 Selling & Advertising ................................................................................ 36


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6.11 Professional Fees .................................................................................... 37 6.12 Depreciation ............................................................................................ 37 6.13 Bad Debts ................................................................................................ 37 6.14 ESB Corporate Centre, Service Agreements & Inter Business Unit Costs ........................................................................................................................ 38 6.15 Uncertain Costs ....................................................................................... 40

7.0 Conclusions and Next Steps ......................................................................... 41 7.1 Summary of Proposed Allowed Revenue 2011 & 2012 ............................. 41 7.2 Summary of Proposed Allowed Revenue for 2010/11 MAR ...................... 41 7.3 Stakeholder Responses and Next Steps ................................................... 42


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1.0 Introduction

1.1 The Commission for Energy Regulation The Commission for Energy Regulation (‘the CER’) is the independent body responsible for overseeing the regulation of Ireland's electricity and gas sectors. The CER was initially established and granted regulatory powers over the electricity market under the Electricity Regulation Act, 1999. The enactment of the Gas (Interim) (Regulation) Act, 2002 expanded the CER’s jurisdiction to include regulation of the natural gas market, while the Energy (Miscellaneous Provisions) Act 2006 granted the CER powers to regulate electrical contractors with respect to safety, to regulate to natural gas undertakings involved in the transmission, distribution, storage, supply and shipping of gas and to regulate natural gas installers with respect to safety. The Electricity Regulation Amendment (SEM) Act 2007 outlined the CER’s functions in relation to the Single Electricity Market (SEM) for the island of Ireland. This market is regulated by the CER and the Northern Ireland Authority for Utility Regulation (NIAUR). The CER is working to ensure that consumers benefit from regulation and the introduction of competition in the energy sector. S.I. No. 60 of 2005, European Communities (Internal Market in Electricity) Regulations, 2005 outlined the functions of the CER.

1.2 Purpose of this paper The purpose of this paper is to seek the views of the public and the CER’s stakeholders with regard to the form of price control proposed along with the level of Allowable Costs for ESB Customer Supply (ESBCS), the Public Electricity Supplier (PES) for the period 2011-2012. In order to make an informed and impartial decision on this topic, the CER wishes to obtain comments from members of the public, the energy industry, customers and all interested parties. The CER commits to considering all views equally and affording each respondent the opportunity to clarify any issue raised in this paper.

1.3 Background Information The CER imposes separate revenue controls on each of ESB’s regulated businesses, namely, Transmission Asset Owner (‘TAO’), Distribution System Operator (‘DSO’) and PES. In addition, the CER regulates the revenue recovered by EirGrid, the independent state-owned body licenced by the CER to act as the Transmission System Operator (‘TSO’).


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The first 5-year price control imposed on the ESB PES business unit commenced in 2001 and concluded at the end of December 2005. Early in 2005, the CER undertook to develop a revenue control to apply to the supply businesses for the next 5-year period, from 2006 to 2010. This involved a thorough analysis of PES’s submission on costs of supplying electricity to customers over this period. Following a consultation period and thorough analysis of the data, the CER’s published its final decision on ‘allowable’ costs and form of revenue control to apply for the business over this 5 year period4. The form of revenue control determines the nature of control placed on the business (e.g., a cap on revenues recovered from customers or a cap on prices charged to customers). It also sets out an efficient level of revenues (made up of allowed operating costs, depreciation charges on capital expenditure (derived from the allowable CAPEX) and an allowable margin) that can be recovered by the business from its customers in a particular operating period. For the second 5-year control period, from 2006 to 2010, the CER decided to allow the PES business a total of €585.8m in allowable costs (in 2004 values). Last year the CER conducted the final review5 under the 2006-2010 revenue control period. During this process the CER examined the appropriateness of using the 2006-2010 regulatory formula given the fall in overall market demand and the impact of increased competition in the domestic market. In April 2010, the CER published its decision on the deregulation of the Irish retail electricity market. The ‘Roadmap6’, set out the competitive milestones for when specific market segments would be deregulated, ceasing the obligations of a price control, with regulated tariffs, on PES. The detailed competition review, published in parallel, concluded that all business markets would be deregulated from 1st October 2010 and that the CER would continue to monitor competition to determine when the threshold for deregulation in the domestic market has been met. In parallel to the Roadmap consultation process, the CER published a decision paper7 setting out the CER’s decision with respect to the regulatory arrangements that will apply from 1st October 2010 for the regulated domestic market. Recognising the increased level of competition in the Irish retail electricity market, changing market dynamics, and the progressive transition to a fully deregulated market, this paper set out the form of price control to apply and defined a Maximum Allowable Revenue to be calculated on an ex post basis. The CER is committed to retaining appropriate regulatory controls to support competition and protect domestic consumers. Tariffs will continue to be set on a

4 2006-2010 ESB Price Control Review PES Report – CER05164 5 ESB PES Allowable costs for the period 1st October 2009 - 30th September 2010 - CER09152 6 Roadmap to Deregulation - CER10058 7 Decision on ESB PES Revenue Regulation Framework - CER10067


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cost reflective basis, in a transparent framework with continued regulatory oversight.

1.4 Structure of this paper

• Section 1 Provides an introduction to the revenue review. • • Section 2 Outlines the background for the current regulatory review.

• Section 3 Sets out the elements of the proposed price control.

• Section 4 Sets out the CER’s approach to the review process

• Section 5 Examines the reasonableness of the underlying assumptions

included in the calculation of PES allowed supply costs.

• Section 6 Examines PES’s historical and forward looking OPEX

• Section 7 Sets out the conclusions and next steps

1.5 Responding to this paper Interested parties are invited to comment on the issues raised in this paper this consultation paper by close of business on Friday 10th September 2010. As responses will be published in full on the CER’s website, respondents should include any confidential information in a separate Annex. Submissions on this paper should be forwarded, preferably in electronic format, to: Fergus O’Toole Commission for Energy Regulation, The Exchange, Belgard Square North, Tallaght, Dublin 24. E-mail: [email protected] Participants are encouraged to explain their positions and the rationale for these positions. Responses that provide rationale will be accorded more weight.


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2.0 Regulatory Background

2.1 Introduction The CER has stated that its goal is to have in place fully competitive and deregulated markets in all segments of the electricity retail market. This is supported by policy coming from the EU, which purports that effective competition is likely to be superior to regulation and thus where markets are effectively competitive the replacement of end user retail tariff regulation is a desirable outcome. The CER considers that a fully competitive retail market can bring real benefits to consumers in terms of the choice and quality of the offers available from suppliers, improved value-added services and potentially lower prices. However the CER intends to keep regulation in place for market segments that do not meet the criteria for deregulation currently being consulted upon as part of the CERs roadmap for the deregulation of the market. The CER proposes to retain regulatory control over those markets that are not deemed to be competitive for the following three reasons: 1. Consumer Protection

To prevent a dominant undertaking (or collectively dominant undertakings) from extracting economic (monopoly) rents through excessive pricing.

2. Encouraging efficiency

In the absence of meaningful competition, regulation can provide the right incentives for rewarding success and penalising failure. Thereby encouraging regulated entities to act efficiently and in the best interest of final customers.

3. Promotion of Competition Proper regulation prevents exclusionary prices that discourage efficient entry by setting retail prices too low in the short term. Through regulation the right market dynamics and price indicators can be put in place in order to encourage new, efficient market entrants.

Where market segments are not deemed to be fully competitive the CER must maintain some form of regulation in order to ensure that consumer protection, efficiency and the promotion of competition. In addressing how this should be done the CER has considered a number of options as to the form of price control to adopt, taking into account the shortcomings of the previous price control, changing market dynamics and the recommendations coming from the 2009 review of K-factors and supply margins.


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2.2PES Supply Price Control 2006 - 2010 The current regulatory control follows on from the prior control for the PES, covering 2006-2010. In 2005 the CER determined the allowed revenues for the 2006-2010 price control. The price control formula is in its final year and concludes on the 31st of December 20108. The 2009 decision on PES allowed costs and revenues for the current tariff period9 concludes on 30th September 2010 and therefore the CER must determine the appropriate costs for the coming period.

The current model for tariff and revenue regulation is based on ex-ante review and analysis of all elements of the price control. The maximum PES revenue formula is set out below;-

Max PES Rev = Base Revenue*(1 + CPI Infl Rate ‐ Efficiency Factor) + Margin + Uncertain Costs + Incentive + Kt-1 + Kt-2

The correction factor, which allows for over and under recovery, was a key element of the price control where;

Kt was the correction factor applying in year t to under or over recovery in year t-1 and was to be determined by the CER on an annual basis. The then three-month Euribor rate was applied to the correction. The correction factor was applied to both the determinants of the PES’s own costs and to any over or under recovery in respect of PES upstream costs. The correction factor also included adjustments for under or over recovery in respect of the components of INCENTt. Kt was determined based on estimated or actual values for each component of Rt and the PES upstream revenue available at the time determined by the CER for PES providing such information in year t in respect of year t-1.

Kt-1 was the correction factor applying in year t-1 to under or over recovery in year t-2 this amount to be determined by the CER on an annual basis. The then three-month Euribor rate was applied to the correction. The correction factor applied to both the determinants of the PES’s own costs and to over or under recovery in respect of PES upstream costs. The correction factor also included adjustments for any under or over recovery in respect of the components of INCENTt. Kt-1 was determined based on estimated or actual values for each component of Rt-1 and the PES upstream revenue available at the time determined by the CER for PES providing such information in year t-1 in respect of year t-2.

8 Allowed revenue was originally calculated on a calendar year basis and then adjusted when the SEM tariff year was aligned with Northern Ireland from 1st October – 30th September. 9 ESB PES Allowable costs for the period 1st October 2009 - 30th September 2010 - CER09152.


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2.3 Elements of Revenue Regulation Framework for 2011-2012 There are two key elements that must be considered in implementing changes to the current regulatory framework, which will serve as the interim arrangements until such time as the market is deregulated in full;

(i) Regulatory Formula

(ii) Internal Supply Costs Review.

In May 2010 the CER published a decision paper10 setting out the Revenue Regulation Framework, including the Regulatory Formula. This paper set out the CER’s decision with respect to the regulatory arrangements that will apply from 1st October 2010 for the regulated domestic market. The CER’s decision changes the form of price control to apply and defines a Maximum Allowable Revenue to be calculated on an ex post basis

The form of revenue control determines the nature of control placed on the business (e.g., a cap on revenues recovered from customers or a cap on prices charged to customers). It also sets out an efficient level of revenues (made up of allowed operating costs, depreciation charges on capital expenditure derived from the allowable CAPEX, and an allowable margin) that can be recovered by the business from its customers in a particular operating period (usually a calendar year). The revenue control can also incorporate incentives for the regulated entity to improve both productive efficiency and customer service performance levels.

This paper examines the Internal Supply Costs that PES has submitted for the 2011-12 period. The CER is setting out how it intends to review these costs and what reasonable and efficient costs will be passed on to domestic customers through the regulated tariffs.

2.4 PES Allowed Revenue Review for the 2011-12 Period The CER considered a number of options when considering the form of price control to apply during 2011-2012. One option that was considered was to maintain the status quo. This would involve maintaining the existing regulatory formula, and reflecting falling demand and diminishing customer numbers in the Kt-1 and Kt-2 K-factor adjustments. The shortcomings of the existing regulatory formula were analysed in detail in CER 10/067. In that Decision, the CER rejects the status quo because it does not sufficiently advance the price control process to take account of changing market conditions.

10 Decision on ESB PES’s Revenue Regulation Framework – CER10067


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CER 10/067 outlines a new revenue regulation framework, which relies on a maximum allowable revenue fixed on an ex-post basis. This new framework promotes competition and brings the system of regulation closer to that of a deregulated market, minimising the impact of the K-factor.


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3.0 Form of Price Control

3.1 Introduction As specified in CER/10/067, for the 2010/11 tariff period,11 the CER will apply a regulatory control to PES based on an ex post determination of maximum allowable revenue (MAR). The formula below illustrates the cost components involved in calculating the MAR, which includes the supply costs addressed in this paper.

MAR (Domestic Customer Category) = Wholesale Generation Costs + Network Charges + Supply Costs + Allowed Margin + PSO Costs

In the prior control period, the CER defined “Allowed Revenue” to include operating expenditure (OPEX), depreciation charges on capital expenditure (derived from the allowable CAPEX) as well as the allowed margin. Allowed revenue also included a customer service incentive payment or penalty linked to the performance of the National Customer Contact Centre. In the 2011-2012 control period, the cost elements that had previously been grouped into “Allowed Revenue” (i.e., supply costs and allowed margin) will be addressed individually through the MAR formula, as further explained in this section.

3.2 Ex ante Approval of Supply Costs This consultation paper sets out the CER’s proposed allowance for Internal Supply Costs for 2011 and 2012. As in prior controls, the supply costs will be approved in advance of the tariff period. The ex ante approval of OPEX charges and allowable CAPEX allows PES to benefit from “regulatory lag” and encourages PES to pursue efficiency-enhancing measures.

3.3 Formula for Adjusting Supply Costs from Year to Year In previous price reviews the CER has developed a control formula in order to capture the year on year adjustments and K-factors. However due to the shorter time period for the 2011-12 price control and the removal of the K-factor adjustment, a specific price control formula of this nature is no longer required.

11 The revenue control will also apply to the 2011/12 period if the domestic sector is not deregulated before then.


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In prior controls, the formula allowed PES to accrue K-factors. PES was allowed to refund revenue surpluses to customers and to recover revenue shortfalls. The CER has largely eliminated this mechanism from the regulatory framework that will be applied to PES during 2011 and 2012 through its decision on ESB PES’s Revenue Regulation Framework. The decision set a +/-3% band around the ex post MAR where over-recoveries within the 3% band are retained by PES, but any excess beyond 3% are applied as a reduction to the following years MAR. Any under-recoveries within the 3% band are applied as an increase to the following years MAR, but any shortfalls beyond 3% are lost to the PES. The final decision resulting from this consultation will set the allowed supply costs for 2011 and 2012. In any subsequent reviews there will be an adjustment for inflation and the inclusion of any necessary uncertain costs. The CER will consult on all subsequent annual revenue reviews.

3.4 Inflation The approach taken by the CER in approving the allowed supply costs for the period 2006 – 2010 was to set allowed costs for a base year and thereafter to link changes in allowed costs to inflation. As noted above, the CER proposes to maintain this approach for the 2011 – 2012 period. In the 2006 to 2010 revenue review the CER indicated that Harmonised Index of Consumer Prices (HICP) would be used however, in practice the Consumer Price Index (CPI) was used. The change from using CPI was not explicitly raised in the consultation or determination papers. Also the revenue formula referred to CPI as the index, while the definitions of CPI in the paper referred to HICP. Given the confusion the CER decided to continue to use CPI as the index. However, as part of this review the CER has decided to re-examine this issue. The following items, which constituting approximately 9.5% of the CPI expenditure weighting, are excluded from the HICP: • mortgage interest; • building materials; • concrete blocks; • union subscriptions; • motor car insurance (non-service); • dwelling insurance (non-service); • motor car tax; and, • motor cycle tax.

The inclusion of mortgage interest in CPI means that the index is affected by changes in the European Central Bank (ECB) interest rate and house prices. Figure 3.4 illustrates the movement of the CPI, HICP and ECB interest rate. The


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indices generally follow the same path. However significant divergence occurs when there are large changes in the ECB interest rate. Recent changes to the ECB interest rate have introduced significant volatility into the CPI.

Source: CSO, ECB Figure 3.4 - HICP, CPI and ECB interest rate

It is questionable whether the pressures on costs have followed the volatility that the CPI has experienced. From highs of +5% in March 2008 to lows of -6.5% in September 2009; the corresponding HICP was +3.7% in March 2009 and -3% in September 2009. This volatility has significant impacts on the charges paid by the final customer and on the revenue that the PES business has to cover its costs. The CER is of the view that using a consumer focused inflation index is preferable and that the HICP is a more appropriate index to use as it is more likely to be less volatile. Stable business revenues will benefit both the final customer and the PES business. Therefore, the CER proposes to use HICP as the inflation index for the 2011-12 period. This will be applied for all future revenue reviews within the period.


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3.5 Incentive Mechanisms During the last revenue control PES was incentivised to improve the quality of the service provided to customers that utilised its National Customer Contact Centre (NCCC). The four specific measurements related to:

• Speed of Telephone Response; • Call Abandonment Rate; • Mystery Caller survey results; and, • Customer Call-Back survey results.

The incentive mechanism captures the value of any penalties or payments in respect of PES’s level of customer service against specific targets set out in two separate incentive mechanisms applied to the ESB Call Centre and PES Customer Charter12. The Customer Charter incentive mechanism has been operational since 1st June 2008 while the Call Centre mechanism, was implemented in 2006. PES actively responded to the performance improvement incentives within the mechanism and significantly improved on the metrics listed above. Recognising the importance of suppliers providing a high quality of customer service, the CER is of the view that the incentive mechanisms put in place in order reward or penalise PES for its performance in this regard should be continued. The reward or penalty allowed in 2011 is based on the performance of PES’s NCCC in 2009 and as a percentage of the allowed revenue in that year. Analysis of 2009 PES accounts, as highlighted in Section 5.3, shows that 90% of operational costs in 2009 can be attributed to the domestic side of the business with the remaining 10% of costs being incurred by the business market side. Therefore the CER is proposing only to allow 90% of the maximum reward or penalty to be included in regulated tariffs from 1st October 2010. This maintains a consistent approach and ensures that costs relating to deregulated customers are not attributed to regulated customers. Percentage targets are set for each of the following categories; speed of telephone response, abandonment rate, mystery shopper calls and a call back survey. In 2009 PES scored above the targets in each of the categories. As a result, PES earned the maximum reward payment of €431,275 for call centre performance in 2009. Thus, reducing this to the 90% level, the value of this incentive term for 2011 is €388,148.

12 For further detail on each of these mechanisms please see the Commission’s Decision paper CER/06/107.


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3.5.1 Continuation of Incentive Mechanisms The incentive mechanism resulted in an improvement in the PES’s performance over the past number of years and as a result the CER is proposing to continue to apply the mechanism in much the same manner. The performance targets are to be kept at 2010 levels, the only change being in the application of the maximum reward and penalty. In previous years the allowed margin has been included in the allowed revenue figure, but from 2010 onwards the CER is proposing to calculate rewards/penalties on the allowed revenue, excluding margin. The CER will continue to assess PES’s performance with regard to incentive mechanisms and include the reward or penalty in subsequent MARs. Table 3.5.1 sets out the targets and forecast maximum penalty and rewards over the next few years. Year 2009 2010 2011 2012

Weights TargetsSpeed of Tel Response 30% 80% 83% 83% 83%Abandonment Rate 30% 5% 5% 5% 5%Mystery Caller 20% 80% 80% 80% 80%Callback Survey 20% 80% 80% 80% 80%

Allowed Revenue 155,259,000€ 115,248,600€ €87,644,000 €83,783,000 Max. Penalty 1.00% 1,552,590€ 1,152,486€ 876,440€ 837,830€ Max. Reward 0.25% 388,148€ 288,122€ 219,110€ 209,458€

Table 3.5.1 – Forecast Maximum Incentive Mechanism Rewards/Penalties

3.6 Uncertain Costs In recent years the allowed revenue formula has incorporated an ‘Uncertain Costs’ term. This term captures PES uncertain costs, as approved by the CER, relating to costs arising primarily outside of the PES’s control. For example, changes to the CER levy or changes in CER policy that affect (both positively and negatively) PES costs. There are no uncertain costs allowed for the 2011 period and while the CER does not envisage that there should be any uncertain costs in 2012, it will consider submissions from PES in advance of setting the 2011/12 tariffs, for costs arising outside of their control and if they are deemed reasonable they may be included in the final allowed revenue for 2012.


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3.7 Margin For the purpose of calculating the 2010/11 MAR the margin is set at 1.3% and will be calculated based on outturn costs on an ex post basis. Outturn costs are calculated from outturn demand, outturn SMPs, capacity costs, network charges, and SEM charges. For the purpose of calculating the 2010/11 regulated tariffs on an ex ante basis the margin will be calculated using forecasts and this will be done closer to 1st October 2010 when the 2010/11 tariffs come into effect. Therefore, the margin calculation will not be consulted on as part of this consultation process and nor will it be included in the final decision on allowed revenue for the 2011-12 period. At the conclusion of the 12 month MAR review period, the CER will conduct a detailed ex post review and consultation on PES tariff revenues and the MAR formula. The margin for the 2010/11 period will be included as part of this consultation.

3.8 Treatment of 2010 Allowed Revenue In the CER’s decision paper on ESB PES Allowable Costs for 2009-201013 the allowed revenue for 2010 was set at €159.77m. Of this total figure, 75% has been included in the 2009/10 PES regulated tariffs. The remaining 25% or €39.94m would normally be included in the 2010/11 regulated tariffs. However, following the deregulation of the business markets, the regulated tariffs for 2010/11 will cover domestic customers only. Therefore the inclusion of the full €39.94m would be inappropriate. In order to bring the 2010 supply costs in line with the methodology being adapted under the new regulatory formula we must first remove the supply margin from last year’s total figure of €159.77m. The supply margin included in that total figure (including inflation) was €25.76m. 75% of this supply margin is being recovered during the current tariff period, and it is necessary to remove the remaining 25% from the €39.94m which leaves €33.50m. Analysis of PES accounts, as highlighted in Section 5.3, shows that 86% of operational costs can be attributed to the domestic side of the business with the remaining 14% of costs being incurred by the business market side. Therefore the CER proposes to include 86% of the €33.50m in the 2010/11 regulated tariffs. This results in a proposed total of €28.81m being included in the 2010/11 MAR.

3. 9 Treatment of Accrued K-factor

Revenues earned from regulated tariffs can be higher or lower than (allowable) outturn costs. A correction or K-factor is the term used in the 2006-2010 price control formula to allow for any under or over recovery to be included in future

13 ESB PES Allowable costs for the period 1st October 2009 - 30th September 2010 CER09152


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years’ tariffs. However in an increasingly competitive market, the allocation of K-factors becomes increasingly complex, potentially having negative consequences for consumers and impacting on competition. Recognising this, the CER issued a decision in 2008 which stated that K-factors should not be included in tariffs where they have a negative impact on competition14. In 2009 the CER also consulted on the future application of K-factor in regulated tariffs15. Further to that consultation the CER has largely eliminated the mechanism from the regulatory framework that will be applied to PES during 2011/12, moving to an ex-post review of revenue that requires in year adjustments to avoid the accumulation of K-factors. This section deals with the accumulation of K-factors, with reference to the dramatic changes to the electricity retail market over the past 18 months.

3.9.1 Accumulation of K-factors In its review of PES’s allowed revenue for 2009/10 the CER provided a breakdown of K-factors totalling €81.15m that were included in the PES submission. These K-factors were driven primarily by; (i) overall reduction in demand as a result of the economic downturn; (ii) demand reduction as a result of customer losses; (iii) increased capacity charges arising from lower all island demand and (iv) increased energy purchase costs arising from changes in the application of loss factors. In coming to its final decision16 on the treatment of K factors at that time, the CER made a number of observations:

• That by allowing PES to recover the K-factors, it would have meant that it would be effectively insulated from the changes in the market place.

• The fact that it would be unreasonable if customers paid higher costs because of increased customer switching.

• The exceptional downturn in the country’s economic circumstances at that time.

• Having reviewed the average cost of supply over the previous number of years, the CER noted that the cost of supply in the 2009/10 tariffs (excluding K-factors) was more closely in line with allowances included in earlier years. In other words, efficient competition in the retail sector was not impacted by the exclusion of K-factors.

• In a market where overall demand, and PES’s demand in particular, was falling, the K-factor model was no longer appropriate.

14 Treatment of K-factors in Retail Tariffs-Letter to ESB CS – CER08049 15 Information Note - Review of K Factors and Supply Margins and Tariff Structures - CER09203 16 ESB PES Allowable costs for the period 1st October 2009 - 30th September 2010 - CER09152


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Taking these factors into consideration, the CER made the decision that the €81.15m K-factor under-recovery would not be recouped in the 2009/10 PES tariffs. At that time the CER did commit to reviewing whether K-factors deemed appropriate should be included in future tariff periods. Following on from last year’s decision, PES has projected an accumulated K-factor to 30th September 2010 of €173.8m. This figure includes the €81.15m from the previous period as well as additional K-factors accumulated over the subsequent 12 months.

3.9.2 Treatment of Accumulated K-factors In an increasingly competitive market, the allocation of K-factors becomes increasingly complex, potentially having negative consequences for consumers and impacting on competition. Recognising this, the CER issued a decision in 2008 which stated that K-factors should not be included in tariffs where they have a negative impact on competition17. In 2009 the CER also consulted on the future application of K-factors in regulated tariffs18. Further to that consultation the CER has largely eliminated the mechanism from the regulatory framework that will be applied to PES during 2011/12, moving to an ex-post review of revenue that requires in year adjustments to avoid the accumulation of K-factors. In deliberating over the appropriate approach for the recovery of all or part of the projected €173.8m, the CER must take into consideration the market structure, as well as what is in the best interests of both customers and suppliers. There have been a number of significant changes to the Irish electricity market over the past 18 months. Aside from the general reduction in overall electricity demand, the growth of competition, has resulted in large numbers of customers switching from PES to independent suppliers, this is particularly evident in the domestic market where independent suppliers had acquired a 25%19 share of domestic customer numbers by the end of Q1 2010. In April 2010, the CER published the Roadmap paper20 which set out the criteria for retail market deregulation, and the decision that all business markets would be deregulated from 1st October 2010. Therefore from the 1st October 2010 only PES domestic customers will have regulated tariffs. As a regulated supplier, PES is allowed to recover its reasonably incurred costs. Regulatory controls are intended to provide the correct package of incentives to drive efficiencies in the regulated company, to reflect how an efficient supplier would behave in a competitive market, to the benefit of consumers. The CER is mindful that the application of the carryover from the current price control does

17 Treatment of K-factors in Retail Tariffs-Letter to ESB CS – CER08049 18 Information Note - Review of K Factors and Supply Margins and Tariff Structures - CER09203 19 Competition Review Q2 2010 CER10116 20 Roadmap to Deregulation CER10058


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not create unintended consequences, such as electricity prices being artificially raised above an efficient level, due to a fall in demand or increased competition. The CER considers that this would constitute a perverse economic logic, and notes that all businesses have had to react to this difficult economic climate, cutting costs to address reductions in consumer demand. The application of the accumulated K-factors to a diminished regulated customer base would present a disproportionate burden on consumers at this time. Therefore the CER is proposing not allow for the inclusion of any K-factors in the 2010/11 regulated tariffs. Recognising that a proportion of the costs may have been legitimately incurred in the context of the prevailing regulatory framework, the CER will give further consideration to potential recovery mechanisms to ensure that ESBCS is not unduly disadvantaged in an increasingly competitive market.


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4.0 CER Review of PES Supply Costs

4.1 Approach Reflecting the range of analysis required the CER has acquired the services of NERA Economic Consulting to assist in the review of PES’s historic and forecast costs. To conduct their review NERA first examined the supply costs and evaluated whether the total supply costs for the PES “enterprise” were reasonable and efficient. The steps involved in this process included the following:

1. An analysis was first undertaken to evaluate PES’s performance over the previous review period to determine whether or not (a) expected efficiencies in OPEX were achieved and (b) any efficiency improvements in the controllable OPEX were achieved. This analysis also sought to identify where any over/under spend had occurred. In addition, any accounting or financial issues were identified, with a view to avoiding any difficulties that these might present at the next review.

2. The historical OPEX analysis and trends found were used as background to the assessment of the forward-looking OPEX. The forward-looking OPEX, as proposed by PES, was benchmarked against comparable companies, and checked for consistency with the trend over the first control period.

3. NERA then performed a third step, which involved assuring that the allocation between regulated and unregulated customers is reasonable.

Further details on the PES supply costs submission and the analysis conducted is provided in the following sections.

4.2 Scope of the Review The review is focused on the regulated aspects of the PES’s activities and in undertaking the review the CER has taken into account:

• Transfers of costs and revenue between businesses • The allocation of corporate centre costs and overheads to PES. • The deregulation of business markets and the separation of PES costs

between the regulated and deregulated sections.


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4.3 Conduct of the Review Process The review process has been carried out in as transparent a manner as possible so as to ensure there is clarity as to the underlying data and assumptions as well as the analysis itself. The review has followed the following steps:

• Following discussions with PES on the feasibility and form in which the data could be provided, a detailed questionnaire was prepared and issued to PES. The questionnaire set out the technical, economic and financial data required by the CER along with deadlines for the provision of resources.

• PES then completed the questionnaire in two stages: providing historic data first and then progressing to forecast information. There was a period during which clarifications and further information was sought from PES.

• The CER and its consultants then analysed the final data set to determine the appropriate regulated revenue to apply to PES for the period 2006 to 2010. During this period, a number of clarifications were sought from PES in order to verify various aspects of the data.


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5.0 Underlying Assumptions This section addresses the reasonableness of the underlying assumptions included in the calculation of PES allowed supply costs for the 2011-12 period.

5.1 Customer Numbers Table 5.1 below shows the actual figures for numbers of customers served by PES as well as the volume of regulated Units Supplied in each year. In addition the table shows the forecast figures for the 2010-2012 period which PES have included as part of its submission. This provides a breakdown of customer numbers into the regulated domestic customer numbers and the unregulated business customer numbers.

Actual ForecastDomestic (Regulated) 2006 2007 2008 2009 2010 2011 2012

Number of Customers 1,767,901 1,877,733 1,946,706 1,776,641 1,434,662 1,211,568 1,069,742

Units Supplied (GWh) 8,322 8,663 9,027 7,815 6,232 4,876 4,061 Table 5.1 – PES Customer Numbers & Energy Supplied

PES estimates that both the number of customers and use per customer will decline through 2012. Table 5.1 above shows that by 2012 the total number of customers served by PES will fall by approximately 40% (relative to 2009) and the volume of energy supplied by PES will fall by nearly 50% (relative to 2009).

The fall in PES’s residential customer numbers is driven by the entry of BGES and Airtricity into the domestic market in 2009. To evaluate the reasonableness of the projected customer losses, the CER examined the most up to date historical switching data. PES-projected market shares are consistent with a linear extrapolation of the recent switching history. Whilst it is recognised that switching is likely to level off at some point, there has been little evidence yet signifying a slowdown in the pace of customer switching. The CER does not find the projected customer losses to be unreasonable in this context. PES is also forecasting a reduction in per customer usage over the next two years. The reason advanced by PES for this is the fact that the higher load factor customers are acquired by competing suppliers, while the lower load factor customers remain with PES. The CER’s own observations support this and it is a trend that NERA have observed in other jurisdictions as well. Therefore the CER is of the view that the above figures are reasonable and is proposing to adopt them in the calculation of PES’s allowed revenue.


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5.2 Projected Efficiency Gains A key question is whether the proposed level of costs could be reduced through better management cost controls and efficiency gains. This is particularly relevant given the expected reduction in customer numbers and sales.

When the outturn costs are compared to allowed levels of expenditure for the historic period it shows that PES did not achieve the efficiency gains that were anticipated in CER/05/164. Further, PES’ cost control measures did not keep up with the declines in its customer base. PES only achieved outturn levels below the allowed amount from CER/05/164 in the following areas: sales and marketing, and premises and call centre costs. In all other cost categories, PES’ outturn result was at or above the allowed amount. The inability of PES to achieve efficiencies over and above those anticipated by the CER in setting the 2006-10 price control indicates a high level of rigidity in the PES cost structure. With a high level of rigidity built into the PES cost structure, it is difficult to expect that OPEX reductions would be feasible at levels that exceed the forecast drop of 23% between 2009 and 2012. Figure 5.2 shows the trends in operating costs excluding exceptional costs over the period 2006-2012.

Figure 5.2 – PES OPEX excluding exceptional and external costs 2006-12

It is also important to take into account the fixed-cost nature of the retail supply business. The large costs for this type of business are overhead expenditures


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(front and back office staffing, billing systems, IT infrastructure, corporate support). While there is clearly some link between the number of customers and level of required expenditure, there is surely a minimum level of cost required regardless of how many customers are taking service.

NERA conducted a review of similar utility companies in other European and North American jurisdictions to determine whether one could cull any useful information from retail supply costs allowed or observed elsewhere. While no direct parallels were found that would permit a like for like comparison to the ringfenced PES serving as SOLR in Ireland it was noted that the supply cost / retailer allowances that are seen are at levels that are within a reasonable range of the PES figures.

PES’ “cost to serve” has historically been in the range of €55 per customer. In the last couple of years, however, the “cost to serve” has increased to roughly €70 per customer since the number of customers PES serves has declined more rapidly than PES has been able to cut costs. For these same reasons, PES’ cost to serve is projected to increase above €80 per customer during the control period.

These numbers compare reasonably to the observed cost to serve for the market in Great Britain. In February 2008, Ofgem began an investigation into the retail markets for electricity and gas supply. The probe examined each segment of the retail gas and electricity market in an effort to determine whether each component was functioning efficiently. Ofgem initially found that the basic cost to serve (excluding overhead) was approximately £40 per electricity customer over the 2005 to 2007 period, with overheads and other costs adding an additional £10 per customer. Since the probe, Ofgem has published a quarterly update on the state of the retail market, the most recent of which estimated the operating cost of electricity retailers at £60 per customer. These numbers are in line with PES’ actual and forecast OPEX and support the reasonableness of PES’ proposal.

On balance, the CER believes that the reductions in supply costs for the 2011-12 period, proposed by the PES in its submission, combined with the additional reductions imposed by the CER through this document, reflect a reasonable level of efficiency gains.

5.3 Regulated/Unregulated Costs Separation NERA reviewed the proposed allocation of costs to regulated and unregulated customer segments. NERA’s review focused on two questions: Is the proposed allocation methodology reasonable and fair? Does the proposed allocation methodology lead to a cross subsidy from

regulated to unregulated customers?


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Proposed allocation methodology PES has historically used the number of customers as the basis for allocating supply costs among customer classes (see ESBCS Tariff Methodology Statement21). For its current submission, PES used a blend of direct cost attributions and allocation techniques. A subset of payroll costs was directly attributed on the basis of time spent by FTE's working on business / residential matters. PES allocated the balance of payroll costs on a per customer basis. In addition, PES directly attributed the costs of token meters to domestic customers. It is standard practice in tariff formulation to assign direct costs (such as meters) and to proportionately allocate joint and common costs. As a result, the CER does is satisfied with the general approach employed by PES. NERA compared the share of total supply costs that had been borne by domestic customers under PES’ cost allocations in prior periods. This is shown in table 5.3 below.

PeriodPercent of Supply Cost Borne by

Domestic SegmentPercent of Supply Cost Borne by

Business Segment

Q1 ‐ Q3 2009 90.22% 9.78%2010 86.20% 13.80%2011 86.28% 13.72%2012 85.71% 14.29%

Table 5.3 – Supply Cost Separation Customer numbers are changing from year to year, and PES is expected to lose market share during 2011-2012. On balance, however, the CER does not find the overall share of total supply costs attributed by PES to the domestic segment to be unreasonable. NERA did not identify any evidence in the proposed cost allocation to suggest that there is any cross subsidization from domestic to business customers.

21 ESBCS Tariff Methodology Statement for Tariff period 1st October 2009 to 30th September - CER09168


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6.0 Operational Expenditure This section examines the PES’s historical and forecast operational expenditure (OPEX) to determine whether the expenditure is prudent and offers value for money to customers.

6.1 Proposed OPEX This section sets out domestic customers OPEX submitted by PES and the CER’s proposed level of allowable OPEX. These are set out in Table 6.1 below and each category of OPEX is subsequently addressed. Opex Cost Category CER Proposed Allowance Difference

2011 2012 Total 2011 2012 Total€,000 €,000 €,000 €,000 €,000 €,000 €,000

Payroll €22,027 €21,492 €43,519 €20,403 €19,907 €40,309 €3,210

Contractors €9,479 €8,414 €17,893 €9,479 €8,414 €17,893 €0

Material & goods & Services €292 €294 €586 €292 €294 €586 €0

Transport & Communications €6,933 €6,153 €13,086 €6,933 €6,153 €13,086 €0

Establishment €230 €232 €462 €230 €232 €462 €0

Computer €276 €278 €554 €276 €278 €554 €0

Insurance €1 €1 €2 €1 €1 €2 €0

Selling & Advertising €5,334 €5,378 €10,712 €4,800 €4,800 €9,600 €1,112

Professional Fees €3,116 €3,142 €6,258 €3,116 €3,142 €6,258 €0

Depreciation €8,947 €8,855 €17,802 €8,747 €8,615 €17,362 €440

Bad Debts €10,489 €9,260 €19,749 €6,571 €5,797 €12,367 €7,382

Other €2 €0 €2 €2 €0 €2 €0

Total Operating costs €67,126 €63,499 €130,625 €60,849 €57,633 €118,482 €12,143

Inter BU costs

Shared Services €4,932 €4,973 €9,905 €4,809 €4,727 €9,536 €369

ITS €10,506 €10,593 €21,099 €10,243 €10,070 €20,313 €786

Telecoms €1,026 €1,034 €2,060 €1,000 €983 €1,983 €77

Networks €4,621 €4,560 €9,181 €4,505 €4,335 €8,840 €341

Networks ‐ token meters €3,085 €3,239 €6,324 €3,008 €3,079 €6,087 €237

Misc. Others €536 €541 €1,077 €523 €514 €1,037 €40

Corporate centre €2,548 €2,569 €5,117 €2,484 €2,442 €4,926 €191

Total Inter BU costs €27,254 €27,509 €54,763 €26,573 €26,151 €52,723 €2,040

Total Supply Costs €94,380 €91,008 €185,388 €87,422 €83,783 €171,205 €14,183

PES Submission

Table 6.1 Proposed Domestic Customers OPEX for 2011-12 period.


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6.2 Review of OPEX The objective in setting an allowed OPEX is to ensure that efficiency improvements continue to be made, to the benefit of customers. The approach taken ensures that the allowed operating expenditures meet this objective Setting allowed OPEX for the 2011-12 price control period involves a number of steps.

1) An analysis was first undertaken to evaluate PES’s performance over the previous review period to determine whether or not (a) expected efficiencies in OPEX were achieved and (b) any efficiency improvements in the controllable OPEX were achieved. This analysis also sought to identify where any over/under spend had occurred. In addition, any accounting or financial issues were identified, with a view to avoiding any difficulties that these might present at the next review.

2) The historical OPEX analysis and trends found were used as background to the assessment of the forward-looking OPEX. The forward-looking OPEX, as proposed by PES, was benchmarked against comparable companies, and checked for consistency with the trend over the first control period.

3) The recent market developments were taken into consideration, including the deregulation of the business market and the requirements this places on the separation of costs between the regulated and unregulated business areas.

As part of the evaluation of future efficiency levels, the OPEX costs were also split between controllable and non-controllable costs. In addition, the implication of the capital expenditure programme was taken into account in the evaluation of required future OPEX. These inputs, along with a bottom-up review of the forecast OPEX submitted by PES, guided the CER’s views on the allowed level of OPEX for the 2006 to 2010 control period.


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6.3 Historic OPEX review The CER has reviewed the data supplied by PES regarding its OPEX expenditure over the 2006-2010 period and also its forecast OPEX spend. Figure 6.3 shows a breakdown of the allowed OPEX as per the 2006-2010 decision and also the outturn OPEX for the period.

Figure 6.3 – Allowed & Outturn Operating Costs 2006-2010

Although the annual average outturn costs exceeds the costs allowed in the original decision back in 2005 the CER has not allowed all of these costs to be passed through in tariffs to final customers. Only costs deemed efficient have been included in the annual revenue reviews over the 2006-2010 period. Figure 6.3.1 below shows the actual level of outturn OPEX in each of the years from 2006 to 2009 as well as the forecast OPEX for 2010-12.


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Figure 6.3.1 PES Total Operating Costs 2006-2012

6.4 Payroll PES’s historic data shows that payroll costs increased over the 2006-2010 period. Wages/Salaries specifically, and "personnel"-type expenses generally have gone up and most noticeably towards the end of the price control period. There have also been variances in the number of employees which decreased in 2008, but increased in 2009. Total customer service centre costs have gone up a little faster than overall payroll, increasing by 33% (€4 million) since 2007. Most of that is driven by higher costs per customer service staff member. PES attribute the recent increase in employees (both FTE and contracted) to the following factors:

1) An increase in workloads at the call centre 2) A recent review of the PES business and business processes

In payroll costs, we also see multiple extraordinary charges associated with the cost of the ESB defined benefit pension plan. These are largely borne by ESB,


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and not by customers, with the exception of a €1.52m contribution towards the pension deficit as outlined in a CER decision paper published in October 200622. However PES project that payroll costs will fall by €3.8 million, or 11%, from 2009 through 2012. This reflects a workforce reduction of 66 FTEs over the same time period partly driven by PES’s plan to close 10 customer service centres as a result of its lower market share. There has been a rapid change in the retail market and PES volumes of customers over the past 18 months. While the CER would expect PES staff numbers to fall over time to reflect this change, it is reasonable to expect some rigidity in staffing levels and there is not an expectation that staff levels would fall as quickly as loads. Therefore it is the CERs view that the staffing numbers submitted by PES for the 2011-12 period are reasonable. In addition the CER has examined the average payroll cost per employee to ensure that it is reasonable. Table 6.4 below shows the average payroll cost per employee from 2009 to 2012 as per the PES submission. The average cost per employee has increased by 2% over the period. The CER has made decisions in previous revenue reviews as to the level of any wage increases up to 2010. However PES submitted payroll costs increase by 1% in 2011 and 2.4% in 2012.

2009 2010 2011 2012Outturn Forecast Forecast Forecast

€ 65,498 € 64,697 € 65,254 € 66,841

PES Average payroll cost per employee

Figure 6.4 – PES Average Payroll Cost Per Employee 2009-12

Note: Payroll figures are presented in 2010€ Both the private and public sectors have had to meet the challenges presented by the current recession. One response has been to cut payroll cost; wages have been cut in both the public and private sectors of the Irish economy. While definitive statistics are not available at this time, a recent ESRI document expects a nominal wage decrease in the region of 6% over the 2009 to 2011 period23 and this is highlighted once again in their Spring 2010 quarterly economic commentary which shows wage growth of -2%, -3% and -1% in 2009, 2010 and 2011 respectively. Therefore the CER is proposing not to allow the full payroll costs submitted by PES, but to reduce the payroll costs by 5%. The ESRI Medium Term Review 200824 forecasts that the average growth in productivity of the Irish economy to be 2.5% per annum over the period 2011 to 2015. The PES’s activities are supported by significant levels of IT investment 22 Electricity Allowed Revenue and Tariff Final Determination 2007 - Overview of the Decision Papers CER06207 23 The ESRI document ‘Recovery Scenarios for Ireland’. 24 ESRI Document - Medium-Term Review: 2008-2015


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and the introduction of competition should provide incentive to drive efficiency gains. The CERs expects that PES would achieve these levels of productivity and are therefore proposing to incorporate this into the allowed payroll costs. Figure 6.4.1 below shows the payroll costs submitted by PES for 2011 and 2012 as well as the level the CER is proposing to allow.

Year PES Submission CER View2011 22,027€ 20,403€ 2012 21,492€ 19,907€ Total 43,519€ 40,309€

Figure 6.4.1 – CER proposed allowance for Payroll Costs 2011 & 2012

6.5 Contractors Contractor costs rose 20% between 2006 and 2009, but are forecast to fall below their 2006 level by 2012. PES attribute the rise in contractor costs to increased need for third-party debt collection contractors and increased outsourcing of call centre costs. Given the rise in bad debt costs and call length and volume, the CER view this increase as reasonable. The forecast drop in contractor costs of 24% between 2010 and 2012 is in line with the drop in customer numbers over the same period. The CER proposes to allow the full cost of contractors for 2011 and 2012.

6.6 Materials for Goods and Service PES’ costs for materials for goods and service have averaged €0.46m between 2006 and 2009, with little discernable trend. They are expected to drop to €0.31m in 2010 and remain there in 2011 and 2012. The CER is proposing to allow the full costs submitted by PES.

6.7 Transport & Communications The cost of transport and communications has risen gradually between 2006 and 2010. Due to lower customer numbers, the cost is expected to fall by 23% by 2012. This fall is in line with the reduction in customer numbers and the CER proposes to allow the full costs submitted by PES.


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6.8 Establishment Premises costs are forecast to increase to €0.25m per annum for both 2011 and 2012. This figure is slightly above the 2006 to 2009 average of €0.2m, but at the same level as the 2010 budget. A premises cost that remains constant in real terms is reasonable, given the fixed nature of this expense.

6.9 Computer PES expects computer costs to remain close to 2009 levels of €0.29m. The average over the 2006 to 2009 period was €0.27m. The CER does not expect large reductions in computer costs during a short (i.e., two-year) control period. The CER therefore proposes to allow the forecast level of cost, as proposed by PES.

6.10 Selling & Advertising Selling and advertising costs increased by an average rate of 8% over the 2006- 2010 control period, although they remained below the level allowed by the CER in CER/05/164. However there was a significant increase in overall selling and advertisings costs between 2009 and 2010, which raised the question of whether the increase is related to ESBCS’ preparation to enter the deregulated market.

PES are expecting higher selling and advertising costs in 2011-2012 and the main types of expenditure included in the non-energy efficiency sales and advertising budget relate to customer care and communications including:

- Explaining and communicating information on tariffs, price changes, understanding your bill and industry changes.

- Bill inserts (customer advise highlighting Customer Charter and vulnerable customer code of practice, payment terms and methods, safety awareness)

- Promotion of lower cost to serve payment methods - Customer Research - Compliance with the Official Languages act - Bill redesign - Customer support ,including

o Support for Know Your Neighbour Week o Support for Positive Ageing week o Saint Vincent de Paul support

- Community support and sponsorships for the GAA All Ireland minor championship, Hockey, U21 Irish Rugby and Feis Ceol.


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PES has submitted for a total of €5.33m in 2011 and €5.38m in 2012. The CER is not satisfied that the increase between 2009 and 2010 of 32% is justified and therefore is proposing not to allow the full cost of selling and advertisings submitted by PES. Instead the CER proposes to allow PES to recover €4.8 million in each year.

6.11 Professional Fees The outturn level of spending for professional fees in the prior control period ranges from €3.0m in 2006 to €3.9m in 2009. PES undertook a thorough review of its business processes, which led to the increase in 2009. For 2011-2012, PES projects professional fees will fall to an annual level of €3.3m. The CER views a reduction from 2009 levels to be appropriate, particularly since the business process review was a one-off expenditure and therefore proposes to allow the full costs submitted by PES.

6.12 Depreciation Depreciation costs increased every year between 2006 and 2009 (a total of 43%), but fell by half between 2009 and 2010. PES attributes the increased depreciation to SEM-related capital expenditures and a new billing system. The fact that the depreciation term on these items is short explains the abrupt drop off in 2010. In keeping with this explanation, the forecast is for depreciation to be markedly lower than prior years going forward. Depreciation will not be eliminated entirely, however. PES has several capital projects planned for the 2010 through 2012 period, which will create depreciation charges totalling €17.8m in the 2011-12 period.

PES has provided a rationale for these new capital programmes, which are IT related. The CER has sought evidence that the capital programs are ones that would have been implemented regardless of the imminent deregulation of the business customer segments. NERA identified one set of activities that were clearly undertaken to prepare for deregulation, which was the IVR Improvements Project. The CER is proposing not to allow recovery of the costs of this project from regulated customers. The CER is proposing to allow a total of €17.4m to be recovered for depreciation over the 2011-12 period.

6.13 Bad Debts Bad debts rose sharply in 2008 (20%) and 2009 (115%) as the economy worsened. PES attributes increased bad debts to economic hardship, lower credit quality customers remaining with the PES tariff, and increased customer switching leading to stranded unpaid accounts. Following the sharp rise in 2009 and 2010, PES project that bad debts will recede gradually from a total of €15m


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for domestic customers in 2010 down to €10.5m and €9.3m in 2011 and 2012 respectively. This assumes improvements to the overall economic climate.

The CER recognises the deterioration in the economic climate over the past number of years and the increase in bad debts this is likely to cause. The latest ESRI forecast contained in spring 201025 quarterly commentary shows both GNP and GDP returning to positive, growth figures in 2011 of 2.75% and 2.5% respectively. Therefore the CER is of the view that PES should see a reduction in the levels of bad debt. PES’s submission includes bad debt levels of 1.6% of turnover in 2011 and 2012. Whilst the CER is aware of the economic situation that prompted the increase in bad debts, the 1.6% level included in the submission is significantly above the average level over the past five years. In order to incentivise PES to reduce the level of bad debt the CER is proposing to allow PES recover bad debts at 1% of forecast turnover. This will reduce the bad debt allowance to €6.57m and €5.8m for 2011 and 2012 respectively.

6.14 ESB Corporate Centre, Service Agreements & Inter Business Unit Costs

A portion of PES’s costs derives from work completed by other parts of the ESB Group for PES. During the 2006-2010 period, this category of cost represented PES’ largest expenditure (when the PSO is included, and second largest expenditure with the PSO excluded). These costs generally reflect the following activities:

1) Allocation of the ESB Corporate Centre costs to PES. The corporate centre is presumed to provide value for each business division and each receives an allocation of the costs.

2) Service Level Agreements. These are services (primarily IT, but also HR, facilities, accounting, procurement) provided by ESB to PES under explicit contracts.

3) Other inter-business unit costs. This includes field services provided by networks, and other services not covered by the service level agreements.

The movement inPSO – particularly the large drop in the PSO from 2006 to 2007 – masks the true movements in ESB-related expenditures over the control period. When PSO is excluded, we see that ESB-related costs were relatively stable during the control period, with a slight net trend downward, driven by a 25 ESRI Quarterly Economic Commentary, Spring 2010


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consistent trend down in payments for other business services. There was, however, an increase in shared services costs of 13% from 2006 to 2009, and a subsequent decrease of 10% in 2010. PES attributes these changes to SEM-related activities. Figure 6.14 below illustrates the trend for inter-business unit costs from 2006-2012.

Figure 6.14 – PES Inter-Business Unit Costs 2006-2012

The ESB-related expenditures are anticipated to remain fairly flat, at between €30 and €31 million per year. These numbers are consistent with the expenditures in 2010, the end of the prior control period. Prior to 2010, they had been significantly higher. The level of ESB-related expenditures proposed by PES is lower than prior approved levels for these costs. The CER recognises that most of these costs will remain after the deregulation of the business market segment takes place and that PES still has licence obligations related to SOLR etc. Therefore the CER is satisfied that the level of inter business costs included in the PES submission is reasonable, however the CER expects that, in line with the ESRI Medium Term Review discussed in Section 6.4, the same increases in productivity that can be achieved in payroll should be seen in the work undertaken by other parts of the ESB group. The CER is therefore proposing that a productivity increase of 2.5% per annum be incorporated into the allowance for ESB Corporate Centre, Service Agreements & Inter Business Unit Costs. This will reduce the allowance to €26.6m and €26.2m for 2011 and 2012 respectively.


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6.15 Uncertain Costs As discussed in Section 3.6, there are no uncertain costs included for 2011, but the CER will consider any submissions made by PES for the 2012 review.


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7.0 Conclusions and Next Steps

7.1 Summary of Proposed Allowed Revenue 2011 & 2012 The CER has set out it proposals for the approach to setting out the PES allowed revenue for the 2011-12 period as well as the proposed total revenues. Table 7.1 below shows the breakdown of the total €171.6m figure, for allowed revenues in 2011-12, that the CER is proposing to allow PES to recover through the regulated tariffs.

Proposed PES Allowed Revenue 2011 2012 Total€,000 €,000 €,000

Opex Cost Category

Payroll €20,403 €19,907 €40,309Contractors €9,479 €8,414 €17,893Material & goods & Services €292 €294 €586Transport & Communications €6,933 €6,153 €13,086Establishment €230 €232 €462Computer €276 €278 €554Selling & Advertising €4,800 €4,800 €9,600Professional Fees €3,116 €3,142 €6,258Depreciation €8,747 €8,615 €17,362Bad Debts €6,571 €5,797 €12,367Inter BU Costs €26,573 €26,151 €52,723Other €3 €1 €4Total Operating costs €87,422 €83,783 €171,205

Additional Costs

Uncertain Costs ‐€ ‐€ €0Incentive Mechanism 388€ ‐€ €388Total Allowed Revenue €87,810 €83,783 €171,593

Table 7.1 Summary of Proposed Allowed Revenue for 2011-12 period

7.2 Summary of Proposed Allowed Revenue for 2010/11 MAR Given that the 12-month MAR period straddles two different calendar years, that is, the last 3 months of 2010 and the first 9 months of 2011, the cost allowance for the PES business (to be reflected in the PES retail tariffs) corresponds exactly to the same 12-month period. Thus the final allowed revenue to be included in


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the 2010/11 MAR period must take account of 75% of the 2011 proposed revenue and the appropriate allocation of the portion of the 2010 allowed revenue applicable to domestic customers – as set out in Section 3.8. The CER is proposing that a total of €94.67m be included in regulated tariffs over the 2010/11 MAR period. The calculation of this figure is shown in table 7.2 below.

Table 7.2 – Allowed Revenue to be included in 2010/11 tariffs

Finally, the CER is proposing not to include any K-factors in the 2010/11 regulated tariffs. Recognising that a proportion of the costs may have been legitimately incurred in the context of the prevailing regulatory framework, the CER will give further consideration to potential recovery mechanisms to ensure that ESBCS is not unduly disadvantaged in an increasingly competitive market.

7.3 Stakeholder Responses and Next Steps The CER is seeking responses from all stakeholders as to the appropriateness of the level allowed in each costs category. In addition the CER has also proposed a number of methodologies for each of the following areas and is seeking feedback as to whether these are appropriate for the 2011-12 period.

• The allocation of 2010 allowed revenue between regulated and deregulated PES customer groups.

• The use of HICP instead of CPI. • The treatment of uncertain costs over the 2011-12 period. • The proposal not to include K-factors in the 2010/11 regulated tariffs.

The Consultation period runs until Friday 10th September and the CER will publi