Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU

Technical Assistance to the Energy Agency of the Republic of Serbia

An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU

Task 2.3 Incentive RegulationGeneral approach to incentive regulation

8 April 2008

Judith Aitken, Waisum Cheng, Katja Keller,

Stefanie Kesting, Ilka Lewington



Objective & Contents

Objective: to discuss with AERS the options in designing a cap-regulation system for Serbia

Contents

1. General Issues

2. Cap-Regulation Methods

3. Building-blocks versus TOTEX-Approach

4. Determinants of the cap-regulation formula

5. Price control retail



General Features



Objectives

• Move to long-term regulation and tariff setting schemes• Provide incentives for network investments • Address quality of supply performance• Provide incentives for efficiency increase • Ensure sharing of benefits from efficiency increase

between regulated companies and users• Ensure sector viability and financial solvency



General Features (1)

• Apply international experience and use advantages of incentive based regulation

• Envisage transition period • New scheme based on longer (e.g. 5 years) regulatory

periods and less frequent regulatory reviews• Companies provide and AERS endorses multi-annual

OPEX and CAPEX projections for the whole duration of the regulatory period




• AERS sets proper incentives for ex-ante efficiency increase

• Regulatory commitment and no reopening during the regulatory period

• Complete price / cost review and revenue resetting at the end of the regulatory period




• Transition period (e.g. 2 years) necessary to:– provide time to AERS to prepare incentive regulation

scheme including • data collection • benchmarking efforts• Investment approval (for the regulatory period)

– provide time to stakeholders to prepare including:• enhance knowledge• legislative changes

• During this time application of current methodologies and in parallel establishment of the new regulation



Regulation Methods



Methods of regulation

• Rate of Return regulation / Cost plus• Cap regulation

– Price cap– Revenue cap

• Yardstick competition



Methods of Regulation / Rate of Return

• Prices / Revenues based on cost plus return on assets • Frequent regulatory reviews • Cost immunisation, weak incentives to increase

efficiencies• Overcapitalisation and gold plating (Averch / Johnson

Effect) • High administrative burden



Methods of Regulation / Yardstick Regulation

• Prices or revenues are indexed to an average of industry performance as opposed to the firm’s own values

• For instance, average cost may be de-linked as

ACi = Sum(ACj)/(n-1), j i

• Problems with the practical implementation of yardstick regulation is that: – firms are inherently different because of factors they cannot

always control;– firms rarely start from the same efficiency position– collusive behaviour is possible – Preparedness of the regulator to accept company’s bankruptcy

is unlikely



Methods of Regulation / Cap Regulation

• Establishes upper limit on prices or revenue • Applies longer regulatory lag• Requires explicitly productivity increase via the price

formulas (X factor) • Allows retention of efficiency gains• Should address explicitly quality of supply • Ensures transparency and stability of price / revenue

development



Cap Regulation

• Majority of the EU countries apply incentive regulation (price / revenue caps):– revenue caps (Norway, Denmark, Bulgaria)– tariff basket caps (the Netherlands, Slovenia, Romania)– hybrid caps (UK)

• Various regulatory formulas in terms of complexity and design:– separate network loss incentives (UK)– automatic revenue adjustments using network cost drivers

(Norway)– integration of quality (the Netherlands, Norway, Italy, UK)



How caps can work?

Price

time

Benefit to customers(lower prices)

Benefit to firm (higher profit)

Expected improvement(RPI-X)

Actual improvement

Regulatory period

Price

time

Benefit to customers(lower prices)

Benefit to firm (higher profit)

Expected improvement(RPI-X)

Actual improvement

Regulatory period



How can caps work?

• The price (or revenue) development path does not need to be necessary decreasing. Increasing path possible in case of: – Inflation is higher than the efficiency requirement of the regulator – High investment needs are recognised by the regulator and

included explicitly in the specified revenue or price path– OPEX (e.g. labour) cost increases with rate higher than inflation

and regulator agrees on this increase – The price control formula incorporates demand growth and

associated revenue adjustments (hybrid revenue cap) – The initial price at start of regulation is below the cost reflective

price level and the there is a need to ensure gradual convergence towards a cost reflective level



Cap Regulation Methods

Cap Regulation

Price Cap Revenue Cap

Tariff Basket CapVariable Revenue

CapFixed Revenue

Cap

Average RevenueCap

Individual Price Cap

Hybrid RevenueCap

Cap Regulation



CapFixed Revenue

Cap

Cap Regulation



CapFixed Revenue

Cap

Average RevenueCap

Individual Price Cap

Hybrid RevenueCap



Price-cap regulation

• Individual price cap

• Price changes depend on– Inflation– Efficiency requirements

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Price-cap regulation

• Tariff basket

• Price level weighted with quantities• Pros:

– Strong incentives to increase efficiency– Tariff setting decision of network operator (ideally)

• Cons: – Rebalancing

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Revenue cap

• Fixed revenue cap

• Annual increase of revenue is fixed • Pros:

– Strong incentives to increase efficiency• Cons:

– Demand changes not reflected in price control– Incentive to overestimate demand growth for the price control

period and to postpone new connections during the price control period

– Financial risks for the network operator

)1(1 tttt XCPIRR



Revenue cap

• Average Revenue Cap• Regulator fixes revenue/kWh for as starting point for the price

control• Revenue/kWh is corrected by annual inflation and efficiency

requirements in order to derive the allowed revenue/kWh for every year of the regulatory period

• Pros– Strong incentives to increase efficiency

• Cons– No relation between cost and revenue during the regulation

period– High financial risk for the network operator– Incentives to increase demand and decrease prices below

efficient level



Revenue cap

• Hybrid revenue cap

• Allowed revenue during the regulatory period depend on e.g. increase in energy delivered (E) or number of customers connected (C)

• Potential cost increases are integrated in regulatory formula• Pros

– Strong incentives to increase efficiency– Limited financial risk for the regulated company

• Cons– Determination of cost driver and weights might be difficult

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TOTEX versus Building Blocks Approach



Building Blocks versus TOTEX

• To what extent are cost analysed separately?– Building Block Approach

• Capital cost and OPEX are analysed separately• Efficiency Benchmarking concentrates on OPEX• Investment approval for regulatory period

– TOTEX Approach• Total cost are considered• Efficiency benchmarking based on total cost• (Planned) investment for the regulatory period not

taken into account for the annual allowed revenue



Building Blocks

OPEX WACC x+ Regulatory Asset Base + AbschreibungenOPEX WACC x+ Regulatory Asset Base +Depreciation

Annual allowed revenue

Projection for the regulatory period



Building Block Approach

• Projection of regulated cost (revenue requirements) during regulatory period

• Cost defined as building blocks: – return on assets (cost of capital and regulatory assets

base); – depreciation– operation and maintenance cost (OPEX)– taxes via a pre-tax WACC or as an explicit cost

element, whereas return is determined on a post-tax basis

– network losses (optional)



Example Building Blocks

Regulatory parametersOpex Efficiency Score 75%WACC 10%Depreciation period 25 yearsAnnual reduction in opex 6.9%

Year 0 Year 1 Year 2 Year 3 Year 4

OPEXInitial Opex 100Opex efficiency score 75%Implied annual reduction target 6.9%Required Opex 100.0 93.1 86.6 80.6 75.0

I nvestments / DepreciationRequired I nvestment 10.0 30.0 25.0 25.0

Required DepreciationFrom previsous investments 20.0 20.0 20.0 20.0 From investments in year 1 0.4 0.4 0.4 0.4 From investments in year 2 1.2 1.2 1.2 From investments in year 3 1.0 1.0 From investments in year 4 1.0 Total Required Depreciation 20.4 21.6 22.6 23.6

RAB/ ReturnsStarting RAB - / - 500 490 498 500 Plus: New investments 10 30 25 25 Minus: Depreciations 20 22 23 24 Ending RAB 500 490 498 500 502 Average RAB 500.0 494.8 493.8 499.2 501.1Required Returns (WACCxRAB) 50.0 49.5 49.4 49.9 50.1

Required RevenuesOpex 100 93.1 86.6 80.6 75.0 Depreciation 20 20.4 21.6 22.6 23.6 Returns 50 49.5 49.4 49.9 50.1 Non-controllable costs 10 12.0 8.0 18.0 12.0 Required Revenues 180.0 174.9 165.6 171.1 160.7

Allowed RevenuesDemand 180 185 190 195 200Price (X-factor applied) 1 0.95 0.90 0.85 0.80 Allowed Revenues 180.0 175.2 170.3 165.5 160.8

Discount factor: 1.00 0.91 0.83 0.75 0.68 Required Revenues - PV 714.2 Allowed Revenues - PV 714.2 X-factor 5.3%NPV (0.00)



Revenue Profiling

• Revenue requirements calculated for each year of regulatory period (initial revenue targets)

• Initial revenue targets include efficient OPEX and CAPEX

• Initial revenue targets converted in smoothed revenue through the setting of X factor (mathematical equivalence of NPV of both revenue streams)

• Dual role is attributed to the X factor: – regulatory drive for efficiency increase; and – revenue “smoother”



Example TOTEX

Approach

Regulatory parametersTotex Efficiency Score 85%Annual reduction in totex 4.0%

Year 0 Year 1 Year 2 Year 3 Year 4

Totex TargetsOpex 100.0 Depreciation 70.0 Returns 150.0 Totex targets 320.0 307.3 295.0 283.3 272.0

Required RevenuesTotex targets 320.0 307.3 295.0 283.3 272.0 Non-controllable costs 10.0 12.0 8.0 18.0 12.0 Required Revenues 330.0 319.3 303.0 301.3 284.0

Allowed RevenuesDemand 330 330 330 330 330Price (X-factor applied) 1 0.96 0.93 0.90 0.87 Allowed Revenues 330.0 318.3 307.1 296.3 285.8

Discount factor: 1.00 0.91 0.83 0.75 0.68 Required Revenues - PV 1,291.0 Allowed Revenues - PV 1,291.0 X-factor 3.5%NPV 0.00



Building Blocks versus TOTEX

• Discussion of pros and cons taking into account the Serbian circumstances



Determinants of price control



Price Control Determinants / Overview

• General characteristics

• Price control formula

• Revenue requirements (Building Blocks Approach)

• Regulatory asset base

• New investments

• Depreciation

• Cost of capital (WACC)

• Efficiency increase and X factor

• Price index

• Quantity forecast error adjustment

• Quality of supply incentives



RAB and Revenue Requirements

• AERS is aware of the concept of RAB and the calcuation of annual revenue requirements

• Changes in a multi-year approach– Calculations based on historic values (e.g. demand,

inflation) or forecast values? – Correction factor to overcome differences– Investment approval for regulatory period– Demand estimation for regulatory period– Projection of OPEX for regulatory period



CAPEX (New investments)

• CAPEX determined at the beginning of the regulatory period for every year of the regulatory period =>no reopening during the regulatory period

• Regulatory ex-ante check for CAPEX inclusion• Regulatory ex-post check whether the approved

(and included) CAPEX plans have been fulfilled



OPEX Projections

• The OPEX development during the regulatory period should account for:

– OPEX changes beyond the companies’ control

– required efficiency increase

• This can be achieved by:

– separation between controllable and non-controllable OPEX

– imposing efficiency increase over the controllable OPEX

– component-based monetary indexation over the main OPEX components

– establishment of functional link between the controllable OPEX and pre-selected physical cost drivers (e.g. GWh or /and number of customers)



Price Index

• Defined by national CPI index • Applies historic values or forecasted values• Adjustments in case of large differences between historic

/ forecast and actual values



• Correction term set to adjust the difference between

actual minus allowed revenue in previous years

Correction Factor



Quality of Supply Regulation

• Efficient new investments explicitly considered in the cap design – = > supports the quality improvement process

• Robust quality regulation scheme including standards and incentives needs to be developed during the first regulatory period

• “Shadow” standards may be introduced in the first regulation period

• Integrated price/quality regulation scheme, Q factor in the price control formula

• Revenue exposed to quality incentives will not exceed a certain percent (e.g. 2 %)



Length of regulatory period

• Trade-off between increased incentives to increase efficiency and increasing risk

• First regulatory period could be shorter• Different length of first regulatory period for gas and

electricity could balance the work of the regulator in times of revision



Information Requirements

• Necessary to determine the revenue requirements and

establish the X final

• Defined by AERS and building on the data requirements

for the current regulatory regime

• Iterated and agree with the companies

• Used for regulatory review reporting and annual

reporting



Implementation / Major Steps

• Agreement for the concept and commitment of stakeholders

• Enforcement of legal changes • Data collection• Calculations to set parameters • Consultation process• Final determination



Implementation / Transition period

• Activities during transition period– Data collection for different purposes (establishment revenue

requirements, benchmarking, macroeconomic data such as CPI,..)

– Preparation of investments and OPEX plan – Assessment of the cost of capital (determination of return on

equity and return on debt for the regulatory period)– Efficiency analysis, performing benchmarking exercise,

determining annual efficiency improvement factors. – Design of quality of supply regulation– Revenue projections for the first regulatory period– Consultation with the regulated companies



Thank you!

Documents

Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU