Principles of Price Regulation

Dr. Konstantin Petrov, DNV KEMA

28 October 2013

Introduction to Network Regulation Module 1: Principles of Price Regulation

Introduction to Network Regulation

14 October 2013

Agenda

1. Introduction to Electricity Regulation

2. Areas of Regulation

3. Scope of Regulation

4. Type of Regulation

5. Regulatory Institutions

6. Regulation in the EU


28 October 2013

Introduction to Electricity Regulation

Competition provides the best service to customers in terms of price and quality of

service. But competition is not feasible in all segments of the power sector.

In areas where competition does not work (e.g. natural monopoly such as

electricity networks) or is legally excluded (exclusive rights given by the law),

regulation is needed.

The major regulatory objectives are to:

- protect consumer interests and eliminate monopoly inefficiency

- ensure financial viability of industry participants (efficient cost coverage)

- ensure equal conditions and non-discrimination of all sector participants

- improve conditions for competition where possible

Regulation is defined as a state intervention that is applied to various company

specific (e.g. prices, revenues, quality of supply) or integral parameters (e.g. market

entry / market design).

Why regulate?

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Characteristics of Electricity (Networks)

Economies

of Scale and Scope

Load flow from generator to consumer uncontrollable

and unpredictable

Investments are capital

intensive

Production needs to equal

demand plus reserve

margin at every point of

time Transmission network

capacity should be able to

accommodate peak load

Network capacity depends

on the location of

generation and load within

the network

Sunk costs

Characteristics of

Electricity (Networks)

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Regulation must balance obligations to both customers and regulated companies

and also the costs and benefits of the regulatory system itself.

Balancing Interests

Costs and Benefit of Regulatory System

Distortions to

industry structure

Costs of operating

regulation

Prevention of

monopoly abuse

Efficiency savings

and lower costs

Customer and Company Interests

Price reductions

Protection against

monopoly abuse

Fair return

Profit

opportunities

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The choice of an adequate regulatory regime requires a definition of the area, scope

and type of regulation, as well as the establishment or assignment of an institution

responsible for regulatory issues.

Choice of Regulatory Regime

Areas of Regulation

Scope of Regulation

Type of Regulation

Regulatory Institutions

Where should be regulated?

What should be regulated?

How should be regulated?

Who regulates?

Choice of

Regulatory

Regime

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Agenda







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28 October 2013

Areas of Regulation – Which areas should be regulated?

Ancillary

Services

Wholesale

Supply

Power

Generation

System

Dispatch

Power

Transmission Power

Distribution

Retail

Supply

Metering

and Billing

Services subject to

regulatory control

Competitive services

Potentially competitive

services

Regulated and Competitive Elements

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Areas of Regulation – Which areas should be regulated?

Traditionally, all business areas in network industries (such as the electricity sector)

had naturally been regarded as monopolies not subject to competition.

However, only the network business is characterised by large sunk costs and

economies of scale and scope, which generate stable market power for incumbent

network owners.

Other business areas of the sector (such as production, wholesale and retail) can be

provided in a competitive process.

A fair and non-discriminatory regulation framework for the transmission and

distribution networks has important implications for supporting wholesale

competition (electricity generation) and retail competition (end-user supply)

Regulation should focus on the network segment

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Agenda







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Scope of Regulation – What should be regulated?

Regulatory Controls

Regulation should ensure: functional market design, reasonable prices

and reasonable quality of supply for regulated services.

Market Functioning

Market design / market

rules

System / network

rules

Market monitoring

Market integration

Other

Unbundling

Security of supply

Innovation

Price Control

Revenue / tariff setting

Efficiency incentives

Investment sufficiency

Innovation

Commercial quality

Continuity of supply

(reliability)

Technical quality

Quality of Supply

Regulatory Controls

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28 October 2013


Elements of Price Control

Setting Revenue

Requirements

Price / Revenue

Adjustments

Efficiency

Assessment

Tariff Design

– Setting an allowance for operation and maintenance cost

– Setting capital cost allowance (including provisions for asset valuation and

depreciation methods, regulatory asset base, cost of capital)

– Setting a price control formula

– Application of adjustment factors: productivity increases, price and volume

adjustment

– Defining length of price control period

– Tariff structures: e.g. use of network charges / connection charges, demand

charges / energy charges / standing charges

– Cost allocation: differentiation for voltage level, location, time of use, energy

use / peak demand

– Assessment of inefficiency of regulated service providers (Benchmarking)

– Techniques: non-parametric models (Data Envelopment Analysis), parametric

models (Corrected Ordinary Least Square, Stochastic Frontier Analysis),

engineering models

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Elements of Quality of Supply

Continuity of

Supply

Technical Quality

Commercial

Quality

– Reliability of electricity supply

– Performance indicators (number and frequency of interruptions)

– Physical properties of electricity

– Performance indicators (voltage variation, dips, flickers)

– Customer service quality

– Performance indicators (complaints from consumers, response time to

consumer complaints, appointments with consumers)

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Agenda







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Type of Regulation – How should be regulated?

Theory vs. practice:

- Differences between regimes in practice less strong.

- Depending on the details of the regulatory regime, differences might only exist in the name of the regime.

- Hybrid forms (combinations of regimes) frequently applied in practice.

- Almost all regimes require a calculation of the company’s cost and price levels.

Forms of Regulatory Price Control

Cap

Regulation

Incentive

Regulation

Rate-of-return

Cost-based

Regulation

Regulatory price

controls

Revenue

Cap Price Cap

Revenue

Sharing

Profit

Sharing

Sliding Scale

Regulation

Yardstick

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Principle:

Prices / revenues based on operating costs plus “fair” rate

of return on capital (cost recovery principle)

Application:

- Frequent (yearly) regulatory reviews

- Price setting theoretically by the companies, but in

practice regulator often determines prices directly

- Traditional form of regulation (USA)

Primary Objective:

limit profits, prevent companies from pricing above costs

Cost-based Regulation – Rate of Return

Rate-of-Return regulation

Return on Capital

Operating cost + Depreciation

Price

time

Influenced by company

Determined by regulator

Incentives for Efficiency Increase weak

Practicability and Information Requirement medium – high

Regulatory Capture / Gaming high / low

Potential for Over-/Underinvestment overinvestment

Regulatory Risk low

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Principle:

Establishes upper limit on prices or revenue

Application:

- Longer regulatory lag and regulatory period (3-5 years)

- Requires explicitly productivity increase via the price

formulas (X factor)

- Allows retention of efficiency gains; should address

quality of supply

Major Forms:

- linked caps (based on projection of capex and opex)

- unlinked caps (formula for adjustment of initial cost

base rather than projection)

Incentive Regulation – Cap Regulation

Incentives for Efficiency Increase medium – strong

Practicability and Information Requirement low - medium

Regulatory Capture / Gaming low / high

Potential for Over-/Underinvestment underinvestment

Regulatory Risk medium

Cap regulation

Actual Cost

Current revenue level

Current revenue + Inflation

Current revenue + Inflation – productivity growth

Efficiency gains

time



Set by regulator

Base level

for next

regulatory

period

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Principle:

Regulator sets target level of revenues the

company is permitted to keep; sharing scheme for

profits and losses

Application:

- Often together with cap regulation

- Sharing is usually done by adjusting the

allowed revenue for the next regulatory period

Main Objective:

“fair” sharing of profits and risks between

company and customer

Incentive Regulation – Sliding Scale and Yardstick

Incentives for Efficiency Increase medium

Practicability and Information Requirement medium

Regulatory Capture / Gaming medium

Potential for Over-/Underinvestment not clear

Regulatory Risk not clear

Sliding Scale

Principle:

Prices or revenues linked to the costs of a peer

group of companies

Application:

- Companies not allowed to charge higher prices

than the mean of the costs of peer group

- Few cases of practical application (Norway, the

Netherlands)

- Decouples allowed revenue from actual costs

Yardstick

Incentives for Efficiency Increase strong

Practicability and Information Requirement medium - high

Regulatory Capture / Gaming low

Potential for Over-/Underinvestment underinvestment

Regulatory Risk medium

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28 October 2013


Depending on the degree of coupling between costs and revenues the models using

incentive regulation can be divided into two major groups.

Linked caps (building blocks): UK, Australia, Central and Eastern Europe (Slovenia,

Macedonia, Romania etc.)

- Allowed revenues based on explicit cost projections for the upcoming regulatory period

- Focus on operating cost efficiency and separate checks of capex plans

- Often supported by supplementary schemes: efficiency carry over, sliding scale

Unlinked (decoupled) caps (often yardstick): Germany, Norway, the Netherlands,

Austria

- Allowed revenues based on regulatory formula (no explicit cost projections)

- Hindsight efficiency analysis using benchmarking on total costs including capital costs

- Often supported by supplementary schemes: quantity terms (pre-specified cost drivers)

incorporated in price control formulas, explicit investment allowances and caps on

inefficiency / floors on efficiency

Incentive Regulation – Linked and Unlinked Approaches

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Agenda







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28 October 2013

Regulatory Institutions – Who regulates?

Roles in the Regulatory Process

Primary and Secondary

Legislation

Regulatory Determinations

Licenses (e.g. generation)

Rules (e.g. market rules)

Consultation and Position

Papers

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28 October 2013

Regulatory Institutions – Who regulates?

Key tasks of the regulator:

- Transparent, consistent, predictable regulatory decisions (crucial for regulatory credibility)

- Consultation with stakeholders and communication with interested public

- Collection and conversion of data into regulatory decisions

- Identification of possible problems and solutions

Key prerequisites:

- Clear transparent rules and procedures for the regulator in the legislation

- Legal basis for regulatory independence (in terms of appointment, decision making and

funding) from government and regulated firms

Role of the Regulator

In order to ensure a transparent, consistent and predictable regulatory

framework without lobbying or governmental interventions, the law

must define rules and rights of the regulator and empower him.

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Agenda





5. Institutional Questions


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28 October 2013

Regulation in the EU

Status Quo of the European Electricity Industry

Customer Generator

Generator

Generator

Transmission

Customer

Customer

System

operation

Supplier

Supplier

Supplier

Distribution

Retail

market

Whole-

sale

market

Since 1996 the European Union has been

promoting the establishment of functional

competitive electricity markets.

EU policy objectives: competitive markets,

secure supply and clean environment

Competitive wholesale and retail electricity

supply

Strict unbundling requirements

Regulated network infrastructure, non-

discriminatory network access

Market integration policy

National RES support schemes and

European ETS

Independent national regulators

Regional coordination policy and

institutional framework (framework

guidelines and codes)

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28 October 2013


Timeline of the EU Electricity Legislation

1998 2003

› Directives 2003/54/EC (Electricity) and Directive 2003/55/EC (Gas)

› Complete market opening (full retail competition – 100% until July 2007)

› Regulated network access (only)

› Legal, functional and informational unbundling

› Creation of independent regulatory agencies

2nd Internal Market Directive 2003

› Directive 96/92/EC (Electricity) and Directive 98/30/EC (Gas)

› Negotiated or regulated third party access (to networks)

› Accounting unbundling

› Market opening – retail competition (first steps – 25% until 1999)

1st Internal Market Directive 1996/1998

1988

› EU Commission working paper

› Aim: Creation of a single European energy market:

– Cross-border transmission and trading

– Liberalisation

– Removal of distortions of competition

Concept of an Internal Market for Energy

› Directive 2009/72/EC (Electricity) and Directive 2009/73/EC (Gas)

› Switching of supplier within 3 weeks

› Roll-out of Smart Metering until 2020 for 80% of household customers

› Tightening of unbundling

3rd Internal Market Directive 2009

1996 2009

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Revenue cap is the currently the most used price control method; selected countries using

revenue cap: Austria, Denmark, Germany, Great Britain, Ireland, Spain and Sweden

Only a few countries use yardstick regulation: The Netherlands, Norway

Although the general method applied is similar, regulatory regimes may be highly different due

to the concrete features and specification of details

The design of regulatory models have been driven by several factors such as national and

regional energy policy, investment requirements, need for efficiency increase incentives, price

levels in the country, political and social factors and many more.

Also, regulatory regimes in different countries exhibit different degree of maturity:

- UK: 20 years history of price control, cap regulation, regulatory periods of 5 years

- Norway: regulation since 1997, moved from cap to yardstick regulation in 2007

- Netherlands: revenue caps 2001 to 2006, moved to yardstick regulation in 2007

- Germany: started applying revenue caps in 2009

- Austria: since 2006, revenue caps for electricity distribution and rate-of-return for electricity transmission

- Several countries in Central and Eastern Europe: moved to cap regulation in the last few years

Regulatory Price Control in the EU

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28 October 2013

End of Session 1.

Dr. Konstantin Petrov

Service Line Leader Markets & Regulation / Business Line Director Gas Consulting Services

DNV KEMA Energy & Sustainability

KEMA Consulting GmbH

Kurt-Schumacher-Str. 8

53113 Bonn

Tel: +49 228 44690 56

Fax: +49 228 4469099

Mobile: +49 173 515 1946

E-mail: [email protected]

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28 October 2013

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Principles of Price Regulation