Tariff Regulation and Profitability of Energy Networks: A Model Analysis for TenneT TSO

1. Machiel Mulderdeputy chief economistNetherlands Competition Authority (NMa)34th IAEE conferenceStockholm, 19-22 June 2011 Tariff regulation and profitability of energy networks A model analysis for TenneT TSO

2. Scope of the research Background: • TenneT TSO is increasing its annual investment level significantly • statements made by industry and others that incentive regulation hinders investments Research question: What is the impact of the regulatory framework on the ability of the TSO to finance its investments? Method: • measure for financeability: NPV (Economic profit) >= 0 • model analysis: • using actual data of the TSO • simulating the impact of the regulatory framework on its revenues • given several scenarios on investments

3. Objective function of the regulator General objective: maximising consumer welfare That means: • consumers should not pay more than is needed to recoup the costs which are really needed to make (i.e. no excess profits) • network operators should be able to finance all the investments needed to have a network that meets the (future) demands of consumers (i.e. return on capital > opportunity costs of capital) The instrument to pursue this objective is price regulation 3

4. Fundamental aspects of price regulation Tightness of regulation The (economic) profit the operator receives in case normal expectations are fulfilled risk of underinvestment risk of illiquidity, non-financeability, bankruptcy tight e.g. rate-of-return with r* <= WACC or: low price cap plus short regulatory lags e.g. low price cap plus long regulatory lags low-powered high-powered e.g. rate-of-return with r* > WACC or: high price cap plus short regulatory lags e.g. high price cap plus long regulatory lags Strength of incentives The extent by which the operator may keep cost reductions or has to pay for cost increases Averch-Johnson effect (‘overinvestment’) risk of supranormal profits wide WACC = weighted costs of capital

5. Tightness depends on the treatment of inefficiencies Outputs Production frontier curves Potential future efficiency improvement Current inefficiency X (firm i) Dilemma: a. if tariffs are set on actual costs, consumers pay more than is technically needed b. if tariffs are set on efficient costs, the firm might be unable to finance investments Inputs

6. Decisions of the network operator Period t Period t+1 Period t+2 Efficiency improvements, investments & finance Efficiency improvements, investments & finance Costs Costs Balance sheet Balance sheet Balance sheet Revenues Revenues Regulatory framework = “Financial ratios” Accounting model: simulating the impact of regulation on financeability

7. Scenarios on investments Investments are assumed to triple in the short term

8. Regulatory revenues depend on past revenues and expected future efficient costs regulatory period Transport-task revenues: Rt = Rt-1 * (1- x) X = (1-Efficient costst=3/Rt=-1) System-task revenues: Rt = Actual costst-2

9. Future efficient costs are based on past realised costs corrected for inefficiencies Actual costs “Efficient” costs

10. Supply of debt capital is restricted by financial ratios (applied by banks) EBIT / Interest Cashflow / interest Cashflow / debt Debt / Assets (gearing)

11. Equity is indispensable to finance investments

12. NPV of economic profit depends on ability of the TSO to meet efficiency standards used in the regulatory framework TSO realises higher efficiency than used in the framework If period for repairing inefficiency is too small

13. Costs of inefficiency: actual costs versus efficient costs resulting from benchmark analysis Costs of inefficiency = actual costs – “efficient costs” 17

14. Allocation of costs of inefficiency among shareholders and consumers Costs of consumers because of “inefficient” network “Contribution” of shareholders 18

15. Conclusion • If the TSO realises the efficiency standards which are used in the regulatory framework, it will have no problems to finance its ambitious investment program: the NPV of the economic profit is positive. • Because of the inefficiency in the network of the TSO (compared to the best practice), someone has to pay for these inefficiencies. It appears that energy-users make a relatively strong contribution. • Realising both objectives of the regulator (i.e. prices <= efficient costs & return on capital > opportunity costs of capital) is only possible if firm is operating on the production frontier. (See NMa Working Paper no 3 (on Repec) for the complete analysis)