Task 2.3 Incentive Regulation General approach to incentive regulation

1. Task 2.3 Incentive RegulationGeneral approach to incentive regulation 8 April 2008 Judith Aitken, Waisum Cheng, Katja Keller, Stefanie Kesting, Ilka Lewington 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

2. Objective & Contents Objective: to discuss with AERS the options in designing a cap-regulation system for Serbia Contents • General Issues • Cap-Regulation Methods • Building-blocks versus TOTEX-Approach • Determinants of the cap-regulation formula • Price control retail 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

3. General Features 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

4. 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 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

5. 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 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

6. General Features (2) • 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 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

7. General Features (3) • 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 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

8. Regulation Methods 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

9. Methods of regulation • Rate of Return regulation / Cost plus • Cap regulation • Price cap • Revenue cap • Yardstick competition 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

10. 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 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

11. 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 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

12. 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 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

13. 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) 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

14. How caps can work? 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

15. 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 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

16. Cap Regulation Methods 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

17. Price-cap regulation • Individual price cap • Price changes depend on • Inflation • Efficiency requirements 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

18. 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 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

19. 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 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

20. 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 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

21. 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 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

22. TOTEX versus Building Blocks Approach 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

23. 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 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

24. x x Regulatory Regulatory + + + + OPEX OPEX WACC WACC Depreciation Abschreibungen Asset Asset Base Base Annual allowed revenue Projection for the regulatory period Building Blocks 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

25. 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) 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

26. Example Building Blocks 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

27. 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” 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

28. Example TOTEX Approach 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

29. Building Blocks versus TOTEX • Discussion of pros and cons taking into account the Serbian circumstances 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

30. Determinants of price control 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

31. 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 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

32. 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 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

33. 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 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

34. 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) 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

35. 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 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

36. Correction Factor • Correction term set to adjust the difference between actual minus allowed revenue in previous years 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

37. 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 %) 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

38. 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 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

39. 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 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

40. 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 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

41. 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 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

42. Thank you! 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