Experience you can trust.
Regulatory Incentives for Investments in Electric Networks
A presentation to European Copper Institute
Dr. Konstantin Petrov / Rosaria Nunes
May 2009
2
Table of Contents
5. Analysis of Regulatory Incentives on Losses - Spain
3. Regulatory Practice - Examples
1. Rationale for Regulation
4. Case Study on Distribution Losses
6. Conclusions
2. Regulatory Models
3
Rationale for Economic Regulation
Scale economies
Scope economies
High initial (sunk) cost
Market failure in relation to externalities (not typical for networks)
One of the regulator’s tasks is to ensure that the transmission and distribution companies do not exploit their market power by operating inefficiently and charging high prices and/or providing inadequate quality of supply.
4
Regulatory Model (1)
Rate of return (also known as cost of service regulation or “cost plus”)
Transparent and easy to apply
Risk of over-capitalisation /over-investment
Rate of Return vs. Incentive Regulation
Rt = TCt-1 + ROR * RABt-1
Total cost in the previous year (inflated)
(Allowed) rate of return
Regulatory asset base
5
Regulatory Model (2)
Price / Revenue Cap
Rate of Return vs. Incentive Regulation
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
Pt = Pt-1 *(1 + CPI - X)
Inflation (consumer price index)
Productivity growth rate
Price in the previous year
6
Regulatory Model (3)
Building blocks
– Implemented as linked (coupled) cap regulation
– Formalised efficiency analysis of controllable OPEX
– Explicit projection of CAPEX for the upcoming regulatory period
TOTEX approach
– Implemented as unlinked (decoupled) cap or yardstick regulation
– Total expenditure level is regulated irrespective of its composition into CAPEX and
OPEX
– Inclusion of capital cost of historic investments into efficiency assessment modelling
– Usually CAPEX standardisation for benchmarking purposes
Building blocks vs. TOTEX approach
7
Regulatory Model (4)
Yardstick Regulation
– Base prices/revenues on an external benchmark, e.g. average cost in
industry
– Transparent, non-intrusive, cost and prices de-linked to a large extent
– Problems with the practical implementation
Quality of Supply
– Cost reduction incentives may lead to quality deterioration
– Quality regulation is necessary (public exposure, minimum quality
standards, incentive schemes)
Other Regulatory Models and Quality of Supply
8
Regulatory Model (5)
Trade-offs between OPEX and CAPEX
Regulation should encourage an efficient mix of OPEX and CAPEX
Inadequate regulation may encourage sub-optimal choices in terms of:
– Spending CAPEX when OPEX is the more efficient option
– Reclassify expenditures
– Delaying investments and causing risks on quality of supply
9
Regulatory Model (6)
Trade-offs between CAPEX and Quality of Supply
Providing higher quality will generally require higher costs – conflicting
incentives
Regulatory system does not provide guidance on what level of quality to
choose => establishment of explicit quality regulation
10
Regulatory Model (7)
Types of losses
– Technical (variable, fixed)
– Commercial
Valuing Losses
– Value of the electricity lost (the cost of generating it)
– Cost of providing the additional transportation capacity
– Cost of the environmental impacts
Regulatory incentive schemes for loss reduction
– Input-based scheme
– Output-based scheme
– Minimum technical standards
Regulation and Network Losses
11
Regulatory Practice – Selected Examples
Country Type of
Regulation
Regulatory
Period
Procurement
Network
Losses
Treatment of Network Losses
Germany Revenue cap 5 yearsNetwork
Operators
Included in the allowed revenue
(but not in the current
benchmarking exercise)
UK Revenue cap 5 years SuppliersExplicit loss adjustment term with
an allowed target level
Spain Revenue cap 4 years SuppliersExplicit loss adjustment term with
an allowed target level
NorwayYardstick
regulation
Allowed
revenue reset
annually
Network
Operators
Included in the allowed revenue
(incentives on physical volumes
via the benchmarking)
The
Netherlands
Yardstick
regulation
4 years
/transm.
5 years /distr.
Network
OperatorsIncluded in the allowed revenue
12
Case Study on Distribution Losses (1)
Indicative assessment of an investment in energy-efficient distribution
transformers
Economic incremental analysis: compares dynamically incremental
investments costs and incremental benefits defined by monetised loss
savings
Case study aims to broadly approximate the Spanish conditions
– Average load factor of 63% (based on previous studies)
– Loss savings monetised at the simulated wholesale market price
– Discount rate set equal to 5% and 6%
Simplified Cost-Benefit Analysis
13
Case Study on Distribution Losses (2)
The Present Value of the additional investment cost equals the Present Value of the reduced losses in 9 to
10 years.
Results 400 kVA transformers (i=5%; i=6%)
-2500
-2000
-1500
-1000
-500
0
500
1000
1 2 3 4 5 6 7 8 9 10 11 12 13Additional investment
Loss savings (i=5%)
Loss savings (i=6%)
NPV (i=5%)
NPV (i=6%)
14
Case Study on Distribution Losses (3)
When the difference in transformer prices decreases by 20%, the pay-back period of the
investment decreases to 7 years (instead of 9 to 10 years).
Results 400 kVA transformers (i=6%; ΔI= +/-20%)
-3000
-2500
-2000
-1500
-1000
-500
0
500
1000
1 2 3 4 5 6 7 8 9 10 11 12 13 Additional investment- A
Additional investment- B
Additional investment- C
Loss savings (i=6%)
NPV- A (i=6%)
NPV- B (i=6%)
NPV- C (i=6%)
15
Case Study on Distribution Losses (4)
When the electricity prices are 10% higher than the simulated future level in the model
(Scenario C), the pay-back period is 9 years for both the 400 kVA and the 630 kVA
transformer.
Results 400 kVA transformers (i=6%; ΔP= +/-10%)
-2500
-2000
-1500
-1000
-500
0
500
1000
1 2 3 4 5 6 7 8 9 10 11 12 13 Additional investment
Loss savings- A (i=6%)
Loss savings- B (i=6%)
Loss savings- C (i=6%)
NPV- A (i=6%)
NPV- B (i=6%)
NPV- C (i=6%)
16
Analysis of Regulatory Incentives on Losses - Spain (1)
Revenue cap with 4 years regulatory period
Formalised in a comprehensive regulatory formula
Include opex, depreciation and return on distribution assets
Does not account explicitly for capex in the regulatory period
Include a quantity term coupled to energy distributed
Include loss adjustment term aiming to encourage loss reduction
Include an incentive scheme for quality of supply
Include efficiency increase factors
Include inflation term
Distribution Price Control
17
Where:
Eperdin-1 : actual losses (%) incurred by distribution company i in year n-1 and calculated as
follows:
Eipf : energy measured at the distribution boundary in year n-1 (MWh);
Eig: energy produced by generators connected to the distribution network (MWh) in year n-1;
Eif: energy invoiced to customers connected to the distribution network (MWh) in year n-1;
Eperdiobj,n-1 : loss target for distribution company i in year n-1 defined as % of the energy
entering the distribution system;
PrEperd: price of energy losses (€/MWh).
Loss incentive scheme in Spain
Pin-1 = 0.8*PrEperd *(Eperdi
obj,n-1– Eperdin-1)*(Ei
pf + Eig)
Eperdin-1= [(Ei
pf + Eig) – Ei
f] /(Eipf + Ei
g)
Pin-1 is capped at +/-1% of the allowed revenue
Analysis of Regulatory Incentives on Losses - Spain (2)
18
Analysis of Regulatory Incentives on Losses - Spain (3)
Economically feasible investments in loss reduction equipment
Sufficiently long period for benefit retention
Trade-off between incremental CAPEX and loss savings
– Output-based regime should include an appropriate cost
allowance on losses to encourage efficient investments
– Input-based regime should incorporate the expected loss
reduction in the allowed cost
Factors that determine the properties of the loss incentive scheme
19
Analysis of Regulatory Incentives on Losses - Spain (4)
Option 1: Implementation of input-based scheme
– It requires specific project-based assessment
– Rolling forward the included assets and keeping the loss targets
reflecting the expected higher performance of the efficient transformers
– Any ex-post adjustment of the RAB should be aligned with proper re-
setting of loss targets
– Not considering the interdependences between the RAB and losses
may cause financial losses for the network operators
Improvement of the Spanish Loss Incentive Scheme
20
Analysis of Regulatory Incentives on Losses - Spain (5)
Option 2: Adjusting the current incentive scheme
– Setting Loss Targets
Use of a long term average of the actual loss values
Use a benchmark as an estimate of the efficient level of losses
– Loss Evaluation
Projected energy wholesale prices of electricity produced
Cost of providing additional transportation network capacity
– Caps on Incentive Payments
upper boundary on the level of risk to the company
reduces incentives to improve performance beyond optimal levels
Improvement of the Spanish Loss Incentive Scheme
21
Conclusions (1)
Incentive regulation encourages efficiency increase and cost reduction
The power of incentives depends on benefits sharing arrangements and
length of regulatory period
System for quality of supply regulation is imperative under incentive
regulation
Economically feasible investments (positive net benefits) in loss reduction
equipment (e.g. efficient transformers) should be encouraged via the
regulatory process
22
Conclusions (2)
Benefit retention period should be sufficiently long to encourage
companies to undertake investments in loss reduction equipment
– Implied in a loss target which is set annually on the basis of moving
average using historic data (e.g. last 15 years)
– Set explicitly for a period of time (e.g. two regulatory periods) by
imposing fix loss target during this time period
Setting network loss targets
– Based on the actual losses during a sufficiently long historic period
– Using some form of benchmarking (relative to the performance of other
companies) or using a reference network model
23
Dr. Konstantin PetrovKEMA Consulting GmbH
Kurt-Schumacher-Str. 8
53113 Bonn / Germany
Phone: +49 228 4469058 Fax: +49 228 4469099 Mobile: +49 173 5151946 e-Mail: [email protected]