This session explains the nature of economic regulation. It discusses the central question why some parts of the electricity value chain remain regulated and are not subject to competition. Furthermore, four main issues regarding an adequate regulatory regime are addressed: · Areas: Where should be regulated? · Scope: What should be regulated? · Type: How should be regulated? · Institutions: Who should regulate? Special emphasis is put on the types of regulation respectively the different forms of price control and their effects (advantages / disadvantages) – including incentive regulation. A short overview on the current legislation and application of price control in the EU completes the session.

1. Introduction to Network Regulation
Module 1: Principles of Price Regulation
Dr. Konstantin Petrov, DNV KEMA
28 October 2013

2. 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
Introduction to Network Regulation
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3. Introduction to Electricity Regulation
Why regulate?
 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).
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4. Introduction to Electricity Regulation
Characteristics of Electricity (Networks)
Load flow from generator
to consumer uncontrollable
and unpredictable
Economies
of Scale and Scope
Investments are capital
intensive
Characteristics of
Electricity (Networks)
Sunk costs
Transmission network
capacity should be able to
accommodate peak load
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Network capacity depends
on the location of
generation and load within
the network
Production needs to equal
demand plus reserve
margin at every point of
time

5. Introduction to Electricity Regulation
Balancing Interests
 Regulation must balance obligations to both customers and regulated companies
and also the costs and benefits of the regulatory system itself.
Customer and Company Interests
Costs and Benefit of Regulatory System
Price reductions
Fair return
Distortions to
industry structure
Prevention of
monopoly abuse
Protection against
monopoly abuse
Profit
opportunities
Costs of operating
regulation
Efficiency savings
and lower costs
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6. Introduction to Electricity Regulation
Choice of Regulatory Regime
 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.
Areas of Regulation
Scope of Regulation
What should be regulated?
Type of Regulation
How should be regulated?
Regulatory Institutions
Choice of
Regulatory
Regime
Where should be regulated?
Who regulates?
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7. 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
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8. Areas of Regulation – Which areas should be regulated?
Regulated and Competitive Elements
Power
Generation
Power
Transmission
Power
Distribution
Retail
Supply
System
Dispatch
Services subject to
regulatory control
Competitive services
Potentially competitive
services
Ancillary
Services
Wholesale
Supply
Metering
and Billing
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9. Areas of Regulation – Which areas should be regulated?
Regulation should focus on the network segment
 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)
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10. 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
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11. Scope of Regulation – What should be regulated?
Regulatory Controls
Regulatory Controls
Price Control




Revenue / tariff setting
Efficiency incentives
Investment sufficiency
Innovation
Quality of Supply
 Commercial quality
 Continuity of supply
(reliability)
 Technical quality
Market Functioning
 Market design / market
rules
 System / network
Other
 Unbundling
 Security of supply
 Innovation
rules
 Market monitoring
 Market integration
Regulation should ensure: functional market design, reasonable prices
and reasonable quality of supply for regulated services.
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12. Scope of Regulation – What should be regulated?
Elements of Price Control
Setting Revenue
Requirements
– 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)
Price / Revenue
Adjustments
– Setting a price control formula
– Application of adjustment factors: productivity increases, price and volume
adjustment
– Defining length of price control period
Efficiency
Assessment
– 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
Tariff Design
– 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
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13. Scope of Regulation – What should be regulated?
Elements of Quality of Supply
Continuity of
Supply
– Reliability of electricity supply
– Performance indicators (number and frequency of interruptions)
Technical Quality
– Physical properties of electricity
– Performance indicators (voltage variation, dips, flickers)
Commercial
Quality
– Customer service quality
– Performance indicators (complaints from consumers, response time to
consumer complaints, appointments with consumers)
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14. 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
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15. Type of Regulation – How should be regulated?
Forms of Regulatory Price Control
Regulatory price
controls
Cost-based
Regulation
Incentive
Regulation
Sliding Scale
Regulation
Rate-of-return
Profit
Sharing
Cap
Regulation
Revenue
Sharing
Revenue
Cap
Price Cap
Yardstick
 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.
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16. Type of Regulation – How should be regulated?
Cost-based Regulation – Rate of Return
 Principle:
Prices / revenues based on operating costs plus “fair” rate
of return on capital (cost recovery principle)
Rate-of-Return regulation
Return on Capital
 Application:
- Frequent (yearly) regulatory reviews
- Price setting theoretically by the companies, but in
practice regulator often determines prices directly
- Traditional form of regulation (USA)
Operating cost + Depreciation
Price
 Primary Objective:
limit profits, prevent companies from pricing above costs
Determined by regulator
Incentives for Efficiency Increase
Influenced by company
Practicability and Information Requirement
Regulatory Capture / Gaming
time
Potential for Over-/Underinvestment
Regulatory Risk
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weak
medium – high
high / low
overinvestment
low

17. Type of Regulation – How should be regulated?
Incentive Regulation – Cap Regulation
 Principle:
Establishes upper limit on prices or revenue
Cap regulation
 Application:
Current revenue level
Current revenue + Inflation
- Longer regulatory lag and regulatory period (3-5 years)
Current revenue + Inflation – productivity growth
- Requires explicitly productivity increase via the price
Actual Cost
formulas (X factor)
Efficiency gains
- Allows retention of efficiency gains; should address
Base level
for next
quality of supply
regulatory
Set by regulator
 Major Forms:
period
- linked caps (based on projection of capex and opex)
- unlinked caps (formula for adjustment of initial cost
base rather than projection)
Influenced by company
Incentives for Efficiency Increase
Influenced by company
Practicability and Information Requirement
Regulatory Capture / Gaming
time
Potential for Over-/Underinvestment
Regulatory Risk
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medium – strong
low - medium
low / high
underinvestment
medium

18. Type of Regulation – How should be regulated?
Incentive Regulation – Sliding Scale and Yardstick
Sliding Scale
Yardstick
 Principle:
Regulator sets target level of revenues the
company is permitted to keep; sharing scheme for
profits and losses
 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
 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
Incentives for Efficiency Increase
medium
Incentives for Efficiency Increase
Practicability and Information Requirement
medium
Practicability and Information Requirement
Regulatory Capture / Gaming
medium
Regulatory Capture / Gaming
Potential for Over-/Underinvestment
not clear
Potential for Over-/Underinvestment
Regulatory Risk
not clear
Regulatory Risk
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strong
medium - high
low
underinvestment
medium

19. Type of Regulation – How should be regulated?
Incentive Regulation – Linked and Unlinked Approaches
 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
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20. 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
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21. 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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22. Regulatory Institutions – Who regulates?
Role of the Regulator
 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
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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23. Agenda
1. Introduction to Electricity Regulation
2. Areas of Regulation
3. Scope of Regulation
4. Type of Regulation
5. Institutional Questions
6. Regulation in the EU
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24. Regulation in the EU
Status Quo of the European Electricity Industry
 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
Generator
Supplier
Customer
 Strict unbundling requirements
 Regulated network infrastructure, nondiscriminatory network access
Generator
Wholesale
market
Generator
System
operation
Supplier
Customer
 Market integration policy
 National RES support schemes and
European ETS
Supplier
Transmission
Retail
market
Customer
 Independent national regulators
 Regional coordination policy and
institutional framework (framework
guidelines and codes)
Distribution
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25. Regulation in the EU
Timeline of the EU Electricity Legislation
2nd Internal Market Directive 2003
Concept of an Internal Market for Energy
› 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
› EU Commission working paper
› Aim: Creation of a single European energy
market:
– Cross-border transmission and trading
– Liberalisation
– Removal of distortions of competition
1988
1996
1998
2003
1st Internal Market Directive 1996/1998
2009
3rd Internal Market Directive 2009
› 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)
› 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
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26. Regulation in the EU
Regulatory Price Control in the EU
 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
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27. 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: konstantin.petrov@dnvkema.com
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28. www.dnvkema.com
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