101012 pr3 response to comments to t for pub · target audience: this decision paper is for the...

Response to comments received to CER/10/102 (consultation on TSO and TAO transmission revenue

for 2011 to 2015)

DOCUMENT TYPE:

Response paper

REFERENCE:

CER/10/207

DATE PUBLISHED:

19th November 2010

QUERIES TO: Jamie Burke ([email protected]) The Commission for Energy Regulation,

The Exchange, Belgard Square North, Tallaght, Dublin 24. www.cer.ie

Abstract: This response paper provides a summary of the views provided by industry in response to the CER’s recent consultation on TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102). This paper also documents the CER’s response to those comments. This response paper should be read in conjunction with the CER’s decision on this matter (CER/10/206).

Target Audience: This decision paper is for the attention of members of the public, the energy industry, customers and all interested parties. It will be of particular interest to parties that directly pay Transmission Use of System (TUoS) charges to EirGrid as Transmission System Operator (TSO) and end-user customers to whom these charges are passed on. Related Documents: CER/10/206 Decision on TSO and TAO transmission revenue for 2011 to

2015 (published alongside this response paper). CER/10/102 Consultation on TSO and TAO transmission revenue for

2011 to 2015 (published alongside this response paper).

3

Executive Summary This response paper provides a summary of the views provided by industry in response to the CER’s recent consultation on consultation on TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102). This paper also documents the CER’s response to those comments. The received comments relate to the following:

• Operating Expenditure • Tariff Re-balancing • Capital Expenditure Proposal • Transmission Incentives • Miscellaneous Comments • WACC – Industry/ESB/EirGrid comments • Financeability – ESB/EirGrid comments • WACC related Capex Delivery Incentive

As outlined above there was a significant level of comment received from ESB and EirGrid in relation to the WACC proposal and Europe Economics (EE) report. To address these issues, EE has prepared a response to these comments and this is included in Appendix A below. This response paper should be read in conjunction with the CER’s decision on this matter (CER/10/206).

4

Table of Contents

Executive Summary .............................................................................................. 3

1.0 Introduction ................................................................................................. 5 1.1 The Commission for Energy Regulation .................................................. 5 1.2 Purpose of this response paper ............................................................... 5 1.3 Background Information ........................................................................... 5 1.4 Structure of this paper .............................................................................. 5

2.0 Comments received to CER/10/102 ............................................................ 7 2.1 Introduction .............................................................................................. 7 2.2 Comments received to CER/10/102......................................................... 7

2.2.1 Operating Expenditure (Opex) Proposals .......................................... 7 2.2.2 Tariff rebalancing ............................................................................. 13 2.2.3 Capital Expenditure (Capex) Proposals .......................................... 13 2.2.4 Incentives ........................................................................................ 17 2.2.5 Miscellaneous comments ................................................................ 19 2.2.6 WACC – Industry Comments .......................................................... 23 2.2.7 WACC – ESB Comments on EE report ........................................... 24 2.2.8 WACC – EirGrid Comments on EE report ....................................... 24 2.2.9 Financeability – ESB Comments .................................................... 25 2.2.10 Financeability – EirGrid Comments ............................................. 26 2.2.11 WACC related capex delivery incentive ....................................... 27

3.0 Conclusion ................................................................................................ 28

Appendix 1 .......................................................................................................... 29

5

1.0 Introduction 1.1 The Commission for Energy Regulation The Commission for Energy Regulation (‘the CER’) is the independent body responsible for overseeing the regulation of Ireland's electricity and gas sector’s. The CER was initially established and granted regulatory powers over the electricity market under the Electricity Regulation Act, 1999. The enactment of the Gas (Interim) (Regulation) Act, 2002 expanded the CER’s jurisdiction to include regulation of the natural gas market, while the Energy (Miscellaneous Provisions) Act 2006 granted the CER additional powers in relation to gas and electricity safety. The Electricity Regulation Amendment (SEM) Act 2007 outlined the CER’s functions in relation to the Single Electricity Market (SEM) for the island of Ireland. This market is regulated by the CER and the Northern Ireland Authority for Utility Regulation (NIAUR). The CER is working to ensure that consumers benefit from regulation and the introduction of competition in the energy sector. 1.2 Purpose of this response paper The purpose of this response paper is to provide:

• a summary of the views provided by industry in response to the CER’s recent consultation on TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102) and,

• a summary of the CER’s response to those comments. 1.3 Background Information Section 2.0 of the decision paper (CER/10/206) published alongside this response-to-comments document provides background information on the consultation process which led to the publication of this paper. 1.4 Structure of this paper This paper is structured in the following manner:

• Section 1 provides an introduction to this paper. It also provides information on where background information can be sourced;

• Section 2 provides a summary of the comments received in response to the CER’s recent consultation on TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102) and a summary of the CER’s response to those comments; and,

• Section 3 provides a conclusion. • Appendix 1 includes a note from our advisors, Europe Economics, to

comments regarding their report on the cost of capital.

6

In addition, the ten responses that were provided to the consultation (CER/10/102) are published alongside the response paper. Those responses were provided by:

• Bord Gáis Energy; • Chambers Ireland; • EirGrid; • Endesa Ireland; • ESB Corporate; • ESB Networks Ltd; • Forfás, IDA Ireland, and Enterprise Ireland; and, • IBEC Large Energy Users working group; • SSE Renewables; • The Irish Wind Energy Association.

The decision paper itself (CER/10/206) is also published alongside this response paper. It should be read in conjunction with this response-to-comments document.

7

2.0 Comments received to CER/10/102 2.1 Introduction On 5th July 2010, the CER published a consultation on revenue that EirGrid (as the Transmission System Operator, TSO) and ESB Networks (the Transmission Asset Owner, TAO) should be allowed to recover from the Transmission Use of System (TUoS) customer over the period 2011 to 2015. Section 2.2 of this response paper provides a compilation of, and the CER’s response to, those comments. 2.2 Comments received to CER/10/102 This section provides a compilation of the comments received to the CER’s recent consultation on transmission revenue (TSO and TAO) for the 2011 to 2015 period. For ease of reference the comments are grouped by topic. 2.2.1 Operating Expenditure (Opex) Proposals

Comment A number of respondents agreed with the PR3 efficiencies proposed by the CER for TSO and TAO opex. One noted that “the proposed efficiencies are appropriate for EirGrid and ESBN given the reduced cost of doing business in Ireland generally and the potential for reductions in labour costs as outlined by the CER and its specialist consultants”. One respondent noted that “CER’s assumptions result in an allowance for Operating Costs which is €36 million lower that ESBN’s forecast...excluding the cost components which are recognised as uncontrollable...the allowed costs are 21% lower than ESBN’s forecasts”. This respondent considered “that its submission was prudent and the anticipated efficiencies in operating costs were factored into the submitted costs” and that “the 2.5% per annum reduction in labour cost/productivity improvement (to be) extremely challenging”. Another stated that “there is scope for further reductions in operating costs that CER is recommending to be achieved by the TSO”. However they did not recommend any specific steps that could be taken by the CER in respect of TSO Opex. One respondent stated that CER’s analysis had “not taken into account the evidence that (its) operating costs are appropriate and in line with market and that the proposed allowance does not provide the necessary resources for

8

EirGrid to meet industry requirements”. The CER “has also not provided for the resources necessary for EirGrid to fulfil its Client Engineering function”. This respondent maintained that “(it) has provided, as part of this process, numerous pieces of evidence that show that its labour cost base is appropriate”. They requested the removal of the 5% reduction in EirGrid’s operating cost. There were two further requests made by this respondent in respect of Opex: • A clause to be included in the PR3 decision paper that the CER “will provide

the revenue associated with providing for an additional controller in the National Control Centre (NCC) upon the Commissioning of the East-West Interconnector”; and

• A clause to be included in the PR3 decision paper that revenues will be

adjusted if labour costs diverge from HICP by +/-2.5%.

Included in the PR3 transmission consultation was a proposal for a TSO ‘clawback’ of €8.48 million (see section 9.8 of the CER’s consultation paper). This respondent requested removal of this clawback “or, at the very minimum, the clawback to be reduced to the €3 million”. They went on to state that “if any clawback is made, a clause to be inserted (into the PR3 transmission decision paper) confirming that this is a once off provision associated with the exceptional uncertainty pertaining at the time of EirGrid establishment and does not represent a change to the underlying incentive regime pertaining”. Finally, this respondent requested the allowance of €150k per annum “related to the costs associated with the non-alignment of the revenue/tariff accounting years”. CER Response As noted in CER/10/102 the CER has carefully reviewed the TSOs and TAOs submissions on Opex for the PR3 period 2011 to 2015. In reaching a view on the appropriateness of the TSOs and TAOs proposals, the CER has taken into account, inter alia:

• The TSOs / TAOs historic performance and the accuracy of previous forecasts;

• The information gained from the accompanying benchmarking analysis

carried out by SKM; and

• The TSOs/ TAOs submissions on projected Opex. One of overarching principles guiding the CER in its proposal is to ensure that the activities being completed by the TSO and TAO and accompanying proposed revenues represent value for money for end-users and are set at an efficient

9

level. The CER accepts that the Opex efficiency targets contained in CER/10/102 are ‘challenging’, however the CER is comfortable that the Opex for the TSO and TAO will drive efficiencies in both utilities and will ensure that end-users are protected. Furthermore no new evidence has been provided by TSO during the consultation period to support removal of this provision. Indeed in the period between publication of the CER’s consultation paper (July 2010) and now (November 2010), the Irish economic situation has continued to deteriorate, with expectations of further salary reductions throughout the economy and no indications of a strengthening of the jobs market. Therefore the CER does not accept the TSO’s arguments in relation to the 5% Po cut – the 5% Po cut will remain. The CER’s position, based on advice from SKM, on the Client Engineering issue is unchanged from that of CER/10/102. The TSO and TAO should revisit the Infrastructure Agreement to determine more economical arrangements. With respect to the TSO submission, in arriving at a value of €11million per Client Engineer (CE), the TSO has taken the total PR2 allowed network Capex spend of approx. €520 million, averaged this over the 5 year control and simply divided by 9. However, even if only the estimated Stage 2 gross spend is used (after allowing for IDC) and also expressed in 2009 asset volumes this total only adjusts to about €500 million, and hence the € million/CE still approximates to €11 million/CE/year. Applying this latter approach to the TSO Deliverability Capex forecast, again adjusted to be Gross Stage 2 spend of €1.82 billion over five years (€365m/year) indicates the need for about 26 CEs at €11million/CE per year. Hence the TSO request for 20 implies an efficiency factor of about 28% for the total period, although this is only equivalent to 5% year on year from 2009. The number of CEs for each year of spend is as follows (assuming no year on year smoothing). Table 1: TSO Deliverability Capex Year 2011 2012 2013 2014 2015 AverageSpend (Gross Stage 2 - €m)

283 405 451 401 283

CEs (at €11m/CE) 20 28 32 28 20 26 CEs with EirGrid efficiency

16 22 25 22 16 20

If the SKM “Stretched Network Needs” capex forecast is used together with the assumed EirGrid efficiency factor the following numbers result.

10

Table 2: SKM Stretched Network Needs Year 2011 2012 2013 2014 2015 Spend (Gross Stage 2 - €m) 189 254 287 303 308 CEs with EirGrid efficiency

10 14 16 17 17

Hence, if only 9 CEs are allowed (as at present) then an 11% year on year additional efficiency is implied.

Such efficiency gains may seem unreasonable if the network develops with the same mix and value as historically. However, it is recognised that a significant proportion of the PR3 projects will be repeats, i.e. 110 kV overhead line reconductoring. Therefore, the CER believes it is not unreasonable to expect a considerable increase in the Project cost/CE input ratio from reduced engineering inputs compared with earlier (learning) projects1. For example, the capital costs of 400 kV overhead lines and substations are typically about four times that of a 110 kV equivalents, with the capital cost ratio of 220 kV to 110 kV equipment also being broadly proportional to voltage, i.e. about 2:1.

The Client Engineering input is not primarily determined by project cost or by operating voltage but rather by individual project characteristics and hence, from a high level assessment it is reasonable to assume that the number of CEs required by the TSO will not be determined by the associated Capex, as implied by the TSOs submission, but rather by the number of individual projects that are underway.

There is no evidence to suggest that the number of CEs required to fulfil the TSOs obligations under the IA should be driven by project Capex values, rather than by project complexity and individual project characteristics. Accordingly, given that the numbers and characteristics of projects during PR3 will be similar to those in PR2, it is reasonable to assume that there is little justification for the TSOs arguments for the number of CEs to increase above those presently employed. Accordingly, the CER remain of the view that it would be inappropriate to increase the allowance for Client Engineering activities. With regard to the request for an additional controller in the National Control Centre (NCC), as confirmed in CER/10/102 the CER will consider, in consultation with stakeholders, allowing costs for TSO requested additional control centre shift staff if and when requirements become clearer during the PR3 period. The CER has recognised that NCC manning may need to be increased and TSO should make a detailed and justified case to the CER when required during the PR3 period. This issue is linked to the East-West Interconnector project and the increase in renewable connections. However the CER does not currently accept

1 As the project mix in PR3 will include a number of extremely high value 220 kV and 400 kV related projects, i.e. where the project value does not necessarily equate to project complexity.

11

the TSO’s position that an additional controller is required in the NCC when the East-West interconnector comes onto the system. The TSO should indicate how the NCC will operate and what IT support is required, when the situation arises where the operation of the system to cater for a large volume of renewables as well as the Interconnector requires additional control centre expertise. Therefore this CER position has not changed during the PR3 consultation period. The CER does not propose to allow an adjustment to transmission revenues if labour costs diverge from HICP by +/-2.5%. Lack of volatility is one of the main reasons why the CER has chosen Ireland based HICP as the indexation factor for PR3. Changes in average hourly wages, as measured by the Central Statistics Office2 (CSO), can provide a volatile picture to the state of labour costs in Ireland. In the 22nd April 2010 CSO paper, “Earnings and Labour Costs Q3 2008 - Q2 2009 (Final) Q3 2009 (Preliminary Estimates)”, ROI average hourly earnings rose in the period Q3 2008 to Q3 2009 by 1.8%. However, this increase in average earnings needs to be viewed in the context of a total 8.4% drop in employment for the same period. In the most recent CSO earnings paper published on 21st October 2010, “Earnings and Labour Costs Q1 2010 - Q2 2010 (Preliminary Estimates)”, average hourly earnings fell in the period Q2 2009 to Q2 2010 by 1.0%. This is combined with a total 3.6% drop in employment for the same period. The CER notes the significant job security benefits associated with the TSO and TAO in a weak labour market. It is clear that current Irish macroeconomic factors are having a volatile impact on ROI average hourly earnings from quarter to quarter and that this macro-wide measurement of earnings is open to significant swings. HICP is a stable index and the CER continues to believe that the TUoS customer is better served with it being used as the PR3 indexation factor. The CER believes that there is no need for an Opex re-opener, which is based on a volatile measurement such as changes in ROI average hourly rates. As noted above the CER and its consultants undertook a detailed review of the PR2 historic performance of the TSO, which established an underspend on internal operating costs of circa €18.3 million. There has been a considerable amount of change to market and industry structures since the time of setting the PR2 determination. These changes include the vesting of EirGrid in July 2006, the signing of the Infrastructure Agreement also in 2006 and the implementation of the Single Electricity Market (SEM) in November 2007. Reflecting these various changes the CER allowed a number costs to be included in the allowed TSO revenue in PR2 subject to an ex-post review. However, the CER stated in 2 Please see following link for various CSO papers: http://www.cso.ie/releasespublications/pr_earns.htm

12

the 2007 to 2010 revenue determinations, that it expected these new and “start-up” costs to be incurred in an efficient manner by the TSO. The CER believes that the clawback of 50% of the €18.3 million TSO underspend accords with the principle of incentive based regulation. As noted in CER/05/143 (PR2 decision paper) and CER/10/102, the CER regulatory model contains and will continue to retain a rolling retention of benefits achieved through costs lower than target levels. Under this model the TSO and TAO will be able to retain these benefits for five years so that they remain neutral as to when in the regulatory cycle those efficiencies are gained. It is up to both the TSO and TAO to prove the creation of additional benefits and request their inclusion in the rolling retention. Where the CER deems that benefits gained have been as a result of forecasting error rather than efficiency gains, these benefits will be clawed back. This does not represent a change to the underlying incentive regime and has always been the case during price control periods. The CER and its consultants identified in CER/10/102 that 50% of this €18.3 underspend as efficiency savings made by the TSO in its activities. However the remainder of the underspend was identified as forecasting errors due to uncertainty at the start of the PR2 period. This CER position has not changed during the PR3 consultation period - the TSO should not receive a windfall benefit from that uncertainty, which would be ultimately paid by the TUoS customer. The TSO currently prepares and compiles its annual accounts compiled on the basis of the statutory accounts for the first 9 months of the calendar year and EirGrid board approved management accounts for the final three months of the calendar year. The CER acknowledges that this is an administrative task associated with the non-alignment of the revenue/tariff accounting years. However no evidence has been provided by the respondent that these accounting costs equate to €150k per annum. The non-alignment of the revenue/tariff accounting years is an issue. However the CER is not proposing to align the revenue tariff with the tariff year for PR3, at the present time, due to reasons laid out in CER/10/102. This is not to say that the issue will not be reviewed in the future, especially if any significant industry changes were to occur. Also, the CER does not feel that the current system of calculating tariffs across two revenue years, i.e. the demand weighted breakdown, is overly onerous and complex and continues to believe that the current system is transparent to stakeholders and to the TUoS customer.

13

2.2.2 Tariff rebalancing

Comment One respondent stated that while it understood that the merits of rebalancing and the value of the rebalancing is not open for consultation, the detail of how the rebalancing is levied on customers should be re-examined by the CER. They stated that it would be more efficient and indeed equitable if the rebalancing was charged wholly through customers’ standing charges as opposed to combined between the standing charge and unit rate. This respondent went on to state that applying the rebalancing through the standing charge only would firstly ensure that the full amount of the €50 million is recovered (and therefore reduce any shortfall considering the demand destruction that has been witnessed in recent years) and would also be more favourable for fuel poor customers. The standing charge for fuel poor customers is currently subsidised by the state, in this regard, the decision to rebalance network tariffs would have minimal impact on costs of fuel poor customers. Another respondent believes that passing all savings on to LEUs would constitute State Aid and that it has not seen any evidence that such a proposal has been notified to or approved by the European Commission. Response There are a number of ways in which the revenue could be allocated to domestic customers for recovery through the standing and unit rates. Recovering all of the revenue through the standing charge could lead to the effects outlined above by the respondent, but customers other than those on the Household Benefits allowance would face a larger increase in their standing charge. Depending on their usage this could have a relatively large impact on their yearly bill. There is no one correct methodology for this, but the CER believes that the methodology outlined in the consultation paper (and repeated in the decision) strikes an appropriate balance between the unit and standing charges. With regard to the second point, the CER is simply implementing a decision made by the Government, communicated in July 2009. Any clarifications on this Government decision should be directed to the Department of Communications, Energy and Natural Resources. 2.2.3 Capital Expenditure (Capex) Proposals

Comment One respondent believed that the delivery of the transmission network in PR3 is of paramount importance. “Failure to deliver this expanded grid not only diminishes the short-term economic contributions possible, it also sustains the

14

significant and growing physical constraints imposed on electricity transfers by the inadequacies of the current network”. With regard to the utilisation of the transmission network, “significant effort should be directed by the TSO, with the TAO supporting, at implementing available industry best practices that allow greater utilisation”. Another respondent noted that the delivery of the PR3 Capex programme will require continued close collaboration with EirGrid in its role as TSO. One stated “that the Capex proposals must be considered in the context of the viability of the business, and ESB’s ability to finance the investment required and to secure a return on that investment as well continuing to adequately remunerate the very substantial investment already made in previous Price Control periods”. One respondent stated that it is vital that the CER ensures “network upgrades are delivered as cost effectively as possible and that major efficiencies are delivered by EirGrid and ESB Networks (ESBN) as proposed in this consultation”. They went on to state “that the proposals strike an appropriate balance between minimising network tariffs and providing for an efficient level of investment in upgrading the transmission network”. Finally, one respondent noted that “there are certain assertions or assumptions in the (SKM and CER) reports with which it either does not concur or which it believes are overstated in their potential benefit. (i) The potential benefits associated with Special Protection Schemes have been overstated. Moreover the wider consequences of their deployment, in terms of longer term network security and operational security would require further consideration. (ii)The full benefits associated with Dynamic Line Ratings are also unlikely to be realised in an Irish context. In particular, the benefits are likely to be greatest in relation to the accommodation of radial connections rather than in a wider meshed network. (iii) The analysis in the paper in relation to N-1 criteria and ‘single dominant circuit characterisation’ fails to take account of the wider-network and load-flow analysis”. However, they acknowledged the flexible approach taken by the CER and SKM with regard to ensuring that the appropriate projects are delivered in a cost effective manner. CER Response The CER believes that the delivery of transmission network assets is fundamental to the success of PR3. Essentially, the purpose of the PR3 Capex review by the CER and its consultants is to ensure that the correct, appropriate and fully justified level of network investment takes place in order to deliver the network capacity required for Gate 3 and to meet Ireland’s 2020 renewable targets.

15

As noted in CER/10/102, the CER believes that while this investment in the Irish transmission system is necessary, we will do all in our power to ensure that PR3 Capex will be incurred as efficiently as possible, which will include implementation of industry best practices where applicable. The efficient delivery of PR3 will be examined by the CER through use of an annual Capex monitoring program and a cost benefit analysis (CBA) template. The refined PR3 Capex monitoring and approvals process will be outlined in conjunction with the PR3 transmission incentives workstream. As part of its response to CER/10/102 the TSO claim to be employing special protection schemes to enable maximum benefit to be obtained from connected generation prior to the completion of associated reinforcements. However, the TSO dismiss longer term reliance on such measures. This dismissal is not supported by any evidence of having given such measures serious consideration and fails to recognise that the mixed nature of the Irish network, where relatively small blocks of intermittent wind based generation are exporting power over similarly rated 110 kV lines, which are only rated at about 100 MVA. As the transmission network is required to be planned and operated securely against the sudden loss of such a line, without any loss of generation, large parts of the network are under-utilised for the greater part (95%) of the time. It is recognised that the Irish grid system operates with spinning reserve broadly equivalent to the largest operating unit (450 MW). Therefore, it is evident that the there is significant scope for the opportunistic use of the network to allow these smaller (100 MW) blocks of generation to both connect and run for the greater part of the time, whilst the network can remain secure against a forced loss of plant of this magnitude.

16

Reference should be made to the existing and planned transmission network diagram (Fig A-2 above taken from the 2010-2016 transmission forecast statement) which demonstrates the sparcity of the network, particularly along the ‘wind rich’ western seaboard. This sparcity, which allows individual ‘transmission corridors’ to be identified and easily monitored using modern data acquisition and processing equipment, lends itself to the application of “special protection systems” (SPS) that can initiate the disconnection of the appropriate block of generation. This will ensure that the transmission system is not overloaded in the event of a sudden loss of a circuit element.

The TSO’s very statement that the use of SPS could negatively impact on system security and quality of supply “would require much wider consideration than that of minimising only network costs” is indicative that the TSO has failed to give the necessary consideration to such schemes in the past or to seriously challenge the arguments referenced in the consultation documents.

17

It appears that the TSO has failed to grasp the benefits that can be gained by the use of dynamic line ratings (DLR), specifically on a network where significant transmission investment is associated with the connection of wind-based generation. They do not present any evidence of any earlier work that they could have undertaken to investigate potential benefits. Indeed the pilot DLR project that they reference has been primarily driven by concerns about circuit loadings when the wind is not blowing, rather than when it is.

The critical reference to the SKM report, where the TSO indicate that SKM has failed to take into account the impact of the use of High Temperature Low Sag (HTLS) conductor types, misses the point that the use of DLR would mitigate the need to introduce such conductor arrangements onto the network. In essence all that DLR is intended to do is to allow the network to make fuller use of freely available network capacity. The arguments to restricting the use of DLR to radial parts of the network are equally flawed, given that one of the perceived operational problems in Ireland with wind generation is that the wind tends to blow everywhere at the same time and hence the capacity of almost every circuit will be enhanced. The use of DLR will simply act to inform the operator of the available network capacity and also warn of actual circuit overloads.

A final comment relating to the use of assumptions about the benefits of SPS and DLR, within the Irish context, is that SKM’s assessment has been based upon a complementary rather than a compound approach, i.e. a relatively conservative assessment has been undertaken. 2.2.4 Incentives

Comment A majority of respondents commented on potential Incentive parameters for the transmission utilities in PR3 and supported the proposed incentives for delivery of enhanced network capacity. One respondent believed that delivery of transmission network in PR3 is paramount and that “providing adequate incentive to the TSO/TAO offers a better path to ensuring delivery of network” and that “incentives should be provided so that where more performance can be derived from the current assets, so should be done”. Another stated that they would welcome the “publication of specific, transparent incentives for ESBN and EirGrid to meet the challenge of delivering a step-change in investment to upgrade the transmission network in a cost effective fashion”. One respondent stated that they did not believe the “proposed (TSO) cap on incentive charges is sufficiently material to be relevant and effective. Recognising that the TSO is asset light at the present time, it will hold a significant asset in the interconnector within the second year of the five-year review period”. This respondent suggested “that there is sufficient scope for the incentive cap to be

18

revised upwards from the second year of PR3. Furthermore, certain of the incentives, such as network delivery, can be shared between the TSO and the Transmission Asset Owner (TAO) in a bid to maximise efficiencies and attribute the burden of delivery appropriately”. This respondent also believed that “where the efforts of the TSO and TAO succeed in reducing costs to customers by delivering infrastructure in a timely fashion they should be rewarded and where the infrastructure is late, a similar reduction in revenues should accrue to the appropriate party that was responsible for the delay...(and) that an incentive should be placed on the TSO in this regard, such that it will actively engage with participants and new investors to develop and build ancillary services that will add benefit to the system and its underlying costs”. Another respondent stated that “single accountability, and end to end responsibility, which will result post asset transfer will at that time enable the Commission to put in place meaningful incentives for network build and will ensure consumers ultimately benefit” and that it wished “to see an increase in the power of incentives in areas highly valued by consumers”. Finally, one respondent believed that “emphasis should be placed on optimising outage plans to ensure maximum availability of the transmission system”. This respondent also requested for the TSOs to be instructed to implement an ancillary services auction, “whereby the lowest bidders could be awarded annual contracts for the provision of ancillary services, with longer-term contracts to incentivise new entrants”. CER response As noted in CER/10/102 the CER is keen to continue the appropriation of incentive mechanisms to the TSO (and now to the TAO) into the PR3 period. Improvements in transmission system performance, grid infrastructure build and achievement of the Government’s 2020 renewables targets will be fundamental to the setting of transmission incentive mechanisms in PR3. The CER has had discussions with the TSO and TAO over the proposed incentive mechanisms during the PR3 consultation period. Proposed transmission incentives for the next incentive period will be consulted on with stakeholders in a separate CER paper in the coming weeks. The East-West interconnector (EWIC) will not be included in the TSO RAB when complete, as the EWIC operator will be a separate licensed entity3. Therefore,

3 Please see the following link: http://www.cer.ie/en/electricity-distribution-network-current-consultations.aspx?article=990f937b-460d-4026-a811-65ed19f4154a

19

the CER doesn’t believe there is sufficient scope for the TSO incentive cap to be revised upwards on the basis of the envisaged completion of EWIC in 2012. EirGrid, under its TSO licence, is already charged with optimising outtages to ensure system security and reliability. The CER does not believe it prudent to set incentive mechanisms for the TSO for an activity it is already required to do by licence4. It is noted that Constraints costs and Ancillary Services payments/ other system charges are now dealt with on an all-island basis5. Arrangements for harmonized Ancillary Services have been consulted on with stakeholders for the last two years6. The CER believes that modifications to the all-island ancillary services arrangements should be dealt with outside of the PR3 transmission regulatory review. The second annual review of Harmonised all-island Ancillary Services Arrangements will be carried out in 2011, where interested parties will have a full opportunity to provide their comments and proposals on ancillary services. However, as stated in CER/10/102 the effective management of Ancillary Services and Constraint levels by the TSO is of concern to the CER. The creation of an incentive mechanism for the TSO to control and indeed reduce these external costs will remain an option for introduction at some point in the PR3, i.e. post completion of the 2011/2012 incentive period. The CER currently believes that it may be appropriate at that point in PR3 to introduce such an incentive, seeing as there should be sufficient experience garnered under the harmonised arrangements on which to base a suitable forecast and incentive design. 2.2.5 Miscellaneous comments

Comment regarding use of HICP Two respondents noted the CER’s proposal to depart from the internationally accepted practice of using the Consumer Price Index (CPI) as the basis of indexation instead of the Harmonised Index of Consumer Prices (HICP). The two stated that CPI is the generally accepted index in regulation for adjusting for inflation and is the most widely used by all other regulators in Ireland and elsewhere, and that it was unclear as to why HICP might be considered a more appropriate choice. One stated that “HICP is not in common parlance”, it

4 Please also refer to AIP-SEM-236-07, Decision on Generation and Transmission Outage Planning. 5 Please see the following link: http://www.allislandproject.org/en/transmission_decision_documents.aspx?article=7ca6878c-058f-4497-8967-23a9c405d302&mode=author 6 Please see following link: http://www.allislandproject.org/en/transmission_current_consultations.aspx?article=e70f9039-921b-4978-815c-563f5128e27c

20

excludes a key cost driver and that using HICP as the indexation factor would create regulatory uncertainty. This respondent stated that the CER’s argument that HICP is likely to be less volatile does not justify such a radical step. They note that this is inconsistent with the CER’s reasoning for the introduction of HICP in the Bord Gáis determination in 2007, which stated that: “the inflation allowed in BGN’s revenue calculations is Irish HICP which is less than the inflation of operating costs which are driven by the CPI. This incentivises BGN to make efficiencies in its operating costs as revenues are inflated at a lower rate than operating costs”. This respondent also stated that even if one was to accept the use of HICP rather than CPI as a legitimate initiative..to incentivise cost reductions...it would be unfair to impose this implicit cost efficiency mechanism on top of the separate, explicitly specified, cost reductions proposed by CER for the utilities. It stated that using both mechanisms is not appropriate and urged the CER to retain CPI as the basis of indexation in its revenue formula. CER Response The CER notes the point made by these two respondents. However, the CER does consider that HICP is an appropriate measure. HICP is less likely to display volatility and the two indices tend to converge in the longer term. The CER believes that the notion that HICP is not in ‘common parlance’ and therefore not appropriate is irrelevant – what is relevant is stable transmission business revenues coming from the application of HICP, which will be a benefit to both the final customer and the transmission utilities. The CER also believes that stable transmission revenues will also promote regulatory certainty, as opposed to uncertainty. The main difference between the two indices is mortgage interest rates and the CER does not see this as having a significant impact or immediate impact on the utilities costs. Comment regarding Generator TUoS One respondent requested clarity on the estimated level and impact of Generator TUoS on business consumers bills during PR3. CER response Generator TUoS levels will not affect Demand business consumers during PR3. Transmission revenue recovered from both Demand and Generators is broken down as follows:

21

i. Transmission controllable costs, e.g. depreciation on RAB, Payroll costs of

TSO/TAO etc are split from Transmission non-controllable costs, e.g. Ancillary services.

ii. Transmission controllable costs are then split 75% Demand customers /

25% Generators. It is this 25% of controllable costs that sets Generator TUoS rates. These Generator TUoS rates have no impact on Demand TUoS rates. Transmission non-controllable costs are paid almost exclusively by Demand (1% of it is Generator Trip payments paid by Generators).

iii. 75% Demand is then broken down 60% Capacity Charge (KW charge)

and 40% Transfer charge (kWh energy charge). With regard to the request by one respondent to meet with the CER to discuss the PR3 transmission revenue profile, the CER is always willing to meet any stakeholder to discuss these matters and we will look to do so with this respondent in the near future. Comment regarding Dispatch Schedule One respondent asked that as part of the PR3 the TSO commits to providing more detail “around the assumptions, inputs and workings of the dispatch schedule”. CER response The CER believes that assumptions, inputs and workings of the dispatch schedule are outside the scope of the PR3 regulatory review. However, this issue is currently being addressed in the all-island Scheduling and Dispatch workstream7, as well as the all-island Locational Signals workstream8. Comment regarding modelling One of the respondents noted that there have been changes made in the revenue control model around the assumptions of the timings of payment. The change in the assumptions has led to a change in the calculation of the overall revenues, due to changes in the discounting treatments of different revenue line items when compared to the revenue model used for PR2.

7 Please refer to the following link: http://www.allislandproject.org/en/renewable_decision_documents.aspx?article=b94b7748-1faf-41e3-975a-a0323d074eca 8 Please refer to the following link: http://www.allislandproject.org/en/transmission_decision_documents.aspx?article=088eef30-d751-4a76-8ac6-d62800950589&mode=author

22

This change has a real impact on revenue streams and financial projections, and this respondent sought clarification from CER on the financial calculations. This respondent believed that the overall effect of the changes may be to reduce the overall revenue, compared to the revenue that would result had the discounting methodology used in PR2 been employed. The respondent was concerned at the lack of clarity around the financial modelling methodology. CER response The assumptions included within the CER model for the 2011 to 2015 period are internally consistent and the CER believes this is the correct treatment. The CER is open to providing any further clarification that is required, but does not see any rational for using different assumptions within the model. Comment regarding ‘factual errors’ One respondent outlined a number of apparent errors in relation to the proposed transmission revenues detailed in CER/10/102 and CER/10/102(f): 1. The calculation of the 2009 baseline Payroll costs against which a 5% reduction has been applied; 2. An error in the Spreadsheet in the derivation of Working Capital; and 3. Adjustments to the Opening Asset Value of the RAB and depreciation profile. CER response The CER has considered TSO’s submission with regard to the appropriate baseline figure for 2009 on which to base the 5% Po cut in TSO payroll. The CER’s objective for PR3 remains, to allow an efficient and fair level of payroll allowance taking on board the expertise and level of staff required by the TSO to carry out its functions, but also considering the current labour market, SKM’s benchmarking exercise, the security benefits of employment with the TSO and the fact that the TSO has been largely insulated from the realities of the economic situation in Ireland over the past 2 years. The CER has now decided to allow payroll allowance of €118.69 million for the PR3 period, taking on board TSO’s concerns over the TSO pension contribution (IAS 19) which were anomalously low in 2009 relative to other years (below 10% of pensionable pay and below cash contributions actually made by the TSO in 2009). Therefore, the CER has decided to apply the same percentage employer contribution into PR3 TSO Salaries and Payroll costs as that applied to the TAO in PR3 – 13.5%. It is important to note that this amendment to TSO Salaries and Payroll costs has no impact on the issue of pension deficit repair in either of the transmission

23

utilities. As stated in CER/10/102 the treatment of the pension deficits within both utilities will not be dealt with as part of the PR3 process. In relation to the second point, the CER acknowledges that there is an error in the working capital spreadsheet. The calculation did not fully include the external opex element of the function. This error has been corrected for the purposes of the final decision. Finally, in relation the third point the CER has worked with the TSO during the consultation phase, based on established CER methodology, to ascertain the correct 2011 opening asset value of the TSO RAB. 2.2.6 WACC – Industry Comments

One respondent highlighted potential flaws from their viewpoint, in the logic used to calculate the WACC: anchoring bias and selective bias. Anchoring bias relates to the use of historic regulatory decisions to make a future decision, thereby anchoring the future decision. With respect to the selection bias, the respondent notes that while European data such as government bond yields and corporate bond spreads are used as input data to calculate the WACC, only British and Irish regulatory decisions are used. In particular the respondent highlights that French government bonds are used as one of the inputs to determine the Irish risk free rate while the risk free used by the French energy regulator in a recent decision is significantly higher9. The respondent suggests that the CER broaden the analysis to include regulatory decisions on WACC from French and German regulators. CER Response The CER acknowledge that anchoring bias is a potential issue. In advising on the level of the WACC the CER’s advisors have reviewed other regulatory decisions as a cross check, however these decisions are not the only information used to estimate the WACC. Therefore we do not believe anchoring bias to be a significant issue. With respect to selection bias, the CER believes that its advisors, Europe Economics have reviewed a broad range of data to arrive at their conclusions and have not been selective in the use of data to support their conclusions. The CER believes that the respondent may be mistakenly comparing a nominal and real risk free rate. Using a real risk free rate and adjusting for the difference in taxation the CER believe that the WACC determined by the French regulator is comparable to that proposed by our advisors. With respect to regulatory decisions from Germany, the CER understand that the form of regulation is different due in large part to the significant number - over nine hundred - of

9 The decision referred to by the respondent can be found on the following web link. http://www.cre.fr/fr/acces_aux_reseaux/reseaux_publics_d_electricite/tarification_acces_aux_reseaux

24

distribution networks in Germany. The German regulator uses a form of yardstick regulation which does not require an ex-ante WACC to be estimated. 2.2.7 WACC – ESB Comments on EE report

The ESB response highlights a number of issues with our advisors report on the WACC for the TAO. Details of these issues are contained in reports by ESB’s consultants, Oxera and Indecon. The majority of the issues are technical in nature and relate to the correct use and manipulation of data in estimating the WACC. The issues can be summarised as: • Failure to include a Blume adjustment in the calculation of beta • Failure to include a Vasicek adjustment in the calculation of beta • The application of a downward adjustment to the cost of debt to take

account of the expected probability of debt default; • The calculation of gearing in comparator companies and the effect on

asset betas • An inconsistent methodology between the risk free rate and debt spread

for Ireland leads to the cost of debt being too low. • Insufficient account of the financial crisis in Ireland and existing

uncertainty;

The CER’s advisors, Europe Economics, have provided a response to each of these comments. This response is attached in Appendix 1. The CER believes that Europe Economics have addressed the points raised by ESB and their consultants. 2.2.8 WACC – EirGrid Comments on EE report

The EirGrid response highlights a number of issues with our advisors report on the WACC for the TSO. The issues can be summarised as: • Failure to acknowledge the characteristics of EirGrid’s business affecting

the Opportunity Cost of Capital; • Failure to acknowledge the EirGrid market experience of Debt Premium;

and • Failure to incorporate Country Risk Premium into cost of capital

calculations. Our advisors, Europe Economics, have provided a response to each of these comments. This response is attached in Appendix 1. The first issue raised by EirGrid is also responded to in Appendix A of Europe Economics report – CER/10/103(j). The CER believes that Europe Economics have addressed the points raised by EirGrid and their consultants.

25

2.2.9 Financeability – ESB Comments

While ESB agrees that an “A” credit rating is the appropriate target credit rating, ESB believes that a WACC of 5% is insufficient to achieve this target. ESB has engaged two consultancy firms to advise them on this matter and both have concluded that the target credit rating is not achievable. Oxera have analysed the assumptions used by CER to support its position and concluded that the assumptions are unrealistic or inconsistent with other aspects of the determination. The issues that ESB have highlighted with CER’s published modelling are that it: • Underestimates the initial debt burden of ESB Networks; • Overestimates the ability of ESB Networks to deal with financeability

issues by using index-linked debt; • Overestimates the discretion available to ESB Networks with regard to

dividend payments; • Does not provide sufficient transparency with regard to the roll-forward of

ESB Network’s debt. CER Response The CER has worked with ESB and its advisors to understand the difference in modelling assumptions used by the CER and ESB. With respect to the first two items, the CER assumed that 70% of debt was conventional and 30% was indexed link. Indexed linked debt has the advantage of lower interest payments at the beginning of the period as a real interest rate is used. This can be used by companies with large capital expenditure programmes to reduce the cash to service the debt in the initial years. However the principle is indexed leading to the annual interest increasing in nominal terms over the period. This type of debt has the advantage of aligning, to a greater degree, with the CER’s decision to apply a real return of ESB’s asset base. ESB have responded to state that there is no market for indexed link debt in Ireland and therefore assuming 30% of their debt is indexed linked is unrealistic. Also using a combination of indexed and conventional debt appears to underestimate the level of debt when compared to a real Regulatory Asset Value (RAV). The CER agrees that when calculating the gearing of the business using some indexed linked and conventional debt divided by a real RAV, it appears that the quantity of debt is underestimated. To do this calculation correctly requires the RAV to comprise real and nominal asset values in the same proportion of the debt. The CER has looked further into the use of indexed debt and the views that credit rating agencies apply to index linked debt.

26

Standards and Poor’s analysis10 effectively ignores the benefits of index-linked debt believing “this approach better captures the after-interest cash flow generated by the company's operations, including the full cost of the debt used to finance those operations.” It should also be noted that in the calculations involving net debt Standard and Poor’s analysis also subtracts the indexation effects from the principle. While Moody’s on the other hand takes into account indexed linked debt as evidenced particularly in its analysis of the water industry in Great Britain. While the CER may accept that there is not currently a market for Irish index linked debt, given that the return on ESB Networks is calculated is using a real return, we would expect ESB to investigate the options of aligning its cost of capital more closely to its regulated return. With respect to the calculation of net debt, the CER has used the historic cost or nominal value of the RAB and a level of gearing consistent with the WACC calculations. The dividend payment policy is a matter for ESB management and its shareholder. However the CER believe that it is reasonable for the dividend policy to be reviewed in light of the significant investments required in the coming years. With respect to the transparency of the debt roll forward calculations, the CER used an average debt balance (the sum of the opening and closing debt divided by two) to calculate the interest incurred during the year. As the amount of new debt incurred in the year in the model is dependent on the interest incurred in that year, the calculation of new debt and interest is iterative. In the model published along with the consultation paper, the CER has used Excel’s goal seek function to calculate the required amount of new debt. To improve transparency the CER will calculate the interest incurred based on the opening debt. 2.2.10 Financeability – EirGrid Comments

Connected to the point made above in section 2.2.8 EirGrid argue that small companies may have to pass tougher credit ratios to obtain a given rating. “It is unlikely that the same WACC applied to a small company, i.e. TSO, and a large company, i.e. TAO, will lead to both being able to achieve their respective credit ratios for a certain rating level”. The CER acknowledges that EirGrid, due to arrangements of the Infrastructure Agreement, is susceptible to external shocks which affect their financeability. It was for this reason that the CER proposed to amend TSO working capital

10 See note from Standard’s & Poor’s entitled Recognizing The Sustainable Cash Cost Of Inflation-Linked Debt For Corporates http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245199751904

27

arrangements from that of PR2 and introduce a pre Project-Agreement working capital cost mechanism, as detailed in CER/10/102. Based on the transmission model published alongside this paper the CER is confident that the TSO, even with a much smaller RAB than the TAO, meets the financeability test for an A credit rating. 2.2.11 WACC related capex delivery incentive

The CER requested respondents to provide views on using a WACC related capex delivery incentive. One respondent noted that there is an implicit incentive already provided for the delivery of the capex programme, i.e. if investments are not made returns are not earned. The respondent states that introducing a ratchet to the WACC which covers the entire RAB results in a broader mechanism that is too diffuse and affects returns on other elements that have nothing to do with delivery of the network. CER Response The CER agrees with the respondent. While the CER believes there is merit in providing an incentive for the delivery of the capex programme there is no overriding reason to link it directly to the WACC. The CER is currently examining a financial incentive mechanism linked directly to the delivery of the transmission capex programme, but which will not be related to and will not impact on the rate-of-return earned by the transmission utilities. Proposed transmission incentives for the next incentive period will be consulted on with stakeholders in a separate CER paper in the coming weeks.

28

3.0 Conclusion Section 2 of this response paper provides a summary of the comments received from industry members in response to the CER’s consultation on the transmission revenue that the TSO can collect through TUoS tariffs during the 2011 to 2015 period (CER/10/102). That section also provides a summary of the CER’s response to those comments. In addition, the ten responses that were provided to consultation (CER/10/102) are published alongside the response paper. Those responses were provided by:

• Bord Gáis Energy; • Chambers Ireland; • EirGrid; • Endesa Ireland; • ESB Corporate; • ESB Networks Ltd; • Forfás, IDA Ireland, and Enterprise Ireland; and, • IBEC Large Energy Users working group; • SSE Renewables; • The Irish Wind Energy Association.

This response paper should be read in conjunction with the CER’s decision on this matter (CER/10/206).

Appendix 1 This section provides a Europe Economics document which provides responses to comments provided by ESB and its consultants as part of the consultation process.