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ERRA Tailor-made Training Course: Principles of Tariff Regulation
Implemented for: Oman Power & Water Procurement Company
December 2-4, 2018 • Muscat, Oman
Economics of Price
Regulation
Ardian Berisha
Energy Regulators Regional Association
2ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Contents
• Economics of Regulation
• Tariff regulation in practice
• Energy balance
• Regulatory Asset Base
• WACC, Depreciation and Return
• Cost recovery principles
• Tariff review process
3ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Where and when to regulate
• Generation and Supply prices
• Market concentration
• Market Power
• Inefficient markets
• Transmission and distribution charges
• Natural Monopolies
• Regulated to move production towards
socially optimal prices
4ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Where and When to regulate
• Herfindahl-Hirschman Index
(HHI)
• Commonly-accepted
indicator of market
concentration
• Square the market shares
of the firms operating in
the market
𝐻𝐻𝐼 = 𝐺12 + 𝐺2
2 + 𝐺32 +⋯+ 𝐺𝑛
2
G G G
TSO/MO
DSO
C C C
S S S
5ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Where and When to regulate
Example
G1=30%, G2=50%, G3=20%
𝐻𝐻𝐼 = 302 + 502 + 202
= 900 + 2500 + 400 = 3800
G G G
TSO/MO
DSO
C C C
S S SHHI Index Market Concentration*
0-1500 Competitive market
1500-2500 Moderately concentrated market
>2500 Highly concentrated market
*As per U.S. Department of Justice
6ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Economics of Regulation
• Demand curve (D)
• Total Costs (TC)
• Fixed costs (FC)
• Variable costs (VC)
• Average Total Costs (FC+VC)/Q
• Total Revenue (TR) p x Q
• Marginal Revenue (MR) – dTR/dQ
• Marginal Costs (MC) – dTC/dQ
• Profit (𝜋) = TR-TC
7ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Econ101 - Demand
• The relationship between
the Price (p) of a product
and its quantity demanded
(q) is reflected in the
Demand Curve
• For any q, there is a max p
that customers are willing
to pay and vice-versa
• The lower the price the
higher the quantity
demanded, as
characterized by the
negative slope of the curve
p
q
D
p1
p2
q1 q2
p3
q3
More basic
products
Less-basic
products
8ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Consumer Surplus
Econ101 – Consumer surplus
• For any quantity demanded
up to q*, consumers were
willing to pay a price above
p*, up to the price
corresponding with the
demand-curve
• The area between the
demand-curve and the
Market Price is therefore a
surplus to consumers, known
as the Consumer Surplus
• Consumers are better off if
the area of consumer surplus
increases
p
q
D
p*
q*
Market
price
p1*
q1*
Additional Surplus
9ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Econ101 – Natural Monopoly
€
q
ATC
• Average Total Cost curve
downward sloping for the whole
range of production;
• If the range of demand is split
equally between two firms, then
they would experience costs of
ATC2
• If only one firm supplies the
whole range of demand then
they can benefit from
economies of scale and the
average total cost for providing
a higher number of output is
lower (c1)q*
ATC2
q2
q1
ATC1
D
10ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Why should it be regulated
p
q
D
MCATC
MR
pm
CS
Economic profit
• If left unregulated, Monopolist
follows profit-maximizing rule
and produces at a q where
MR=MC
• Monopolist charges at pm
because that’s the price
consumers are willing to pay for
that level of quantity
• Consumer surplus is reduced
compared to a scenario where
quantity would be set where
marginal benefit is equal to MC,
represented by the D-curveqm
pso
qso
11ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inefficient but still better off (reminder)
p
q
D
MCATC
MR
CS
pso
qATC
pATC
DWL
p
q
D
MCATC
MR
pm
CS
Economic profit
qm
pso
qso
DWL
Unregulated monopoly ATC-pricing
12ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Possible remedies (1/3)
• Apply two part tariffs
• Apply a fixed charge (capacity charge or customer
charge) to cover fixed costs;
• Apply a variable charge (energy charge) to recover those
costs which change with the level of production and set
to MC;
• Regulated monopoly receives the same total revenue
(albeit from different “sources”)
• More efficient unless customers are priced-out of the
market
• Apply fixed charge in inverse proportion to elasticity of
demand
13ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Possible remedies (2/3)
• Apply optional tariffs which better suit the
consumption preferences;
• Some customer prefer higher fixed costs and
lower variable cost. Others prefer a higher
average cost but no connection/standing/fixed
charge;
• Adjusting to these preferences, subject to cost
recovery, can increase total welfare.
14ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Possible remedies (3/3)
• Apply Ramsey-Boiteux pricing
• Use elasticity of demand as an indicator of customer
likeliness to reduce consumption as a result of the
fixed tariff
• Apply prices closer to MC to consumption which is
more elastic
• Apply prices closer to AC to consumption which ir
more inelastic
15ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Examples of MC and ATC pricing
Assumptions:
Fixed cost of providing service = €95,000,000
Variable cost of providing service =39 €/MWh
𝑇𝐶 = 95,000,000 + 39𝑄
Demand function
𝑄 𝑝 = 15,000,000 − 90,000𝑝
Total revenue
𝑇𝑅 = 𝑝 ∙ 𝑄 𝑝 = 15,000,000𝑝 − 90,000𝑝2
16ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example (Marginal Cost pricing)
Regulator sets prices at MR=MC
(Qd=11.49 TWh)
Since
𝑇𝐶 = 95,000,000 + 39𝑄
Then
𝑀𝐶 = 39 => 𝑃 = 39
Profits
𝜋 = 𝑇𝑅 − 𝑇𝐶= 39 ∗ 11.49 − 95,000,000 + 39 ∗ 11.49
𝜋 = −95,000,000
Company does not recover fixed costs
p
q
D
MC=PATC
11.49
CS
Losses
17ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example (Average Total Cost 1/2)
𝑇𝐶 = 95,000,000 + 39𝑄
𝑄 𝑝 = 15,000,000 − 90,000𝑝
𝑇𝑅 = 𝑝 ∙ 𝑄 𝑝= 15,000,000𝑝 − 90,000𝑝2
Solve for TC as a function of p
𝑇𝐶 =
=95 ∙ 106 + 39(15 ∙ 106 − 90,000𝑝)
Solve quadratic TR=TC
𝑝 = 47.87 𝑄𝑑 = 10.6 TWh
p
q
D
MCATC
10.6
CS
39.0
47.9
DWL
18ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example (Average Total Cost 2/2)
What is the deadweight loss to society?
Area of the purple triangle
𝐴𝑟𝑒𝑎 =1
2∙ 𝑏 ∙ ℎ =
=1
2∙ 11.49 − 10.6 𝑇𝑊ℎ
∙ 47.9 − 39.0 €/𝑀𝑊ℎ= €7.1𝑚
p
q
D
MCATC
10.6
CS
39.0
47.9
DWL
11.49
19ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example (Two-part tariffs)
Principle:
• Recover fixed costs through a
standing/fixed/per-customer charge
• Recover variable costs through MC-
pricing
Ex:
Assume S=450,000 customers
𝐶𝑢𝑠𝑡. 𝑐ℎ𝑎𝑟𝑔𝑒 =95,000,000
450,000= 211.1
𝐸𝑛𝑒𝑟𝑔𝑦 𝑐ℎ𝑎𝑟𝑔𝑒 = 𝑀𝐶 = 39 €/𝑀𝑊ℎ
p
q
D
MCATC
10.6
CS
39.0
47.9
DWL
11.49
20ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Comparison
• Two-part tariffs favor
large consumers due to
the presence of a fixed
cost
• In this case all consumers
up to 263.75 kWh are
better off with an average
price
• Those customer can be
priced-out of the market,
leading to inefficient
outcomes
3
4
5
6
7
8
9
0 50 100 150 200 250 300 350 400 450 500
c/kW
h
monthly kWh consumption
ATC avg price
2-part Avg Price
21ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Regulation in practice – chart of contents
lessexport
revenues
plusImport
Purchase Costs
Power Purchase Costs
Subsidies
Unregulated Income
Maximum Allowed
Revenues (MAR)
Operating Expenses
DepreciationAllowed Return
Wholesale Power
Purchase Costs
Regulatory Asset BaseRABt=(RABt-1)-DEP+CAPEX
multiplied byWACC
divided byAsset Life
+ + + - =
Investment Plan Energy Balance
22ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
TSO revenue-setting process
Capital Costs
MAXIMUM ALLOWED REVENUES (MAR)
Operating Expenditures Deductions from MAR
Allowed Return
Depreciation
Asset LivesRAB
WACCRAB Other Operating Costs
Base Opex
Maintenance Costs
Cost of Losses [TSO]
Personnel Costs
Cost of Ancillary Services [TSO]
Inter-TSO Compensation Mechanism (ITC) [TNO]
Other Non-Tariff Income
x
/
23ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Energy Balance
• The Energy Balance is the main input sheet of the
MAR calculation and is the main driver behind the
revenue components;
• Energy balance drives investment in generation,
transmission and distribution infrastructure;
• Built using the bottom-up approach with the
expected level of sales being the main determinant
of all the other values;
• Energy required to meet domestic demand is
calculating by adding allowed level of losses to the
expected sales at both T and D-level;
24ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Energy Balance
Energy Balance Year 1 Year 2 Year 3 Year 4 Year 5
Energy Entering Transmission System GWh 4,089.4 4,446.6 3,809.7 4,216.9 4,223.8
Transmission Losses % 1.7% 1.7% 1.8% 1.7% 1.7%
GWh 111.2 112.6 110.3 109.0 107.0
Energy Required to meet Transmission Load GWh 3,978.2 4,334.0 3,699.4 4,107.8 4,116.8
Transmission-level sales 553.0 947.0 542.0 858.3 867.3
Aluminium plant 1 GWh 449.0 842.0 434.0 687.0 700.0
Aluminium plant 2 GWh 104.0 105.0 108.0 108.0 104.0
Industrial plant 3 GWh 63.3 63.3
Energy Required to meet Distribution Load GWh 3,425.2 3,387.0 3,157.4 3,249.6 3,249.6
Distribution-embedded generation GWh 110.0 120.0 130.0 140.0 140.0
Distribution-level sales GWh 3,535.2 3,507.0 3,287.4 3,389.6 3,389.6
Distribution losses and unbilled energy
Technical and commercial losses % 8.0% 7.0% 6.0% 6.0% 6.0%
GWh 282.8 245.5 197.2 203.4 203.4
Sales to final customers GWh 3,252.4 3,261.6 3,090.1 3,186.2 3,186.2
25ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inclusion of Capex into RAB
• Main challenge for regulators: The appropriate
level of capex to be recovered from regulated
tariffs
– Asymmetry of information (regulated entity is better
informed about the level of capex and the associated
cost)
– Incentive to inflate costs (so as to gain on the difference
between the approved and actual cost)
– Incentive to increase total investments (also referred to
as “gilding” – occurs when there are differences between
allowed and actual cost of capital - WACC)
26ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Asset lives
• Used to calculate Depreciation allowance for regulated utility
RABt/Asset life=DEPCt
• Distinguish between technical and economic asset lives
• Asset life set to technical life, unless specifically demonstrated by utility that this is not the case (use economic lives instead)
27ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Smoothing and profiling of capex
28ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
OECD study on Infrastructure Investment
• OECD conducted a study on Fostering investment
in infrastructure (2015)
• Lessons learned from country experiences in
enhancing private sector participation and end-
user affordability in infrastructure sectors were
compiled
“Increasing private participation in infrastructure
investment requires an investment regime that
provides clarity and predictability for investors…”1
1OECD Fostering investment in infrastructure (January 2015)
29ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
WEF study on Strategic Infrastructure Risk
MitigationRisk Mitigation Framework2
2 WEF Study on Mitigation of political and regulatory risks in Infrastructure project Risk Mitigation Framework (2015)
30ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Reducing investor risk
• Facilitating infrastructure investment requires a
stable and predictable regulatory framework which
provides clarity to investors;
• Regulators should seek to reduce discretionary
practice when assessing/reviewing the
reasonableness of capex plans by having defined
evaluation criteria
• Gradually building regulatory credibility
increases investor confidence and reduces cost of
capital, ultimately providing added value to
customers.
31ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inclusion of Capex into RAB (1/4) (rewind)
Main challenge for regulators: The appropriate
level of capex to be recovered from regulated
tariffs– Asymmetry of information (regulated entity is better
informed about the level of capex and the associated
cost)
– Incentive to inflate costs (so as to gain on the difference
between the approved and actual cost)
– Incentive to increase total investments (also referred to
as “gilding” – occurs when there are differences between
allowed and actual cost of capital - WACC)
32ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inclusion of Capex into RAB (2/4)
Regulators often apply both ex-ante and ex-post reviews in
order to match allowed and actual capex
Ex-ante (before the commencement of the Regulatory Period)
the Regulator assesses the necessary capex of the Regulated
entity and the associated cost
– Extension expenditure assessment
– Replacement expenditure assessment
– Proposed costs are weighed against investment databases and
previous allowances
– Regulators may choose to study specific projects which are major
investment cost drivers (ex. new HV lines, large SS installations, etc)
– Benchmarking studies, independent consultancy reviews, prudency
tests are often conducted.
33ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inclusion of Capex into RAB (3/4)
Ex-post assessments are conducted to supplement
ex-ante reviews conducted prior to the Regulatory
Period
Differences between allowed and actual costs are
reviewed by the Regulator:
– Differences due to strategic deferrals from the base
plan;
– Differences due to (in)efficient investment
procurement and management;
– Regulator may choose to claw back differences in
costs (if actual<allowed) or compensate the utility (if
actual>allowed)
34ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Inclusion of Capex into RAB (4/4)
Ex-post regulatory review can be conducted without
ex-ante approvals
– Under such schemes, the regulated companies would be
incentivized to only invest in highly efficient investments
which they believe would be allowed by the Regulator;
– On the other hand regulated companies are exposed to
the risk of having their having their capital investments
disallowed and therefore not recovering investment
costs.
– This may reduce capital investments and place the mid-
term to long-term security and quality of supply at risk
35ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
RAB build-up
Opening RAB 2018
Approved Capex RP1
Depreciation RP1
Closing RAB RP1
Opening RAB RP1
Pre-approved Capex 2018
+ - =
Depreciation 2018
Closing RAB 2018+ - =
Opening RAB2019
-> to 2022
36ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
What RAB value?
• Cost-Based approach
• Historic cost• Value at the price paid for the assets when commissioned
• Investors recover cost paid for the asset
• Customers pay the actual cost of the investment
• Current cost• Value at the current cost of using the asset
• Economic efficiency – costs of serving at this point in time
• Technological change implies change in value
• Economic value • Value generated by the asset
• Circularity issue
37ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
What RAB value: Current cost
• Current cost evaluation
Indexation
• Adjust historic value of assets using cost index (CPI, HICP)
Replacement cost
• Revalue at the current cost of purchasing the same asset
Modern Equivalent Asset
• Revalue at the current cost of the asset with the same capability
Optimized replacement cost
• Determine optimal network design required to provide same service and value assets at its costs
38ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
What RAB value: economic value
• Economic value of
income generated
by the assets
• Takes into account
broader picture:
performance of the
company, bad
debts, losses
• Circularity issue
RAB is economic
value
Economic value based
on net income
Net income=
D + R + Opex
R component depends on
RAB
39ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
CAPEX Benchmarking tools (1/2)
• Overview of main regulatory models (RoR,
Price/Revenue cap, Yardstick regulation)
• Major capex assessment models
• Regulatory tests (NPV, IRR, CBR, PBP)
• Standard cost approach (using unit costs to
determine ex-ante reasonableness EUR/km of
0.4 kV line)
• Econometric models (OLS)
• Integrated Efficiency Analysis
40ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
CAPEX Benchmarking tools (2/2)
Source: Konstantin Petrov’s presentation on capex benchmarking tools, Budapest (2018)
41ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Overview of benchmarking approaches in
Europe
Source: Srini Parthasarathy presentation on European approaches to benchmarking capex, Budapest (2018)
42ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Asset utilization, stranded assets (1/2)
• Asset stranding can happen as
a result of reduced volumes
(environmental policy
objectives, role of gas) or
changing market conditions
(abolishment of PPAs)
• Regulator’s role in recovering
stranded costs
• Depreciation policy to
recover stranded costs;
• Asset valuation methods
• Premium return in WACC
against future volume
risk
Source: Konstantin Petrov’s presentation on asset
utilization and stranded assets, Budapest (2018)
43ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Weighted Average Cost of Capital (WACC)
• Represents the weighted average return required by debt and equity holders to invest in the regulated business
𝑊𝐴𝐶𝐶 = 𝑔 ∙ 𝑟𝑑 +(1 − 𝑔) ∙ 𝑟𝑒
Where
g gearing ratio (calculated as d/(d+e))
rd return on debt
re return on equity
44ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Weighted Average Cost of Capital (WACC)
• “Efficient” financing cost– 1a) Estimate an ‘efficient’ financing cost – estimating the
risk-free rate based on yield-to-maturity of Governmental
bonds
– 1b) Estimate an “efficient” financing co –risk-free rate
calculated based on another EUR denominated bond and
adjusted for additional risk factors
• Actual/historical financing cost– Set the cost of debt equal to the actual weighted average
cost of financing incurred by the licensees
– Reflect actual gearing ratio (subject to some reasonable
gearing domain – e.g. 0.4-0.7)
– Set the RoE according to CAPM estimations for others
45ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Return on debt
𝑟𝑑 = 𝑟𝑓 + 𝐷𝑅𝑃
Whererd return on debt
rf Risk-free rate (proxied by the country’s sovereign debt bond yield)
DRP Debt Risk Premium – the additional premium that is associated with providing debt to a particular investor
46ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
10-year Yield rates in select EU countries
47ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Yield rates have generally gone down…
48ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Return on equity
• The “standard” approach applied by regulators in determining the Re is the Capital Asset Pricing Model (CAPM)
• According to CAPM, return required by investors is sum of rf rate plus a premium equivalent to equity risk premium, compensating for additional risk of investing in equity markets
• This ERP is multiplied by a coefficient (Beta) which adjusts for whether the risk of the particular investment is higher or lower than general risk in equity markets
49ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Return on equity
𝐶𝐴𝑃𝑀 = 𝑟𝑓 + 𝛽 ∙ 𝐸𝑅𝑃Where
rf is the risk-free rate
β is the covariance between the return of the individual stock of the
company with the return of the market
ERP is the equity risk premium which represents the additional risk investors
face in holding equity shares
50ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Beta
• Beta represents the volatility of the returns of a particular stock compared to the volatility of the returns of the whole stock market;
• If companies are not listed on the stock market then benchmarking analysis is used;
• Asset vs. Equity Beta should be taken into account in sampling, to reflect the fact that companies in the sample may have different leveraging levels
51ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Beta values for EU countries
0,0
0,2
0,4
0,6
0,8
1,0
1,2
Electricity Transmission Beta Values across a range of EU countries
Source: ERRA research
52ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Beta values for EnCT SP + ERRA Members
Source: ERRA research
0
0,2
0,4
0,6
0,8
1
1,2
1,4
Georgia FYROMacedonia
Kosovo 3* Croatia*6 Montenegro(3)
Albania (3) Serbia (3)
Beta Values ERRA & ENCS
53ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Equity/Market Risk Premium (ERP or MRP)
Source: ERRA research
54ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Illustration of WACC levels
Source: EY study: Mapping power and utilities regulation in Europe
55ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Operating and Maintenance Costs
• Sum of all operating
and maintenance costs
required for providing
regulated service
• Main cost line items
include personnel
expense and
maintenance costs
• In some cases cost of
transmission/distributi
on losses included
56ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Operating and Maintenance Costs
• Regulators set allowed
O&M costs by
comparing cost levels
between comparable
companies
(benchmarking)
• Efficiency factors
applied to encourage
savings to customers
(incentive-based
regulation)
Source: ERO provisional evaluation DSO Opex
57ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Treating actual vs. allowed differences
• Set benchmark value
for 1st year of
Regulatory Period
• Apply efficiency factor
to incentivize savings
• Apply savings sharing
factor (0-100%) to
share benefits 15,0
17,0
19,0
21,0
23,0
25,0
27,0
2012 2013 2014 2015 2016E
xpen
dit
ure
EU
Rm
Allowed vs. Actual Operating and Maintenance Costs
Allowed Opex Actual Opex
58ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Setting the efficiency factor
Approach to starting value
Calculation of efficiency factor
Starting value set at 2016 actual values
• Efficiency factor includes removal of existing inefficiencies and general productivity improvement
Starting values set at ‘efficient’ cost levels
• Efficiency factor only includes general productivity improvement
Eff
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Efficiency factor = general productivity improvement
+ licensee-specific inefficiency removal
Baseline efficiency factor = general
productivity improvement only
• Efficiency factor depends on how the starting
value is set
59ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Setting a baseline efficiency factor
• A baseline efficiency
reflects efficiency gains
yielding from general
productivity on top of
economy-wide
productivity growth
• Refer to regulatory
decisions on
productivity growth
• Number of studies is
limited
60ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Should efficiency gains be carried over?
• Company’s incentives to reduce costs fall towards
the end of the Regulatory period
• Companies accumulated gains are therefore higher
if efficiency is increased in first year of Regulatory
period rather than the last
Company gain Actual expenditure
61ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Network losses
• Distribution losses can effectively be broken down into two
main categories:
• Technical losses – energy that is lost in the system for technical/physical reasons in line heating or transformers
• Commercial losses – energy that is delivered to
customers but not billed, and that is not technical
• A one percent decrease in technical losses represents
implies 1% less energy is required to be input to the grid
• A one percent decrease in commercial losses may
represent only a 0.2% less energy required to be placed to
the grid (energy is still consumed, only more efficiently)
62ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Factors affecting network losses
Technical losses Commercial losses
Main factors affecting
• Condition of the grid• Lack of systematic
investment program• Grid overloads/wire
heating
• Lack of frequent and systematic checking of metering points
• LV metering devices easy to tamper
• Lack of rule of law• Lack of access to supply site
Possible remedies • Encourage investment in strengthening/replacing network
• Stable regulatory framework recovering the cost of investment
• Cost recovery tariffs
• Replace meters with those more difficult to tamper;
• Seal boxes and place in a visible position to avoid by-passing;
• Invest in PR, improve company reputation/credibility
• Engage in management to identify cooperating staff
63ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Incentivizing Distribution loss reductions
t t+1 t+2 t+3 t+4 t+5
Periodic
Review
-x%-x%
-y%-y%
-x%
Where x>y
64ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example: Step 1 – Energy Balance
• Start with the level of sales at 1st Year of Regulatory Period. Increase this
value annually by the forecast percentage increase in sales (ex. 3%) as
shown in row (a)
• Divide final sales by (1-%AL) where AL is allowed losses in percentage terms
as shown in row (b) below
• This will give the total figure of energy that has to enter the network to
cover the sales + losses as shown in row (d). Deduct sales from this number
to get total losses (to get row (c))
units 2018 2019 2020 2021 2022
Allowed Allowed Allowed Allowed Allowed
First regulatory period
(a) Forecast sales GWh 3,179.0 3,274.4 3,372.6 3,473.8 3,578.0
(b) Allowed losses % 11.0% 10.0% 10.0% 9.0% 8.0%
(c)=(d)-(a) Allowed losses GWh 392.9 363.8 374.7 343.6 311.1
(d)=(a)/(1-(b)) Total distribution energy GWh 3,571.9 3,638.2 3,747.3 3,817.3 3,889.1
65ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example: Step 2 – Regulatory Asset Base
• Assume Opening RAB value is €148,940,000. Start with level of annual
investments you approved for the Regulatory Period (row (e))
• In year 1 of the Regulatory Period, add the approved investments to the
starting value (row (h))
• Calculate Depreciation by dividing the starting value and half of the annual
addition by the asset life (row (i))
• Add rows (g), (h) and (i) to get the closing balance in Year 1. This will be the
starting value in Year 2.
units 2018 2019 2020 2021 2022
Allowed Allowed Allowed Allowed Allowed
(g) Opening balance €000 148,940.0 166,640.3 176,228.9 188,054.6 202,436.2
(h) Additions in year €000 23,049.1 15,400.0 18,000.0 21,000.0 18,000.0
(i)=-((g)+0.5*(h))/(f) Depreciation €000 -5,348.8 -5,811.3 -6,174.3 -6,618.5 -7,047.9
(j)=(g)+(h)+(i) Closing balance €000 166,640.3 176,228.9 188,054.6 202,436.2 213,388.3
66ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example: Step 3 – Return and Depreciation
• Calculate the WACC (in this case it’s given at 7.2%) and multiply by the
average of the opening and closing RAB values in a given year to calculate
allowed return (row (l))
• Present depreciation as the negative of the figure in row (i).
units 2018 2019 2020 2021 2022
Allowed Allowed Allowed Allowed Allowed
(g) Opening balance €000 148,940.0 166,640.3 176,228.9 188,054.6 202,436.2
(h) Additions in year €000 23,049.1 15,400.0 18,000.0 21,000.0 18,000.0
(i)=-((g)+0.5*(h))/(f) Depreciation €000 -5,348.8 -5,811.3 -6,174.3 -6,618.5 -7,047.9
(j)=(g)+(h)+(i) Closing balance €000 166,640.3 176,228.9 188,054.6 202,436.2 213,388.3
(k) WACC % 7.20% 7.20% 7.20% 7.20% 7.20%
(l) = (k) x ((g)+(j))/2 Allowed return €000 11,360.9 12,343.3 13,114.2 14,057.7 14,969.7
(m)=-(i) Allowed Depreciation €000 5,348.8 5,811.3 6,174.3 6,618.5 7,047.9
67ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example: Step 4 – Opex and losses
• Assume you decided to apply a 3% Annual Efficiency Factor to O&M costs
from the 2nd to the 5th year of the Regulatory Period.
• Assume starting O&M costs in the first are €38,929,000
• Calculate Year 2 O&M by deducting 2% out of the starting value. Calculate
Year 3 O&M by deducting 2% from the resulting value in Year 2 and so on…
• Assume Wholesale Power Purchase Costs for Losses are set at 32.8 €/MWh.
• Calculate the cost of losses of by multiplying the volume of losses (row (c))
with the average price in row (p).
units 2018 2019 2020 2021 2022
Allowed Allowed Allowed Allowed Allowed
(n) Efficiency Factor % 3.00% 3.00% 3.00% 3.00%
(o)=Allowed(t-1)*(1-(n)) Allowed O&M €000 38,929.0 37,761.1 36,628.3 35,529.4 34,463.6
(p) WA Power Purchase Cost €/MWh 32.8 32.8 32.8 32.8 32.8
(q) Cost of losses €000 12,887.5 11,933.3 12,291.3 11,268.8 10,205.1
68ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Example: Add (l) (m) (o) and (q) to get MAR
units 2018 2019 2020 2021 2022
Allowed Allowed Allowed Allowed Allowed
(g) Opening balance €000 148,940.0 166,640.3 176,228.9 188,054.6 202,436.2
(h) Additions in year €000 23,049.1 15,400.0 18,000.0 21,000.0 18,000.0
(i)=-((g)+0.5*(h))/(f) Depreciation €000 -5,348.8 -5,811.3 -6,174.3 -6,618.5 -7,047.9
(j)=(g)+(h)+(i) Closing balance €000 166,640.3 176,228.9 188,054.6 202,436.2 213,388.3
(k) WACC % 7.20% 7.20% 7.20% 7.20% 7.20%
(l) = (k) x ((g)+(j))/2 Allowed return €000 11,360.9 12,343.3 13,114.2 14,057.7 14,969.7
(m)=-(i) Allowed Depreciation €000 5,348.8 5,811.3 6,174.3 6,618.5 7,047.9
(n) Efficiency Factor % 3.00% 3.00% 3.00% 3.00%
(o)=Allowed(t-1)*(1-(n)) Allowed O&M €000 38,929.0 37,761.1 36,628.3 35,529.4 34,463.6
(p) WA Power Purchase Cost €/MWh 32.8 32.8 32.8 32.8 32.8
(q) Cost of losses €000 12,887.5 11,933.3 12,291.3 11,268.8 10,205.1
(r) = (l)+(m)+(o)+(q) Total MAR €000 68,526.2 67,849.0 68,208.1 67,474.4 66,686.2
69ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Adjustments within the Regulatory Period
ETR8
Actual
ETR9
(2015)
Allowed
ETR9
(2015)
Actual
ETR10
(2016)
Proposed
Allowed Losses
Percentage of allowed losses % 1.84% 1.80% 1.74% 1.80%
Assumed transmission flows GWh 5,916.4 6,162.9 6,313.4 6,331.8
Weighted average power purchase costs €/MWh 31.2 28.24 30.3 32.7
Actual allowed cost of losses 2.9 3.2
Forecast allowed cost of losses 3.1 3.7
LSACt-1 €m 3.0 3.1
LSSCt €m 3.0 3.9
Reward for achieving the loss target -0.14
*Loss sharing factor 50%
70ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Pricing principles
• 2015 EC study on tariff design for distribution systems
System sustainability Economic efficiency Protection of stakeholders
Tariffs should be sufficient to fully recover costs
Productive efficiency (efficient investments and operational expenses)
Transparenct methodology is published and available to all parties
There should be an adequate rate of return proportional to the risks
Allocative efficiency (avoidconsumption from peak, flexible)
Non-discriminatory pricing between categories
Achievable incentive components (i.e. targets)
Cost reflective – charges reflect the cost of service
Equitable, simple and predictable tariffs
Tariff components must add up to equal the total revenue allowed
Innovation promotional –tariffs should not be a barrier to innovation
Stable and consistent tariff regulation and regulatory framework
71ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Marginal Cost pricing
• The Marginal Cost is the
additional incremental cost
which results from providing of
an additional unit of output
• For the distribution system, the
marginal cost of distributing
another unit of electricity is
almost zero, as long as there is
spare capacity
• If there is no spare capacity
then MC is high (due to
necessary investments)
• We use LRMC in order to avoid
price jumps when there is no
spare capacity and investments
have to be made
Spare capacity
Marginal cost
Average costInvest-
ment
72ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
LRMC
Where
LRMC = Long-run Marginal Cost
growth related opex is the incremental annual cost of operating and
maintaining the newly constructed network and connection assets
over the forecast period;
growth related capex is the annualized capital expenditure to meet
the additional demand
incremental demand is the forecast change in kW demand
compared to the base year
73ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
LRMC
• The growth-related opex part is relatively
simple to determine because opex has a
more defined relationship with increasing
demand (generally linked to fuel costs, for
example);
• Determining the growth related capex is
more complicated because it accounts for
investments associated with an increase in
demand
74ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
LRMC
1. Prepare forecast demand characteristics (line a)
2. Estimate cost of additional investment to meet characteristics (line b)
3. Calculate LRAIC as ratio between (b) and (a)
4. Calculate Annuity of LRAIC and add Opex-related LRMC to get the total LRMC
Calc. Item 2017 2018 2019 2020 2021
- Weighted Average Asset Life years 20
- Weighted Average Cost of Capital (WACC) % 8.80%
a Incremental load MW 20 25 30 30 30
b NPV 104
c Investments 000 € 4,490 4,951 5,153 5,349 5,649
d NPV 19,833
e=d/b LRAIC €/kW/yr 190.9
f Annuity of LRAIC €/kW/yr 20.6
g Long-run O&M costs €/kW/yr 5.2
h=f+g LRMC €/kW/yr 25.8
75ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Revenue-setting process
• Tariff-setting is a complex technical process
• Impacts tend to be oversimplified by civil society/media – high social
pressure. Keeping stakeholders involved is key
• Reduces possibilities of external intervention/arbitrary decision making
• Enhances independence
• Increases investor confidence, reduces cost of capital
Outline process and share with stakeholders
Step 1
Preliminary applications
received
Step 2
Final applications
received
Step 3
Regulatory public
consultation
Step 4
Response to comments
paper issued
Step 5
Final regulatory
decision taken
Step 6
76ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Key messages to take away (1/3)
• Regulate only natural monopolies or those
competitive segments where market
produces inefficient outcomes
• Natural Monopolies occur when the
demand of the whole market can be
supplied at a lower cost by one firm than
more firms due to economies of scale
77ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Key messages to take away (2/3)
• Setting prices to marginal costs provides
efficient outcomes but does not recover
fixed costs
• Setting prices to average costs recovers
total costs of service but consumption is
reduced therefore generates DWL
• A combination of fixed and variable tariffs
can help reduce DWL and increase efficiency
of outcomes
78ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Key messages to take away (3/3)
• Pricing Rules adopted by Regulators need to
provide clarity, stability and predictability to
investors/developers;
• Incentive-based regulation reduces
information asymmetry and efficiency
factors set by regulators should be
ambitious but reachable by utilities.
• Stakeholder consultation/counterparty
cooperation important to achieving buy-in
W
THANK YOU
FOR YOUR ATTENTION!
ERRA Tailor-made Training Course: Principles of Tariff RegulationDecember 2-4, 2018 • Muscat, Oman
Ardian Berisha
E-mail: [email protected]
Web: www.erranet.org