January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 1 Incentive Regulation to Achieve Service Quality Case study: Romania Maria Manicuta ANRE, Romania

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 2 Content 1. What is meant by “incentive regulation” 2. Regulating price and quality by incentives 3. Price control elements 4. Quality control elements 5. International experience (quality)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 3 Incentive regulation aims  Steering the regulatory process from the outside  Being not intrusive yet decisive  Reaching the goal of value for money to consumers subject to the constraint of financial viability for the companies by stimulating them to act in such a way that is convenient to both (“incentive compatibility”)  Making incentives tangible (not symbolic) and easy (not complex) to regulated companies

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 4 Regulatory Alternatives Romania: Rate of Return until 2004 Price Cap for Distribution from 2005 Revenue Cap for Transmission from 2005 Price and Revenue Caps Yardstick Competition Rate of Return Comparative Company- specific Prospective Retrospective Performance Based Regulation

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 5 Guaranteed returns Predictable Transparent But No incentives to cut costs Gold-plating Intrusive Guaranteed returns Predictable Transparent But No incentives to cut costs Gold-plating Intrusive Incentive to cut costs Greater customer protection But Risk of windfall profits Quality of Service could degrade Less transparent Incentive to cut costs Greater customer protection But Risk of windfall profits Quality of Service could degrade Less transparent Rate of Return Incentive-Based Regulation Incentive-Based Regulation Incentive regulation mimics competitive market behavior and provides better incentives for cost reduction. Additional arrangements regarding quality of service are, however, necessary Comparison of Incentives: ROR versus Incentive Regulation

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 6 Comparison of Incentives: ROR versus Incentive Regulation  Characteristics Ex-post adjustment of prices Regulation period either very short or not pre- determined Legalistic character (and potentially litigious)  Evaluation Weak efficiency incentives Over-capitalization: “Averch-Johnson” effect Strong incentives for high quality

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 7 Rate of Return regulation pros & cons  Guards against excessive or unduly meager earnings Provides earnings stability  Allows current prices to reflect recent changes in market conditions Initial cost forecasts are less critical, as they are effectively updated on an ongoing basis  May involve frequent costly and contentious regulatory hearings  Consumers, rather than the regulated firm, bear much of the market risk  Provide limited incentive for cost reduction  Incentives for over capitalization- Averch-Johnson effect (1962)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 8 Performance-based regulation (PBR)  This is commonplace in the USA  Establishes a regime of rewards and penalties for firms who over- or under-achieve in terms of a number of pre-set performance indicators  It is relatively complex to administer and does not conform to the concept of non-intrusive regulation, but it provides the right incentives if fine-tuned (difficult in practice)  In Europe, it is mostly applied to quality levels as opposed to prices/costs (see below)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 9 Cap regulation  Characteristics Ex post adjustment of prices Regulation period pre-determined Arm’s length approach by regulator  Evaluation Stronger efficiency incentives But quality may become a problem (under-investment strategies are possible)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 10 Determinants of Regulatory Caps Cap Regulation – General Formula P(t) = P(t-1) * [1 + CPI – X] P(t) - price (or revenue) at time t P(t-1) -price (or revenue) at time t-1 CPI - consumer price index (or a proxy for it) X - expected productivity increase parameter è Cap Regulation incentivises monopoly companies to control costs, but  Quality of Service should be explicitly considered in the regulatory framework!

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 11 The tariff basket: Pros Strong incentives for efficiency improvement Flexibility: companies are allowed to set their tariff components themselves Strong incentives to adopt efficient pricing strategies Where prices reflect marginal costs, revenue follows costs as demand changes, limiting the financial exposure of firms to risk and forecasting error Cons Tariff re-balancing is possible (but sub-caps can be imposed) All inherent drawbacks of caps regarding quality, X factor setting etc.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 12 The tariff basket: Key Feature The tariff basket approach limits price increases in terms of a weighted average of the prices of a basket of services. The key features of this approach are: under a strict tariff basket approach, licensees have an incentive to adopt efficient pricing strategies - where the weights are reviewed over time, or reflect actual output with a lag, this conclusion no longer follows strictly; variations in volumes yield additional revenues at actual tariff rates; and where tariffs reflect marginal costs, total revenues will track costs as volumes change, limiting the financial risk faced by distributors.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 13 Revenue cap: Key Feature Under a pure revenue cap form of price control, distribution/transmission licensees are permitted to earn as specified level of income, regardless of volume of service. Such a control has the following features: an error correction mechanism is required to account for over and under recoveries of revenue in individual years; potential for a deterioration in provision of services, to both new and existing customers, resulting from an incentive to reduce the volume of service; no systematic relationship between revenues and costs, implying the potential for sustained profits or losses; and the risk associated with fluctuations in volume is borne directly by network operatror, unless customer numbers are included in the determination of the level of the revenue cap.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 14 Fixed revenue cap: Pros Strong incentives for efficiency improvement Flexibility: companies are allowed to set their tariff components No incentive for gaming with demand (revenue is fixed ex ante) No bias against demand-side management No close link between cost and revenue (a pro and a con) Cons Network service providers fully exposed to fluctuations in profits and losses, hence to higher risks and higher required rates of return on capital Tariff rebalancing is possible (but sub-caps possible) Incentives to discourage new connections in order to limit demand All inherent drawbacks of caps regarding quality, X factor setting

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 15 Revenue cap in Romania Under the revenue cap form of price control the correction mechanism concerns the following factors to recover the revenue in each individual years: The annual forecasted congestion cost; The annual forecasted quantity and cost of losses; The annual CPI (%); The fluctuations in volume of service; The cross-border trade payment obligations.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 16 Quality Regulation by Incentives  Rationale for quality regulation  Quality dimensions and indicators  Options for quality regulation  Setting up incentive schemes (Q- factor) for the quality of service

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 17 Rationale for quality regulation  Competition leads to optimal price and quality Levels and Differentiation  Unbundled network monopoly Rate of return: Inherent high quality (gold- plating) Incentive regulation: Quality is kept under scrutiny, but potential quality degradation  Trade-off between price and quality regulation

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 18 Regulatory Policy Objectives Reliability costs Reliability => Costs => Outage costs Total Social Costs Optimum Present Level

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 19 Quality dimensions and indicators 1. Reliability of Supply Frequency and duration of outages 2. Voltage Quality Frequency deviation, voltage level, phase symmetry, etc. 3. Commercial Quality Indicators: Billing, Metering, Keeping appointments, Handling complaints, etc.  Generally, reliability is considered the most important dimension

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 20 Reliability Indicators  SAIFI: System Average Interruption Frequency Index measures the number of outages experienced by users. It is calculated by dividing the number of customer interruptions by the total number of customers served. The number of customer interruptions is the total number of interrupted customers for each interruption.  SAIDI: System Average Interruption Duration Index provides a measure for the average time that customers are interrupted. It is calculated by dividing the total customer interruption duration by the total number of customers. The customer interruption duration is defined as the aggregated time that all customers were interrupted. SAIDI is a high level indicator representing the overall performance of the network.  CAIDI: Customer Average Interruption Duration Index Is a measure for the average time required restoring service to the average customer per interruption. It is calculated by dividing the total interruption duration by the total number of interruptions.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 21 Reliability comparisons - Europe Source: CEER/EnergieNed

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 22 Reliability comparisons - International

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 23 Options for quality regulation COMPLEXITY EFFECTIVENESS HIGHLOW HIGH 1. Indirect 2. Minimum Standards 3. Incentive Schemes

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 24 Indirect Quality Regulation (1)  Empowering the informational and negotiation position of customers Publish information about its own performance or relative to that of others Customer’s representation in advisory boards Customer committees Public ownership Dedicated bodies to handle conflicts Liability legislation

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 25 Indirect Quality Regulation (2)  Performance publication used by practically all regulators  Relatively simple to implement and limited regulatory involvement  Main associated problems Effectiveness is questionable  But: Brand value may matter Transaction costs can be high Monopolist can exploit regulation at its own advantage – for example by putting the blame on a too harsh regulatory price control

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 26 Minimum Standards (1)  Floor to the performance level  Violation leads to a fine or tariff rebate  Two types of standards Overall standards relate to network quality at the system level. Examples of such standards are ‘customer minutes lost’, ‘percentage of customers with an outage’, or an aggregated quality index Individual standards put limits to the level of performance delivered to individual customers. These usually come in the form of a limit to the number or duration of outages for any customer

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 27 Minimum Standards (2)  Define clearly the boundaries for quality levels  Fines can provide companies with strong incentives to deliver adequate quality levels  Main associated problems Discrete rather than continuous relationship between quality and price Question of the level the standard and fine(s)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 28 Incentive Schemes (1)  Can be considered as an extension of a standard  Price and quality are closely related Better performance leads to a reward Worse performance leads to a penalty  The most effective if configured properly  But also the most complex to implement

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 29 Incentive Schemes (2)  Mapping price and quality  Setting the quality target  Setting the incentive level (penalty / reward)

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 30 Setting the Quality Target  Usually based on historic levels  Regulatory objectives determine periodic adjustments of the target Fixed: Administratively determined Adjusted: Similar to price caps / yardstick competition  Important to keep the link with price regulation

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 31 Setting the Incentive Level  Link to the level of return Plus / Minus basis points returns E.g. PBR in the USA  Economic approach Marginal quality value E.g. Norway, the Netherlands  Estimating quality value (outage costs) Different empirical methods available Large number of quantitative studies

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 32 Performance Standards - Principles  Specific performance standards may be made part of the licence conditions.  Such standards must be capable of measurement and comparison over a period of time and cannot be general in nature.  The standards must therefore relate to specific levels of attainment that can be quantified.  Self -measurement by the licensee is appropriate, subject to regulatory audit.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 33 Performance Standards – Example(1)  Supply reliability Number of outages over a period of time per connected customer. Restoration of supplies in the event of supply outages (maximum time for restoration).  Notice of supply interruption for planned outage Minimum time for notice.  Customer connections Minimum time for connection of new supplies.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 34 Performance Standards – Example (2)  Time to respond to customer requests for certain services: Arrange appointment: within 3 working days. Provide estimate for work: within 10 working days. Investigate voltage complaints: within 10 working days. Response to customer queries on bills and charges: within 5 working days.  Meter readings: minimum number of firm readings per year.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 35 Performance Standards – Penalty payments  Penalty payments need to be set in accordance with the severity of the failure and the customer inconvenience caused.  If the payments are too low, the penalties may be less costly than the cost of rectifying the cause of the failure. On the other hand, they cannot be too high otherwise customers may seek to maximize payments.  A careful balance is therefore required.  Licensees may be more concerned with the number of failures than the financial cost.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 36 Quality of Service in Romania the implementation and monitoring the performance standards for distribution and supply (commercial and technical) without penalty payments or incentives; the performance standards revision according to international requirements in order to continually increase the level of supply service quality the new, revised performance standards implementation and a part of general performance indicators becoming guaranteed for the second regulatory period ( ) the Price Regulation forecasts the introduction of payment penalties for non- fulfillment of certain guaranteed performance indicators as follow: è A correction factor regarding the observance of the minimum performance standards will be introduced in the evaluation formula for the annual revenues. è The yearly level of revenues associated to this penalty-bonus risk will not be over 2% of the revenues.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 37 Quality of Service in Romania Guaranteed performance indicators:  tariff cuts off for electricity supply with voltage deviations: - for the household consumers : 1% for each 1% deviation; - for industrial consumers: negotiable according to the supply contract;  (limited) compensation payments for the interruptions due to the proved damages;  number of public relation centers organized for the benefit of the consumers;  ensuring the electricity metering, which means the existence of the meter units in all settlement points;  the supplier’s duty to supply any consumer situated in its service area.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 38 Quality of Service in Romania General performance indicators:  to conclude the supply contract in less than 15 calendar days from the complete submission of the documents;  to draw up a connection offer to the network in maximum 30 calendar days from the written request of each potential consumer;  to solve the complaints on meter units functioning and to verify the accuracy of the issued invoices in less than 10 working days;  to provide with intervention teams in less than 1 hour for large cities, 3 hours for smaller cities and 24 hours for rural areas;  to respond the complaints on voltage level in less than 15 calendar days;  to respond at every written request of the consumers in less than 30 calendar days, except requests with other type of deadlines.

January 31-February 2, 2006 Workshop on Regulatory Monitoring of Electricity Sector Almaty, Kazakhstan 39 Thank you for your kind attention! Maria Manicuta Tel: Fax: