1 Investment workstream, GRI NW Investments and Incentives an economic perspective Machiel Mulder Office of Energy Regulation Netherlands Competition Authority (NMA) GRI Meeting Brussels, 26 February 2009

2 Investment workstream, GRI NW 1.Background: a.desire for timely, efficient and effective investments b.objective: improving investment climate 2.Factors hindering investments according to stakeholders a.regulation b.long-term dimension of investments c.liquidity of markets 3.Incentives a.defining incentives b.testing incentives Outline

3 Investment workstream, GRI NW 1. Background GRI NW searches for timely, efficient and effective investments in gas infrastructure. Does this mean: as soon as possible? as cheap as possible? as large as possible? From an economic point of view, the answer is no. In economic term, GRI NW searches for optimal investments in gas infrastructure.

4 Investment workstream, GRI NW 1. Timely investments The optimal time of investment is when the present value of the net cash flows is maximised Cashflow Time Invest- ment 0 Revenues t=0t=3t=1t=2t=5t=4t= NPV = - 5 (discount factor = 10%) Postponing the investment by 1 year makes it break even

5 Investment workstream, GRI NW 1. Efficient investments Efficiency includes several aspects: productive efficiency: using the most efficient technique in the most efficient way allocative efficiency: allocating goods in the optimal way, i.e. meeting user’s demand taking into account all costs and benefits dynamic efficiency: developing new techniques, suppling new products to users

6 Investment workstream, GRI NW Output A (e.g. long-term capacity) Output B (e.g. short-term capacity) 1. Efficient investments X (inefficient investment) Production possibilities curve catching up innovation Efficient investments result in maximum output per input

7 Investment workstream, GRI NW 1. Effective investments Effective means: delivering the products demanded by the market (i.e. market value) contributing to competition & security of supply (i.e. external effects) Effective investments are at the right place have the optimal size

8 Investment workstream, GRI NW 1. Objective: improving investment climate The theoretical benchmark is that in well-functioning markets, economic agents make optimal decisions: prices reflect scarcity and give signals to both producers and consumers to respond optimally because producers maximise their profits, they will try to be as efficient as possible (i.e. best technique, innovation) However, the gas market is not equal to this theoretical benchmark: regulated agents (regulatory uncertainty) long-term investments (commitment problem) no market for international coordination external effects on security of supply and competition Focus of GRI NW

9 Investment workstream, GRI NW 1. Investment climate: how to create a balanced framework? TimelinessEffectiveness Efficiency Investment climate Currently: Regulation focuses mainly on efficiency Objective: Fostering effectiveness and timeliness without losing on efficiency

10 Investment workstream, GRI NW 2. Factors hindering cross-border investments Views of stakeholders on regulation: lack of coordination between regulators and regulatory regimes hinders coordinated Open Season and investment projects absence of legal obligations to align investments with neighbouring TSOs limited length of regulatory period in some countries creates uncertainty lack of clarity of regulated tariff regimes for cross-border investments hinders both TSO and shippers in making commitments ‘old fashioned’ investment criteria which are to much focussed on short-term efficiency

11 Investment workstream, GRI NW Views of stakeholders on TSOs Open Seasons are difficult to coordinate and favour long-term bookings, enabling TSOs to delay any decision making process TSOs hinder investments by wanting long-term commitments from the market 2. Factors hindering cross-border investments

12 Investment workstream, GRI NW Views of stakeholders regarding the market: poor development and lack of liquidity of spot market which increases uncertainty about future demand absence of liquid secondary market which increases uncertainty for investors 2. Factors hindering cross-border investments

13 Investment workstream, GRI NW 2. How does the optimal investment regime look like? Views stakeholders: a stable, predictable and fair return on investments coordinated planning from both sides of the market binding commitments from the market for a certain amount of capacity cooperation between regulators and TSOs compatible regulatory frameworks View regulator/government: framework should foster efficient investments preventing stranded assets risks and rewards should be balanced

14 Investment workstream, GRI NW 1. Analytical framework Timeliness bonus/malus for timing (compare NorNed) Problem Incentives Effectiveness Efficiency higher rate of return ex ante approval of investments longer regulatory period exemption of regulation bonus/malus for available capacity CPI-X regulation to raise productive efficiency 3. Incentives Note: be aware of trade-offs: e.g.: incentive for effectiveness might reduce efficiency

15 Investment workstream, GRI NW 3. Testing incentives for investments EXTERNAL ENVIRONMENT - demand for gas - domestic production Behaviour REGULATORS / GOVERNMENTS - ex post /ex ante assessment - rate of return on capital - length of regulatory period Behaviour SHIPPERS Behaviour TSOs -need for capacity -uncertain about future sales -risks of investments -need for certainty about revenues (use of) investments Measuring the performance: a.In time? b.The optimal size? c.Efficient technique ? t