1. Estimation of Long Run Capacity Costs Gas TCMF 26 th April 2006

2. 2 Aims  To clarify different approaches that can be used for pricing capacity  Long run marginal costs (LRMCs) and incremental costs (LRICs)  Why different approaches can be taken and their implications  Supply and demand assumptions  To explain current approaches for entry/exit capacity pricing  To set out potential options for consideration

3. 3 Estimation of Long Run Marginal Costs (LRMCs)  For a small (marginal) change in capacity, the marginal cost at Q approximates the gradient of the cost curve at Q  The price of capacity at the level Q is based on the marginal cost at Q  Long run costs assume that investment can be made to accommodate a change in capacity (c.f. short run costs = no investment made) Cost Quantity (Capacity) Small change in Quantity = marginal increment Q gradient at Q ~ y/x = marginal cost y x change in Cost

4. 4 Estimation of Unit Incremental Costs (LRICs)  In general, y/x no longer approximates the gradient of the cost curve at Q  The interpretation given to y/x is a unit incremental cost of moving from the capacity level Q to the new capacity level  The LRIC does not represent the price at the new capacity level  LRIC based prices will signal costs of providing additional capacity Cost Quantity (Capacity) Large change in Quantity change in Cost Q y x y/x = incremental cost

5. 5 LRMCs at Different Capacity Levels  LRMCs at Q 1 and Q 2 are used to set prices for capacity levels of Q 1 and Q 2 respectively  The same marginal increment is used in calculating each LRMC  Prices generated will signal costs of maintaining a higher capacity level = forecast future LRMCs  The change in total cost can be also be estimated Cost Quantity (Capacity) Q1Q1 Q2Q2 Large change in Quantity marginal increment change in Cost

6. 6 Marginal Costs and Unit Incremental Costs Why are they applied? Marginal Costs (LRMCs)  Generates the route costs of capacity  Targets costs of maintaining a given capacity level at Users requiring that capacity  Represents the price for a given capacity level Unit Incremental Costs (LRICs)  Generates the route costs of moving to an increased capacity level  Targets investment costs at Users, but not necessarily only those requesting additional capacity  Represents the average price over the increment in capacity

7. 7 Marginal Costs and Unit Incremental Costs Implications Marginal Costs (LRMCs)  Easier to understand?  Can be modelled using a single Pricing model  Implicit assumption that investment has been made to generate the required capacity level  Costs can be targeted at Users by ensuring commitment model/economic test recovers appropriate revenues Unit Incremental Costs (LRICs)  More difficult to understand how price schedules calculated  Requires more sophisticated modelling for larger increments  Implicit assumption that investment needs to be made to generate the required capacity level  Post-investment marginal costs may reduce significantly due to economies of scale

8. 8 Marginal Costs and Unit Incremental Costs Supply and Demand Assumptions Marginal Costs (LRMCs)  Currently only applied for administered exit capacity charges  Single “central” supply/demand case used with small increment to generate entry-exit route costs  An option could be to define supply substitution/load absorption rules to generate realistic multiple base cases to reflect large changes in capacity level Unit Incremental Costs (LRICs)  Currently provides basis for entry UCAs and entry capacity reserve prices  Single “central” supply/demand case used with varying increments to generate entry-exit route costs  An option could be to remove the indivisible increment assumption to generate more appropriate results i.e. calculate total system reinforcement costs rather than route costs

9. 9 Where are long run costs used (and why)? Current assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Costing approach Pricing adopted

10. 10 Where are long run costs used (and why)? Current assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Costing approach Unit Incremental Costs Pricing adopted Based on 2001 LRICs

11. 11 Where are long run costs used (and why)? Current assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Costing approach Unit Incremental Costs Pricing adopted Based on 2001 LRICs [Discounted] price set from UCAs

12. 12 Where are long run costs used (and why)? Current assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Costing approach Unit Incremental Costs Pricing adopted Based on 2001 LRICs [Discounted] price set from UCAs LRICs updated annually

13. 13 Where are long run costs used (and why)? Current assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs Adjustment/ Scaling Pricing adopted Based on 2001 LRICs [Discounted] price set from UCAs LRICs updated annually Based on 2001 LRMCs with annual scaling

14. 14 Where are long run costs used (and why)? Current costing assumptions Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs Adjustment/ Scaling Pricing adopted Based on 2001 LRICs [Discounted] price set from UCAs LRICs updated annually Based on 2001 LRMCs with annual scaling

15. 15 Gas TCMF - Areas for Review Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price Schedules Exit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs Adjustment/ Scaling Pricing adopted Based on 2001 LRICs [Discounted] price set from UCAs LRICs updated annually Based on 2001 LRMCs, scaled and rebalanced from previous years

16. 16 Alternative approach (1): Decoupling UCAs and LRIC based incremental capacity prices Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges/Reserve Prices Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs Unit Incremental Costs Marginal Costs Unit Incremental Costs Adjustment/ Scaling Potential Outcome “System” LRICs with modified S/D assumptions? LRMCsLRICs*LRMCsLRICs* * Could be based on price schedules or a single price

17. 17 Alternative approach (2): Decoupling UCAs and System LRIC for Entry incremental prices Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs Unit Incremental Costs Marginal Costs Unit Incremental Costs Adjustment/ Scaling Potential Outcome “System” LRICs with modified S/D assumptions? LRMCs “System” LRICs with S/D balancing rules LRMCsLRICs

18. 18 Alternative approach (3): Decoupling UCAs and LRMC based incremental capacity prices Entry UCAs Baseline Entry Capacity Reserve Prices LTSEC Reserve Price SchedulesExit Capacity Charges Requirement Revenue drivers for incremental capacity Efficient allocation of baseline capacity Incremental capacity investment signal Efficient allocation of baseline capacity Incremental capacity investment signal Revenue Recovery Costing approach Unit Incremental Costs Marginal Costs* Adjustment/ Scaling Potential Outcome “System” LRICs with modified S/D assumptions? LRMCs with S/D balancing rules * Assumes investment has been made, could be based on price schedules or a single price