1. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Task 2.3 Incentive Regulation General approach to incentive regulation 8 April 2008 Judith Aitken, Waisum Cheng, Katja Keller, Stefanie Kesting, Ilka Lewington

2. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Objective & Contents Objective: to discuss with AERS the options in designing a cap-regulation system for Serbia Contents 1.General Issues 2.Cap-Regulation Methods 3.Building-blocks versus TOTEX-Approach 4.Determinants of the cap-regulation formula 5.Price control retail

3. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU General Features

4. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Objectives Move to long-term regulation and tariff setting schemes Provide incentives for network investments Address quality of supply performance Provide incentives for efficiency increase Ensure sharing of benefits from efficiency increase between regulated companies and users Ensure sector viability and financial solvency

5. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU General Features (1) Apply international experience and use advantages of incentive based regulation Envisage transition period New scheme based on longer (e.g. 5 years) regulatory periods and less frequent regulatory reviews Companies provide and AERS endorses multi-annual OPEX and CAPEX projections for the whole duration of the regulatory period

6. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU General Features (2) AERS sets proper incentives for ex-ante efficiency increase Regulatory commitment and no reopening during the regulatory period Complete price / cost review and revenue resetting at the end of the regulatory period

7. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU General Features (3) Transition period (e.g. 2 years) necessary to: –provide time to AERS to prepare incentive regulation scheme including data collection benchmarking efforts Investment approval (for the regulatory period) –provide time to stakeholders to prepare including: enhance knowledge legislative changes During this time application of current methodologies and in parallel establishment of the new regulation

8. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Regulation Methods

9. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Methods of regulation Rate of Return regulation / Cost plus Cap regulation –Price cap –Revenue cap Yardstick competition

10. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Methods of Regulation / Rate of Return Prices / Revenues based on cost plus return on assets Frequent regulatory reviews Cost immunisation, weak incentives to increase efficiencies Overcapitalisation and gold plating (Averch / Johnson Effect) High administrative burden

11. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Methods of Regulation / Yardstick Regulation Prices or revenues are indexed to an average of industry performance as opposed to the firm’s own values For instance, average cost may be de-linked as AC i = Sum(AC j )/(n-1), j  i Problems with the practical implementation of yardstick regulation is that: –firms are inherently different because of factors they cannot always control; –firms rarely start from the same efficiency position –collusive behaviour is possible –Preparedness of the regulator to accept company’s bankruptcy is unlikely

12. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Methods of Regulation / Cap Regulation Establishes upper limit on prices or revenue Applies longer regulatory lag Requires explicitly productivity increase via the price formulas (X factor) Allows retention of efficiency gains Should address explicitly quality of supply Ensures transparency and stability of price / revenue development

13. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Cap Regulation Majority of the EU countries apply incentive regulation (price / revenue caps): –revenue caps (Norway, Denmark, Bulgaria) –tariff basket caps (the Netherlands, Slovenia, Romania) –hybrid caps (UK) Various regulatory formulas in terms of complexity and design: –separate network loss incentives (UK) –automatic revenue adjustments using network cost drivers (Norway) –integration of quality (the Netherlands, Norway, Italy, UK)

14. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU How caps can work?

15. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU How can caps work? The price (or revenue) development path does not need to be necessary decreasing. Increasing path possible in case of: –Inflation is higher than the efficiency requirement of the regulator –High investment needs are recognised by the regulator and included explicitly in the specified revenue or price path –OPEX (e.g. labour) cost increases with rate higher than inflation and regulator agrees on this increase –The price control formula incorporates demand growth and associated revenue adjustments (hybrid revenue cap) –The initial price at start of regulation is below the cost reflective price level and the there is a need to ensure gradual convergence towards a cost reflective level

16. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Cap Regulation Methods

17. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Price-cap regulation Individual price cap Price changes depend on –Inflation –Efficiency requirements

18. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Price-cap regulation Tariff basket Price level weighted with quantities Pros: –Strong incentives to increase efficiency –Tariff setting decision of network operator (ideally) Cons: –Rebalancing

19. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Revenue cap Fixed revenue cap Annual increase of revenue is fixed Pros: –Strong incentives to increase efficiency Cons: –Demand changes not reflected in price control –Incentive to overestimate demand growth for the price control period and to postpone new connections during the price control period –Financial risks for the network operator

20. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Revenue cap Average Revenue Cap Regulator fixes revenue/kWh for as starting point for the price control Revenue/kWh is corrected by annual inflation and efficiency requirements in order to derive the allowed revenue/kWh for every year of the regulatory period Pros –Strong incentives to increase efficiency Cons –No relation between cost and revenue during the regulation period –High financial risk for the network operator –Incentives to increase demand and decrease prices below efficient level

21. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Revenue cap Hybrid revenue cap Allowed revenue during the regulatory period depend on e.g. increase in energy delivered (E) or number of customers connected (C) Potential cost increases are integrated in regulatory formula Pros –Strong incentives to increase efficiency –Limited financial risk for the regulated company Cons –Determination of cost driver and weights might be difficult

22. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU TOTEX versus Building Blocks Approach

23. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Building Blocks versus TOTEX To what extent are cost analysed separately? –Building Block Approach Capital cost and OPEX are analysed separately Efficiency Benchmarking concentrates on OPEX Investment approval for regulatory period –TOTEX Approach Total cost are considered Efficiency benchmarking based on total cost (Planned) investment for the regulatory period not taken into account for the annual allowed revenue

24. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Building Blocks OPEXWACC x + Regulatory AssetBase + Abschreibungen OPEXWACC x + Regulatory AssetBase + Depreciation Annual allowed revenue Projection for the regulatory period

25. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Building Block Approach Projection of regulated cost (revenue requirements) during regulatory period Cost defined as building blocks: –return on assets (cost of capital and regulatory assets base); –depreciation –operation and maintenance cost (OPEX) –taxes via a pre-tax WACC or as an explicit cost element, whereas return is determined on a post-tax basis –network losses (optional)

26. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Example Building Blocks

27. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Revenue Profiling Revenue requirements calculated for each year of regulatory period (initial revenue targets) Initial revenue targets include efficient OPEX and CAPEX Initial revenue targets converted in smoothed revenue through the setting of X factor (mathematical equivalence of NPV of both revenue streams) Dual role is attributed to the X factor: –regulatory drive for efficiency increase; and –revenue “smoother”

28. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Example TOTEX Approach

29. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Building Blocks versus TOTEX Discussion of pros and cons taking into account the Serbian circumstances

30. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Determinants of price control

31. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Price Control Determinants / Overview General characteristics Price control formula Revenue requirements (Building Blocks Approach) Regulatory asset base New investments Depreciation Cost of capital (WACC) Efficiency increase and X factor Price index Quantity forecast error adjustment Quality of supply incentives

32. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU RAB and Revenue Requirements AERS is aware of the concept of RAB and the calcuation of annual revenue requirements Changes in a multi-year approach –Calculations based on historic values (e.g. demand, inflation) or forecast values? –Correction factor to overcome differences –Investment approval for regulatory period –Demand estimation for regulatory period –Projection of OPEX for regulatory period

33. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU CAPEX (New investments) CAPEX determined at the beginning of the regulatory period for every year of the regulatory period =>no reopening during the regulatory period Regulatory ex-ante check for CAPEX inclusion Regulatory ex-post check whether the approved (and included) CAPEX plans have been fulfilled

34. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU OPEX Projections The OPEX development during the regulatory period should account for: –OPEX changes beyond the companies’ control –required efficiency increase This can be achieved by: –separation between controllable and non-controllable OPEX –imposing efficiency increase over the controllable OPEX –component-based monetary indexation over the main OPEX components –establishment of functional link between the controllable OPEX and pre-selected physical cost drivers (e.g. GWh or /and number of customers)

35. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Price Index Defined by national CPI index Applies historic values or forecasted values Adjustments in case of large differences between historic / forecast and actual values

36. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Correction term set to adjust the difference between actual minus allowed revenue in previous years Correction Factor

37. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Quality of Supply Regulation Efficient new investments explicitly considered in the cap design –= > supports the quality improvement process Robust quality regulation scheme including standards and incentives needs to be developed during the first regulatory period “Shadow” standards may be introduced in the first regulation period Integrated price/quality regulation scheme, Q factor in the price control formula Revenue exposed to quality incentives will not exceed a certain percent (e.g. 2 %)

38. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Length of regulatory period Trade-off between increased incentives to increase efficiency and increasing risk First regulatory period could be shorter Different length of first regulatory period for gas and electricity could balance the work of the regulator in times of revision

39. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Information Requirements Necessary to determine the revenue requirements and establish the X final Defined by AERS and building on the data requirements for the current regulatory regime Iterated and agree with the companies Used for regulatory review reporting and annual reporting

40. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Implementation / Major Steps Agreement for the concept and commitment of stakeholders Enforcement of legal changes Data collection Calculations to set parameters Consultation process Final determination

41. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Implementation / Transition period Activities during transition period –Data collection for different purposes (establishment revenue requirements, benchmarking, macroeconomic data such as CPI,..) –Preparation of investments and OPEX plan –Assessment of the cost of capital (determination of return on equity and return on debt for the regulatory period) –Efficiency analysis, performing benchmarking exercise, determining annual efficiency improvement factors. –Design of quality of supply regulation –Revenue projections for the first regulatory period –Consultation with the regulated companies

42. Technical Assistance to the Energy Agency of the Republic of Serbia An EU funded project managed by the European Agency for Reconstruction, EuropeAid/122829/D/SV/YU Thank you!