1. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Pricing and Liberalisation Pricing in a Liberalised Energy Market Guido Pepermans Economics Department and Energy Institute K.U.Leuven

2. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Structure of the Talk l The liberalisation process l The general principles of pricing l Stranded costs l Cross-subsidies l Transmission pricing

3. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE The Liberalisation Idea Generation Transmission Distribution Customer One vertically integrated company BEFORE LIBERALISATIONAFTER LIBERALISATION GenCo Transmission Grid Company Distribution Company Distribution Company Distribution Company Regulated

4. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Before the Liberalisation - Belgium Electrabel 92% SPE 4% Autoproducers 4% Generation Transmission Distribution CPTE Mixed Intermunicipalities 80% Pure Intermunicipalities 20% Customer Direct Customers 33% SME Industry 47% Households 20% Regulator CCEG

5. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE After the Liberalisation - Belgium ElectrabelSPEAutoproducers Generation Transmission Distribution CPTE (ELIA) Mixed Intermunicipalities 80% Pure Intermunicipalities 20% Customer Direct Customers 33% SME Industry 47% Households 20% Regulators CCEG for the Captive customers (SME, Industry, Households) CREG for the Eligible customers (Direct customers) Competitors

6. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE General Principles of Pricing - 1 l Desirable criteria for a pricing rule Provide incentives for efficiency(p = MC) Allow suppliers to cover their costs(p > AC) Non-discriminating Transparent l PROBLEM: Natural monopoly match efficiency and cost recovery  Solutions  Ramsey pricing  Two-part tariffs  Peak-load pricing

7. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE General Principles of Pricing - 2 quantity price pRpR O C Market Demand O Market Supply quantity price O B Market Demand O

8. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE General Principles of Pricing - 3

9. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 1 l Problem What to do with past investments?  Were ‘guaranteed’ to be recoverable through price increases  In an open market, this ‘guarantee’ falls away Problem mainly for private monopolists l Definition is important As recovery of stranded costs is foreseen in the European Directive

10. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 2 Fixed or sunk costs that were imposed (  approved ) by the regulator and that cannot be recovered via the market if the market is opened up for competition

11. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 3 MC E AC I AVC I pRpR B A MC I AC I AVC I OIOI O E =q D MC I E1E1 E2E2 E3E3 MC E q* pCpC

12. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 4 Price covers the average costs Average variable cost Average fixed non-strandable cost Average fixed strandable cost Price of electricity generation = Average cost = Average economic profit

13. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 5 Price covers average variable costs and average fixed non-strandable costs Average variable cost Average fixed non-strandable cost Average fixed strandable cost = Average cost = Average economic profit (= loss) Price of electricity generation

14. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 6 Price covers average variable costs but not average fixed non-strandable costs Average variable cost Average fixed non-strandable cost Average fixed strandable cost = Average cost = Average economic profit (= loss) Price of electricity generation

15. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Stranded Costs - 7 l Conclusion From the point of view of efficiency  Stranded cost recovery is not necessary If recovery is allowed  It should be competitively neutral  An upper limit on allowable recovery  Size of the strandable cost

16. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 1 l General pricing principles Should reflect marginal costs Should allow to recover total costs l Misunderstandings Uniform pricing may imply cross-subsidies Price differentiation does not necessarily indicate cross-subsidies

17. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 2 l Definition of cross-subsidy-free prices For all customers  Price is below the average stand-alone cost  The cost of self-providing the good or the service  An upper bound on cross-subsidy free prices  Price not lower than the average incremental cost  A lower bound on cross-subsidy-free prices l Why is there a problem? Wrong incentives Distributive considerations

18. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 3 Assume a given revenue requirement : 190 Bln = (25.000+50.000) x 2 BEF + 40 Bln BEF Variable costs 2 BEF/kWh Variable costs 2 BEF/kWh Liberalised market (25.000 GWh) Regulated market (50.000 GWh) Joint costs 40 Bln ABC A : Joint costs fully allocated to the regulated market p L =2 BEFp R =2,8 BEF B : Joint costs evenly allocated to both markets p L =2,8 BEFp R =2,4 BEF C : Joint costs fully allocated to liberalised market p L =3,6 BEFp R =2 BEF

19. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 4 l Where can they occur?

20. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 5 l Cross-subsidies in a partially liberalised belgian electricity market Intentional misallocation of joint costs in generation Transmission tariffs l Why do they occur? Historical reasons Unintentional misallocation of joint costs Stranded costs Predatory pricing Intentional misallocation of joint costs

21. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Cross-subsidies - 6 l How to reduce the potential for unwanted cross- subsidies Price cap regulation or yardstick competition Speed up the liberalisation process Better control of cost allocation exercise

22. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 1 l What makes transmission pricing of electricity difficult? Fixed transmission capacity Cost recovery Some physical laws apply to electricity transport  Law of least resistance Belgium is part of a European network in which it cannot control flows  Dutch import from France via Belgium or via Germany? l Transmission costs and capacity limits will play an important role in the competitive process

23. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 2 l Alternative pricing systems for transmission  Cost coverage  Incentives for optimal siting of generation and consumption  Incentives for efficient operation, investment and cost minimisation by the transmission company Postage stamp  Fixed fee per MWh  Simple cost recovery  No incentives for correct siting of generation and consumption  No incentives for cost minimisation of system operator

24. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 3 Distance related tariff  Fee proportional to distance  Cost recovery easy  No perfect incentive for siting generation and consumption  No incentives for cost minimisation of system operator Marginal cost pricing  Cost recovery not guaranteed  Good siting incentives if also future tariffs are announced  Better incentives for cost minimisation

25. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 4 l A proposal for Belgium (Energy Institute) Mixture postage stamp and marginal cost pricing  Postage stamp  Individualised costs  Non-individualised costs  Costs not directly linked to actions of generators and consumers  Congestion correction for some sites (discount or extra margin)  Incentive for overall cost efficiency  based on yardstick competition

26. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 5 l The fixed component Covers  Individualised costs  Reactive power for outlyers, connection costs, metering and billing  Non-individualised costs  Allocation based on last year’s  Peak demand: grid maintenance,black start capacity, personnel and operating costs and return on investment  Energy use: reserve capacity, reactive power and voltage control and grid losses  Avoid cross-subsidies

27. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 6

28. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 7 l Incentives for optimal grid use and siting A grid quality charge (GQC)  Based on typical and critical load flows of previous year  Nodes are evaluated w.r.t. Congestion, loss, stability and reliability problems  Nodes causing extra problems get a surplus charge  Nodes relieving problems get a negative charge  Overall the net revenue from the GQC for the system operator is zero  Avoid incentives to create congestion

29. KATHOLIEKE UNIVERSITEIT LEUVEN ENERGY INSTITUTE Transmission Pricing - 8 l Incentives for efficient grid operation and investment SO is rewarded or penalised for delivering good or bad quality (measured by overall system reliability)  Benchmarking  Compare with neighbouring countries  Investing improves quality of the service  Avoid over-investment  Make the SO the residual claimant for a share of grid investment