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Romanian Energy Regulatory Authority

INCENTIVE SCHEME FOR INVESTMENT AND QUALITY OF SUPPLY ON TRANSMISSION

TARIFFS IN ROMANIA

Viorel Alicuş, Otilia Marin,

Florentina Mihăilescu

Athens, 2008

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Regulatory Regime For Price Control

Content

Objectives of Regulation Regulatory Regime Transmission Caps Characteristics Cost Allocation and Tariffs

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Regulatory Regime For Price ControlBackground

•Monopoly companies have to be regulated (the natural competition is missing);•Regulation = set of measures applied to the companies parameters as prices, revenues, quality of supply, market operation;•Regulation must balance obligations both to customers and regulated companies:

-Price reductions & Fair return-Protection against monopoly abuse &Profit opportunities

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Regulatory Regime For Price ControlScope

The major scope of price control is to: protect consumer interests (a fair allocation, between TSO and

customers, of the gains resulted from the increase of efficiency over the targets set

by Regulator);

prevent the TSO monopolistic rent;ensure financial viability of the company;ensure equal conditions and non-discrimination of all

market participants;promote efficient investments in the transmission

network;promote efficient operating and maintenance practices;promote continuous improvement of the quality of the

transmission service.

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Regulatory Regime For Price ControlScope

The aim of a price control (PC) regulation is:•to protect consumers, while•ensuring the company remains viable and has an incentive to operate efficiently. The control is a constraint on the overall level of the company revenue and corresponding prices:• not too harsh so that the company remains viable, • not too light, consumers paying unnecessarily high prices, which is undesirable. Romanian regulator have selected and implemented in the year 2004 the revenue cap regulation, as form of PC, applied from 2005 year to the TSO, for a 3/5 years regulatory period (2005-2007/2008-2012).

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Regulatory Regime For Price ControlScope

Regulatory Control ensures reasonable prices and reasonable quality of supply for regulated services.

Prices •Setting Initial Price / Revenue and its adjustment

•Efficiency assessment and its integration in the price

Quality of supply

•Commercial Quality

•Continuity of Supply

•Voltage Quality

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Choice of Regulatory RegimeType of regulation

Depending on the regulatory strategy and information availability, regulation could be conducted in different way: •Price Control Rate of Return Cap Regulation Yardstick Regulation Performance-Based Regulation •Quality of Supply Public Exposure Standards Incentive Quality Schemes

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Choice of Regulatory RegimeType of regulation

Return on CapitalOperating cost + DepreciationPrice

Actual Cost

Current price level1 + CPI1 + CPI - X

Profit

RORIncentive RegulationRevenue Cap

Different types of incentive and treatment of profit

-Venitul urmăreşte strict costurile -Revederea frecventă a reglementării -Evită orice deviaţie substanţială între costuri - venituri

-Decuplează costurile de venituri -Permite companiei să reţină profituri intermediare

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Choice of Regulatory RegimeType of regulation

RORROR

Different types of incentive and treatment of profit

Venituri Garantate Venituri Previzibile Transparenţă

Dar, Fără stimulente de reducere a costurilor

Stimulente de reducere a costurilor O protecţie mai mare a utilizatorilor

Dar, Risc de profituri oneroase Risc în diminuarea Calităţii Serviciului Transparenţă redusă

Incentive RegulationRevenue Cap

Incentive RegulationRevenue Cap

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Choice of Regulatory Regime Revenue cap method advantages

•To minimise complexity: let the companies to set their prices

•To preserve the relationship between revenues and costs

•To increase operation efficiency on the entire regulation length

•To ensure stable transmission revenue

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Price Control Characteristics

•General Characteristics•Price Control Formula •Revenue Requirements•Regulatory Asset Base •New Investment (CAPEX)•Depreciation •Cost of Capital (WACC) •Efficiency increase and X factor •Network Losses Cost•Congestion Cost•Price Change Index •Quantity Forecast Error Adjustment

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Price Control CharacteristicsGeneral Characteristics

•Revenue cap method-applied to the transmission network service (connection service, system operation service and other non-regulated service are excluded) •Regulatory period’s length: First period - 3 years, Subsequent periods – 5 years •Revenue cap requirements •Moderate efficiency increase requirements •Real, risk-adjusted pre-tax WACC•Linear depreciation•Consumer Price Index

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Price Control CharacteristicsRevenue Cap Formula

R regulated,t – the revenue cap for the year t;R reference the regulated revenue for the previous year of the regulatory period p;

)1]()1(1[1

, SKRKRRXCPIR ptreft

smooth

t

kktregulated

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Price Control CharacteristicsRevenue Cap Formula

k the number of the years t of the regulatory period p;

CPIk the annual consumer price index increase of the year t;

Xfinal,smooth - the percentage determined by the regulator, the same for each year t- costs reducing by the efficiency increasing and the need to obtain a smooth trend of the regulated revenues for all years of the regulatory period;

KRt - the algebraic sum of revenue corrections for each year t of the regulatory period p (quantity, losses&congestion costs).

KRp - the revenue corrections for the regulatory period p (investments).

S - the service quality factor applied to regulated revenue.

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Price Control Characteristics

Revenue Requirements

For the first regulatory period (2005-2007), the Romanian regulator approved the cost components if its cover the expenditure corresponding to:

•efficient investments, •controllable O&M and •losses reduction.

In this way, the regulator has assured the majority of incentive regulation aims, without a comprehensive approach for integration of quality in price control. This is one important task for the second regulatory period (2008-2012). Without additional quality regulation measures, it is possible these incentives to lead to quality degradation

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Price Control Characteristics

Revenue Requirements

•Revenue Requirements aim to provide an assessment of the current and prospective costs

•Revenue requirements are calculated for each year of the

regulatory period (initial target revenues)

•The major cost elements subject to regulatory treatment are:•Return on assets (weighted average cost of capital(WACC) applied to regulatory assets base);•Assets Depreciation cost•Operation and maintenance cost (OPEX)•Network Losses cost •Network Congestion Cost

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Price Control CharacteristicsInitial target revenue

Vinitial,target,t=CCreference(1–Xiniţial)t+ CNCt+Dt

+LOSt+CONt+CBTt +RAt

where:t - each year of the regulatory period;V initial,target,t undiscounted required revenue, in real terms, for the year t;CC reference the controllable O&M costs, for the year t; CNC t uncontrollable O&M costs, for the year t;

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Price Control CharacteristicsInitial target revenue

Dt annual amortization corresponding to the assets that are included in the RAB for the previous year (t-1), and the amortization corresponding to the assets commissioned or decommissioned in the year t;LOSt forecasted values of the acquisition cost of the electricity covering grid losses;CONt forecasted values of the network congestion removing cost;CBTt forecasted values of the payment liabilities of the cross border trade;RAt return on asset;Xinitial, efficiency factor applied to the controllable costs, based on an international benchmarking with comparable utilities.

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Price Control CharacteristicsINCENTIVES FOR CONTROLLABLE COSTS REDUCING

The revenue-cap mechanism aims to provide incentives for better productivity in the assumption that the company is able to control its level of costs. There are some costs there are not under the company’s control and therefore, it would not be reasonable to expect any productivity improvements in this area. Such non-controllable costs may include items as taxes, regulatory contributions, costs resulting from force majeure. OPEX typically includes the costs of personnel, maintenance, buildings and office rentals, administration, transportation, etc. The company could adjust its level of OPEX in a relatively short period. For example, it could reduce its maintenance activities according to new investments achievement, dispose of personnel, or attract additional staff. In the first and second regulatory period, the TSO will be allowed to keep the profit over the efficiency gains level established by regulator. To compute the caped revenue for the third regulatory period, the regulator will determine the efficiency gains over the established target for the second regulatory period and which will be 50% shared with the customers of the transmission service (gains sharing mechanism) and respectively 50% with the TSO.

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INCENTIVES FOR CONTROLLABLE COSTS REDUCING

The consequences of increasing/reducing of efficiency factor level are reflected in the study case shown in the table below.

Controllable cost (CC) Regulatory period p-1, years:

Reference 1 2 3

Forecasted values 100 99 98 97

X forecasted 1%

Forecasted improvement (1-x) 0.99 0.99 0.99

Forecasted values *(1-IPC) 106 111 114

Registered values 100 94 84 89

Registered yearly improvement (1-x) 0.94 0.90 1.06

Additional profit 5 14 8

X registered 6% 10% -6%

X registeredyearly average

3,5%

80% X reg= X new 2,8%

(1-X new)

0.97

Reference values 101 regulatory period p

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Price Control CharacteristicsINCENTIVES FOR CAPEX COSTS REDUCING

Regulator recognizes that cost reductions should not be pushed by prohibitive regulatory arrangements that would not allow investors to earn adequate return on asset. When setting caps, regulator should consider that their level is sufficient to cover not only efficiently incurred O&M costs, but also an adequate return on both existing assets and new economical justified investment. CAPEX has a long-term nature and is controllable only in the longer run; in the short run, CAPEX can be considered fixed. These costs typically relate to investments for rehabilitate or extending network capacity as well as for upgrading quality. Investment might be characterized by substantial fluctuations in cash spending from year to year. For this reason, averaging CAPEX spending for the years of the regulatory period has to be smoothed. Companies have two sources to finance their investments, debt and equity. For these finance sources, the company should pay interest and a dividend respectively. These combined costs (weighted average) determine the company’s costs of capital and it is applied to the assets value registered in each year of the regulatory period. The forecasted investment program by TSO is very important and could lead to revenue reducing for the next regulatory period, taking into account the correction due to investments is made once at the end of the regulatory period.

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Price Control CharacteristicsINCENTIVES FOR CAPEX COSTS REDUCING

If the investment program was lower as compared to the one approved by the regulator for the previous regulatory period p-1, regulated asset base (RAB) will be adjusted by reducing in the regulatory period p.

The additional investment, which was completed due to exceptional conditions, as compared to the approved program for a certain regulatory period, can be introduced in RAB at the beginning of the next regulatory period only with the approval of the regulator.

The delayed / advanced investment as compared to the approved plan are quantified and sent to the regulator in order to be subtracted from / added to the RAB corresponding to the next year of the regulatory period.

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Price Control CharacteristicsINCENTIVES FOR LOSSES COSTS REDUCING

Some of non-controllable costs are considered non-controllable while in reality, these costs can be influenced by the company. For example network losses costs are driven by three factors: measured losses quantity (kWh), the price for losses acquisition (lei/kWh) and measured losses unbalancing quantity. If the regulator would consider network losses fully non-controllable, the company would have neither incentive to reduce these losses, nor to purchase the electricity at lowest price possible. As follow, the Romanian regulator will adopt, for the second regulatory period, a cap for the forecasted losses quantity. The registered cost under 10% / above this cap will represent additional/less profit for each tariff period. A new measure was implemented in order to reduce the losses unbalancing quantity needed to be purchase on balancing market by limiting this value to 2% of monthly value of regulated losses quantity. It have to be mentioned that, from the second regulatory period, the losses unbalancing costs are items of controllable costs.

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Price Control CharacteristicsINCENTIVES FOR QUALITY OF SUPPLY- IMPROVEMENT

In the short term the regulator will need to make sure that no uneconomic degradation of quality occurs, and in the longer term it will need to provide incentives for a desired level of quality. In addition, regulator has taken further steps to ensure that certain performance and quality standards are met. This involves mainly prescription of certain standards and using financial incentives based on reward and penalty schemes.

Way the quality is important? Because:•Demand for quality increases with economic grows•Consumers attach more importance to quality•Monopoly firms may provide suboptimal quality•Power industry reform adversely affects quality.

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Price Control CharacteristicsINCENTIVES FOR QUALITY OF SUPPLY- IMPROVEMENT

There are three network service quality types: Continuity of Supply (Reliability) – describes the availability of the electricity and is characterized by the number and duration of interruptions and some other indices specified in the Grid Code and included in the TSO yearly report.Technical Quality – describes the physical parameters of the electricity and covers aspects such as voltage and frequency stability, voltage dips, over-voltages or harmonic distortions and it requirements are forecasted in the Grid Code and are monitored by regulator.Commercial Quality – describes the customer service quality including the quality of all relationships between a service provider and a user and it is monitored by regulator which approved the framework contracts.

The quality factor S links prices from quality. These two items are closely related: each quality level is associated with a price adjustment. The company’s performance is compared to some quality target: deviations result in either a penalty or a reward. The level of the penalty or reward can be capped and dead bands may be applied.

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Price Control CharacteristicsINCENTIVES FOR QUALITY OF SUPPLY- IMPROVEMENT

The level of revenues associated to the reward/ penalty schemes established by the Romanian regulator will not be over ± 2,5% of the yearly revenue for the second/third regulatory period.

Quality Incentive Schemes For the first year of application, the Romanian regulator has proposed for performance incentives scheme 3 with dead band.

Quality Level (q)Low High

Rew

ard

Pen

alty 1. Minimum Standard

2. Continuous

4. Dead Band

3. Capped

Financial Incentive (Φ)

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Price Control CharacteristicsINCENTIVES FOR QUALITY OF SUPPLY- IMPROVEMENT

Structure of the performance incentives scheme comprises the service component and market impact component. These components set out:•the parameters that apply to each TSO•the requirements with which the values to be attributed to the parameters must comply, and•the maximum revenue increment or decrement that a TSO may receive under each component of the scheme.

For the first year of application, the Romanian regulator has proposed 2 indicators for service component:•Energy Not Supplied (ENS) – (MWh)•Average Interruption Time (AIT) – (h)

and 1 indicators for market impact component:•the number of dispatch intervals where an outage on a TSO network results in a network outage constraint with a marginal value greater than a specific value X (Eur/MWh).

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Price Control Characteristics Regulatory Asset Base, RAB (1)

RAB = RABinitial +CAPEX –Depreciation - -Capital Contribution - Asset Disposal RABinitial = Company’s book value at the end of the previous year of the regulatory period (fixed assets plus working capital)

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Price Control Characteristics Regulatory Asset Base, RAB (2)

To be included in RAB•New investment CAPEX (IA)

To be deducted form RAB•Depreciation•Capital contribution –capital provided by Government, consumers or other parties. (This capital is not eligible to earn return) •Asset disposal

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Price Control CharacteristicsNew Investment (CAPEX) (1)

•Regulator checks the inclusion in RAB of efficient CAPEX programs before the beginning of the regulatory period •If the actual CAPEX less than the planned CAPEX, Regulator should identify the natures of gains

•If the efficiency gains result from management efforts to enhance efficiency, these gains can remain with the company

- 100 % for the first regulatory period- shared 50 % / 50 % with the consumers for the second and the subsequent regulatory periods

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Price Control CharacteristicsNew Investment (CAPEX) (2)

•If the efficiency gains result from deliberate investment postpone, Regulator will require claw back using negative revenue adjustment in the following regulatory period.The revenue adjustment will include depreciation and return on CAPEX using a compounding formula to accommodate the inflation and the time value of money•If the actual CAPEX exceeds the planned CAPEX, the overspending will be eligible for an inclusion in the RAB, only after an explicit permission by Regulator.RAB will be forwarded between two regulatory period through inflating the actual incurred CAPEX and the corresponding depreciation

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Price Control CharacteristicsDepreciation

•Straight line depreciation applied to un-depreciated value of

assets over n years (existing RAB at the beginning of first

regulatory period).

•Depreciation applied to accumulated un-depreciated value of

new assets at the start of each year of the regulatory period,

plus a percentage of new assets forecasted for that year

(commissioning dates are uncertain)

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Price Control CharacteristicsReturn on Asset

Regulators determine the allowed RA return on assetas the real term, pre-tax, risk adjusted Weighted Average Cost of Capital (WACC) applied to RAB:

RA=WACC*RAB

EC= after-tax cost of equity in real terms,

kE =share of equity in total capital structure

DC=pre-tax cost of debt in real terms

kD =share of debt in total capital structure

T=profit tax rate

kDDCTkEECWACC 1/

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Price Control CharacteristicsEfficiency Increase and X Factors (1)

•Initial revenue targets include efficient OPEX and CAPEX •Efficient OPEX achieved through imposing a pre-determined

efficiency increase requirements (X initial) on the controllable

OPEX •X initial, set equal to 1 % for the first regulatory period•For the second regulatory period X initial set at 80 % from

the actually achieved efficiency improvement but not less than

1 % •Benchmarking can also be applied in the future

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Price Control CharacteristicsEfficiency Increase and X Factors (2)

A dual role is attributed to X final :

•regulatory driver for efficiency increase (imposed through X initial); and •revenue “smoother” (imposed through X final,smooth);

Initial revenue targets is converted into ‘smoothed’ revenue through the X final,smooth (financial equivalence, in terms of NPV, for both revenue streams). Revenue streams through the regulatory period is used in real terms (treatment of inflation).

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Price Control CharacteristicsNetwork Losses

•Cost of transmission losses procurement there is part of the network service costs

•Loss targets is defined by Regulator for each regulatory period•Cost of transmission losses is derived on the basis of the physical transmission electricity quantities and valued at a price defined by TSO and Regulator •Companies allowed to keep all profits obtained from loss

reduction beyond the level set by Regulator for the duration of

the regulatory period

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Price Control CharacteristicsCongestion Cost

•To remove the congestions TSO has to pay the redispetched

generators•TSO is allowed to collect money from the transmission service

users (G and L) to cover these costs using location congestion

charges (incorporated in the transmission use of network

charge)•In the first regulatory period Regulator will estimate the

congestion costs using historic data. •The annual forecasted congestion cost will be adjusted annually

through the correction term in the transmission revenue cap

formula

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Price Control CharacteristicsPrice Change Index

•Regulator can use an ex-ante CPI forecast

•If the annual CPI (%) higher than than 20%, the TSO is entitled to demand a tariffs increasing

.

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Price Control CharacteristicsQuantity Forecast Error Adjustment

•Demand forecast and corresponding transmission electricity

quantities are developed by TSO and then reviewed by

Regulator

•Adjustment for quantity forecast error •quantity correction term is equal to the difference

between revenues (forecast revenue minus actual revenue)

and costs (difference between forecast and actual cost of

procurement of losses)

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Cost Allocation and Tariffs

Determined by the TSO and based on the revenue requirements

allowed by Regulator.

Regulator will monitor the cost allocation to ensure charges free of

cross-subsidising.

Principles:

•set on a location basis, imposed to load and generator

•efficiency signal based on Marginal Cost pricing (marginal

transmission losses and congestion)

•revenue requirements covering

.

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Cost Allocation and TariffsDefinition of the transmission service

The total cost TSO has to bear, including the cost associated to congestions, must be balanced by revenues, which in their turn are based on the transmission service -TS- tariff.

The transmission tariff should ensure that the total cost of the transmission operator be fairly and entirely allocated on beneficiaries.

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Cost Allocation and TariffsMarginal costs and necessary revenues

Communities function and progress most satisfactorily when prices for goods and services are based on marginal costs.For the TS, only marginal costs from the delivery (d) and receipt (r) nodes are of interest,

MCTS = MCd + MCr Marginal costs are of short run -SR- if TS is delivered through the existing transmission capacities.

MCSRk = MCSR

l-k + MCco-k

Marginal costs are of long run -LR- if an additional transmission capacity in the main grid is required for the service delivery (additional cost of losses and capacity increasing).

MCLRk = MCLR

l-k + Mcc-k

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Cost Allocation and TariffsMarginal costs and necessary revenues

TSO registers the short run marginal costs, but revenues are based on long run marginal costs.

TSO can decide whether to invest in the network reinforcement or to pay for additional lost energy and congestion when:

ΣMCSRi x Pi ΣMCLR

i x Pi

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Cost Allocation and TariffsMarginal costs and inactive (stranded) capacities

Usually, the TS is characterised by the preponderance of fixed costs.The economy of scale phenomenon represents the main hindrance in setting up the transmission tariffs strictly according to the marginal costs value.Therefore, both transmission cost components should be adjusted:

tG = MCd + ; tL = MCr + ; tTS = tG + tL

Additional components are introduced in the tariff to calibrate the total cost and the revenue. These are: -market access fees - the additional service of the network, as a physical support of the electricity market, offered to market participants -capacity fees - fixed costs but this method apparently does not provide the required consistency.

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Cost Allocation and TariffsMethod to balance costs with revenues: the capacity fee

This component can be applied either to the transmitted energy, within the monomial tariff, = = CF

or distinctively, within a binomial tariff structure,t’TS = MCTS; t”TS = CF;

Components representing fixed costs are open to criticism because marginal costs are mingled with average costs with little theoretical support.

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Cost Allocation and Tariffs 6 generation nodes

This component can be applied either to the transmitted energy, within the monomial tariff, = = CF

or distinctively, within a binomial tariff structure,t’TS = MCTS; t”TS = CF;

Components representing fixed costs are open to criticism because marginal costs are mingled with average costs with little theoretical support.

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Cost Allocation and Tariffs 8 loads nodes

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48

Methodology To Establish Tariffs For Electricity

Transmission Service

References

•Methodology To Establish Tariffs For Electricity Transmission Service - ANRE methodology•Transmission Service on a Deregulated Electric Market - Jean Constantinescu, CIGRE, Regional Meeting, Romania, June 2001•Revenue Cap in Electricity Transmission - KEMA consulting•Service target performance incentive scheme – Australian Energy regulator