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Dr. Konstantin Petrov, DNV KEMA
11 November 2013
Introduction to Network Regulation Module 3: Regulatory Investment Incentives
Introduction to Network Regulation
11 November 2013
Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
2
Introduction to Network Regulation
11 November 2013
Sector Trends and Investment Drivers
3
Liberalisation, Gas & Electricity
Directives (and related legal and
regulatory framework and
arrangements)
Regional integration and
harmonisation
Climate policy (support of renewable
energies, CO2 emission trading,
energy efficiency)
Security of supply
Political Technological Economic
Major Sector Trends…
Political trends reflect the major
elements of the European energy
policy.
Technological trends are mainly driven
by climate policy and technological
progress.
Economic trends are mainly driven
by general economic development,
sector specifics and energy policy.
Development of RES technologies
Smart metering / smart grids
Network technology
Energy storage
Electric vehicles
Energy use / energy efficiency
Shale gas developments
Ageing assets and replacement
needs
Increasing shares of RES and
changing load flow patterns
Market prices and missing money
problems
Financial burden of RES support
schemes
Mergers / take-overs
Demand growth
Increasing regional trade
Introduction to Network Regulation
11 November 2013
Sector Trends and Investment Drivers
4
Increase in renewable
generation
Demand growth
Connection of non-
renewable generation
Reshuffle of merit order
Asset age
Drivers
Investments to connect / integrate renewable
generators and to accommodate the
interconnection flows
De-carbonisation of transport and heat sector will
likely be achieved by a greater use of electricity
(electrical vehicle, heating) which may require
additional investments in (distribution) networks
Significant investments are required to connect
non-renewable generation and to manage
network flows
With the change of production technologies
connected to the network (and potentially market
arrangements), merit order will also change and
may lead to new investments
Replacement needs due to aging assets
Network Implications
Administrative / legal –
mainly due to long
administrative
permission process
Structural – related to
the organisation of the
network operators
Financial – raising
capital on financial
markets
Regulatory – adequacy
and effectiveness of
investment incentives
Potential Barriers
…Lead to Need for Investments
Introduction to Network Regulation
11 November 2013
Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
5
Introduction to Network Regulation
11 November 2013
Classification of Investments
6
For regulatory purposes investments are often classified in two major groups:
market-based and reliability investments.
Reliability
investments
Market-based
investments
Transmission
network
Investment characteristics matter for the choice of the
investment appraisal methods by the regulator.
Distribution
networks
Cross-border
interconnections
Introduction to Network Regulation
11 November 2013
Classification of Investments
Investments in transmission and distribution networks exhibit different properties due
to the functions of the networks.
7
Transmission Networks and Interconnections
• A limited number of projects with large
investment volumes
• Long planning periods
• Large variability of annual investment budgets
due to the impact of singular large projects
• Often various projects and/or technical
alternatives exist
Distribution Networks
• A large number of projects with usually lower
investment volumes
• Shorter planning periods
• Strong relationship with the local demand and
generation characteristics
• Lower impact of the individual project
lumpiness
Minimizing costs while keeping system reliability
Maximizing net benefits, based on explicit analysis of the benefits resulting
from benefits
vs.
Introduction to Network Regulation
11 November 2013
Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
8
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
Ensure efficient and sufficient level of investment: regulators should recognize the
on-going changes and provide adequate response in terms of a consistent set of
investment incentives
Ensure the integration of capital costs resulting from investments in the allowed
revenues
Provide an adequate return on assets to encourage investors to undertake
necessary investments
Innovation should be explicitly addressed in the regulatory frameworks
Remove administrative barriers: legislation / permitting procedures should support
the acceleration of network construction
9
The Role of Regulation
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
10
Investments are considered in the allowed revenue through the capital costs (depreciation and return on assets).
Opex Capital costs
Revenue Requirements
Regulatory Asset
Base (RAB) Rate of Return
Network Losses Labour Return on Assets Depreciation Materials /
Services
Allowed Revenue = Opex + Depreciation + (RAB ● Rate of Return)
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
11
The regulatory asset base (RAB) aggregates the net values of the assets used to provide the regulated services.
Regulatory
Asset
Base
Existing assets
Investments
Asset disposal
Depreciation
Capital
contribution
Working
capital
Construction
works in
progress
RAB Closing Value =
RAB Opening Value
+ Investments
– Depreciation
– Asset Disposal
+/- Change of Working
Capital
+/-Change of Capital
Contribution
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
12
Regulation Key Incentive Features Key Issues
Regulation model,
linked caps
(building blocks)
Base the revenues during a regulatory period on an
ex-ante assessment of the efficient levels of operating
and capital expenditure.
Appear attractive because of the link between revenues
and projected costs. At the same time they allow the
projected costs to be checked for efficiency and allocate
the anticipated efficiency increases to customers.
Regulation model,
unlinked caps
Do not link revenues to costs during the regulatory
period and typically do not require cost projections.
Instead they apply a regulatory formula that annually
adjusts the allowed revenue whereby the starting point
is based on the company’s actual cost in a pre-
specified year.
May provide the regulated companies with a strong
incentive to undertake only efficient investment. On the
other hand, the regulatory threat that capital costs of
investments can be disallowed ex-post could discourage
even efficient investment projects.
Ex-post efficiency
analysis
Applies the actual (total) costs (including investments)
incurred by the company and set the efficiency
increase factor based on a benchmarking analysis of
these costs (totex analysis).
The incorporation of the undertaken investments into the
ex-post efficiency analysis require addressing several
issues resulting from the long-term nature of capex.
Ex-ante capex
assessment
Used in the building blocks approach and may apply
engineers' reports, benchmarking against other
businesses and the submission of business plans.
There might be a serious information asymmetry present
in relation to capital expenditure.
Quality of supply Regulators apply standards and incentive schemes to
encourage quality of supply. Application in the majority
of EU countries.
The key issues in the quality of supply regulation relate to
the quality of data collection and data measurement.
Regulators in Europe have been applying various types of incentive schemes for
network investments.
Introduction to Network Regulation
11 November 2013
Regulatory Investments Incentives
13
Regulation Key Incentive Features Key Issues
Cost of Capital
/ WACC Mark-
ups
Weighted Average Cost of Capital (WACC) is a commonly
used method for determining a return on an asset base.
WACC is set equal to the sum of the cost of each individual
component of the capital structure weighted by its share.
Application in majority of EU countries.
CAPM is the dominant model for estimation of cost of
capital. There are several issues related to the
application of CAPM related to the data and
assumptions.
Revenue
Driver /
Quantity
Adjustment
Factor
The main purpose of quantity adjustment factors in the
regulatory formulas is to provide continuity in terms of capex
and opex recovery. These factors link the allowed revenue to
pre-selected cost drivers.
The main issues are related to the design and
specification of the quantity adjustment factor in order
to adequately reflect the cost impact.
Asset
Valuation
Regulators may use different methods to value the RAB,
which is a key determinant of prices that may be charged for
regulated services in the future. Application vary in EU
countries.
The application of these methods is synchronized
with the concepts of cost of capital and depreciation.
The concept may have a strong impact and be
challenged by the industry if it requires optimising-out
certain assets of the RAB (regulatory stranding).
Construction
work in
progress
Construction work in progress (CWIP) is the money spent on
an asset that has not been commissioned at the relevant time.
With regard to inclusion in the RAB, regulators vary widely in
their treatment of funds used for construction.
Regulators may encourage investments by allowing
capitalization of debt and equity costs incurred by the
service provider during the construction period.
Alternatively the regulator can permit inclusion of cost
of capital (allowed return on debt and equity) in the
allowed revenue during the construction period.
Innovation
Incentives
Innovative investments may be encouraged by introduction of
binding standards (obligation to built), explicit investment
allowances, exclusion from efficiency analysis, increased rate
of return on ‘innovative investments’.
Differentiation of ‘innovative investments’,
need to move from pilot / demonstration projects to
arrangements that are also sustainable.
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
Regulation should provide a robust analytical and coordinated framework to support
the selection of adequate and efficient investments on national and regional level.
14
OBJECTIVES
TOOLS
Time: Ex-ante vs.
ex-post check
Methods:
Determ. vs. stochastic,
non-paramteric vs.
econometric, economic
/social versus financial
Scope: OPEX; CAPEX;
TOTEX; SOTEX
Orientation:
Project-specific vs.
total investments;
new investments vs.
total asset base
Adequate
investment level
Recovery of
efficient cost
Selection of best
alternative
Regional
coordination
Introduction to Network Regulation
11 November 2013
Regulatory Investment Incentives
Cost-Benefit Analysis (CBA) has been increasingly used by regulators for evaluation
of new investments in important projects.
15
Alternatives
Incremental
impact on the
continuation of
status quo
Uncertainty
Regional
effects
Δ Costs • CAPEX
• OPEX
• External costs
Δ Benefits • Producer Surplus
• Consumer Surplus
• Benefits TSO/ or
Investor
In
cre
me
nta
l
effe
cts
Perspective
of the
analysis
Esse
ntia
l
ch
ara
cte
ristic
s
of C
BA
Investment
Introduction to Network Regulation
11 November 2013
Agenda
1. Introduction into Investment Incentives
2. Regulatory Regimes and Investment Incentives
3. Treatment of Investments in Price Control
4. Practical Experience
16
Introduction to Network Regulation
11 November 2013
Practical Experience
17
Regulators have been using various arrangements.
Instrument Examples for Implementation
Regulation model, linked caps (building blocks) UK, Ireland, Finland
Regulation model, unlinked caps Germany, Norway
Ex-post efficiency analysis Germany, the Netherlands, Norway, Austria
Ex-ante capex assessment UK, Ireland, Germany (investment budgets)
Investment Allowance Germany, Austria
Cost of Capital / WACC mark-up Austria, Italy
Asset Valuation Application varies in EU countries
Construction work in progress (CWIP) Regulators vary widely
Revenue Driver / Quantity Adjustment Factor Germany, UK, Austria, Norway (1997-2006)
Innovation Incentives UK, Italy
Efficiency Carry-Over Schemes Austria
Introduction to Network Regulation
11 November 2013
Practical Experience
Development of a trans-European energy infrastructure; major challenges:
coordination and financing
Guidelines published in May 2013: Implementation of priority corridors / areas and a
regulatory framework to promote necessary investments
Identification of eligible projects:
- General criteria: project is viable in a social, economic and environmental way; contributes to
the energy policy and infrastructure targets; at least two member states involved
- Specific criteria: market integration,
security of supply (diversification,
secure system operation) and
sustainability (integration of RES,
GHG avoidance)
Cost Benefit Analysis
18
Example: Projects of Common Interest
Source: European Commission 2013
Introduction to Network Regulation
11 November 2013
End of Session 3.
11/11/20
13
Dr. Konstantin Petrov
Service Line Leader Markets & Regulation / Business Line Director Gas Consulting Services
DNV KEMA Energy & Sustainability
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8
53113 Bonn
Tel: +49 228 44690 56
Fax: +49 228 4469099
Mobile: +49 173 515 1946
E-mail: [email protected]
Introduction to Network Regulation
11 November 2013
www.dnvkema.com