Electricity Markets Regulation - Lesson 1 - Regulation General Principles

Training on Regulation A Webinar for the European Copper Institute Webinar 1: Regulation – General Principles Dr. Konstantin Petrov / Dr. Daniel Grote 23.10.2009 http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-1

Agenda 3. Scope of Regulation 2. Areas of Regulation 4. Methods of Regulation 5. Institutional Questions 6. Consultation and Communication 1. Objectives of Regulation 7. Regulatory Performance

1. Objectives of Regulation Definition and Objectives Regulation is needed in areas where competition does not work (e.g. natural monopoly such as electricity networks) or legally excluded (exclusive rights given by the law). Regulation is state intervention applied to various company specific (e.g. prices, revenues, quality of supply ) or integral parameters (e.g. market entry/ market design) .

The major regulatory objectives are to:

protect consumer interests and eliminate monopoly inefficiency

ensure financial viability of industry participants (efficient cost coverage)

ensure equal conditions and non-discrimination of all sector participants

improve conditions for competition where it is possible

1. Objectives of Regulation

Economies of scale

Capital intensity

Peak-load based

Locational specificity

Direct connections to consumers

Characteristics of Electricity Networks

1. Objectives of Regulation Choice of Regulatory Regime Areas of Regulation Scope of Regulation Type of Regulation Regulatory Institutions Where should be regulated? What should be regulated? How should be regulated? Who regulates? Choice of Regulatory Regime

1. Objectives of Regulation Balancing Interests Regulation must balance obligations to both customers and regulated companies and also the costs and benefits of the regulatory system itself. Costs and Benefit of Regulatory System Distortions to industry structure Costs of operating regulation Prevention of monopoly abuse Efficiency savings and lower costs Customer and Company Interests Price reductions Protection against monopoly abuse Fair return Profit opportunities

2. Areas of Regulation Regulated and Competitive Elements Ancillary Services Wholesale Supply Power Generation System Dispatch Power Transmission Power Distribution Retail Supply Metering and Billing Services subject to regulatory control Competitive services Potentially competitive services

3. Scope of Regulation Regulatory Controls Price Control Regulatory Controls Quality of Supply Market Functioning Setting Revenue Requirements Price / Revenue Adjustments Efficiency Assessment Commercial Quality Continuity of Supply Market Rules / Contract Rules System / Network Rules (Grid Code) Market Monitoring Technical Quality Tariff Design Security of Supply Other Unbundling Cross-border Issues

3. Scope of Regulation Price Control Setting Revenue Requirements Price / Revenue Adjustments Efficiency Assessment Tariff Design

Setting OPEX allowance

Setting capital cost allowance (asset valuation, depreciation, regulatory asset base, cost of capital)

Price control formula

Adjustment factors (productivity increases, prices, volume adjustment)

Length of price control period

Tariff structures (e.g. use of network charges / connection charges, demand charges / energy charges / standing charges)

Cost allocation (differentiation for voltage level, location, time of use, energy use / peak demand)

Assessment of inefficiency of regulated service providers (Benchmarking)

Techniques: non-parametric models (Data Envelopment Analysis), parametric models (Corrected Ordinary Least Square, Stochastic Frontier Analysis), engineering models

3. Scope of Regulation Quality of Supply Continuity of Supply Technical Quality Commercial Quality

Reliability of electricity supply

Performance indicators (number and frequency of interruptions)

Physical properties of electricity

Performance indicators (voltage variation, dips, flickers)

Customer service quality

Performance indicators (complaints from consumers, response time to consumer complaints, appointments with consumers)

3. Scope of Regulation Market Functioning Market Rules / Contract Rules System / Network Rules Market Monitoring Security of Supply

Day-ahead market (participation, submission of offers, price determination, settlement); balancing market (procurement of reserves, balancing energy, settlement of imbalances); congestion management; customer switching procedures

Planning conditions (standards, data, protection), connection conditions, system operation (frequency control, voltage control, managing disturbances), metering requirements..

Compliance monitoring, competition monitoring (market concentration, anti-competitive behaviour), market performance analysis (structural, behavioural, modelling), market performance indicators (e.g. Herfindahl-Hirschman Index, Lerner Index), reporting statistics.

Adequacy of generation, network development, supply and demand balancing, operational security

3. Scope of Regulation Other Unbundling Cross-border Issues

Unbundling requirements (accounting, functional, legal, ownership)

Interconnection capacity determination, interconnection capacity management, market integration.

4. Methods of Regulation Regulatory Control Price Control Quality of Supply Power Market Rate of Return Price and Revenue Cap Incentive Schemes Indirect Quality Controls Ex-ante Endorsement of Rules Monitoring of Market Performance and Corrective Actions Minimum Performance Standards Yardstick Competition Overview

4. Methods of Regulation Price Control

Prices or revenues based on costs plus “fair” rate of return

Frequent regulatory reviews

No/low incentives for cost reductions / efficiency improvements

Overcapitalisation and gold plating (Averch/Johnson Effect)

Establishes upper limit on prices or revenue

Applies longer regulatory lag (3-5 years)

Requires explicit efficiency increase via price formula (X factor)

Allows retention of efficiency gains; should address quality of supply

Strong incentives for efficiency improvements

Decouples individual costs from allowed prices / revenue

Allowed prices / revenues linked to regulated industry performance

Strong incentives for efficiency improvements

Effect similar to the dynamics of competitive forces

Rate of return regulation Cap regulation Yardstick regulation

4. Methods of Regulation Quality of Supply

Better performance than quality target leads to reward / worse performance to penalty

Reward / penalty increases / decreases the allowed revenue

Various mathematical specifications of incentive function

Information requirements, public exposure

Customer participation

Resolution of conflicts

Minimum performance level

Violation leads to a fine or tariff rebate

Overall and individual quality levels

Incentive Schemes Indirect quality controls Minimum Performance Standards

5. Regulatory Institutions Expression of Regulatory Regime

Primary and Secondary Legislation

Regulatory Determinations

Licenses (e.g. generation, transmission, distribution, supply, trading)

Rules (e.g. Market Rules , Grid Code, Pricing Rules)

Consultation and Position Papers (define regulatory views and expectations)

5. Regulatory Institutions Sector specific regulators Courts Competition Authorities Legislators DG Competition National Comp. Authorities National/Regional Regulators Agency for the Cooperation of Energy Regulators (ACER) from 2011 European Court of Justice National courts Energy Law Secondary Legislation National Parliaments National Governments Industry National industry associations EU Council ENTSO-E EU Commission EU Parliament Who regulates?

5. Regulatory Institutions

Directives 96/92/EC, 2003/54/EC and 2009/72/EC

Internal market for electricity

Unbundling

Regulated third-party access (independent electricity regulator)

Market opening (free choice of supplier)

 100% since July 2007

Regulations (EC) No 1228/2003, Regulation (EC) No 714/2009

Cross-border transmission (congestion management, allocation, charges)

 ENTSO-E (European Association of TSOs) since July 2009

Regulation (EC) No 713/2009

Agency for the Cooperation of Energy Regulators (ACER) by 2nd half 2011

Relevant EU Electricity Legislation

5. Regulatory Institutions

Transparent, consistent, predictable regulatory decisions crucial for regulatory credibility

Independence in terms of:

Appointment

Decision making

Funding

Independent of government

Separate regulation from discretionary interventions of the government such as - pre-election price cuts or end-user prices below cost-reflective prices

- subsidies to the national industry

- cross-subsidies between different customer groups

Independent of regulated firms

Limit lobbying and influence by firms trying to capture special privileges and benefits

Why should the regulator be independent ?

5. Regulatory Institutions How is the regulator accountable?

Define clear transparent rules and procedures for the regulator in the legislation

Regulatory impact assessment – to demonstrate the effect of regulatory decision

Dispute resolution through a third institution (e.g. Competition Authority) or Court

Budget approved by Government or Parliament

Annual Report – describes the activities of Regulator and is publicly available

6. Consultation and Communication

Regulation must be clearly communicated to stakeholders

Cooperation stems from good communication

Regulator dependent on information provided by regulated firms

Data exchange is generally formalised via standard data requests

Objectives

6. Consultation and Communication

What data to collect?

Cost and technical data, demand information (including forecasts), supporting macroeconomic info, business and financial plans

How to collect it?

Define and publish rules of data collection in guidelines; translate guidelines into regulatory account forms to be filled in; opportunity for feed-back by companies; consult on quality of received data

How to interact with companies?

Send data templates to the companies; companies get back to the regulator with data and

observations; process should be public; commercially sensitive data kept confidential

How to consult with the companies?

Workshops on preliminary results; recurring consultations; publish final consultation documents

How to interact with the Government?

Formal interactions (budget plans, financing); consensus efforts; political marketing; political pressure; lobbying

Main Tasks

7. Regulatory Performance

Efficiency (allocative and productive)

Prices

Investment

Quality of supply

Competition

Innovation

Financial performance

Administrative burden

Environment

Employment

Economic growth

Regulatory Impact Assessment – Outcomes of Regulation

7. Regulatory Performance Regulatory Impact Assessment – Process

Description of the problem (objective and rationale)

Identification of alternatives

Estimation of costs and benefits of each alternative (quantified and monetised)

Identification of winners and losers and their potential gains and losses

Consultations with stakeholders and communication with interested public

Clear choice of preferred alternative

Ex-post review of regulatory outcome

7. Regulatory Performance Factors Affecting Sector Performance and Regulatory Performance Based on: Sanford V. Berg (2009), Characterizing the Efficiency and Effectiveness of Regulatory Institutions, PURC Working Paper Industry Risk Perception Objectives, Priorities General Economic Conditions Input Markets Regulatory Rules/Policies Structural Policy Behavioural Policy Legitimacy, Credibility Industry Conditions Structure Behaviour Performance Corporate Governance Historical Experience Institutional Conditions Regulatory Governance Design Processes

End of Webinar 1.