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Investment Incentives


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Session 3 focuses on the regulatory treatment of investments and incentives for investments. Finding an adequate balance between efficient and sufficient investments is one of the major tasks for regulators. They can use various approaches to assess and encourage investments necessary to provide reliable and efficient services. In this session we explain the types of investments and their integration in the regulatory price control. We also present different regulatory incentive schemes to encourage investments. Finally, we provide examples from international regulatory practice.

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Investment Incentives

  1. 1. Introduction to Network Regulation Module 3: Regulatory Investment Incentives Dr. Konstantin Petrov, DNV KEMA 11 November 2013
  2. 2. Agenda 1. Sector Trends and Investment Drivers 2. Classification of Investments 3. Regulatory Investment Incentives 4. Practical Experience Introduction to Network Regulation 11 November 2013 2
  3. 3. Sector Trends and Investment Drivers Major Sector Trends… Political  Political trends reflect the major Technological Economic  Technological trends are mainly driven  Economic trends are mainly driven elements of the European energy policy.  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) by climate policy and technological progress.        Development of RES technologies Smart metering / smart grids Network technology by general economic development, sector specifics and energy policy.  Ageing assets and replacement needs  Increasing shares of RES and changing load flow patterns Energy storage  Market prices and missing money Electric vehicles Energy use / energy efficiency Shale gas developments problems  Financial burden of RES support schemes  Mergers / take-overs  Demand growth  Increasing regional trade  Security of supply Introduction to Network Regulation 11 November 2013 3
  4. 4. Sector Trends and Investment Drivers …Lead to Need for Investments Drivers  Increase in renewable generation  Demand growth Network Implications  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  Connection of nonrenewable generation  Reshuffle of merit order  Asset age  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 Introduction to Network Regulation 11 November 2013 4 Potential Barriers  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
  5. 5. Agenda 1. Sector Trends and Investment Drivers 2. Classification of Investments 3. Regulatory Investment Incentives 4. Practical Experience Introduction to Network Regulation 11 November 2013 5
  6. 6. Classification of Investments For regulatory purposes investments are often classified in two major groups: market-based and reliability investments. Reliability investments Market-based investments Investment characteristics matter for the choice of the investment appraisal methods by the regulator. Cross-border interconnections Transmission network Introduction to Network Regulation 11 November 2013 6 Distribution networks
  7. 7. Classification of Investments Investments in transmission and distribution networks exhibit different properties due to the functions of the networks. Transmission Networks and Interconnections vs. • • • • Distribution Networks • 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 • • • 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 Introduction to Network Regulation 11 November 2013 7
  8. 8. Agenda 1. Sector Trends and Investment Drivers 2. Classification of Investments 3. Regulatory Investment Incentives 4. Practical Experience Introduction to Network Regulation 11 November 2013 8
  9. 9. Regulatory Investment Incentives The Role of Regulation  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 Introduction to Network Regulation 11 November 2013 9
  10. 10. Regulatory Investment Incentives Investments are considered in the allowed revenue through the capital costs (depreciation and return on assets). Allowed Revenue = Opex + Depreciation + (RAB ● Rate of Return) Revenue Requirements Capital costs Opex Materials / Services Network Losses Labour Depreciation Return on Assets Regulatory Asset Base (RAB) Introduction to Network Regulation 11 November 2013 10 Rate of Return
  11. 11. Regulatory Investment Incentives The regulatory asset base (RAB) aggregates the net values of the assets used to provide the regulated services. Existing assets Depreciation Regulatory Asset Base RAB Closing Value = RAB Opening Value Capital contribution Working capital Construction works in progress Asset disposal + Investments – Depreciation – Asset Disposal +/- Change of Working Capital +/-Change of Capital Contribution Investments Introduction to Network Regulation 11 November 2013 11
  12. 12. Regulatory Investment Incentives Regulators in Europe have been applying various types of incentive schemes for network investments. 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 prespecified 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. Introduction to Network Regulation 11 November 2013 12
  13. 13. Regulatory Investments Incentives Regulation Key Incentive Features Key Issues Cost of Capital / WACC Markups 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 13
  14. 14. 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. 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 OBJECTIVES Adequate investment level Selection of best alternative Recovery of efficient cost Introduction to Network Regulation 11 November 2013 14 Regional coordination
  15. 15. Regulatory Investment Incentives Incremental effects Essential characteristics of CBA Cost-Benefit Analysis (CBA) has been increasingly used by regulators for evaluation of new investments in important projects. Alternatives Perspective of the analysis Uncertainty Incremental impact on the continuation of status quo Regional effects Investment Δ Costs • CAPEX • OPEX • External costs Δ Benefits • Producer Surplus • Consumer Surplus • Benefits TSO/ or Investor Introduction to Network Regulation 11 November 2013 15
  16. 16. Agenda 1. Introduction into Investment Incentives 2. Regulatory Regimes and Investment Incentives 3. Treatment of Investments in Price Control 4. Practical Experience Introduction to Network Regulation 11 November 2013 16
  17. 17. Practical Experience 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 17
  18. 18. Practical Experience Example: Projects of Common Interest  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 Source: European Commission 2013 Introduction to Network Regulation 11 November 2013 18
  19. 19. End of Session 3. 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: Introduction to Network Regulation 11 November 2013 11/11/20 13
  20. 20. Introduction to Network Regulation 11 November 2013