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a blog from young economists at Nova SBE


Economic Regulation in the Electricity Distribution Sector in Ireland

Commission for Energy Regulation (CER) is responsible for the regulation of the electricity sector and, in particular, it plays a major role in transmission and distribution of electricity. For a better understanding of the electricity distribution sector in Ireland, the other activities should also be considered: generation, transmission and commercialization.

First, the generation market is fully liberalised, leading to an increase in competition in recent years. Regarding transmission, EirGrid is the independent state-owned body licensed by the CER to act as unique transmission system operator (TSO) and is responsible for the operation, development and maintenance of the system. Third, the distribution of electricity constitutes a natural monopoly and the company that explores that service is ESB Networks, the distribution system operator (DSO). ESB Networks also owns the transmission system and is responsible for carrying out the maintenance and construction of the system. Furthermore, relatively to commercialization, there are a number of electricity suppliers licensed by CER to supply electricity to retail customers. However, ESB Electic Ireland (formerly called ESB Customer Supply), an independent business unit within ESB, still nowadays operates as the Public Electricity Supplier. Hence, it is required to supply all customers who are not served by another supplier.

CER applies an incentive based approach to regulate the distribution sector. CER uses a Revenue cap in order to control the revenues/charges of the DSO, and in doing so it considers different elements/issues. First, the incentive regulation can be broadly described as a CPI-X model since an inflation index is assigned to the base allowable revenue.  However, the efficiencies enter mainly in the incentive to provide the service with a cost below the forecasted values of capex and opex, whereas the X is used to smooth out the allowed revenue over the regulatory period (2011-2015). Second, other costs that are in equation and do not enter in the base level of revenue allowed are the costs the regulator is not able to forecast (Uncertain costs) and costs that lie outside the business’s control (Pass-through costs). CER objective is to minimize both these kind of costs. Further incentives are also considered in the formula, but are limited. An example is the incentive to improve quality of supply to the “worst served customers”, where the regulator’s objective is to ensure that although outages in cities and villages do not affect the same way, they must receive equal treatment from the electricity distributor. Finally, the regulator introduce two correction factors, whose role is to balance the revenue equation according to differences between actual and forecasted values across time.

The key principles that lie behind this formula do not concern only efficiency. In fact, the maximum revenue allowed should be sufficient in order to develop, operate and enhance the distribution system and to provide a reasonable return on assets.

A direct rule is not applied to the distribution tariffs because they are directly determined by the specification of the maximum revenue allowed. However, they need the approval of the regulator.

 

 

Diogo Ribeiro, 1707 Management

Mariana Costa, 1902 Management

Riccardo Passeggeri, 677 Economics

Rita Taborda, 1943 Management

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Economic Regulation in Norway

The electricity market in Norway is not static but it has adjusted itself according to the necessities. In 1990 influenced by some initiatives of market liberalizations, for instance New Zeeland and UK, a necessity for better performance Norway’s electricity market started a reform. Again in 1997 it was introduced a new regulatory model based in incentives (revenue cap) that replaced the rate of return model in which there was a lack incentives for efficiency.

Norway electricity network has three levels of electricity grids: distribution grid, regional grid and central grid (national transmission system) and is divided into 5 market areas for electricity, which means different prices for different parts of the country, depending on supply and demand in each area. Its regulation is made at a national level through NVE and at European Level by the European Union. Contrary to what happens in other European countries the distribution sector in Norway has many independent companies (more than 150) with big differences in terms of size and density of consumers served. And there are only one TSO the Statnett SF.

Regarding competition the price of this power is calculated through the balance of bids and offers of producers, distributors, traders, energy companies, large consumers and TSO in the Nord Pool Spot (NPS) market. In order to guarantee balancing of supply and consumption participants have to adjust their bid when imbalances appear. Under the regulation of 7th May 2002 Nº 448, TSO has the power to declare volumes at an electricity spot price for the area. According to the Norwegian Competition Authority (NCS) every retails entity in the electricity market or network business need to have a trading license.

Regarding unbundling restrictions, it is possible for network and supply companies to be bundled if the number of their consumers is at most 100 000. For the ones with a higher number in addition to the unbundling requirements these companies are require to participate in a compliance program.

The Norwegian regulatory model is incentive-based, as its main purpose is to give incentives to the firm to be efficient in both prices and quality. Under this model the companies have some flexibility in adjusting individual prices taking into account elasticity, that is, if needed they will increase prices in the markets where the demand is more inelastic. This revenue cap is determined by NVE, the objectives are evaluated periodically but should last a minimum of 5 years. Companies are notified before the beginning of the year facilitating their decision about tariffs (which are two part tariffs). Additionally firms can also ask for connection charges. The formula of revenue cap is based in several costs that the firm will incur where 40 % of the costs are based the firm’s actual costs, while the others 60 % are based on a cost norm.

Finally even being called as Revenue cap its important to refer that there is a big approximation to the concept of Rate of Return since the Revenue cap calculation is only based on costs but the revenue cap will not only allow for the coverage of the costs incurred but also allow for benefits of cost savings activities.

 

Andreia Parreira

Maria Almeida

Pedro Cardoso

Rita Cordeiro

 


Electricity Distribution Regulation in the UK

Supplying electricity across the UK involves four key activities: generation, transmission, distribution and retail sales. The largest part of the generated energy comes from large scale power stations connected directly to the national transmission grid[1]. Electricity is transported over long distances at high voltages, with National Grid being the firm responsible for such activity. In the following stage, the Distribution Network Operators (DNOs) transfer the electricity from the substations (transmission) to homes and businesses. Finally, there is a competitive market in which firms compete to sell the electricity to the final consumer.

In reality, the UK was one of the first European countries to privatize the electricity distribution companies which required the implementation of a mechanism of incentives. In particular, they introduced an innovation regarding price regulation: the RPI-X mechanism. This restrains the prices charged by distribution network operators to a annual growth rate of no more than the rate of inflation (Rate of Price Index) minus a productivity improvement factor. This system has two particular features: it means that consumers will be better off since the prices of electricity will go down in real terms, while also working as an incentive, since the DNOs have to improve their efficiency if they do not want to see their revenues going down, in real terms.

This regulatory scheme was quite successful at the time, spreading to several countries and persisting until the present days in the UK. However, it may also create some distortions, such as loss of quality resulting from firms wanting to reduce costs being, therefore, additional incentives needed.

Currently, in the UK, there are 14 electric distribution companies (owned by six different groups). Each distribution network operator (DNOs) must have a license and it is responsible to provide the distribution service in a certain regional area.

The distribution companies themselves provide only delivery services and don’t contract nor buy or produce electricity for resale to final customers – a competitive function referred to as “electricity supply” – though they may have functionally separated or “ring fenced” supply affiliates that do so. Their activities, prices and revenues are subjected to the regulation framework set out by the UK Office of Gas and Electricity (Ofgem). In addition to the DNOs, there are also smaller distributions network operators which are known as Independent Distribution Operators (IDNOs) operating within the regions covered by the DNOs.

Every five years, there is an Electricity Distribution Price Control Review (DPCR) which involves a review of the entire regulatory framework concerning electricity distribution. The main purpose of these reviews is to ensure that the mechanism provides the proper incentives to the DNOs. Therefore, such reviews include the basic information regarding the way in which DNOs are regulated and get their revenue. Ultimately, it aims at “encouraging the type of behavior that will deliver the services that DNOs’ customers want at reasonable prices over the next five-year period” (Ofgem 2009c). Furthermore, Ofgem has also other objectives and it has created incentive mechanisms to deal with them. Particularly, it wants to promote the UK transition to a low carbon economy.

The main conclusion one can make of this report is that Ofgem did not settle for setting the leading RPI-X regulatory framework, but rather keeps on applying to real life economics the main breakthroughs in regulatory theory. In DPCR rules, one can easily identify the Laffont-Tirole model of a linear menu of contracts, complemented by monetary performance-based incentives (using yardstick regulation) to develop quality of service and green investments. All of this is done while keeping in mind that regulatory risk should be kept low.

 

[1] The number and the type of power stations are an individual decision of each company, which have to respect the current government policies.

 

Filipe Silvério 617

João Garcia 618

Samuel Cardoso 624

Rita Azevedo 625


Regulation of Electricity Distribution in the Czech Republic

Having joined the European Union in 2004, the Czech Republic is a prosperous and stable economy with a
GDP per capita of roughly $26,300. Most of the country’s economy has beenprivatized, including banks and
telecommunications. With respect to its energy market, the country produces more electricity than it
actually consumes, leading to an electricity export of roughly 10 TWh per year. The main source of
electricity stems from solid fuels (about 55%). In order to reduce dependence on low-grade brown coal as
the major source of energy, nuclear power is one of the main alternatives for the energy production,
accounting for about 30% of total power needs.

The Czech Energy Regulatory office (ERO) was founded in January 2001. It is responsible for regulations in
energy market in the Czech Republic. Regarding the regulation of distribution of electricity it started to
regulate this market in January 2002. Since then, there has been three regulatory period. The first one
lasted three years with following two other each lasting five years. ERO is using revenue-cap
method as its regulation method of electricity distribution market.

Revenue cap regulation includes rewards and penalties to induce operators to achieve desired
goals. The method is to regulate the maximum allowable revenue that a company can earn. This
aims to provide the company an incentive to maximize its profits by minimizing the costs. Revenue
cap regulationallows the company to keep the cost savings achieved during the regulatory lag.
Revenue cap regulation gives incentives for efficiency improvements and technological
innovations and it can reduce the incentives for over-capitalization. In some cases it may
discourage the development of quality and limit the powerful incentive to increase the sales and
competition. It is typical for electricity distribution business.

The Czech market is been criticised by the OECD for being too concentrated and lacking
competition. The effects of this can be seen in the difference of energy prices pre- and post-tax
between Czech and its neighbouring countries. The main culprits are the national company CEZ
which controls most of the market. The company has been accused of corruption, and of being
anti-competetive, but has yet to be punished for anything.

Iva Tyburcová #1671
Petri Lehtonen #1736
Sebastian Peek #1702
Markus Eyting #1722


Regulation of electricity distribution in Italy

The state-owned monopolist Enel had control over the entire Italian electricity market including the transmission and distribution until it was privatised in 1999. This happened under the supervision of the independent energy regulator AEEG who was founded four years earlier. Nowadays the Italian market is one of the most liberalised markets for energy in Europe as generation, imports, exports and supply are completely open for competition. Although there are more than 100 electricity-generating companies, prices for energy remain among the highest within the ranks of the OECD.

 

Regulation of the electricity market

Distribution being a natural monopoly was not included in the liberalisation. Instead 135 distribution operators (DSO) carry it out on the basis of concessions that are issued by the state. Enel Distribuzione however still covers 86,2% of the distribution.

The regulation of energy prices was not uniform since Italy started to reform the sector in accord with the European Union strategy on electricity liberalisation. Until 2004 distribution was regulated by price-caps with a review period of three years and the option to adjust in case of unforeseen events as rising oil prices. Between 2000 and 2003 the real decrease in tariffs was 4% p.a. While this approach has advantages in terms of cost efficiency it has drawbacks regarding the quality of service. Hence the regulatory bodies introduced a type of quality regulation that was based on a reward and penalty scheme. It made the distribution tariff dependent on the continuity of supply and penalised the average number of minutes of unplanned interruptions that exceeded three minutes.

As of 2004 a more complex regulatory mechanism was introduced that combined features of rate-of-return regulation (RoR) with those of price-caps. Capital investments are remunerated with a fix RoR of 6,8% p.a. at an annual decrease in operational costs of 3,5%.

 

Economic Analysis and Conclusion

In general one can say that the Italian authorities are trying to balance the advantages of some mechanisms with the disadvantages of others. Cost efficiency can be compromised when using a rate of return on capital investments as the fix compensation on capital creates incentives to overinvest in capital and avoid measures that would decrease the capital base to increase levels of profit. This is known as the Averch-Johnson effect. AEEG tries to counterbalance this effect by introducing a price-cap and requiring a decrease in operational costs. The regulator’s commitment problem with respect to the length between review periods and the uncertainty about the evolution of costs persist. Further the price-cap mechanism can have negative effects on the quality of service as firms have an incentive to reduce costs. The regulatory bodies implemented incentive based quality regulation to countervail the drawback of the price-cap. Cambini et al. (2013) find evidence pointing to a positive relationship between quality of service and cost efficiency in this specific case. This combination of several instruments may seem to outperform the use of a single one by combining incentives and cost covering at the same time. Nevertheless it is questionable whether this sort of regulation was effective as the prices for electricity in Italy remain among the highest of OECD members.

 

Ana Beatriz Luís, #648
João Araújo, #638
João Ritto, #623
SLH, #685


The Unbundled Electricity Market in the Netherlands

The electricity market is one of the most regulated sectors of the economy. This is because electricity is an essential commodity with high fixed costs involved in the infrastructure for its transport. This means that natural monopolies often arise in different parts of the electricity supply chain and market regulation is called to intervene by promoting competition and efficiency.

In the Netherlands, the case is not different. The Dutch energy market has been going through changes in the last few years and, due to EU legislation, is now separated in three different stages: production, transmission and distribution. The Netherlands opted for a system of full ownership unbundling, which is the complete splitting of energy producer companies from those that own the networks.

Transmission System Operators (TSOs) are responsible for the transport of energy from the producers to a node closer to demand centers. Then, Distribution System Operators (DSOs) come into place to make the bridge with the final consumers.

In the first stage, market concentration is not a problem once there are many electricity producers in the Netherlands. However, both TSOs and DSOs are natural monopolies and, therefore, they should be subject to a close attention of the regulatory authorities. While a single private company is entirely responsible for transmission in the whole country, TenneT, the distribution is assured by nine regional companies owned by the Dutch government. The goal of this setup is to allow competitive markets to arise where it is possible, as in production, and effectively regulate natural monopolies. In the Netherlands, the national regulatory authority responsible for energy issues is, since 2013, the Authority for Consumers and Markets (ACM).

The regulator uses a system of turnover regulation (revenue-cap) for the transmission tariffs with a yardstick for efficiency. In the case of the TSO this uses partially an international benchmark, combined with a frontier shift based on productivity growth for other TSOs. Regarding DSO, the performance is compared and each one of them is rewarded or punished based on its relative performance. For DSO this is not only based on efficiency but also on the quality of the service provided. As it is broadly known, quality factor may be a very subjective concept but the Dutch regulatory authority found a very concrete measure of quality, namely the System Average Interruption Duration Index (SAIDI), which is the average interruption of electricity provision per consumer. For the TSOs quality is regulated through quality standards requirements and not with financial incentives, so the quality factor does not enter this rule.

The allowed revenue follows from the expected volumes. Based on this, the DSOs and TSO present a tariff proposal to the ACM for all the tariff components each year. This proposal is assessed and either approved or adjusted by the ACM. The set of interactions between the regulator and subject finally results in a maximum tariff, which is binding for the next year.

Regulatory periods are generally between 3 and 5 years with the revenue adjustment being reviewed afterwards. Throughout the period several assessments take place with data being collected by the regulatory entity to check whether market actions have been legal.

Revenue-cap has the advantage of avoiding quantity risks for the regulated company which is an important factor in the electricity market given demand is outside the control of distributors. One important disadvantage when compared to rate-of-return is that it might impact investment given that a great part of the risk is taken by the company.

Concluding, the effects of regulation on both TSO and DSOs should be seen as a way to improve efficiency in the market, by approaching the efficient outcome. On the one hand, the price cap imposition provides the firm strong incentives to reduce costs and tends to induce optimal pricing. On the other hand, yardstick competition creates a further incentive for efficiency, assuming the possibility of no collusion. However, among all these mechanisms, the one that seems to really increase competition is, since 2011, the unbundling legislation. The successful accomplishment of this regulation promoted a competitive environment in the electricity industry that did not exist before. In this sense, unbundling in the Netherlands achieved the result that regulation theory would predict, i.e. to create competition in electricity industry by separating production from distribution. This is indeed one of the main messages that other countries can take from the Dutch electricity industry.

Diogo Mendes | Jorge Santos | Nuno Lourenço | Stefan Leeffers
Economics of Regulation