Training Module on Electricity Market Regulation

TRAINING PROGRAM on ELECTRICITY MARKETS REGULATION

A series of eight webinars has been delivered, focusing on electricity regulation with the objective of delivering knowledge in and understanding of regulation issues. The training program provided and disseminated relevant knowledge related to conceptual properties and practical applications of regulation in the electricity industry. The webinars are designed in clear and understandable form in order to allow successful participation of a non-expert audience.

This training was delivered by regulation experts of KEMA Consulting directed by Konstantin Petrov, energy economist and electrical engineer with major expertise in the areas of market design, regulatory economics and pricing. Dr. Petrov has worked in more than 25 countries in Europe, Australia, Asia, South America and North Africa.

SCOPE(click on the topic title to access the webinar recording and download the slides)

 

CONTENTS

Session 1 explains the nature of economic regulation. Economic theory advocates that firms have the strongest incentives to provide best service to customers in terms of price and quality of service when they are in competition. Therefore, energy industry reforms have introduced competition wherever possible (e.g. production, wholesale and retail activities). Competition, however, is not feasible in all segments of the energy sector; transmission and distribution networks remain regulated. In many cases, regulators control and monitor production and supply activities. Go to presentation of Session 1.

Session 2 discusses the design of electricity markets. The technical characteristics of the electric power industries require a number of specific measures to enable the creation of an effective and well functioning energy market. There are several types of markets, such as cost- and price-based pools, mandatory and voluntary markets, as well as bilateral and single buyer markets. Go to presentation of Session 2.

Session 3 explains different forms of price control. Under rate of return regulation, the regulator sets prices for the company in such a way that they cover the utility’s costs of production and include a rate of return on capital that is sufficient to maintain the investors’ willingness to replace or expand the company’s assets. This method has been criticised in that it does not provide sufficient incentives to control and reduce costs. Numerous regulatory methodologies (revenue caps, price caps, yardstick competition) have been developed to counteract the deficiencies of rate of return regulation to various degrees. All these alternative methodologies focus on the establishment of incentive mechanisms by moving from rate of return to incentive based forms of price regulation, and to the application of comparative approaches by means of benchmarking as opposed to the only individual performance assessment of the regulated service providers. Go to presentation of Session 3.

Session 4 explains how the regulated revenue is set and the role of regulatory asset base (RAB). The allowed revenue for provision of regulate services include the operating cost, depreciation and return on regulated assets. The return if calculated as the allowed rate of return (cost of capital) is charged on the regulatory asset base. The RAB is a measure of the net value of the company’s regulated assets and is estimated for each year of the regulatory period. Go to presentation of Session 4.

Session 5 explains the role of cost of capital. Investors will be interested in an engagement in the regulated industry, if projects allow them to meet financial requirements. These financial requirements are measured against the benchmark of earnings to be made in other product markets, in industries in other countries or the international capital markets. Put in financial terminology, investors will be comparing the net present value of cash flows from an investment in the power industry to alternative investment opportunities. Only if investment in the particular country is as profitable as some alternative investment will the investor decide on the particular project. The weighted average cost of capital (WACC) methodology is a widely accepted method for calculating the cost of capital. It is understood by both the finance community and the industry, and is consistent with the methodology used by many regulators. Go to presentation of Session 5.

Regulatory authorities usually look for aggregate efficiency assessments that support the setting of efficiency increase factors (regulatory benchmarking). Session 6 explains various mathematical techniques to assess efficiency. Partial (one-dimensional) measures of performance (performance indicators) are the simplest forms to perform comparisons between different companies. Multi-factor (total) models are used to account for the relationships between different input and output factors. Go to presentation of Session 6.

Session 7 explains the role of quality of supply regulation. In an unbundled energy industry, the responsibility for providing reliable energy supply is distributed to a number of players. Production companies operate in a market environment and provide capacity according to the market arrangements. Networks are regulated and requirements to their reliability are imposed by network codes, industry licenses, performance standards and quality incentive schemes. Sometimes regulators design supplementary market-based incentives for producers to encourage the provision of existing and new capacity. Quality of supply of energy networks is characterised by two additional elements: product quality (voltage quality for electricity and substance quality for gas) and commercial quality. Product quality is related to technical characteristics of electricity and gas. Usually there are national or regional technical standards for product quality. Commercial quality measures the quality of services provided by network operators to connected customers in terms billing, meter readings, responding to complaints etc. Commercial quality is usually regulated by performance standards imposed by national regulators. Go to presentation of Session 7.

The conversion of the allowed revenue into tariffs is explained in Session 8. We discussed the main pricing principles and methods of electricity pricing. Then we extend the discussion towards the price setting of the different activities in the electricity supply chain. The individual technical and economic characteristics of the energy activities require different approaches and models for their pricing. While generation and supply charges should incorporate substantial component associated with the fuel costs, network charges need to cover largely fixed capital cost. Go to presentation of Session 8.