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Dr. Konstantin Petrov, DNV KEMA 11 November 2013 Introduction to Network Regulation Module 3: Regulatory Investment Incentives

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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Page 1: Investment Incentives

Dr. Konstantin Petrov, DNV KEMA

11 November 2013

Introduction to Network Regulation Module 3: Regulatory Investment Incentives

Page 2: 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

Page 3: Investment Incentives

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

Page 4: Investment Incentives

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

Page 5: 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

5

Page 6: Investment Incentives

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

Page 7: Investment Incentives

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.

Page 8: 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

8

Page 9: Investment Incentives

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

Page 10: Investment Incentives

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)

Page 11: Investment Incentives

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

Page 12: Investment Incentives

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.

Page 13: Investment Incentives

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.

Page 14: Investment Incentives

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

Page 15: Investment Incentives

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

Page 16: Investment Incentives

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

Page 17: Investment Incentives

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

Page 18: Investment Incentives

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

Page 19: Investment Incentives

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]

Page 20: Investment Incentives

Introduction to Network Regulation

11 November 2013

www.dnvkema.com