Performance-based regulation of energy utilities in Central Europe and Baltic states

Performance-based regulation of energy utilities in Central Europe and Baltic states

Ondřej MACHEKDepartment of Business EconomicsFaculty of Business AdministrationUniversity of Economics in PragueCzech Republic

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How to regulate energy prices?

• Allow a company to cover eligible expenses and earn a reasonable return on capital

Revenue requirements

RR = O&M + T + D + (RB RoR)

RR revenue requirements

O&M operation&maintenance costs

T taxes

D depreciation and amortization

RB rate base (total assets – accumulated depreciation)

RoR rate of return (usually WACC)

Ondřej MACHEK 28th May 2011

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Cost-of-service regulation (COS)• Classical method

• Simple and straightforward

• Principle: sum up the expenses, add the rate of return and calculate the tariffs

• Does not simulate competitive pressures

• Incentive to overinvest and to invest imprudently

• Tariffs must be reviewed frequently

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Performance-based regulation

• Reduce the negative impact of information asymmetries

• Incentive to reduce costs in order to earn profits

• Price cap or revenue cap

• Price cap: P(t) = (1 + RPI – X) . P(t-1)

• Revenue cap: R(t) = (1 + RPI – X) . R(t-1)

- RPI inflation rate- X industry productivity growth

• If the price or revenue cap is based on a company’s own costs, then the negative effects of COS regulation (overinvestment, gold plating etc.) are not fully eliminated

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Regulatory benchmarking

Deterministic methods Stochastic methods Data envelopment analysis

N(0,σ2)


Idea of benchmarking: base RR not on a firm‘s own costs, but on a relative efficiency measurement

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Yardstick competition

• Set the cap only with respect to the performance of other companies

• „Pure benchmarking“

• Difficult to implement

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Summary of regulatory methods

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Performance-based Regulation in Central Europe and Baltic States

• Former member states of the Eastern Bloc

• Short history and a low experience

• Regulatory methods vary

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Czech Republic

• The first regulatory period started in 2001 and lasted three years

• The second and the third regulatory period had five years

• Revenue-cap

• No benchmarking has been used in tariff setting


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Slovakia

• The first regulatory period started in 2003 (revenue-cap)

• Three years long regulatory periods

• The fourth regulatory period (2012-2016) will be five-year long

• In the third regulatory period (2009-2011), the methodology changed to a price-cap scheme

• No benchmarking has been used in tariff setting


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Hungary

• First regulatory period in 1997

• Four-year long regulatory periods

• Price-cap

• MEH is using a special non-frontier method of benchmarking


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Poland


• Three-year long regulatory periods

• Revenue-cap

• Benchmarking only in electricity distribution

• Gas transportation and distribution – no benchmarking

• Bayesian random effect model (a SFA method) has been used


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Slovenia


• Before, tariffs had been set by the government below the cost level

• Price-cap

• For electricity distribution and transmission, the regulatory period lasts three years and modern benchmarking is used

• For gas distribution and transportation, the period lasts only one year and no benchmarking is used

• The methodology used for benchmarking has is a crosscheck of both COLS and DEA


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Estonia

• Three-year regulatory periods both for electricity and gas sectors (from 2006)

• Price-cap

• The methodology used for benchmarking has been the COLS method


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Lithuania

• The regulatory periods last three years (from 2002)

• A hybrid cap method

• 50/50 price and revenue cap

• As there are only two distribution companies, no benchmarking has been used, due to a lack of data


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Latvia

• The regulatory period beginning years differ for electricity and gas sectors.

• Price-cap method

• The Latvian regulator has been applying a non-frontier TFP method (Tornquist TFP indices) for benchmarking


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Summary

Country Regulatory period length (years)

Czech Republic 3, 5, 5

Slovakia 3, 3, 3, 5

Poland 3, 3, 3, 3

Hungary 4, 4, 4, 4

Slovenia 3, 3, 3

Estonia 3, 3

Lithuania 3, 3, 3, 3

Latvia 3, 3, 3

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Conclusion

• All countries apply some form of performance-based regulation

• Price-cap is the most widely used method

• Except of the Czech Republic, Slovakia and Lithuania, all countries use benchmarking methods in tariff setting

• Most surveyed countries use three-year regulatory periods

• Possibilities of development:

• Reduce market concentration to obtain a larger sample of firms

• Unbundle large vertically integrated companies

• Cooperate with the private sector in order to establish an acceptance of the regulation results

• Harmonize regulatory frameworks to reduce the disparity of companies


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Thank you for your attention
