Electricity network tariff regulation The Italian experience Claudia Malandra - Emma Putzu

1. Autorità per l’energia elettrica e il gas • Electricity network tariff regulation • The Italian experience • Claudia Malandra - Emma Putzu • Tariffs department • Milan, 4th march 2010 Autorità per l’energia elettrica e il gas – Tariffs Department

2. Summary • Introductory notes • Electricity network industry in Italy • Transmission • Distribution • Metering • Tariffs department main tasks • General questions related to network tariffs regulation • Criteria for tariffs regulation: the Italian legal framework • Criteria for tariffs regulation: the AEEG objectives • Tariffs setting process • Determination of the allowed costs • Cost allocation to customers groups • Tariffs setting • Domestic tariffs and vulnerable customers protection scheme

3. Transmission – From vertical integration to ownership unbundling • 1962: nationalization of electricity industry: ENEL owns more than 90% of National Electricity Transmission Network • 1993: beginning of privatization process (ENEL Spa) • 1999: reorganization of electricity sector - a separated company is constituted as independent system operator (ISO) under National Decree n. 79/99: property and management of National Transmission Network have to been separated • 2004: from ISO to TSO – re-unification of ISO and ownership into a new independent electricity grid company (TERNA Spa) independent from ENEL – full ownership unbundling Transmission assets are owned by: Terna Spa ( 98%), companies owned by municipalities, Railroad and other private companies Progressive acquisition of assets from other owners

4. Transmission – Key Figures • Length of the lines: • 380 kV about 11.000 km • 220 kV about 11.000 km • 150-120 kV about 40.000 km • Trafo station: • 380 kV N. 131 • 220 kV N. 148 • 150/132 kV N. 100 • Number of transporters: • 7 but … 98,23% of the network is owned by TERNA • Regulatory asset value or Rate Asset Base (RAB) (2008): • 6.000 million Euro • Allowed operating costs (2008): • 340 million Euro • Allowed capital costs (2008): • 710 million Euro Remuneration of net invested capital Total installed capacity: 119 GVA

6. Distribution – From vertical integration to legal and functional unbundling • 1962: nationalization of electricity industry (ENEL) • Beside ENEL survived local distribution companies, owned by municipalities, small distribution companies operating in small non interconnected islands and a few other small companies (mutual companies) • In general all the companies were vertical integrated • 1993: beginning of privatization process (ENEL Spa) • 1999: reorganization of electricity sector – ENEL and companies serving more than 100.000 final customers have to create a separate company for distribution and supply (legal unbundling) ENEL Distribuzione Spa is constituted 2007: legal and functional unbundling of distribution and supply for companies serving more than 100.000 final customers companies serving less than 100.000 final customers have to guarantee accounting unbundling of distribution and supply distribution companies are also responsible for metering activities

7. Distribution – Key Figures • Length of the lines (31 December 2008): • High and very high voltage (km) 20,061 • Medium Voltage (km) 372,239 • Low Voltage (km) 815,041 • Numbers of distributors: • 143 • Regulatory Asset Base (RAB) (2008): • 21,000 million Euro • Allowed operating costs (2008): • 2,000 million Euro • Allowed capital costs (2008): •  2,500 million Euro • Commercial costs of distribution •  630 million Euro

8. Metering – Key Figures • Regulatory asset value or Rate Asset Base (RAB) (2008): •  3,200 million Euro • Allowed operating costs (2008): •  260 million Euro • Allowed capital costs (2008): •  520 million Euro

9. Tariff department main tasks • Criteria for regulating tariffs of regulated infrastructures (electricity and gas) • Focus on non-competitive activities: • Electricity: transmission (HV), distribution (MV, LV) and metering • Tariffs setting and periodical revisions • Unbundling criteria and monitoring unbundling implementation • Functional unbundling (focus on infrastructural companies governance) • Transparency of accounts • Tariffs setting for levies (system charges) applied in order to finance activities of general interest (financing of R&D, decommissioning of old nuclear power plants, incentives to renewable energy)

10. Prices and electricity tariffs in the III regulatory period Price/Tariff Costs Generation Price Fuel and dispatching costs Dispatching FOCUS ON Transmission Transport Tariff (TRAS c€/kWh) Transmission costs Distribution Tariff Distribution Distribution costs Metering costs Metering Metering tariff (MIS1 MIS3) Supply Supply costs Price

11. Incidence of regulated activities on the final average customer bill (first quarter 2010) Taxes 14,0% (B) System charges 8% Infrastructures cost and metering 15,4 % (A) Production costs 63,8% (A) Production costs are inclusive of fuel costs, fixed generation costs dispaching costs. Production-capacity and interruptibility service, service remunerations and UC1 UC6 and PPE components (B) System charges are inclusive of all components, plus component Uc4 and component MCT

12. Criteria for tariffs regulation: legal framework • Law no. 481/95 • Transparency • Use of pre-determined criteria • Safeguard the interest of users and consumers • Reconcile the economic and financial objectives of electricity companies with general social objectives, environmental protection and efficient use of resources • Single tariff, by class of customers, at national level • Use of price-cap formula to increase efficiency

13. Criteriafor tariffs regulation: AEEG objectives • Incentive to efficiency: price-cap & profit-sharing • Transparency: separated transparent tariffs for different activities (transmission, distribution etc.), set in advance in order to avoid cross-subsidies between regulated and non-regulated activities • Simplicity: clear and simple tariffs for regulated activities facilitate the possibility to compare the non-regulated part of the final price (supply) and, therefore, competition in liberalised segments • Stability of regulation: reduce regulatory risks and, as a consequence, cost of capital

14. The allowed costs Price cap Profit sharing Efficiency incentives OPERATING COSTS + DEPRECIATION Standard life + CAPITAL REMUNERATION Regulatory asset base

15. The operating costs Operating costs or costs of external resources (personnel, procurement of materials and services) have to be reported in separate accounts and have to be documented Annual revision by price cap mechanism + Profit sharing Any operating cost reduction achieved in the first regulatory period, as a result of productivity gain over the 4% per-year target, has been shared between electricity companies and customers. The companies’ share of the extra-gains was set at 50% in the last price control review.

16. CAPEX • RAB = • + net asset value • + circulating capital • - Trust fund recovery Historical revalued cost Rate of return WACC CAPITAL REMUNERATION

17. Capital remuneration (WACC) Equity cost: CAPM Debt cost: Risk free rate(*) + spread over (depending from real cost of regulated companies WACC Capital remuneration is calculated as weighted average of cost of equity and debt cost Weighted Average Cost of Capital(WACC) (*) Risk free rate is calculated using the 12 month average of gross returns on the 10-years Treasury bond (BTP) benchmark taken by Bank of Italy

18. The WACC formula (1) Where: Ke is the return allowed on equity T is the tax rate E is the equity D is the debt Kd is the debt rate tc is the tax shield rpi is the expected average inflation rate

19. The WACC formula (2) • The allowed return on equity has been calculated according to the CAPM methodology. CAPM is a model describing the relationship between risk and expected return that is used in the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. • Ke = rf + i (rm– rf) • Where: • rf risk free rate •  systematic risk of the activity • rm expected market return

20. The WACC formula (3) • Parameters and rates used to fix WACC for 2008-2011 period

21. Capital remuneration: more incentives for new investments • Adequate incentives for new strategic investments • Price-cap regulation needs quality regulation in order to avoid risks of lack of investments and bad technical performance • Quality regulation may not be sufficient: specific incentives for new investments (extra remuneration for some strategic investments crucial to facilitate competition)

22. From the allowed costs …to the cost allocation matrix LV - Customers MV - Customers HV - Customers Transmission Grid HV – Distribution Grid MV - Distribution Grid LV - Distribution Grid Metering Billing & Co.

23. Cost allocation to different customer groups LV - Customers MV - Customers HV - Customers Street lighting Street lighting Household Other uses Other uses

24. Cost allocation criteria 1/1 Network features Transmission Grid Meshed network – shared resource Peak demand of customer groups HV – Distribution Grid Cost allocation criteria • Fix costs of transmission and distribution are allocated to different type of users on the basis of the load profile (in different hours of the day there is a different congestion so different costs) • Tariff component is calculated as energy consumption in each price period of each customer group weighted by prices per unit where prices are set following a peak load pricing approach

25. Cost allocation criteria 2/2 Network features Costs allocation criteria Costs are independent from the peak demand Maximum subscribed demand of power (MV) customers/ Maximum subscribed demand of power corrected by a contemporary factor for LV customers Mostly radial network – only partially shared resource MV - Distribution Grid Radial network/ Mostly dedicated resource Costs are independent from the peak demand; Effective demand of power LV - Distribution Grid Metering Partially dedicated/Partially shared resources Contractual average complexity of customer groups/ Costs of dedicated equipment Subscribed demand Billing & Co.

26. Balancing stability and cost reflectivity Cost reflectivity Stability The allocation criteria are the same from 1999 In order to balance the two potentially conflicting objectives of tariff stability and cost reflectivity, for the second and third regulatory periods the Italian Regulator, has decided only to adjust the vector of tariff constraints at the beginning of each regulatory period in function of the total allowed cost variations, keeping steady the cost allocation weights

27. Transmission and Distribution Services: Tariffs by Customer Types (€c/kWh)

28. The tariff system evolution 1997 – First tariff reform (del. 70/97) First code of tariff regulation (2001) 2000 – 2003: First regulatory period 2004 – 2007: del. n.5/04 Second regulatory period Pool (1/4/2004) Supply full opening (1/7/2007) Social protection for vulnerable clients (2008-2009) 2008 – 2011: del. n. 348/07 Third regulatory period

29. Relevant features of the tariff structure before the regulatory intervention • Tariffs did not reflect cost structure by customer class • Tariffs were higher than costs for non-residential low- voltage customers • Tariffs were lower than costs for high-voltage customers • Special tariff regime for State Railways, aluminium smelters and energy-intensive industries • Tariffs did not reflect cost of services (No unbundling between generation, transmission and distribution costs)

30. Relevant features of the tariff structure in the first and in the second regulatory period • Four yearly revision of tariff criteria (duration of regulatory period) • Tariffs were more cost reflective for different class of consumers • Unbundling of different costs of transmission, distribution and generation • The Regulator set the constraint on revenues and companies set tariffs • Distributors propose and the regulator approves tariffs options. Tariff options have to comply with constraints V1 and V2 set by the Regulator

31. Transmission and distribution tariff (not for domestic users) (del. no. 348/07) • Transmission tariff • Single tariff, by class of customers, at national level (energy tariff expressed in euro cent per kWh, flat without variation according to consumption level), yearly revision • Distribution tariff • Single tariff, by class of customers, at national level • Compulsory tariff for all distributors joint with a compensation mechanism in order to guarantee costs recover • Yearly revision • Three parts tariff • Flat component expressed in euro cent per customer per year • Power component expressed in euro cent per kW per year • Energy component expressed in euro cent per kWh

32. Metering tariff (not for domestic users) (del. no. 348/07) • Metering service • Meter installation, maintenance, meter riding and billing. • Metering tariff • Single tariff, by class of customers, at national level • Yearly revision • Flat tariff • MIS1: Power component expressed in euro cent per customer per year • MIS3: Energy component expressed in euro cent per kWh (only for street lighting)

33. The tariffs revision method Tariffs component are fixed at the beginning of the regulatory period (four years) and yearly revised: Capex component (non subjected to price cap): The tariff components covering the allowed costs for the return on invested capital are adjusted annually by reviewing the capital itself using the average annual change in the gross fixed investment deflator measured by the National Statistics Office, and taking into account: any net investments carried out by companies the previous year; the incremental remuneration for new strategic investments, and the energy variation Operating cost are subjected to price cap and revised yearly : In the third regulatory period has been set a target productivity gain (X-factor) of 2.3% for transmission, 1.9% for distribution and 5% for metering.

34. Domestic tariffs • Three domestic tariffs: D1, D2 and D3 • D1 tariff is a reference tariff for domestic customers. • It is a cost reflective tariff but it is not applied to the customers • D2 tariff is for domestic customers in their place of residence, with contractual power till 3.3 kW (about 80% of domestic customers). • D3 tariffs is for: • domestic customers in their place of residence with contractual power over 3.3 kW and • domestic consumers in their spare homes (about 20% of domestic customers). • Tariffs D2 and D3 are set on the basis of the level of D1 tariff.

35. D1 structure • D1 is a three parts tariff: • Flat component: expressed in euro cent per customer per year; • Power component: expressed in euro cent per kW per year; • Energy component: expressed in euro cent per kWh, (flat, without variations according to consumption level)

36. D2 and D3 structure • D2 and D3 are three parts tariffs: • Flat component • Power component • Energy component: increasing when the consumption level increases

37. D2 and D3 as transitory tariffs • D2 and D3 cross-subsidies are relevant • low-consuming customers with D2 pay less than high-consuming ones with D2 and customers with D3 • For example, single men could pay less than low income families with a lot of children • Tariffs D2 and D3 are considered transitory tariffs moving towards D1 tariff. • Subsidies removal have to be gradual and linked to the implementation of a special tariff for vulnerable customers (the so-called “social tariff”). • .

38. D2 convergence towards D1 Total Expenditure for residential customers(taxes not included) Autorità per l’energia elettrica e il gas

39. D3 convergence towards D1 Total Expenditure for non-residential customers(taxes not included) Autorità per l’energia elettrica e il gas

40. Social tariff and vulnerable customers • Social tariff is based on a political decision from the Parliament and Government • Vulnerability is defined according to economic or health conditions: • People with economic disadvantages • Customers in weak health conditions, requiring specific electrical appliances in order to survive • Additionality of benefits for customers in both conditions Autorità per l’energia elettrica e il gas

41. Social tariff Aim • To guarantee an average saving of 20% in electricity expenditure • The system is fully compatible with competitive energy markets • Compensation • Lump sum varying with the number of family members • Applied as a discount in the billing • Burden recovery • “Ad hoc” tariff component charged to all final users of the electric system, based on electricity consumption Autorità per l’energia elettrica e il gas

42. Access to social tariff • Based on existing indicators of family’s economic conditions (ISEE), already in use for TLC, schools, etc • ISEE is an indicator of poverty, not of “fuel poverty” • Application form ahs to be processed by local authorities (Municipalities) • Local authorities send relevant information to distributors through a computer system • Local authorities and distributors make controls • Activation of the discount in the billing • Yearly renovation required with new ISEE Autorità per l’energia elettrica e il gas

43. Figures • Social tariff system has been working since 2009 • Families which apply before February 2009 received the compensation for 2008 too. • More than 1 million people were admitted to the compensation in 2009 (about 90% for economic disadvantages; less than 10% for weak health conditions) Autorità per l’energia elettrica e il gas

44. Customers’ savings Economic disadvantages Yearly revision according to D2 trend Autorità per l’energia elettrica e il gas

45. Customers’ savings Weak health conditions Yearly revision according to D2 trend Autorità per l’energia elettrica e il gas

46. Characteristics of the regulated pricing system for domestic consumers • Convergence towards cost-reflective tariff • Protection more focused on really vulnerable customers • Neutrality with respect to the liberalisation process • Promotion of efficient use of resources • Coherence with EU Directive Autorità per l’energia elettrica e il gas

47. Thank you Questions?

48. Back up

49. THE WACC FORMULA (4) • Parameters and rates used to fix WACC for 2004-2007 period

50. X factor Activity Regulatory period Transmission Distribution Metering 2000-2003 4.0% 4.0% 4.0% 2004-2007 2.5% 3.5% 3.5% 2008-2011 2.3% 1.9% 5.0% Planned productivity gains (X-factor) for the annual updating of operating costs