Regulation in Energy Business

1. Regulation in Energy Business Blahoslav Němeček Energy Regulatory Office Prague

2. EU Energy PolicyTargets Prague

3. Bigchallenge for 2020 How much are we ready to pay? Prague

4. New situation – 3rd package • Crucial points • Cooperation of regulators – ACER • Coordinated cooperation of TSOs in gas and electricity (ENTSO-G, ENTSO-E) • More independent and powerful national regulators Prague

5. 3rd package expectations 3rd Package will enable faster progress: • ‘top-down’ Framework Guidelines and binding network codes can ensure harmonized rules • National regulatory authorities will have wider European duties – not just national ones • 10 year network development plans will encourage more joined-up networks Prague

6. New age – after 3rd package • Crucial things for cross-border trade are directly done by Regulations • Main areas for implementation resulting from Directives are: • Regulator’s independency • Unbundling issues • TSO certification • Costumer protection • Key role for ACER and ENTSO-E & ENTSO-G Prague

7. Regulator’s new cross border EU mandate • promote a competitive, secure and environmentally sustainable internal electricity and gas market within the Community in close cooperation with the Agency, the regulatory authorities of other Member States and the Commission; • duty to ensure compliance of TSOs and electricity and gas undertakings with Directives and other relevant Community legislation, incl. cross border issues; Prague

8. Regulator's important powers • can take binding decisions on electricity and gas undertakings; • carry out investigations and decide upon and impose any necessary and proportionate measures to promote effective competition and ensure proper functioning of the market; • require any information from electricity and gas undertakings; • impose effective, proportionate and dissuasive sanctions. Prague

9. Independence of NRAs • NRA can take autonomous decisions independently from any political body • decisions of the NRA are immediately binding and directly applicable • NRA has separate budget allocation with autonomy in the implementation of the allocated budget • approval of the budget by the national legislator cannot be used to influence the NRA's priorities • NRA must have adequate human and financial resources to carry out its duties Prague

10. Role of ACER • ACER shall cooperate with NRAs and TSOs to ensure the compatibility of regulatory frameworks between the regions with the aim of creating a competitive internal market • where ACER considers that binding rules on such cooperation are required, it shall make appropriate recommendations Prague

11. Czech RegulatorActivities • Price regulation • Support of RES, CHP and secondary energy sources • Quality supply monitoring • Grid connection • Market rules • Statistics • Market integration, international affairs • Questions, disputes… Prague

12. General information about power system in the Czech Republic Total installed capacity: 20 073 MW Number of electricity generation licence holders: 13 301 (only 8 with installed capacity > 200 MW) TSO (lines 400 kV and 220 kV): ČEPS, a.s. (www.ceps.cz) Number of regional DSOs: 3 Number of licensed local DSOs: 297 Number of licensed electricity traders: 321 Electricity Market Operator: OTE, a.s. (www.ote-cr.cz) Prague

13. Electricity market opening • 1st January 2002 – eligible customers with consumption 40 GWh • 1st January 2003 – eligible customers with consumption 9 GWh • 1st January 2004 – end customers with continuous metering except households • 1st January 2005 – all end customers except households • 1st January 2006 – all end customers Prague

14. Electricity Market Principles Electricity supplier (trader) + = Network operators Customers Generators Monopol activity Physical flow Payment Contractual relations (supplier x customer) Prague

15. Electricity supplier changes Prague

16. Price regulation in electricity sector Prague

17. Regulated prices in electricity • Electricity transmission over the transmission system • Electricity distribution over particular voltage levels (HV, MV, LV) • Price for meeting the extra costs related to the purchase of electricity from renewable sources, combined heat & power and secondary sources paid by final customers • System services • Market Operator activities • Electricity from combined heat & power plant - CHP, electricity from secondary sources • Electricity production from renewable sources(feed-in tariffs + bonuses) • Decentralized (distributed) generation ERO Price Decisions Prague

18. Main regulatory principles Fixed regulatory periods • I. period: 1.1.2002 – 31.12.2004 • II. period: 1.1.2005 – 31.12.2009 • III. period: 1.1.2010 – 31.12.2014 • Main regulatory principles are valid during whole regulatory period and set beforehand • During regulatory period only external factors taken into account (consumption, inflation, wholesale price of electricity ) • Individual tariffs for transmission and distribution licence holders Prague

19. Process of prices adjustment • 1. step – delivery of DSO’s,TSO and MO regulatory sheets from previous and regulated year • 2. step – informationfrom ERO to TSO and MO about prices for transmission,system services andMO services • 3. step – informationfrom ERO to DSO concerning distribution prices • ERO Price Decision no later than 30. November Prague

20. Price setting methodology fortransmission & distribution Basic component for prices each year: method RPI-X: allowed revenues AR = AC + D + PP = r . RAB AR … allowed revenues AC … allowed costs D … depreciation r … rate of return (return on operating assets), applied value ofWACC P … profit RAB … regulated assets base Prague

21. Price setting methodology fortransmission & distribution Average prices for regulated activities c = TR / PM where TR = AR + VC c … average price for each activity in regulated year PM … planed amount of technical units (MWh) TR … total revenues AR … allowed revenues VC … variable costs During the regulatory period are taken into account: • changes of assets net book value • inflation – combined index (Producer price index, Wage escalation index) • changes of technical units • requirement for efficiency growth – factor X applied on costs Prague

22. AR (allowed revenues) VC (costs of loses) Price for reserved capacity Price for using networks Transmission Price for transmission – 2 components Prague

23. Transmission Price for reserved capacity • Calculated from the allowed revenues • Allowed revenues lowered by part of the revenues from auction • Allowed revenues divided according to the capacity balance on the interface between transmission and distribution system • Average of 4 winter maximum consumption balance from TS • Not paid by generators, exporters and pumped storage hydro plants Price for using networks • Calculated from the variable costs (=loses in transmission system) • Not paid by exporters Prague

24. AR (allowed revenues) VC (costs of losses) Price for reserved capacity Price for using networks Distribution • Price for distribution on VHV and HV – cumulative postage stamp with 2 components: • price for reserved capacity (CZK/MW . year, CZK/MW . month) • price for using networks (CZK/MWh) Prague

25. Distribution – VHV, HV Price for reserved capacity • Calculated from the allowed revenues • Allowed revenues divided by the total capacity, which is expected to be reserved by the end-users of DS in the next year • 2 possibilities of capacity reservation • yearly (paid once per month) • monthly • There are special payment in case of exceeding the booked capacity (price for exceeding reserved capacity = 4 times more Price for using networks • Calculated from the variable costs (=loses in distribution system)  division by total amount of consumption (MWh), expected to be realized by the end-users of DS in the next year • Limits of technical loses (TL) and commercial loses (CL) with decreasing characteristic of CL • Prices mainly reflect increase of wholesale price of electricity Prague

26. Distribution – LV • A different situation: • a wide scale of tariffs on LV (11 for small commercials, 9 for households) • no continuous metering (implementation = very high costs) → a different solution needed (load profiles - 8 categories) • Targets: • keep the tariff structure in accordance with the character of consumption • keep the price relations between tariffs • keep the price structure: • Capacity charge according to circuit-breaker size (CZK/A) • Energy charge (CZK/MWh) – 1 time zone, 2 time zones (HT, LT) • Inputs: • allowed revenues on LV level, total costs on loses (loses limits set) • tariffs statistics; limiting point Prague

27. Distribution – LV Allocation: • keeping recent price relation between tariff categories • keeping limiting point between tariff categories (=annual consumption whereat it is more suitable for the customer to change the tariff) Prague

28. System servicesMarket of Ancillary Services - Balancing market Market of ancillary services established in 2001 and operated by ČEPS • Ancillary services procurement • tenders (long term, year, quarter), approx. 95% of total PR, SR, TR, quick start and operating reserve • day-ahead market (approx. 5% of total PR, SR, TR and operating reserve) • direct agreement with providers (regulation of reactive power, black start and islanding) • balancing energy from balancing market and abroad • Providers • 19companies with pre-qualification Prague

29. Price regulation Prague

30. Basicinformation about regulatory period • Duration of the regulatory period is 5 years (1. 1. 2010 - 31. 12. 2014) • Methodology of regulation - revenue-cap • Progressive recognizing of investment into RAB • Granting of the accounting depreciation into the regulation • Annual calculation of WACC reflecting market signals Prague

31. Parameters of the regulatory formula for the III.RP - RAB • Unbundling process 2005 – 2007 • Distributional assets reevaluated • Depreciated Optimized Replacement Cost (DORC) method applied • Reevaluation coefficient • DSO – (1,4 -2,6) higher coefficiant in gas sector • TSO – (3,4) electricity TSO already reevaluated • Assets not automatically included into RAB • Progressive recognizing of reevaluated assets to the RAB on the basis of investment activity • Motive companies to invest to a higher degree Prague

32. Parameters of the regulatory formula for the III. RP - WACC where: WACCNHBTnominal value of WACC before tax WACCNHATnominal value of WACC after tax T effective tax rate D debt E  equity re cost of equity rd cost of debt rf risk free rate of return ERP market-related risk premium [equity risk premium] βLlevered beta βunLunlevered beta Prague

33. WACCRiskfree fate rf (1) The key issue for calculating the risk-free rate of return is to determinethe following: • Maturity of government bonds • In recent years, regulatory authorities have mostly preferred medium-term bonds, which better match companies’ financial planning • The current rate of return, or rate of return from long-term averages • historical values are not available Prague

34. Company Country Industry Unlevered beta % D Tax Levered beta Europe Elektricity distribution and transmission 0.34 Cegedel SA Luxembourg ET, ED 0.35 0.05 0.30 Elia System Oper Belgium ET 0.15 0.13 0.34 0.12 0.26 National Grid UK ED, ET, GD, GT 0.39 0.49 0.30 Red Electrica Spain ET 0.67 0.48 0.33 0.43 0.37 Societa Elettrica Sopracenerina SA Switzerland ET 0.37 0.01 0.21 Terna Italy ET 0.44 0.46 0.35 0.30 0.58 Eszak-Magyar Hungary ED 0.59 0.03 0.20 0.34 Gas distribution and transmission 0.53 Scottish & Southern Energy PLC UK GD, GT 0.62 0.24 0.30 Centrica Plc UK GD 0.42 0.29 0.30 0.35 0.37 United Utilities UK 0.43 0.23 0.30 Ascopiave Italy GD 0.25 0.01 0.33 0.24 0.27 Snam Rete Gas Italy GT 0.39 0.42 0.33 Enagas Spain GT 0.67 0.50 0.33 0.44 0.37 WACCUnlevered beta βunL (1) • The beta coefficient expresses the degree of risk of investment in a given market segment (for example, distribution, transmission) in relation to the risk of investment in the market as a whole . • There are many options for deriving this coefficient. The Office has analysed the following two: • Computing the coefficient on the basis of data from stock markets Prague

35. Distribution, power Austria Poland Slovenia Portugal Estonia Finland France Ireland Sweden NL Hungary Italy average 0.41 Beta unlevered 0.33 0.60 0.16 0.48 0.30 0.45 0.40 0.48 0.28 0.22 0.41 0.38 Luxemburg Transmission, power Slovenia Finland Poland NL France Estonia Hungary Austria Ireland Italy Portugal average Beta unlevered 0.16 0.30 0.60 0.30 0.45 0.35 0.31 0.22 0.33 0.40 0.37 0.22 0.33 Distribution, gas Slovenia Austria Denmark France France NL Ireland Italy UK Portugal Hungary average Beta unlevered 0.18 0.33 0.40 0.30 0.58 0.30 0.43 0.49 0.46 0.44 0.43 0.39 Transmission, gas Slovenia Finland NL UK Ireland Italy Portugal Hungary Austria average Beta unlevered 0.15 0.30 0.30 0.45 0.41 0.38 0.58 0.49 0.33 0.38 WACCUnlevered beta βunL (2) • Computing the coefficient on the basis of regulatory practice The Office has set beta as follows: Electricity transmission 0.30% Electricity distribution 0.35% Gas transmission 0.35% Gas distribution 0.40% Prague

36. WACCEquity risk premiumERP (1) • shows the investors’ risk expressed as the difference between the rate of return on the market portfolio of a particular country and the risk-free rate of return • based on the difference between the return on government bonds and the return on shares in the “ideally” distributed portfolio • ERO analyzed two approaches • Estimate based on expectations • expectations differ significantly in each part of the economic cycle such as boom, stagnation, and recession • Estimate based on historical data • derived from values achieved on the US capital markets since 1928 using Professor Damodaran’s database Prague

37. WACCEquity risk premiumERP (2) Prague

38. WACCEquity risk premiumERP (3) • Risk Premum US + Default spread CZ = ERP Czech Republic 5% = 6,4 % Prague

39. WACCDebt to equity ratio • European regulators use the ratio of capital distribution and consider use of 60% of debt to be the optimum approach • Office conducted first step that indicates to companies to reconsider their structure of capital employed Prague

40. WACC Cost of debt (Dp) • Derived from credit default swap (CDS) • Czech companies not traded on the stock exchange • On the basis of implicit (or synthetic) rating • the interest coverage rate = EBIT / Interest Expense or • Determine directly cost of debts • From the time series of the Czech National Bank • Actual interest rates for non-financial companies • Volumes in excess of CZK 30 million, and were fixed for one to five years Prague

41. WACC - result Prague

42. WACC - limits Prague

43. Quality regulation • Measured with the help of a combination of the SAIDI and SAIFI • indicators, represented in the same proportion 50:50, • Bonuses/penalties are expected to be applied no earlier than from the third year of the third regulatory period (2013 - 2014) • Data collection from 1st January 2009 • Bonuses or penalisation will be related to the level of profit • Preliminary parameters: • The insensitivity band: ± 5% • Maximum penalty/bonus at 15% of failure/improvement: ± 3% of profit for the respective regulated year Prague

44. Quality regulation ERO will apply quality regulation according to the figure bellow Prague

45. Quality regulation Prague

46. Regulation of quality of service commercial quality continuity of supply voltage quality (EN 50 160) Basic tools for quality regulation: • Publication of quality of services report • Exercising guaranteed standards services • Penalty for infringement • Incentive mechanism • Modification of Allowed Revenues on the basis of some criteria: • Continuity of supply • Frequency of interruptions and duration of interruptions • Customers complaints • Index of customer’s satisfaction • Losses of networks • Etc. Weighted criteriacan be used Prague

47. Integrated incentive regulatory scheme generally: ARt = ARt-1 * (1+RPI-X) ± Q AR – allowed revenues RPI (CPI) – inflation X – factor efektivity Q – financial bonus or penalty Way of setting–up bonus orfine: Q = ΔARt = PQ * (SQ – DUQt-2) PQ- price of quality SQ -requested level of quality indicator(standard) AQ – actually reached level of quality indicator Prague

48. Dependency of allowed revenues on quality services Standard level of quality indicator Bonus SQ Necessary to know the quality price PQ (on the base of research) • Amount of losses (financial) caused by electricity shortage • Willingness to pay for elimination of blackout (WTP) • Willingness to accept compensation for shortage (WTA) actual level of quality indicator PQ AQ Low quality High quality ΔAR Angular coefficient Fine Prague

49. Prices of quality Source:Third Benchmarking Report on Quality of Electricity Supply, 2005 Service Quality Regulation in Electricity Distribution and Retail, 2007 Prague

50. Standard level of quality indicator Bonus SQ limit ΔARMax actual level of quality indicator AQ AQmin Low quality High quality AQmax ΔAR PQ Angular coefficient ΔARMin Fine Penalization and bonification limits Great Britain, Ireland, Netherlands Prague