Pricing and Liberalisation Pricing in a Liberalised Energy Market

1. Pricing and LiberalisationPricing in a Liberalised Energy Market Guido PepermansEconomics Department and Energy Institute K.U.Leuven

2. Structure of the Talk • The liberalisation process • The general principles of pricing • Stranded costs • Cross-subsidies • Transmission pricing

3. The Liberalisation Idea BEFORE LIBERALISATION AFTER LIBERALISATION One vertically integrated company Generation GenCo GenCo GenCo GenCo Transmission Transmission Grid Company Regulated Distribution Distribution Company Distribution Company Distribution Company Regulated Customer

4. Before the Liberalisation - Belgium Regulator Electrabel92% SPE4% Autoproducers4% Generation CPTE CCEG Transmission Pure Intermunicipalities20% Mixed Intermunicipalities80% Distribution Direct Customers33% SMEIndustry47% Households20% Customer

5. After the Liberalisation - Belgium Regulators Electrabel SPE Autoproducers Competitors Generation CCEGfor the Captive customers(SME, Industry, Households) CPTE (ELIA) Transmission CREGfor the Eligible customers (Direct customers) Pure Intermunicipalities20% Mixed Intermunicipalities80% Distribution Direct Customers33% SMEIndustry47% Households20% Customer

6. General Principles of Pricing - 1 • Desirable criteria for a pricing rule • Provide incentives for efficiency (p = MC) • Allow suppliers to cover their costs (p > AC) • Non-discriminating • Transparent • PROBLEM: Natural monopoly • match efficiency and cost recovery • Solutions • Ramsey pricing • Two-part tariffs • Peak-load pricing

7. price price B C pR Market Supply Market Demand Market Demand O O O O quantity quantity General Principles of Pricing - 2

8. price price B E pM G D F Average cost H pR Marginal cost C Market Demand Market Demand O O O O quantity quantity Marginal revenue General Principles of Pricing - 3

9. Stranded Costs - 1 • Problem • What to do with past investments? • Were ‘guaranteed’ to be recoverable through price increases • In an open market, this ‘guarantee’ falls away • Problem mainly for private monopolists • Definition is important • As recovery of stranded costs is foreseen in the European Directive

10. Stranded Costs - 2 Fixed or sunk costs that were imposed ( approved) by the regulator and that cannot be recovered via the market if the market is opened up for competition

11. Stranded Costs - 3 MCE MCI ACI AVCI ACI MCI pR E1 B pC MCE A E2 AVCI E3 OI OE=qD q*

12. Stranded Costs - 4 Price covers the average costs Price of electricity generation = Average economic profit Average fixed strandable cost Average fixed non-strandable cost = Average cost Average variable cost

13. Price of electricity generation = Average economic profit (= loss) Average fixed strandable cost Average fixed non-strandable cost = Average cost Average variable cost Stranded Costs - 5 Price covers average variable costs and average fixed non-strandable costs

14. Average fixed strandable cost = Average economic profit (= loss) Price of electricity generation = Average cost Average fixed non-strandable cost Average variable cost Stranded Costs - 6 Price covers average variable costs but not average fixed non-strandable costs

15. Stranded Costs - 7 • Conclusion • From the point of view of efficiency • Stranded cost recovery is not necessary • If recovery is allowed • It should be competitively neutral • An upper limit on allowable recovery • Size of the strandable cost

16. Cross-subsidies - 1 • General pricing principles • Should reflect marginal costs • Should allow to recover total costs • Misunderstandings • Uniform pricing may imply cross-subsidies • Price differentiation does not necessarily indicate cross-subsidies

17. Cross-subsidies - 2 • Definition of cross-subsidy-freeprices • For all customers • Price is below the average stand-alone cost • The cost of self-providing the good or the service • An upper bound on cross-subsidy free prices • Price not lower than the average incremental cost • A lower bound on cross-subsidy-free prices • Why is there a problem? • Wrong incentives • Distributive considerations

18. Cross-subsidies - 3 A B C Liberalised market (25.000 GWh) Regulated market (50.000 GWh) Variable costs 2 BEF/kWh Variable costs 2 BEF/kWh Joint costs 40 Bln Assume a given revenue requirement : 190 Bln = (25.000+50.000) x 2 BEF + 40 Bln BEF A : Joint costs fully allocated to the regulated market pL=2 BEF pR=2,8 BEF B : Joint costs evenly allocated to both markets pL=2,8 BEF pR=2,4 BEF C : Joint costs fully allocated to liberalised market pL=3,6 BEF pR=2 BEF

19. Where can they occur? Cross-subsidies - 4

20. Cross-subsidies - 5 • Cross-subsidies in a partially liberalised belgian electricity market • Intentional misallocation of joint costs in generation • Transmission tariffs • Why do they occur? • Historical reasons • Unintentional misallocation of joint costs • Stranded costs • Predatory pricing • Intentional misallocation of joint costs

21. Cross-subsidies - 6 • How to reduce the potential for unwanted cross-subsidies • Price cap regulation or yardstick competition • Speed up the liberalisation process • Better control of cost allocation exercise

22. Transmission Pricing - 1 • What makes transmission pricing of electricity difficult? • Fixed transmission capacity • Cost recovery • Some physical laws apply to electricity transport • Law of least resistance • Belgium is part of a European network in which it cannot control flows • Dutch import from France via Belgium or via Germany? • Transmission costs and capacity limits will play an important role in the competitive process

23. Transmission Pricing - 2 • Alternative pricing systems for transmission • Cost coverage • Incentives for optimal siting of generation and consumption • Incentives for efficient operation, investment and cost minimisation by the transmission company • Postage stamp • Fixed fee per MWh • Simple cost recovery • No incentives for correct siting of generation and consumption • No incentives for cost minimisation of system operator

24. Transmission Pricing - 3 • Distance related tariff • Fee proportional to distance • Cost recovery easy • No perfect incentive for siting generation and consumption • No incentives for cost minimisation of system operator • Marginal cost pricing • Cost recovery not guaranteed • Good siting incentives if also future tariffs are announced • Better incentives for cost minimisation

25. Transmission Pricing - 4 • A proposal for Belgium (Energy Institute) • Mixture postage stamp and marginal cost pricing • Postage stamp • Individualised costs • Non-individualised costs • Costs not directly linked to actions of generators and consumers • Congestion correction for some sites (discount or extra margin) • Incentive for overall cost efficiency • based on yardstick competition

26. Transmission Pricing - 5 • The fixed component • Covers • Individualised costs • Reactive power for outlyers, connection costs, metering and billing • Non-individualised costs • Allocation based on last year’s • Peak demand: grid maintenance,black start capacity, personnel and operating costs and return on investment • Energy use: reserve capacity, reactive power and voltage control and grid losses • Avoid cross-subsidies

27. Transmission Pricing - 6

28. Transmission Pricing - 7 • Incentives for optimal grid use and siting • A grid quality charge (GQC) • Based on typical and critical load flows of previous year • Nodes are evaluated w.r.t. Congestion, loss, stability and reliability problems • Nodes causing extra problems get a surplus charge • Nodes relieving problems get a negative charge • Overall the net revenue from the GQC for the system operator is zero • Avoid incentives to create congestion

29. Transmission Pricing - 8 • Incentives for efficient grid operation and investment • SO is rewarded or penalised for delivering good or bad quality (measured by overall system reliability) • Benchmarking • Compare with neighbouring countries • Investing improves quality of the service • Avoid over-investment • Make the SO the residual claimant for a share of grid investment