The Regulatory Approach to Fostering Investment

1. The Regulatory Approach to Fostering Investment David Halldearn Ofgem 28 September 2006

2. Context • EU action on a number of fronts moving towards single energy markets eg. • Green Paper – Commission Strategy Paper expected December • Competition cases – ongoing merger cases and Sectoral Enquiry • Regional Initiatives • Political drivers: Competitiveness, Security of Supply and Climate Change

3. Importance of Infrastructure • Successful response to all aspects depends upon developing an integrated grid – the fundamental basis for a single market • Grid infrastructure must come from private companies – Govts should not “pick winners” • Therefore, creating environment for investment is vital

4. The scale of the task • Commission Green Paper – “around 1trillion euros will be needed over the next 20 years” • Commission report on TEN-energy, Oct. 2005 – €100bn needed to 2023 in gas infrastructure: • €48bn in transmission systems • €22bn in storage • €6 in future interconnections • €23bn in import pipelines and LNG terminals • €1bn in existing import projects

5. Financing Infrastructure Investment • Companies need: • Clear, long term market signals • Regulatory certainty • Fair rate of return • Neither currently exists for cross-border investments

6. The theory – how to pay for infrastructure • Two approaches possible: • “Fully Regulated” Investments • “Contract” investments • Both feasible, and necessary, within competitive single market: • but both must meet above 3 criteria ie. transparency and certainty leading to fair returns

7. The “Regulated” approach: • TSOs invest to meet required security/operating standards • Investment in “regulated asset base” (if efficient) earns a fair rate of return through tariffs paid by network users, who therefore bear costs (and risks) • Works well where users are the direct beneficiaries of investment • Robust regulatory framework must exist for RTPA and RPI-X price control regulation to be applied

8. “Contract” / “Merchant” investment • Long term contracts represent a commitment of a forward income stream against which capital markets will invest • Competition concerns must be addressed, but the circumstances vary from market to market • Conditions on contracts must trade off certainty (cost of capital) with pro-competitive access measures – such as open season, third party access reservations, limits on contract duration • Conditions must reflect local circumstances

9. The practice: how does it work on the ground? • Electricity: • Regulation of natural monopolies works within Member States • But TSOs “use” each others networks, so ITC scheme invented • Extra-EU issues not resolved (eg SEE) • Gas • Regulation works within Member States • TSOs “use” each others networks (and other upstream infrastructure too). No regulatory mechanism for cost recovery or cost allocation • Accepted industry practice based on long term contracts to support extra-TSO network investment • No viable alternative has been promoted, despite serious competition concerns

10. The way forward? • Current EU legislative framework does not create environment for investment – because focus is within national markets not between them • Therefore cannot create effective single market • Action needed to facilitate both types of cross-border investment • Further EU legislation necessary

11. Regulated Approach at EU level: TSO Responsibilities • National TSOs have national rules for building and operating their networks. We need European rules • A ‘European Grid Code’ must have: • European security standards, especially at borders • Joint system planning arrangements • Provision for co-operation between TSOs for operation of the networks and emergency arrangements • Proper oversight • Do we need a “European Centre for Energy Networks” organisation to manage all this? • No - but greater co-ordination is required through eg. GIE

12. Regulated Approach at EU level: Regulators’ Responsibilities • National Regulators to look at the interests of European consumers not just national consumers • Regulators need to ensure that TSOs have certainty about the return on their cross border investments, just like national ones • Costs and risks need to be allocated fairly for cross border investments. The Inter-TSO Compensation Mechanism (ITC) goes some way to achieving this in electricity. But what about gas? • Proper unbundling remains an essential prerequisite for an efficient European (or even national) grid. • Do we need a European regulator? Probably not - but greater co-ordination is required through eg. ERGEG+?

13. Contract Approach at EU level: Guidelines • Europe’s gas supplies depend on ‘merchant’ investment in pipes and LNG infrastructure to bring gas to Europe’s borders • Long term contracts need a framework so investors can rely on them without precluding competition eg. consistent principles for TPA exemptions • Guidelines should be developed • Recent case law should be enforced (Decision C-17/03)

14. Summary • Infrastructure investment central to single energy market , and therefore to meeting political drivers • Current legislative framework not creating environment for investment • Both “regulated” and “contract” investment necessary at EU level • But requires new legislation (on TSOs and Regulators) and guidelines (on contracts) to balance certainty with competition

15. Promoting choice and value for all gas and electricity customers