Economic and quality regulation of electricity service - International experience

1. Economic and quality regulation of electricity service - International experience Nepal, November 2018

3. Three pillars to be addressed to achieve sustainable good performance of the power sector in an emerging country • Systematic optimized (least-cost) planning and implementation of investments in all segments of the supply chain • Government’s responsibility • Needed to address security of supply in a context of growing demand • A specific approach is needed for electrification to move towards universal access • Efficient operational performance of service providers (utilities) in all business areas: electricity supply, commercial functions, management of corporate resources • Electricity sector exists to serve consumers • Financial sustainability: revenues (tariff + subsidies) allowing recovery of costs of efficient service provision • Tariff revenues allocated among categories of consumers (tariff charges) to recover costs incurred for efficient service provision. • “Social safety net” to protect low-income users unable to pay cost-reflective charges • Adequacy of institutional and organizational arrangements should be assessed considering the key matters above

4. Regulation is needed only for services provided in monopolistic conditions - Network transmission and distribution - Generation and retail are potentially competitive activities • Objectives of regulation • - Ensure that electricity consumers receive a service of good quality at fair prices • - Ensure that efficient service providers earn a reasonable return on equity allocated to investments • Regulation involves economic and service quality aspects • - Economic: price setting and adjustments • - Service quality: setting standards, procedures for monitoring compliance and regime of penalties, and effectively enforce them Regulation of electricity service

5. Approaches for economic regulation of network industries • Asymmetry of information • Close relation current cost-price • No incentive to efficiency • Complexity in monitoring • No incentive to optimal investment • Risk of over-investment Cost Plus or rate of return (ROR) • Asymmetry of information • Temporary cost-price lag • Strong incentive to efficiency • No incentive to improvements in quality of service (specific mechanisms must be designed and implemented) Performance or incentive based (PBR)

6. Distribution: a single name for two separate businesses: • Network • Core business: “network capacity service” at high, medium and low voltage • Main characteristics: natural monopoly; regulated prices (tariffs) • Retail supply • Core business: power & energy trade between sellers (producers and/or retailers) and final consumers • Main characteristic: potentially competitive activity Electricity distribution: network & retail supply businesses

7. Electricity distribution: network & retail supply businesses • Eligible (free) consumers • Freedom to choose supplier (eligibility) is given initially to large consumers. • Technical requirements for eligibility and economic transactions must be set (i.e. metering and conciliation). • Distribution companies are electricity suppliers (retailers) of small and medium (ineligible) consumers - Key aspect to ensure security of supply in sectors with increasing demand - Distribution and retail companies must sign long-term supply agreements to enable investments in new generation and transmission capacity: competition FOR the market

8. Predominant approaches for electricity service regulation in reforming countries in Latin America

9. Starting Conditions of the reform process in Latin America (LA) • In the 80s and early 90s the electricity sector was the main source of huge economic losses and related fiscal burden in several Latin American countries due to: • Distorted pricing regimes • Bad quality of service provided to users • High losses (technical and non technical) in supply • Low equipment availability • Inefficient investment process (technical and financial planning and execution), particularly in construction of large hydropower plants in the 70s and 80s • - Root causes were "institutional": sector policies, market structure, skills, lack of incentives and inadequate supervision. A new institutional and regulatory framework was needed

10. - • In all cases the regulatory framework was designed considering some key elements: • - Definition of applicable standards on quality of service and mechanisms to effectively monitor performance and enforce compliance • Rights and obligations of service providers (distribution and retail companies): • Meet all demand and provide adequate service in their specified service areas • - Provide “open access” to their networks to parties allowed to trade power (suppliers and eligible consumers) • - Apply tariffs rates that ensure business sustainability (allow to cover costs of supply and earn a reasonable return on invested equity) if it is efficiently managed The predominant approach: Performance Based Regulation (PBR) for network businesses (T&D) .

11. - • Principles of the new institutional and regulatory structure of the electric sector were defined through specific laws. • - In some countries (Peru and Chile) laws contain not only the principles but also the specific procedures (and even the formulae) to be followed for calculation of regulated prices (transmission and distribution tariffs). In other countries, the specific procedures and formulae are contained in the regulatory decrees and license or concession contracts. Guidelines are in the laws. • - The whole set of norms (law, decrees, contract) is in general very specific (low flexibility for discretionary interpretation by involved agents). • - To maximize legal certainty provided to investors, key articles of the law and regulatory decrees are included as part of the concession or license contracts. They will stay valid for these contracts even if repealed as norms of general application (Brazil). The predominant approach: Performance Based Regulation (PBR) for network businesses (T&D) .

12. Multi-year tariff periods with periodic adjustments within each period and “full reset” at the beginning of a new cycle PRICE CONTROLS QUALITY MONITORING The existence of captive users creates the need to monitor quality of electricity supply and customer service OBLIGATION TO SUPPLY • Transmission and Distribution companies must allow third party access to their networks if there is spare capacity available. OPEN ACCESS Performance Based Regulation (PBR) for network businesses (T&D) • Distribution companies have the obligation to meet all required consumption in their service areas. They cannot discharge this obligation on the basis of lack of generation or transmission facilities.

13. Performance Based Regulation (PBR) for network businesses (T&D) – Economic aspects • Objective • To set optimum Revenue Requirement (average tariff level) and tariff structure • To allocate efficiency gains between customers and distribution companies • Tools • Definition and implementation of a Multi- Year Tariff (MYT) structure, with values of RR and tariff charges set for a whole tariff period (i.e. 4 to 5 years) • Scheduled tariff reviews (RESET) at the end of each tariff period • Stability and predictability within a tariff period: tariffs are adjusted only according to predefined criteria, formulae and time schedules • Principles of the MYT valid for the whole period of license or concession contract, and included in the legal framework and in the contract itself Continued...

14. Performance Based Regulation (PBR) for network businesses (T&D) – Economic aspects • Revenue cap • Revenue yield • Price cap (basket case) • Price cap (for each category rate) PBR is almost always combined with benchmarks • - Comparison with a reference efficient enterprise (i.e. the “ Reference Utility (RU)” approach); • - Company’s own historic performance; with a group of similar utilities) Some degree of freedom to distribution company to set the table rate. Anglo Saxon approach Regulatory control on tariff structure and rates. Latin American approach. Used when a transition phase is needed

15. GC TAV DAV Performance Based Regulation (PBR) for network businesses (T&D) – Economic aspects • “PASS-THROUGH” of non manageable costs: • - Power and energy prices - Ancillary services • - Transmission charges (HV and sometimes MV) • DISTRIBUTION ADDED VALUE (manageable costs) • - Network expansion and renovation • O&M • - Retail services • - Energy and power losses (physical amounts)

16. The case of Argentina in the 90s Licenses from 40 to 100 years. Competition for the market within 15 year - period Initial 10-year tariff period followed by 5-year periods Incentive Based Regulation: Category by category Price Cap Tariffs set in USD, adjusted every 6 months according to evolution of price indexes (US indexes) Maximum allowed losses within the tariff period At the end of each tariff period a full tariff review (level and structure) is performed. Physical by pass not allowed

17. The case of Brazil (the last reform in the 90s) 4/5-years tariff periods Concessions for 30 years Incentive Based Regulation: Category by category Price Cap Tariffs set in local currency, adjusted every year within a tariff period according to evolution of predefined indexes At the end of each tariff period a Revenue Requirement review is conducted, including full resetting of allowed revenues and determination of an annual X factor for the following tariff period Physical by pass not allowed

18. Performance Based Regulation (PBR) for network businesses (T&D) – Emerging lessons • Successes: • Sustained improvement in quality of existing services • Higher operational and financial performance of distribution companies • Substantial and sustained reduction of overall losses achieved through adequate regulatory schemes and proper management • Failures • Almost no progress in connection of new consumers in rural and low density areas • Limited enforcement of quality standards

19. Performance Based Regulation (PBR) for network businesses (T&D) – Loss reduction - To reduce losses from high starting values is in most cases cheaper and easier to achieve than building and operating new generation and network capacity - The Latin American approach: allowance on total losses set for the whole tariff period: • A single number (Argentina: 12.5% for every year of the first 10 years tariff period) • A trajectory (Colombia: 20% for 1998, 15% for 1999 and 1% less for every next year of the 5 years period 1998-2002) - As cost of losses for the distribution company is generation & transmission cost, this provides strong incentive for reduction below allowance, to move from financial losses into financial earnings.

20. Performance Based Regulation (PBR) for network businesses (T&D) – Loss reduction - Total losses (mainly non-technical) were significantly reduced in short time without significant expenditure or investment. Examples: in Chile losses were reduced by 50% in 7 years and in Argentina the same reduction was achieved in 3 years • Good management and strong governance • Focus initially on large customers (“field” approach in the 90s) • Use of technology: capacitors in MV networks, current limit devices, twisted cables, shielded networks, etc. • Optimizing the pricing system; TOU rates, reactive power penalties and incentives • Agreements between companies and government for the very low-income or dangerous areas - “Revenue Protection” projects supported by Advanced Metering Infrastructure (AMI) replaces field inspections for large customers

21. Performance Based Regulation (PBR) for network businesses – quality of service - Clear rules define applicablestandardson: - Technicalproduct (voltagefluctuations, etc.) - Technicalservice (frequency and durationofinterruptions) - Commercialservice - Crucial importance of enforcing rules by systematic performance monitoring - Implementation of procedures for monitoring compliance of standards for every individual consumer, supported by Management Information Systems (MIS)

22. The retail business – Eligibility criteria • Minimum contracted power to have the right to choose electricity supplier • Argentina 0.03 MW (initially 5 MW ) • Chile 2.00 MW • Colombia 0.50 MW (initially 2.00 MW) • Panama 0.50 MW • Perú and Bolivia 1.00 MW, • Guatemala 0.10 MW, • Nicaragua 2.00 MW, • Brazil 3.00 MW at 69 kV (initially 10 MW) • Trajectory towards full retail competition stopped in all cases to enable investments in new generation and transmission capacity and ensure security of supply:

23. Calculation of Revenue Requirement Pedro Antmann

24. Calculation of capital expenditures (CAPEX) • - Pedro Antmann

25. Calculation of CAPEX

26. Calculation of CAPEX - Alternative approaches

27. Design of the optimized network • Optimized network is designed starting from the information on the existing one by: • Defining representative segments based certain parameters: average demand, voltage of supply, linear density of consumers, topology of streets and roads • Optimizing each representative segment • Capacity of transformers and size of conductors. • Topology of the existing network is not modified • Current design and construction procedures are considered • Incorporating (if necessary) equipment to meet quality standards (breakers, isolators, reclosers and other switchgear) • Expanding results of typical sectors to the whole network

28. Other parameters in calculation of CAPEX • Allowed cost of capital: CAPM/WACC • Economic depreciation: Considering actual lifetime of assets

29. Calculation of operating expenditures (OPEX) Pedro Antmann

30. Determination of Allowed OPEX • Two main approaches - Top–down benchmarking - Comparison carried out at cost or production level (“econometric”): - Positive results in developed reforming countries (UK and others) - Requires availability of enough homogeneous data (not usual in developing reforming countries) • - Bottom–up benchmarking (“reference utility”) - Comparison (costs or physical inputs carried out at process level (“engineering”) - Task frequencies and physical (human and material) resources required compared. - Positive results in developing countries where homogeneous data are not available

31. Allowed OPEX - Design of the Reference Utility (RU) Design of the Reference Utility (RU): • There is one RU related to each real distribution company • RU is the ideal efficient company related to the real distribution company designed to: • Provide electricity distribution and retail supply services to the consumers currently attended by the real company • Meeting the applicable standards on service quality • RU is “built-up” considering the main blocks of processes and activities (P&A) that must be carried out in each business area to efficiently provide distribution and retail services

32. Allowed OPEX - Design of the Reference Utility (RU) • RU is designed based on the existing information describing all the processes and activities required to serve existing customers of the real distribution company: • O&M of electricity networks • Commercial activities: reading meters, preparation and delivery of bills, collection, attention of customers (personalized and call center) • Centralized functions (shared services): finances and accounting, administration of human resources, procurement and logistics • Frequency of execution of each P&A is defined and related human and material resources determined in physical terms • Physical resources are transferred into costs considering representative prices of the markets where P&A must be performed

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