Presentation to FTS of Russia

1. Presentation to FTS of Russia 26 April 2012

2. UK Grid – Issues associated with the Third Energy Package Anna Saksonov

3. Regulation of GB Gas and Electricity Networks post Third Package Anna Saksonov, Senior Legal Adviser Legal Markets, Ofgem

4. Third Package Will examine regulation of GB gas and electricity networks following the implementation of Third Package in Great Britain (GB). Third Package – 2 Directives (gas and electricity), 3 Regulations (gas, electricity, establishment of Agency for Cooperation of Energy Regulators (ACER)). Transposition deadline into domestic legislation by Member States was 3 March 2011. GB transposing legislation came into force on 10 November 2011. Link to the Electricity and Gas (Internal Markets) Regulations 2011: http://www.legislation.gov.uk/uksi/2011/2704/contents/made

5. Key requirements of Third Package Independence of the national regulatory authority (NRA). Unbundling of transmission system operators (TSOs) from generation/ production and supply undertakings. New powers and duties of NRA – new cross- border objectives, monitoring duties. Enhanced consumer protection measures.

6. Independence of NRA (1) Ofgem has been designated as the NRA for GB by the Utilities Act 2000. NRA must be functionally independent from any public or private entity and act independently from any market interest. Must take autonomous decisions, independently from any political body in relation to its functions as the designated NRA. Must not seek or take direct instructions from any Government or other public or private entity when carrying out the regulatory tasks set out in the Directives.

7. Independence of NRA (2) Concept of instructions is to be interpreted broadly - “any action calling for compliance and/or trying to improperly influence an NRA decision and thus includes the use of pressure of any kind on NRA’s staff or on the persons responsible for its management.” In GB Ofgem is already an independent impartial regulator therefore largely compliant with Directives. Independence of Ofgem strengthened - new provision in legislation that members of the Authority may not seek or take any instructions that may compromise independence of Ofgem when carrying out regulatory tasks as the NRA for GB.

8. Unbundling of TSOs One of central provisions of Third Package is requirement for TSOs to unbundle from generation/ production and supply interests. Requirement for TSOs to be certified pursuant to one of the unbundling models set out in the Third Package. We are responsible for administering the certification process for GB TSOs – this is a regulatory task so have to be independent.

9. Certification deadline (1) Certification process set out in the Gas Act 1986 and in the Electricity Act 1989. Requirement to be certified by 3 March 2012 for current and future holders of gas transporter, gas interconnector, electricity interconnector and electricity transmission licences. If TSO licensed but not yet operational, no legal requirement to be certified.

10. Certification deadline (2) Authority can extend deadline to 3 March 2013 if (1) TSO not part of a vertically integrated undertaking and no senior officer is also officer of relevant producer/ supplier, or (2) for reasons beyond TSO’s and Authority’s control cannot make certification decision by 3 March 2012. Future TSOs will also need to be certified (e.g. new interconnectors and offshore transmission owners (OFTOs))

11. TSOs to be certified by Ofgem Ofgem is expecting certification applications from 3 onshore electricity TSOs, 4 electricity interconnectors, 1 onshore gas TSO, 4 gas interconnectors and 4 OFTOs. Ofgem is working closely with the Commission and with ACER when certifying TSOs. Close cooperation with NRAs in other Member States in relation to certification of cross-border infrastructure.

12. GB unbundling models for gas TSOs Full ownership unbundling 9(9) derogation – more effective independence of the TSO than ITO model Independent system operator (ISO) Independent transmission operator (ITO) Holder of major infrastructure exemption under Third Package (Article 36 Gas Directive) Holder of major infrastructure exemption under Second Package (Article 22 Gas Directive) or substantially similar to such a person

13. GB unbundling models for electricity TSOs Full ownership unbundling 9(9) derogation – more effective independence of the TSO than ITO model ISO Holder of major infrastructure exemption under Third Package (Article 17 Electricity Regulation) Holder of major infrastructure exemption under Second Package (Article 7 Electricity Regulation)

14. Certification process 4 months to make preliminary certification decision (unless ask applicant for additional information, restarts clock). European Commission 2 months to provide opinion (or 4 months if asks for ACER opinion on compliance with unbundling rules). We have to take “utmost account” of European Commission’s opinion and make final certification decision within 2 months of receiving it. For Article 9(9) applications European Commission has veto. Final decision to be notified to applicant, Secretary of State (SoS), European Commission.

15. Third country clause (1) If application made on or after 3 March 2013 and applicant is a person from a third country or a person controlled by a person from a third country, the Authority must notify the SoS and the European Commission that an application has been made; and (b) enclose any information which the Authority has and thinks is relevant to the question of whether the security of supplies in the UK or any other EEA state would be put at risk by certification of the applicant.

16. Third country clause (2) SoS must prepare a report on whether the security of supplies in the UK or any other EEA state would be put at risk by certification. SoS must send the report to the Authority within the 6 weeks of receiving notification of application from the Authority. Authority may decide not to certify if on the basis of opinion expressed by the European Commission the Authority thinks that certification would put at risk security of supplies in any EEA state. Authority must not certify if a report prepared by SoS states that certification would put at risk security of supplies in the UK or in any EEA state .

17. Principal objective Directives contain new cross border objectives for the NRA relating to promoting an internal market and eliminating restrictions on trade between Member States (see Annex) . Principal objective of the Authority, which is to protect the interests of existing and future consumers will be amended to comply with new objectives of the NRA in the Directives. Now consumers’ interests include the fulfilment by the Authority (when carrying out regulatory tasks as the NRA) of the objectives set out in Directives. Internal market and cross border element will therefore be part of Ofgem’s principal objective.

18. New monitoring duties & information gathering powers Authority already had some of the regulatory tasks set out in the Directives (see Annex), therefore GB was already partly compliant. Number of new broad monitoring duties introduced investment plans of TSOs network security and reliability transparency, including of wholesale prices level of market opening and competition prices for household consumers New power to require information for the purposes of monitoring. Offence to alter, suppress or destroy documents which we required to produce.

19. Consultation and co-operation New requirement that we must (wherever we think fit) consult and co-operate with ACER and with NRAs with a view to: Integration of national markets Promotion/facilitation of co-operation between TSOs Optimal management of networks Promotion of jointly managed cross-border trade and allocation of cross-border capacity Ensuring adequate level of interconnection capacity Co-ordination of development of network codes Co-ordination of regulation of markets incl. rules on congestion management.

20. Consumer protection neasures GB has a large number of obligations in legislation and in licences relating to consumer protection. GB was already compliant with some of the requirements of the Directives. Some new requirements in licences and in legislation to implement consumer protection measures. New obligations on suppliers relating to 3 week switching, energy consumer checklist, provision of final bill within 6 weeks of switching, information that has to be included in consumer contracts.

21. Annex

22. Cross-border objectives (now part of principal objective) When carrying out regulatory tasks/ in close consultation with other NRAs take all reasonable measures in pursuit of following objectives: Promoting competitive, secure and environmentally sustainable internal market and effective market opening Developing competitive / properly functioning regional markets Eliminating restrictions on trade between member states … Development of secure, reliable and efficient non-discriminatory systems that are consumer oriented … Facilitating access to the network for new generation capacity … Ensuring system operators and users granted sufficient incentives … to increase efficiency … Ensuring consumers benefit through efficient market functioning and promoting competition … Protection of vulnerable customers and contributing to compatibility of data exchange procedure for customer switching …

23. Regulatory tasks of the NRA (1) Fixing or approving transmission or distribution tariffs or methodologies (transparent criteria) … Ensuring TSOs, DSOs and SOs comply with EU obligations … Co-operating re cross-border issues with ACER and NRAs … Complying with and implementing legally binding decisions of ACER/Commission … Annual report to member state/ACER/Commission re fulfilling duties … Ensuring no cross-subsidies between transmission, distribution, storage, LNG and supply … Monitoring investment plans of TSOs … Monitoring compliance with and reviewing past network security performance … and setting/approving quality of service standards … Monitoring transparency incl. wholesale prices … Monitoring level and effectiveness of market opening and competition incl. domestic prices, switching rates, disconnection rates and domestic complaints …

24. Regulatory tasks of the NRA (2) Monitoring restrictive contractual practices … Respecting contractual freedom re interruptible and long-term contracts if compatible with EU law … Monitoring time for transmission and distribution connection / repairs … Helping ensure consumer protection measures effective and enforced … Publish annual recommendations on compliance of supply prices with Article 3 of Directives 2009/72/EC and 2009/73/EC … Ensuring customer access to consumption data … Monitoring implementation of rules on roles and responsibilities of TSOs, DSOs, suppliers and customers … Monitoring investment in generation … Monitoring technical co-operation between EU and third country TSOs … Monitoring implementation of safeguards as per Article 42 Directive 2009/72/EC and Article 46 Directive 2009/73/EC … Contributing to compatibility of data exchange processes for most important market processes …

25. Regulatory tasks of the NRA (3) Monitoring access to storage, linepack and other ancillary services … may including reviewing tariffs … Monitoring correct application of criteria that determine whether storage facility falls under Article 33(3) or (4) of Directive 2009/73/EC … In carrying out these duties we must, whilst preserving our independence, consult with TSOs and co-operate with NRAs.

26. RAV Regulation – framework and issues Bob Davey

27. Overview of GB regulated utilities • Utilities are asset intensive businesses and in network only businesses (no supply activity) asset related costs (ie depreciation and return) are typically the vast majority of revenues • The Regulatory Asset Value (RAV) is therefore at the heart of the regulatory system • If there is confidence in: • Stability of the RAV • Durability of the RAV • Transparency of the RAV • It will allow • Funds to be easily raised • At relatively low rates of return • For long duration • To the benefit of lower charges for consumers

28. Investor perceptions • RAV is a cornerstone of investment • Allowed return can vary • Depreciation rates can vary • Value must remain intact • Need to build confidence over time in stability and predictability of RAV • Net Present Value of future cashflows must => RAV • Consultation feedback: “long term investment with opportunity for acceptable returns based on predictable and stable cashflows” • Typical values • Gearing (Debt/RAV) - 60-65% • Cost of debt funding - 5% (2% real) • Cost of equity - 7% real • Asset Life - 45 years

29. Cash Opening RAV Closing + - Depreciation - proceeds of = RAV additions RAV sale Key requirements • For RAV to be effective: • Need transparent rules • Regulatory body to act consistently and transparently in decision making • Clear methodology/ definitions to add values • Deal with stranded asset risks

30. RAV Opening value • In Ofgem we use a financial capital maintenance approach • In a financial capital maintenance approach the value of investors investment is maintained in real terms as opposed to the operating capability of the network. We do this by index linking the RAV to a widely acceptable measure of general inflation. • The main alternative is an operational capital maintenance approach - MEAV (modern equivalent asset value) • The approach has implications for assessing the initial value • For our utilities the initial value was set following privatisation to reflect the investment made by investors • The initial values were in general significantly lower than the MEAV valuations

31. Depreciation & Disposals Depreciation • We believe the appropriate approach is to use economic asset lives • Generally quite long for infrastructure assets – 45 years • Longer periods spread recovery of investment over period that reflects the period in which asset will be in use • We have used accelerated rates of 20 years in the past • The period used does not affect value of cash flows but does affect the timing of return of investment and cash flows Disposals • Generally low for disposal of pipes or wires but can be more substantial, for example, for land • We deduct proceeds of any disposals from RAV • All benefits attributable to consumers who have been funding the assets • Can introduce some incentives on management to sell surplus land by allowing company to retain a portion of sales proceeds.

32. RAV additions • At each Price Control we agree a funded level of additions • Licensees are remunerated during the price control period for this assumed level (ie they receive deprecation funding and return on investment as if the investment had been made). • In our annual reports we update forecast with actual additions so that the markets have a latest view of our provisional RAV (subject to efficiency review) • Actual additions are therefore based on actual spend • Traditionally at the next Price Control we will review the efficiency of the expenditure and disallow any inefficient spend • We then confirm an opening RAV number with actual additions for the next period (subject to amending final year forecast spend)

33. Adding costs to the RAV • At the price control review the RAV is projected forward using allowed costs • When operators report their actual costs these are reviewed and the allowed actual costs, subject to a sharing factor, are used to update RAV • The sharing factor enables operators to keep a portion of any efficient underspend but only allows a portion of efficient overspend to enter RAV

34. Recent developments • Under our RIIO framework we have moved to the use of totex in determining RAV additions • Totex is total allowable capex and opex (excluding items dealt with as pass through costs) • A fixed percentage of totex is treated as additions to RAV with the remainder funded in the year incurred • We also now have a sharing factor for over and under spend of totex so that these are shared with consumers. E.g. an overspend of £10m and sharing factor of 50% would see £5m being treated as totex with the remainder being funded by shareholders.

35. Returns allowed – the balancing act Ben Shafran

36. The regulatory balancing act • How do we do it? • Allowed return on the Regulatory Asset Value • Financeability assessment • Return on Regulatory Equity (RoRE) analysis Facilitate investment in the networks Protect the interests of consumers

37. Approach to the allowed return • We set an allowed return on the Regulatory Asset Value (RAV) based on an estimate of the Weighted Average Cost of Capital (WACC) • We set a real vanilla WACC – i.e. we exclude the impact of inflation • Our approach to the WACC consists of: • Pre-tax cost of debt – updated annually based on a 10-year trailing average index • Post-tax cost of equity – estimate based on the Capital Asset Pricing Model (CAPM) and sense-checked against other measures • Notional gearing - an assumption based on credit rating agencies’ target gearing ratios for network companies with BBB-A credit rating, and sense-checked against observed gearing levels of the companies we regulate • Under RIIO, the allowed return may be set at different levels for sector and/or companies that face materially different cash flow risks

38. Cost of debt indexation • Following consultation we decided on an index of bonds with 10+ years remaining maturity and credit ratings in the range BBB-A • The network companies have typically been able to raise debt at a lower cost than the prevailing market rate • At the start of each price control period the cost of debt will be set based on a long-term historical average • It will then be adjusted annually to account for movements in the index

39. Cost of equity - CAPM • CAPM parameters have been affected by the crisis: negative real risk-free rate in the UK, high equity risk premium • We ignore short-term volatility and focus on long-term trends: risk-free rate has been declining for 15 years, but overall returns on equity have been stable in the long-term • Equity beta for regulated companies very low (around 0.5-0.6) but we typically make a more conservative estimate close to 1

40. Cost of equity – sense checks • To ensure that we set the cost of equity at an appropriate level, we sense-check the CAPM range against alternative measures: • Regulatory precedents, in order to ensure consistency over time • Market data, such as premiums to RAV when network companies are sold • We also consider estimates from the Dividend Growth Model (DGM) and the Residual Income Model (RIM), although both have limitations

41. Financeability • The Authority has a ‘financing duty’ to ensure that price control settlements allow network companies to finance their activities at economic cost • We measure financeability with reference to various ratios that assess the ability of a company to meet its obligations to its debt and equity providers • On the debt side, the notional company should achieve ratios that are consistent with the target levels set by the three major rating agencies for regulated network companies to attain a rating in the range BBB-A • On the equity side, we target low and stable ratios for: • Regulated Equity/EBITDA • Regulated Equity/Regulated Earnings

42. Return on Regulatory Equity (RoRE) • RoRE is a common measure that shows the impact of all variations in outturn and ranks their relative importance • We are using RoRE to estimate a likely performance range of the price control settlement, essentially indicating the likely level of risk for the companies • RoRE helps us identify whether the overall settlement achieves an appropriate balance between risk and return

43. Benchmarking Adam Cooper

44. Benchmarking Benchmarking is an important part of UK economic regulation Comparisons within sectors – water, electricity and gas distribution Less easy for GB transmission – three electricity operators of different scale, one gas operator. Can also use the past as a benchmark, but transmission networks are changing in size. Opex/Business support Unit costs Age based modelling

45. Benchmarking Two types of benchmarking undertaken for RIIO Totex benchmarking Disaggregated benchmarking

46. Totex Benchmarking Comparing total expenditure of transmission companies against identified cost drivers. Using total expenditure avoids problems with capex and opex definitions Use international comparators Ofgem kicked off a project in September 2010 Wrote to international regulators seeking common data Legal and practical issues meant that we could only use US data from FERC. Collected data on 28 electricity companies and 26 gas companies to compare with GB TOs

47. Totex Benchmarking Identified cost drivers – for electricity these included: Length of network Energy transmitted Age of assets. Used econometric analysis to rank the transmission companies Difficulty over comparability of data (eg pole km, circuit km, controlling for voltages, depreciation rates) Decided to place less weight on the results compared to other cost analysis tools. We will be publishing an initial report in Summer 2012.

48. Disaggregated Benchmarking We are able to benchmark specific costs in order to determine efficiency Particularly useful for asset replacement, but also for new connections and for business support costs. For asset replacement, companies provide costs of specific projects (eg replace a 275kV transformer or 10km of overhead line). We can compare this to: Historic costs and allowances Other GB TOs International TOs We use specialist engineering consultants to determine whether project costs are efficient, and will set allowances at the level of efficient costs.

49. Disaggregated Benchmarking Business support costs (HR, IT, Property) can be compared to other non-transmission companies We collect cost information with standard definitions across transmission and electricity and gas distribution companies We have also bought information from a specialist benchmarking consultancy firm (Hackett) regarding the business support costs in other network businesses (eg mobile telephones, railways)

50. Benchmarking – the future We hope to work with other energy regulators to share information and develop robust benchmarking studies for transmission We are also looking for TOs to provide evidence that they use benchmarking or market testing to determine that their costs are efficient.