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Pulling the plug on electricity price regulation

...a few regulators are adopting hybrid and innovative models to assess and incentivise quality and performance indicators for electricity regulation.

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Regulation aims to balance obligations to both customers and providers. However there are other factors (apart from regulation) that can influence electricity prices. These include changes in demand, generation and legislation. Some countries (such as Estonia, Latvia and Ireland) are abandoning regulation and determining prices based on demand and supply only (with tax regulation). This is due to the preference of regulators for open electricity markets as they believe price regulation can distort the operation of the electricity sector and is a risk to security of supply. However this emerging trend is very slow and it is unlikely that electricity price regulation will be eliminated in the near future.

When a company is the sole supplier of a particular product or service in a market without regulation it is free to charge its customers high prices instead of simply recovering its actual costs and earning a reasonable return on capital. Electricity providers are classic examples of such companies. The electricity distribution industry is typically characterised by a series of national and/or regional monopolies which are regulated to ensure there is no abuse of monopoly power.

Regulation aims to protect customers from exploitation and give incentives/confidence to providers so that they can continue efficient operations and investments. The electricity sector in Belgium provides a recent example of the need for efficient regulation. The Belgian government introduced safety net regulation in 2012 to address concerns about inefficient electricity pricing structure as higher prices were being charged compared to neighbouring countries. Consequently a temporary nine month freeze on prices was applied until December 2012. Under the regulation Belgium’s complex pricing structure was made transparent (by basing it on energy exchanges) and indexation was changed from monthly to quarterly. In 2013 the powers of the Commission for the Regulation of Electricity and Gas (CREG) were increased and now CREG plays a much greater role in regulating electricity prices. This has resulted in increased switching rates and number of suppliers and products. There has also been a decrease in market concentration and prices (which are now comparable to neighbouring countries).

In a typical regulatory process the regulator allows an electricity provider to recover costs that a comparable efficient provider would expect to incur during the regulatory period. Before every regulatory period each provider submits details of its anticipated future costs which are assessed by the regulator. The regulator can make changes to the proposed costs if it believes they are incorrect or inefficient. Based on the final costs the regulator determines either the revenue that the provider can earn or the prices that can be charged by the provider. For example in Australia Distribution Network Service Providers (DNSPs) are regulated by the Australian Energy Regulator (AER). The amount of revenue earned by a DNSP is determined by AER every five years based on the National Electricity Rules (NER). The DNSP can recover a return on capital, operational expenses, asset depreciation costs and tax liabilities. The return on capital (generally the largest cost component) is found by calculating the regulated asset base (RAB) and applying a regulatory weighted average cost of capital (WACC). Though the general approach is similar a variety of regulatory methods and models are have been used in different Australian states.

There are two broad types of regulation methods – cost-based and incentive-based (Exhibit 1). Cost-based regulation is the traditional approach and is still being used in some countries including Cyprus, Greece and Malta. It is being rapidly replaced by incentive-based regulation which can be applied using several models such as yardstick, cap regulation and sliding scale models. Although yardstick and sliding scale models are less popular, the use of cap regulation models – price cap and revenue cap – has increased significantly in recent years. Examples of countries using the price cap model are Malaysia, New Zealand and Slovakia. The other form of cap regulation, revenue cap, is used in several countries including Australia, Czech Republic and Germany. However it is worth noting that model implementation may not be identical for two countries using the same type of regulation.

Exhibit 1: Economic models for electricity price regulation [Source: Network Strategies]
Economic models for electricity price regulation. Source: Network Strategies

Even though regulation is broadly based on the models mentioned in Exhibit 1 the actual implementation can vary significantly from the pure form. In fact a few regulators are adopting hybrid and innovative models to assess and incentivise quality and performance indicators for electricity regulation. The regulator in United Kingdom (Ofgem) has proposed a sophisticated model for electricity price regulation. From 2015 Ofgem intends to use an advanced regulatory framework with Revenue = Incentives + Innovation + Outputs (RIIO). This framework aims to promote smarter and cost-effective networks by supporting electricity providers to make long-term investments and deliver cost-effective outputs on time.

April 2014

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