As power supply undergoes a global transition from natural monopolies to emerging markets and in some cases within already fully competitive sectors, designing cost-reflective, efficient and user-empowering rates is becoming an increasingly complex task as a wide array of variables come into play. New technologies and efficiency-gaining processes continuously impact cost structures, as does electricity coverage expansion. Subsidies in electricity rates are also a critical component when discussing power supply ratemaking, while the evolution of market conditions can bring about new ways of setting rates that further consolidate the market by fostering transparency and providing certainty. By pinpointing these intricacies linked to electricity tariff ratemaking, Francisco Salazar, Coordinator of the International Confederation of Energy Regulators (ICER) and Founding Partner of Enix, opened the discussion surrounded by industry experts to delve into these issues during the seventh edition of the World Forum of Energy Regulators in Cancún.
Efficiency, the golden-standard of electricity rates
The name of the game in ratemaking is efficiency. This involves efficiency in investment flows, infrastructure operations and the use of energy services related to price reliability, quality, safety and supply security. “The regulatory regime in Australia is designed to provide networks with incentives to operate efficiently but also to fulfill their reliability and security obligations,” shared Paula Conboy, Chair of the Australian Energy Regulator (AER). “We set revenue for networks for a period of five years, based on an efficient building blocks estimate, integrating CAPEX, OPEX and appropriate levels of financing costs, taxes and depreciation. Once this revenue is set, it is locked for five years and networks are free to operate as efficiently as possible underneath that revenue umbrella.” She explained that the country moved further from cost cutting to actually generating efficiency gains through a service-target performance incentive scheme with appropriate planning at both distribution and transmission levels. “Increasingly, with recent market shifts, a much more integrated approach to planning is required. Consultation is underway in Australia toward an integrated system plan to look at not only poles and wires but zones particularly inducive to renewable energy,” she added.
Spillover effects between wholesale and retail markets
Allocating risks and benefits of technological innovations between operators and consumers over time is also a major variable in the ratemaking equation. Opting for a network operating costs and capital costs approach for efficiency requirements is one side of the coin. Bringing down network costs based on productivity gains and efficiency savings benchmarks coupled with a quality factor in the formula makes up the other side, according to Annegret Groebel, Vice President of the Council of European Energy Regulators (CEER). “When an energy market opens, it is critical that cost savings and efficiency gains are passed on to the consumers as they have the right to choose their supplier from a wide array of options,” she explained. “Compared to Telecoms, the price decrease is comparably low while [in the particular case of Germany] taxes and other charges such as the one promoting and subsidizing of renewables amount to close to 50 percent of retail prices. It makes it difficult to see the benefits to the consumer so we try to measure it by looking at the switching rate. We have facilitated switching by requesting all operators to use the same standards for the procedure to foster consumer trust in the system.” She highlighted that ensuring customers get not only affordable energy but efficient service cost-based energy is the critical factor, compared to distorting market prices through customer subsidies. Ensuring wholesale and operators’ savings are passed on by bridging this efficiency and incentives scheme with the retail market is key.
How far can regulators go in ratemaking and affordability?
Injecting competitive forces and a sense of accountability into historically monopolistic markets, given that no monopoly gives up its role lightly is no easy task, as Scott Hempling, Adjunct Professor at the Georgetown University of Law, points out. Hempling raised seven major directives that effective policy-makers draft before they start setting rates:
- Finding services that answer customer needs.
- Setting performance standards.
- Finding market structures that will cost-effectively provide these services.
- Describing the types of companies that will provide these services cost-effectively.
- Deciding the financial compensation programs that will discourage a zero-sum game with winners and losers.
- Designing competition to find the best people available.
- Holding suppliers accountable by basing compensation on performance.
Three main lessons can be drawn out from this process, according to Hempling:
Put performance first. Regulators can align compensation with performance through three tools: standards, an effective compensation formula, and accountability. “Standards revolve around deciding what outcome is and working toward it. It is not so easy to quantify being at the frontier of innovation,” Hempling says. Finding a way other than quantification to establish innovation is at the core of the challenge. “Finding people who understand technology, consumers, what motivates business and integrating them to civil service is part of the solution.” Hempling highlighted what is often an expertise and resource gap: utilities always know more than regulators, “meaning they can propose standards they can meet easily but coat them as standards with a thick shroud of difficulty before the regulator so as to raise compensation.
Eliminate biases that favor the incumbent monopoly. “Utilities think long term and look to be the companies that dominate market structures for the next century,” says Hempling, to the detriment of market structures and a level playing field competition. “Preventing the “Too Big to Fail” precept must be part of the discussion with the utilities. Assets—generation, transmission, distribution, employees—remain if they fail.”
Rethink the notion of affordability. For Hempling, the regulator’s role is to signal to political actors when prices are going to be too high for the poor. This should be publicized loudly so political actors are accountable.
What of financing and subsidies?
Power production projects are design to last under a long-term perspective to operate at optimal efficiency throughout their entire lifecycle. Being a primarily financial business, focused on mitigating short, mid and long-term risks, energy projects rely on long-term sustainability. For Ariel Yépez, Chief of the Energy Division at the Inter-American Development Bank (IDB), sustainability in energy projects is triple-faceted: financial, environmental and social.
For Yépez, making electricity rates affordable goes well beyond subsidies. “The right incentives and mechanisms must be in place to mimic competitive markets,” she said. When looking at pricing and tariff mechanisms, the IDB focuses on the outcome of incentives parallel to the regulatory instruments that energy policies drafted by the political sphere implements, as it serves both financial sustainability and service provision to a group of people who politicians consider priority, Yépez explained.
When dissecting electricity rate subsidies, the IDB Energy Division Chief believes a separation between the decision relevant to the regulator from that of the policymaker is in order. “Through their ministries and agencies, policymakers focus on the options available to make services available to vulnerable segments of the population,” Yépez said. “In some cases, subsidy design is flawed and falls short on the right approach. As a development bank, our interactions with different governments allow to evaluate the different subsidy mechanisms in place to make sure they are the right ones and target the right social strata.”
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