1. Autorità per lenergia elettrica e il gas 1 Incentive-based regulation of electricity distribution in Italy FSR Workshop Improving and extending Incentive-based regulation Clara Poletti Italian Regulatory Authority for Electricity and Gas 24 November 2006

2. Autorità per lenergia elettrica e il gas 2 Outline Legal Framework for tariff regulation Distribution tariff regulation: necessary steps Conclusions

3. Autorità per lenergia elettrica e il gas 3 Legal Framework for tariff regulation (1) 1995 (Law 481): an independent regulator, Autorità per lenergia elettrica e il gas (AEEG) is established; the law delegates the regulator to implement an price cap type of regulation. 1997: AEEG starts its operations; 1999: transposition of the 96/92/EC directive into national law (Legislative decree 79/99) a new incentive-based regulation for electricity distribution is approved by AEEG, starting from 2000

4. Autorità per lenergia elettrica e il gas 4 Legal framework for tariff regulation (2) General principles (Law 481/95 and 290/03): price cap regulation; price discrimination on geographic ground not allowed; Price-cap applied only to opex; Revaluation of invested capital; Allowed return on invested capital based on long term risk-free rate; profit sharing set at 50%;

5. Autorità per lenergia elettrica e il gas 5 Legal framework for tariff regulation (3) Regulatory period at least 3 years (2000-2003; 2004-2007) Adjustment rule within the regulatory period: Pt = Pt-1 * (infl –x + y + DSM) Pt is a share of the distribution tariff equal to operational costs; Inf is inflation; X is the productivity rate; Y is a measure of unexpected increase in costs due to exogenous factors; DSM is an adjustment factor to recover costs related to demand side management regulation.

6. Autorità per lenergia elettrica e il gas 6 Distribution tariff regulation: necessary steps un-bundle the existing all inclusive tariff; decide how much price flexibility to leave to the distributor; set the price level for the base period equal to average distribution costs; define a compensation mechanism to take care of differences in costs among distributors; define an adjustment rule for the following years of the regulatory period; define the productivity parameter X

7. Autorità per lenergia elettrica e il gas 7 Distribution tariff regulation: necessary steps un-bundle the existing all inclusive tariff; decide how much price flexibility to leave to the distributor; set the price level for the base period (year 2000) equal to average distribution costs; define a compensation mechanism to take care of differences in costs among distributors; define an adjustment rule for the following years of the regulatory period; define the productivity parameter X

8. Autorità per lenergia elettrica e il gas 8 First step: new tariffs structure for non- residential customers Transmission Distribution Commercial costs of distribution Commercial costs of supply Metering Fuel costs Transmission Distribution + Commercial costs of distribution Metering Supply + commercial cost of supply 1999 2006 Distribution

9. Autorità per lenergia elettrica e il gas 9 Distribution tariff regulation: necessary steps un-bundle the existing all inclusive tariff; decide how much price flexibility to leave to the distributor; set the price level for the base period (year 2000) equal to average distribution costs; define a compensation mechanism to take care of differences in costs among distributors; define an adjustment rule for the following years of the regulatory period; define the productivity parameter X

10. Autorità per lenergia elettrica e il gas 10 Second step: how much flexibility (1) given that information asymmetry is mainly on costs, distributors are allowed to price discriminate: Multipart tariff structures; Menu of different tariffs that each customer can choose. price discrimination is allowed only among customers of the same Type (i.e. customers with similar demand elasticity) price cap is made of two constraints: One on total revenue One on the tariff each customer is asked to pay

11. Autorità per lenergia elettrica e il gas 11 Second step: how much flexibility (2) Customers categories: Residential customers; Low voltage public lightening; Other low voltage customers; Medium voltage public lightening; Other medium voltage customers; High voltage customers.

12. Autorità per lenergia elettrica e il gas 12 Second step: how much flexibility (3) cap on total revenue (V1): cap on the annual revenue which can be obtained by the distributor from each customer category (verified ex-post). Total revenue <= 1*N + 3*kWh Where: 1 is euro cent per withdrawal point (N) 3 is euro cent/kWh

13. Autorità per lenergia elettrica e il gas 13 Second step: how much flexibility (4) Cap on tariffs (V2): the total amount paid by each customer to the distribution company must be less or equal to the amount that she would have paid if the reference tariff TV2 were applied. The TV2 tariff, determined by the regulator, is a three part tariff: TV2=f( 1, 2, 3 ) 1 is euro cent; is euro cent per KW; is euro cent per KWh;

14. Autorità per lenergia elettrica e il gas 14 Second step: how much flexibility (6)

15. Autorità per lenergia elettrica e il gas 15 Distribution tariff regulation: necessary steps un-bundle the existing all inclusive tariff; decide how much price flexibility to leave to the distributor; set the price level for the base period equal to average distribution costs; define a compensation mechanism to take care of differences in costs among distributors; define an adjustment rule for the following years of the regulatory period; define the productivity parameter X

16. Autorità per lenergia elettrica e il gas 16 Average unit costs incurred by the major Italian companies, covering about 98% of the electricity transported in Italy. Data extracted from 2001 companies unbundled accounts. operational costs + depreciation ( life span relevant for infrastructures depreciation is set by the Authority, in line with the average life span used in other European countries) + a fair return on net invested capital (invested capital * WACC) Third step: set the price level for the base period (1)

17. Autorità per lenergia elettrica e il gas 17 Third step: set the price level for the base period (2) 1 components: 1 (disMT), distribution costs on medium voltage level; 1 (disBT), distribution costs on low voltage level; 1 (cot), commercial distribution costs; 3 components: 3 (disAT), distribution costs on high voltage level; 3 (disMT), distribution costs on medium voltage level; 3 (disBT), distribution costs on low voltage level; (cot), commercial distribution costs.

18. Autorità per lenergia elettrica e il gas 18 Third step: set the price level for the base period (3) TV2=f( 1, 2, 3 ) With: 1 = 1 (cot)* 1 (euro cent per withdrawal point) 2 = [ 1 (disMT)+ 1 (disBT)]* 2+ [ 3 (disMT)+ 3 (disBT)+ 3 (cot)]* 4 (euro cent per kW) 3 = 3 (disAT)* 3 (euro cent per kWh)

19. Autorità per lenergia elettrica e il gas 19 Third step: set the price level for the base period (4) Operational costs - profit sharing Any operating cost reduction achieved in the first regulatory period, as a result of productivity gain over the 4% per-year target, has been shared between electricity companies and customers. The companies share of the extra-gains was set at 50% as required by law no. 290/03.

20. Autorità per lenergia elettrica e il gas 20 Third step: set the price level for the base period (5)

21. Autorità per lenergia elettrica e il gas 21 Distribution tariff regulation: necessary steps un-bundle the existing all inclusive tariff; decide how much price flexibility to leave to the distributor; set the price level for the base period equal to average distribution costs; define a compensation mechanism to take care of differences in costs among distributors; define an adjustment rule for the following years of the regulatory period; define the productivity parameter X

22. Autorità per lenergia elettrica e il gas 22 Fourth step: define a compensation mechanism (1) Uniform price constraint: the revenue cap must be the same for all distributors; but costs may be different; Compensation mechanism: necessary to allow distributors to recover their costs; but can distort incentives

23. Autorità per lenergia elettrica e il gas 23 Fourth step: define a compensation mechanism (2) General compensation mechanism: based on cost factors outside the distributors control (e.g. climate factors; customers density, etc.) factor identified by econometric analysis: customer density Compensation () = ( 1*N + 3*kWh) * f(customers density)

24. Autorità per lenergia elettrica e il gas 24 Fourth step: define a compensation mechanism (3) Specific compensation mechanism: distributors can apply for a specific compensation if they are not able to recover costs; cost of service regulation among 167 distributors around 20 applied

25. Autorità per lenergia elettrica e il gas 25 Conclusions Next regulatory period starting on 2008 Some questions to be faced: is the hybrid mechanism working? is V1 a good approximation of the distribution cost function? is price flexibility to be confirmed?

26. Autorità per lenergia elettrica e il gas 26 Thank you www.autorita.energia.it