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 of electricity service
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. Cost Plus or rate of return (ROR) Performance or incentive based (PBR)
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. Electricity distribution: network & retail supply businesses
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. A new institutional and regulatory framework was needed
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. The predominant approach: Performance Based Regulation (PBR) for network businesses (T&D)-
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). .

12. Performance Based Regulation (PBR) for network businesses (T&D)
Multi-year tariff periods with periodic adjustments within each period and “full reset” at the beginning of a new cycle
The existence of captive users creates the need to monitor quality of electricity supply and customer service
Transmission and Distribution companies must allow third party access to their networks if there is spare capacity available.
PRICE CONTROLS
QUALITY MONITORING
OBLIGATION TO SUPPLY
OPEN ACCESS
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. Performance Based Regulation (PBR) for network businesses (T&D) – Economic aspectsGC
TAV
DAV
“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. Incentive Based Regulation: Category by category Price Cap
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 )
- 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 applicable standards on:
- Technical product (voltage fluctuations, etc.)
- Technical service (frequency and duration of interruptions)
- Commercial service
- 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 MW
Colombia 0.50 MW (initially 2.00 MW)
Panama MW
Perú and Bolivia MW,
Guatemala 0.10 MW,
Nicaragua 2.00 MW,
Brazil 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
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Pedro Antmann
ERAV
Peds
Calculation of Revenue Requirement
Pedro Antmann

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

25. Calculation of CAPEX Regulatory Asset Base (RAB)
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Peds
Calculation of CAPEX
Regulatory Asset Base (RAB)
Two main views on what RAB represents:
- Shareholder financial investments in the company (maintenance of the financial equity of the business in real terms)
- Physical assets of the company (ability of the enterprise to maintain production of the same level of goods and services over time).
Pedro Antmann

26. Calculation of CAPEX - Alternative approaches
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Peds
Calculation of CAPEX - Alternative approaches
Regulatory Asset Base (RAB): Physical capacity view (cost-based).
Two main approaches:
- Book value (historic cost valuation, widely used for reporting purposes)
- Replacement cost (replace installation with newest technology able to perform the same functionality)
Two options
- Optimized/efficient network replacement cost
- “Greenfield” (existing network is not considered)
- “Incremental”: optimization starting from the existing network
- Existing network replacement cost
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27. Design of the optimized network
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Peds
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
Market competition is thus more effective than regulation in promoting efficiency.
The combination of necessity and direct connection implies large potential exploitative power and ensures that regulation or public ownership is politically inevitable. separating the potentially competitive parts of the electricity supply industry from the natural monopoly parts that must inevitably remain regulated is good public policy.
Pedro Antmann

28. Other parameters in calculation of CAPEX
Pedro Antmann
Peds
Other parameters in calculation of CAPEX
Allowed cost of capital: CAPM/WACC
Economic depreciation: Considering actual lifetime of assets
Market competition is thus more effective than regulation in promoting efficiency.
The combination of necessity and direct connection implies large potential exploitative power and ensures that regulation or public ownership is politically inevitable. separating the potentially competitive parts of the electricity supply industry from the natural monopoly parts that must inevitably remain regulated is good public policy.
Pedro Antmann

29. Calculation of operating expenditures (OPEX)
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Pedro Antmann
ERAV
Peds
Calculation of operating expenditures (OPEX)
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30. Determination of Allowed OPEX
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Peds
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
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31. Allowed OPEX - Design of the Reference Utility (RU)
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Peds
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
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32. Allowed OPEX - Design of the Reference Utility (RU)
Pedro Antmann
Peds
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
Market competition is thus more effective than regulation in promoting efficiency.
The combination of necessity and direct connection implies large potential exploitative power and ensures that regulation or public ownership is politically inevitable. separating the potentially competitive parts of the electricity supply industry from the natural monopoly parts that must inevitably remain regulated is good public policy.
Pedro Antmann

33. Thank you!