This document provides an overview of regulatory investment incentives for electricity and gas networks. It discusses major sector trends driving investment needs, such as increasing renewable energy and demand growth. Investments are classified as either market-based or reliability-focused. Regulatory approaches to incentivizing efficient investments are examined, including revenue caps, cost-benefit analysis of projects, and allowing a return on a regulated asset base. Practical examples from countries like the UK, Germany and Norway are also reviewed. The presentation aims to help regulators design frameworks that ensure adequate and efficient network investment.

1. Introduction to Network Regulation
Module 3: Regulatory Investment Incentives
Dr. Konstantin Petrov, DNV KEMA
11 November 2013

2. Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
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3. Sector Trends and Investment Drivers
Major Sector Trends…
Political
 Political trends reflect the major
Technological
Economic
 Technological trends are mainly driven
 Economic trends are mainly driven
elements of the European energy
policy.
 Liberalisation, Gas & Electricity
Directives (and related legal and
regulatory framework and
arrangements)
 Regional integration and
harmonisation
 Climate policy (support of renewable
energies, CO2 emission trading,
energy efficiency)
by climate policy and technological
progress.







Development of RES technologies
Smart metering / smart grids
Network technology
by general economic development,
sector specifics and energy policy.
 Ageing assets and replacement
needs
 Increasing shares of RES and
changing load flow patterns
Energy storage
 Market prices and missing money
Electric vehicles
Energy use / energy efficiency
Shale gas developments
problems
 Financial burden of RES support
schemes
 Mergers / take-overs
 Demand growth
 Increasing regional trade
 Security of supply
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4. Sector Trends and Investment Drivers
…Lead to Need for Investments
Drivers
 Increase in renewable
generation
 Demand growth
Network Implications
 Investments to connect / integrate renewable
generators and to accommodate the
interconnection flows
 De-carbonisation of transport and heat sector will
likely be achieved by a greater use of electricity
(electrical vehicle, heating) which may require
additional investments in (distribution) networks
 Connection of nonrenewable generation
 Reshuffle of merit order
 Asset age
 Significant investments are required to connect
non-renewable generation and to manage
network flows
 With the change of production technologies
connected to the network (and potentially market
arrangements), merit order will also change and
may lead to new investments
 Replacement needs due to aging assets
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Potential Barriers
 Administrative / legal –
mainly due to long
administrative
permission process
 Structural – related to
the organisation of the
network operators
 Financial – raising
capital on financial
markets
 Regulatory – adequacy
and effectiveness of
investment incentives

5. Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
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6. Classification of Investments
For regulatory purposes investments are often classified in two major groups:
market-based and reliability investments.
Reliability
investments
Market-based
investments
Investment characteristics matter for the choice of the
investment appraisal methods by the regulator.
Cross-border
interconnections
Transmission
network
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Distribution
networks

7. Classification of Investments
Investments in transmission and distribution networks exhibit different properties due
to the functions of the networks.
Transmission Networks and Interconnections vs.
•
•
•
•
Distribution Networks
•
A limited number of projects with large
investment volumes
Long planning periods
Large variability of annual investment budgets
due to the impact of singular large projects
Often various projects and/or technical
alternatives exist
•
•
•
A large number of projects with usually lower
investment volumes
Shorter planning periods
Strong relationship with the local demand and
generation characteristics
Lower impact of the individual project
lumpiness
 Minimizing costs while keeping system reliability
 Maximizing net benefits, based on explicit analysis of the benefits resulting
from benefits
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8. Agenda
1. Sector Trends and Investment Drivers
2. Classification of Investments
3. Regulatory Investment Incentives
4. Practical Experience
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9. Regulatory Investment Incentives
The Role of Regulation
 Ensure efficient and sufficient level of investment: regulators should recognize the
on-going changes and provide adequate response in terms of a consistent set of
investment incentives
 Ensure the integration of capital costs resulting from investments in the allowed
revenues
 Provide an adequate return on assets to encourage investors to undertake
necessary investments
 Innovation should be explicitly addressed in the regulatory frameworks
 Remove administrative barriers: legislation / permitting procedures should support
the acceleration of network construction
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10. Regulatory Investment Incentives
Investments are considered in the allowed revenue through the capital costs
(depreciation and return on assets).
Allowed Revenue = Opex + Depreciation + (RAB ● Rate of Return)
Revenue Requirements
Capital costs
Opex
Materials /
Services
Network Losses
Labour
Depreciation
Return on Assets
Regulatory Asset
Base (RAB)
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Rate of Return

11. Regulatory Investment Incentives
The regulatory asset base (RAB) aggregates the net values of the assets used to
provide the regulated services.
Existing assets
Depreciation
Regulatory
Asset
Base
RAB Closing Value =
RAB Opening Value
Capital
contribution
Working
capital
Construction
works in
progress
Asset disposal
+ Investments
– Depreciation
– Asset Disposal
+/- Change of Working
Capital
+/-Change of Capital
Contribution
Investments
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12. Regulatory Investment Incentives
Regulators in Europe have been applying various types of incentive schemes for
network investments.
Regulation
Key Incentive Features
Key Issues
Regulation model,
linked caps
(building blocks)
Base the revenues during a regulatory period on an
ex-ante assessment of the efficient levels of operating
and capital expenditure.
Appear attractive because of the link between revenues
and projected costs. At the same time they allow the
projected costs to be checked for efficiency and allocate
the anticipated efficiency increases to customers.
Regulation model,
unlinked caps
Do not link revenues to costs during the regulatory
period and typically do not require cost projections.
Instead they apply a regulatory formula that annually
adjusts the allowed revenue whereby the starting point
is based on the company’s actual cost in a prespecified year.
May provide the regulated companies with a strong
incentive to undertake only efficient investment. On the
other hand, the regulatory threat that capital costs of
investments can be disallowed ex-post could discourage
even efficient investment projects.
Ex-post efficiency
analysis
Applies the actual (total) costs (including investments)
incurred by the company and set the efficiency
increase factor based on a benchmarking analysis of
these costs (totex analysis).
The incorporation of the undertaken investments into the
ex-post efficiency analysis require addressing several
issues resulting from the long-term nature of capex.
Ex-ante capex
assessment
Used in the building blocks approach and may apply
engineers' reports, benchmarking against other
businesses and the submission of business plans.
There might be a serious information asymmetry present
in relation to capital expenditure.
Quality of supply
Regulators apply standards and incentive schemes to
encourage quality of supply. Application in the majority
of EU countries.
The key issues in the quality of supply regulation relate to
the quality of data collection and data measurement.
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13. Regulatory Investments Incentives
Regulation
Key Incentive Features
Key Issues
Cost of Capital
/ WACC Markups
Weighted Average Cost of Capital (WACC) is a commonly
used method for determining a return on an asset base.
WACC is set equal to the sum of the cost of each individual
component of the capital structure weighted by its share.
Application in majority of EU countries.
CAPM is the dominant model for estimation of cost of
capital. There are several issues related to the
application of CAPM related to the data and
assumptions.
Revenue
Driver /
Quantity
Adjustment
Factor
The main purpose of quantity adjustment factors in the
regulatory formulas is to provide continuity in terms of capex
and opex recovery. These factors link the allowed revenue to
pre-selected cost drivers.
The main issues are related to the design and
specification of the quantity adjustment factor in order
to adequately reflect the cost impact.
Asset
Valuation
Regulators may use different methods to value the RAB,
which is a key determinant of prices that may be charged for
regulated services in the future. Application vary in EU
countries.
The application of these methods is synchronized
with the concepts of cost of capital and depreciation.
The concept may have a strong impact and be
challenged by the industry if it requires optimising-out
certain assets of the RAB (regulatory stranding).
Construction
work in
progress
Construction work in progress (CWIP) is the money spent on
an asset that has not been commissioned at the relevant time.
With regard to inclusion in the RAB, regulators vary widely in
their treatment of funds used for construction.
Regulators may encourage investments by allowing
capitalization of debt and equity costs incurred by the
service provider during the construction period.
Alternatively the regulator can permit inclusion of cost
of capital (allowed return on debt and equity) in the
allowed revenue during the construction period.
Innovation
Incentives
Innovative investments may be encouraged by introduction of
binding standards (obligation to built), explicit investment
allowances, exclusion from efficiency analysis, increased rate
of return on ‘innovative investments’.
Differentiation of ‘innovative investments’,
need to move from pilot / demonstration projects to
arrangements that are also sustainable.
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14. Regulatory Investment Incentives
Regulation should provide a robust analytical and coordinated framework to support
the selection of adequate and efficient investments on national and regional level.
TOOLS
Time:
Ex-ante vs.
ex-post check
Methods:
Determ. vs. stochastic,
non-paramteric vs.
econometric, economic
/social versus financial
Scope:
OPEX; CAPEX;
TOTEX; SOTEX
Orientation:
Project-specific vs.
total investments;
new investments vs.
total asset base
OBJECTIVES
Adequate
investment level
Selection of best
alternative
Recovery of
efficient cost
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Regional
coordination

15. Regulatory Investment Incentives
Incremental
effects
Essential
characteristics
of CBA
Cost-Benefit Analysis (CBA) has been increasingly used by regulators for evaluation
of new investments in important projects.
Alternatives
Perspective
of the
analysis
Uncertainty
Incremental
impact on the
continuation of
status quo
Regional
effects
Investment
Δ Costs
• CAPEX
• OPEX
• External costs
Δ Benefits
• Producer Surplus
• Consumer Surplus
• Benefits TSO/ or
Investor
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16. Agenda
1. Introduction into Investment Incentives
2. Regulatory Regimes and Investment Incentives
3. Treatment of Investments in Price Control
4. Practical Experience
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17. Practical Experience
Regulators have been using various arrangements.
Instrument
Examples for Implementation
Regulation model, linked caps (building blocks)
UK, Ireland, Finland
Regulation model, unlinked caps
Germany, Norway
Ex-post efficiency analysis
Germany, the Netherlands, Norway, Austria
Ex-ante capex assessment
UK, Ireland, Germany (investment budgets)
Investment Allowance
Germany, Austria
Cost of Capital / WACC mark-up
Austria, Italy
Asset Valuation
Application varies in EU countries
Construction work in progress (CWIP)
Regulators vary widely
Revenue Driver / Quantity Adjustment Factor
Germany, UK, Austria, Norway (1997-2006)
Innovation Incentives
UK, Italy
Efficiency Carry-Over Schemes
Austria
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18. Practical Experience
Example: Projects of Common Interest
 Development of a trans-European energy infrastructure; major challenges:
coordination and financing
 Guidelines published in May 2013: Implementation of priority corridors / areas and a
regulatory framework to promote necessary investments
 Identification of eligible projects:
- General criteria: project is viable in a social, economic and environmental way; contributes to
the energy policy and infrastructure targets; at least two member states involved
- Specific criteria: market integration,
security of supply (diversification,
secure system operation) and
sustainability (integration of RES,
GHG avoidance)
 Cost Benefit Analysis
Source: European Commission 2013
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19. End of Session 3.
Dr. Konstantin Petrov
Service Line Leader Markets & Regulation / Business Line Director Gas Consulting Services
DNV KEMA Energy & Sustainability
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8
53113 Bonn
Tel: +49 228 44690 56
Fax: +49 228 4469099
Mobile: +49 173 515 1946
E-mail: konstantin.petrov@dnvkema.com
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20. www.dnvkema.com
Introduction to Network Regulation
11 November 2013