ELECTRICITY DISTRIBUTION
STRATEGIES AND BUSINESS IMPLICATIONS
Joao N. Baptista, Chairman of EURELECTRIC Networks Committee
Good morning Ladies and Gentlemen,
As chairman of the EURELECTRIC Networks Committee, it is for me a pleasure to briefly
introduce our Conference dedicated to “Electricity Distribution – Strategies and Business
Implications”.
Exactly three years ago, in November 2001, EURELECTRIC had its previous Seminar on
“Distribution Networks Strategy”. In the meantime, besides other activities, a
benchmarking exercise was performed by a specific WG of the Networks Committee and a
new WG “Distribution Issues” has been working hard for roughly 1.5 years on the current
operating environment of this business. A report of the WG is nearly ready for approval
and a brief outline of its main findings and conclusions will be presented in this
Conference.
On the other hand, the Conference takes place at a very timely moment for our
EURELECTRIC activities and is an excellent opportunity to provide feedback on some of
the more pressing and controversial issues.
As you know, in June 2003, a new Directive on the development of the internal electricity
market was published – Directive 2003/54. Its provisions give a strong push to the
reorganisation of the sector, to the access to the system and to the opening up of the
markets. Those provisions are particularly relevant for the distribution and supply
businesses, considering the large amount of companies affected, the huge number of
customers involved and the rules and procedures to be put in place.
The key aspects of this Directive are:
•
Fully opens electricity markets, within a tight time schedule;
•
Introduces national regulatory authorities;
•
Reinforces network access and unbundling;
•
Strengthens Power System Operators (both TSOs and DSOs);
•
Compels Member States to comply with the Directive from 1st July 2004 onwards.
The Directive 2003/54/EC updates the previous Directive 96/92/EC also related to the
common rules for the internal market in electricity. Concerning the activities of
distribution companies, the new Directive stipulates:
•
Non-discriminatory access to distribution networks;
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•
Legal (though not ownership) separation between distribution and supply functions
within vertically-integrated companies;
•
Independent/effective decision-making framework for distribution business (e.g.
appropriate organisational and remuneration measures), as distinct from the
vertically-integrated parent company, and
•
Sharing of appropriate information between distribution companies and other
infrastructure companies (transmission) to ensure the safety and efficiency of the
system.
One fundamental principle of deregulation of energy utilities is the introduction of
competition at the point of supply, leaving the distribution (and transmission) network as a
natural monopoly and having the energy supply function transferred to the competitive
arena. The distribution network business continues to operate under a regulatory
framework, providing distribution services, at controlled prices, to all suppliers, under
rules for third party access.
In this environment, issues of transparency of cost structures, non-discriminatory access to
network services and the need for separate management inevitably lead to pressures for
separation, or unbundling, of the distribution business.
For the today’s Conference, four major topics have been selected among a large set of
options. During the rest of my intervention I will briefly comment on some of the issues to
be discussed in each session.
Session 1 – OVERALL FRAMEWORK. UNBUNDLING
Session 1 addresses the practical implications of unbundling and reports some practical
experiences.
In what concerns Unbundling of DSOs, the new Directive requires Accounting, Functional
and Legal Unbundling. These requirements go some steps further than Directive 96/92/EC.
The basic elements of the unbundling regime are:
Accounting unbundling (art. 19): requirement to keep separate accounts between regulated
and competitive activities by 1st July 2004. For supply, and until complete market opening
(1st July 2007), separate accounts are required for sales to eligible and non-eligible
customers.
Functional unbundling (art. 15): management may not participate in other activities of the
vertically-integrated undertaking and appropriate measures are envisaged to ensure
independence of the network management.
Legal unbundling (art.15): of the TSO and the DSO from other activities not related to
Transmission and Distribution.
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The new role of distribution companies includes a strict implementation of the unbundling
provisions in order to create a level playing field for all the market players. For integrated
companies, this implies not only the establishment of new structures in management,
organisation and internal data exchange but also the introduction of new accounting
procedures.
It is easily understandable that the unbundling of a distribution business will require the
separation of a complex web of business functions and relationships – both internal and
external - developed over many years, typically in legally complex and layered
organisations, and likely to have key business processes substantially undocumented. It is a
“jigsaw puzzle" business model, carefully structured along many years, that is going to be
strategically separated and reconstructed to form new business models and whose process
has one goal: the separation of the supply function from the network function.
It seems a rather simplistic objective. But it depends on a number of underlying business
streams covering a wide range of issues such as value maximisation, business rationale,
culture, growth, performance, human resources, customers and even geography.
At a practical level, it is necessary to address the detailed implementation of some major
issues like:
•
Business Processes - unbundled businesses will typically split into network, supply
and, potentially, common/shared services functions – for example, Finance, Human
Resources and Information Technologies. Inevitably, it will be necessary to
establish different and formal processes between the supply and network functions,
covering areas such as customer switching, metering and capacity management.
•
Organisation and Structures - the Directive envisages a clearly decision-making
autonomy between the management of the network and the management of the
supply functions. Indeed, this should be extended to the design of "appropriate
measures" applicable to the professional interests of the management teams.
•
Systems and Data - this covers invariably a key set of activities and will impose the
separation of potentially highly integrated applications and databases, without
impairing the resulting businesses to operate effectively. Examples are the core
customer database and customer management/billing applications where the
deregulated environment requires a clear separation between the assets (e.g. meters,
connections) and the supply data (e.g. prices, services, consumption).
The detailed design of the resulting unbundled business models will vary according to
factors such as the legacy organisation structure, the overall industry structure and the
regulatory priorities. But a certain number of structural themes will invariably apply in all
cases.
From the Directive perspective, it can be argued that the logic to separate power
distribution into “supply business” and “wires business” is more than just a response to the
requirement for transparency and non-discriminatory access. In fact, the characteristics of
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the businesses are different - customers, products, value drivers, business strategies – and
in a competitive environment require different strategic management and controls.
For the European distribution utilities, the unbundling process is not optional and
represents a fundamental, and probably non-reversible, restructuring. Further, it redefines
the objectives and the revenue streams for the two unbundled businesses: distribution and
supply.
The success of such a process is crucial to the viability of the companies concerned, and
imposes a careful identification and examination of the major critical success factors. The
efforts to achieve it should not be underestimated, knowing that the effects of the
unbundling will extend throughout the organisation and impact fundamentally on core
business processes, structures and systems.
It will certainly be most interesting to listen about the progresses already achieved in
various countries and how they have been overcoming the inherent difficulties.
Session 2 – REGULATION of DSOs
Natural monopolies have traditionally been subject to regulation because they pose risks to
the society by accruing excess profits and costs at the expense of the customers dependent
on their services. However, creating, through regulation, an efficient business environment
in electricity distribution is a challenging task because of the nature of the industry.
Capacity costs are the electricity distribution industry’s paramount cost factor. Regulation,
thus, is challenged to find a balance between optimal capacity expansion, which requires
cost-coverage and stable signals, and optimal capacity utilisation, which is associated with
fluctuating prices.
In practice, regulators have attempted to face the challenge by developing regulatory
models that meet the requirements of different interest groups: customers, distribution
companies, investors and society.
1) From the customers’ point of view, the regulatory model should protect them from
excess prices of monopoly services. In other words, customers dependent on monopoly
services should not be overcharged and the quality of those services should be sufficient.
These principles require an explicit determination of reasonable prices and appropriate
quality levels and the definition of the role of power quality in regulation.
2) From the distribution companies’ point of view, the regulatory model should give
incentives for optimal capacity expansion and capacity utilization, and it should treat
distribution companies equally. The proper incentives are important to keep distribution
networks in appropriate shape. To avoid conflicting incentives, the signals of regulation
should be consistent with the planning and operating principles of distribution networks.
3) From the investors’ point of view, the regulatory model should protect their rights by
ensuring reasonable returns on investments. Regulation should not weaken the
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competitiveness and attraction of the distribution industry. To fulfil this goal, emphasis
must be put on the methods used to define regulatory asset bases, on allowing reasonable
returns on capital, and on duly accounting for the risks of the distribution business.
4) From the society’s point of view, the costs of performing regulatory activities should be
in relation with the presumable cost savings. The regulator should not interfere with minor
company-specific details and the information required should not unnecessarily complex
and cumbersome for the distribution companies to produce.
Regulators are expected to allow distribution companies sufficient returns to cover the
costs of capital, and they should explicitly disclose, in advance, the methods used in
determining the regulatory asset base, the fundamentals of reasonable operational costs and
reasonable capital expenditures. WG “Distribution Issues” of EURELECTRIC has
collected examples of regulation principles and practices in most European countries. All
these countries are subject to EU legislation either directly or through European Economic
Area Agreements.
Let me now say some words about benchmarking.
Benchmarking has been around in the USA for decades, as a way to measure performance.
It is receiving growing attention in Europe and being used as a regulatory tool to set the
“X” factor in price-cap regimes. European regulators also adopt new techniques,
apparently more sophisticated than those employed in the USA.
However, to the extent benchmarks are drawn from elsewhere, trends in other regulatory
environments must be closely examined to determine whether or not they have any value
and, in particular, to take into account the differences in the network characteristics of the
distributors under regulation. Regulators should be wary when applying external
information, given that configurations and operating procedures of each distributor are, to
some extent, different.
Benchmarks should be used carefully to address the subtleties and complexities of
economic regulation. While recognising that regulators may want, rightly, to make
adjustments to the cost projections on which they base price-cap decisions, regulatory
processes should not seek to depart too far from the circumstances specific to each and
every regulated firm.
Benchmarking of electricity distribution companies differs significantly from
benchmarking of other industries. It is a challenging task due to the diversity in operational
environments. The costs of electricity distribution vary greatly depending on geographic
and demographic issues. Even companies, which seem to have similar operational
conditions, could have very different cost structures. No benchmarking method can yet
accurately appraise the efficiency of each company. Therefore, results of benchmarking
should be taken with precaution for regulatory purposes, because of their direct impact
upon companies’ profits.
We all look forward to hear about potentially contrasting views on this rather “hot” issue.
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Session 3 – INVESTMENT STRATEGIES
Not surprisingly, given the nature of regulated networks and the dependency of the
regulated income stream, this is a subject that attracts considerable debate and, I should
add, concern. The major drivers for investment are known: the need to meet new demand
growth, the need to reinforce networks (for example, to improve resilience and quality of
service) and the need to replace parts of the existing system.
In the comments and statements from managers of distribution companies a certain number
of themes comes recurrently to the surface:
•
Concern at the impact of regulation on returns;
•
The ease with which networks are apparently overlooked or taken for granted;
•
The difficulty of securing planning permission (which is particularly dramatic for
TSOs).
The regulatory frameworks and the role of the authorities involved in this field vary largely
from country to country. In general, the economics, energy or industry ministries still
occupy a central role in energy policy. However, the sector-specific regulatory authorities
have become important actors throughout Europe in ensuring network access and
approving network tariffs. Their competencies vary significantly within the Member
States, due to their different resources and regulatory practices, although their European
wide cooperation is increasing. It must be said that harmonization of regulatory
competencies, procedures and approaches is a prerequisite for a fair internal electricity
market.
A report published by EURELECTRIC on “Business Trends in the European Power
Industry – The Financial Situation of Distribution Business” clearly shows that, for a
significant number of pure distribution companies in Europe, despite being fully regulated
players and, consequently, engaged in less risky activities, returns on investments are not
being sufficient to cover their costs of capital. And the trend seems to be worsening.
In addition, there is a need in many countries to upgrade or renew ageing or deteriorating
networks. This places demands on the ability of companies to raise the necessary capital
from the markets, which requires financially sound companies.
In this framework, the current general mood within companies looks somehow negative
and suspicious, not only due to difficulties experienced in obtaining regulatory approvals
and incentives for long-term investments but also due to the uncertainty about the stability
and predictability of regulatory procedures.
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Session 4 – CUSTOMER FOCUS. QUALITY OF SUPPLY. CUSTOMER
SWITCHING
When looking at the operating environment of Distribution companies it is important to
evaluate the quality of service they provide. This is generally called quality of supply,
although the responsibility depends rather on the distributor than on the supplier (that is
why it makes little sense for consumers to change supplier in order to get a product of
“better” quality, “strictu sensu”).
According to the regulatory regime, overall standards of quality may affect allowed
revenues, usually through a penalty/reward system. In other cases, the performance is
measured but has no direct financial impact.
The quality standards of distribution, as well as the required metering, should be ensured
by the system operators. The growing requirements of better quality customer service and
improved satisfaction focus both on technical issues (duration and frequency of
interruptions) and on service issues (call centre operations, metering and billing
procedures, connection to grid services). If customers are not satisfied with the service, the
regulators interfere. Which leads to tightening regulation models and which raises the
question about the position of DSOs regarding the relationship between quality standards
imposed on them and the existence (or absence) of corresponding economic incentives.
It will be interesting to hear and compare current experiences in this area.
Another aspect of the relation with the consumer is freedom of choice. With the total
opening of the market it will be essential to establish efficient operational procedures that
enable small consumers to genuinely choose their supplier. The internal market will only
deliver its potential benefits if consumers participate actively. Clear and complete
information for consumers is one of the keys to a successful opening up of the markets.
The arrangements for switching supplier, such as the date on which it takes effect, the
reading of the meter, the registration of the change of supplier and the necessary
information exchanges should be decided by the authorities, namely regulators, in close
cooperation with the electricity supply industry and other stakeholders.
Competition in supply is primarily about offering price savings. This is not surprising as
most customers cite price as the main (or only) factor when it comes to sign a new supply
contract. However, price will not indefinitely remain the sole focus. Competition will make
prices offered by different suppliers to gradually converge, as happened in other liberalised
markets. Then, in order to appeal to customers, utilities will need to turn to their customer
service standards and improve them.
In a liberalised market, acquiring new customers is primarily price-driven, while customer
retention is closely linked to the quality of service. Companies will face, rather soon, a
choice between investing in service quality to the consumer - to retain more of their
customers - or competing on price for new customers - to replace those driven away by
poor service.
Finally, a word of caution.
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Competition is not an end in itself. It is, rather, an important means of achieving economic
efficiency and providing benefits to consumers. These benefits are not automatic: if the
transaction costs of introducing competition are very high, they may outweigh the gains.
Moreover, efficiency benefits may be shared unequally. Economists worry more about
efficiency than equity, but equity considerations can make an efficient policy politically
unacceptable. Therefore, both transaction costs and equity requirements are important
aspects of competition, namely for domestic consumers.
Already in certain countries households are allowed to switch suppliers every month, or
even at shorter intervals, at no cost to the consumer. This policy helps competing suppliers
attract customers away from their current suppliers. However, compared with a monopoly
situation, this approach increases enormously the number of potential “transactions” (in
this case changes of supplier) to be managed by the industry. Billing systems must be
changed to allow customers to switch between suppliers quickly and cheaply and
experience shows that the cost of building such systems, where they exist, has been pretty
high.
This means that competition is costly. Evaluations of what consumers are getting for their
money should be performed, (which should include the “time costs” they incur to make
switching decisions). On the other hand, a great deal of consumers has not taken – and
maybe will not take – any benefit from competition because they have not changed
supplier (and have no intention to change).
So, it seems legitimate to ask: is it fair or efficient to compel all consumers to pay for the
high cost of setting up new systems, when some may have no interest in switching? Is it
fair to “socialise” switching costs for domestic consumers?
With this intervention my intention was essentially to raise your interest for the topics of
the various sessions and to stimulate the discussion, even at the expense of some
intentionally arguable statements. I would be happy if I managed to do it.
Thank you for your attention.
Brussels, 9 November 2004
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