Regulation, efficiency and the
incentive dilemma with
smart grid investments
SASE 2011
Christine Müller
Madrid, 24 June 2011
0
Agenda
• Project background: IRIN
• Regulation and smart grids

Context

Approach

Theory

Results
• Conclusion
1
Project background: IRIN
• The research project IRIN - Innovative Regulation for Intelligent
Networks - deals with the design of an adequate institutional framework
that supports efficient and effective network development towards smart
grids.
• Central research questions are:

Advancing incentive regulation with respect to smart grids? (WIK)

Which network pricing system sends effective signals for efficient
coordination of network, generation and load installations? (BEI)

Which advancements should be made to incentive regulation to adequately
account for network innovation and transformation? (Öko-Institut)

Are changes required to the current legal framework? (RUB)
2
Energy networks and regulation
• Grid-bound energy supply: natural monopoly (subadditive cost function)
•
Cournot-price (monopolist sets price above marginal cost)
 market failure
 justifies regulatory action (network access and network charges)
• Aim: provide regulatory incentives that network operators actively pursue
welfare-economical aims
•
allocative efficiency
•
productive efficiency
•
dynamic efficiency (technological progress/innovation)
3
New challenges in the energy sector
• The regulatory classification of technological progress in grid-bound energy
supply becomes increasingly crucial due to ambitous decarbonisation and
sustainability targets
• These imply new challenges for networks due to:
•
Distributed, intermittent, offshore generation patters (renewables)
•
Connection of new energy sources / bi-directional energy flows
•
Demand-side management/prosumer

Intelligent network control mechanisms (ICT) needed to integrate
remote and fluctuating production units efficiently into the grid
4
Key: Smart Grids
Smart grids are considered as the key to tackle these challenges.
This requires investments/innovation and the right (regulatory) incentives.
.
Source: European Technology Platform Smart Grids
5
Regulatory dilemma?
Do current forms of incentive regulation provide the right incentives or do we face a
regulatory dilemma with respect to investments and innovation in a smart grids context?
€
Allowed tariffs
(regulated)
Benefits due to
cost reduction
Cost of network
operation
Increasing network investment needs due to
decarbonisation and sustainability targets
t
Source: WIK
6
Approach
• Analysis and evaluation of cost- and incentive based regulatory regimes in
terms of their incentivation of investments and innovation in energy
networks
• Reference: three efficiency measures
• Basis: literature review
7
Theory
Efficiency measures
Allocative efficiency (static)
• Theoretical foundation for the regulation of a natural monopoly
• Objective: Pareto-optimum (marginal cost = marginal utility)
Investments
Regulation
• But: Production not necessarily cost efficient
Productive efficiency (static)
• Given output with minimal cost
• Focus of regulatory measures: efficiency gains/cost reduction
• Maximise welfare with constant technology
Dynamic / innovative efficiency
• Dynamic sector development: investment and innovation
• Long term value for money
• Maximum welfare over time / short term static inefficiency
8
Theory
Cost- vs. incentive-based regulation: regulatory approach
Rate-of-Return / Cost-Plus
Incentive Regulation
Rate-of-Return
Price-Cap / Revenue-Cap
• Regulator allows fixed return on capital which
cannot be exceeded by the regulated
company
• Regulator ex-ante approves a price or revenue
cap and determines an inefficiency reduction
path („x-factor“) per regulatory period
• Benchmarking („as-if competition“)
• If company succeds in reducing costs below
targets it may retain the obtained surplusses
Cost-Plus
Yardstick Competition (YC)
• Revenues are limited to a certain markup on
the effective costs of production
• Tariffs derived from virtual reference firm
(yardstick) based on average cost of reference
companies
• Cost reduction (catch-up) according to
yardstick
• Penalty/reward depends on companies
individual situation vis-à-vis the yardstick
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Theory
Cost - vs. incentive-based regulation: investment incentives
Rate-of-Return / Cost-Plus
Incentive Regulation
Rate-of-Return
Price-Cap / Revenue-Cap
• Incentive to maximise CAPEX within the
threshold of the allowed return (A-J-effect)
• Incentive to reduce costs depends on level and
design of x-factor (benchmarking)
• No incentives to invest efficiently and to
reduce CAPEX
• Strong incentives to short-term cost reduction
(especially OPEX)
Cost-Plus
• Incentive to artificially boost cost as they are
directly transformed in regulated tariffs
• Risk of plunge in CAPEX (focus on short-term
efficiency gains, no incentives for long term
optimisation of capital structure)
• Waste of resources („gold-plating“)
Yardstick Competition
• Strong incentive to invest efficiently
• Issue of comparability
• Risk of collusion / investment retention
10
Theory
Cost- vs. incentive-based regulation: incentives for innovation
• How to incentivise innovation (CAPEX intensive asset innovation) in a smart grid
context?
• Network innovation in grid-bound energy supply are rather discussed cursorily in
academic literature
• Experiences mainly come from other infrastructure markets (telecoms)
• Overall conclusion from academic theory: difficulty/challenge to anchor adequate
regulatory incentives to enhance dynamic efficient investments
• No sound theoretical treatise on the role of dynamically efficient investments in
grid-bound energy supply
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Results (1)
Efficiency measure
Cost-based regulation
Incentive-based
regulation
Allocative efficiency
Productive efficiency
Dynamic efficiency
Process innovation
(OPEX)
(Asset-) innovation
(CAPEX)
Academic void
12
Results (2)
Investment categories and their incentivation*
Type of
investment
Replacement
Art
Ersatzinvestition
der Investition
investment
Expansion
Erweiterungsinvestition
Art der Investition
investment
(Asset)-innovation
Art
Netzinnovation
der Investition
Objective
Angemessenes Niveau der
Adequate level of
ArtVersorgungsder Investition
continuity of supply
zuverlässigkeit
Capacity
(Integration
Art der Investition
EEG-/CHP/Offshore plants)
ArtSmart
der Investition
Grids
grids
Instrument
Q-Element**
Art der
Q-Element
Investition
Bonus/Malus
Investment budgets (TSO)
Investitionsbudgets
Art der Investition
E-Factor (DSO)***
Mechanism
Standards (mit Pönalen)
Cost
Internalsierung
internalisation
Konzept der dnb Kosten
Cost-based regulation
Regulatorische Akzeptanz
Regulatory
dilemma
* On the basis of the German regulatory framework
** Planned for 2012 (reliability)
*** Includes component for DG
13
Conclusion
• Dynamic efficient investments are the essential catalyst to facilitate smart grids to
tackle the overarching sustainability and decarbonisation targets.
• Theory: Incentive regulation does not sufficiently stimulate dynamic efficiency in
the sense of explicit regulatory stimuli for asset innovation leading to a
dynamically efficient CAPEX allocation (in a smart grid context).
• Complex trade-offs to adjust the right incentives (regulatory dilemma)
• Terra incognita in economic theory/academic literature
 Further enlargement on this topic within IRIN
14
WIK Wissenschaftliches Institut für Infrastruktur
und Kommunikationsdienste GmbH
Christine Müller
Postfach 2000
53588 Bad Honnef
Germany
Tel.: +49 2224-9225-85
Fax: +49 2224-9225-68
E-Mail: [email protected]
www.wik.org