Improved Regulatory Models For Efficient Investment and Loss Reduction in Electricity Networks

Final Report.
Analysis of Insufficient Regulatory Incentives for Investments

into Electric Networks. An Update.
submitted to: European Copper Institute (ECI),

Avenue de Tervueren 168, b-10; B-1150 Brussels; Belgium
submitted by: KEMA Consulting GmbH,

Kurt-Schumacher-Str. 8, 53113 Bonn, Germany
Dr. Konstantin Petrov / Rosaria Nunes
Bonn, January 2009

Experience you can trust
This document has been prepared by KEMA on behalf of ECI and may not be published or made available to
third parties without the prior permission of KEMA.
Table of Contents
1. Introduction ............................................................................................................................ 1
2. Overview of Regulatory Models ............................................................................................. 3
2.1 Rationale for Economic Regulation .............................................................................. 3
2.2 Current Regulatory Models........................................................................................... 5
2.2.1 Rate of Return Regulation ................................................................................ 5
2.2.2 Cap Regulation ................................................................................................. 6
2.2.3 Yardstick Regulation ....................................................................................... 12
2.3 Quality of Supply ........................................................................................................ 13
3. Analysis of Regulatory Schemes in Selected Countries ...................................................... 15
3.1 Great Britain ............................................................................................................... 15
3.1.1 Institutional Background ................................................................................. 15
3.1.2 Electricity Transmission .................................................................................. 15
3.1.3 Electricity Distribution ..................................................................................... 21
3.2 Germany ..................................................................................................................... 29
3.3 Netherlands ................................................................................................................ 37
3.4 Norway ....................................................................................................................... 43
3.4.2 Electricity Transmission and Distribution ........................................................ 43
3.5 Spain .......................................................................................................................... 46
4. Analysing Incentives for Efficient Investments ..................................................................... 60
4.1 Classification of Economic Efficiency ......................................................................... 60
4.2 Choice of Regulatory Model ....................................................................................... 61
4.3 Treatment of OPEX and CAPEX ................................................................................ 62
4.3.1 Cap Regulation - Building blocks versus TOTEX approach ........................... 66
European Copper Institute i Proprietary
Update Study Insufficient Regulatory Incentives January 2009
Table of Contents
4.4 Treatment of Losses ................................................................................................... 68

4.4.1 Network Losses .............................................................................................. 68
4.4.2 Valuing Losses ............................................................................................... 69
4.4.3 Incentive Schemes for Loss Reduction .......................................................... 71
5. Case Study on Distribution Losses ...................................................................................... 73
5.1 ERGEG’s Position Paper............................................................................................ 74
5.1.1 Benefits of Losses Reduction ......................................................................... 74
5.1.2 Calculation of Network losses......................................................................... 74
5.1.3 Procurement of Network Losses..................................................................... 75
5.1.4 Regulatory Incentive Mechanisms .................................................................. 75
5.2 Simplified Cost-Benefit Analysis ................................................................................. 75
5.2.1 Approach ........................................................................................................ 76
5.2.2 Results ............................................................................................................ 80
5.3 Analysis of Regulatory Incentives in Spain................................................................. 85
5.3.1 Distribution Loss-Reduction Incentive Scheme .............................................. 85
5.3.2 Feasible Investments ...................................................................................... 86
5.3.3 Benefit Retention Period ................................................................................. 86
5.3.4 Trade-off between Incremental CAPEX and Loss Savings ............................ 87
5.3.5 Improvement of the Spanish Loss Incentive Scheme ..................................... 87
5.3.6 Integration of Cost of Losses into the Revenue Requirements ...................... 90
6. Conclusions ......................................................................................................................... 91
7. Selected References............................................................................................................ 94
APPENDIX 1 Germany – Cap Setting Methodology ................................................................ 98
APPENDIX 2 Germany - Quantity Adjustment Factor for Distribution ................................... 100
APPENDIX 3 Case Studies on Network Losses .................................................................... 102
European Copper Institute ii Proprietary

Tables
Table 1: Transformer Purchase Price and Estimated Losses.....................................................78

Table 2: Projected wholesale price (simple annual average) in Spain (from 2008 to 2020) .......80
European Copper Institute iii Proprietary

Figures
Figure 1: Cap regulation with decreasing price level ....................................................................8

Figure 2: Types of cap regulation ...............................................................................................10
Figure 3: Regulatory Account .....................................................................................................32
Figure 4: Economic regulation from 2007 – Annual procedure...................................................45
Figure 5: Allowed revenues and tariff setting..............................................................................46
Figure 6: Benefits associated with operating expenditure savings .............................................63
Figure 7: Benefits associated with capital expenditure savings..................................................65
Figure 8: Results 400 kVA transformers .....................................................................................81
Figure 9: Results 630 kVA transformers .....................................................................................81
Figure 10: Results 400 kVA transformers (i=6%; ΔI=+/-20%) ....................................................82
Figure 11: Results 630 kVA transformers (i=6%; ΔI=+/-20%) ....................................................83
Figure 12: Results 400 kVA transformers (i=6%; ΔP=+/-10%) ...................................................84
Figure 13: Results 630 kVA transformers (i=6%; ΔP=+/-10%) ...................................................84
Figure 14: Illustration of Reduction of Allowed Inefficient Costs .................................................99
European Copper Institute iv Proprietary

1. Introduction
In 2002 KEMA Consulting prepared a report on “Insufficient Regulatory Incentives for Efficient
Investments into Electric Networks” for the European Copper Institute (ECI). In this report KEMA
Consulting studied the properties of the regulatory regimes in three countries (Britain, the Neth-
erlands and Spain) and their potential impacts for investing in efficient capital-intensive equip-
ment for electricity networks. The study identified several reasons why such equipment may not
be purchased by companies operating under cap regulation.
The ECI has asked KEMA Consulting to update the previous study, analysing incentives for effi-
cient investments taking into account the current regulatory models. In addition, KEMA should
extend the study by adding a new chapter. The new chapter deals with the regulatory treatment
of distribution network losses in the context of the new European Commission (EC) regulations.
The Strategic European Energy Review puts a clear focus on greenhouse gas emissions; there-
fore the European Commission has set a strategic objective to reduce CO 2 emissions by (at
least) 20% by 2020. The efficient use of energy and reduction in primary energy consumption
would help to achieve the targets. The Energy Efficiency Action Plan has set an indicative goal
of reducing energy consumption by 20% by 2020. It suggests several initiatives to improve en-
ergy efficiency in the coming years. Network loss reduction in the power systems is one of these
initiatives. This issue was discussed in the recent consultation paper “Treatment of Losses by
Network Operators” published by the European Regulators Group for Electricity and Gas
(ERGEG) 1 . ERGEG is currently developing a set of recommendations for establishing effective
loss reduction incentives for the electricity network operators.
The structure of the remainder of this report is set out as follows:
Chapter 2: Overview of Regulatory Models
This chapter takes a closer look at the regulatory models in Europe and describes their main
characteristics. This chapter serves as an initial step in preparing the discussion on incentives
for efficient investments.
1
This Position Paper may be found at www.energy-regulators.eu/portal/page/portal/EER_HOME
European Copper Institute 1 Proprietary

Chapter 3: Analysis of Regulatory Schemes in Selected Countries
This chapter contains a detailed description of the regulatory regimes in five selected countries
namely Great Britain, Germany, the Netherlands, Norway and Spain, in order to demonstrate
how the regulatory models are implemented in practice.
Chapter 4: Analysing Incentives for Efficient Investments
Whereas the two previous chapters provide an examination of theoretical developments and
applications of regulatory models in practice, this chapter focuses on how regulation provides
incentives to encourage efficient investments and loss reduction programmes.
Chapter 5: Case Study on Distribution Losses
The chapter provides a summary of the ERGEG’s report on the regulatory incentives for loss
reduction. In addition, we prepare examples for cost benefits analysis supporting the decision to
invest in an energy-efficient distribution transformer. A case study is carried out for Spain.
Chapter 6: Conclusions and Recommendations
This chapter summarises the project findings and provides recommendations for potential im-
provements.

2. Overview of Regulatory Models
2.1 Rationale for Economic Regulation
In a narrower definition, regulation may be defined as any actions by government or specialised

authorities to control specific parameters of companies, such as price, revenue, cost and quality
(KEMA, 2002).
The traditional economic rationale for regulation concerns the maximisation of efficiency in mo-
nopolistic industries.
Economic theory advocates that firms have the strongest incentives to provide best service to
customers in terms of price and quality of service when they are in competition. Therefore,
power industry reforms have introduced competition wherever possible (e.g. power generation,
wholesale and retail markets). Competition, however, is not feasible in all segments of the
power sector; transmission and distribution networks (and their related functions such as system
control and balancing) remain natural monopolies.
Natural monopolies arise if duplication of an infrastructure or service provision is uneconomic,

i.e. the character of the technology and demand dictate that the service is cheaper if the de-
mand is met by a single firm rather than by competing firms. The underlying source of this prob-
lem is subadditivity of costs. Assume that one firm produces a given level of output x and that
there are two other firms producing x’ and x’’ such that x’+x’’=x. Then, subadditivity implies that
c(x) <c(x’)+c(x’’) in which c(x) stands for the costs to produce the given output x. More gener-
ally, a natural monopoly arises if the condition c(∑x i ) < ∑c(x i ) applies.
The main sources of the existence of subadditivity of costs are economies of scale and econo-
mies of scope. Economies of scale imply that average costs fall with increasing output. The
most prevalent source of economies of scale is fixed costs, costs that are incurred irrespective
of the level of output. For example, in the case of large transmission lines or gas pipelines, the
capacity of the pipe can be increased without a commensurate increase in investment costs. As
another example, it is cheaper on a per household basis to deliver electricity to all the house-
holds in an area, than for two companies to deliver electricity to half the households in an area.
This is because the latter would require unnecessary duplication of a major part of the distribu-
tion network. Economies of scale may also occur because firms with a larger scale of opera-

tions may also be able to reduce costs by having proportionately lower overheads or by being
able to employ more specialised and efficient personnel.
Scope economies can be found in the joint provision electricity and telecommunication services
using the same infrastructure components.
Sometimes it is argued that the presence of economies of scale is not sufficient by itself to elimi-
nate the possibility of some form of competition. This is because even in the presence of scale
economies, competition might be likely in a market if it were possible for an entrant to gain mar-
ket share by undercutting the incumbent’s prices, and then exit from the market when the in-
cumbent firm responded with a price cut of its own. In such circumstances, the simple threat of
competition would be enough to prevent the possibility of excess monopoly profits. If this proc-
ess is to work, however, the entrant must be capable of leaving the industry without incurring
excessive costs when the incumbent firm responds by cutting its prices. For this to be the case,
the technology must be such that the entrant does not have to make irrecoverable investments
in order to enter the market, in other words there must be no “sunk costs”. Electricity distribution
networks need large and long-lived investments that cannot be recovered before an entrant
leaves the industry. Hence the role of potential competition in disciplining an incumbent firm with
a monopoly distribution network is very limited.
As a result the monopolistic areas of electricity businesses (i.e. transmission and distribution)
are controlled and monitored by regulatory authorities. One of the regulator’s tasks is to ensure
that the transmission and distribution companies do not exploit their market power by operating
inefficiently and charging high prices and/or inadequate quality of supply. In other words, a good
regulatory regime should provide companies with similar opportunities and incentives to those
they would face in a competitive market. However, in mimicking market forces, the regulators
should also balance this duty with the need to consider the interests of network owners, in order
to ensure that network businesses earn a reasonable rate of return on their (efficient incurred)
investment (Scarsi and Petrov, 2004).
A further economic rationale for regulation is to deal with the market failure in relation to exter-
nalities. Some transactions give rise to societal benefits or costs that are not internalised into
the market’s pricing mechanism. They concern the third party effects of certain transactions that
the principal parties are not economically motivated to consider as part of their pricing analysis.
For example, incentive regulation mechanisms can be designed to encourage utilities to main-
tain and improve energy efficiency and environmental protection practices.

2.2 Current Regulatory Models
2.2.1 Rate of Return Regulation
Under rate of return pricing, the regulator sets prices for the utility in such a way that they cover
the utility’s costs of production and include a rate of return on capital that is sufficient to maintain
the investors’ willingness to replace or expand the company’s assets. Hence it is referred to as
rate of return regulation. This regulation method is also known as "cost of service" or "cost-plus"
regulation (with the allowed rate of return representing the "plus" element). It is still widely prac-
ticed in the USA while in Europe many regulators have implemented incentive regulation
schemes.
An example of a simplified formula for rate of return price control is set out below.
Rt  TC t 1  ROR * RABt 1
Where:
Rt allowed revenue in t
TC t-1 total cost in the previous year (inflated)
ROR (allowed) rate of return
RAB t-1 regulatory asset base
It shows that the allowed revenue in the year concerned, year t, is set equal to costs (operating
and maintenance costs and depreciation) of the previous year, plus an amount to give a normal
return on the capital invested. The allowed revenue is converted in tariffs which remain the
same for a period until they are reviewed in the next round. The allowed revenue and prices are
generally set usually every one or two years.
Rate of return regulation is flexible and responsive to the regulatory authority’s wishes concern-
ing service quality and other matters, because the regulatory authority can allow or disallow any
costs it chooses.
It has nevertheless two well-known and significant disadvantages. Firstly it does not provide in-
centives to control and reduce costs. The company knows it will be able to recover increasing
costs with a subsequent increase in price in the following year. Provided that price reviews take

place with sufficient frequency, the company pays no penalty for inefficiency. Suppose the regu-
lator tries to reduce costs by setting prices so that costs in real terms are a certain percentage
lower than last year’s costs. The company has no incentive to make these costs savings; if they
are made, they are in effective immediately taken from the company and given to consumers in
the form of lower prices. The company does not gain from efforts to reduce costs, as the rate of
return earned on capital is still the same. Hence there is no reward for the effort of holding costs
down or reducing them.
Secondly, it provides an incentive for the company to over-invest in capital equipment and plant.
Assuming that the rate of return is set at an adequate level, the regulated company could invest
more and more in plant and equipment and other assets and therefore under rate of return regu-
lation, the company can earn an adequate return on its larger investment. This incentive is
clearly increased if the utility is earning a higher than normal rate of return. This feature of rate
of return regulation is sometimes known as “gold-plating” 2 . It can be difficult for the regulator to
identify this over-investment by inspecting investment plans, and hence prevent it from happen-
ing.
Numerous regulatory methodologies have been developed to counteract the deficiencies of rate
of return regulation to various degrees. All these alternative methodologies focus on the estab-
lishment of incentive mechanisms by moving from rate of return to incentive based forms of
price regulation, and to the application of comparative approaches by means of benchmarking
as opposed to the only individual performance assessment of network service providers.
2.2.2 Cap Regulation
The “cap” refers to the upper limit that is placed on prices or revenue, hence the term “price
cap” or “revenue cap”. It was first applied on a large scale to British Telecom in the UK in 1984.
Cap regulation is designed to give the utility a strong incentive to reduce costs. This is partly
done by setting the prices or revenues that a company can earn over a number of years inde-
pendently of the costs it incurs over this time. It is also achieved by allowing the company to
keep at least a portion of the benefits of any efficiency improvements over an assumed level of
improvements.
Under cap regulation, prices or revenues are set in advance usually for a period of three to five
years, allowing the company to benefit from any cost savings made during that period, but re-
2
This behaviour is also known as Averch-Johnson effect (see Averch and Johnson (1962)).

calculated at regular intervals in order to bring them back into line with underlying costs. The
main difference between cap regulation and traditional rate of return regulation is that under the
former system, prices are no longer directly based on the company’s actual costs. At one ex-
treme, under a pure rate of return scheme, prices would be set on the basis of the company’s
actual costs. This provides no incentives for higher productivity. The other extreme is to com-
pletely unlink prices from actual costs; this provides very strong incentives for productivity im-
provement. Cap systems are located somewhere between these two extremes. That is, prices
and costs are detached from each other, but not to their full extent; there still remains some in-
terdependency.
In order to take account of unpredictable rates of inflation in an economy, a cap regulation re-
gime typically allows a company to vary its prices / revenue in any year by an amount linked to
the overall level of inflation, as measured by the percentage change in an appropriate price in-
dex. This is often on an historical basis. This inflation adjusted price / revenue level is then usu-
ally adjusted by a percentage, the X factor that reflects, among other things, the real change to
costs that the regulator assumes is reasonable. The name “RPI-X” is often used, as RPI (or Re-
tail Prices Index) is the name of the general prices index in the UK.
The starting level and the development path of prices / revenue are fixed such that under nor-
mal conditions, the utility will earn a fair rate of return in each period. This implies the imposition
of a time path of price / revenue ceilings for a period usually extending over several years. The
easiest way to calculate the price path is according to the following formula:
Pt  Pt 1  (1  CPI  X )
Where:
P price;
CPI inflation (consumer price index);
X productivity growth rate; and
t time index.
The same formula could be applied to a revenue cap replacing the price (P) with the revenue
(R) of the company.

Figure 1 depicts a possible price development path over the regulatory period 3 . If the regulated
company manages to improve its efficiency more than is required by the regulator, an additional
profit is generated (yellow field).
Benefit to customers
(lower prices)
Price
Expected improvement
(RPI-X)
Benefit to firm
(higher profit) Actual improvement
time
Regulatory period
Figure 1: Cap regulation with decreasing price level
The price / revenue development path does not need to be necessarily decreasing. There are
several cases where the company may be allowed to increase its network charges. The circum-
stances where this might occur can be as follows:
 Inflation is higher than the efficiency requirement of the regulator;
 High investment needs are recognised by the regulator and included explicitly in the
specified revenue or price path;
 OPEX (e.g. labour and/or material cost) increases with a rate which is higher than gen-
eral inflation and the regulator agrees on this increase;
 The price control formula incorporates demand growth and associated revenue adjust-
ments; and
3
The regulatory period is generally defined as the period of time for which the upper limit to prices or
revenues is set in advance. Often this upper limit is indexed over the regulatory period to a measure of
inflation and/or changes on other cost drivers.

 The initial price / revenue at the start of regulation is below the cost reflective price level
and there is a need to ensure gradual convergence towards a cost reflective level.
2.2.2.1 Types of Cap Regulation
As mentioned above, in cap regulation the cap, or upper limit, may be placed on prices or reve-
nue. Price caps can be divided into:
 “Individual” price caps, where the regulator sets the upper limit for each individual price.
This is the most direct form of price control, but its application is limited to situations
where the number of services provided is small and stable and costs are easily identifi-
able.
 “Tariff baskets”, where prices are grouped into one or more baskets on the basis of the
services to which they apply. A representative weighted average price for the basket is
calculated and an upper limit or “cap” is then applied to the weighted average price. The
service provider faces a cap on this weighted average price, which increases over time
on the basis of a RPI-X formula. Advantages of tariff baskets include that in theory the
business has an incentive to adopt economically efficient prices and it is consistent with
the principle of light-handed regulation. However, the tariff basket is sometimes found in
practice to be difficult to understand and to implement. In deriving the weighted average
price, the weights chosen may be based on a range of factors, these factors are typically
based on either the revenue or quantity shares of each service in the basket. These
weights may be fixed at the start of the regulatory period and then held constant
throughout the period, or alternatively, reset at suitable intervals.
While with price caps the limit is applied to the actual price or an average of the actual prices
charged, with a revenue cap, the upper limit is applied to the revenue earned. Revenue caps
can be divided into:
 “Fixed revenue” caps or a pure revenue cap as it is sometimes referred to. The cap or
upper limit of revenue is set at the start of the control period as an absolute amount and
is adjusted each year only for general price inflation and the X factor. It is sometimes
called a “fixed” cap, because the amount of allowed revenue does not normally vary
automatically with a change in volume.
 What we refer to as a “variable revenue” cap and which we define as one where the al-
lowed revenues are indexed (in addition to “CPI-X”), generally to some measure of

change, in one or more other cost drivers, e.g. units distributed or customer numbers or
length of network. An advantage of this type of cap is that it allows an automatic ad-
justment for some changes in costs that are beyond the control of the service provider.
One form of cap not covered above is the “average (or unit) revenue” cap, sometimes also re-
ferred to as an “average yield” cap or “revenue yield” cap. These are sometimes classified as
price caps and sometimes as revenue caps. Under an average revenue cap, an upper limit is
placed on the average revenue per unit of throughput the business is permitted to earn in any
year. The average revenue is then allowed to vary per year on the basis of a ‘RPI-X’ formula.
One of the features of an average revenue cap is that it provides incentives to the regulated
business to increase sales, which may or may not be an advantage.
The term “hybrid cap” was initially used (in the early 1990s) to describe a “hybrid” of a revenue
and price cap but is now used sometimes to describe a wide variety of forms of revenue cap or
average revenue cap with some linkage to demand (i.e. units distributed or sold). Because of
the ambiguity over the meaning of the term “hybrid cap” and to avoid confusion, we generally do
not use the term when describing caps.
4
The above classification is summarised in Figure 2 below.
Cap
Regulation
Price Cap Revenue

Cap Cap
Individual Price
IndividualPrice Average
Fixed Revenue
Variable Revenue Variable Revenue
FixedRevenue Fixed Revenue
Tariff
Tariff BasketCap
Cap Cap
Cap Cap
Cap Cap
Figure 2: Types of cap regulation
4
For ease of presentation, this excludes the “hybrid” cap, which is a generally a hybrid of a revenue cap
and some form of price cap. The cap can be expressed as an upper limit either on revenue or on average
prices.

2.2.2.2 Price versus Revenue Caps
One basic difference between price and revenue caps is the way they respond to changes in
the quantity demanded. Under a price cap, a service provider’s revenue will move in the same
direction as any change in the quantity demanded, and hence the risk of an unexpected change
to demand can be said to lie with the service provider. Under a revenue cap, the level of reve-
nue is guaranteed for the service provider, and hence the risk of a demand change can be said
to lie with the customer.
The appropriateness of the different types of cap will depend partly on how the costs of provid-
ing the regulated service change with differences in demand. For example, assume that cost
structure of a business is such that the average cost per unit sold does not vary with a change
in the volume sold. Under a simple price cap, the business’ average revenue will not vary with a
change in the volume sold and total costs will move in proportion with total revenue. Hence a
price cap would be appropriate in that under it there should be no change in the service pro-
vider’s rate of return with a change in demand.
On the other hand, if there were little change in total costs with a difference in demand, then a
revenue cap incorporating properly selected cost drivers may be a more appropriate means of
price control. However, depending on how the price cap regime is designed, a price cap
scheme may encourage the service providers to establish efficient tariffs systems, e.g. using
tariff basket caps.
2.2.2.3 Setting the Cap
The most commonly-used ways of setting the cap are the:
1. Building blocks approach – under this the regulator first assesses the maximum regu-
lated revenue (MAR) of the regulated entity for each year of the regulatory period by as-
sessing separately for each year the components of the maximum revenue; e.g. the
OPEX, depreciation, regulated assets base (RAB) and (in order to calculate the depre-
ciation and RAB) the CAPEX. The next step is to convert this series of MARs into a cap
formula with a starting value that is adjusted each year by an X factor and inflation. The
regulator does this by selecting the starting value and calculating an “X” so that the pre-
sent value of the revenues under the cap formula should be the same as the present
value of the series of projected MARs. This step is referred to as the “smoothing” pro-
cedure and we refer in this report to the resultant X as the “smoothing X”.

2. Total expenditure or TOTEX approach - under this approach, the regulator does not
consider OPEX and CAPEX projections separately on a year by year basis. Tradition-
ally, no differentiation is made between OPEX and CAPEX. The potential for efficiency
increases in the TOTEX is determined entirely from a benchmarking exercise. Some
regulators (e.g. in Norway, Germany and Austria) set the annual TOTEX efficiency re-
duction equal to the X in the cap formula. Others, e.g. in the Netherlands, use the
“smoothing procedure” described above for the building blocks approach. In this case,
they apply the annual TOTEX efficiency reduction to get the projected maximum allowed
revenue for each year. Using this step would allow the regulator, for instance, to add
non-controllable costs to the maximum allowed revenue for each year, before applying
the smoothing procedure.
We discuss the differences between the two approaches further in Chapter 4.
2.2.3 Yardstick Regulation
Under the regime of yardstick regulation, prices or revenues are indexed to an average of indus-
try performance as opposed to the company’s own values. Yardstick regulation is not based on
an assessment of the cost position of individual utilities but upon a comparison of prices or cost
positions and cost determinants between companies. Under a "yardstick" mechanism based on
price information, utilities are not allowed to charge higher prices than some statistical mean
price that is calculated over all utilities, unless this was justified by their "special operating condi-
tions".
This form of price control was suggested by Shleifer (1985) 5 . Each in a group of comparable
regional monopolists has a price cap determined by the average cost of the others in the group.
The advantages of this method of regulation include that it is transparent, non-intrusive, com-
pletely de-linked from the price control and there is little scope of gaming. It provides a strong
incentive to operate better than the yardstick as this would generate profits. In turn, more effi-
cient operation will bring down the yardstick and will hence lower prices to end-customers in the
longer term. This effect is very similar to the dynamics of competitive forces.
However, it tends to require frequent calculation and provides strong incentives to firms to in-
crease their volumes sold. In addition, problems with the practical implementation of yardstick
regulation include that:
5
See Shleifer, A. (1985) “A Theory of Yardstick Competition”, Rand Journal of Economics, Vol. 16, pp.
319-327.

 it can only be applied to services where there is a sufficient number of comparative firms
whose data can be used to form the yardstick;
 firms are inherently different because of factors they cannot always control;
 firms rarely start from the same efficiency position;
 collusive behaviour is possible; and
 due to decoupling of cost and revenue, the regulator should be prepared to accept bad
financial performance and even bankruptcy of regulated companies.
2.3 Quality of Supply
In the case of rate of return regulation, utilities are generally free to define their own investments
and quality levels. In line with economic theory, this tends to create incentives for oversized in-
vestments and quality. Not surprisingly, many regulatory regimes therefore focus on preventing
this type of inefficiency and sub-optimally high levels of investment. Simple types of cap regula-
tion, on the other hand, may allow a regulated company to reduce both its cost and its quality of
supply by cutting investment, maintenance, or personnel with the aim of increasing profits. Both
theory and practice suggest that incentive regulation without additional quality measures even-
tually leads to quality degradation: the strong costs reduction incentives may have the perverse
effect of choosing sub-standard quality levels. Price and quality are inextricably bound together:
higher quality involves higher cost hence higher prices. At some point, there will be an optimal
trade-off between the costs and benefits of quality; this happens when the marginal benefits of
quality are equal to the marginal costs of delivering this quality. Ideally, the regulatory system
would render such an optimal outcome.
There are a number of quality regulation instruments available and being used by regulators.
One of the simplest instruments is public exposure. The idea is that exposure to public judgment
(customers, media, etc.) encourages companies to maintain and, if necessary, improve quality.
Publishing information can also support customers or customer representation groups in nego-
tiations with the companies. The advantage of indirect instruments is that it is not necessary to
define which level of quality should be targeted at and the direct regulatory costs are relatively
low. However, the effectiveness of publishing information can be limited, as public opinion may
not be highly influential in the case of a monopolist.
Another method is then the use of minimum standards which come in the form of limits to the
number and duration of outages. This may or may not result in a penalty. Usually two types of

minimum standards are used: overall standards or guaranteed standards. Overall standards
measure performance at the system level (e.g. customer minutes lost, percentage of customers
with an outage, or some aggregated quality index). The disadvantage is that they only pick up
the average performance; there may still be substantial differences between individual custom-
ers. This leads to allocative inefficiency due to the lack of the penalties’ discriminating power.
Individual standards score better in this regard as they relate to the level of service delivered to
individual customers. Here compensations are given to those who were actually affected by
sub-standard performance. The symbolic value of the individual compensation can also be quite
substantial. The general disadvantage of minimum standards is that companies who are ex-
pected to maximise profits will be driven towards them i.e. they will not deliver higher quality
levels than strictly required. The effect of this is that quality levels will eventually converge to-
wards the level of the standard which is not likely to be the optimal level in any case.
Quality incentive schemes can be seen as an extension of a minimum standard because they
introduce a direct link between the company’s revenue and the level of quality performance.
Performance can be measured at different levels ranging anywhere between the system level
and the performance delivered to individual customers. The penalty/reward structure maps the
level of performance with the financial impact (either a penalty or reward). There are a large
number of possible incentive structures. The structure may be symmetrical or asymmetrical,
continuous or discrete, etc. Dead bands may be applied while the amount of penalties and re-
wards may or may not be bounded. The level of penalty and award is essential. Setting too low
penalties (or too high rewards) may hamper the incentives while too high penalties can increase
risk for the company.

3. Analysis of Regulatory Schemes in Selected
Countries
While the theoretical literature on regulatory models is quite rich, it still provides relatively little
guidance for practical application in real world circumstances. Therefore, it is important to take
into account international experience, in order to identify “existing facts” in the regulatory prac-
tice.
To illustrate the impact of regulation on investment decisions by electric utilities, this section
comprises a detailed description of the regulatory regimes in five selected countries, namely
Great Britain, Germany, the Netherlands, Norway and Spain. Each of these countries is dis-
cussed separately, starting out with a brief general overview. In addition, the price control formu-
lae, which are at the heart of the price regulation of network companies, are explained in detail.
3.1 Great Britain
3.1.1 Institutional Background
Electricity reforms have been led by the Electricity Act of 1989, the Utilities Act 2000, the Com-
petition Act 1998 and the Enterprise Act 2002 which resulted in the unbundling and privatisation
of the electricity industry and introduction of access to the networks and competition into the
wholesale and retail markets. The market has been fully open for all customers since 1998. In
the area of electricity, the Office of the Gas and Electricity Markets (Ofgem) is responsible for
protecting consumers, which it does by promoting competition, wherever appropriate, and regu-
lating the monopoly companies which run the electricity networks.
3.1.2 Electricity Transmission
The price control formula and conditions for the Transmission Operators (TOs) are contained in
their licences. This price control does not cover the revenues of transmission system operation

activities. We have used the Electricity Transmission Licence of the National Grid Electricity
Transmission (NGET) 6 , as the source of our findings.
3.1.2.1 Cap formula
The current price control runs from April 2007 - March 2012 and is based on a revenue cap.
This is referred to as the Transmission Network Revenue Restriction and has the following for-
mula:
TO t  PR t  TIRG t  PT t  IPt  CxIncRA t  LC t  IE t  ER t  DIS t  TS t  K t
Where:
TO t is the maximum revenue;
PR t is the base transmission revenue; see 3.1.2.2 below;
TIRG t is the aggregate of the annual revenue allowances for specified transmission investment
projects relating to the transmission investment for renewable generation (TIRG); see
3.1.2.7 below;
PT t is the revenue adjustment term for allowed pass through items; see 3.1.2.4 below;
IP t is the revenue adjustment term for incentive payments; see 3.1.2.5 below;
CxIncRA t is the revenue adjustment term for the capital expenditure incentive (it equals zero for
all years other than that starting in April 2012); see 3.1.2.7 below;
LC t is the revenue adjustment term for the full recovery of efficiently logged up costs ad-
justed for financing costs (it equals zero for all years other than that starting in April
2012); see 3.1.2.6 below;
IE t is the specified allowance for the costs associated with the issuance of new equity (ap-
plies to the Scottish TOs, SPTL and SHETL, only);
ER t is the specified allowance for the price control extension reconciliation revenue adjust-
ment term;
6 http://www.ofgem.gov.uk/Networks/Trans/Pages/Trans.aspx

DIS t is the difference between the total amount charged to the licensee (i.e. NGET) by Scot-
tish Hydro-Electric Transmission Ltd. (SHETL) and Scottish Power Transmission Limited
(SPTL) in respect of site-specific charges (i.e. charges for necessary items in carrying
out of works and the provision and installation of electric lines or electrical plant or me-
ters) and the total income recovered by the licensee in respect of excluded services in
relevant year “t-1” from customers;
TS t is the difference between the total amount charged to the licensee by SHETL and SPTL
in respect of transmission owner undertaking works (which include works at a relevant
connection site) and the total income received by the licensee in respect of users who
terminate relevant bilateral agreements for connection and/or access rights to the trans-
mission system for relevant year “t-1” (including capital contributions);
Kt is the revenue restriction correction term; see chapter 3.1.2.3 below.
All of the above terms are for year “t”, unless noted otherwise, which means the 12 months
starting 1 April of year “t”.
3.1.2.2 Cap-setting methodology
Ofgem uses the building block approach to set the cap. Through the “base transmission reve-
nue” term “PR” in the cap formula, what are effectively the controllable costs are adjusted each
year for annual inflation (RPI) and, from 2008 onwards, for an efficiency factor, “X”. PR is calcu-
lated from 2008 onwards from the following formula:
 RPI t  X 
PR t  PR t 1  1  
 100 
Where:
PR t-1 is the base transmission revenue in relevant year “t-1” and shall be calculated in the
same manner as PR t (references to the relevant year shall be used);
RPI t is the percentage change (whether of a positive or a negative value) in the arithmetic
average of the Retail Price Index numbers published or determined with respect to each
of the six months from May to October (both inclusive) in relevant year “t-1” and that is
published or determined with respect to the same months in relevant year “t-2”;

X is set at two. Ofgem views it is appropriate to establish a rising revenue profile to ensure
that revenues are aligned more closely to the rising trend of CAPEX due to substantial
increases in investment envisaged over the 5 year period.
3.1.2.3 Restriction correction term
The revenue restriction correction term, K, is the main mechanism for adjusting the maximum
revenue for differences between the maximum and actual revenues of the TO. It is calculated
according to the following formula:
 I  PI t  
K t   ARt 1  TOt 1 1  t
 100 
ARt 1 is the transmission network revenue for year “t-1”;
TOt 1 is the maximum revenue in year “t-1”, except for 2007, when it is the maximum revenue
(Mt) for 2006;
It is the average specified rate (which is the average of the daily base rates of Barclays
Bank PLC current from time to time during the period in respect of which any calculation
falls to be made);
PI t is the penalty interest rate in year “t” which is equal to:
 Four, where  ARt 1  TOt 1  has a positive value and transmission network revenue in
year “t-1” exceeds the maximum revenue in year “t-1” by more than 2.75 per cent;
 Zero, otherwise.
3.1.2.4 Cost pass-through items
The regulator notes in its final proposals for the current price control (Ofgem, 2006) that it ac-
cepts that transmission companies incur OPEX costs over which they have little or no influence
(non-controllable). It recommends a continuation of the approach under which several items of
non-controllable costs are subject to pass-through arrangements, such that the companies are

able to recover the costs that they actually incur. It notes that licence fees (paid to the regulator)
will be treated as non-controllable OPEX.
The cost pass-through term PT t in the transmission revenue cap formula consists of the sum of
a number of items that are listed in the transmission licence 7 . For some of these items the term
PT t includes the full amount of the cost incurred by the TO in year “t” . For others the term PT t
includes an amount equal to the difference between an assumed cost (specified in the licence)
and the actual cost incurred in year “t”.
3.1.2.5 Incentive payments
The revenue adjustment term for incentive payments (IP) equals the sum of three components
that concern respectively 8 :
 Reliability incentive: the maximum revenue is adjusted in year “t” to give a pen-
alty/(benefit) for under/(over) performance in year “t-1” against a loss of supply volume
target;
 Innovation funding incentive: in year “t”, this passes through a specified percentage
(equal to 80%), linked to the TO’s base transmission revenue (PR in the cap) for year “t”,
of spending on eligible R&D projects. The schemes for transmission will ring-fence an
amount equal to the greater of 0.5 per cent of allowed revenue or £5,000,000 each year;
 Rates of leakage of SF 6 (Sulphur Hexafluoride): if for year “t” the actual leakage rate is
less than the target leakage rate, the leakage term equals 0.002 * the TO’s base reve-
nue.
3.1.2.6 Logged-up costs
The “logged-up costs” approach is a mechanism for handling what the regulator refers to as
“known unknowns”. These are specified costs that are dependent on external factors and whose
7
For further details see Special Condition D4 of the Electricity Transmission Licence for National Grid
Electricity Plc.
8
Further details of the incentive payments can be found in Transmission Price Control Review: Final Pro-
posals, Ref 206/06, December 2006, (Chapter 9) and in the Electricity Transmission Licence of National
Grid Electricity Plc (Special Condition D5).

level over the regulatory period is uncertain. These costs can have a CAPEX and/or an OPEX
element.
The general procedure is that the TO "logs up" (i.e. records) with the regulator the costs in-
curred under the specified cost categories over 2007-2012. It does this by recording the costs in
its annual Regulatory Reporting Pack submissions. The costs are subject to an ex-post effi-
ciency check at the next price review by the regulator. The TO is then remunerated at the be-
ginning of the next regulatory period (i.e. in the year starting April 2012) via the “logged-up
costs” term LC t for the efficiently incurred eligible costs.
3.1.2.7 Capital expenditure
Transmission investment for renewable generation (TIRG)
The allowed revenue in year t for specified investment projects relating to renewable generation
is calculated according to the formula provided under the above term. For NGET, the specified
projects include circuit reinforcement relating to the England - Scotland Interconnection. One of
the reasons these investment projects are treated separately under the TIRG term is that they
involve high levels of expenditure and their timing and actual cost are uncertain.
In certain specified conditions, the TO can apply to the regulator for a change to some of the
components of the TIRG term. Any change requires the regulator’s approval, via a determina-
tion.
Capital Expenditure Incentive
As noted above, the revenue adjustment term for the “capital expenditure incentive” equals zero
in all years other than the year starting April 2012. It is designed to provide a one-off adjustment
to maximum revenue in the first year of the next price review period, starting in April 2012, to
achieve a number of objectives with regard to the CAPEX spend in the current review period
(April 2007- March 2012). These objectives include, among others 9 :
9
Further details of the capital expenditure incentive revenue adjustment can be found in Transmission
Price Control Review: Final Proposals, Ref 206/06, December 2006 (Chapters 7 and 9) and in the Elec-
tricity Transmission Licence of National Grid Electricity Plc (Special Condition D9).

 Providing a mechanism that automatically adjusts revenues in response to changing
demands for capacity on the transmission system from new and existing generators.
This is done by applying “revenue driver” parameters (in £/MW) to changes, from the
baseline assumed at the price review, in generator connection capacity and in flows on
the network that occur over the regulatory period. The adjustment is made at the start of
the next price review period, as it is not until the end of the current period (2007 to 2012)
that the full change in connection capacity can be seen;
 Provide a mechanism by which companies should bear 25% of the cost, or receive 25%
of the benefit, arising from the differences between actual and allowed CAPEX;
 Adjust the maximum revenue for CAPEX that is deemed inefficient by the regulator.
Such CAPEX will not be included in the regulatory asset value (RAV) when it is rolled
forward from April 2007 to March 2012; all other CAPEX is included in the RAV.
The present exceptions to the capital expenditure incentive include those specified cost items
that are subject to logging-up and capital expenditure under the Transmission Investment for
Renewable Generation (TIRG) scheme.
Capital expenditure safety net
The “capital expenditure safety net” provides a mechanism that would trigger a review of
CAPEX allowances in the event of a major shortfall of the actual CAPEX relative to the allowed
CAPEX. It would be triggered if at any stage in the regulatory period, annual actual CAPEX is
more than 20% below the annual allowed CAPEX. Once the mechanism was triggered, the
regulator would assess the level of CAPEX. If the regulator were satisfied that the shortfall is
due to a timing shift of large projects and that the level of actual CAPEX is likely to revert back
to the allowed level, no changes would be made. Otherwise the regulator would expect to re-
duce the allowed CAPEX and would seek to modify the TO’s licence to lower the base revenue
to reflect the lower allowed depreciation and return on the RAB.
3.1.3 Electricity Distribution
There are fourteen regional electricity companies (REC) in Great Britain; each responsible for a
distribution services area. Britain is currently in its fourth electricity distribution price control, set
for a period of five years.

Two price controls now apply to the distribution charges:
 One charge restriction relates to the level of allowed demand revenue that may be re-
covered from demand use of system charges by the licensee;
 The other charge restriction relates to the level of allowed network generation revenue
that may be recovered from generation use of system charges by the licensee.
In addition, there are separate charge restrictions on the metering charges and charges levied
by the distribution business outside its distribution services area.
Here we further discuss only the restriction on the allowed demand revenue; as we understand
that the others are not relevant to the scope of work.
Many aspects of the revenue adjustment for distribution demand revenue are similar to those for
transmission, and our review below is largely based on identifying the differences between the
two. The document we use is the distribution licence issued in 2005 (Ofgem, 2005).
3.1.3.1 Cap Formula
The current price control runs from April 2005 to March 2010 and is based on a revenue cap,
which is referred to as the “allowed demand revenue”. This is calculated according to the follow-
ing formula:
AD t  BR t  PT t  IPt  KD t
Where:
ADt is the allowed demand revenue;
BRt is the amount of base demand revenue; see 3.1.3.2 below;
PT t is the revenue adjustment for allowed pass through items; see 3.1.3.4 below;
IPt is the total amount of incentive revenue, in year “t” (the incentive revenue includes the
incentive adjustment for distribution losses, quality of service and innovation funding in-
centive; see 3.1.3.5)
KDt is the correction factor, whether of a positive or negative value; see 3.1.3.3.
All of the above terms are for year t, unless otherwise noted, which means the 12 months start-
ing from 1 April of year t. In the following sections, we describe these terms and how they are

treated when adjusting the allowed revenue. Firstly we look at the general methodology used to
set the cap.
3.1.3.2 Cap-Setting Methodology
Ofgem uses the building block approach to set the cap. There are two steps which first involve
determining the maximum allowed revenue (separate assessment of OPEX (benchmarking) and
CAPEX for every network operator using cost projections). The second step is the decision on
revenue path during the regulatory period, the initial price cut (P0) in the first year of the regula-
tory period and then an annual price change (X factor) in the second to fifth year of the regula-
tory period.
Through the “base demand revenue” term “BR” in the cap formula, what are effectively the con-
trollable costs are split between the:
 Extra high voltage (EHV) premises; and
 High voltage (HV) and low voltage (LV) premises.
Both the EHV and the LV/HV costs are adjusted each year for annual inflation and, from 2006
onwards, for an efficiency factor “X” (using an adjustment index similar to that used for trans-
mission). In addition, the LV/HV costs are also adjusted annually by a “growth term” based on:
 50% of the annual growth in units distributed per voltage category weighted by a
specified price for each category, and
 50% of the annual growth in metering points.
The annual growth for the year t index is set equal to year t values divided by year t-1 values.
Hence the forecast, rather than actual growth in units or metering points, will have to be used
when calculating the allowed demand revenue on an ex-ante basis. This means that the correc-
tion factor will need to adjust for, among other things, the impact of the difference between fore-
cast and actual variables of the growth index.
The base demand revenue is calculated using the formula given in paragraph 4 of special con-
dition B1:
BRt  PU * GRt  PE  * PIADt  MGt

Where:
PU revenue allowance for low voltage (LV) and high voltage (HV);
PE revenue allowance for extra high voltage (EHV);
GRt growth term
  Poi * Dit C 
GRt  0,5 *   t  * GRt 1
  Poi * Dit 1 C t 1 
P0i for each distribution unit category i (voltage level) the corresponding value of P0 that ap-
plies in respect of that category
Dit total number of units distributed in year t to premises directly connected to the distribu-
tion system in distribution unit category i.
Ct number of energised or de-energised exit points on the licensee’s distribution system in

the relevant year t,
PIADt price index adjuster, which in the relevant year commencing 1 April 2005 has the value
of 1 and in each subsequent relevant year is derived from the following formula:
 RPI t  X 
PLADt  1   PLADt 1
 100 
Where:
RPIt percentage change in RPI (calculated as for transmission)
X Productivity improvement factor
MGt Merger adjustment is set equal to a specified base amount inflated by growth in the RPI.
3.1.3.3 Correction Factor
The correction factor KD is the main mechanism for adjusting the allowed demand revenue for
differences between the allowed and actual revenues of the distribution licensee. The formula
for calculating this is basically the same as that for the revenue restriction correction term, ex-

cept that the penalty interest rates are different and, superficially, different names are used for
some variables. It is calculated according to the following formula:
 I  PRt  
KDt  RDt 1  ADt 1  * 1  t
 100 
RDt 1 is the regulated demand revenue for year “t-1”
ADt 1 is the demand revenue in year “t-1”, except for 2007, when it is the maximum revenue
(Mt) for 2006.
It is the average specified rate (which is the average of the daily base rates of Barclays
Bank PLC current from time to time during the period in respect of which any calculation
falls to be made.)
PRt is the penalty interest rate in year t which is equal to:
 Three, where the combined distribution network revenue 10 in year “t-1” exceeds the
combined allowed distribution network revenue 11 in year “t-1” by more than 2.0 per
cent;
 Zero, where the combined distribution network revenue in year “t-1” is less than the
combined allowed distribution network revenue in year “t-1” by more than 2.0 per
cent;
 1.5, otherwise.
3.1.3.4 Cost Pass-Through Items
The pass-through term PT t in the distribution demand revenue cap formula consists of the sum
of a number of items that are listed in the distribution licence (Ofgem, 2004) and also given be-
low. For some of these items (items 3 and 4), the term PT t includes the full amount of the cost
10
The combined distribution network revenue is the total amount of regulated demand revenue and net-
work generation revenue.
11
The combined allowed distribution network revenue is the total amount of allowed demand revenue and
allowed network generation revenue.

incurred by the TO in year “t”. For others (items 1 and 2), the term PT t includes an amount
equal to the difference between an assumed cost (specified in the licence) and the actual cost
incurred in year “t”. Item 5 is effectively a revenue item.
The items included in PT t are:
 The revenue adjustment term for the licence fee payments (made to the regulator) in
year “t”
 The revenue adjustment term for the non-domestic rates paid in year “t”.
 An amount representing an adjustment for other pass-through costs. This is defined

as settlement run-off costs (whose calculation is specified) plus those costs which
the licensee considers, and the regulator approves, should be treated as miscellane-
ous pass-through items
 An amount in year t representing an adjustment for Arrangements for the Recovery

of Uncertain Costs. (See section 3.1.3.6 below.)
Minus:
 the amount received by the licensee arising from any direction given by the Secre-
tary of State in accordance with the Energy Act in relation to assistance for high cost
distributors.
We understand that the correction factor will adjust the allowed revenue for any deviation (in
million £) between the ex ante and ex post values of these cost pass-through items.
3.1.3.5 Incentive Payments
The revenue adjustment term for incentive payments (IPt) is derived in accordance with the fol-
lowing formula (Ofgem, 2004):
IPt  ILt  IQt  IFI t
Where:
ILt is the distribution losses incentive adjustment in year t;

IQt is the quality performance incentive adjustment in year t; and
IFI t is the innovation funding incentive adjustment in year t.
The term ILt is calculated by the following formula:
ILt  LR * PIALt *  ALt  Lt 
Where:
LR is the distribution losses incentive rate set at £48/MWh for units distributed after 1 April
2005;
PIALt it assumes the value 1 in 2004 and in each subsequent year is adjusted for inflation (us-
ing Retail Price Indices);
Lt is the adjusted distribution losses calculated through the difference between adjusted
system entry volumes and adjusted units distributed 12 ; and
ALt is an amount representing the target level of distribution losses.
The quality performance incentive adjustment (i.e. IQt ) provides for revenue adjustments to re-
flect the performance of the licensee in achieving targets for quality of supply, to reward best
practice and to adjust for severe weather with regard to supply restoration. 13
The innovation funding incentive scheme ( IFI t ) is designed to provide for revenue adjustments
that reflect the performance of the licensee in relation to its investment in innovation. This term
is calculated in accordance to the following formula:
IFI t  ptrit * min IFIEt 0.005 * CBRt   KIFI t 
Where:
12
For further details see Special Condition C1 of the electricity distribution licence (paragraphs 3 to 5).
13
For further details on the formula to derive the quality performance incentive adjustment see Special
Condition C2 of the electricity distribution licence.

IFIEt is the eligible IFI expenditure for year t;
CBRt means combined distribution network revenue i.e. the total amount of regulated demand
revenue and network generation revenue;
ptrit is the pass-through factor applicable for the relevant year t as set out in Special Condi-
tion C3 of the electricity distribution licence; and
KIFI t is the IFI carry forward in relation to the incentive scheme as established in the IFI an-
nual report for year t-1.
Not all variables in these three components would be known accurately before the start of year
t, i.e. when the ex ante maximum revenue is set. Hence, as noted in section 3.1.3.3, the differ-
ence between the forecast and actual values of these components would be included in the cor-
rection made with the correction term, K t .
We note that the regulator may at any time change the allowed losses percentage used in cal-
culating the losses adjustment. The change would, however, not take effect until the year after
that in which it was changed.
3.1.3.6 Arrangements for the Recovery of Uncertain Costs
This mechanism is designed to enable revenue adjustments to recover the efficient costs in-
curred within certain categories of costs pursuant to the licensee’s compliance with specified
enactments. The cost categories are:
 Electrical Safety, Quality and Continuity (ESQCR) costs (Electrical Safety, Quality
and Continuity Regulations 2002);
 Road occupation costs (made pursuant to the New Roads and Street Works Act
1991);
 Permit scheme costs (pursuant to the Traffic Management Act 2004).
The licensee may, by notice to the regulator, propose a revenue adjustment if it believes that
the costs of complying with the above legislation are likely to be a material amount, i.e. likely to
exceed 1% of base demand revenue for year t = 2005.

The Authority may, within four months, determine (or reject) the revenue adjustment. If it has
made a determination on the application within four months of receiving it, the licensee may no-
tify the regulator that the adjustment will take effect. Any revenue adjustment will be included as
an allowed pass-through item.
3.2 Germany
The electricity regulator in Germany is the Federal Network Agency (Bundesnetzagentur) for
Electricity, Gas, Telecommunications, Post and Railway, which operates within the scope of
business of the German Federal Ministry of Economics and Technology. The legal framework
for electricity and gas is set in the Energy Industry Act (EnWG), which came into force in July
2005. The Ordinance for Incentive Regulation (BMWi, 2007) contains the rules for calculating
the allowed revenues of the regulated network operators for electricity (and gas), both transmis-
sion and distribution networks. Under the Ordinance, the electricity transmission and distribution
network activities are subject to a revenue cap and the first regulatory period is five years long,
from 2009-2013 for both transmission and distribution.
As the German regulator is finalising the preparations for the introduction of incentive regulation
by 1 January 2009, the chapter on Germany cannot be based on what happens in practice, but
rather on the provisions of the Ordinance and our understanding of how these are likely to be
interpreted.
The same revenue cap formula is used for the transmission and distribution networks, except
that the transmission formula does not have the quantity adjustment term or quality factor which
the distribution formula has. The Ordinance sets out the revenue cap formula for distribution in
full, while for transmission it does not provide the full formula but explains the exceptions from
the distribution formula.

3.2.2.1 Cap Formula
The German electricity transmission network is divided into four control areas, each of which
has a separate TSO providing both transmission network infrastructure and system operation
functions 14 . The revenue cap below covers both these functions.
Under the Ordinance the allowed revenues of each TSO are calculated according to the reve-
nue cap which we understand would be written as follows 15 :
 VPI t 
EOt  KAdnb ,t  KAvnb, 0  1  Vt   KAb ,0    PFt 
 VPI 0 
Where:
EO t is the allowed revenue, year “t”
KA dnb,t is the non-controllable costs, year “t”
KA vnb,0 is the “efficient costs”, base year
Vt is the reduction factor for inefficient costs in year t
KA b,0 is the inefficient costs, base year
VPI t is the CPI for year “t-2”
VPI 0 is the CPI base year
PF t is the general productivity factor year “t”
Further explanation of these terms is given below and in Appendix 1.
14
The four TSOs are: E.ON Netz GmbH; RWE Transportnetz Strom GmbH; Vattenfall Europe Transmis-
sion AG; and EnBW Transportnetze AG.
15
The ordinance does not contain this formula; it is KEMA’s formulaic interpretation of the description in
the Ordinance of the revenue cap that applies to the transmission companies.

3.2.2.2 Cap Setting Methodology
The regulator does not use the building blocks approach, but sets the cap on the basis of
TOTEX adjusted for efficiency increases. The network’s total costs are divided between:
 Non-controllable costs (KAdnb,t in the cap formula), and
 Controllable costs (KAvnb,0 + KAb,0 in the cap formula).
The controllable costs are adjusted for two efficiency components:
 A general productivity improvement target, (PF t in the cap formula) which the ordi-
nance sets as 1,25% p.a. in the first regulatory period;
 An individual (to each company) efficiency improvement target, which according to

the ordinance is determined from a range of benchmarking techniques.
The individual efficiency target is used to determine the percentage of controllable costs that are
considered inefficient and the reduction factor for inefficient costs (V t in the cap formula) is set
so that these costs are reduced to zero over a ten year period.
The ordinance provides that cost data of the regulated companies for 2006, adjusted to base
year prices, shall be used in establishing the opening value for the first year of the price review
period, i.e. 2009 16 .
3.2.2.3 Revenue Adjustments – Regulatory Account
The main mechanism for adjusting for differences between allowed and actual revenues is the
“regulatory account”. Such an account is established for each regulated company to record over
time the deviations between the actual and the allowed revenues.
The regulated company is required to submit to the regulator by 30 June each year the realised
revenue and energy transmitted for the previous year (January to December). The regulator has
the responsibility first to approve these and secondly to calculate the difference between the ac-
tual and allowed revenues, which it records in the regulatory account.
16
For the second regulatory period (2014-2018) the cost data used to determine the opening value is de-
rived from the year 2011.

When calculating the allowed revenue (i.e. the ex post allowed revenue), we understand that
the regulator will use the actual values for the non-controllable costs. In other words the regula-
tory account mechanism will take account of the impact of:
 The differences between the forecast and realised values of the non-controllable
costs (listed below); and
 “Price-setting deviation”, as defined in section 3.2.2.2 above.
The amount in the regulatory account will accumulate interest based on the average risk free
rate on government bonds over the last ten years as published by the Deutsche Bundesbank.
The total balance in the regulatory account by the start of the fifth year of each regulatory period
will be recovered over the following period, via the non-controllable cost items. Hence for the
first period, the total balance, including interest, accumulated in the account for the first four
years of the period will be recovered / repaid with interest over the five years of the next regula-
tory period as an addition/ deduction of non-controllable costs over this time 17 .
The figure below illustrates an example of how the regulatory account works:
Regulatory Account Regulatory Account

1. Regulatory Period 2. Regulatory Period
Year 1 2 3 4 5 6 7 8 9
Deviation
+
Revenue Cap
- -A1 Balance is shared over 5 years

(1+i)4 of the following regulatory
period. Either as addition /
Upward deviation is A2
beared by the network
deduction to non-controllable
operator. Interest is
( 1+i)3 costs
applied on the average A3
(1+i)2 Interest rates will apply!
fixed capital
-A4
(1+i)
Figure 3: Regulatory Account
17
For the second price control period, the balance on the regulatory account from year five of the first
regulatory period to year four of the second regulatory price period will be recovered / repaid over the five
years of the third control period.

If the actual realised revenues exceed by more than 5% of the allowed revenues in one year
(say year t), the network operator is required to adjust its allowed revenues and network
charges accordingly by 1 January of presumably the following year.
3.2.2.4 Non-controllable Costs
The ordinance specifies that the non-controllable costs are:
 Those associated with a legal obligation (under the Renewable Energy Act 2004)
that the network operator must abide by. For example, it has the obligation to con-
nect a power plant generated by renewable energy to its network;
 Concession levy. This is a fee or some type of ‘right’ that the network owner has to
pay to the municipality. For example, for a cable under a street, the network owner
has to pay for the ‘use’ of the area under the street;
 Taxes, including property tax and other operating taxes but excluding corporation
tax;
 Upstream network charges, e.g. the cost for distribution networks of purchasing
transmission services (does not apply to transmission networks);
 The net balance from the regulatory account;
 Additional costs of constructing underground cables for, e.g. network reinforcement;
 Costs for payment to embedded generators (avoided network charges) (does not
apply to transmission networks);
 Costs of the employee committee/staff council. Companies are required to have such
committees/councils if they have more than a minimum number of employees;
 Agreements made with the unions in regard to salaries e.g. standardised benefits,
pensions etc for all employees who are part of the salary scheme set by the unions.
Also additional employee agreements made between the employee and employer
which do not fall under the general union’s agreements are included here. These in-
clude bonuses and targets set on an individual basis and private health insurance;

 Investment budget allowance. An explanation of this is given below; it applies only to
transmission.
3.2.2.5 Investment Budget Adjustment
For TSOs there is a mechanism called the “investment budget”, which enables the allowed
revenue (ex-ante) to be adjusted, between price reviews, for the capital costs (depreciation and
allowed return) of certain types of investments. These investments would include those required
for the expansion or reinforcement of the transmission network, connection of new generators or
the integration of the national with international networks. Specific examples include:
 New lines to connect off-shore power plants;
 New underground cables;
 Necessary restructuring measures to ensure the technical security of the network is

maintained.
The TSO is required to apply for the investment budget at least 6 months before the start of the
calendar year in which the cost of the investment will be shown, either as a full amount or par-
tially in the accounts of the TSO. One approval can be requested to cover an investment taking
place over several years. The capital return on the approved investment budget for each year
will be included in the non-controllable costs for the duration of the approval. After expiry of the
duration of the approval, the residual asset value of the investment budgets will be transferred
to the regulatory asset base.
It is not yet clear whether the investment budget component of the non-controllable costs will be
adjusted by the regulator on an ex post basis for differences between the approved and realised
costs.
3.2.3.1 Cap Formula
There are over 800 distribution system operators in Germany. As explained earlier, their allowed
revenues are set using the same cap formula that is used for transmission, except that the dis-
tribution formula has two additional terms for quantity and quality adjustment.

The cap formula for distribution is as follows:
 VPI 
EO t  KA dnb ,t  KA vnb , 0  1  V t  * KA b , 0 *  t
 PF t  * EF t  Q t
 VPI 0 
Where:
EF t is the quantity adjustment term, year t
Qt is the quality adjustment term, year t
All other terms are as defined above in section 3.2.2.1 for transmission.
The description in section 3.2.2.2 of the methodology for setting the transmission cap also ap-
plies to distribution.
The “quality adjustment term” in the distribution cap formula will not be mandatory until the sec-
ond regulatory period. Its possible application in the first regulatory period is not yet fully defined
and is not covered any further here.
Distribution network losses are procured by network operators and included in the allowed reve-
nue. However, costs of network losses were not included in the benchmarking exercise of the
regulator (Sumicsid 2007).
3.2.3.2 Revenue Adjustments – Regulatory Account
The above description for transmission of the revenue adjustments via the regulatory account
mechanism also applies to distribution, as does the list of non-controllable items, with the ex-
ception of the inclusion of capital costs from the investment budget. As noted above, distribution
network operators are not able to apply for an investment budget.
3.2.3.3 Quantity Adjustment Factor
The “quantity adjustment factor” provides a mechanism for a distribution company to ask the
regulator for an adjustment to the allowed revenue if changes to specified cost drivers cause
controllable costs to increase by more than a certain percentage (0.5%). If the distribution com-
pany considers these conditions have been met, say in year t, it must submit to the regulator a
formal request by 30 June of year t+1 in order for these changes to be considered. If approved

by the regulator, the allowed revenue for year t+2 will be adjusted through the approved quantity
adjustment term (EF t ).
The specified cost drivers are:
 Energy supply area;
 Number of connection points;
 Peak Load (relevant for the transformation level of the networks) 18 .
The quantity adjustment term is calculated for each voltage level (HV, MV, LV) and for each of
the transformation phases (HV-MV, MV-LV). The formula is given in Appendix 2 19 .
3.2.3.4 Quality Adjustment Factor
In accordance with the legislation, quality regulation will be adopted in the electricity sector at
the beginning of the second regulatory period (from 2014) at the latest.
The quality factor depends on several quality indicators: duration of outages (UD), frequency of
outages (UH), unserved energy (NGE) and volume of lost load (NGL). In each case the devia-
tion of the network operator from the reference value for the quality indicator is determined (=
expressed in the brackets of the formulae). This value is monetised and weighted to determine
the quality factor:
Qt  UD  qUD  UDRe f  UDNetz,t   UH  qUH  UHRe f  UHNetz,t  
 NGE  qNGE  NGERe f  NGENetz,t    NGL  qNGL  NGLRe f  NGLNetz,t 
Where:
Qt profit or loss for quality in year t of the regulatory period.
 Weighting factor for the quality element (sum of these factors equals 1)
18
In Germany the quantity adjustment factor differs for each network level. While energy supply area and
number of connection is considered to be relevant for line costs, peak load is the major driver of trans-
former costs.
19
We note that the formula for the quantity adjustment factor refers to variables for year t, which appears
inconsistent with the provisions in the Ordinance that the adjustment is made on a time-lagged basis (i.e.
by two years).

g Monetising factor (value of each quality indicator)
The BNetzA is currently investigating the values of the quality indicators for different customer
groups. In addition, the decision on how to determine the reference value for the quality indica-
tors is still outstanding.
3.3 Netherlands
According to the Electricity Act 1998, separate companies are charged with operating transmis-
sion and distribution electricity networks. In the Netherlands there is only one transmission sys-
tem operator (TSO), TenneT, who is responsible for the transmission of electricity at national
level (i.e. it manages networks of 220kV and above). The regional network operators, on the
other hand, are responsible for provision of electricity distribution services in the different re-
gions.
The regulation in the Netherlands is carried out by the Office of Energy Regulation (“Ener-
giekamer” 20 as of 1 June 2008). This regulatory body is subordinated to the Ministry of Eco-
nomic Affairs and operates as a chamber within the Netherlands Competition Authority (NMa).
The current regulatory period in the Netherlands (for electricity transmission) is the third one and
extends from the year 2007 up to and including the year 2010. The system of regulation for the
current regulatory period includes three main changes compared to the previous one. One
change relates to the duration of the regulatory period, which was extended from three to four
years. In addition, a frontier shift was introduced which applies to the operating costs and the
cost of capital of the investments after the year 2000. Another change refers to the method for
calculation of the allowed cost of capital. The Board of Directors of the Netherlands Competition
Authority (the Board) is responsible for determining what level of compensation for the cost of
capital is reasonable in the case of TenneT (NMa, 2006a).
20
Previously known as Directie Toezicht Energie (Dte).

3.3.2.1 Price control formula
The Dutch TSO is regulated on the basis of revenue caps. TenneT's tariffs are set to cover its
efficient costs. The total allowed revenues are adjusted annually in line with the relative change
in the consumer price index (CPI) and the required efficiency increase (X factor). The allowed
revenue is determined annually using the following formula:
 CPI  X 
TI t  1   * TI t 1
 100 
Where:
TI the total revenues based on the tariffs for the year t respectively for year t-1;
CPI the relative change in the consumer price index; and
X the discount to promote efficient operations (“X factor”).
Prior to the regulatory period, the Board estimates the CPI on the basis of the latest information
available. At the end of the regulatory period, the allowed revenue is corrected to account the
difference between the estimated and actual inflation. This difference is incorporated in the tar-
iffs for the next regulatory period.
3.3.2.2 Exceptional investment
To guarantee security of supply in the Netherlands, a separate assessment system is used for
assessing investments in expansion. The system for regulating TenneT deviates from the sys-
tem used to regulate the regional electricity companies. Yardstick competition does not apply to
the regulation of TenneT.
During a regulatory period, TenneT may submit a proposal for an exceptional investment to the
regulator. TenneT submits such proposals annually to the regulator before 1 October together
with the annual tariff proposal. If the regulator approves the proposal for the exceptional invest-
ment, TenneT is allowed to adjust its tariffs to account for the operating cost and annual capital
return (depreciation and return on assets) of the approved investments.

3.3.2.3 The X factor
The “X factor” represents the annual efficiency increase which TenneT is required to achieve
during the regulatory period. The efficiency increase consists of two components: individual effi-
ciency increase and frontier shift. The individual efficiency position is estimated on the basis of
an international TSO benchmark study. The international TSO benchmark applies standardised
cost to ensure comparability among the TSOs in the sample. The comparison is carried out
against the average and frontier performance.
The frontier shift parameter is based also on this international study and supplementary re-
search investigating the productivity development. The frontier shift usually ranges from 1.5% to
2.5%.
In contrast to the distribution companies, a quality term is not imposed on TenneT. Instead the
TSO is required to maintain a single reserve for interruptions, set out in the Grid Code (NMa,
2006b).
The Board of Directors of the Netherlands Competition Authority (the Board) sets the tariffs
each year. The Board determines the efficiency increase (X factor), the quality term (q factor)
and the volume parameter of each tariff component for every distribution network for the period
from 2007 up to and including 2009 (the third regulatory period).
The regulatory scheme consists of two components:
 Price incentive scheme aiming to promote efficiency via an efficiency increase factor
(X factor). The distribution price control is based on yardstick regulation. In the sys-
tem of yardstick regulation, the efficiency increase is based on the average change
in productivity of the network operators. The change in productivity is the percentage
change in the standardised economic costs per unit of standardised output. Network
operators who reduce their cost per unit of output by more than the average opera-
tor, will achieve a higher return on assets.
 Quality incentive scheme aiming to promote quality of supply via a quality term (q
factor). The major purpose of the quality factor is to ensure proper balance between
cost reductions and quality and prevent deterioration of quality in the long term. The
design of quality also applies the logic of yardstick regulation where the annual qual-

ity improvement is driven by the average quality performance of network industry. If a
network operator invests in quality and achieves higher quality than other network
operators, this network operator may therefore charge higher tariffs.
In accordance with the Electricity Act, the Board determines the volume parameters at the start
of the regulatory period. These volume parameters apply for the entire regulatory period. A cor-
rection is made in the case of changes in the volumes, compared to those used to determine
the allowed revenue in the preceding regulatory period.
3.3.3.1 Determining the allowed revenues
The allowed revenue is determined with the following formula:
 CPI  X  q 
TI t  1   * TI t 1
 100 
Where:
TI total revenues from the tariffs for the year t or, alternatively, the year t-1, i.e. the sum of
the products of each tariff of the network operator and the volume parameter for the
network operator for each tariff component;
CPI change in the consumer price index;
X efficiency factor;
q quality term.
The initial revenue for the third regulatory period is set equal to the allowed revenue for 2006.
The total allowed revenues are adjusted annually in line with the consumer price index (CPI),
the X factor and the q factor.
The Board may additionally adjust the tariffs in the case of incorrect or incomplete data.
3.3.3.2 Standardised economic costs
In order to ensure the comparability between the companies for the purposes of efficiency ana-
lysis, new reporting standards (regulatory accounting rules) were drawn up. The network opera-
tors report annually on (amongst others) cost data, taking into account the regulatory accounting

rules. The rules set standard asset life for regulatory purposes and rules for establishment of
regulatory asset base. Based on the rules, the companies calculate their standardised costs in-
cluding the annual capital return, i.e. standard depreciation and return on assets (regulatory as-
set base multiplied by the rate of return) using the standardised asset value. 21
3.3.3.3 The q factor
Quality of supply has a number of different dimensions. In line with the classification of the
Council of European Energy Regulators, these may by grouped under three general headings:
commercial quality, reliability (continuity of supply) and power quality. Power quality is a term
used to refer to distortions of the ideal sinus-shaped alternating current. The commercial quality
refers to the contact which takes place between a network company and a consumer. Reliability
is a measure for the ability of the network to continuously meet the demand from customers.
This can be divided into two elements: the first is related to assuring sufficient capacity on the
long term (adequacy) so that the network service can be delivered. The second relates to
whether this network service can actually be delivered in the short run i.e. customers can be
supplied with electricity. The Board regards reliability as the most important dimension of qual-
ity. In addition to reliability, there are also other dimensions of quality: voltage quality and com-
mercial quality.
There are several indicators that can be used to measure the reliability, e.g. System Average
Interruption Duration Index (SAIDI), System Average Interruption Frequency Index (SAIFI), and
Consumer Average Interruption Duration Index (CAIDI). SAIDI is considered to be a composite
indicator because SAIDI is the product of SAIFI and CAIDI. Therefore, the Board applies SAIDI
in the quality incentive scheme. The Board applies also individual standards for reliability and
commercial quality outside of the incentive scheme.
The q factor reflects the adjustment to the tariffs in relation to the quality delivered. In practice,
the q factor results in an increase in the total allowed revenues if a network operator's quality
performance is above the average in the Dutch network industry. The level of the “q factor” is
capped and floored by 5 % of the allowed revenue, i.e. the reward and penalty are not more
than 5% of the allowed revenue. The q factor is computed as a difference between the target
21
Every period the Board carries out research to determine the cost of capital for network operators. The
change of the cost of capital leads to changes in the return on assets, i.e. in the total standardised costs.
Such changes may result in ex post (retrospective adjustments) to the X factor. The Board has decided to
no longer recalculate the X factor retrospectively from the third regulatory period onwards. The advantage
of this is that the network operators and (potential) investors are given more certainty with regard to the
allowed revenues. Furthermore, this makes the system applied more transparent and simpler.

quality level and actual quality performance. The target quality is set at the beginning of every
regulatory period. The actual quality is determined on the basis of the level of the average an-
nual interruption duration realised and measured for each connected consumer for all the years
comprising the regulatory period, except the last year, and the last year of the preceding regula-
tory period. 22 (NMa, 2006d).
3.3.3.4 The X factor
In the second regulatory period, the X factor was determined on the basis of the difference in
productivity between two different years (2002 as compared to 2005). In contrast to the second
regulatory period, the X factor for the third regulatory period is not estimated. The X factor for
the third regulatory period is determined on the basis of the observed annual average change in
productivity of all network operators during the second regulatory period. Accordingly the aver-
age change in productivity realised during the third regulatory period will be used to set the X
factor for the fourth regulatory period.
The Total Factor Productivity method is used to measure the change in productivity 23 . In the
Dutch case, the input is based on the standardised costs and the output is based on the com-
posite output. The composite output is an approximation of the realised sales in, amongst oth-
ers, kilowatts and kilowatt hours on the various sections of the grid, expressed in Euro. The
composite output is calculated by weighting the output of an individual network operator with the
average sector tariffs. This can be compared to calculating the total allowed revenues, using as
the tariffs the average tariffs for the sector (NMa, 2006e).
3.3.3.5 Tariff adjustment for regional factors
The Board has admitted that DELTA Netwerkbedrijf B.V. (DNWB) incurs higher costs than other
network operators and that these costs are beyond the control of the company. The higher costs
22
Since the registration of interruptions prior to 2004 was not complete, the Board decided to determine
the actual quality using data for 2004 and 2005. The actual quality performance used to determine the q
factors for the third regulatory period is based on data for 2004 and 2005.
23
Total factor productivity growth rates can be calculated by using the ratio of the output index divided by
the input index. Thus, TFP = (output index)/(input index), with both the input and output indices being
given by the weighted averages of all inputs and outputs used for production, respectively. Weights are
equal to the inputs’ and outputs’ cost/revenue shares in total cost/revenue, respectively.

are caused by regional differences in the network operation conditions between DNWB and the
network companies. 24 Therefore DNWB is allowed to charge higher tariffs.
3.4 Norway
The Norwegian Water Resources and Energy Directorate (NVE) is the power industry regulator
in Norway. The NVE is a directorate under the Ministry of Petroleum and Energy, with responsi-
bility for managing the country’s water and non-fossil energy resources. The Norwegian Energy
Act 1991 sets out the legal framework for the regulation of the network companies. NVE is re-
sponsible for monitoring grid management and operations, and it is responsible for regulation of
the transmission and distribution electricity networks (NVE, 2007).
In Norway, a large number of companies operate the electricity network. Statnett SF (the TSO)
owns the main transmission network and is responsible for tariffs, system operations and the
development of the main network system. The responsibilities of the TSO are not limited to the
central network alone, but it is also extended to regional transmission and distribution when
necessary. Statnett is a public enterprise, owned by the State through the Ministry of Petroleum
and Energy, and is subject to regulation by NVE through price controls. There are approximately
200 electricity distribution companies in Norway. The distribution companies are usually owned
by local municipalities and are also regulated by NVE.
3.4.2 Electricity Transmission and Distribution
For the purpose of setting revenue caps and tariffs, the electricity network is split into three lev-
els: the central network (transmission system) i.e. 420kV-132kV; the regional network (132kV-
30kV) and the distribution network (22kV). Tariffs are paid at all points in the network with
physical exchange between the network levels, and the network owners pay the same tariffs as
end-users connected at the same network level.
24
The main reason for cost differences is the need to construct “water crossings” in DNWB’s supply area.

As of 1 January 2007, the regulatory model changed from a revenue cap regulation with a 5
year regulatory period to revenue caps based on a yardstick formula. This regulation will be
evaluated after 5 years, which means 2011.
The yardstick formula for calculation of the allowed revenue of the regulated networks is based
on 40% actual cost and 60% cost norm resulting from benchmarking analysis, with a two year
lag.
IRt  0.4 * (C t  FQt  2 )  0.6 * C t  JP
Where:
IRt is the revenue cap in year t for a network company
Ct inflation adjusted cost base from year t-2
F vector of inflation adjusted KILE fees
Qt  2 vector of quantity of non-delivered energy in year t-2
C t the cost norm for the company
JP adjustment factor for new investments
In transitory phase the two terms are weighted 50% rather than 40% and 60%.
The TSO (Statnett SF) is regulated based on the same formula. However, as a TSO it receives
an additional allowance annually for system operation cost.
Figure 4 illustrates the annual procedure followed for the purpose of economic regulation.

Figure 4: Economic regulation from 2007 – Annual procedure
Source: Annual Report to the European Commission (2007)
The cost base is set on the basis of company specific costs (including OPEX, depreciation, re-
turn, cost of losses and the cost of energy not supplied (CENS)) as reported in the last financial
reports (i.e. from 2005). OPEX and CENS costs are adjusted for inflation using the consumer
price index (CPI). The CENS item is included in the cost base and in the cost norm as any other
cost.
The regulatory asset base is based on book values (historical cost minus accumulated depre-
ciations) of all assets by the end of year t-2 plus 1% working capital. The WACC is based on the
annual average of a 5 year government bond plus a risk premium of approximately 3.1% with a
risk free nominal rate of 5%.
The cost norm is set annually using benchmarking analysis and taking into account any differ-
ences in external conditions. The benchmarking for electricity distribution applies Data Envel-
opment Analysis (DEA) using national data sample. For Statnett SF, NVE applies an interna-
tional benchmarking with other European TSOs. The cost norms are calibrated so that the
average annual return for all the regulated network companies is equal to the annual rate of re-
turn (i.e. the WACC).
In addition, a correction factor is applied in order to adjust for investments (extension and re-
placement) not included in the revenue cap due to the two year lag. The adjustment for invest-
ments aims to adjust for the time values of money.
The network companies are responsible for the tariff setting (incorporating the expected CENS)
in compliance with the established revenue caps. The companies are required to report their

tariffs and changes over the year to NVE. Every year the regulator checks the difference be-
tween allowed 25 and actual revenue. The differences are considered through corrections in the
allowed revenue for the following years. The correction process is shown in Figure 5.
Figure 5: Allowed revenues and tariff setting
Source: Annual Report to the European Commission (2007)
3.5 Spain
The Ministry of Industry, Tourism and Trade has the task of establishing the rules and regula-
tions for market design and operation in order to carry out the regulation of system operation
25
The allowed revenue applies the actual CENS.

and regulated activities. The ministry also has the responsibility for transmission system plan-
ning. Regulatory approval and permits for the construction of transmission and distribution facili-
ties are under the responsibility of the regional and local authorities.
The National Energy Commission (CNE) is the energy regulatory authority in Spain. The CNE
has primarily a consultative role but is allowed to request information from the regulated indus-
try. The Commission submits reports to the ministry which are used in the regulation and sys-
tem planning processes.
In accordance with the Electric Power Act, Red Eléctrica de Espana (REE) is the national trans-
mission system operator responsible for provision of the transmission system services in the
country. There are 326 distributors registered in the Ministry of Industry, Tourism and Trade
Registry. The main 5 distribution companies are: Endesa Distribución Eléctrica, S.L.U., Iber-
drola Distribución Eléctrica, S.A., Unión Fenosa Distribución, S.A., Hidrocantábrico Distribución
Eléctrica, S.A.U. and Electra de Viesgo Distribución, S.L.U. The rest of the companies are dis-
tributors providing services in small municipalities and medium sized towns.
Proposals to develop the electricity transmission network
As the system operator and manager of the transmission network, Red Eléctrica de Espana has
to prepare a proposal every four years for the network development. The proposal contains a
forecast for the construction of new lines, cables, substations, etc and their implementation
schedule for a time period of six to ten years ahead. The proposal is submitted to the Ministry of
Industry, Tourism and Trade. Based on this proposal, the ministry prepares a transmission net-
work development plan. In the process of the preparation of the plan the ministry also considers
a report submitted by the National Energy Commission.
The transmission network development plan is submitted for approval by the Council of Minis-
ters. Once it has been approved by the Council of Ministers, the development plan for the
transmission network is sent to the Congress of Deputies under the provisions of article 4.2 of
Act 54/1997.

Remuneration of transmission activities
According to Article 16 of the 1997 Electricity Act “the remuneration of transmission activity shall
be stipulated in regulations and shall allow the remuneration to each agent to be set by taking
into account investment costs, operation and maintenance of facilities and other necessary
costs for the performance of their activities”.
Currently, the economic arrangements governing transmission activities are subject to two main
legal documents: Royal Decree 2819/1998 and Royal Decree 325/2008. The former provides a
detailed framework to determine the allowed revenues of transmission companies with regard to
the cost of the network. The latter applies to transmission facilities that have come into opera-
tion after 1 January 2008. By virtue of the Royal Decree 325/2008, Article 6 (on accredited cost
associated to new investments authorised by competitive bidding procedure) and Appendix V of
the Royal Decree 2819/1998 are revoked.
Royal Decree 2819/1998
The Royal Decree 2819/1998 states that before 31 January of each year “n”, the Ministry of In-
dustry and Energy shall publish the allowed remuneration to the transmission activity of each
company “i” or group of companies for year “n”. The allowed transmission revenue is calculated
by the Ministry of Industry and Energy according to:
TRin  TR1998in  IINTin  IDin
Where:
TRin allowed transmission costs for the company “i” or group of companies in year ”n”
TR1998in allowed transmission costs adjusted to the year “n” using the following formula:
n   IPC j  X j 
TR1998in  TR1998i *  1    

j 1998   100 
TR1998in allowed transmission cost for the company “i” or group of companies in 1998 (for
transmission assets that have come into operation before 31st December 1997).
These values are available in Appendix I of the Royal Decree 2819/1998

IPC n forecasted change in the consumer price index for year “n”
IINTin allowed cost on December 31st of year “n” associated to the set of new invest-
ments that have been come into operation between 1 January 1998 and 31 De-
cember of year “n-1”, made by the company “i”. This shall be calculated as fol-
lows:
  IPC n  Yn 
IINTin  IINC in  iind in  IINDin 1 * 1   
  100 
IINCin allowed cost on 31 December of year “n” associated to the set of the new in-
vestments authorised by the competitive bidding procedure, that come into op-
eration between 1 January 1998 and 31 December of year “n-1”, made by the
company “i”
iind in allowed cost on 31 December of year “n” of the new directly authorised invest-
ments made by the company “i”, that have come into operation in year “n-1”
IINDin 1 allowed cost on 31 December of year “n” associated to the investments author-
ised directly and that have been commissioned between the years 1998 and “n-
2”, both inclusive, by the company or group of companies “i”.
  IPC n 1  Yn 1 
IINDn 1  iind in 1  IINDin  2 * 1   
  100 
X, Y efficiency indices
IDin incentive on availability of facilities of the company “i” in year “n”.
The transmission company is encouraged to provide higher availability, and in this way higher
reliability, by using the incentive availability index (ID). 26
The value of indices X and Y are set by the Ministry of Industry and Energy for a maximum pe-
riod of four years. At the end of this period the ministry should publish new values for the indi-
26
Further details on ID may be found in Chapter IV of Royal Decree 1955/2000.

ces. If significant changes in the macroeconomic framework occur, the ministry may revise the
indices prior to expiry of the period of four years.
The final values of any official consumer price indices of previous years which are available at
the time of calculation may be used to determine TRin .
In summary, the allowed revenue for provision of transmission services is based on cost of the
services also including efficiency increase factor. The allowed revenue for assets acquired prior
1998 is rolled forward by using the inflation and efficiency adjustment.
Royal Decree 325/2008
As previously mentioned, Royal Decree 325/2008 applies to transmission assets that have
come into operation after 1 January 2008. This regulatory framework includes three main new
elements: harmonisation of rates of return between activities, asset valuation based on adjusted
net values and creation of incentives for efficiency in line with “good regulation”.
According to Royal Decree 325/2008, the allowed revenue for each transmission asset “i” in
year “n” is calculated as follows:
Rin  CI in  COM in
Where:
CI in investment cost of fixed asset “i” in year “n”
COM in operation and maintenance costs of fixed asset “i” in year “n”
The annual capital cost of transmission facility “i” in year “n” is calculated as follows:
CI in  Ain  RFin n  start operating year
Where:
Ain depreciation of the investment in fixed asset “i” in year “n”
RFin return on the fixed asset “i” in year “n”.

The depreciation is determined in accordance with the following formula:
 VI 
Ain   i  * 1  TA
m 1
m  1
 VU i 
Where:
VI i allowed cost associated to the investment in fixed asset “i” as defined in Resolu-
tion of the General Direction of Energetic Policy and Mines
VU i regulatory asset life of fixed asset “i” expressed in years. These values are avail-
able in Appendix I of the Royal Decree 325/2008
TA interest rate assuming a constant value of 2.5% for all the years
m number of years passed after the operation has started.
The return on assets for asset “i” in year “n” is calculated as follows:
RFin  VNI in * TRi n  start operating year
Where:
TRi rate of return on fixed asset “i”. This rate is equal to the yield of long term (10
years) government bonds increased by 375 basic points.
VNI in net asset base of fixed asset “i” in the beginning of year “n. This base is calcu-
lated according to the following formula:
 VI 
VNI in  VI i  m  1 * i  * 1  TAm 1
 VU i 
The annual unit values used to determine the operation and maintenance costs of fixed asset “i”
COM in are set by Order of the Ministry of Industry, Tourism and Trade (upon proposal of the
CNE) for a period of four years. The values are adjusted annually using an adjustment factor
(IA):

IA  0,15 * IPRI  x   0,85 * IPC  y 
Where:
IPRI annual change in the producer price index for equipment goods;
IPC annual change in the consumer price index;
x 50 basic points;
y 100 basic points.
Regulatory development
Recently, CNE prepared a new regulatory model for the electricity distribution activity. This
model is based on a system of management accounting known as “regulatory accounting”. The
rules and guideline information for regulatory accounting purposes were published on 12 Sep-
tember 2007 in Circular 1/2007. The information for regulatory purposes is audited and manda-
tory only for electricity distribution companies. The new Circular introduces four new informa-
tional tools as described below:
 Regulatory accounting: it is based on normal statutory accounts and considers, for

each cost centre, 27 the OPEX as well as financial and similar expenses and reve-
nues;
 Technical and economical assets register: substations, transformers, lines, cables,

capacitors, maintenance crews, protective devices, etc.;
 Network’s Business Plan: each company has to prepare and publish for the next four
years an investment plan including the planned investments (by type of asset) nec-
essary to meet demand;
27
A cost centre is defined as the minimum unit in which it is possible to split the organisational structure of the
company from a managerial and economical surveillance point of view.

 Reference Network Model: it allows the design of efficient distribution network ac-
cording to the commonly accepted planning principles and taking into account tech-
nical and geographical constraints.
Remuneration of distribution activities
The regulatory period for distribution activities is 4 years long. At the beginning of each regula-
tory period, the Ministry of Industry, Tourism and Trade revise the necessary parameters for the
calculation of “reference remuneration” (to be used during the regulatory period). This is led by
CNE and is carried out through a consultation process to the distribution companies (this should
be done before 1 November of the last year of the regulatory period). The consultation process
includes a proposal for each parameter and the level of reference remuneration estimated
based on regulatory accounting information (properly audited) submitted by the distribution
companies 28 .
The remuneration scheme applicable to distribution networks is subject to Royal Decree

222/2008 (which revokes Chapter III of the Royal Decree 2819/1998).
The CNE is in charge of proposing a reference remuneration level for each distribution com-
pany, which is determined for each regulatory period using the following formula:
i
Rbase  CI base
i
 COM base
i
 OCDbase
i
Where:
i
Rbase reference remuneration level for distribution company “i”;
i
CI base remuneration for investments. These investment costs include straight line linear
depreciation term for fixed assets and a remuneration term for net assets for
each distributor (return on assets). The return is calculated by using the weighted
average cost of capital representative for the distribution activities;
28
However, companies with less than 100,000 customers are allowed to request a revision of allowed
costs resulting from a demand increase or any other relevant circumstance. The regulator (CNE) is re-
sponsible for evaluating those circumstances and, consequently, for proposing the respective remunera-
tion to the Ministry of Industry and Energy.

i
COM base remuneration for operation and maintenance costs. These costs are determined
taking into account the typology and characteristics of the distribution facilities of
each distributor. The reference network model is used in the determination of op-
eration and maintenance costs for distribution companies;
i
OCDbase remuneration for other costs necessary for the development of the distribution
activities. This covers marketing costs, metering, access and connection to the
network, as well as network planning and energy management.
The annual remuneration for distribution activities for each distributor “i” during the four years of
the regulatory period shall be determined using the following formulae:
R0i  Rbase
i
* (1  IA0 )
R1i  R0i * (1  IA1 )  Y0i  Q0i  P0i
 
R2i  R1i  Q0i  P0i * 1  IA2   Y1i  Q1i  P1i
R3i  R
i
2  Q1i  P * 1  IA   Y
1
i
3 2
i
 Q2i  P2i
R4i  R i
3  Q2i  P * 1  IA   Y
2
i
4 3
i
 Q3i  P3i
i
Rbase reference remuneration level for the company “i” established by the Ministry of
Industry, Tourism and Trade (see further details below)
R0i reference remuneration level for the company “i” adjusted to the year of the cal-
culation
Rni remuneration attributed to the distribution activity in year “n” of the regulatory pe-
riod
Qni 1 incentive or penalty term regarding electricity quality supply applicable to com-
pany “i” in the year “n” (according to quality performance in year “n-1”) – this in-
centive is calculated according to Annex 1 of the Royal Decree 222/2008 (see
further details below)
Pni1 incentive or penalty term applicable to company “i” in year “n” for reduction of
losses (according to the targets established in year “n-1”) – this incentive is cal-

culated according to Annex 2 of the Royal Decree 222/2008 (see further details
below)
IAn adjustment factor in year “n” calculated as follows:
IAn  0,2 * IPC n 1  x   0,8 * IPRI n 1  y 
Where:
IPC n 1 annual change in the consumer price index
IPRI n 1 annual change in the producer price index for equipment goods
x and y efficiency factors assume values of x=0.8 and y=0.4 for the regulatory period
2009-2012. Nonetheless these values may be changed by Order of the Ministry
of Industry, Tourism and Trade
Yni1 change of the allowed revenue for distribution company “i” associated with an
increase in the distribution activity during the year “n-1”. Such variation covers
the increase in investment costs, operation and maintenance costs and other
costs caused by an increase in demand and it is calculated using the “incre-
mental reference network model”.
Reference remuneration levels (additional provision - Royal Decree 222/2008)
The reference remuneration level used to calculate the remuneration of the distribution activity
“i” for regulatory period 2009-2012, is adjusted according to the following formula:
R0i  2008  R2007

i

*1,028 * 1  D2007
i
* Fe i 
Where:
Fe i scale factor applied to distribution company “i”. Such factor will be specified for
each distribution company upon proposal of the CNE and shall be approved by
ministerial order. This factor should take into account the investment elasticity of
energy demand for each distribution area;

D2007
i
increase of annual average demand in the facilities of the distribution company “i”
in year 2007, adjusted by temperature and technical conditions (expressed in
percentage);
i
R2007 for each distribution company will assume the values stipulated in the Royal De-
cree.
Incentive for quality (Annex 1 - Royal Decree 222/2008)
The incentive to improve quality is defined in Article 8 (Royal Decree 222/2008) and can be cal-
culated through the following formula:

Qni 1  0,03 * Rni 1 *  Ui * X Ui ,n 1   SU
i i
* X SU , n 1   RC * X RC , n 1   RD * X RD , n 1
i i i i

Where:
Qni 1 incentive or penalty resulting from quality incentive scheme for distribution com-
pany “i” in year “n” (taken into account compliance in year “n-1” with targets es-
tablished for quality supply). The incentive for quality Qni 1 may assume values in
between +/-3% of Rni 1 .
X Ui ,n 1 indicator of compliance in terms of quality supply in the urban areas in which

company “i” operates, during the year “n-1”
 TIEPI U  REAL ,n 1   NIEPI U  REAL ,n 1 

X U ,n 1  1    1  
  
 TIEPI U OBJETIVO,n 1   NIEPI U OBJETIVO,n 1 
TIEPI is the installed capacity equivalent interruption time at medium voltage

(1kV<V≤36 kV);
NIEPI is the installed capacity equivalent number of interruptions at medium voltage

(1kV<V≤36 kV);

 Ui weighting factor for the urban area 29 for the purpose of quality incentives for the
distribution company “i”;
i
X SU , n 1 indicator of compliance in terms of quality supply in the semi-urban areas in
which company “i” operates, during the year “n-1”;
 TIEPI SU  REAL ,n 1   NIEPI SU  REAL,n 1 

X SU ,n 1  1    1  
TIEPI   NIEPI 
 SU  OBJETIVO , n 1   SU OBJETIVO , n 1 
 SU
i
weighting factor for the semi-urban 30 area for the purpose of quality incentives for
the distribution company “i”
i
X RC , n 1 indicator of compliance in terms of quality supply in the concentrated rural ar-
eas 31 in which company “i” operates, during the year “n-1”
 TIEPI RC  REAL ,n 1   NIEPI RC  REAL ,n 1 

X RC ,n 1  1    1  
 RC  OBJETIVO , n 1   RC  OBJETIVO , n 1 
 Rc
i
weighting factor for the concentrated rural area for the purpose of quality incen-
tives for the distribution company “i”
i
X RD , n 1 indicator of compliance in terms of quality supply in the scattered rural areas 32 in
which company “i” operates, during the year “n-1”;
 TIEPI RD  REAL ,n 1   NIEPI RD  REAL,n 1 

X RD ,n 1  1    1  
 RD  OBJETIVO , n 1   RD  OBJETIVO , n 1 
29 Urban area: are those municipal districts in a province with more than 20,000 supplies, including pro-
vincial capital cities even though they do not reach the figure stated above.
30 Semi-urban area: all of the municipal districts in a province with between 2,000 and 20,000 supplies,
excluding provincial capital cities.
31 Concentrated rural area: all those municipal districts in a province with between 200 and 2,000 sup-
plies.
32 Scattered rural area: all those municipal districts in a province with fewer than 200 supplies, as well as
the supplies located outside the population centres that are not industrial or residential estates.

 RD
i
weighting factor for the scattered rural area for the purpose of quality incentives
for the distribution company “i”.
The values of TIEPI REAL , n 1 and NIEPI REAL , n 1 are the values of TIEPI and NIEPI registered in
the distribution facilities of the company “i” during the year “n-1”, calculated in accordance with
Order ECO 797/2002 of 22 March (see below).
The values of TIEPI OBJETIVO,n 1 and NIEPI OBJETIVO, n 1 for each area are values of TIEPI and
NIEPI established as limits for compliance of the continuity of quality in year “n-1”.
The values of X ZONA,n 1 cannot be higher than 1 and lower than -1.
Incentives for loss reduction (Annex 2 - Royal Decree 222/2008)
The loss incentive term in year “n”, Pni1 is capped at +/- 1% of the allowed revenue in year “n-1”,
Rni 1 and is calculated as follows:
i

Pni1  0.8 * PrEperd * Eperd obj  
, n 1  Eperd n 1 * E pf  E g
i i i

Where:
Eperd ni 1 actual losses (%) incurred by distribution company “i” in year “n-1” and calculated
as follows:
Eperd i

E i
pf 
 E gi  E if
n 1
E i
pf  E gi 
Where:
E ipf energy measured at the distribution boundary in year “n-1” (MWh);
E gi energy produced by generators connected to the distribution network (MWh) in

year “n-1”;

E if energy invoiced to customers connected to the distribution network (MWh) in
year “n-1”
i
Eperd obj , n 1 loss target for distribution company “i” in year “n-1” defined as percentage of the
energy entering the distribution system.
PrEperd price of energy losses (€/MWh).

4. Analysing Incentives for Efficient Investments
The previous section has dealt with economic regulation in the investigated countries. Building
upon this background, this section focuses on the investment incentives resulting from the regu-
latory policies. We also discuss the associated regulatory aspects related to encouraging the
proper balance between expenditure and reducing network losses.
In the next section, section 4.1, we start with a short classification of the concept of economic
efficiency. Section 4.2 deals with the general incentives for investments, while section 4.3 con-
sider the problem of setting proper incentives to encourage the right trade-off between CAPEX
and OPEX. Finally, section 4.4 explains the treatment of losses and the role of loss incentive
schemes.
4.1 Classification of Economic Efficiency
Economic efficiency is defined in three main ways in economic literature. Firstly, technical or
productive efficiency refers to the use of resources in the most technologically efficient manner
which means obtaining the minimum cost to produce a given set of outputs.
The second measure of economic efficiency, known as allocative efficiency, refers to the effi-
cient distribution of productive resources among alternative uses so as to produce the optimal
mix of output. Allocative efficiency is measured by the total social surplus, which is the sum of
producer and consumer surplus assuming that market prices represent costs and benefits to
society. Producer surplus is given simply by economic rents i.e. the difference between reve-
nues and costs. Consumer surplus is provided by the difference between consumer willingness
to pay and the going price at the given output. As long as the marginal willingness to pay by
consumers is higher than the marginal costs of producing the unit, an increase in output in-
creases total surplus and consequently allocative efficiency. Maximum allocative (or Pareto) ef-
ficiency (given the existing demand and supply conditions) is reached when costs and willing-
ness to pay are equal at the margin.
Dynamic or inter-temporal efficiency represents the third way of defining economic efficiency. In
general terms, dynamic efficiency refers to the economically efficient usage of scarce resources

through time, and thus, it embraces allocative and productive efficiency in an inter-temporal di-
mension 33 .
The notion of allocative efficiency is largely concerned with the impact of prices on an efficient
use of resources, and is thus mainly related to the structure of prices for services delivered.
Productive and dynamic efficiency, on the other hand, are connected to production processes
and investment decisions of a company providing a particular type of product or service; in this
case the transmission and distribution service of an electric network. Therefore, we mainly focus
on the latter two types of efficiency. Herein we discuss how the characteristics of a regulatory
regime may influence the strength of the incentives for efficient / inefficient investments into
electric networks.
4.2 Choice of Regulatory Model
The underlying principles of economic regulation have been outlined in section 2.2. To summa-
rise, in general rate of return regulation does not provide companies with the strong incentives
to pursue and achieve cost reductions that cap and yardstick regulation do.
The disadvantages discussed above of rate of return regulation are one of the main reasons for
the now widespread use in Europe of various types of incentive regulation. All five investigated
countries apply incentive regulation. While Great Britain, Germany and Spain apply different
forms of revenue caps, Norway and the Netherlands use yardstick approaches. In all these
countries, with the exemption of Norway, the regulatory period is set at three or more years. In
Norway the allowed revenue is reset every year, however the allowed revenue is decoupled
from the actual costs.
Under cap regulation, at the end of the regulatory period the allowed revenue has to be reset
and realigned with the firm’s cost base, thus effectively passing to consumers completely or par-
tially any unanticipated efficiency gains the firm might have achieved. Under yardstick regula-
tion, the allowed revenue is also reset though not necessarily by aligning it with the regulatee’s
own cost base.
33
“Discussions of dynamic efficiency often refer to the gains that result from innovation and new ways of doing
business. The Austrian economist Joseph Schumpeter explained dynamic efficiency as: competition from the new
commodity, the new technology, the new source of supply, the new organization, competition which commands a
decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing
firms but at their foundations and their very lives.”

The revenue resetting process is different in the various regulatory regimes discussed above.
While Norway is based on the frequent recurrent benchmarking which automatically links part of
the allowed revenue to the costs of the most efficient company, the resetting in Germany and
Spain is based on investigating the efficiency of the company using the last observed actual
costs and setting efficiency targets for the next regulatory period. In contrast, the UK regulation
is based on a comprehensive review of costs aiming to set prospective OPEX and CAPEX
streams for the next regulatory period.
Depending on the regulatory arrangements for benefit sharing, the company may completely
retain the cost savings resulting from efficiency increase. On the one hand, the greater the
share of benefits the regulated network businesses are allowed to retain, the greater their incen-
tives will be to make cost savings, and hence, the greater the extent of those savings which can
eventually be passed on to consumers. On the other hand, the greater the share regulated net-
work businesses are allowed to retain, the longer customers will have to wait before the benefits
from efficiency savings are passed through to them. Whether an increase in incentive power
benefits customers depends on how large the increase in savings is compared to the impact of
the diminished share of benefits retained by customers. This implies that there is some optimal
length of retention period, which maximises the benefits received by customers. In practice, it is
not possible for the regulator to identify what this optimal retention period might be. The optimal
relationship between gains retained and efficiencies achieved would depend on the underlying
assumptions regarding the responsiveness of the regulated businesses (in terms of cost reduc-
tion and innovation) to changes in the share of efficiency gains they retain.
Recent discussions in European and Australian regulatory practice demonstrate that regulatory
policies that permit keeping the efficiency savings between two regulatory periods are increas-
ingly gaining in popularity. This approach allows a longer efficiency carry-over period, e.g. for
the entire duration of the second price control period or for a pre-determined period from the oc-
currence of savings (e.g. 5 years).
4.3 Treatment of OPEX and CAPEX
In this section, we explain why it is important not only that the incentives to achieve savings in
operating costs and in capital expenditure are sufficiently strong but also that they do not distort
choices between the two kinds of expenditure.

There are some trade-offs between capital and operating costs that a company considers when
taking expenditure decisions. For example, one company may rationally choose to save on
CAPEX by spending more on OPEX. For instance, if overhead lines are subject to more inspec-
tions and maintenance (which represent an increase in OPEX) they will probably last longer be-
fore full replacement (which means savings in CAPEX). In order to provide the company with
incentives to make an efficient decision, it is important that the regulatory regime does not unin-
tentionally distort this decision-making.
Whilst OPEX levels are generally reasonably stable over time, CAPEX is different. Investment is
lumpy, and can be postponed by the regulated service provider. Regulated network service pro-
viders facing pressure to cut costs may be tempted to delay investments, since the conse-
quences of doing so are less immediate and obvious than the effects of cutting operating ex-
penditure. On the other hand that it may be easer for an inefficient business initially to make
OPEX savings more easily than investment savings. The latter may be encouraged if regulation
tends to provide stronger incentives to reduce OPEX than CAPEX, as is shown in the rest of
this section.
The table below¡Error! No se encuentra el origen de la referencia. shows that if a company

reduces annual operating expenditure by € 1000 and if it retains all the benefit of this saving for
the regulatory period (say 5 years) and then passes all of the saving through to customers, the
present value of the benefit retained by the company is € 4100 (based on a discount rate of
7%). If the company retains 50% of the saving (i.e. € 500 per year) for 10 years before the full
benefit is passed through to consumers then the value retained by the company has a present
value of € 3500.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Case 1:
OPEX saving 1000 1000 1000 1000 1000
Present value of benefit 4,100.20 €
Case 2:
OPEX saving 500 500 500 500 500 500 500 500 500 500
Present value of benefit 3,511.79 €
Figure 6: Benefits associated with operating expenditure savings
Under regulation using explicit projection of planned investments, e.g. cap regulation using
building blocks without forward of efficiency savings between two regulatory periods, CAPEX in
recognition of the long-lived nature of these costs is treated differently to operating costs. Typi-
cally, they are rolled into an asset base, which is then depreciated over time and on which a rate
of return is allowed. Companies are rewarded for making savings against their CAPEX budgets
through their RAB. For the years between price controls, prices are set on the basis of an open-

ing value together with a stream of projected capital expenditure figures. If a regulated company
is able to save € 1000 compared to its projected investment per year, then it earns the rate of
return plus a depreciation payment on the € 1000 saved for the years until the next price review.
At each review, the RAB and depreciation payments are recalculated on the basis of actual in-
vestments, and the benefit of any capital expenditure saving passed through to customers.
¡Error! No se encuentra el origen de la referencia. The table below shows the benefits of a
reduction in capital expenditure by € 1000 in all years of the regulatory period. The present
value of a reduction in capital expenditure by € 1000 each year is around € 1440 (assuming an
asset lifetime of 20 years and a rate of return of 7% charged on the closing value). This value is
considerably lower than the benefit associated with a similar operating expenditure saving (i.e. €
1440 versus € 4100).

Year 1 Year 2 Year 3 Year 4 Year 5
CAPEX saving (Year 1) 1000 950 900 850 800
Depreciation 50 50 50 50 50
Closing value of saving 950 900 850 800 750
Return 66.5 63 59.5 56 52.5
Benefit retained 116.5 113 109.5 106 102.5
Present value of benefit 450.91 €
CAPEX saving (Year 2) 1000 950 900 850

Depreciation 50 50 50 50
Closing value of saving 950 900 850 800
Return 66.5 63 59.5 56
Benefit retained 116.5 113 109.5 106
CAPEX saving (Year 3) 1000 950 900

Depreciation 50 50 50
Closing value of saving 950 900 850
Return 66.5 63 59.5
Benefit retained 116.5 113 109.5
CAPEX saving (Year 4) 1000 950

Depreciation 50 50
Closing value of saving 950 900
Return 66.5 63
Benefit retained 116.5 113
CAPEX saving (Year 5) 1000

Depreciation 50
Closing value of saving 950
Return 66.5
Benefit retained 116.5
Present value of benefit (total) 1,442.16 €
Figure 7: Benefits associated with capital expenditure savings
This simplistic analysis, based on recurring operating and capital expenditure savings, shows
that incentives to reduce achieve efficiencies in CAPEX are weaker than incentives to do so
with OPEX (see Frontier Economics, 2003). In addition, if for instance the allowed operating ex-
penditure is set on the basis of the industry average, whereas allowed capital expenditure is set
on a company specific basis, then incentives to reduce operating expenditure are likely to be
even stronger. Similarly, a company may have little incentive to realise an investment in ex-

change for lower operating cost, if the investment exceeds a pre-specified allowed value and if
operating cost may be passed through to consumers.
The next section discuses the treatment of investments under cap regulation.
4.3.1 Cap Regulation - Building blocks versus TOTEX approach
In chapter 2, we described the most commonly-used ways of setting the cap; the building blocks
and the TOTEX approaches. We explain the differences between these further below, espe-
cially in terms of the implications for investments.
4.3.1.1 Building blocks approach
Under the building blocks approach, the regulator needs to assess an efficient level of OPEX as
well as an efficient level of CAPEX. For investments, regulators typically set the allowed level on
the basis of the company’s own investment projections. The investments may be checked sepa-
rately for prudence and consistency with the company’s long term investment plans. At the start
of the regulatory period, the company would be asked to provide the regulator with an overview
of its intended investments during the next regulatory period. The regulator may then develop a
view of which investments to include in the regulatory asset base (RAB) or simply accept the
company’s projection as it is. Investments that have been allowed into the RAB will be com-
pletely recouped through the allowed depreciation while the company would also earn a rate-of-
return over the un-depreciated portion of these investments.
This approach is attractive because it links revenues to costs, allowing for efficient costs and the
risk-adjusted rate of return to be considered, and efficiency gains to be identified for sharing with
customers. Where there are strong investment and maintenance needs in the near future, the
building blocks approach is generally considered to be more suitable in such situations; as it
enables a specific allowance to be made for the higher investment and maintenance.
A disadvantage of the building blocks approach to CAPEX is that it may create adverse incen-
tives for the company to overstate its investment projections in order to increase the allowed
RAB and hence revenue for a particular regulatory period. A related problem is that the com-
pany may also try to strategically allocate operational related expenditure under CAPEX if the
regulatory strategy for the latter cost category is less strict. Furthermore, by capitalising OPEX,
the company can further inflate its RAB and consequently earn higher returns.

Once the capital expenditure plan has been set, the company would in principle be free to de-
cide its own investment level. At the end of the regulatory period, it may well be that the com-
pany invested less than originally planned. This difference would, as the company may claim,
be due to higher productivity and therefore, in the spirit of cap regulation, should be awarded to
the company. Although this line of reasoning is in principle correct, it may be that (part of) the
resulting savings are in fact driven by inflated investment projections or deliberate under-
investments rather than genuine productivity improvements.
To mitigate this problem, an investment target could be imposed. If actual investments turn out
to be lower than the target, then prices are accordingly adjusted downwards. Similarly, no ex
post allowances would be provided for investments in excess of the target. Alternatively, the
regulator could impose a band of desired investment levels with a minimum and maximum tar-
get; investments exceeding this band would not or would only be partially allowed into the RAB.
This approach however comes at the cost of weaker incentives for efficiency increase on the
CAPEX front. The regulator would (partially) claw back cost savings irrespective of whether
these are the result of strategic under-investing or due to genuine productivity improvements.
This might discourage the companies to achieve any productivity improvements in the area of
CAPEX as there would not be any financial rewards attached to this in any case (Petrov, 2006).
4.3.1.2 TOTEX approach
Under the TOTEX approach, the problem of investment assessments is effectively bypassed..
Another advantage of the TOTEX approach is that it provides an incentive to the service pro-
vider to be indifferent to the mix of inputs and deliver it required output at the lowest total cost .
Further, under the TOTEX approach, the regulator does not need to develop a view on whether
a given investment proposal should be allowed or not. Rather, the regulator considers the actual
total costs (including investments) incurred by the utility and sets the X factor based on a
benchmarking analysis of these costs (Ajodhia et al, 2005).
Furthermore, under the TOTEX regime, companies have more discretion whether they invest or
not. The threat that investments may be rejected, or partially disallowed, in the process of
benchmarking would provide an incentive to the regulated company to only undertake efficient
investment. Such an incentive is necessary because the regulated company is likely to hold bet-
ter information than the regulator about the prospective efficiency of a proposed investment.
Therefore, by making the company accept the consequences of its investment decisions, the
probability that inefficient investment will take place is weakened.

On the other hand, the regulatory threat that due to the ex-post benchmarking, capital return of
investments can be disallowed could discourage regulated companies to implement even good
investment projects. Also, there may be capital expenditure that is planned and conducted in
good faith that eventually proves “imprudent” on an ex-post basis. Obviously, the straight appli-
cation of the TOTEX model without quality regulation schemes may disregard the prospective
needs of network investments and may put some hazards on reliability.
The big challenge in the application of the TOTEX analysis is the CAPEX measurement for the
purposes of efficiency analysis. Measuring CAPEX provides just an “instantaneous” (at a certain
time point) efficiency assessment. A number of issues, resulting from the long-term nature of
CAPEX, should be solved before the regulator decides to apply a TOTEX method. Notable ex-
amples of challenges to ensure CAPEX comparability relate to differences in depreciation pol-
icy, capitalisation policy and network asset age of the regulated companies. 34
4.4 Treatment of Losses
4.4.1 Network Losses
A general definition of network losses is the kWh consumed by the network in moving power.
They are measured as the difference between total energy metered into and metered out of the
network over a given time period. Losses dissipate energy (kWh) so that it is necessary that the
input of energy to any voltage level must be sufficient to supply those losses in additional to the
requirements of consumers. The cost of network losses is effectively the cost of the additional
power required over and above consumer’s demand to compensate for that lost in the transmis-
sion process.
Losses can be categorised into:
 Technical losses (also referred to as “physical losses”) – these are units that are
transformed to heat and noise during the transmission and therefore are physically
lost;
34
Investments are typically undertaken at different time intervals and tend to vary considerably in size.
Investment lumpiness might be characterised by substantial fluctuations in cash spending from year to
year, which could lead to misleading results in the benchmarking. Averaging CAPEX spending for a num-
ber of years can partially smooth out the figures, but will not completely account for differences, in particu-
lar when companies turn out to be at different stages of their investment cycles.

 Commercial losses (also referred to as “non-technical losses”) – these are units that
are delivered and consumed, but for some reason are not recorded as sales. The
sources of commercial losses include: meter bypass, meter tamper, theft, inaccurate
reported energy usage, errors in collecting and processing meter data, a consump-
tion level lower than the threshold to which the meter is sensitive, low precision me-
tering equipment, or even no metering equipment installed.
Technical losses can be split into:
1. Variable losses, also referred to as “load”, or “copper” losses, which:
 Occur mainly in lines & cables, but also in copper in transformers;
 Vary with current – in proportion to square of current;
 Contribute to 2/3 to 3/4 of technical losses in the entire grid, from high voltage to low
voltages. The copper losses are, however, specifically dominant in the low voltage
cables and lines.
2. Fixed Losses, also referred to as “non-load” or “iron” losses, which:
 Occur mainly in transformer cores;
 Do not vary with current;
 Occur as long as transformer is energised.
In the high voltages lines, another source for fixed losses is the corona loss. These vary with
voltage (and physical wire diameter) and weather conditions such as rain and fog.
4.4.2 Valuing Losses
4.4.2.1 Cost to Society
It can be argued that the full cost to society of technical losses on a network consists of:
1. the value of the electricity lost (e.g. the cost of generating it);
2. the cost of providing the additional transportation capacity on the transmission and, in
the case of distribution network losses, distribution networks; and
3. the costs of the environmental impacts associated with the additional generation and
network capacity that is needed to cover losses. We note also that if the cost of the ex-

ternalities of generation are internalised through some measure, such as a carbon tax,
then the cost of the environmental impact should be included in the value of the lost
electricity and there should be no need to account for it separately.
Often the wholesale market price, where available, is used to value losses. However, wholesale
market prices are more a measure of short-run marginal cost (SMRC). According to economic
theory, any investment decisions for long-lived infrastructure should best be taken on the basis
of long-run marginal cost (LRMC). One may therefore conclude that wholesale market prices
are not necessarily the best estimate for the cost of future losses and may tend to under-
estimate real costs if there is overcapacity in a market. However, LRMC are not usually known
and their estimation is subject to assumptions. On the other hand, wholesale market prices are
transparent, objectively measurable and easily obtainable and hence are often used to measure
the value of losses.
As an aside we note that a reduction in non-technical losses will represent a reallocation of,
rather than a reduction in, electricity consumption 35 , and hence non-technical losses do not in-
volve the above costs. Instead of a direct improvement in social welfare, a redistribution of
benefit will occur from those consumers whose full consumption is identified, under the meas-
ures to reduce commercial losses, to suppliers and general consumers.
4.4.2.2 Time Variation
The values of all three components (of the cost of technical losses) listed at the start of the
above section vary according to time of day and time of year, as follows:
 The cost of purchasing a unit of electricity is generally much higher in times of high de-
mand than when demand is low;
 Similarly, it is predominantly during periods of high demand that the existence of losses
leads to higher capacity requirements on transportation networks;
 To the extent that marginal generators tend to have higher emission rates than the aver-
age generator, a similar profile exists for environmental costs;
 At times of peak demand, the level of losses is also higher in both absolute and percent-
age (of energy distributed) terms (the latter occurs because the variable loss rate in-
creases over-proportionally with demand).
35
Assuming there is no fall in demand when those customers who have not been paying for all their elec-
tricity consumption are required to pay the full cost.

This variation with time means that using a fixed value per unit of losses may fail to provide the
correct incentives to the distributor reduce losses. For example, it will not signal to the company
that the benefits of a reduction in losses at times of peak demand, e.g. due to demand man-
agement, are likely to be considerably greater than the benefits of a reduction in losses at times
of low demand, e.g. due to switching off a transformer at this time. In regulatory practice, how-
ever it is common to use single fixed values.
4.4.3 Incentive Schemes for Loss Reduction 36
If the OPEX or CAPEX required to reduce losses is allowed for in the revenue requirements and
the allowed return on this CAPEX is adequate, it could be argued that this would provide suffi-
cient incentive to the network operator to reduce losses to the point where the regulator no
longer allows OPEX or CAPEX aimed at reducing losses. Offsetting this, however, are the
strong cost-cutting incentives provided by cap regulation. Although the allowance should include
for appropriate expenditure on losses, for example for installing low-loss transformers, the com-
panies have an incentive to reduce expenditure by investing in conventional equipment in order
to retain a share of the savings.
It is obvious that some sort of regulatory mechanism is needed to incentivise the network opera-
tors to reduce losses. Further in this section we look at the following options for providing incen-
tives to network operators to reduce losses to an efficient level:
 An output-based scheme;
 An input-based scheme; and
 Minimum technical standards.
4.4.3.1 Output-based Scheme
Under an output-based scheme, companies are encouraged to reduce losses by incentives

placed on a recorded reduction in their loss rate relative to some target. Such scheme can be
viewed as internalising for the distributor the benefits of reducing their losses and often involves
giving a benefit per unit that losses are reduced.
36
Section 4.4.3 draws heavily on a consultation document (Ofgem, 2003) published by the regulator of energy in
Great Britain.

One of the main advantages of an output based incentive is that it leaves the companies to de-
velop and decide on ways to reduce losses, making it likely that loss reductions will be achieved
at minimum cost. Another advantage is that it is possible (theoretically at least) to set the incen-
tive so that the companies reduce losses to an efficient level. An output-based incentive is gen-
erally also reasonably transparent with low administrative and compliance costs.
Generally the incentive is linked to the actual level of losses. There are, however, often a num-
ber of problems involved with accurately recording losses and this is one of the disadvantages
of using an output-based mechanism. For example, the volatility in reported losses is likely to
reduce the effectiveness of the output-based incentive. Despite these problems, it is generally
considered that the best measure of a company’s performance in controlling losses is an esti-
mate of the actual level of losses.
4.4.3.2 Input-based Scheme
Under an input-based mechanism the incentive for network operators to reduce losses would be
placed on inputs rather than outputs. For example, by estimating the contribution to loss reduc-
tion from a particular piece of equipment compared to the one most commonly installed, opera-
tors could be given this sum to encourage the installation of such equipment.
Compared to an output-based mechanism, this has the advantages that total system losses
would not need to be estimated and the problems arising from distortions to reported losses will
be avoided. Instead, the number of, e.g., transformers installed in a year would need to be re-
corded. The incentive would in this case be closely linked to the effort spent and would be fo-
cused on areas where companies can control losses.
Another advantage of such a system is that all the benefits from reductions in losses are given
in the same year as the equipment is installed. This would make the trade-off between different
types of equipment easier to make for distributors and it would reduce any uncertainty regarding
future incentives.
However, it is not clear how this approach would ensure that efficient decisions are made. For
example, the expected benefit from installing a low loss transformer rather than a low cost trans-
former will depend on the local characteristics of the network where the transformer is installed.
It will therefore be hardly possible to estimate the expected impact on losses accurately without
spending significant resources.

Furthermore, it would be difficult to target more than a few of the areas in which network opera-
tors may affect losses. Trade-offs exist between the costs and benefits of over-sizing lines and
cables that will be difficult to address using an input-based incentive. There are also operational
considerations that may affect losses, such as the location of system open points, which cannot
without difficulties be targeted by an input-based incentive.
4.4.3.3 Minimum Technical Standards
Under a minimum standards scheme, there would be minimum requirements on the specifica-
tions of certain equipment to be installed on a network. Under such a scheme, the cost of meet-
ing these standards would need to be allowed for in the allowed revenue. Hence the scheme
could be viewed as a sort of input-based incentive and would have similar advantages and dis-
advantages.
The scheme would, however, appear to be less effective than an input incentive in encouraging
the most appropriate equipment to be installed in a specific location as the company would be
likely to choose the least costly option that fulfils the minimum standards. It is therefore difficult
to see how such an effort could replace an incentive mechanism.
5. Case Study on Distribution Losses

The main objective of this chapter is to present a cost-benefit analysis designed to assess the
value to society of investing in energy-efficient distribution transformers. We have developed a
simplified investment analysis that compares the additional costs (additional investment costs)
with the additional benefits (network losses reduction) resulting from investing in an energy-
efficient transformer as opposed to a conventional one. The loss savings are monetised using
the expected development of the wholesale prices. At the request of ECI, this case study is bro-
adly tailored to the Spanish conditions.
In addition, in this chapter we discuss some improvements to strengthen the incentives to invest
in loss reduction equipment.
As requested by ECI, this chapter also provides a summary of the European Regulators’ Group
for Electricity and Gas’s (ERGEG’s) position paper on “Treatment of Losses by Network Opera-
tors”, and it is to this that we turn first.

5.1 ERGEG’s Position Paper
In July 2008, ERGEG published the above position paper on losses for public consultation. This
document provides a platform for further discussion and development of recommendations on
setting loss reduction incentives for the network operators.
The paper covers the following aspects of network losses: definition of losses within the EU;
measurement of network losses; procurement; financial recovery of network losses and incen-
tives for their reduction. The analysis carried out by ERGEG to date has focused on the current
practices related to treatment of losses in a sample of seventeen EU countries and Norway.
In particular, case studies from some European countries (namely Austria, Czech Republic,
Finland, France, Norway, Portugal and Sweden) are presented in ERGEG’s Position Paper as
representative of the different regulatory models currently available. Appendix 3 provides a sum-
mary of each of the case studies.
The main ideas presented in the Position Paper are briefly summarised below.
5.1.1 Benefits of Losses Reduction
The preliminary analysis conducted by ERGEG shows that for the 18 countries considered, the
average losses in transmission networks are between 1% and 2.6 % and the losses in distribu-
tion networks are between 2.3% and 11.8% of energy entering the network. ERGEG believes
that a reduction of non-technical and technical losses can lead to more efficient provision of
transmission and distribution services. The reduction of technical losses is essential and can be
achieved by the companies, at least in the medium term, by appropriate investments in the net-
works.
5.1.2 Calculation of Network losses
Losses are calculated for each voltage level and their valuation methodology depends on the
metering equipment. In the case of continuous metering, network losses are calculated by
hourly energy balance (i.e. difference between hourly injection and load curve). This is the typi-
cal case at high voltage levels. At low voltages levels, no hourly metering is generally available
and the technical losses are estimated from the physical characteristics of the network and es-
timated demand patterns.

5.1.3 Procurement of Network Losses
There are two main options to procure losses. In most cases network operators purchase net-
work losses from different sources, for example, like power exchanges, bilateral contracts
and/or auctions/tenders. Alternatively, suppliers might be responsible for the procurement of
losses. In those cases, suppliers purchase additional energy to compensate estimated losses,
In countries such as Finland, France, Norway, Sweden and the Czech Republic, the costs for
procurement of losses are included in the allowed network revenue. In Austria, there is a special
tariff for losses which is differentiated by voltage level of time (peak and base time zones). In
contrast, in Portugal and Great Britain, the supplier is responsible for purchasing energy to com-
pensate network losses using pre-determined loss profiles.
5.1.4 Regulatory Incentive Mechanisms
Based on the ERGEG’s Position Paper the approaches taken to the regulation of network
losses can be classified as follows:
 No regulatory or incentive mechanisms (e.g. Finland, France);
 Network losses are treated as any other costs in the regulatory regime (e.g. Norway);
 A certain allowed rate of losses may be recovered via special tariffs (e.g. Austria,
Czech Republic); and
 An incentive mechanism allowing the network operator to be rewarded/penalised for

the differences between a reference and actual value (e.g. Portugal, Great Britain).
5.2 Simplified Cost-Benefit Analysis
In this section, we assess the value of an investment in energy-efficient distribution transform-

ers. This causes social costs due to the need to produce (including also CO 2 emissions) and
transport additional energy to cover the distribution network losses.

5.2.1 Approach
5.2.1.1 Additional investments and loss savings
In order to assess the value to society of investing in efficient transformers, we compare a con-
ventional transformer with an efficient transformer at both the 400 and the 630 kVA levels.
Our assessment is based on a marginal approach, in that we compare the additional costs to
society of investing in the more efficient transformer with the benefits to society from the reduc-
tion in losses. As the costs and benefits are incurred over a long period of time, we discount
both the costs and benefits using a social discount rate.
5.2.1.2 Discount Rate 37
The social discount rate measures the rate at which a society is willing to trade present for fu-
ture consumption. It is one of the most critical inputs used in cost benefit analysis of public pro-
jects and it is particularly relevant when considering projects with a long time horizon.
Two types of social discount rates are used in practice:
1. The first is based on the value to society of the next best alternative use of the resources
in question (i.e. the real rate of return that would be earned on a marginal project in the
private sector). This is referred to as the “social opportunity cost” (SOC) of the proposed
investment.
2. The second is based on the argument that an individual’s time preference is likely to
vary depending on whether it concerns an individual’s decision on invest-
ment/consumption or a public one. Hence it is argued that the appropriate discount rate
is one based on a “social time preference” (STP) that assigns current values to future
consumption based on society’s evaluation of the desirability of future consumption.
Generally the country-based STP rate will be lower that SOC-based rate. In practice it is likely
that a single rate, whether an SOC or an STP rate, would not be appropriate in all cases and the
37
This section draws heavily on Lopez (2008).

analysis of different public interventions would require the use of different discount rates. This is
shown by the following examples 38 :
1. The European Commission (EC) recommends the use of:

 An SOC rate in those cases where the financial return of a project is an important
public concern (e.g. investment by a public enterprise that is expected to operate
without subsidies)
 An SPT rate for the more standard cost benefit analysis of public projects
2. Spain uses 6% for transport projects but a lower STP based 4% for water projects.
3. In the US, the Office of Management and Budget recommends a rate of 2.5 to 3.0% (de-
pending on the horizon of the projects under consideration) based in the costs of borrow-
ing for the government to assess the cost effectiveness of potential interventions and 7%
rate for cost benefit analysis.
Given the environmental benefits of the investment under question and the long term nature of
these benefits, we consider that a discount rate based on STP would be more appropriate and
use the STP-based rate of 5 % to 6 % referred to above for Spain for our base case.
5.2.1.3 Estimating Costs and Benefits
As explained above, the analysis involves comparing the additional costs to society of investing
in the more efficient transformer with the benefits to society from the reduction in losses from
using a more efficient transformer.
On the cost side, we assume that the additional cost to society of investing in the more efficient
transformer equals the purchase price of the more efficient transformer minus the purchase
price of the conventional transformer. This assumes that the type of transformer results in no
other differences in costs, e.g. maintenance costs or environmental costs of producing the more
efficient transformer. Table 1 below sets out the purchase prices of the transformers used in our
study. These were provided by the European Copper Institute.
We value benefits with the loss savings, i.e. the reduction in losses in kWh multiplied by the es-
timated cost of each kWh of losses. The cost of losses is based on the simulated wholesale
38
Ibid.

market price. We don’t consider an allowance for any additional network capacity required to
transmit the extra energy which might slightly underestimate benefit of the reduction in losses.
We explain below first how we estimate the reduction in losses and then how we model the
wholesale price.
5.2.1.4 Estimation of Losses
As explained in section 4.4.1 above, technical network losses can be split between those that
vary with current (in proportion to square of the current) sometimes referred to as “load” losses
and those that do not, sometimes referred as “non-load” losses. In estimating the losses result-
ing from the different transformers we estimate non-load and load losses separately.
Our estimate of the losses in kW for each of the transformers are shown in Table 1 below and
are taken from data provided by ECI.
Table 1: Transformer Purchase Price and Estimated Losses
Rating (kVA) 400 630
Conventional Efficient Conventional Efficient

Transformer Transformer Transformer Transformer
Efficiency
D0Ck B0Ck D0Ck B0Ck
class
Purchase
8,890.0 10,845.8 11,890.0 14,505.8
price (euro)
Load losses
4,600 3,850 6,750 5,600
(W)
Non-load
750 610 940 800
losses (W)
Source: ECI
In order to value the benefit of the reduction in network losses, it is necessary to convert the es-
timate of losses in kW to an estimate of the losses that would accrue over a year, i.e. loan esti-
mate that is in kWh. We do this using the following formula (Targosz, 2005):
 
Eloss  PNL  PL * I 2 * 8760

Where:
Eloss total energy loss in kWh;
PNL is the non-load loss expressed in kW;
PL is the load loss in kW;
I is the root-mean-square average of the instantaneous loads (accumulated over a period

of time) of the transformer; and
8760 is the number of hours in a year.
As the level of variable losses depends on current, estimating the level of variable losses (in
kWh) in a transformer substation requires an estimate of load flow. This is done via the term “I”
in the above equation. In order to estimate this term, we assume, based on previous studies, an
average load loss factor of 63% for each transformer and assume that the loading is constant
over the transformer life.
5.2.1.5 Monetising loss savings
In order to derive the wholesale market prices, we model the Spanish market as a simplified uni-
form cost-based auction where a generator bids at the level of its short-run marginal cost. These
costs are based on fuel forecast in real terms include a carbon tax on the generators. The mar-
ket price (system marginal price) is set at the level that equates the total supply and demand.
The generator is paid the market price for the amount at which the marginal cost is less than or
equal to the market price. If demand were higher than the available capacity, then in the short
term some customer demand would not be met and the market prices will increase to the level
of value of lost load.
Our estimated wholesale market price is set equal to the system marginal price, provided by the
above modelling, plus a mark-up. In the real world, market prices may be and are usually higher
than generation marginal cost since markets are not perfectly competitive. The major reason for
imperfect market conduct is the level of concentration of market power. In practice the traders
and generators often price, at least in the longer-term, their contracts using long-run marginal
cost (or long-run average) cost to avoid risks of durable financial losses over time, but also to
consider more realistically the future market performance. Also due to uncertainties of such
things as the cost of fuel, prices in the “real world” contain implicitly a risk premium that covers

such uncertainty which therefore inflates the prices compared to the prediction of a perfectly
competitive markets model. 39 We set the mark-up at 10 % and increase the system marginal
price by this per cent. The resulting wholesale market prices are shown in Table 2 below from
2008 to 2020. The value shown in the table for each year is the annual average wholesale mar-
ket price; this equals the average of the hourly system marginal price.
Table 2: Projected wholesale price (simple annual average) in Spain (from 2008 to 2020)
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Price 65.01 62.92 65.34 65.67 66.22 67.43 67.65 67.43 67.54 65.67 65.34 66 65.89
(€/MWh)
Source: KEMA
5.2.2 Results
5.2.2.1 Base Case (Discount Rates of 5% and 6%)
Figure 8 and Figure 9 show the present value of the additional investment and of the lower net-
work losses (non-load and load losses) resulting from the use of an energy-efficient transformer
with rated capacity of 400 kVA and 630 kVA, respectively (compared to conventional transform-
ers).The figures show the PV calculated with a 5% and a 6% discount rate.
As shown in the figures for both the 630 and the 400 kVA transformers, the present value (PV)
of the additional investment cost equals the PV of the reduced losses in nine to ten years. In
other words, society would start to receive a pay-back on its investment in the more efficient
transformer after eight to nine years and would continue to receive benefits for the remainder of
the 30 or more year life of a transformer. The 630 kVA transformer has a slightly higher PV than
the 400 kVA, with the higher reduction in losses offsetting the higher initial investment cost.
39
Previous KEMA studies of European markets using a specific model SYMBAD (“Simulation of bidding actions
and decision”) have shown mark-ups varying between 5 % and 20 %. SYMBAD is based on the supply function
equilibrium (SFE) approach for simulating the behaviour of the participants in an electricity market. The SFE ap-
proach assumes that facing uncertain demand, rather than competing only with fixed prices or quantities, generators
will compete in price and quantity schedules, i.e. supply functions.

1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13
Additional investment
-500 Loss savings (i=5%)
Loss savings (i=6%)
-1000 NPV (i=5%)
NPV (i=6%)
-1500
-2000
-2500
Figure 8: Results 400 kVA transformers
1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13
-500 Additional investment
Loss savings (i=5%)
NPV (i=5%)
-1500 NPV (i=6%)
-2000
-2500
-3000
Figure 9: Results 630 kVA transformers

5.2.2.2 Sensitivity to Transformer Purchase Costs (6% Discount Rate)
Figure 10 and Figure 11 consider a 20% decrease/increase (shown as scenario B/C in the fig-
ures) on the base case, purchase prices of the distribution transformers that are listed in Table 1
(the base case purchase prices is shown as scenario A in the figures ). We used a discount rate
set at 6% for these scenarios.
As shown in Figure 10, for the 400 kVA transformer, when the difference in transformer prices 40
decreases by 20% the PV of the additional investment cost equals the PV of the reduced losses
in seven years. In other words, society would start to receive a pay-back on its investment in the
more efficient transformer after seven years (instead of nine to ten years). Conversely, if the dif-
ference in transformer prices increases by 20 % the pay-back period is twelve to thirteen years.
The results are similar for the 630kVA transformer, with slightly larger differences in payback
periods between the scenarios B and C and the base case, A (than for the 400 kVA trans-
former) as the 630 kVA transformer is more expensive.
1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13
Additional investment- A
-500 Additional investment- B
Additional investment- C
NPV- A (i=6%)
-1500 NPV- B (i=6%)
NPV- C (i=6%)
-2000
-2500
-3000
Figure 10: Results 400 kVA transformers (i=6%; ΔI=+/-20%)
40
Note that we are assuming an equal decrease in both the price of the conventional transformer and the
more efficient transformer.

1500
1000
500
0
Additional investment- A
1 2 3 4 5 6 7 8 9 10 11 12 13
-500 Additional investment- B
Additional investment- C
NPV- A (i=6%)
-1500
NPV- B (i=6%)
NPV- C (i=6%)
-2000
-2500
-3000
-3500
Figure 11: Results 630 kVA transformers (i=6%; ΔI=+/-20%)
5.2.2.3 Sensitivity to Electricity Prices (6% Discount Rate)
Figure 12 and Figure 13 demonstrate the impact of a one-off, 10% decrease/increase in the
wholesale market price in each year (shown as scenario B/C in the figures) compared to the ba-
sic expected development of wholesale electricity price in Spain (shown as scenario A in the
figures). We use again a discount rate set equal to 6%.
The results show that when the electricity prices are 10% higher than our forecast (Scenario C),
society would receive a pay back in nine years for both the 400 and the 630 kVA transformer.
On the contrary, if the electricity prices are 10% lower than our forecast, the pay-back period will
be 12 years for the 400 kVA transformer and 11 years for the 630 kVA transformer.

1000
500
0
1 2 3 4 5 6 7 8 9 10 11 12 13 Additional investment
Loss savings- A (i=6%)
-500 Loss savings- B (i=6%)
Loss savings- C (i=6%)
-1000 NPV- A (i=6%)
NPV- B (i=6%)
NPV- C (i=6%)
-1500
-2000
-2500
Figure 12: Results 400 kVA transformers (i=6%; ΔP=+/-10%)
1500
1000
500
0 Additional investment
1 2 3 4 5 6 7 8 9 10 11 12 13 Loss savings- A (i=6%)
-500 Loss savings- B (i=6%)
Loss savings- C (i=6%)
-1000 NPV- A (i=6%)
NPV- B (i=6%)
-1500 NPV- C (i=6%)
-2000
-2500
-3000
Figure 13: Results 630 kVA transformers (i=6%; ΔP=+/-10%)
Given the long life (around 30 years) of a transformer, it can be argued that under the explained
modelling assumptions a change in the payback period of a year or two will not have a signifi-

cant impact on the economic viability of the proposed investment. On this basis, the results can
be held to reasonably stable to variability in the parameters tested in sections 5.2.2.2 and
5.2.2.3.
5.3 Analysis of Regulatory Incentives in Spain
This section deals with the current incentive mechanism on network losses for distribution com-
panies in Spain and, using the results of the above cost benefit study, discusses some im-
provements to strengthen the incentives to invest in loss reduction equipment.
5.3.1 Distribution Loss-Reduction Incentive Scheme
For ease of reference, we summarise here the detailed description in Chapter 3.5.3 above of
the regulation of distribution network prices in Spain. The regulatory period for distribution com-
panies is four years with a base revenue set for the first year of this period. This revenue pro-
vides an allowance for the remuneration of investments (depreciation and return on the assets)
and of OPEX. The base revenue is automatically adjusted during the four-year regulatory period
for inflation, efficiency and changes in the quantity of distributed energy. The indexation to the
change in energy distributed aims to provide additional revenue to cover the assumed increase
in OPEX and investment costs caused by an increase of distributed energy.
In addition to the above allowance, distribution companies in Spain face a financial incentive to
reduce the overall distribution network losses. As described in chapter 3.5.3 the Spanish dis-
tributors receive an explicit loss incentive allowance determined by the difference between the
target and actual level of losses valued at a price set by the regulator. The overall reward or
penalty resulting from the regulatory scheme is capped at 1 % of the allowed revenue in the
previous year.
The loss incentive scheme intends to encourage distribution companies to take operational and
investment decisions to reduce losses by rewarding out-performance and penalising under-
performance based on a target level of losses. Below we list and discuss the major factors that
determine the properties of the loss reduction incentive scheme.

5.3.2 Feasible Investments
The level of network losses depends, among other things, on the network equipment used by
network companies. The regulator should ensure that network companies face appropriate in-
centives to invest and manage their assets. Despite technological advancements that have re-
duced the costs of manufacturing lower-loss assets, it is very unlikely that benefits from reduc-
ing losses will be strong enough to justify the premature replacement of assets. However, as
networks are extended and assets are replaced, the benefits to the company of reducing losses
could affect the design and investment decisions.
In theory, an optimal level of losses will be obtained when the marginal cost of reducing losses
equals the marginal benefit. The regulatory system should be designed to provide adequate in-
centives to the distributor to invest in loss-reducing projects only if they are economically feasi-
ble. We define an economically feasible investment in efficient transformers as one where the
cumulative benefits to society from loss reduction over the asset life time should be higher than
the additional costs to society of purchasing the efficient transformer (see chapter 5.2). With
other words the regulation should allow to the distributor to receive for such projects sufficient
revenue via the regulated network charges to recover the investment in these asset over a pe-
riod equal or preferably shorter than their lifetime.
5.3.3 Benefit Retention Period
The loss adjustment factor attempts to give some return for investment in loss reduction. The
loss targets are reset regularly to ensure that the loss savings resulting, for example from effi-
cient transformers, are transferred to customers.
Our cost benefit assessment above indicates that under the described modelling assumptions,
the benefits of investing in a more efficient transformer would start to outweigh the costs after
about nine years. The same result would also apply to the distributor’s assessment of the in-
vestment if:
 The additional costs for the distributor are the increase in purchase costs of the trans-
former;
 The distributor receives a benefit per kWh of reduced losses equal to the simulated
wholesale price used in our assessment;
 Similar discount rate is appropriate for the distributor.

If this were the case, a benefit retention period that equals the length of the regulatory period
would appear rather short to justify the benefits from investments in efficient transformers. While
we recognise that the customers should be able to participate in the benefits, it remains essen-
tial to provide the distributor with a sufficiently long period to retain the benefit of the investment
in order to encourage the distributors to undertake the investments.
5.3.4 Trade-off between Incremental CAPEX and Loss Savings
As noted above the price control gives an allowance for CAPEX. The presumption is that the
allowed expenditure is the efficient one overall, including any necessary expenditure to ensure
that losses are at an efficient level. The mechanisms of the price control then reward network
companies for efficiency gains in CAPEX (and also OPEX) spending by allowing them to retain
a share of the benefits from efficiency savings compared to the allowance.
If the regulatory arrangements are output-based but do not include appropriate cost allowance
on losses, the companies may have an incentive to reduce their capital expenditure by investing
in conventional transformers which may not be the better choice for society. In an input-based
regime, the regulator may allow the cost of efficient transformers but should incorporate the ex-
pected loss reduction in the allowed cost of losses. Otherwise the network operators may be
encouraged to install efficient transformers even if these investments do not provide an eco-
nomic alternative.
To avoid this, it is necessary to ensure that companies face the correct incentives on loss reduc-
tion.
5.3.5 Improvement of the Spanish Loss Incentive Scheme
5.3.5.1 Implementation of Input-based Scheme
There are a number of options to amend the loss adjustment scheme. One way is to apply an
input-based scheme. This would require specific loss reduction investments to be identified and
economic assessments to be carried out in each case. The benefits of loss reduction CAPEX
can be assessed by the companies or independent auditor. The approved investments will be
included into the regulatory asset base and into the allowed revenue via the return on assets
and depreciation.

As the asset life of the transformer is longer than the regulatory period, the regulator should pro-
vide balanced and consistent policy in the process of resetting the price control including:
 Rolling forward the included assets and keeping the loss targets reflecting the ex-
pected higher performance of the efficient transformers;
 Any ex-post adjustment (total and partial exclusion of assets) of the RAB should be
aligned with proper re-setting of loss targets; and
 Not considering the interdependences between the RAB and losses in the resetting
process may cause financial losses for the network operators.
The implementation of an input-based scheme looks theoretically appealing. However it remains

unclear whether specific project-based assessment for loss reduction equipment can be effec-
tively implemented. This will require detailed investigation in order to estimate the expected im-
pact on losses accurately. For example, the expected benefit from installing an efficient trans-
former rather than a low cost transformer will depend on the local characteristics of the network
where the transformer is installed. Moreover, dividing investments into different groups defined
by the purposes of the investments creates micro-optimisation tasks aiming to minimise the cost
attributed to the respective purpose, but might lead to a sub-optimal solution for the total costs.
Finally, the need to approve ex-ante specific groups of investments does not seem immediately
compatible with the current distribution price control in Spain which does not apply detail in-
vestments checks.
5.3.5.2 Adjusting the Current Incentive Scheme
Given the long-term nature of investment decisions on distribution network assets, it is important
to set clearly what benefit or penalty a network company will receive from its performance. If the
network company suspects that an incentive mechanism will change at the next price control,
they will probably assign less importance now to any benefit or penalty due after that time. Un-
der the current scheme, the benefits depend on the target loss level, the price of energy and the
incentive term cap.
Setting Loss Targets
As explained above, according to the current loss incentive scheme in Spain, distribution com-
panies are rewarded or penalised by increasing or decreasing their allowed revenue by the cost

of the difference between their actual distribution losses and a target level of losses, valued at a
specified price for energy losses.
The losses target, defined as a loss percentage, can be annually set at the average of the ac-
tual loss values of a number of previous years. The discussions in Great Brittan and Australia
have shown that the period used to calculate the average losses target should be long enough
to provide a stable target and avoid overweighting the actual performance in the last years. The
Spanish model can be strengthened by choosing a sufficiently long period, e.g. of 15 years, to
calculate the loss targets. During this period the benefits will be transferred gradually to custom-
ers through continuous tightening of the loss targets over time incorporating the actual
achievements in reducing losses from previous years. Alternatively the calculated loss target
can be fixed for a sufficiently long predetermined period, e.g. set equal to two regulatory peri-
ods. The advantages of this approach are that it implicitly takes into account the network char-
acteristics and operating environment of the company in question. Disadvantages include the
fact that historic performance does not always provide an accurate guide to the scope for future
performance.
Finally, an estimate of the efficient level of losses can be used as a benchmark. The move to
the efficient level may be done on a step by step basis. From a theoretical perspective, loss tar-
gets that are set relative to the performance of other companies (i.e. in some form of bench-
marking) or using reference network model give strong incentives to improve performance. The
challenge in this case will be to properly account the differences in the companies’ operating
environment.
Loss Evaluation
Ideally the loss reduction should be valued at projected energy wholesale prices of electricity
produced (internalising the emissions) plus the cost of providing additional transportation net-
work capacity. While the transportation part of the costs of losses is relatively stable over time,
the energy prices are not. Hence, it is important that the incentive reflects a good evaluation of
energy losses using the projected wholesale market prices.
Caps on Incentive Payments
A further consideration is whether any cap should be placed on the total amount of company
revenue that can be exposed to the incentive/penalty mechanism. In the current scheme in
Spain, the overall reward or penalty resulting from the loss incentive scheme is capped at 1 %
of the allowed revenue. Advantages of having a cap on penalties include the fact that it puts an
upper boundary on the level of risk to which the company is exposed. This might be considered

important in an environment where there is considerable uncertainty, for example, where factors
outside a company’s control can have a significant impact on penalty/incentive levels, or where
current data availability and quality make future performance uncertain. A cap on rewards might
also be considered attractive in that it provides a way to prevent companies from having incen-
tives to continue to improve their performance beyond optimal levels. A percentage of the reve-
nue cap, as opposed to an absolute cap, has the advantage of taking into account the fact that
companies are different in size, meaning that an absolute cap would have greater proportional
impacts on some companies than on others. The main disadvantage of a cap is the distortion on
the incentive scheme. Capping the rewards may discourage investments as the benefits will not
be entirely internalised which would negatively affect the economic feasibility of the investments.
Estimation of the impact of the cap on distribution loss incentives in Spain is beyond the scope
of this study. For the future it will be useful to provide detailed investigation of this issue and
assess the effectiveness of the cap.
5.3.6 Integration of Cost of Losses into the Revenue Requirements
According to this approach the cost for purchasing energy to cover losses are incorporated into
the total cost for provision of distribution services and benchmarked as any other costs. This
approach is compatible with the TOTEX model which does not separate between different types
of cost. In this case companies are exposed regularly to recurrent benchmarking which esti-
mates the relative efficiency position of the companies. Although the model does not provide a
guarantee that assets will not be optimised, it provides balanced incentives to the companies to
decide on the combination between investments and operating expenditures. A similar model
has been used in Norway Differently from Norway however; the Spanish regulator distinguishes
between efficiency increase for OPEX and CAPEX. While such an approach might be an at-
tempt to differentiate between the efficiency of operating and capital costs, this may unbalance
the incentives and limit the freedom of the companies to choose the best combination of input
factors.

6. Conclusions
The issue of regulatory incentives is particularly important in the new context determined by EU
regulations on CO 2 and reductions on energy consumption. The European Commission estab-
lished as a strategic objective the reduction of both CO 2 emissions and primary energy con-
sumption by 20% by 2020. Therefore it is relevant to analyse how the regulatory schemes in
place in different countries may promote the energy efficiency of regulated activities and lead to
reduced network losses.
Compared to rate of return regulation, incentive regulation provides stronger incentives to re-
duce costs; presumably the longer the time between price reviews, the stronger the cost-
reduction incentives. Depending on the regulatory arrangements for benefit sharing, the time for
which the company may completely retain the cost savings resulting from efficiency increase will
vary. It can be argued that the greater the share of benefits the regulated network businesses
are allowed to retain, the greater their incentives will be to make cost savings, and hence, the
greater the extent of those savings which can eventually be passed on to consumers.
Incentive regulation, on the other hand, may encourage a regulated company to reduce both its
cost and its quality of supply by cutting investments and operating costs with the aim of increas-
ing profits. Both theory and practice suggest that incentive regulation without additional quality
measures eventually leads to quality degradation. Thus, under incentive regulation, the use of a
system in the medium to long term to regulate the quality of supply is imperative.
All five investigated countries apply incentive regulation. While the UK, Germany and Spain use
different forms of revenue caps, Norway and the Netherlands use yardstick approaches. All
regulatory models presented work with pre-defined regulatory periods. With the exemption of
Norway, these periods are three years or longer. In Norway the allowed revenue is reset annu-
ally and is partially decoupled from the actual costs.
The regulators in the investigated countries employ incentive schemes to encourage loss reduc-
tion. In the Netherlands and Norway, network losses are procured by network operators and
their costs are treated like any other costs of the allowed revenue. In contrast, network losses in
UK and Spain are procured by suppliers. The regulators in these countries include explicit loss
adjustment terms in the price control formulae for electricity networks to encourage loss reduc-
tion. The loss adjustment term rewards only the difference between actual and target losses. In
Germany network losses are procured by network operators and included in the allowed reve-

nue. However, costs of network losses were not included in the current benchmarking exercise
of the regulator.
Ideally the regulatory regime should encourage the installation of loss reduction equipment (like
efficient transformers) only if the investment in such equipment is economically feasible. Eco-
nomically feasible investment means that the cumulative discounted social benefits from loss
reduction over the asset life time is higher than the cumulative discounted social costs of the
additional investment required for the efficient transformer.
The regulator may allow the cost of loss reduction equipment but should incorporate the ex-
pected loss reduction in the allowed cost of losses. On the other hand the companies will be en-
couraged to invest in loss reduction equipment only if the regulator allows them to internalise
the benefits resulting from loss savings. For this purpose, the regulator should keep the allowed
losses high enough for a sufficiently long period of time. The latter is particularly relevant where
costs and revenue are decoupled during the regulatory period like in Spain.
The regulatory regime in Spain provides an allowance for capital return and operating expendi-
ture (OPEX) related to the existing asset, which forms the base revenue. The base revenue is
automatically adjusted during the regulatory period using inflation, efficiency increase and in-
crease of the distributed energy. It seems that the regulatory model does not apply ex-ante in-
vestments checks and relies more on hindsight efficiency assessment.
The Spanish distributors receive an explicit loss incentive allowance determined by the differ-
ence between the target and actual level of losses valued at a price set by the regulator. The
overall reward or penalty resulting from the regulatory scheme is capped at 1 % of the allowed
revenue.
We investigated the net benefit to society of investments in energy efficient distribution trans-
formers using broadly the main principles of the current Spanish distribution price control. Under
the applied modelling assumptions we found that society would start to receive a pay-back on
the investment in the more efficient transformer after around nine years and would continue to
receive benefits for the remainder of the asset life of a transformer.
While we recognise that the customers should be able to participate in the benefits, it remains
essential to ensure that companies can retain the benefits for period of time, which would en-
courage the companies to undertake the investments. This can be done by choosing a suffi-
ciently long period, e.g. of 15 years, to calculate the loss targets. During this period the benefits
will be transferred gradually to customers through continuous tightening of the loss targets over
time incorporating the actual achievements in reducing losses from previous years. Alternatively

the calculated loss target can be fixed for a sufficiently long predetermined period, e.g. set equal
to two regulatory periods.
Finally, the loss targets can be set relative to the performance of other companies (i.e. in some
form of benchmarking) or using a reference network model give strong incentives to improve
performance. The challenge in this case will be to properly account the differences in the com-
panies’ operating environment.

7. Selected References
 Ajodhia, V.; Kristiansen, T.; Petrov, K. (2005); Total Cost Efficiency Analysis for
Regulatory Purposes: Statement of the Problem and Two European Case Studies.
 Averch, H.; Johnson L.L. (1962): Behaviour of the firm under regulatory constraint.
American Economic Review 52: pp. 1052-1069.
 Baumol, Wil J. (1977); On the Proper Cost Tests for Natural Monopoly in a Multi-
product Industry; 809 American Economic Review.
 Comisión Nacional de Energy (CNE) (2008); Public consultation on the methodology

for estimation of the cost of capital for electricity regulated companies - Final pro-
posal presented by CNE; April 2008.
 Comisión Nacional de Energía (CNE) (2007); Spanish Electric Power Act, as

amended by the Law 17/2007.
 European Regulators’ Group for Electricity and Gas (ERGEG) (2008); Treatment of
Losses by Network Operators; ERGEG Position Paper for public consultation; Ref:
E08-ENM-04-03 15 July 2008.
 Evans D J, Sezer, H (2005); Social Discount Rates for Member Countries of the Eur-
pean Union, Journal of Economic Studies, Vol. 32, Issue 1, pp 47-59.
 Frontier Economics (2003); Developing Network Monopoly Price Controls: Work-

stream B. Balancing Incentives.
 German Federal Ministry of Economics and Technology (BMWi) (2007) Netzentgelt-

verordnungen, 29 October 2007.
 Hertog, Johan den (1999); General Theories of Regulation; Economic Institute/

CLAV, Utrecht University.
 KEMA Consulting GmbH (2002); Insufficient Regulatory Incentives for Efficient In-
vestments into Electric Networks; Report prepared for European Copper Institute;
April 2002.

 Lopez, H, (2008), “The Social Discount Rate: Estimates for Nine Latin American
Countries”, Policy Research Working Paper 4639, Office of the Chief Economist,
Latin America and the Caribbean Region, The World Bank, June 2008.
 Ministry of Industry, Tourism and Trade (2008); Royal Decree 222/2008 dated March
18th, Remuneration of distribution activities.
 Ministry of Industry, Tourism and Trade (2008); Royal Decree 325/2008 dated March
4th, Remuneration of transmission activities (applied to transmission facilities starting
its operations in 1st January 2008).
 Ministry of Industry, Tourism and Trade (2007); Circular 1/2007 - rules and guide-
lines information for regulatory accounting purposes; September 2007.
 Ministry of Industry, Tourism and Trade (2000); Royal Decree 1955/2000, dated De-
cember 1st, Regulating Transmission, Distribution, Trading and Supply Activities and
Authorisation Procedures for Electric Power Facilities.
 Ministry of Industry, Tourism and Trade (1998); Royal Decree 2819/1998 dated De-
cember 23rd, Regulating Electric Power Transmission and Distribution Activities.
 Netherlands Competition Authority (NMa) (2006a); Method Decision number 102135-

46 for determining the X factor and the volume parameters for the national grid man-
ager; September 2006.
 Netherlands Competition Authority (NMa) (2006b); Addendum A to the Method Deci-

sion – description of the method for determining the X factor and the volume parame-
ters.
 Netherlands Competition Authority (NMa) (2006c); Method Decision number 102106-

89 for determining the price cap to promote efficient operations and the volume pa-
rameter of each cost driver; June 2006.
 Netherlands Competition Authority (NMa) (2006d); Addendum A to the Method Deci-

sion - Method decision in relation to the Q factor for regional electricity grid managers
for the third regulatory period.

 Netherlands Competition Authority (NMa) (2006e); Addendum A to the Method Deci-
sion – Method decision in relation to the X factor and volume parameters for regional
electricity grid managers in the third regulatory period.
 Norwegian Water Resources and Energy Directorate (NVE) (2007); Annual Report
on Regulation and the electricity market to the European Commission; June 2007.
 Ofgem (2007); Electricity Transmission Licence of the National Grid Electricity Plc,
July 2007.
 Ofgem (2006); Transmission Price Control Review: Final Proposals, Ref 206/06, De-
cember 2006.
 Ofgem (2005); Modification of Conditions in the Distribution Licence Granted Under

Section 6(1) (c) of the Electricity Act 1989, Authorised in March 2005.
 Ofgem (2004); Electricity Distribution Price Control Review – Appendix – draft price
control licence modifications, December 2004.
 Ofgem (2003); Electricity distribution losses – A consultation document, Ref 03/03,

January 2003.
 Ofgem (1999); Reviews of Public Electricity Suppliers 1998 to 2000, Distribution

Price Control Review, Draft Proposals, August 1999.
 Petrov, K.; Scarsi, G.C.; Virendra, A.; Keller, K. (2006); Issue Paper: Determination
of X Factor; Report prepared for Energy Regulators Regional Association (ERRA);
August 2006.
 Scarsi, G. C. and Petrov, K. (2004); Regulation by Incentives in Electricity and Gas

Networks.
 Shleifer, A. (1985); A Theory of Yardstick Competition, Rand Journal of Economics.
 Sumicsid (2007); Development of Benchmarking Models for German Electricity and

Gas Distribution, Final Report.
 Targosz Roman (2005); The Potential for Global Energy Savings from High Effi-
ciency Distribution Transformers, European Copper Institute; February 2005.

 Woolf, Tim and Michals, Julie (1995); Performance-Based Ratemaking: Opportuni-
ties and Risks in a Competitive Electricity Industry, The Electricity Journal, October
1995.

APPENDIX 1 Germany – Cap Setting Methodology
This Appendix provides further detail on how the revenue cap is set for the networks in Ger-
many, in particular the incorporation of the efficiency assessment. It applies to both transmission
and distribution, unless noted otherwise, and the references to the formula terms are the same
as those to the formula in section 3.2.2.1.
According to the German Energy Act, the efficiency requirements (i.e. X factors) for network op-
erators include two components: a general efficiency improvement target and an individual effi-
ciency improvement target. The Ordinance on incentive regulation fixes a general productivity
increase (PF t ) while individual efficiency increase targets for the regulatory period are deter-
mined in a benchmarking analysis by the regulator. The overall productivity increase is set as
1.25% p.a. in the first regulatory period and 1.5% p.a. in the second regulatory period as speci-
fied in the Ordinance.
For the individual efficiency increase for the distribution network operators TOTEX benchmark-
ing is used. The techniques used are Stochastic Frontier Analysis (SFA) and Data Envelopment
Analysis (DEA) as specified in the Ordinance. From both of these techniques the regulator uses
the best-off results. This means that in setting the individual efficiency increase target, the best
result or scores resulting from either the SFA or DEA are used for the individual network opera-
tor. As already mentioned, the Ordinance requires the total cost of the network operator as an
input to the model. As output the following factors are required: number of connection points,
area supplied, network length and coincident peak. The regulator is free to add further parame-
ters in the benchmarking exercise considering the special geological factors, embedded genera-
tion, etc.
For the TSOs, the Ordinance states that an international benchmarking analysis would be con-
ducted using SFA and DEA techniques. A benchmarking exercise based on the 4 TSOs would
not be sufficient, so the sample will consist of countries that are in the European Union. If data
to conduct an international benchmark are not available, the Ordinance states that a benchmark
analysis will be done with a ‘model’ or ‘reference’ network.
The result of the benchmarking exercise is the efficiency number of the company. By multiplying
the efficiency with the controllable cost, the efficient cost of the company is determined. The
controllable cost minus the efficient cost gives the inefficient cost. The annual reduction of the
inefficient cost of the regulated companies calculates as 1/10 of the inefficient cost.

As an example, the figure below shows the share of costs. As explained above, the inefficient
costs for the base year are determined from a benchmarking analysis of the network operators.
The Ordinance states that the maximum inefficiency of network operators is capped at 40%.
This means that the minimum efficiency is 60% which should be improved over a period of 10
years running over 2 regulatory periods.
KAb,0: Inefficient costs (base year)
Max. 60% of the total cost after

deduction of non-controllable
split over 10 years
KAvnb,0: efficient costs”, base year
(1. Regulated period)
KAdnb,t: non-controllable costs,

year t
Year 1 Year 10
Figure 14: Illustration of Reduction of Allowed Inefficient Costs
In the price control formula the annual reduction is given by V t . For illustration, the V t reduction
factor for inefficient costs in the regulatory formula can be understood as follows:
For example a network operator’s inefficient costs amount to 100 thousand Euros in the base
year. These inefficient costs should be eliminated over a period of 10 years according to the Or-
dinance.
So in t=1 of the regulatory period the allowed inefficient costs are equal to (1 minus 1/10 of 100
thousands Euros = 90 thousand Euros). One tenth of the inefficient cost is deducted from the
‘original’ allowed inefficient cost (base year). In year t=2, 1 minus 2/10 of 100 thousands Euros
= 80 thousand Euros are the allowed inefficient costs and so on. This is gradually applied over
the course of the price review, however an updated cost assessment of the network operators
for the second regulatory period (year 6-10) would be made and a new efficiency improvement
target for this period would be published where appropriate.

APPENDIX 2 Germany - Quantity Adjustment Factor
for Distribution
As noted above, the “quantity adjustment factor” provides a mechanism for the distribution com-
pany to ask the regulator for an adjustment to the allowed revenue if changes to specified cost
drivers cause controllable costs to increase by more than a certain percentage (0.5%).
The quantity adjustment term is calculated for each voltage level (HV, MV, LV) and for each of
the transformation phases (HV-MV, MV-LV). The following formula will be used to calculate the
quantity adjustment term for the three voltage levels:
1  Ft ,i  Fo ,i  1  AP  APo ,i 
EFt , Ebene _ i  1  * max   * max t ,i
 2  ;0 
2  Fo ,i   APo , i 
Where:
EF t, Ebene i is the quantity adjustment term of voltage level i in year t of the regulatory period
F t,I is the size of network area for voltage level i in year t of the regulatory period
F o,t is the size of network area of voltage level i in base year 0
AP t,I is the number of connection points in voltage level i in year t
AP o,I is the number of connection points in base year
The following formula will be used to calculate the quantity adjustment term for the two trans-
formation phases:
 L  L0,i 
EFt , Ebene _ i  1  max t ,i ;0 
 L0,1 
Where:
EF t, Ebene i is the quantity adjustment term of transformation phase i in year t
L t, i is the load per transformation phase i in year t of the regulatory period

L 0,i is the load per transformation phase in base year 0
Weights are applied to the quantity adjustment term for each voltage level and transformation
phase when these are combined to give the overall quantity adjustment term. In the Ordinance it
is not clear how the weighting is determined. However, in an earlier document published by the
regulator on Incentive Regulation (30 June 2006), it states that the weights are determined by
the weight of total cost per voltage level by the overall total cost of the network company as
shown in the formula below:
 GK 0, Ebene _ i 
EFt    EFt , Ebene _ i *
Ebene _ i  GK o 

Where:
GKo , Ebene i is the total cost of voltage level in base year
GK 0 is the total cost of network operator in base year.

APPENDIX 3 Case Studies on Network Losses
The ERGEG’s Position Paper on “Treatment of Losses by Network Operators” includes some
case studies describing different models adopted for treatment of losses by the respective net-
work operators. This section provides a summary of each of the case studies.
Austria
In Austria, the TSOs and DSOs are in charge of calculating losses on an annual basis, which
are then audited by the regulator. The losses are related to regular network operation, fraud,
wrong identification or measurement, unidentified output as well as metering fault on identified
output. The in-house consumption is not included. The network operators should procure en-
ergy for losses using market-based arrangements. The losses in the transmission network are
metered, whereas the losses in the distribution network are based on empirical formulas.
The price for losses is based on a formula which takes into account the peak and the base
prices (i.e. price at the stock exchange). In 2007 the price for losses was 55.38 €/MWh.
The recognised losses are included in the tariffs and defined as a maximum level in % based on
2003. The incentive regulation of the DSOs excludes losses but a new mechanism is under de-
velopment.
Czech Republic
In the Czech Republic, total losses (technical and non-technical losses) consist of total injec-
tions to the network minus total withdrawals from the transmission and distribution system. They
are determined by network type, by voltage level and by the global energy balance of the sys-
tem and networks in the following year. In general each customer has a metering system but the
amount of the electricity balance is also used for losses calculation (due to non-metered losses
and small consumers non-continuing metering).
In 2007, the total transmission losses were around 0.9 TWh and the total distribution were 4.6
TWh. The network operators are responsible for purchasing electricity necessary to cover net-
work losses and this is done by annual tenders (supervised by the regulator).

The costs of losses are covered through the variable component of transmission and distribution
charges (i.e. the price of network usage). The price of network usage is calculated using the fol-
lowing formula:
NU i  CLi / TU i
Where:
NU average price of network usage expressed in CZK/MWh;
CL cost of losses expressed in CZK; and
TU planned technical quantities (in MWh).
Costs of losses are covered by regulated transmission and distribution charges but only up to
“total allowed rate of losses (including technical and non-technical)”, which is defined by the
regulator. In 2007, the “allowed rate of losses” was 1.5% for the transmission company and be-
tween 6.3-7.9% for the individual distribution companies. During the regulatory period 2005-
2009 the allowed non-technical losses of distribution companies decrease annually. The al-
lowed technical losses remain constant.
Finland
In Finland, losses include physical losses and metering errors. The in-house consumption is
measured and can be separated from the network losses. Losses are calculated annually ex-
post by network type and voltage level.
Although all customers are metered, the meter reading is done once a year by the company or a
customer which means that estimates and load profiling is used in calculation of losses.
In Finland the law/regulation does not establish specific measures on loss reduction to be un-
dertaken by the network operators. However, the network operators consider loss reduction in
the network planning process and the selection of asset types.
The network operators are responsible for purchasing energy to compensate losses through a
market-based method (i.e. from PEX or bilaterally) and the price equals the price in PEX (Nord-
pool). Cost of network losses are included in the network tariffs and no regulatory incentives are
applied for losses.

France
Network losses in France comprise physical losses, unavoidable thefts, metering errors and in-
house consumption. In addition, public lighting is considered a loss when no metering system is
in place. Losses are calculated using the system energy balance and differentiated by network
type and voltage level. For balancing, network losses are quantified 2 days in advance using
hourly loss profiles.
The network operators use the loss reduction as a criterion for selection between technical solu-
tions in the planning phase of network development. They are responsible to purchase losses
and can procure energy until 2 days before the real time. The cost of losses is included in the
network charges.
Currently there is no explicit incentive mechanism on losses but the regulatory authority to-
gether with the network operators are considering the introduction of such a scheme in the next
regulatory period (i.e. 2009-2011).
Norway
Losses are defined as the difference between metered input and metered output from the net-
work and they are calculated by network type. The losses in the transmission network are more
accurate due to hourly metering, whereas in the distribution, metering is done manually by the
households.
The network operators are responsible for buying energy to compensate network losses either
on the Nord Pool Spot or bilaterally. Prices are volume weighted area price, based on the
monthly area price (from the Nord Pool Spot) and monthly volumes from NVE’s consumption
statistics.
In Norway, the annual allowed income for transmission and distribution companies is based on
a 40/60 split between the companies’ costs with a two year lag (which includes also network
losses) and a norm cost (based on a benchmarking analysis). However, only the physical losses
are included in the cost base and the benchmarking exercises. The network losses are included
in the yardstick income regulation. Hence, if the cost of reducing the network losses is less that
the reduced cost of losses, the company will be measured as more efficient and will get a higher
rate of return.

Portugal
In Portugal, network losses are calculated by the global energy balance of the system and in-
clude physical losses, unavoidable theft and metering errors. In-house consumption is paid for
by regular tariffs and public lighting is not treated as a loss. Losses are calculated by network
type and voltage level by the global energy balance of the system and networks. Losses for the
current year are calculated through hourly loss profiles proposed by the network operators (sub-
ject to approval by the regulator).
The network operators use the loss reduction as a criterion for selection between technical solu-
tions in the planning phase of network development. In addition, the Government approved the
National Plan for Climatic Changes, which establishes a maximum percentage of total network
losses (8.6%) to be reached by the network operators until 2010. This objective was already
reached in 2006.
Concerning the procurement of losses, each supplier has to inject its own energy for compensa-
tion of the losses related to the consumption of its clients. This is done based on hourly loss pro-
files approved by ERSE. Therefore, there is no specific tariff for losses.
In Portugal, the Tariff Code includes an incentive mechanism to reduce losses in distribution
allowing the DSO to be rewarded (charged) if it achieves total distribution losses lower than
(above) a reference value established by the regulator on an annual basis. This incentive
mechanism applies only to distribution networks.
Sweden
Losses are calculated by network type and they are defined as the difference between meas-
ured consumption and production. Due to the type of metering in place, the losses in the distri-
bution network will be less accurate than in the transmission network. One important develop-
ment in Sweden was the rollout of AMR (the meters of all customers will have to be read at least
on a monthly basis by July 1, 2009), which is expected to reduce losses.
In the transmission network, the marginal costs are calculated hourly for all nodal points. The
network operators are responsible for purchases of energy (on the Nord Pool Spot or bilaterally)
in order to compensate expected losses.
For the transmission network, losses are covered by the dependent tariff while the fixed part of
the tariff covers capital costs. The regulation of local networks is based on the network perform-

ance assessment model and is done ex-post (but an ex-ante method is under consideration).
The network performance assessment model is based on a reference grid for each company
and reference losses are priced with the average spot price of the previous year.


Improved Regulatory Models For Efficient Investment and Loss Reduction in Electricity Networks

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Improved Regulatory Models For Efficient Investment and Loss Reduction in Electricity Networks

Hochgeladen von

Copyright:

Verfügbare Formate

Final Report.

Analysis of Insufficient Regulatory Incentives for Investments

submitted to: European Copper Institute (ECI),

submitted by: KEMA Consulting GmbH,

Dr. Konstantin Petrov / Rosaria Nunes

Bonn, January 2009

4.4 Treatment of Losses ................................................................................................... 68

European Copper Institute ii Proprietary

Table 1: Transformer Purchase Price and Estimated Losses.....................................................78

European Copper Institute iii Proprietary

Figure 1: Cap regulation with decreasing price level ....................................................................8

European Copper Institute iv Proprietary

The structure of the remainder of this report is set out as follows:

Chapter 2: Overview of Regulatory Models

European Copper Institute 1 Proprietary

Chapter 4: Analysing Incentives for Efficient Investments

Chapter 5: Case Study on Distribution Losses

Chapter 6: Conclusions and Recommendations

European Copper Institute 2 Proprietary

2.1 Rationale for Economic Regulation

In a narrower definition, regulation may be defined as any actions by government or specialised

Natural monopolies arise if duplication of an infrastructure or service provision is uneconomic,

European Copper Institute 3 Proprietary

European Copper Institute 4 Proprietary

2.2.1 Rate of Return Regulation

TC t-1 total cost in the previous year (inflated)

ROR (allowed) rate of return

RAB t-1 regulatory asset base

European Copper Institute 5 Proprietary

2.2.2 Cap Regulation

European Copper Institute 6 Proprietary

CPI inflation (consumer price index);

X productivity growth rate; and

European Copper Institute 7 Proprietary

Figure 1: Cap regulation with decreasing price level

 Inflation is higher than the efficiency requirement of the regulator;

European Copper Institute 8 Proprietary

2.2.2.1 Types of Cap Regulation

European Copper Institute 9 Proprietary

Price Cap Revenue

Figure 2: Types of cap regulation

European Copper Institute 10 Proprietary

2.2.2.3 Setting the Cap

The most commonly-used ways of setting the cap are the:

European Copper Institute 11 Proprietary

We discuss the differences between the two approaches further in Chapter 4.

2.2.3 Yardstick Regulation

European Copper Institute 12 Proprietary

 firms rarely start from the same efficiency position;

 collusive behaviour is possible; and

2.3 Quality of Supply

European Copper Institute 13 Proprietary

European Copper Institute 14 Proprietary

3.1 Great Britain

3.1.1 Institutional Background

3.1.2 Electricity Transmission

European Copper Institute 15 Proprietary

3.1.2.1 Cap formula

TO t  PR t  TIRG t  PT t  IPt  CxIncRA t  LC t  IE t  ER t  DIS t  TS t  K t

TO t is the maximum revenue;

PR t is the base transmission revenue; see 3.1.2.2 below;

European Copper Institute 16 Proprietary

Kt is the revenue restriction correction term; see chapter 3.1.2.3 below.