Introduction
Rate setting for local distribution companies (LDCs) is often a labor-intensive task for both regulators and LDCs. In Canada, most regulators use some form of rate of return regulation, which involves rate setting mechanism that require very complex and involved cost and performance tracking. One way to avoid this somewhat heavy involvement of the regulator might be to follow the Dutch approach of using price-cap regulation with yardstick competition.
In this approach the regulator simply calculates what the average level of the reported cost per customer class is amongst the appropriate LDC peer group (which includes both operational and capital expenditure costs and a base level return on investment component) and only authorizes rates per customer that will recover this average level of cost.
Those LDCs that can outperform this average cost level (i.e. have lower costs) can then earn a higher rate of return. Similarly, those who do not meet the cost performance standard will earn less than the base allowed return on investment.
This form of rate setting maximizes the freedom and efficiency of the regulated entities and is used in some European countries such as the United Kingdom and the Netherlands. Below we will outline how this kind of regulation is being implemented in the Netherlands.
The Dutch Context
To understand the Dutch approach you first must understand the structure of the regulated energy services sector in the Netherlands. The Netherlands is 250 times smaller than Canada in surface area, but with fully half the population of Canada the country requires a dense electricity and gas distribution network to be able to provide the needed energy services. These services are delivered by eight LDCs through about eight million electricity and seven million gas connections1. These LDCs operate both electricity and gas networks with the three largest LDCs serving more than 90 per cent of the electricity and gas connections. The electricity and gas networks are separately regulated and the LDCs are at least legally unbundled and cannot act as a supplier of the commodity.
The Netherlands has one energy regulator (the Authority for Consumers and Markets2), whose independence is guaranteed by European directives.3 This (national) regulator is responsible for implementing directly binding European regulation and the Dutch Electricity and Gas Acts4 and regulations based on these acts. The Electricity Act and Gas Act prescribe the implementation of price-cap regulation for LDCs.
Price-Cap Regulation with Yardstick Competition
The basis for both revenue and price-cap regulation is that LDCs are incentivized to decrease their cost level with respect to the previous cost level by an efficiency gain or productivity increase (X-factor). The costs of an LDC can then only increase at a rate equal to the increase in the consumer price index (CPI), or whatever measure of inflation has been chosen, less the identified X-factor.5 In price-cap regulation6 with yardstick in the Netherlands, the regulator sets a maximum consumer tariff per customer class for a certain time period (the “price period”, usually three to five years). An example of a customer class is a consumer connection with a certain capacity.
The maximum consumer tariff is based on the efficient cost level of the electricity or gas distribution sector. This efficient level is equal to the average costs per unit output of the sector plus a general productivity increase, which was until the current price period (2011-2013) based on the average cost reduction in a previous price period.7 The X-factor reflects the reduction in costs or the productivity increase an individual LDC has to achieve to reach the efficient level at the end of a price period. The average X-factors for the next price period (2014-2016) are 4.7 per cent for the electricity8 and 6.7 per cent for the gas9 sector.
The X-factor thus leads to a decrease in allowed revenues to a level that is equal to a return for the efficient costs at the end of a price period. This includes a market conform rate of return for investments, because in the Dutch system both operational and capital costs are included in the regulation. The market conform rate of return is based on an estimate of the weighted-average-cost-of-capital (WACC) for a certain price period.10,11 The WACC enters the regulation in three ways: historical values are used to calculate the general productivity increase, the WACC for the current price period (6.2 per cent) is used to calculate the efficient costs at the beginning of the new price period (TI2014)12 and the WACC for the next price period (3.2 per cent) is used to estimate the efficient costs at the end of the next price period (TI2016).13,14
Price-cap regulation with yardstick competition creates a strong incentive for cost reduction, as an LDC that is able to beat the targetted efficiency level (the yardstick) may keep the profit. This incentive is mainly due to the fact that the tariffs are fixed for the price period (and the incentive increases if the price period is extended). The cost efficiency of the whole sector is increased by this competition, so that in the next price period the consumers will benefit via lower tariffs. The method is a relatively light-handed form of regulation that minimizes the administrative burden for both the utilities and the regulator, as the utilities do not have to report individual investments and the regulator is not concerned with how the utilities decrease their costs.
An important prerequisite for yardstick competition is that LDCs have comparable costs for a certain customer class. This is not the case if there are regional differences between cost situations of the LDCs. Examples of possible regional cost differences in the Netherlands include LDCs whose systems might have more water crossings and LDCs that face higher local taxes or other such fees. If a regional difference in the Dutch approach leads to substantial higher costs per customer class for that individual LDC and these costs are considered to be “structural and non-controllable” by the LDC, then the LDC is allowed a higher tariff per customer class.15 At present, despite attempts by LDCs to claim certain of these regional costs differences the only (recognized) regional difference that LDCs have been able to substantiate to the regulator’s satisfaction are some local taxes.16
Efficiency Versus Quality
As indicated above, price-cap regulation with yardstick competition leads to strong incentives for cost efficiency.17 Surveys in the Netherlands have shown that the total costs of the distribution networks, which includes both operational and capital costs, have decreased substantially:18 4.6 billion Euros for electricity (from 2000-2011) and 2.4 billion Euros for gas (from 2001-2011). For the new price period from 2014 to 2016, the costs of electricity distribution will decrease with 8 per cent and for gas with 6.5 per cent.
There is a fear however, that the strong incentive to decrease costs might lead to underinvestments by LDCs in attempts to keep their costs down. A large survey in 2009, ordered by the regulator, did not find proof that LDCs have shown a tendency to underinvest in previous years19, a conclusion confirmed by a more recent report.
Still, to help guard against possible underinvestment, two mechanisms have been introduced to balance efficiency and quality of the energy infrastructure. Electricity LDCs are not only subject to an X-factor, but also to a quality factor known as the Q-factor. The Q-factor should reflect the (non-financial) performance of an LDC20 and leads to a bonus (or a malus) for an LDC if its performance is better (or worse) than its peers.21 Moreover, for both electricity and gas LDCs there is a policy rule that prescribes which processes LDCs must have implemented for managing the quality and the capacity of the networks and that obliges the LDCs to report about these processes to the regulator every two years.
Innovation and ‘Specials’
In general, competition between companies is thought to lead to innovation.22 Some people therefore argue that yardstick competition between utilities in the Netherlands leads to innovation within the electricity and gas distribution sectors. This seems to be true as far as the innovation is aimed at cost efficiency improvements, but it is less clear for broader forms of innovation that would benefit the energy system at large.23 Both to address the risk of underinvestment mentioned above and to facilitate innovation beyond just cost control, a new instrument for ‘special’ investments by LDCs was included in the Electricity Act and Gas Act from July 2011.
The idea of the instrument is to give LDCs more security about their return on investment for some investments rather than within the system of yardstick competition. Investments that need this extra security are ‘special’ investments: investments that are in the public interest, but that do not get a sufficient reward in the yardstick competition, either because other LDCs are not doing them (or at least not on the same scale) or because they do not generate (sufficient) output gains compared to the costs. A ‘special’ investment will always get a separate remuneration within a price period, which means it is kept outside the regulated asset base that is used for yardstick competition. After that, the LDC will keep receiving a separate remuneration as long as the investment is still considered ‘special’.
Conclusions
Price-cap regulation with yardstick competition has led to significant efficiency gains in the Dutch electricity and gas distribution sectors. It is a form of regulation with a relatively low administrative burden and in which some (regional) differences between utilities can be accounted for. Given the success of this form of rate setting in the Netherlands and other European jurisdictions, it has the potential to improve the cost efficiency performance of North American LDCs.
Recently a new instrument was introduced in the Netherlands to provide extra financial security for ‘special’ investments. The drawback of such an instrument is that it takes investments out of the yardstick competition and thus potentially weakens the incentive system. Moreover, it requires an additional administrative burden, which makes the regulation less light-handed. However, the instrument is not yet used by the LDCs, perhaps indicating that the regulation is working fine and that, at the moment, no extra measures are needed.
* Hugo Schotman is an energy consultant from the Netherlands, who is based in Ottawa. He specializes in energy regulation, integration of renewable energy sources and smart energy networks. Before moving to Canada in 2012, he was a senior project manager at the Netherlands Authority for Consumers and Markets (ACM), where he worked on the regulation of the quality of energy networks and of investments in network innovation. He has given presentations on these subjects and is the author of several publications. The author would like to express his sincere gratitude to Yvonne Beyer, Lisette de Boer and Marga Buys of the ACM for their valuable comments on the manuscript. The contents of this publication are however the sole responsibility of the author and can in no way be taken to reflect the views of the ACM.
1 Netbeheer nederland, online: Energie Trends 2012 (in Dutch) <www.netbeheernederland.nl/Content/Files/file/EnergieTrends2012.pdf>.
2 Authority for Consumers and Markets, online: ACM <https://www.acm.nl/en/>.
3 Directives 2009/72/EC (electricity) and 2009/73/EC (gas).
4 Electricity Act 1998: http://wetten.overheid.nl/BWBR0009755/geldigheidsdatum_16-09-2013, Gas Act: http://wetten.overheid.nl/BWBR0011440/geldigheidsdatum_16-09-2013. These Acts implement the EU energy directives and national energy policies.
5 In a formula: TIE=(1+CPI-X)×TIB, with TIE the total revenues (or efficient costs) at the end of the price period and TIB the total revenues (or efficient costs) at the beginning of the price period.
6 The main difference with revenue-cap regulation is that in price-cap regulation the total income is sensitive to changes in the volume of a certain customer class.
7 In the new decisions for the next price period (2014-2016), the general productivity increase is based on a longer period (from 2005), because a sector-wide cost rise in the previous price period has lead to negative X-factors (and thus rising prices) in the current price period.
8 Autoriteit Consument and Markt, Toezicht regionale netbeheerders elektriciteit: X-factoren regionaal netbeheer elektriciteit (2014-2016) (in Dutch), online: ACM <https://www.acm.nl/nl/onderwerpen/energie/elektriciteit/regulering-regionale-netbeheerders/x-factoren-regionaal-netbeheer-elektriciteit-2014-2016/>.
9 Autoriteit Consument and Markt, Toezicht regionale netbeheeders gas: X-factoren regionaal netbeheer gas (2014-2016) (in Dutch), online: ACM <https://www.acm.nl/nl/onderwerpen/energie/gas/regulering-regionale-netbeheerders/x-factoren-regionaal-netbeheer-gas-2014-2016/>.
10 Dan Harris, Bente Villadsen & Francesco Lo Passo, Calculating the Equity Risk Premium and the Risk-free rate (26 November 2012), online: The Brattle Group <https://www.acm.nl/nl/download/bijlage/?id=10972>.
11 Dan Harris, Bente Villadsen & Francesco Lo Passo, The WACC for the Dutch TSOs, DSOs, water companies and the Dutch Pilotage Organisation (4 March 2013), online: The Brattle Group <https://www.acm.nl/nl/download/bijlage/?id=10974>.
12 Supra note 5 (Compare with TIB in the formula).
13 Supra note 5 (Compare with TIE in the formula).
14 Autoriteit Consument and Markt, Methodebesluit regionaal netbeheer elektriciteit (2014-2016) (in Dutch), online: ACM <https://www.acm.nl/nl/download/publicatie/?id=12002>; Autoriteit Consument and Markt, Methodebesluit regionaal netbeheer gas (2014-2016) (in Dutch), online: ACM <https://www.acm.nl/nl/download/publicatie/?id=12003>.
15 This does not lead to an overall rise in consumer tariffs, only to a shift of income from the LDCs that do not have these extra costs to the LDC that does.
16 Since the transfer of high voltage lines to the transmission operator, water crossing longer than 1 km are no longer substantial. The density of the network, with possible higher costs for rural areas, has been under discussion for a long time, but has not been proven to be a regional difference yet.
17 It also leads to a level-playing field, in which LDCs have the same costs per unit output.
18 Tariefregulering in retrospectief: Inventariserend en structurerend feitenonderzoek, Berenschot, 11 April 2012 (in Dutch).
19 Investeringen in energienetwerken onder druk? Een beoordeling van het reguleringskader, PriceWaterhouseCoopers, October 2009 (in Dutch).
20 The Gas Act prescribes a quality indicator for gas, but this was set to zero by the regulator, as the most important attribute of distributing the commodity is not the quality of the commodity, but the safety of the network and it was deemed not prudent to include safety in the yardstick competition.
21 In a formula: TIE=(1+CPI-X+Q)×TIB.
22 See for example Mike Cleland et al, “Economic Regulation and the Development of Integrated Energy Systems” (September 2012) ICES Literacy Series – Paper No. 3.
23 Autoriteit Consument and Markt, “Zienswijze en consultatie: Consultatie over innovatie (in Dutch), online: ACM
<https://www.acm.nl/nl/publicaties/publicatie/7009/Consultatie-over-innovatie/>.