© Frontier Economics Ltd, London.
Investment climate of the Dutch gas
transmission system operator - relation
to the method of regulation
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Contents
1 Introduction 3
2 The investment climate 5
3 The influence of regulation on the investment climate 9
Motivation for regulation ... 9 Regulation’s impact on investment climate ... 10 How can regulation get it wrong? ... 11
4 Regulation and GTS’ investment climate 21
An overview of GTS regulation ... 21 Analysis of GTS regulation ... 24
5 Summary and recommendations 35
Tables & Figures
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Figure 1. Investment framework 6
Figure 2. Investment framework for a regulated firm 10
Figure 3. Reasons for profitability test to fail under regulation 12
Figure 4. Regulation's influence on funding 17
Figure 5. Allowed Revenues 2012 for Transport & Balancing and Quality Conversion, Opex and Capex Share (in prices of 2008) 22 Figure 6. Allowed Revenues and underlying costs for Transport &
Balancing service and RoR 25
Figure 7. Impact of higher opex for material and energy on headline
RoR 27
Figure 8. Impact of higher Replacement investments on the achievable
RoR compared to WACC 29
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Introduction
1
Introduction
1.1 The NMa has asked Frontier Economics Ltd to assist with a study of the investment climate facing the Dutch Gas Transmission System Operator by addressing three questions:
1. What are the determinants of the investment climate for GTS?
2. How and to what extent are these determinants set or influenced by the method of regulation (taking into account of the relevant balance between reasonable tariffs for users and an appropriate return on investment)? and 3. What are the lessons learned – both positive and negative – for
developing a method of regulation for GTS that facilitates necessary and efficient investments while guaranteeing reasonable tariffs for users? 1.2 This report presents our findings in relation to these questions.
Genesis of the NMa’s concerns
1.3 Two key factors have motivated the NMa/EK‟s request for a study of how the method of regulation for GTS affects the investment climate. These are:
The Dutch Trade and Industry Appeals Tribunal has recently annulled the Method Decisions for regulation for gas transportation, gas balancing and quality conversion covering the period 2009 to 2012, requiring NMa/EK to reconsider its previous Method Decisions.
Any revised Method Decisions need to provide an appropriate return on investment and incentives for GTS to invest in the construction of new infrastructure for which shippers have sufficient economically justified demand. Potential drivers of the requirement for investment include, in particular:
The current decline of indigenous gas production is making it necessary to invest in LNG import terminals and enter new long-term gas supply contracts;
New sources of supply have much less swing than that offered by indigenous gas fields and there is therefore a need for increased gas storage;Introduction
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Relationship between GTS and Gasunie
1.4 In an early implementation of ownership unbundling the originally integrated gas company, Gasunie, was split in 2005 into a gas trading company (now called
GasTerra) and a gas transportation company. The split of Gasunie took place through a buy-out by the Dutch State of the shares originally held by Shell (25%) and ExxonMobil (25%) in the infrastructure part of Gasunie. The Ministry of Finance agreed on a price of 2.8 € billion. In 2005, Gasunie‟s tangible fixed assets (in effect GTS‟s gas transport network and ancillary services assets) were re-valued by Gasunie from 1 € billion to 5.1 € billion as of December 31st.. 1.5 GTS is a 100% subsidiary of Gasunie and operates as an independent provider of
gas transmission services in the Netherlands: this role is defined in the Gas Act. The assets used to provide gas transport services are nevertheless owned and financed by its parent company, formally NV Nederlandse Gasunie.
1.6 For the purposes of this report we treat GTS and Gasunie as though they were combined as a single entity. Unless we specify the contrary, references to GTS can be read as referring to the combination of GTS and Gasunie.
Organisation of our report 1.7 This report is organised as follows:
Section 2 identifies the generic questions that any firm would need to address in order to arrive at a decision on whether or not to invest in a particular project. The investment climate consists of the external factors that have the potential to affect the investment decision ;
Section 3 reviews the ways in which, for a regulated industry, the method of regulation impinges on the investment climate. It also provides a framework for analysing whether a particular regulatory regime does or does not provide appropriate incentives for investment.Draft
The investment climate
2
The investment climate
2.1 In this section we identify the generic features of the investment climate for a firm. We consider how economic regulation impinges on the investment climate in Section 3.
2.2 While there is a huge literature describing and explaining the behaviour of firms, it is sufficient for our present purposes to see them as entities who in general seek to maximise the value they are able to create for their shareholders. In doing this firms may seek to maximise the present value of their profits but they are obliged to do this within a number of constraints. Constraints may include but not be limited to:
the laws of the jurisdiction in which the company operates,
the company‟s articles of association or equivalent;
the availability of finance; and
the management and skills capacity of the firm.2.3 Some constraints are from the company‟s perspective immutable, eg the legal environment. Others may be relaxed at a cost, eg the availability funds or the management capacity of the firm.
2.4 Investment decisions, as other decisions of a firm, are taken in order to maximise the present value of profits, subject to prevailing constraints. The framework for investment decisions is illustrated graphically in Figure 1. In essence a firm identifies a market opportunity (Block 1) and then analyses the economics of that opportunity having regard to the inputs that exploitation of the investment opportunity requires (Block 2), eg investment funds, management resources etc. 2.5 Each of the inputs required to exploit an opportunity has a cost, which becomes
one of the inputs to the assessment of profitability. If all inputs are available without constraint, the investment decision for any isolated project depends solely on its profitability. If input resources are constrained or if there are major interactions between projects, eg certain projects are mutually exclusive, the investment decision formally drops out of more complex maximisation of profit, subject to the prevailing constraints.
2.6 Generically, we may define the investment climate as the set of factors external to the firm that might be expected to affect the outcome of an investment decision. Hence, the investment climate consist of all those factors that affect:
The investment climate
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the cost, or opportunity cost, of the inputs that the firm would requireto put into producing the outputs;
the risk characteristics of the business; and
the constraints within which the firm must operate.Figure 1. Investment framework
2.7 As we will go on to explore in the next section, the way in which economic regulation interacts with factors affecting the firm‟s expectations is limited. In essence economic regulation has the ability to affect:
the revenue stream that the firm is able to earn; and
the business risks that firm faces, which are in turn reflected in the availability and cost of capital.2.8 Given this perspective, it is reasonable view the effect of regulation as its effect on two tests:
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The investment climate
with the cost of the capital that is required to finance it. The cost of capital, in turn depends on the risks that the project entails. Corporate finance theory suggests that shareholders with an ability to hold a diversified portfolio of assets are primarily concerned with systematic risk rather than diversifiable risk. However, even diversifiable risk may increase the required rate of return.
Key parameters for this test are:
a project‟s net-revenues / rate of return
the riskiness of the investment (primarily systematic); and
the related cost-of-capital.
Financeability test - If the profitability test is passed, does the firm have adequate access to capital to make the investment without incurring costs and risks that reverse the result of the profitability test? In addition to the meeting the condition of overall profitability, the firm needs to be able to finance the investment, given the financial circumstances in which it operates and the sources of new finance that are available to it. In essence in this case, GTS needs to have a feasible strategy to finance its investment programme without breaching the financial covenants imposed by existing lenders and without incurring such risks that new investment becomes so costly as to reverse the outcome of the profitability test.More generally, it is usually considered undesirable to raise the firm‟s actual cost of capital materially by causing it to be over geared, even if this would not lead to the investment becoming unprofitable. In practice regulators frequently set a benchmark credit rating which they will enable the regulated firm to maintain under reasonably efficient management.
Key parameters for this test therefore are:
the regulated firm‟s current and projected financial position (e.g. gearing level, operating cash flow, interest cover etc)
existing loan covenants;
the firm‟s credit rating; andThe investment climate
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2.9 Only if both tests lead to a positive assessment will the climate be conducive to investment and hence the firm decide to go ahead. 1
1 This is a simplification. There might be other reasons for an investment decision, e.g. political
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The influence of regulation on the investment
climate
3
The influence of regulation on the
investment climate
3.1 Before discussing exactly how economic regulation affects investment decisions we first analyse the motivation for economic regulation and hence why regulated firms will perceive it as being in their interests to say that existing regulation is not conducive to investment.
Motivation for regulation
3.2 Economic regulation is generally applied to firms that have a natural monopoly. If unregulated (and free of the more general strictures of competition law), a firm would be expected to invest less and supply less than is socially optimal. It would be expected to set higher prices to ration demand to more limited capacity, thereby capturing as producer surplus value that would in a competitive market be consumer surplus. The result of this behaviour would normally be that the firm earned more than its cost of capital, with its returns including an element of monopoly rent.
3.3 Economic regulation is designed to prevent a firm from benefitting from such restriction of output, with the result that output is nearer to that which is socially optimal. Typically regulation does this both by limiting tariffs/revenue and by imposing service obligations.
3.4 In broad terms most economic regulation is designed to allow a reasonably efficient firm to earn just its cost of capital, emulating the profitability that would be achieved if the industry were competitive2. This can be done by restricting the allowed rate of return directly or by the restriction of either revenue or prices in an incentive regime.
3.5 Whatever the precise mechanism of the restriction, the intention is that the prospective return (at least for an averagely efficient firm) should be equal to the cost of capital and no more. Hence, if regulation did not make the profitability of investment only very marginally attractive, there is a prima facie case that it would not be doing its job properly.
3.6 Inevitably, it is in a regulated firm‟s interests to imply that it has no incentive to invest and hence requires a more generous regulatory regime.
2 This is a principle that is often espoused but needs clarification. If the activity were indeed provided
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Regulation’s impact on investment climate
Figure 2 shows an adaptation of the investment framework previously described in Figure 1, introducing regulation. Regulation has the effect of moderating the business opportunity that the firm perceives notably by constraining revenue. It may also, by its effect on risks, change the cost of capital which financial markets would demand for the activity.
Figure 2. Investment framework for a regulated firm
Market characteristics / costs / revenues Potential investment WACC •Maximise value •Feasibility within constraints Price Risk Volume Risk Financial market conditions Interest level Risk assessment 1 2 Investment decision Market opportunity (Output market) Input markets Financial market, other inputs... Regulation Allowable costs / revenues Achievable Rate of Return 3
3.7 Although the intention of regulation is, if anything, to increase rather than decrease investment, it clearly has the potential to be such a strong influence on a firm‟s assessment of an opportunity that it could cause a firm to reject an opportunity that it would be socially desirable for it to accept3.
3.8 As already discussed, in essence any investment decision ultimately is subject to the two key tests of profitability and financeability. In a normal (unregulated) firm, market circumstances ultimately set the parameters determining the decision for each test, e.g. through determining:
3 We note that in reality investment decisions for a regulated company are rather more complex. The
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The influence of regulation on the investment
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the demand for services and the quantum and characteristics of the revenue that can be earned as well as the cost of providing those services; or
the rate of return investors require and the ease with which finance can currently be raised.3.9 In a regulated industry, such as gas transmission, regulation has a major influence on many of the most important of these factors determining the outcome of these two tests. Specifically, regulation determines:
the obligations of the regulated firm, which largely determine the need for investment;
the allowable revenue that the firm can earn;
the nature and structure of the tariffs that the firm can charge which, together with market factors, determine the risk characteristics of the business; and
the financial market‟s assessment of the stability of the firm‟s financial performance.3.10 While most attention is focussed on the ability of regulation to disincentivise investment, regulation can, through socialisation of costs remove risks that might in other circumstances have inhibited investment.
3.11 Regulation and market circumstances together make up the complete picture of
the circumstances surrounding the prospective investment (ie the investment climate) and hence the decision as to whether or not to proceed.
3.12 Regulation does not affect the criteria that investors will apply in deciding
whether to invest in a project but it will affect whether the firm is able to meet the criteria set.
How can regulation get it wrong?
3.13 In this section, we focus on the ways in which regulation might adversely affect
investment decisions in an unintended way, developing a general framework in which to explore the problems that regulation may cause. We address the two key tests in turn, namely:
the profitability test; and
the financeability test. Profitability testThe influence of regulation on the investment
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It can simply leave the firm with inadequate revenue to cover costs,including the cost of capital; or
It can distort investment decisions by the difference in the regulatory treatment of investment and operating costs.3.15 We address these in turn.
Inadequate cost recovery
3.16 An investment in a regulated business will fail the profitability test if the effective rate of return (RoR) that is feasible under regulation is less than the cost of capital that reflects the risks associated with that business. The scheme in Figure 3 illustrates the principal ways in which this can occur.
Figure 3. Reasons for profitability test to fail under regulation
Profitability test fails if effective RoR is less than WACC (reflecting the risk), because
Headline RoR too low
Headline RoR sufficient, but effectively lower
Methodological issues Parameter issues
Source: Frontier Economics
3.17 The rate of return that can be achieved by a regulated investment might be too
low for either (or both) of two reasons:
The regulator has underestimated the required RoR (i.e. cost of capital) – In this case the “headline” rate of return allowed under regulation is not sufficient to meet the criterion of the profitability test. That is the rate of return that the regulator believes is equal to or greater than the true weighted average cost of capital (WACC) is in fact below the true WACC. Under these circumstances any rational firm with an option not to invest will choose not to do so; and/or
The regulator misestimates the ability of the firm to earn the allowed headline RoR – In this case the “headline” RoR allowed under regulation may be sufficient. However, circumstances do not allow the company to realise this return. In consequence, it may be the case that the effective rate of return that can be earned from an investment does not meet the true cost of capital as perceived by investors in that type of business.3.18 Whether or not the first becomes an issue particularly depends on the
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The influence of regulation on the investment
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to which this methodology considers the factual determinants of a regulated company‟s cost of capital. While this in practice might be subject to controversy in individually cases, we understand that this is the subject of a specific study being commissioned by EK and hence we do not elaborate on the estimation of the WACC in this report.
3.19 From our experience the second possibility is a constant issue for debate in almost every regulated sector in any country. We therefore focus on this aspect in the remainder of this subsection. Possible reasons for the effective allowed RoR falling short of the headline value can be can be classed as falling into one of two categories:
methodological issues; or
parameter estimation issues. We will discuss each category in turn.Methodological issues
3.20 A methodological issue exists if, even when the outcome for all costs and revenues is exactly as forecast, the regulated firm will still not earn a true rate of return equal to the intended headline rate. For example, a regulator might grant an adequate WACC to a company, but the method of regulation might not provide a return on investment immediately from the time at which the investment was actually made but rather only from some later time when the asset in question was already operational. This would mean that, under precisely normative performance, the regulated company would never earn the headline allowed rate of return because a proportion of the investment that it had made was earning a zero return and only the rest was earning the headline rate. Hence the weighted average of the returns would always be less than the headline rate.
3.21 There are various ways in which similar problems could occur in practice, e.g.:
Time lags – If for instance there is a significant time lag between the time an investment is made and the time at which that investment is added to RAB and hence becomes eligible to earn a rate of return under the existing approach to the calculation of allowed revenue.The influence of regulation on the investment
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depreciation is handled a minimum of one year‟s depreciation, and possibly more, would fail to be recognised in the allowed revenue calculation.
Parameter issues
3.22 Even if the methodology is internally consistent and hence capable of allowing
the headline rate of return to be earned under normative performance, a problem would still arise if the regulator were consistently to underestimate the costs (either opex or capex) that the firm will incur or to overestimate the quantum of sales that regulated firm will make. (We use the word „consistently‟ not because a major one off error in estimation cannot cause problems but because any attempt to set normative efficient costs will be subject to some errors. So long as the errors are small and not biased against the regulated firm, they should not cause a major problem.) However, we also note that there is a school of thought that suggests that welfare outcomes are not symmetric and outcomes in which the regulated firm does slightly better rather than slightly worse than intended are preferable).
3.23 In the following, we describe typical examples of these kinds of errors:
Underestimation of required capex (if revenue does not adjust automatically) – In the context of an aging network, where replacement investments are expected to rise consistently for some time, any backward-looking approach to the determination of capex requirements for replacement investment tend to lead to systematic underestimation.
Underestimation of efficient opex – A key danger in incentive regulation systems is the setting of overly aggressive efficiency targets. In our experience there are two typical reasons for this.
The first stems from the observation of historic performance. Regulated firms may make rapid gains in the first years after they are subject to incentive regulation but inevitably productivity growth slows when the majority of the „fat‟ has been eliminated. An assumption that historic rates of productivity growth can be extrapolated will be likely at some point to lead to an overestimate of future savings;Draft
The influence of regulation on the investment
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Overestimation of the volume of sales – In this context the word „volumes‟ refers to the quantity of the product sold by the regulated company (e.g. references to volume should encompass sales of capacity for a network operator, not just the transportation of a volume of commodity). If the actual volumes fall short of the volumes on which the tariff calculation has been based, revenues will also fall short of the anticipated value, leading to a reduction in the achieved rate of return.Distortion of profitability
3.24 As firms seek to maximise profits, they will react to the incentives that they face. All firms face, to a greater or lesser degree, a trade off between opex and capex. Investment (capex) can be spent now in order to reduce future opex. An unregulated firm faces incentives which do not distort the choice between opex and capex and by and large firms can be expected to make efficient decisions to minimise cost with prices determined by the market and not by their own costs. 3.25 Regulated firms, especially firms which do not have a peer group enabling
benchmarking alone to determine allowable costs, are in a different position. Their reported costs have an effect on their revenue because allowed revenue has is influenced by actual costs incurred. The problem arises because regulatory regimes do not necessarily treat capex and opex in the same way. If the regulatory regime is not neutral as between capex and opex, the investment decision may be distorted. For example, in the early years of UK energy network regulation, there is a consensus that the regulator was more comfortable benchmarking opex than capex or the capital stock. This had the effect that capex was subject to a higher degree of pass through than opex and hence decisions were biased in favour of capex. In our experience it is more common to find a bias in favour of investment but the actual bias in any given case depends on the way in which the price control is set.
Financeability test
3.26 Simply having an expectation that reasonably well managed projects will earn an
adequate profit is not a sufficient condition for being able to invest. Funds also need to be available. If the regulated business needs to expand rapidly it can be short of funds even if it is profitable.
3.27 The regulatory issues that surround financeability of investment are generally less
to do with „mistakes‟ in a regulatory regime than with simply the extent to which the regulatory regime has the flexibility to cope with periods in which heavy investment needs to be made. The other key issue is the relationship between the firm‟s regulated business and the other activities that the firm may undertake.
The influence of regulation on the investment
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first discuss briefly the generic sources of funds that a firm may be ableto use for investment;
we then identify the main sources of funds on which we would expect GTS to need to rely;
we then go on to discuss how regulation can affect the availability/cost of funds from these sources; and
finally, we discuss the issue that a firm‟s financial position is derived only partially from the regulated business.Generic sources of funds
3.29 Investments may be financed from one or more of the following sources of funds:
existing cash reserves;
future cash flows generated by operations;
proceeds of disposals; or
external capital (either equity or debt).As illustrated in Figure 4, regulation has potentially direct and indirect impact on all sources of funding:
Through determining the three main parameters of a regulated company‟s cashflow, regulation directly influences the ability for self funding based on future cashflow (and past regulation affects the existing cash reserves).
Through its influence on cashflow and profitability, regulation affects a company‟s ability to attract new investment in the form or either debt or equity;
Additionally, both the nature and the stability (or otherwise) of regulation may change the investors‟ perceptions of risk.Draft
The influence of regulation on the investment
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Figure 4. Regulation's influence on funding
Main sources for finance
Cash reserve / disposals Future cashflow
Debt Equity
RAB x Allowed RoR
+ depreciation of RAB – interest – tax – dividends
Cost of debt depend on credit rating Depend on current ownership
structure
Depend on historic cashflow Main influence of
regulation
Regulator directly influences cash-flow through three bold parameters
Regulator creates an additional source of risk through unpredictable changes to the regime
Cashflow impacts access to
Source: Frontier Economics
3.30 We elaborate further on these effects in the following subsections.
Internal cash generation (for self financing)
3.31 When allowed revenue is designed to give a particular rate of return on RAB, the
cash generated by the regulated business and available for investment can be thought of as being approximately:
3.32 RAB x Allowed RoR + depreciation of RAB – interest – tax – dividends
3.33 Regulation has a role to play in determining three of these parameters: the RAB,
the allowed rate of return and the depreciation rate on which the allowed revenue calculation is based. However, the regulator may have limited freedom in terms of what can be done with these parameters. Both the value of RAB and the allowed rate of return should be set on an objective basis and not flexed to meet an internal cash generation target. Any flex in these would either over or under reward the company.
3.34 The only parameter over which it is practicable to use some discretion is the rate
The influence of regulation on the investment
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higher. This would change the time profile of the cash flow that the investors receive but not alter its present value.
3.35 The other regulatory „fix‟ has an economically very similar effect. It is to include an element in the allowed revenue that is regarded as a consumer contribution to financing capital investment. The amount financed in this way would be subtracted from the RAB in the calculation of future allowed revenue, reducing allowed revenue at that time which has the effect of „paying back‟ the consumer. 3.36 Both methods have the same present value of the stream of revenue that an
investment generates. Both methods have the effect of asking consumers to pay more now and less later to ease a financing constraint. The advantage of the second method is that it is more flexible and allows a particularly tight year for cash flow to be managed without deviating from more sensible longer term arrangements.
3.37 Both mechanisms leave the return earned by the company unaltered.
3.38 In this context it is worth noting that the need for increased cash flow may arise
directly as an „absolute‟ shortage of funds for the firm or may arise because the firm would otherwise be in breach of loan covenants that have been imposed by existing lenders.
Additional capital (debt or equity)
3.39 If a company‟s financing plans requires it to raise external debt or equity, either
as a replacement for existing debt or as additional capital to finance increased investment, then the company must face the disciplines of the capital market. I.e. the company has to compensate investors for the risk that they take. Relevant considerations depend on the type of capital being raised:
Debt - The cost of new debt issues can be thought of as being determined by the credit rating of the borrower. A company may get into a position where its credit rating is downgraded, raising the potential cost of new debt, before it falls foul of existing loan covenants. Hence, the need to maintain a sufficiently strong financial position in order to be able to borrow may be the binding financial constraint. Generally, regulators try to avoid putting a regulated firm in a position where the only way in which it can fulfil its obligations is to become over geared and pay expensively for new debt4.
4 Although regulators are not responsible in any way for the financing decisions that regulated firms
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The influence of regulation on the investment
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Equity – While the cost of equity will ultimately also be driven by the systematic risk involved in a company‟s activity (and therefore in principal the same parameters as for debt become relevant), in practice the ability of a company to raise equity will further be influenced by its current ownership structure. While a listed public company might have relatively easy access to private equity, conditions may be different for a 100% state owned company where there is only one provider of equity and that provider may face non commercial constraints on its ability to inject further equity.3.40 The issues that arise for a regulator are therefore:
What credit rating should the regulator make it feasible for a company to maintain? ; and
How should the regulator do this?Draft
Regulation and GTS’ investment climate
4
Regulation and GTS’ investment climate
An overview of GTS regulation
4.1 Although the Dutch Trade and Industry Appeals Tribunal has recently annulled the Method Decisions for regulation for gas transportation, gas balancing and quality conversion covering the period 2009 to 2012, it is worthwhile to have a deeper look at the Method Decision for GTS. This allows us to understand the principles of regulation applied to GTS and to identify drawbacks in the Method Decision that may bias investment decisions either negatively or positively. 4.2 In this section we describe the Method Decision for GTS by answering the
following questions:
How did Energiekamer determine the allowed revenues for GTS?
How did Energiekamer determine the allowed operating expenditures for GTS?
How did Energiekamer determine the allowed capital expenditures for GTS?
How did Energiekamer convert the allowed revenues into a price cap? Allowed revenue – Determining the revenue path4.3 Whether ultimately controlled by a revenue cap (2006-2009) or a price cap (2009-2012), the control has been based on an assessment of what should be the allowed revenue5. Figure 5 shows the values for the allowed revenues at the end of the regulatory period 2012, which were used to calculate the revenue path for the period 2009-2012.6 The allowed revenues in 2012 for the transport & balancing and quality conversion services were €770m and €104m, respectively. Allowed revenues consist of an allowed opex and capex elements. One can also see from Figure 5 that the capex element for the transport & balancing service dominates the allowed revenues.7
5 We note that the Dutch Trade and Industry Appeals Tribunal annulled the 2006-2009 Method
Decision partly because it was based on a revenue cap system.
6 All revenues and costs are stated in prices of 2008.
7 For further calculations we only focus on the transport & balancing services, because this is the area
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Figure 5. Allowed Revenues 2012 for Transport & Balancing and Quality Conversion, Opex and Capex Share (in prices of 2008)
T&B Q-conv OPEX 2012 CAPEX 2012 € 770 Mio. € 104 Mio. Source: Energiekamer
4.4 Based on the revenues at the start of the regulatory period 2008 (BI2008) and the allowed revenues at the end of the regulatory period in 2012 (EI2012) X-factors were calculated such as to be consistent with the following formula:
4.5 Thus, EK‟s objective in setting the X-factor was to determine a revenue path bringing the starting value to the allowed value at the end of the regulatory period. EK used a stable path with no initial discontinuity, instead of a P0 cut, which is common, for example in the UK regulation. The joint X -factor for the transport and balancing was set at 6.2%. The X -factor for the quality conversion services was set at - 1.6%.
Revenues – Determining the allowed opex for 2012
4.6 One of the principles of Energiekamer, when regulating energy networks, is to avoid using companies‟ costs forecasts in setting the allowed revenues. Energiekamer bases its Method Decisions on the latest available audited cost figures from profit & loss statements. This principle was also used for determining the allowed opex for GTS in 2009-2012. Energiekamer used 2007 figures for opex, which were indexed by CPI and a productivity offset to convert them into 2008 values.
4.7 Energiekamer differentiated between opex for labour and opex for material and energy. The value of the productivity offset (PV) for labour costs was set at 2%. For the opex for material and energy the productivity offset was calculated based on past performance leading to a value of 8.2% for the transport & balancing service and -7% (ie an increase in opex) for quality conversion services.
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Regulation and GTS’ investment climate
4.8 The allowed opex for labour (opexarb)8 in 2012 are calculated according to the following formula:
Revenues – Determining the allowed capex for 2012
4.9 Energiekamer calculated the allowed capex for 2012 as the sum of the depreciation 2012 and the cost of capital 2012, i.e. WACC multiplied with RAB 2012. In order to calculate depreciation in 2012 and the RAB for 2012, Energiekamer had to forecast the annual replacement investments for the period 2009-2012. The forecast was based on the three year average of replacement investments for 2005-2007 and amounted to € 52 Mio. per year.
4.10 Based on annual replacement investments of € 52 Mio. Energiekamer rolled
forward the starting value of the RAB in 2007 to 2012 and calculated the capex to 2012. Energiekamer did not apply any productivity offset on capex.9
4.11 Investments in extensions of the network are treated in a different way. Although
not formally added to RAB, they are treated in a manner that is equivalent to becoming part of RAB at the end of the year in which they become operational. Energiekamer assumes that the commissioning date is always the 1 July. Thus, the depreciation for the first year of operation is only half the normal annual amount. Not only are the investment costs remunerated, the rolled up opportunity cost of finance during construction (ie WACC applied to the whole value of all capex) is also treated as an investment and remunerated.
4.12 Additionally, Energiekamer increases the allowed opex by an amount equal to 5%
of the investments costs reflecting potential higher opex due to an increase in the physical asset stock. Energiekamer does not look to see if the higher opex would really arise during the regulatory period. According to the Gas Act, GTS must make its tariff application by 1st September each year. GTS can apply for the inclusion of costs related to any assets that are operational at that time. GTS has asserted that there is an uneven pattern of asset commissioning with a disproportionately high share of for assets being commissioned shortly after tariff application. This uneven pattern seems plausible to us as gas assets are often commissioned shortly before the winter in which they will be needed. If there is an uneven pattern, proposing tariffs by the 1st of September can be inconvenient.
8 The calculation for the opex for material and energy are calculated in the same way.
9 It has to be stressed that this is different from the treatment of the CAPEX for the electricity
transmission operator, TenneT, where productivity offsets are also applied in respect of CAPEX.
4 2008
, 2007 ,
2012arb OPEX arb (1 cpi PVarb) (1 PVarb)
Regulation and GTS’ investment climate
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Tariffs – converting allowed revenues into prices.
4.13 Energiekamer used a price cap for the regulatory period 2009-2012. This means
that the prices or a price basket follows a certain path. Energiekamer uses 2007 volumes as the weighting factors for the price basket. In the case of a price cap the regulated company bears the volume risk.
4.14 The allowed revenues are converted into tariffs by determining tariffs for which
the equation Allowed revenues in year t = Volumes 2007 * Tariffs in year t holds. Thus, if there exists a rising trend for gas demand than the price cap will create an upside for GTS coming from higher outturn volumes than 2007 volumes.
Analysis of GTS regulation
4.15 Based on our discussions with GTS and Energiekamer, we have analysed the
main elements of the latest Method Decision for GTS in order to assess the extent to which the method of regulation may have had an impact on the two key investment tests:
profitability; and
financeability. Adequate profitability test4.16 In this subsection we analyse whether the method of regulation applied by the
Energiekamer should be expected under normative performance to lead GTS to over or under recover costs including the cost of capital in the regulatory period 2009-201210. We focus on:
determination of the Revenue Path
determination of allowed opex
determination of allowed capexAll calculations are based on the figures for the Method Decision 2009-2012.
Determining the Revenue Path
4.17 As shown above, Energiekamer used a stable revenue path to move smoothly
from starting revenues to its estimate of allowed revenues at the end of the regulatory period. The revenues at the end of the regulatory period reflect the total costs. The impact on the headline RoR of this procedure depends on the
10 We note that the method of regulation is designed to encourage cost reduction below the normative
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relation between the total costs and the starting revenues and the relation between the total costs and the revenues during the regulatory period. If for example the starting revenue in 2008 is higher than the total cost in 2008 then GTS can earn an additional profit, because in this case allowed revenues tend to be above the underlying allowed total costs until the end of the regulatory period in 2012.
4.18 Based on the figures for the transport & balancing and quality conversion service one can show that the revenue path allowed additional profits on top of the WACC for GTS. For the following calculation we assume that the underlying costs set by Energiekamer were appropriate. Figure 6 shows the results for the transport & balancing service. The allowed revenues from 2009-2011 are always higher than the underlying costs11, leading to a mark-up on the WACC ranging from 1.3% to 0.4% pa. We get similar results for the quality conversion service, with a mark up on WACC ranging from 0.9% to 0.6% pa.
Figure 6. Allowed Revenues and underlying costs for Transport & Balancing service and RoR12 936 877 822 770 864 831 800 2009 2010 2011 2012 Mi o .€
Revenues Total Costs
6.8% 6.4% 5.9% 5.5% 2009 2010 2011 2012 RoR WACC
Source: Frontier calculations
4.19 In other jurisdictions, for example in the UK and Austria, regulators set the allowed revenue path in two stages:
P0 cut – at the start of the regulatory period the regulator reduces the starting revenues in an initial step to align them with the starting total costs. If revenues are lower than the total costs the regulators increases them.
Stable path in following years – during the regulatory period the regulator sets a stable path to align revenues and underlying total cost during the regulatory period.
11 For calculating the underlying costs we assume that GTS can manage to fulfil the productivity
offsets on opex.
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4.20 The combination of P0 and the X factor are set such that the present value of
revenue is expected to be equal to the present value of all costs. This then takes account of the costs that the firm is expected to incur in the intermediate years as well as at the end of the period.
4.21 We note that it does not automatically follow that the method applied by Energiekamer will be too generous. It is just that by focussing on allowed costs in the terminal year, there is no certainty that, even with precisely normative efficiency performance, GTS will earn the intended allowed RoR.
4.22 We recommend that Energiekamer should consider modifying its approach to
setting an allowed revenue path to be one which meets the criterion that the expected present value of revenue should be equal to the expected present value of costs.
Converting allowed revenues into tariffs
4.23 As shown above Energiekamer used volumes from year 2007 to convert allowed
revenues into tariffs for the regulatory period 2009-2012. This means that the outturn revenues from GTS are only in line with the allowed revenues if volumes are stable at 2007 levels. But based on gas transportation demand data for the Netherlands we would expect a rising volume. This allows GTS to earn an extra profit for each volume unit exceeding 2007 levels, because the incremental revenue from selling one unit more gas tends to be higher than the incremental cost.
4.24 In other jurisdictions, for example in the UK, regulators are using a revenue cap,
for which volume has only a limited influence, to align the allowed with outturn revenues. The regulated companies set the tariffs based on forecasted volumes, where the tariffs multiplied with the forecasted volumes are equal to the allowed revenues for the next year. At the end of the year the outturn revenues are compared with the allowed revenues. Any difference is accounted to the company or the customers.
4.25 We recommend that the system of regulation should be made more robust to outturn volumes by making allowed revenue track more closely the normatively expected costs that would arise at any given volume. This could be done in two ways, depending on what is legally possible:
Setting a price cap that has the economic effect of being a revenue cap – i.e. the price cap would have the form of an allowed revenue divided by the actual volume served. Energiekamer would need to take legal advice to ensure that this is a legitimate approach under the Gas Act.Draft
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Determining the allowed opex for 2012
4.26 Energiekamer determines the productivity offset for opex for material and energy
– including fuel gas – based on past performance and determined a value of 8.2% for the transportation & balancing service, i.e. meaning an annual reduction of 8.2% of these costs. In our discussion with GTS, the company criticised this productivity offset because it is based to a large extent on non-controllable opex, the market price for fuel gas. The increase in performance was only the consequence of falling gas prices in the past and there should have been no expectation that such a trend would continue over the prospective price control period.
4.27 Based on figures for the transport & balancing service, one can show that there is a big impact of higher outturn opex for material and energy than allowed by Energiekamer caused by non-controllable cost items, e.g. stable not falling gas prices, on the underlying costs and hence the achievable RoR. Figure 7 compares the allowed revenues and the outturn total cost. We assume as an illustration that due to stable gas prices the outturn opex for material and energy remains stable and does not decrease annually by the Energiekamer value of 8.2% pa. From Figure 7 one can see that the higher non-controllable opex would shift the achievable RoR below the WACC in the third year of the regulatory period.
Figure 7. Impact of higher opex for material and energy on headline RoR
936 877 822 770 892 872 851 832 2009 2010 2011 2012 Mi o .€
Revenues Total Costs
6.3% 5.6% 4.9% 4.2% 2009 2010 2011 2012 RoR WACC (5,5%)
Source: Frontier calculations
4.28 Energiekamer argues that this is only a short term problem because, for the next
regulatory period, the performance will be calculated based on the past again and over time things will average out.
4.29 We have two comments in relation to the present method:
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investment must be maintained as a reserve in case of gas prices that are high relative to the mechanistic allowance made by Energiekamer.
This regulatory treatment of gas costs is also unnecessary. The Dutch gas market is one of the most liquid markets in Europe. This means that this element of future costs could be estimated using gas forward prices and, if desired there are shorter term or spot gas prices that could be used to deal with deviations from the predicted value.4.30 In electricity, network losses pose a similar problem. Indexation to an
appropriate energy price, at least in respect of a normative volume is a sensible way to deal with a cost mover which the utility has very limited control. For example, the Austrian and also the Norwegian regulators calculate the cost for networks losses based on a prices index from the EEX and Nordpool, respectively.
4.31 We recommend excluding the non-controllable gas price from the productivity
offset. Instead, we recommend that the allowance for cost elements that are driven by the gas price be linked to a transparent gas price index.
Determining the allowed capex for 2012 – Replacement investments
4.32 Energiekamer determines the replacement investments for the regulatory period
based on the average replacement investments of the past. In our discussion with GTS the company claimed that, owing to the age of its assets, it is expecting higher replacements investments in the future than in the past. Thus, the calculated capex for 2009-2012 based on the three year average from 2005-2007 of €52m tends to underestimate GTS replacement needs.
4.33 The treatment of replacement costs may create a problem in terms of the
normatively achievable Rate of Return owing to:
a methodological issue – time lag problem in including higher investments in the RAB; and
a parameter issue – underestimation of replacement investments.4.34 We have tried to explore the possible impact on the normatively achievable rate
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Figure 8. Impact of higher Replacement investments on the achievable RoR compared to WACC 936 877 822 770 874 846 819 794 2009 2010 2011 2012 Mi o .€
Revenues Total Costs
6.7% 6.2% 5.7% 5.2% 2009 2010 2011 2012 RoR WACC (5,5%)
Source: Frontier calculations
4.35 In an second step we tried to isolate the effect of higher replacement investments
on the Rate of Return by comparing the headline Rate-of-Return for the case:
Case 1 – € 52 Mio. Replacement Investments (Method Decision)
Case 2 – € 100 Mio. Replacement Investments4.36 Figure 9 shows indicative results. The cumulative impact of higher replacements
investments in 2012 on the Rate of Return is 0.3%.
Figure 9. Impact of higher Replacement investments on RoR
6.8% 6.4% 5.9% 5.5% 6.7% 6.2% 5.7% 5.2% 2009 2010 2011 2012 Case 1 Case 2
Source: Frontier calculations
4.37 There might be a problem for the normatively achievable RoR if in the coming
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4.38 In other countries regulators deal with this problem by relying on forecast values
when setting the allowed revenues. In order to avoid inflated forecasts from companies, regulators are auditing companies‟ forecasts by themselves or by technical consultants. The UK regulator, Ofgem, for example compares the companies‟ forecast with the forecast of a technical consultant. Based on the difference between these two forecast its sets different incentives rates for future efficiency gains.
4.39 We recommend that Energiekamer should evaluate if GTS is entering a new
investment cycle for replacement investments, expecting higher replacement needs than in the past. If this is the case then Energiekamer should consider introducing a more forward looking estimation of replacement expenditure.
4.40 In passing, we also note that the present method implicitly assumes that the RAB
associated with existing investment changes smoothly from its starting value before the regulatory period to its terminal value. If there is specific information about the timing of replacement investment, this should also be taken into account.
Determining the allowed capex – Extension investments
4.41 Based on our understanding of how Energiekamer includes extension
investments into the RAB and the allowed revenues that follow from this, we do not see a systematic problem. Energiekamer takes into account:
investment costs, including full finance cost during construction;
depreciation;
finance cost during construction also include cost of equity; and
additional operating costs, as a quite generous percentage of total investments costs (also including finance costs during construction);4.42 Currently we only see two issues which might be worthwhile to address:
Flexible timing for including extension investments – GTS complains that the gas year (starting in October) does not correspond with the tariff year (latest possible tariff proposal end of September). New assets are usually commissioned at the start of the gas year, thus after the latest possible tariff proposal. This means that the new assets can only be included in the next tariff proposal.Draft
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4.43 We recommend a flexible inclusion of extension investments into the tariffs to
avoid time lags. Additionally, Energiekamer should evaluate the actual commissioning times of GTS for their assets and the impact on the achievable RoR arising from the mid-year assumption.
Distortion of profitability
4.44 As noted in Section 3, regulatory regimes have the potential to distort decisions if different forms of cost that a firm can choose give rise to different revenue consequences. This could well be the case with the most recent Method Decision applied to GTS.
4.45 Subject to confirmation of our analysis above, it would appear that every euro of
new capex spent by GTS gives rise to a present value of revenue that is equal to one euro. In essence, this amounts to a complete pass through of new capex. 4.46 As we understand it, the treatment of replacement capex is a little different.
Incremental replacement capex would not give rise to any incremental revenue until the start of the next regulatory period. However, from that point on, it would be added to RAB and be subject to full recovery. The precise ratio of the present value of incremental revenue to investment will depend on the time in the regulatory cycle that the replacement investment will be made, but will always be quite high for long life fixed assets, although always less than 1.0. For short life fixed assets, e.g. IT, the recovery ratio (present value of incremental revenue as a ratio of capex) could be quite low, depending when in the regulatory cycle the investment is made.
4.47 The position with respect to incremental opex expenditure is more difficult to characterise. In particular it depends on how the productivity offset factor is set. In order explore the issue in more depth, we first assume that the productivity factor is set independently of the GTS‟ actual costs. Under these circumstances and applying the Method Decision mechanically, an extra euro of opex spent with the period of three years which will determine allowed opex in the next period will raise the three year average by 1/3€. If the annual opex allowed in the following period is raised by the same amount before the productivity factor is applied then the value of revenue recovered is 1/3€ in each year of the next regulatory period, reduced by the applicable productivity factor. To arrive at a present value, this incremental revenue stream also needs to be discounted for the timing of its receipt.
4.48 An incremental euro of opex spent in a year not falling within the three year period used to set next period‟s allowed opex would not give rise to any incremental revenue. The recovery ratio would be zero.
4.49 The average value of revenue obtained from a euro of opex changes according to
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when it is spent the length of the next regulatory period and the cost of capital applied to get to a present value). Outside the three year period, extra opex will lead to zero extra revenue.
4.50 We now introduce the complication that the productivity factor may be
influenced by the cost performance of GTS. If Energiekamer is able to base its view of allowed opex on benchmark costs that are entirely independent of GTS‟s own costs, then incremental opex expenditure by GTS would lead to no increase in allowed revenue. However, if benchmarking is necessarily imperfect and Energiekamer has to take account not only of benchmark costs but also GTS‟s own costs, we would expect that a one euro increase in GTS‟s actual costs would lead to an increase in allowed revenue but that this increase would be less than one euro. We do not know how much reliance Energiekamer is able place on benchmark data as opposed to GTS‟s own costs in arriving at its view of allowed opex and hence we cannot make a quantitative judgement about exactly what amount of revenue would be generated by a GTS decision to spend an extra euro on opex.
4.51 Based on this analysis, we conclude that there is no good reason to believe that
capex and opex decisions receive neutral treatment under the most recent Method Decision. While we are unable to reach a quantitative estimate of the bias, we think it is much more likely that the present system is biased in favour of capex rather than opex.
4.52 In summary, if a euro of capex expenditure would save a present value of opex
of one euro, the regulatory regime would on average favour rather than discourage the investment. In this particular respect, we conclude that the regulatory regime is overly conducive to investment.
4.53 We note that this incentive bias is not uncommon and has been recognised, for
example, as a feature of energy network regulation in the UK. It is possible that such a bias has led to two effects: firstly a real substitution of capex for opex and secondly, even without a substantive change in real activity, a rebadging of some opex as capex owing to the more favourable regulatory treatment of the latter.
4.54 Given the potential for this effect, we would recommend that Energiekamer also
take steps in monitoring GTS (as other networks) to guard against problems arising from distorted incentives.
Financeability test
4.55 The most recent Method Decision appears not to include any explicit mechanism
to take account of financeability as an issue, except in the sense that, subject to the comments above, profitability is addressed. Hence, there is no impediment from the perspective of profitability to raising additional capital.
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GTS, to maintain appropriate financial ratios, but there is no standing prescription defining how a problem will be dealt with. Were Energiekamer to find evidence of a financeability problem, it would reconsider the relevant Method Decision. However, we understand that, so far, there has not been a problem pointing to the need for changing a Method Decision.
4.57 The outstanding question is therefore whether GTS has legitimate investment needs that would be infeasible without adaptation of the current method for setting price controls. Ultimately, this is an empirical question that can only be answered by financial modelling of the position that would obtain if a revised price control were set based on updated estimates of RAB, WACC etc, coming out of the current studies to determine these parameters. Given the nature of this study, we confine ourselves to comments on the hypothetical results of such modelling.
4.58 If it appears that GTS would generate a sufficient cashflow to fund the equity portion of new investment allowing increased borrowing to fund the rest without causing a GTS to breach its target gearing level of 70% then there is no particular problem. (We think that 70% is a reasonable level at which to set the maximum gearing of a utility such as GTS.) However, if an adverse change in any price control parameter suggested that GTS will not be able to maintain gearing below 70%, Energiekamer will be faced with a dilemma.
4.59 We do not know Dutch law well enough to know whether Energiekamer would
have the vires to adapt the price control decision method to bring forward revenue and ease a financing constraint. If it does not, there is no more to discuss on the issue. If it does, the question is then should it? There is no clear right or wrong answer to this question. The policy ultimately adopted may depend on the circumstances.
4.60 If the need for investment arises solely within the regulated industry, it may be
reasonable to ask consumers to pay more in advance. For example, if the investment arose because capacity constraints were being reached and a large indivisible investment was required to relieve the capacity constraint then a price path for users of the system that rose before the investment was made temporarily suppressing demand and allowing investment to be deferred, with commensurately lower tariffs later, might be expected to be economically more efficient than a price path that only rose after the new asset was operational and the capacity constraint was relieved.
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4.62 If the investment that is causing the wider company to hit a financial constraint is an investment outside the regulated business, there is no real case for asking regulated consumers to finance it through paying higher prices early, even if the as a group they will be repaid later. This would be akin to forcing regulated consumers to make an involuntary investment in a business that had nothing to do with them.
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Summary and recommendations
5
Summary and recommendations
Generic investment climate
5.2 Generally, the investment climate for every firm consists of all those factors that affect the value of the outputs that will be produced, the cost of the inputs that the firm requires to put into producing the output, the risk characteristics of the business, and the constraints within which the firm must operate.
5.3 The firm will only undertake an investment if the investment passes two tests:
Profitability test: Does the reward in terms of net revenues (profit) adequately remunerate the investment, having regard to the risks involved?
Financeability test: If the profitability test is passed, does the firm have adequate access to capital to make the investment without incurring costs and risks that reverse the result of the profitability test?Regulated firm and investment climate
This is also true for the regulated firm. But regulation adds a further aspect. The intention of regulation is that the prospective return, given normative performance, should be equal to the cost of capital and no more, implying limited room for additional profits. Hence, if regulation did not make the profitability of investment only very marginally attractive, there is a prima facie case that it would not be doing its job properly. Inevitably, it is in a regulated firm‟s interests to imply that it has no incentive to invest and requires a more generous regulatory regime.
Impact of regulation on the investment climate
We showed that the way in which economic regulation interacts with factors affecting the firm‟s expectations is limited. In essence economic regulation has the ability to affect:
the revenue stream that the firm is able to earn; and
the business risks that firm faces, which are in turn reflected in the availability and cost of capital.5.4 It is important to stress that regulation can, through socialisation of costs, remove risks that might in other circumstances have inhibited welfare increasing investments.
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elements of regulation are set wrongly, but also positive, by removing risks from investors.
How can regulation get it wrong
5.6 Regulation might adversely affect investment decisions in different ways. It can simply leave the firm with inadequate revenue to cover costs, failing to pass the profitability test. The regulatory issues that surround financeability of investment are generally less to do with „mistakes‟ in a regulatory regime than with simply the extent to which the regulatory regime has the flexibility to cope with periods in which heavy investment needs to be made.
Recommendations based on Method Decision 2009-2012
5.7 We analysed the latest Method Decision 2009-2012 in the framework discussed above. We tried to identify elements of regulation which might be in conflict with the profitability and financeablity test. As a consequence, we recommend changes to the Method Decision which are in favour of GTS. On the other hand we also identified elements allowing „unjustified‟ extra profits to GTS. This seems to be in conflict with the general task of regulation to restrict the return to the cost of capital and no more. Hence, we recommend also changes in favour of the consumers.
Recommendations – in favour of GTS
