Pricing and Liberalisation
Pricing in a Liberalised Energy Market
Guido Pepermans
Economics Department and Energy Institute
K.U.Leuven
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Structure of the Talk

The liberalisation process

The general principles of pricing

Stranded costs

Cross-subsidies

Transmission pricing
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The Liberalisation Idea
BEFORE LIBERALISATION
AFTER LIBERALISATION
One vertically integrated
company
Generation
GenCo
GenCo
GenCo
Distribution
Company
Distribution
Company
Distribution
Company
Regulated Regulated
Transmission
Grid Company
Transmission
Distribution
GenCo
Customer
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Before the Liberalisation - Belgium
Regulator
Electrabel
92%
SPE
4%
Autoproducers
4%
CPTE
Transmission
Mixed
Intermunicipalities
80%
Direct
Customers
33%
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Generation
SME
Industry
47%
Pure
Intermunicipalities
20%
Households
20%
CCEG
Distribution
Customer
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After the Liberalisation - Belgium
Regulators
Electrabel
Competitors
SPE
Autoproducers
CPTE (ELIA)
Mixed
Intermunicipalities
80%
Direct
Customers
33%
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SME
Industry
47%
Generation
Transmission
Pure
Intermunicipalities
20%
Households
20%
Distribution
CCEG
for the Captive
customers
(SME, Industry,
Households)
CREG
for the Eligible
customers
(Direct
customers)
Customer
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General Principles of Pricing - 1

Desirable criteria for a pricing rule

Provide incentives for efficiency
(p = MC)

Allow suppliers to cover their costs
(p > AC)
Non-discriminating
 Transparent


PROBLEM: Natural monopoly

match efficiency and cost recovery
 Solutions
 Ramsey pricing
 Two-part tariffs
 Peak-load pricing
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General Principles of Pricing - 2
price
B
pR
C
Market Supply
Market Demand
O
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quantity
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General Principles of Pricing - 3
price
B
E
pM
G
H
F
D
Average cost
pR
Marginal cost
C
Market Demand
O
quantity
Marginal revenue
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Stranded Costs - 1

Problem

What to do with past investments?
 Were
‘guaranteed’ to be recoverable through price increases
 In an open market, this ‘guarantee’ falls away


Problem mainly for private monopolists
Definition is important

As recovery of stranded costs is foreseen in the
European Directive
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Stranded Costs - 2
Fixed or sunk costs that were imposed ( approved) by
the regulator and that cannot be recovered via the
market if the market is opened up for competition
FIXED OR SUNK COSTS IMPOSED
BY THE REGULATOR?
Full recovery
RECOVERABLE
VIA THE MARKET
Partial recovery
No
Yes

Strandable
No

Not strandable
Not stranded
Not stranded
Non-recoverable
part is stranded
Not stranded
stranded
Not stranded
Table 1 : The definition of strandable and stranded costs.
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Stranded Costs - 3
MCI
ACI
AVCI
MCE
ACI
MC
I
pR
pC
E1
B
A
MCE
E2
AVCI
E3
OI
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q*
OE=qD
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Stranded Costs - 4
Price covers the average costs
Price of
electricity
generation

Average fixed strandable cost
Average fixed non-strandable cost
Average variable cost
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
= Average economic profit
= Average cost
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Stranded Costs - 5
Price covers average variable costs and average
fixed non-strandable costs
Price of
electricity
generation
Average fixed strandable cost
Average fixed non-strandable cost
Average variable cost
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

= Average economic profit (= loss)
= Average cost
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Stranded Costs - 6
Price covers average variable costs but not
average fixed non-strandable costs
Average fixed strandable cost
Price of
electricity
generation
Average fixed non-strandable cost
Average variable cost
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

= Average economic profit (= loss)
= Average cost
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Stranded Costs - 7

Conclusion

From the point of view of efficiency
 Stranded

cost recovery is not necessary
If recovery is allowed
 It
should be competitively neutral
 An
upper limit on allowable recovery
 Size of the strandable cost
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Cross-subsidies - 1

General pricing principles
Should reflect marginal costs
 Should allow to recover total costs


Misunderstandings
Uniform pricing may imply cross-subsidies
 Price differentiation does not necessarily indicate
cross-subsidies

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Cross-subsidies - 2

Definition of cross-subsidy-free prices

For all customers
 Price
is below the average stand-alone cost
 The cost of self-providing the good or the service
 An upper bound on cross-subsidy free prices
 Price
not lower than the average incremental cost
 A lower bound on cross-subsidy-free prices

Why is there a problem?

Wrong incentives

Distributive considerations
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Cross-subsidies - 3
Liberalised market
(25.000 GWh)
A
B
C
Regulated market
(50.000 GWh)
Variable
costs
Variable
costs
2 BEF/kWh
2 BEF/kWh
Joint costs
40 Bln
Assume a given revenue requirement :
190 Bln = (25.000+50.000) x 2 BEF + 40 Bln BEF
A : Joint costs fully allocated to the regulated market
pL=2 BEF
pR=2,8 BEF
B : Joint costs evenly allocated to both markets
pL=2,8 BEF
pR=2,4 BEF
C : Joint costs fully allocated to liberalised market
pL=3,6 BEF
pR=2 BEF
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Cross-subsidies - 4

Where can they occur?
Large Industrial
Market share :  35% (H.T.)
Generation
Small Industrial
Market share :  30%(H.T. and L.T.)
Households
Market share :  35% (L.T.)
Belgian generation companies :
Electrabel ( 92% market share)
SPE ( 8% market share)
Grid operator : CPTE
Transmission
Pure and Mixed intermunicipalities
Regulated at the Regional level. Cross-subsidies in distrisbution activities are
not considered in this study
Distribution
Table 1 : the structure of the electricity market and the potential cross-subsidy flows.
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Cross-subsidies - 5

Cross-subsidies in a partially liberalised belgian
electricity market
Intentional misallocation of joint costs in generation
 Transmission tariffs


Why do they occur?
Historical reasons
 Unintentional misallocation of joint costs
 Stranded costs
 Predatory pricing
 Intentional misallocation of joint costs

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Cross-subsidies - 6

How to reduce the potential for unwanted crosssubsidies

Price cap regulation or yardstick competition

Speed up the liberalisation process

Better control of cost allocation exercise
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Transmission Pricing - 1

What makes transmission pricing of electricity
difficult?
Fixed transmission capacity
 Cost recovery
 Some physical laws apply to electricity transport

 Law

of least resistance
Belgium is part of a European network in which it
cannot control flows
 Dutch

import from France via Belgium or via Germany?
Transmission costs and capacity limits will play
an important role in the competitive process
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Transmission Pricing - 2

Alternative pricing systems for transmission
 Cost
coverage
 Incentives for optimal siting of generation and consumption
 Incentives for efficient operation, investment and cost
minimisation by the transmission company

Postage stamp
 Fixed
fee per MWh
 Simple cost recovery
 No incentives for correct siting of generation and consumption
 No incentives for cost minimisation of system operator
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Transmission Pricing - 3

Distance related tariff
 Fee
proportional to distance
 Cost recovery easy
 No perfect incentive for siting generation and consumption
 No incentives for cost minimisation of system operator

Marginal cost pricing
 Cost recovery not guaranteed
 Good siting incentives if also future tariffs are announced
 Better incentives for cost minimisation
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Transmission Pricing - 4

A proposal for Belgium (Energy Institute)

Mixture postage stamp and marginal cost pricing
 Postage
stamp
 Individualised costs
 Non-individualised costs
 Costs not directly linked to actions of generators and consumers
 Congestion
correction for some sites (discount or extra
margin)
 Incentive for overall cost efficiency
 based on yardstick competition
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Transmission Pricing - 5

The fixed component

Covers
 Individualised
costs
 Reactive power for outlyers, connection costs, metering and
billing
 Non-individualised
costs
 Allocation based on last year’s

Peak demand: grid maintenance,black start capacity, personnel and
operating costs and return on investment

Energy use: reserve capacity, reactive power and voltage control and
grid losses
 Avoid cross-subsidies
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Transmission Pricing - 6
Function
Individualised
cost component
Non-individualised cost component
allocated on the basis of
Peak-Demand
Energy use
Maintenance cost
X
Reserve capacity
X
‘Normal’ Reactive power and voltage control
X
Connection costs for new customers
X
Reactive power for outlyers
X
Black start capacity
X
Grid losses
Metering and billing
X
X
Labour and operational costs
X
Return on assets
X
Table 1: Summarising table.
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Transmission Pricing - 7

Incentives for optimal grid use and siting

A grid quality charge (GQC)
 Based
on typical and critical load flows of previous year
 Nodes
are evaluated w.r.t. Congestion, loss, stability and
reliability problems
 Nodes causing extra problems get a surplus charge
 Nodes relieving problems get a negative charge
 Overall
the net revenue from the GQC for the system operator
is zero
 Avoid incentives to create congestion
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Transmission Pricing - 8

Incentives for efficient grid operation and
investment

SO is rewarded or penalised for delivering good or bad
quality (measured by overall system reliability)
 Benchmarking
 Compare with neighbouring countries
 Investing
improves quality of the service
 Avoid over-investment
 Make the SO the residual claimant for a share of grid investment
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