Article 14 March 2013

Setting the right charge in electricity distribution

A recent Market Court ruling introduces new rules on the maximum amount of fees you can charge as an electricity distribution system operator in Finland.

On 21 December 2012, the Market Court remitted the Finnish Energy Market Authority’s decisions on the methods on assessing the reasonableness of electricity distribution service prices back to the Energy Market Authority for reconsideration. However, the Market Court only arrived at this result for one point of appeal concerning the so-called efficiency incentive. Otherwise, the Market Court confirmed the appealed elements of the Energy Market Authority’s methodology and effectively set the limits for the tariffs the operators may charge during years 2012–2015.

• The Market Court found that the unlimited outage costs in the efficiency incentive of the regulatory model could lead to an unreasonable and disproportionate result, but confirmed the Energy Market Authority’s views in a number of other significant issues related to a reasonable rate of return and the valuation of the regulated asset base of the operator.

• According to the Market Court ruling, the Energy Market Authority’s wide discretion means that its decisions will be remitted for reconsideration only in cases where the Market Court holds that an operator’s right to a reasonable return on invested capital is compromised.

• The judgment is relevant not only for current licensed system operators, which have been regulated since 1995, but also for owners of electricity distribution systems in industrial and other closed sites.

• While these other distribution systems are currently exempted from regulation, this is expected to change once the new Electricity Market Act is passed. The reasonableness of pricing in such distribution systems will be assessed retrospectively on the basis of possible complaints using a regulatory model very similar to the one that was subject to the Market Court ruling.

What is a reasonable return?

Pursuant to the current Electricity Market Act (386/1995), the pricing of electricity distribution services must be reasonable. After the necessary operating, maintenance and upkeep costs, the system operators are entitled to a reasonable rate of return on capital invested.

The Energy Market Authority confirms the methodologies on assessing this reasonableness of pricing in distribution, high voltage distribution and transmission networks for a regulatory period covering four years by issuing the so-called confirmation decisions before the period begins.

After each regulatory period, the Energy Market Authority confirms whether the collected transmission fees have exceeded the defined reasonable return and obliges or entitles the operators to reduce or raise the tariffs accordingly during the next period.

Wide discretion versus the requirements of precision and predictability

The provisions regulating pricing are based on the Directives 2003/54/EC and 2009/72/EC concerning common rules for the internal market in electricity, which require, inter alia, that the confirmed methodologies must allow the necessary investments in the networks to be carried out in a manner allowing these investments to ensure the viability of the networks.

The Court of Justice of the European Union has established in case C-278/08, Commission v Sweden, that such investments can be expected from economic operators only if the methodologies are sufficiently precise and provide a satisfactory level of predictability.

The conflict between these requirements of precision and predictability and the obligation of the Energy Market Authority to further develop the methods have led to a number of appeals in the Market Court and the Supreme Administrative Court before, during and after the previous regulatory periods.

The Supreme Administrative Court established in its yearbook decision KHO 2010:86 that the Electricity Market Act provides the Energy Market Authority with a wide discretion to develop the methods. The Supreme Administrative Court ruled that since on the basis of presented evidence it was not possible to state whether the calculation method applied by the Energy Market Authority led to a better result than the one suggested by the appellants as regards estimating the reasonable return, the Market Court should not have quashed the Energy Market Authority’s decision and alter the applied method. In practice, this key judgment sets a fairly high burden of proof on the appellants.

In its decision of 21 December 2012, the Market Court made a reference to this ruling, noting that the Supreme Administrative Court had stressed that account had to be given not only to the viewpoint of the customers but also to whether the regulatory model had allowed a reasonable return on invested capital. The Market Court stated that on appeal, it must assess whether the Energy Market Authority’s methodology or certain elements therein, either by themselves or as a part of a larger whole, lead to an unreasonable result. If such deficiencies are found, the Energy Market Authority must alter the methodology to the necessary extent.

Applied efficiency incentive remitted for reconsideration

In its decision, the Market Court found that the system operators had been able to prove that the efficiency incentive included in the methodology contained such deficiencies that could compromise an operator’s right to a reasonable return on invested capital.

In brief, the efficiency incentive allows efficient system operators to accrue more return than less efficient ones. It is thus designed to encourage the operators to limit their operational costs.

The efficiency incentive is based on, inter alia, half of the operator’s total disadvantage costs caused by outages.

The maximum amount of these outage costs was not limited in the Energy Market Authority’s regulatory model, thus causing the risk that should a major storm or other extreme natural phenomenon cause substantial outages, the actualised unlimited outage costs could lead to significant sanctions from inefficiency that could reduce the operator’s amount of allowed return unreasonably.

The Market Court ruled that due to this structural deficiency, the Energy Market Authority’s decisions have to be altered, but noted that as the Energy Market Authority has a wide discretion to develop the methodology, the required alterations would be most appropriately considered and implemented by the Energy Market Authority itself. Consequently, the Market Court decided to remit the decisions to the authority for reconsideration instead of amending the methodology by itself, as was primarily demanded.

Future of electricity distribution regulation

The Market Court dismissed all other numerous complaints related to the Energy Market Authority’s methodology that had been lodged by the distribution system operators. It also dismissed the appeals by high voltage distribution and transmission system operators in their entirety, thus confirming the Energy Market Authority’s regulatory model to a large extent. Only the transmission system operator has made an appeal on the ruling to the Supreme Administrative Court.

Among these other claims, some particularly noteworthy ones concerned the core principles of assessing and defining the value of the regulated asset base that were disputed for the first time before a court, as well as the different premiums included in the WACC (weighted average cost of capital) model used to define the reasonable rate of return, the cost of debt and the StoNED (stochastic nonparametric envelopment of data) method used to assess the relative efficiency of the system operators.

However, the Energy Market Authority’s methodology is in many respects of a general nature, designed to apply to distribution systems in cities and rural areas alike, where the operating territories have substantial differences as regards, e.g., the excavation circumstances of the underground cables, the value of plots of substation land and other technical distribution system solutions. All of these affect the regulated asset base and consequently the allowed return on capital. Because of these differences, many elements of the methodology contain the possibility for individual exceptions accepted or rejected by the Energy Market Authority on the basis of separate applications.

Furthermore, the forthcoming Electricity Market Act significantly tightens the level of service reliability required from operators, forcing them to heavily invest on underground cabling, looping and backing up of the distribution system as well as to raise the yearly upkeep expenses by clearing high and medium voltage aerial powerline ways and the neighbouring areas of trees and keeping the lines weatherproof to minimise outages caused by storms and other natural phenomena. In the future, outages could cause not only potentially substantial sanctions based on the quality and efficiency incentives of the regulatory model, but also based on legislation in the form of strict standard compensations for interruptions in service. In addition, the operator’s obligation to develop the system will be clarified in the new Act. It has been suggested that he neglect of this obligation may be sanctioned by fines up to 10 per cent of the operator’s turnover.

To ensure that all these requirements are fulfilled and that electricity system operations still are viewed as an attractive business, the right to a reasonable return on invested capital becomes more important than ever. The Energy Market Authority has made public that the new Electricity Market Act may require some alterations to its regulatory model. The Energy Market Authority will consider and implement these alterations on its own initiative. These alterations are assumed to become applicable from January 2014 onwards.

Pricing in closed distribution systems

The Market Court ruling and these prospects carry relevance not only for the licensed distribution system operators, but also for the numerous undertakings owning and operating electricity systems in industrial, commercial or shared services sites (such as factory and other production sites, airports and hospitals) that are currently unregulated.

The Ministry of Employment and the Economy is currently preparing a Government Bill for a new Electricity Market Act that fully implements the Third Electricity Directive 2009/72/EC into Finnish legislation. The Government Bill is expected to be issued in Spring 2013 and the new Act shall enter into force in during 2013.

According to the available information, many of the above-mentioned, currently unregulated electricity systems will be regulated as closed distribution systems under the new Act.

Consequently, the pricing of electricity distribution in such systems must be reasonable too, although this will be assessed retrospectively on the basis of possible complaints by customers of these networks.

It is likely that the Energy Market Authority will assess the reasonableness of pricing and return on invested capital in closed distribution systems though a regulatory model very similar to the one applied for distribution system operators and now mostly confirmed by the Market Court.

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