GAS TRANSMISSION PRICING MODELS FOR ENTRY-EXIT SYSTEMS AND IMPLEMENTATION OPTIONS

Transcription

1 GAS TRANSMISSION PRICING MODELS FOR ENTRY-EXIT SYSTEMS AND IMPLEMENTATION OPTIONS MAURICE VOS 1, BERT KIEWIET AND KONSTANTIN PETROV Abstract This paper discusses different cost allocation models for gas transmission pricing under the entry-exit system. The paper starts with outlining the main objectives that may be aimed for when designing entry-exit tariffs for gas transmission networks. It discusses the primary reasons for implementing certain objectives and the often conflicting goals that one is confronted with when calculating transmission tariffs and designing its structure. We subsequently discuss four different cost allocation models that may be used to set tariffs under the entry-exit system. These models are applied to two different gas transmission network topologies with the aim to assess the advantages and disadvantages of these tariff calculation models in terms of cost reflectivity in relation to network topology. Keywords: gas networks, transmission pricing, entry-exit, regulation 1 Corresponding author ( preferred correspondence). All co-authors are with DNV KEMA. The content of this paper reflect the authors personal views. Address: DNV KEMA, Energieweg 17, 9743 AN Groningen, The Netherlands. Maurice.Vos@dnvkema.com, Tel

2 Nomenclature I = number of entry points J = number of exit points i = entry point i {1,, I} j = exit point j {1,, J} k = node/intersection between network sections S ik = network section between entry point i and intersection k S kj = network section between node k and exit point j S kk = network section between node k and another node k = technical capacity of network section S (2) = booked capacity at entry point i = booked capacity at entry point j UC S = unit cost of network section S UC ij = sum of unit cost for transporting gas from entry i to exit j P ij = set of network sections used to transport gas from entry point i to exit point j UC = unit cost matrix TN i = entry tariff for entry point i TN * i, i = intermediate entry tariff for entry point i obtained during the calculation TX i = exit tariff for exit point j TX * i, i = intermediate exit tariff for exit point j obtained during the calculation R allowed = allowed revenue D i = distance from entry point i to reference node k D j = distance from exit point j to reference node k ec = unit cost expressed in monetary value per unit of capacity per pipeline length = length of a network section S 2 A network section denoted by S can either mean S ik, S kk or S jk

3 = flow though network section S D ij = distance between entry point i and exit point j D = matrix with distances between entry point and exit points PN i = proportion of entry point i s technical capacity relative to total technical entry capacity PX j = proportion of exit point j s technical capacity relative to total technical exit capacity AD i = capacity weighted average distance for entry point i AD j = capacity weighted average distance for exit point j WN i = weight of entry point i WX j = weight of exit point j R i = revenue to be recovered by entry point i R j = revenue to be recovered by exit point j = entry-exit split expressed as share of revenues recovered by entry capacity α = scaling factor to attain allowed revenue

4 1 INTRODUCTION In 1998, the Member States of the European Union unanimously adopted Directive 98/30/EC concerning common rules for the internal market in natural gas. The overall objective of this directive was to create an open internal market for natural gas in Europe and increasing competition whilst taking due account of security of supply. The common understanding in EU-bodies is that the entryexit model is most suitable in serving the objective of a non-discriminatory network access on the transmission level. This process has eventually resulted in the Third Energy Package. According to Regulation (EC) NO 715/2009 (the Gas Regulation ) of the Third Energy Package, the entry-exit model is mandatory and should be implemented by the EU member states. The Gas Regulation defines precise requirements for the basic transmission tariff model for gas systems: the decoupling of entry-exit charges and the non-discrimination between domestic transport and transit. According to Article 13, tariffs shall be set separately for every entry point into or exit point out of the transmission system and network charges shall not be calculated on the basis of contract paths. In addition, the Gas Regulation specifies that the Agency for the Cooperation of Energy Regulators (ACER) is to develop Framework Guidelines for rules regarding harmonised transmission tariff structures. The European Network of Transmission System Operators Gas (ENTSOG) shall then develop a network code on harmonised transmission tariff structures which shall be compliant with the framework guidelines. In July 2013, ACER published a consultation document on the scope and main policy options for Framework Guidelines on harmonised transmission tariff structures. This document contains a revised chapter on cost allocation methodologies. ACER revised this section following the request of the European Commission by listing a limited number of cost allocation methodologies, specifying how they determine the tariffs and describing under which circumstances they can be used. Statement of the Problem This paper discusses the major gas transmission pricing model groups and to explain how they allocate the costs to the entry and exit points. Furthermore, the analysis assesses the applicability of these different pricing models to different network topologies.

5 Paper outline The remainder of the paper is structured as follows: Chapter 2 provides a short introduction of the Entry-Exit Model. Chapter 3 focuses on the major pricing principles. Chapter 4 describes the nature of the major gas transmission pricing models and provides two case studies with calculation examples. In Chapter 5 we have drafted a conclusion on the applicability of the different pricing models.

6 DSO level TSO level DNV KEMA Energy & Sustainability 2 ENTRY-EXIT MODEL Under the entry-exit model, capacity contracts for input and withdrawal of gas are separated and independent of one another - there is no linked contract path. The service entitlement is to bring gas into the system (entry capacity) or to remove gas from the system (exit capacity), and such services can be obtained by the same or different network users. As a result of this, network users neither need to specify a specific transmission path nor distance, but merely the network points they intend to use for entry and exit into/out of the system. In addition, a virtual trading point assures that the entry and exit points are truly independent from one other, as network users are allowed to transfer gas at this virtual point. A network user that has only contracted entry capacity could sell gas at the virtual trading point, whereas network users, who only have access to exit capacity, can buy this gas. The VP is not tied to a physical point within the system and it is accessible without specific VP entryexit capacities. From the entry and exit points the network users have free access to the virtual point; in the scheme below this is indicated with the blue arrows. A VP allows title transfer of gas. Cross border N X Cross border VP Trading Production Storage LNG Local N X Local Directly connected customers Storage Figure 1: Schematic representation of an ideal entry-exit system (DNV KEMA, 2013) X Under certain conditions, network users are free to use any combination of entry and exit points in an entry-exit model. Firstly, the network user needs to have capacity booked at the respective network points and the actual flows may not exceed this capacity. Furthermore, the network points need to be within the same entry-exit zone. However, once the network user has booked its capacity at the network points, it is free to use it independently from any commodity transactions. The network user s costs are dependent on the total amount of capacity booked and the associated tariff. This tariff may

7 differ between the different entry and exit point and is dependent on the cost allocation methodology applied.

8 3 MAIN OBJECTIVES OF TARIFF SETTING This section introduces the main objectives in tariff setting. First, discuss the requirements that stem from the Third Energy Package. However, from a practical point of view, experience shows other aspects might also be important. These practical aspects are discussed in this section as well. Next, we present the pricing concepts that can be used. A pricing concept determines, amongst others, in which way the price of the services is structured (e.g. variable and fixed charges). Part of the pricing concept is the choice for the type of cost that needs to be recovered. These can be either marginal cost or average cost. 3.1 Requirements from the Third Energy Package The Third Energy Package specifies the following criteria according to which tariffs for access to the network are to be determined: Cost reflectivity Non-discrimination Avoid cross-subsidisation Economic efficiency Cost recovery Transparency We discuss these criteria separately below. Cost Reflectivity Cost-reflectivity forms the basis in tariff setting. In general terms, this means that the price a user pays for a service is closely related to its underlying cost. If tariffs are not cost reflective, then the difference between the price of the transport service and the costs of providing it can be regarded as a penalty or burden that is born by transport customers. In the context of the provision of gas transmission services under the entry-exit regime, cost-reflective means that the charges for a unit of booked capacity reflects the cost the TSO incurs to ensure reliable transport from any entry to any exit point. Obviously, the judgment as to whether a tariff system is cost reflective or not will, to a large extent, depend on the cost allocation models. According to the underlying mathematical properties and depending on the network topology, the gas flows and the

9 location of network assets, network charges may exhibit different levels at the different geographical regions. In general to achieve a full cost reflectivity under any cost allocation concept is not possible. This is firstly because the individual users / products are usually clustered in groups and tariffs are set for the respective groups. Secondly, there is a large part of the network assets that are jointly used and no unique and right way to allocate the cost of these assets. Non-Discrimination A key element of tariff setting is the requirement to ensure that a level playing field is created for all network users. This requires the notion of treating all users equally, irrespective of size, ownership or other factors. In practice, this means that all users should face the same methodology for calculating charges, but not necessarily the same charges. Another aspect is related to price discrimination. Price discrimination arises when: the same (homogenous) good is sold to different customers at different prices; or inhomogeneous goods are sold to different customers at prices which deviate from the different cost of servicing these customers, i.e. if the price differences between customers are not related to the differences in the cost of servicing them. In the context of gas transmission services, it means that network users procuring the same service at the same time and location and class of system point should incur the same charge. There might be cases where price discrimination may preserve to a certain extent the efficiency properties of the tariff structure. A typical example is the application of Ramsey 3 pricing in the context of exit / entry split of the allowed revenue. Assuming the capacity demand at domestic exit points is less elastic than those at the entry points, a larger proportion of costs can be allocated to the domestic exit points. This approach can be considered as inequitable because it charges different customers different prices for the same product. Furthermore, regulatory and competition policy may limit the scope for even efficient price discrimination. Avoid Cross-Subsidies The economics of pricing states that no exact solutions exist for the allocation of costs to products (e.g. long- and short term capacity) and customer classes (e.g. domestic and international users). This is because the apportioning of the total cost of the combined delivery of product or products to more 3 The general result of the Ramsey pricing is that the departure from marginal cost pricing should be inversely proportional to the price elasticity of demand of the relevant product, i.e. inelastic customers should be charged the higher prices, thus bearing the higher costs. The principal idea is that the demand structure should not be heavily distorted by the allocation of the sunk cost.

10 than one customer groups or products requires arbitrary allocation of savings resulting from such a combined delivery. Generally, a cross subsidy exists where one group of customers pays more than its stand alone cost of supply, while another group of customers pays less than its incremental cost of supply. A set of prices is said to be subsidy free if the price for each service is above average incremental cost and below the average stand alone cost. 4 Within the price bounds set by incremental and stand alone cost, numerous different pricing schemes are possible - each corresponding to a different allocation of costs between products or users. They would not be regarded as including cross subsidies. The costs (allowed revenue) of gas transmission networks are largely fixed and sunk and are, in practice, greater than revenues accruing through pricing via average incremental cost pricing. For example, if we consider pipeline capacity as a sunk cost and in the absence of congestion, the average incremental costs for short-term capacity will be equal to the marginal cost to transport gas, i.e. rather low. In the short-term, it will be inefficient to set prices for short-term capacity higher and contribute to the sunk cost recovery as such prices may hamper beneficial trade. On the other hand, in order to secure revenue recovery, one needs to increase the prices for long-term capacity with the risk of not being able to sell it and enter into revenue under recovery problems. In practice, the potential questions related to cross-subsidies will depend mainly on the cost allocation methods and the associated perception of cost-reflectivity. This explains the high degree of judgement necessary for cost allocation. Economic Efficiency An efficient pricing structure should provide both short and long-term signals to the transmission operator to operate, maintain and expand the network optimally; and the network users to make use of the transmission network according to the costs that they impose (allocative efficiency). Ideally, the tariff structure should signal to users the additional (marginal) costs that they impose on the regulated company and encourage the operator to utilise its assets optimally (both day-to-day and in the longer term). Such signals are usually implemented by geographically differentiated tariffs (locational signals). 4 The basis for these limits is usually discussed in the context of the analogy to competitive markets. Prices above the stand alone costs can be sustained in the long run only through the existence of entry barriers or other restrictions that prevent bypass. With open entry, a customer cannot be charged more than the stand alone cost of the service provision, otherwise another business could enter the market and provide the service at a lower price. Conversely, the incremental costs represent a minimum as a business would not offer its services to a customer that could not pay at least the incremental cost for this service. Otherwise, the business would improve its profitability by not supplying that customer.

11 Cost Recovery Achieving this objective involves ensuring that price regulation allows the regulated transmission business to recover the operating and maintenance costs and capital costs that are commensurate with the efficient provision of the transmission service. Since significant economies of scale are prevalent in the provision of gas network services, marginal cost pricing alone may not secure cost recovery and, therefore, need to be adjusted. Transparency It is essential that pricing rules are clearly understood and therefore transmission tariffs should be understandable and transparent. In this case, a user can readily determine the charges it will face and respond to them. Excessively sophisticated approaches may appear to promote efficiency at first sight, but they may appear as a black box to network users. Under such circumstances, users may not respond adequately to the corresponding economic signals. A clear and understandable tariff structure will also reduce the administrative burden, and thus ease implementation. Furthermore, to avoid disputes the tariff regime needs to be based on clear and explicit rules as far as possible. Finally, transparency can be seen as a prerequisite for general acceptance by users and the general public. 3.2 Practical Requirements Besides the requirements outlined above, other important practical requirements may need to be taken into account, such as: Stability and predictability Stakeholder acceptance Efficient regulation Macro-economic constraints We discuss these requirements below. Stability and Predictability The principle of stability and predictability of regulation is an essential requirement for the regulated transmission companies to be able to confidently plan for the future and be assured that their investments will not be threatened by unexpected changes in the regulatory environment. Any uncertainty regarding the tariff arrangements will increase the risk associated with such investment, and also the additional costs associated with such risks. Establishing a predictable tariff regime will therefore play a critical role in encouraging efficient new investment. Key mechanisms for providing

12 predictability in regulation include a transparent decision making process, avoiding ambiguities and discretionary rights, provision of clear timetables for price reviews. The stability and predictability of the tariff level is another important question. While stable and predictable tariffs are an important factor for the shipper s decision, the changes of the underlying costs and the associated regulatory reviews may objectively lead to periodic fluctuations of the transmission tariffs. The tariff resets will also depend on the specific regulatory arrangements with respect to revenue / tariff adjustment schemes during the regulatory period and between the two regulatory periods. Finally, tariff reforms may often lead to high price changes for certain customer groups. In some cases, the new tariff regimes may require significant adjustment to and re-balancing of existing tariffs. Where this is the case, transition rules, which provide as much stability as possible, are desirable. Stakeholder Acceptance Tariff reforms and introducing cost reflective tariffs may often lead to high price changes for certain customer groups. While the computation of cost reflective tariffs is a quantitative effort and depends mainly on the quality of the available data and the selected method, their implementation may have significant impact to network users and to other stakeholders in general. Therefore, in order to enhance stakeholders acceptance, transmission arrangements which provide as much stability as possible, may be desirable. Efficient Regulation The pricing methodology should encourage efficient operation whilst keeping a reasonable regulatory burden. It is important that the regulated service provider does not incur excessive or unnecessary costs as a result of the price control. Efficient regulation will aim to minimise the costs to the service provider of complying with the regulation. It should also take into account the costs to the regulator of administering the regulations. Macroeconomic Constraints On some occasions, constraints of a macroeconomic nature might play their role in limiting regulators and companies in their actions. Constraints, like inflation control and regional development policy etc. may prevent regulators and companies from pursuing full price readjustment / realignment.

13 3.3 Pricing Concepts Average Cost and Marginal Cost Pricing As explained in the introduction to this section, an important aspect of a pricing concept is the type of costs that need to be recovered. These costs can be either marginal cost or average cost. The average cost approach refers to the total existing costs incurred by the service provider, divided by the number of units of the provided regulated product. This approach is backward looking and aims to distribute the actual costs over the delivered quantities. The approach of using marginal cost-based prices as signals for efficient utilisation of regulated service attempts to replicate the outcome on the competitive market whereby producers sell at the competitive market price whenever it is equal to or greater than their marginal cost. Marginal costs can be defined as the costs incurred in supplying a small increase in demand of the relevant commodity. Thus, in order to be able to apply the marginal cost concept the increment (for instance m³/day or kwh/hour) must be defined. Depending on whether capital stock is kept constant or investments can be added, marginal (average) cost can be further divided into short and long-run marginal (average) cost 5. For instance, short run marginal costs are defined as the additional costs arising when one additional transported unit is demanded and the installed capacity remains constant. In contrast, long-run marginal costs also take into consideration the capital investment incurred by the regulated company when one additional transport unit is demanded. Marginal cost (and ideally long run marginal cost) pricing provides signals for efficient resource allocation, but usually does not allow the business concerned to recover costs. Hence in practice, prices are sometimes based on average costs or a mixture of average and marginal costs that provides some of the pricing signal advantages of marginal costs and ensures cost recovery. In some instances, the cost allocation model chosen will determine whether marginal or average costs can be used or not; in others there will be a choice. The differences in calculating network tariffs by average cost pricing and marginal cost pricing are briefly touched upon in the following table. 5 For instance, short-run marginal costs (SRMC) are defined as the additional costs arising when one additional unit is demanded and the installed capacity remains constant. Long-run marginal cost (LRMC) is the cost of producing an increment in output when capacity can be altered. Strictly speaking, marginal costs are the additional cost for an infinitely small change of demand, whereas incremental cost relate to changes of a specific size. Since it is practically impossible to determine the real marginal cost of a gas network, all methods basically rely on some kind of incremental cost as a proxy for marginal cost. Therefore, incremental cost (and correspondingly long run average incremental cost, LRAIC) is frequently used in practice instead of marginal cost, when referring to the cost of an increment of use sustained over a long period.

14 Table 1: Differences between marginal cost pricing and average cost pricing Marginal Cost Pricing (MC) Average Cost Pricing (AC) Economic Efficiency High Relatively low Cost Recovery Efficient Regulation Clarity and Transparency Non discrimination Implementation in Practice Adjustments are needed to marginal cost tariffs to ensure cost recovery Depends on the regulatory role in the tariff setting process. MC pricing may require sophisticated modelling and result in lower clarity / transparency High but also depends on adjustments for cost recovery Used to provide short and long-term locational signals (e.g. congestion), but may require sophisticated modelling It results automatically from the cost allocation Depends on the regulatory role in the tariff setting process Depends in the cost allocation scheme, but in general easier understandable Variable depends on the rules for cost allocation and tariff setting Usually used in network where no physical congestion is likely to occur in the short-term future Tariff Structure and Cost Drivers To ensure that costs are properly allocated, the costs should be classified into categories that reflect the main factors determining the level of overall costs of providing the relevant service. The term tariff structure usually refers to the number and form of the tariffs. As such, a tariff may consist out of different charges. These are normally chosen to allow, among other things, the cost of serving the customer to be more accurately reflected by a tariff element. In order to recover its costs, the network operator needs to decide on the relevant cost drivers to use in allocating costs. In gas transmission, costs are usually influenced by either the transported gas quantities or by the booked capacities. In order to recover the costs associated with the transported gas quantities a commodity charge may be designed; for booked capacities a capacity charge can be applied. Capacity charges are levied against a network user s entitlement to use the network, where the entitlement to use the network would normally be expressed in terms of a maximum daily rate reserved by the user, either in volumetric or energy terms. Commodity charge is levied on actual usage or throughput, i.e. an amount per volume unit consumed.

15 A basic design choice for any tariff scheme is how much of the cost recovery target should be met by capacity charges, and how much by commodity charges. Typically, fixed costs should be recovered by the capacity charge and variable costs by the commodity charge. The gas transmission pricing models discussed, and in general, treat the allocation of fixed costs and thus calculate capacity charges. Therefore, in the remainder of this paper, we will only use capacity charges and not commodity charges.

16 4 COST ALLOCATION MODELS This section discusses four cost allocation models that may be used in setting gas transmission tariffs: 1. Postage Stamp Model 2. Matrix Approach 3. Distance to Virtual Point Model 4. Capacity Weighted Distance Model For each of the models, the starting point is the revenue the network operator is allowed to earn for providing the transmission services. As the determination of the allowed revenue is not discussed in this paper, we focus solely on the allocation questions and assume an arbitrary value for the allowed revenue in the examples we discuss. Furthermore, for all cost allocation models, except for the postage stamp model, it is required to build a suitable representation of the network. In practice, the following guidelines are usually applied: Main interconnecting points with other systems (including upstream and storage sites) are usually represented by a separate entry point (i). Exit points (j) can either be regarded as physical delivery points or main connections to other systems. Alternatively, several physical exit points located in each other s vicinity may be grouped into a single zonal exit point. The network itself should be represented such that main pipelines (usually above a certain size) are shown. Also, the network should subsequently be segmented into different network sections. Network segmentation generally increases the cost-reflectivity of the entry and exit tariffs. Hence, the goal is to choose network sections such that they closely represent the actual path of the gas flows in the network to increase cost-reflectivity while keeping the calculation manageable. Segments are usually defined conjunctions between two network nodes (k) with roughly homogenous technical characteristics, e.g. same number of lines, diameters and pressure. 6 For example, in segmenting the network, it is common practice that at least compressor stations are represented as a node located between different network sections. Furthermore, parallel pipelines are normally treated as a single network section. 6 A node is an entry point, a pipeline junction, transfer station or an important delivery point to end customers.

17 In sum, segmenting the network leads to a collection of network sections between entry points and nodes (S ik ), between two nodes (S kk ) or between nodes and exit points (S kj ). Together with the allowed revenue this segmentation forms the basis for the tariff models discussed next. 4.1 Postage Stamp Model The postage stamp model is the most straightforward of all cost allocation models that support the entry-exit access model. In its classical application, a single uniform tariff is applied to either the entry points or the exit points. As this tariff should recover the allowed revenue, the costs are allocated to entry and exit points in proportion to the booked capacity. Postage stamp models have been widely used in the transmission pricing prior to the introduction of the entry-exit regime. Also currently several Member States of the European Union apply systems with uniform tariffs to all entry and to all exit points; however, the tariff applied to the entry points may differ from the one applied to the exit points. In a certain way, these more elaborate solutions may be regarded as a specific implementation of the classical postage stamp model. Also, access to gas distribution networks is commonly implemented by the postage stamp model. In deriving the postage stamp tariff, the basic starting point is the revenue the network operator is allowed by providing the transmission services. In order to calculate a capacity charge, the share of the allowed revenue to be recovered by capacity charges should be provided. Also, in case of more elaborate versions, which specify both a tariff at the entry points and the exit points, it is required to have the booked capacity at these entry points and exit points. Furthermore, it is required to impose an entry-exit split which distributes the revenue to be recovered between the entry points and the exit points. In short, entry (respectively exit) tariffs can be calculated by dividing the revenue to be recovered from the entry (exit) points by the total amount of capacity booked at the entry (exit) points. Algebraically this may be formulated as: (Eq. 1) (Eq. 2) The postage stamp model does not provide any locational signals and loses the advantages in terms of cost reflectivity which is particularly relevant for transmission networks with longer distances. Postage

18 stamp systems would likely involve cross subsidies between network users due to the uniform tariff level. 4.2 Matrix Approach The matrix approach is the second model we discuss. The matrix approach has been widely documented in literature. Hunt (2008) was the first to provide a worked example of the matrix approach. In 2010, Alonso et al. explained their application of the matrix approach to calculating entry-exit tariffs for Spain. Recently, Bermúdez et al. (2013) explained the application of the matrix approach to the Spanish system as well. However, their approach is more detailed compared to the one adopted by Alonso et al. as the Spanish gas transmission network is segmented in smaller sections. Furthermore, they highlight some of the design choices one faces in calculating entry-exit tariffs using the matrix approach. Finally, Apolinário et al. (2012) provide an overview of the introduction of entry-exit tariffs in Portugal by using the matrix approach. For deriving the unit cost of every network section, they have used the historic asset cost. Furthermore, they have separated the grid connection and the costs for gas regulation and metering stations (GMRS) from the unit cost calculation and allocated these costs specifically to the exit points. This approach led to an entry-exit split that equals 26%:74%, indicating that a large share of the revenue is recovered through the exit tariffs. The calculation of entry and exit tariffs using the matrix approach starts again with the allowed revenue and a segmentation of the network. Next, costs are allocated to network sections by distributing the allowed revenue over the different network sections. Usually, the allowed revenue is attributed to network sections by using external keys which serve as an indicator of network size. Although different keys can be used, the key that is frequently used is the replacement costs for the different network sections. This approach bears some similarity with marginal cost pricing. When using the replacement costs of the different network sections as a key, the total allowed revenue is apportioned over the different network sections ( ) by allocating the share of the allowed revenue that equals the share of the network section s replacement costs in relation to the total replacement costs of the network. That is, if a network section s replacement cost is 3% of the total replacement cost of the entire network, that particular network section is allocated 3% of the allowed revenue. The replacement cost of each pipeline can be calculated by using typical replacement cost used for high-level engineering studies.

19 After allocating the cost to network sections, the unit costs for each network section are derived. This can be done by dividing the allocated share of the allowed revenue to that particular network section by its technical capacity ( ). Technical capacity is usually preferred over used or booked capacity as low utilisation may lead to higher unit costs and possibly to higher entry or exit tariffs. Consequently, this may result in signals opposite to what would be desired. The unit costs of each network section are thus calculated by: (Eq. 3) Alternatively, the unit costs can also be calculated by reference to long run average incremental cost in case a marginal cost pricing concept is applied. This approach requires one to calculate the additional cost associated with the increase in capacity of each segment. It is detached from the allowed revenue and requires additional adjustments to ensure revenue recovery. The next step is the actual calculation of the entry and exit tariffs. First, a unit cost matrix (UC) is constructed. The unit cost matrix has as many rows as the representation of the network has entry points (I) and as many columns as it has exit points (J). Hence, its dimensions are (I x J). The elements of the unit cost matrix are the sum of the unit costs along a specific path between an entry point and an exit point (UC ij ). Thus, for each of these entry-exit combinations, the total sum of the unit costs incurred when using the associated transmission path from the respective entry to exit is calculated. ( ) (Eq. 4) If it is assumed that P ij is the set of network sections (UC S ) that are used to transport gas from entry point i to exit point j, element UC ij can be calculated as follows: (Eq. 5) The set P ij may be obtained by the application of the shortest-path algorithm. Instead of minimising the total distance between an entry point and an exit point, the sum of the unit costs are minimised. The network sections selected by this algorithm for each combination of entry point i and exit point j provide the set P ij. It is not possible to directly use the unit cost of the pipeline sections as tariffs. The reasons for this are twofold. First, in an entry-exit system some individual pipelines (or the network sections identified) do not have a specified tariff if they do not serve any entry or exit point but are, for example, a backbone of the transmission system. The unit cost of such a pipeline section cannot be recovered by entry or

20 exit tariffs immediately as there are no entries or exits connected to this section. In addition, the same backbone pipeline section might be used for transporting gas between two adjacent pipeline sections; the unit cost of the backbone pipeline system must consequently be factored into the entry and exit tariffs of these adjacent pipeline sections. It is however possible to calculate the entry and exit tariffs using the unit cost matrix. From the unit cost matrix it is known that the cost of transporting gas from i to j equals UC ij. Therefore, the sum of the tariff at entry point i and that of exit point j should equal UC ij. However, in many cases it is not possible to determine these values algebraically. In order to calculate entry and exit tariffs, the following quadratic programming problem needs to be solved: ( ) (Eq. 6) (Eq. 7) In this problem, the sum of the least squared differences between the sum of the tariffs at entry point i and exit point j and the unit costs of this path UC ij are minimized. One constraint is imposed which assures that the calculated entry and exit tariffs are nonnegative. The final step in the tariff calculation is to make supplementary adjustments in order to reduce the transition impact, to strengthen the acceptance and support the affordability of the pricing reform. These adjustments may be done in two ways: First, additional constraints can be imposed to the problem defined in Equation 6 (e.g. minimum ratio between the different exit tariffs or a fixed split between the revenues obtained from the entry points and the exit points). Secondly, it could be required to scale the tariffs to obtain the allowed revenues as the minimisation problem above might result in an under recovery. In this case the tariffs derived above are multiplied by a single factor that equals the ratio of the allowed revenue and the revenues obtained when applying the tariffs calculated above. For instance, multiplying the tariffs obtained from the application of the minimisation problem above with the capacity that is expected to be booked is given by: (Eq. 8) However, R * is potentially lower than R allowed as, for example, the technical capacities of the network sections that were used to derive the unit cost are possibly lower than the booked capacities. Therefore, all tariffs (TN i and TN j ) need to be scaled to with a factor α:

21 (Eq. 9) 4.3 Distance to the Virtual Point Model The distance to the virtual point model is based on the assumption that the entry and exit tariffs should reflect the costs of bringing gas to the virtual point, a defining feature of the entry-exit model, of the system. The costs are thus allocated to the different entry and exit points based on the distance to the virtual point (or the reference node). This methodology results in different tariffs for different interconnection points and thereby can provide for locational signals. Similar to the matrix approach, the calculation starts with the specification of the allowed revenue (R allowed ) of the network operator. Also similar, network sections are defined on the basis of a representative schematic of the network under consideration. After the network sections have been identified, the procedure continues with calculating the flows through the network at peak demand conditions. In contrast to the matrix approach, which is based on technical capacities, the flows through the network sections in the virtual point-based model have a clear direction. That is, flows in the network are either directed to the reference node (positive flow) or in the direction opposite of the reference node (negative flow). These flows ( ) can be derived by means of matching supply and demand while minimising the total distance travelled through the network 7. Alternatively, a snap-shot of the network can be used to provide directions of the flows. The next step is to calculate the distance 8 ( ) of each entry point i and exit point j to the chosen reference node k (i.e. the virtual point ) inside the network 9. This distance is equal to the sum of the lengths of the network sections used to transport gas from the entry (or exit) point to the reference node. However, it should be noted that the lengths of the network sections have a direction that aligns with the flows in the network as derived under peak conditions (hence we apply the notation ). If set P ik contains the network sections (S) used to transport gas between entry point i and reference node k, the distance is calculated as: 7 It is important to note that in case flows are determined by minimising the distanced travelled through the network, important features of physical gas transport are being neglected. For example, gas does not necessarily follow the shortest path through the network; it follows the path of the least friction which is dependent on a number of parameters including distance. 8 As an alternative to distances, replacement costs can be used as well as was done in the matrix approach. 9 The resulting tariffs are independent of the choice of the reference node (representing the virtual point).

22 (Eq. 10) Thus, the total distance for an entry point equals the sum of the distance of the segments used for transporting gas to the virtual point. Distances in the same direction as the dominant flow are positive, whereas distances in the opposite direction of the dominant flow direction are negative. For an exit point, the total distance between the virtual point and that exit point is taken. These distances may be negative, which can be interpreted as cost savings. These distances will need to be converted into tariffs; however, negative values cannot be used to set capacity prices. Therefore, it is required to remove these negative values by making an additive adjustment: all values are increased with a single constant such that no negative distances remain. Consequently, it is required to set a minimum but arbitrary tariff level. Distances can be converted into tariffs by multiplying them with a constant (ec) representing the unit cost of the underlying infrastructure. This constant is expressed in a monetary value per unit of capacity per pipeline length (e.g. /GWh/day/km). This results in: (Eq. 11) (Eq. 12) In the next step a second adjustment is made to impose an entry-exit split ( ) to the tariff calculation. To this end, all tariffs as calculated above are corrected by a single but yet unknown constant c. This constant can be derived by solving the following relation for c: (Eq. 13) To proceed, constant c is added to all tariffs for the entry points and subtracted from the tariffs at the exit points. This provides adjusted values for the tariff (TN * i = i + c and TX * j = j - c). These can subsequently be scaled such that the multiplication of these adjusted tariffs with the booked capacities results in the allowed revenue. Scaling the adjusted tariffs in this way results in the entry and exit tariffs. Thus, (Eq. 14) And as may be unequal to R allowed, we need to adjust TN i * and TX j * with a factor α to obtain the eventual entry and exit tariffs TN i and TX j :

23 (Eq. 15) (Eq. 16) (Eq. 17) 4.4 Capacity-Weighted Distance Model In the capacity-weighted distance model, we start again by setting the allowed revenue and creating a segmented network representation. This step is thus equal to the first step in the matrix approach and the distance to the virtual point model. Next, a matrix D is created which has as elements the distances (D ij ) between every entry point i and every exit point j. In contrast to the distance to the virtual point model, the direction of the flow under peak demand conditions is not taken into account. Matrix D thus looks as follows: ( ) (Eq. 18) The procedure continues by calculating the proportion (PN i and PX j ) of the technical capacity of each entry point and exit point relative to the total entry and exit technical capacity. This step is shown in Equation 19 and Equation 20 for the entry and exit points respectively. (Eq. 19) (Eq. 20) The next step is to calculate the so-called capacity weighted average distance for each entry point (AD i ) and exit point (AD j ). This is the weighted average distance from an entry point to each exit point. The distance between entry point i and exit point j is multiplied by the share of the technical capacity of exit j in relation to the total technical exit capacity. These values are summed for all combinations of entry points and exit points. In formula: (Eq. 21)

24 (Eq. 22) We continue by calculating the weight (WN i or WX j ) of each entry point and exit point as the ratio of the product of its technical capacity with its capacity weighted average distance and the sums of these products: (Eq. 23) (Eq. 24) In a subsequent step, the entry-exit split is applied. For each entry (and exit) point we can calculate the revenue to be recovered by these points. If the entry-exit split is denoted by, the revenue to be recovered by each entry and exit point can be calculated by (Eq. 25) (Eq. 26) Taking into account the booked capacities for each entry and exit point, we can calculate the tariffs as follows: (Eq. 27) (Eq. 28) 4.5 Calculation Examples In this section we discuss the application of the four cost allocation models introduced in the previous section to two different fictitious networks. The first example resembles a transit network whereas the second example is ring-shaped Case Description Transit Network The first network resembles a typical yet highly simplified transit network. It consist out of a main 36 inch trunk pipeline of 400 km, separated in sections of 100 km, and three spur lines of each 5 km in

25 length and 12 inch in diameter. The exit points may represent domestic consumption, whereas Entry 2 would be domestic production. The network is shown below in Figure 2. Entry 1 Entry point 100 km 36 inch Exit 1 Exit point Node Entry 2 5 km 12 inch Exit 2 Exit 3 Figure 2: Schematic representation of the modelled transit network

26 Tariff [ /kwh/day/year] DNV KEMA Energy & Sustainability The booked capacities at each of the entry and exit points are shown in Table 2 below. Table 2: Assumed booked capacities [GWh/day] in the transit network Point Booked capacity [GWh/day] Entry Entry Exit Exit Exit We have applied the four models discussed in Section to the transit network described above. The resulting tariffs for the entry and exit points are presented in the figure below. 0,5 0,4 0,3 0,2 D2VP Matrix CWD PS 0, Entry Exit Figure 3: Results for the transit network (D2VP = distance to virtual point model, Matrix = matrix approach, CWD = capacity-weighted distance model, PS = postage stamp)

27 The calculation results show that the main entry and exit point are priced similarly for each model. This is different from the smaller entry and exit point in the transit network. This has a number of reasons. In the distance to virtual point model the exit closest to the main entry are priced lower (exit 1 < exit 2 < exit 3). Though less pronounced, this effect is also observed in the capacity weighted distance model. The main reason for this is that exit 1 is closest to the main entry point in the network. Therefore, the value of the chosen cost driver (i.e. total distance) is lower. This effect is lessened in the capacity weighted distance where, as the name suggest, next to distance as a cost driver also the capacity at the exit points capacity is taken into account. The trend is different in the matrix approach where exit 2 is priced higher compared to exit 3 in the other models. The explanation for this lies in the fact that the unit costs of the spur line to exit 2 is higher than spur line to exit 1. In the matrix approach the tariffs are determined such that the tariff combinations overall reflect the underlying unit costs as close as possible. Both spur lines have the same diameter and length, and thus the same replacement costs. But at exit 2 only 2.3 GWh/day is booked compared to 2.5 GWh/day for exit 1. In this approach the resulting unit cost ( /GWh/day) of the spur line to exit 2 is thus higher Case Description Ring-Shaped Network The second case we described is a ring-shaped network in which the main pipelines form a hexagram. There are three entry point feeding gas into the network and three exit points. This projection may resemble a ring-shaped network where gas may enter the system via different entry points (e.g. LNG terminals, long-distance import pipelines, gas storage sites). Furthermore, gas primarily exits inside the network itself and little gas is exported to other countries. The network is shown in Figure 4 below.

28 Entry 1 Entry point 5 km 20 inch Exit 1 20 km 20 inch Exit point Node Exit 3 Entry 2 Exit 2 20 km 24 inch Entry 3 Figure 4: Schematic representation of the modelled ring-shaped network For the ring-shaped network, the booked entry and exit capacities are similar to the transit network, but distributed across the entry and exit points in a different manner. This is shown in Table 3 below. Table 3: Assumed booked capacities [GWh/day] in the ring-shaped network Point Booked Capacity [GWh/Day] Entry Entry Entry Exit Exit Exit The application of the four cost allocation models from Section to the ring-shaped network described above leads to the following tariffs for the entry and exit points (Figure 5).

29 Tariff [ /kwh/day/year] DNV KEMA Energy & Sustainability 0,5 0,4 0,3 0,2 D2VP Matrix CWD PS 0, Entry Exit Figure 5: Results for the ring-shaped network (D2VP = distance to virtual point model, Matrix = matrix approach, CAWD = capacity-weighted distance model, PS = postage stamp) As in the results for the transit network, the tariffs for the postage stamp model are uniform for each entry and exit point. Due to the choice of the allowed revenues and booked capacities these results are the same as for the transit network. Furthermore, the tariffs as calculated under the distance to virtual point model are equal to the postage stamp tariff as well. This is because of the symmetry in the network topology. This symmetry leads to a situation where the distances between the reference node and the entry (exit) points are the same for each combination. As the distance to the virtual point model does not take into account the fact that the booked capacities are different, the entry tariffs are equal to each other and so are the exit tariffs. Furthermore, the chosen entry-exit split of 50% and the fact that entry capacities and exit capacities are the same, results in entry and exit tariffs being all equal. In some ways the capacity weighted distance model has similarities to the distance to the virtual point model as it also takes into account distances. However, it does not take into account flow directions, but does take into account booked capacities. In the capacity weighted distance model, the resulting entry tariffs are the same as postage stamp tariff. This results from the fact that the booked capacities at the three exit points are equal to each other in combination with the symmetry and therefore the