REGULATED TARIFF DESIGN IN A LIBERALIZED POWER SYSTEM: THE CASE OF SPAIN

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1 IIT Working Paper IIT I. First version: September 2006; this version: October DRAFT REGULATED TARIFF DESIGN IN A LIBERALIZED POWER SYSTEM: THE CASE OF SPAIN Carlos Vázquez, Carlos Batlle and Ignacio J. Pérez-Arriaga The objective of this paper is to develop the methodology that the White paper for the reform of the regulatory scheme of the power generation in Spain proposes to improve the current one in force in Spain to design the default power tariff. After describing briefly the Spanish situation, the basic criteria that should be taken into account to face the design of a regulated electricity tariff and a revision of the different methodologies that can be considered to define the regulated tariff energy price are also reviewed. I INTRODUCTION The Spanish Electric Power Act (Ley del Sector Eléctrico 54/97), CNE (2005), in concordance with the provisions contained in The European Parliament (2003) intends to establish an electricity market according to the principles of objectiveness, transparency and free competition. These rule reformed the Spanish power sector radically, by restructuring the incumbent vertically integrated companies 1 and introducing wholesale and retail competition. It replaced an ambiguous 1994 Electricity Act that unsuccessfully tried to liberalize only a fraction of the wholesale and retail markets and that was never applied. In principle, the price of this market should be passed to consumers, either directly through their purchases in the market itself, or through their purchases from any retailer, or even through the default tariff for those consumers who might decide to remain under the regulated scheme. 1 This restructuring basically consisted in a legal separation between the regulated activities (distribution) and the activities that were opened to competition (generation and retailing) in the vertically integrated companies. System Operation and most of transmission had been unbundled some years before. * {Carlos.Batlle, Carlos.Vazquez, Julian.Barquin}@iit.upcomillas.es Instituto de Investigación Tecnológica, Universidad Pontificia Comillas, Sta. Cruz de Marcenado 26, Madrid, Spain. 1

2 Regulated tariff design in a liberalized power system: the case of Spain / 2 Since 2003 all consumers are free to choose supplier, although all of them -at least for the time being- may stay under a regulated tariff. At the end of any year n the Government set the collection of default tariffs applicable to every type of consumer during year ( n+ 1). In principle, the values of these tariffs were not updated in any form once the actual market prices were known. Moreover, the calculation of the default tariffs during most of the last years has seriously underestimated the market prices, therefore resulting in the so-called tariff deficit at the time of the economic settlement of the different business activities. Evidently this has led to conflicts between the utilities and the Government. Ad hoc rules had to be fabricated to cope with this and other unforeseen situations. This problem was compounded when in 2003 a Royal Decree established a path of evolution of the regulated tariffs -within a narrow band of ±1,4%- until 2010, almost with total independence of the market prices. So far, in all instances the Government has finally decided that the tariff deficit will be paid by the consumers, conveniently distributed during the next few years. This is obviously a non sustainable situation. This paper presents and develops the tariff design methodology proposed in the White paper for the reform of the regulatory scheme of the power generation in Spain, (Pérez-Arriaga 2005), elaborated by the co-authors of the present paper, under the direction of its last author. The paper is structured as follows: in next section we briefly describe the basic criteria that should be taken into account to face the design of a regulated electricity tariff and review the different methodologies that can be considered to define the regulated tariff energy price. In section III we develop the methodology to design the default tariff we propose for the Spanish power system. Conclusions are summarized in section IV. II DESIGN PRINCIPLES OF A REGULATED ELECTRICITY TARIFF Each remaining component of the regulated tariff should be well calculated in order to have a successful design. The basic criteria its design should follow will be presented in the next section together with some calculation models.

3 3 / IIT Working Paper IIT I A Basic design conditions Every regulated tariff design should be inspired by the respect to the following principles: Sufficiency: industry viability should be guaranteed by the recuperation of its costs. Efficiency: the regulated tariff should send the appropriate economic signals, using marginal prices when possible, to stimulate efficiency in both the short and the long term. Additivity: this principle derives from sufficiency and efficiency. Final price must be the result of the addition of its component costs. Non discrimination: all users should bear the same cost for the same use of the good. Transparency: regulated tariff calculation should be public in both its results and calculations. Stability: regulatory uncertainty should be minimized. Simplicity. Consistency: the methodology used should be coherent with the situation of the region where it is implemented and its regulatory framework. Additional considerations, like the social commitment for unprotected customer groups. These criteria conflict sometimes with each other -for example, simplicity usually clashes with efficiency-, so a reasonable compromise between them should be established taking into consideration the particular situation of the region considered. Considering these principles and the desired compromise between them in each case, the regulated tariff calculation methodology must be determined. A pool pass-though is, as stated below, neither the only nor the best alternative to calculate the regulated tariff price. The most used models will be briefly described in the next section.

4 Regulated tariff design in a liberalized power system: the case of Spain / 4 B Calculating a price Several different methodologies can be used to define the regulated tariff energy price. International experience has resorted mainly to the following alternatives: Pool pass-through. It generates efficient economic signals to consumers, although unforeseen fluctuations are lost. The time period between adjustments determines the risk level assumed by consumers. Complete pass-through, i. e. including long term purchases. In this case, risk results from the proportion between the terms allocated to each market -as discussed above, this is the methodology we propose in the Spanish White Paper-. A solution of this nature has already been implemented in Chile, where an additional price cap is established. Maximum expected price. That would be a relevant alternative when the aim is to expel all customers from the regulated option to the competitive market and leave the regulated tariff as a last resort one. It is important to note that keeping such a possibility shows interesting social advantages, as it would provide electricity services to customer groups that could have very large switching costs or that are not accepted by any supplier. An alternative close to this one was implemented in the U.K. before the regulated tariff was finally suppressed. Yardstick competition. It recognizes the average price of the purchases made by the distribution companies, so they can either make a net profit or incur a loss. A softer version of this model was considered in Holland, with a prescribed percentage of the purchases remunerated according to a bare pass-through and the remaining amount subject to a yardstick competition payment. Auctions. Captive demand can be auctioned. For example, this procedure was implemented in Texas to choose the last resort regulated tariff provider. Light-handed regulation. Each supplier sets its price in a competitive environment. This model was used in Germany, Victoria or Finland.

5 5 / IIT Working Paper IIT I Once one of the models has been selected regarding the peculiarities of the market structure and the regional situation, the final price should be calculated by adding the desired shopping credit. The integral regulated tariff would also incorporate the fixed terms that would result from other regulated costs -transmission, distribution and other regulatory costs and subsidies-. However, a good regulated tariff design and a competitive retail environment cannot be effectively implemented if some prerequisites are not met. In particular, a well-functioning wholesale market and the lack of vertical integration between distribution and retail businesses are more than desirable conditions. These conditions are not present in every market, giving origin to additional difficulties for the retail market deregulation. The first one of these obstacles, the wholesale market power issue is analyzed and illustrated with the example of the Spanish case in (Batlle 06). The other is reviewed in (Vázquez 06), providing also some regulatory guidelines to avoid their negative effects. Hereafter, we develop the methodology to design the default tariff we propose for the Spanish power system III METHODOLOGY TO DESIGN THE DEFAULT TARIFF A General considerations We recommend maintaining a default tariff for all consumers, as it exists today, which should gradually disappear, starting with the larger consumers, once sufficient conditions of competition and market maturity have been achieved. Both the default tariff for end-use consumers -also called integral default tariff, as it contains both the energy component and the network and other regulated charges in the access tariff- and the access tariff must be determined with a methodology that respects the aforementioned principles. Therefore, the (integral) default tariff for a given consumer category -e. g. small firms connected to the low voltage distribution grid- must be obtained by adding, to the corresponding access tariff, the energy market price that suits best the profile of consumption of this type of consumers.

6 Regulated tariff design in a liberalized power system: the case of Spain / 6 It is critical that the default tariff should not provide a refuge to the consumers with a price advantage over the prices that can be offered by the retailers that have to obtain their energy from the wholesale market. The Spanish Energy Regulatory Commission, CNE, should be responsible for proposing the specific methodology for tariff design and also for computing the tariff each year, to be approved by the Government. The Government should be responsible for approving the methodology for tariff design and it should refrain from intervening in the computation of the tariff and concentrate on the energy policy decision. B Energy price to be passed-through The deregulation model in Spain is configured as a model that enables trading in an official organized market -forward supply, daily market and intraday market- and trading outside of it -bilateral contracts between producers, retailers and its qualified consumers including financial contracts-. During this first eight years of market functioning, most transactions have been carried out in the daily market, OMEL. This pool has not been officially mandatory but, due to certain regulatory flaws as well as other considerations related to the market structure and the tariff design, the bilateral (OTC) market development has been negligible. The recent start of the Iberian market and the amendment of some of the design flaws, allow to augur a faster development of the business outside the pool. It is not trivial to decide which is the energy market price that should be passed-through to the default tariff, since this depends on how the retailers-selling-at-a-tariff are allowed to purchase their energy. While the daily energy market has to some extent been compulsory, there were not much debate about which this price should be. The scenario changes somewhat when turning to the discussion of the impact of forward contracting on regulated tariffs. The relevant item in the discussion is not the forward market per se, but how and to what extent the cost of market price purchases can be passed-through to the regulated tariff. Two conflicting criteria need to be considered in this discussion:

7 7 / IIT Working Paper IIT I On the one hand, the regulated tariff should be more or less stable and, as far as possible, known in advance. One obvious method would be to estimate power prices for the forthcoming year, use this value to draw up the tariff and include any deviation between the ex ante prevision and the reality as detected a posteriori in the following year s tariff. The problem with this approach is that it may become unwieldy in the event of wide deviations. Another way to avoid the risk associated with short-term variations in the energy price is to enter into forward arrangements to buy a substantial part of the demand subject to tariff rates and use the forward contract price as the price of power included in the tariff. This second option, in which the volatility of the spot price is offset by contracts, is much more effective in meeting the stability requirements relevant to the energy price transferred to the tariff. Ideally, then, a substantial share of the power needed to cover regulated demand should be purchased under forward contracts. Moreover, as mentioned in the preceding sub-item, a reasonable level of liquidity in the shortterm market is another very beneficial feature. There is some concern in certain markets in Holland 2, for instance that larger system agents might use the timing of power sales as a strategic variable to exercise market power. Indeed, these agents might tend to conduct most of their operations on the forward market, thereby avoiding any relevant participation on, or barely submitting reasonable offers to, the spot market. This means that if a smaller agent, after negotiating a long-term power sales contract, encounters short-term deviations rises in its customers demand, for instance it will be unable to find players willing to sell the energy needed at a reasonable price, and will have to pay a very high price for the energy required to cover such deviations. Larger players, however, can offset this type of deviations at a reasonable cost by drawing from other generators in their portfolio. Therefore, the lack of short-term liquidity is ultimately a way of penalizing smaller actors. 2 See, for instance, the paper drafted by the Dutch regulator, DTe, Development of Liquidity of the Dutch Electricity Market Observations and Recommendations, March 2004.

8 Regulated tariff design in a liberalized power system: the case of Spain / 8 For these reasons, any substantial reduction in the volume of trading on the spot market could eventually constitute an obstacle to competition. While this effect can be avoided to some extent by obtaining reasonable prices for ancillary services, which limit the cost of deviations, at the same time it provides support for the premise that a sufficiently significant portion of demand purchases here, regulated demand purchases should be kept on the short-term market. There are, therefore, arguments both for and against purchasing all regulated demand under long-term forward contracts. A reasonable solution consists in seeking a balance by covering, for instance, 60% of the regulated demand on the long-term market and 40% on the spot market. These percentages can be changed in either direction, depending on the relative weight allocated to the above two arguments. C Long-term contracting for customers under the regulated tariff The next question is to determine what contracting on the long-term market means, exactly. On forward markets, unlike the daily market, the power corresponding to a given hourly interval can be traded during several sessions often under continuous-trading terms where it is possible to buy or sell power for a given future time slot, anywhere from several years to a few days in advance-. A decision must therefore be made as to which of these energy prices is to be passed-through to the tariff. And, furthermore, some criterion needs to be established that will enable regulated retailers, the distributor in the Spanish case, to decide how to time their purchases. The concerns over intra-group trading acquire growing importance in this context. In fact, operations between a regulated retailer and a generator, when both pertain to the same holding, are not mere bilateral agreements with no further consequences for other system stakeholders: as these transactions are used, in principle, to determine the regulated tariff, they have an impact on the cost of the energy demanded by the regulated customers. In a context where the tariff reflects all the power purchases made by regulated retailers, a contract at a higher price would signify higher profits for the generator and higher prices for consumers. Regulated retailer purchases and the way they are transferred to the tariff must, then, be subject to some manner of control.

9 9 / IIT Working Paper IIT I One initially recommendable measure would consist in ignoring intra-group sales and purchases when calculating the regulated tariff. This principle should indisputably be applied to bilateral arrangements, but also to forward contracts negotiated on an organized market particularly when that market is not wholly mature and not particularly liquid at all hourly intervals, for the existence of many time slots in which to negotiate forward contracts establishes conditions that enable vertically integrated agents to conclude intra-group transactions on the market. Nonetheless, the possibility of manipulating the regulated tariff is not the only advantage to vertical integration. For a generator, having a source of information on how -at least someregulated suppliers are going to purchase energy constitutes a considerable competitive advantage that enables it to estimate its prices better than its rivals. It takes little imagination to see why a regulated supplier might seek a relatively illiquid interval on the forward market to make its purchases that would be primarily supplied by the generators pertaining to its holding. In a similar vein, purchases to cover regulated demand could conceivably be used to raise prices at certain times to favor group generators selling in those intervals. In short, power purchases to meet demand at regulated prices can be programmed to maximize business group profits, which may be quite different from programming such purchases to reduce purchase costs to naught. In a perfect, infinitely liquid market with a large number of arbitrage dealers, of course, any attempt such as described above to use the forward market to enhance market power would be offset by arbitrage maneuvering to earn a profit. But where markets are less liquid, such as is usually the case in incipient electricity markets, such manipulation is possible and more so if agents are free to decide the timing of the purchase of all or part of the energy needed to meet regulated demand. For all the foregoing, a prudent approach is recommended hereunder. The proposal is to establish in advance, a series of forward market sessions at which regulated demand suppliers must purchase their energy. As these sessions are publicly defined, all generators would be able to participate on this market, guaranteeing the highest possible level of competition, which is a way to lower the potential for price manipulation. Regulated demand suppliers would not be free to manage energy procurement: the timing of their power purchases would be statutorily determined,

10 Regulated tariff design in a liberalized power system: the case of Spain / 10 and the cost incurred, i. e., the price paid on these reference markets, would be directly acknowledged. More specifically, the process would be as follows: Each regulated supplier would be responsible for a certain portion of the demand at regulated prices. Consequently, 60% of the demand would have to be purchased by the respective regulated supplier on the forward market and the remaining 40% on the spot market. The 60% might be divided, for instance, into four 15% tranches, corresponding to four quarterly purchases. Once every quarter, the regulator would establish a certain forward market session during which regulated suppliers would have to conclude one-year forward contracts to purchase 15% of their uncovered demand. In other words, power to meet demand would be sold by 15% tranches one year in advance. The tariff would reflect the costs incurred in such purchases directly. This arrangement would make it unnecessary to eliminate intra-group purchases from price calculations, since the problem would be solved by the competition inherent in the purchase process. Be it said in this regard that the volume of energy to be purchased would be based on the demand forecasts made by regulated suppliers. Such forecasts could of course be used to elude or manipulate the obligation to operate on the forward market -typically, by systematically underestimating provisions-. One possible solution would be for the System Operator to forecast demand, but this approach does not appear to be particularly recommendable. An alternative solution would be to introduce some manner of slight penalization on demand forecasts. This second arrangement is advocated here. Using merely indicative numerical values, the proposal would be as follows:

11 11 / IIT Working Paper IIT I The error in estimated demand -as per the purchases made on the forward market- would be computed as soon as information on real demand is forthcoming. For errors of under 2%, an increase of x % over the forward market price would be applied to the following year s prices. For errors of over 5%, a deduction of y % over the forward market price would be applied to the following year s prices. D Concentration of forward market operations One possibly problematic feature of this arrangement is that, while generating a substantial volume of forward market trading, it concentrates such trading in a small number of sessions. This is contrary in a way to the most common philosophy underlying forward markets, where trading is continuous, and thus tends to distort the nature of such markets. What is more, non-regulated agents might attempt to take advantage of the establishment of preset dates for regulated demand markets and the associated liquidity to effect their own operations, thereby further increasing market concentration on those dates. In any event, the role of power purchases to meet regulated demand is not to enhance forward market liquidity, but simply to acquire the energy associated with such consumers under the best possible terms 3. Trading volumes in the other forward market sessions will depend largely on the remaining agents, who will freely decide whether or not to engage in forward trading. This proposal lends no particular support to the forward market other than the very relevant fact that it assures a considerable volume of energy trading and the concomitant fees but nor it certainly does not hinder its development, either. Market liquidity will depend on the initiative of the agents involved. 3 Other solutions have been proposed, such as establishing the reference price as the arithmetic mean of all forward market sessions; such solutions do tend to encourage all regulated suppliers to participate actively in trading activities, but this should certainly not be the aim of the regulated tariff.

12 Regulated tariff design in a liberalized power system: the case of Spain / 12 E Incentives for purchasing on optimum terms Another possibly controversial characteristic of the arrangement proposed is its restriction on procurement management by regulated suppliers. Such players would be obliged to buy on certain designated markets, preventing them from detecting and seizing opportunities to buy at a lower price than obtained under the regulator s criteria. In fact, they would be unable to optimize their decisions about the most suitable market for buying power and provided no incentive for purchasing the energy needed to meet tariff customer demand as inexpensively as possible. The approach adopted, which avoids the problems inherent in vertical integration by limiting the decisions open to regulated suppliers, comes at this cost. The outcome is justified, however, by the fact that the problems associated with market manipulation are more severe than this lack of incentive. Indeed, if regulated supplier purchases were used to maximize a vertically integrated group s overall profit, the result would in all likelihood be higher consumer prices. Generally speaking, in a reasonably efficient market, the savings associated with optimizing power purchases are relatively small, whereas the costs deriving from market manipulation are potentially very high. In any event, a tariff design that would provide incentives for regulated suppliers to optimize their purchases may be in order in future if the regulator finds that the forward market is sufficiently mature and extremely liquid, and that the effects of vertical integration cease to constitute a problem because they are offset by arbitrage dealer action. One appealing idea in this regard would be to use an average value as defined below instead of each supplier s entire power purchase price as the amount to be transferred to the default tariff, while allowing tariff suppliers to freely determine their preferred combination of markets for purchasing the energy needed to meet their customers demand. The rationale behind this scheme is two-pronged. On the one hand, the creation of incentives for suppliers, even suppliers that sell power at a default regulated rate, to buy energy at the lowest possible price constitutes good regulatory practice. On the other, under Spanish regulations the default tariff is the same for all consumers in a given category, regardless of the identity of their default supplier. One fairly general expression for an incentive mechanism that would enhance the efficiency of transferring power prices to the tariff is given below:

13 13 / IIT Working Paper IIT I d d D t t t p = α p + (1 α) p where d p t is the power price accepted for a retailer s default tariff in hour t. α, whose value ranges from zero to one, introduces the retailer risk into the equation: risk -and incentive- are both nil if α is one and maximum if α is zero. d p t is the average price of power for the retailer at hour t. D p t is the average market price of power for sale to default tariff customers in hour t. Note that α needs not to be zero for there to be a single default tariff. The single default tariff may be determined from the average purchase price of power on the organized market for single tariff purchases, while at the same time the above expression may be applied to determine the purchase cost accepted for each supplier in the settlement process; i.e., as if its default tariff had been defined to be not the single tariff, but determined from its acknowledge power price. When determining the price of power bought by a given supplier, account must be taken of the purchase costs in each of the short- or long-term organized markets on which it trades. With the procedure proposed, the incentive to buy power at the lowest possible price is much greater than under existing Spanish legislation, where the average is computed from short-term market transactions only. And the spread between short- and long-term market prices would be much wider in general, increasing both risk and incentive. Another alternative, based on a similar philosophy, would consist in using the above scheme and α coefficients (1 α), but replacing the average purchase price paid by all regulated suppliers with a reference market -or combined market- price determined by the regulator. The combination of reference markets discussed in the preceding proposal -the daily market and four forward market reference sessions, one per quarter- could be used for this purpose, as might any other price index found to be representative -the daily market only, for instance, or the average of the forward value. The advantage of this alternative over the solution of transferring the average price for all suppliers is that it behaves more robustly in the event of possible tacit marketplace collusion. If, on the contrary, the reference market determined by the regulator failed to reflect

14 Regulated tariff design in a liberalized power system: the case of Spain / 14 optimal power purchases, the price conveyed to end customers under this variation would be higher than calculated using average prices. In any event, we do not propose using any such approach in this first stage, but rather a solution which restricts regulated retailers procurement choices with a view to reducing the potential for market manipulation. An incentive model such as described in the preceding paragraphs should not be considered as a reasonable alternative until market liquidity rises to high enough levels and the volume of trading suffices to take advantage of the vast majority of the opportunities for arbitrage. IV CONCLUSION In this paper, we have reviewed the issue of the suitability and proper design methodology of a default power tariff, particularizing the analysis for the Spanish case. We recommend maintaining a default tariff for all consumers, as it exists today, which should gradually disappear, starting with the larger consumers, once sufficient conditions of competition and market maturity have been achieved. Both the default tariff for end-use consumers and the access tariff must be determined with a methodology that is transparent, sufficient and that preserves additivity. The (integral) default tariff for a given consumer category must be obtained by adding, to the corresponding access tariff, the energy market price that suits best the profile of consumption of this type of consumers. To decide which is the energy market price that should be passed-through to the default tariff, we propose to strike a balance between the volatility of relying just on the spot price of the daily market and prescribing the acquisition of this energy by long-term contracts in organized public auctions. Therefore, it is proposed that the energy-market price to be used in the computation of the default tariff should be obtained as a prescribed weighed average of the price of energy in the short-term market -40%, for instance- and the price of acquisition of energy in one-year contracts by the retailers-selling-at-a-tariff in organized auctions that take place at regular intervals

15 15 / IIT Working Paper IIT I throughout the year; for instance, four auctions per year, where 15% of the energy that is required by each retailer is purchased at each auction 4. It is critical that the default tariff should not provide a refuge to the consumers with a price advantage over the prices that can be offered by the retailers that have to obtain their energy from the wholesale market. This is achieved by the methodology that has just been described. The principle of sufficiency requires that ex post adjustments are introduced in the tariffs to account for any deviations that may take place in the values that were estimated when computing the tariffs -for instance, demand growth, energy market prices or electricity production with wind generators-. These adjustments, depending of their magnitude, may take place annually, every three months or whenever the deviation exceeds a prescribed threshold. V REFERENCES C. Batlle, C. Vázquez, M. Rivier and Pérez-Arriaga, J. I. (2006). Market power mitigation proposals for the Spanish wholesale electricity market. IIT Working Paper IIT A, Instituto de Investigación Tecnológica, Universidad Pontificia Comillas, Madrid, CNE (2005). Spanish Electric Power Act. Unofficial English translation, Volume 7, 3rd Edition, 2005, Comisión Nacional de la Energía, available at The European Parliament and the Council of the European Union (2003), Directive 2003/54/EC of the European Parliament and the Council of 26 June 2003 concerning common rules for the internal market in electricity and repealing Directive 96/92/EC, Official Journal of the European Union, L 176/37. Pérez-Arriaga, J. I., C. Batlle, C. Vázquez and M. Rivier (2005). White paper for the reform of the regulatory scheme of the power generation in Spain, (in Spanish) for the Ministry of Industry, Tourism and Trade of Spain, July Indeed, the recent instruction ITC/2129/2006 forces distribution companies to acquire some 5% of their energy in organized long term auctions, which can be interpreted as a first step towards the suggested direction.

16 Regulated tariff design in a liberalized power system: the case of Spain / 16 Vázquez, C, C. Batlle, S. Lumbreras and Pérez-Arriaga, J. I. (2006). Designing retail power business regulation under vertically integrated market agents: regulated tariffs and the case of Spain. IIT Working Paper IIT-06-0XX, Instituto de Investigación Tecnológica, Universidad Pontificia Comillas, Madrid, 2006.