Cost Reflective Tariffs: Balancing Commercial and Socio-economic Imperatives The MYTO Perspective

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1 14th 15th May 2013 Cape Town, South Africa Cost Reflective Tariffs: Balancing Commercial and Socio-economic Imperatives The MYTO Perspective Sam Amadi, Ph.D Chairman/Chief Executive Officer Nigerian Electricity Regulatory Commission (NERC) Nigeria

2 Outline Introduction Investors and Customers Expectations The MYTO Tariff Principles Pricing Assumptions Process used to construct the MYTO and set the average tariff Reviews of MYTO Building blocks Pricing generation Pricing transmission and distribution/retailing Revenue requirement table 2011 Major review of the MYTO The Tariff Orders Commercial and Socio-economic Imperatives New tariff classes Conclusion

3 Introduction The reform agenda of the Nigeria s electric power sector industry (NESI) out of necessity. The reform agenda of the Nigeria s electric power sector industry (NESI) out of necessity. Economic regulation adopted to attract investment due to drop in generation capacity, poor transmission network, dilapidated distribution network and higher level of commercial losses.

4 Investors Expectations Mitigation of all systematic and unsystematic risks All Costs recovery Best Return on Investment Take or Pay Contract 100% Exchange Rate Risk Bankable Contracts Regulatory Certainty

5 Customers Expectations Availability of affordable supply of electricity; Reliable and safe supply of electricity; Protection from exploitation by operators; Participation and consultation to transparency in all activities of the Regulator and Operators; Prompt response to customers issues and complaints; Value for Money.

6 The MYTO A unified way to determine total industry revenue requirement Provides a 15-year look ahead for tariff in the sector due to long gestation period required for investors to recoup investment MYTO will be used to set wholesale and retail prices in the NESI Enables recovery of costs and allows reasonable profits, i.e., the revenue requirement

7 Tariff Principles MYTO sets tariffs for the three electricity sectors based on certain principles and assumptions, namely: Cost recovery/financial viability licensees recover efficient costs, including a reasonable return on capital Signals for investment tariffs should encourage an efficient level and nature of investment (e.g., location) Certainty and stability of the tariff framework enables private sector investment Efficient use of the network tariffs should reflect the marginal costs that users impose on the system, influence efficient use and reduce cross-subsidies Allocation of risk the tariff framework should allocate risks efficiently to those best placed to manage them. Risks such as Operational Risks, Financial Risks (interest, currency etc), Payment Risks, Business Risks etc.)

8 Tariff Principles Simplicity and cost-effectiveness the framework should be simple and not costly to implement Incentives for improving performance it should incentivise cost reduction and quality of service Transparency/fairness it should be transparent and ensure open access to monopoly networks Flexibility/robustness it should cater to unforeseen changes in the market Social and political objectives it should provide for the achievement of social goals such as universal access and demand-side management

9 Pricing Assumptions Minor reviews (Bi annual) Inflation Major (5 yrs) Capital Expenditure Operating Expenditure Gas price Revenue collection efficiencies Exchange rate Generation Capacity Expansion of the transmission and distribution networks Weighted average cost of capital (WACC), etc

10 The Process used to construct the MYTO and set the average tariff Inputs to the tariff; forecasts of load, capacity, fuel costs, investment, Levels of losses, customer numbers, O & M costs Generation costs, life cycle cost methodology Transmission tariff Building Blocks Distribution & retail tariff Building Blocks Final retail tariff To consumers

11 What are the Building Blocks? There are three standard building blocks used in this approach: Return on capital, payments to both debt and equity providers, estimated by WACC Return of capital, depreciation allowance to pay for run down of capital and replacement Operating costs, includes fuel, variable and fixed O & M, overheads, administration

12 Pricing Generation in the MYTO The price for generation will be based on the most economically efficient new entrant Those generating with PPAs will continue to operate and be paid according to their PPAs Wholesale price are set in two parts: Capacity and Energy charges escalating with inflation and exchange rate

13 Pricing transmission and distribution in Nigeria NERC has used a building blocks approach in setting tariff for transmission and distribution Building blocks approach is used extensively in regulated industries. It provides the benefits of both price cap and incentive based regulation It is simple a way of bringing together all of the industry s costs in a consistent accounting framework

14 Revenue requirement table Total Generation Wholesale generation costs + PPAs Annual NERC Licence charge Total Generation Transmission Opex Var O&M Costs Opex Subtotals Return on Working Capital Depreciation Bulk Trader Charges NERC Charge Admin costs (fixed) Fixed O&M Costs Ancillary service charge Total Transmission All Discos Opex O&M Costs Total Three building blocks Opex Subtotals Return on Capital Depreciation NERC charge Total Distribution Admin costs (fixed) Fixed O&M Costs

15 Major Review of the MYTO The MYTO allows for minor and major reviews The 2013 major review was brought forward to 2011 in response to existing economic realities and policy considerations MYTO 2 takes effect from 1 st June 2012

16 Assumptions reviewed The major review is an overhaul of the existing model and will involve the Commission reviewing the following inputs: o Available generation capacity o Capital expenditure o Operating costs o Fuel costs o Forecast of electricity demand o Interest rates o Appropriate expansion of the TCN and distribution networks o Weighted average cost of capital o Collection efficiencies o Reduction in cross subsidies, etc

17 Assumptions reviewed (2) Methodology & assumptions Issues with the methodology for generation, transmission & distribution/retail New entrant model FITs Propose assumptions for solar photovoltaic, small hydro, wind and biomass Propose assumptions for coal Tariffs for Coal

18 Revised Key Financial Assumptions Assumption Old New Nominal risk free rate (%) Exchange rate (N/US $) % above CBN rate Nominal market Rate of Return(%) Nominal cost of debt (%) Nominal pre tax WACC (%) Inflation(%) Real WACC (incl. tax)

19 Commercial Imperatives - Rationale for Cost- Reflective Tariff Full efficient cost recovery is mandated by the S.76, EPSR Act, 2005 ALL businesses to remain in business and grow must cover their costs and provide a reasonable return Without a cost-reflective tariff, no utility provider will enter any market, however large the market The absence of a cost-reflective tariff is a key reason for the failure of the power sector to serve Nigerians for the past three decades

20 Commercial Imperatives - Rationale for Cost- Reflective Tariff Wrong projections in MYTO 1, especially load projections, e.g., 16,000 MW in 2011 Increase in natural gas supply and transport prices Inclusion of Feed-in Tariffs (Wind, Solar, Biomass and Small Hydro) Inclusion of tariff for coal-fired generation Increasing inflation rates and depreciation of Naira Need to provide added incentives to attract private sector Need to reduce unnecessary consumptions and wastages Need to have more pre payment meters to discourage estimated billing Thus the recent Major Review started with a Consultation Paper published in May 2011

21 Socio-economic Imperatives - Measures to Reduce Price Hike Impact Each Disco has tariffs reflecting it uniqueness in terms of cost, location and customer profile The MoF has provided maximum subsidy of =N=50bn (2012) and =N=50bn (2013) This subsidy will be applied to residential customers only NERC has retained the lifeline tariff at N4.00/kWh to all those consuming below 50kWh/month Cross subsidies from large R, C and D customers to small residential customers are implicit in tariff design because the FG subsidy is not sufficient Tariff design has reduced classes from 19 to 14.

22 Conclusion It is important that electricity tariffs are balanced to enable investors recover efficient costs and make reasonable profit. It is equally important that Regulators consider the socio-economic implications of cost reflective tariffs just as shown in the development of the MYTO in Nigeria.

23 THANK YOU Contact us at: Adamawa Plaza, Plot 1099 First Avenue, Off Shehu Shagari Way, Central Business District, Abuja Website:

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