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The Regulatory Approach to Fostering Investment

David HalldearnOfgem

28 September 2006

Context

EU action on a number of fronts moving towards single energy markets eg.– Green Paper – Commission Strategy Paper expected

December– Competition cases – ongoing merger cases and Sectoral

Enquiry – Regional Initiatives

Political drivers: Competitiveness, Security of Supply and Climate Change

Importance of Infrastructure

Successful response to all aspects depends upon developing an integrated grid – the fundamental basis for a single market

Grid infrastructure must come from private companies – Govts should not “pick winners”

Therefore, creating environment for investment is vital

The scale of the task

Commission Green Paper – “around 1trillion euros will be needed over the next 20 years”

Commission report on TEN-energy, Oct. 2005 – €100bn needed to 2023 in gas infrastructure:– €48bn in transmission systems– €22bn in storage – €6 in future interconnections– €23bn in import pipelines and LNG terminals– €1bn in existing import projects

Financing Infrastructure Investment

Companies need:– Clear, long term market signals– Regulatory certainty– Fair rate of return

Neither currently exists for cross-border investments

The theory – how to pay for infrastructure

Two approaches possible:– “Fully Regulated” Investments– “Contract” investments

Both feasible, and necessary, within competitive single market: – but both must meet above 3 criteria ie. transparency

and certainty leading to fair returns

The “Regulated” approach:

TSOs invest to meet required security/operating standards

Investment in “regulated asset base” (if efficient) earns a fair rate of return through tariffs paid by network users, who therefore bear costs (and risks)

Works well where users are the direct beneficiaries of investment

Robust regulatory framework must exist for RTPA and RPI-X price control regulation to be applied

“Contract” / “Merchant” investment

Long term contracts represent a commitment of a forward income stream against which capital markets will invest

Competition concerns must be addressed, but the circumstances vary from market to market

Conditions on contracts must trade off certainty (cost of capital) with pro-competitive access measures – such as open season, third party access reservations, limits on contract duration

Conditions must reflect local circumstances

The practice: how does it work on the ground?

Electricity:– Regulation of natural monopolies works within Member States– But TSOs “use” each others networks, so ITC scheme invented– Extra-EU issues not resolved (eg SEE)

Gas– Regulation works within Member States– TSOs “use” each others networks (and other upstream

infrastructure too). No regulatory mechanism for cost recovery or cost allocation

– Accepted industry practice based on long term contracts to support extra-TSO network investment

– No viable alternative has been promoted, despite serious competition concerns

The way forward?

Current EU legislative framework does not create environment for investment – because focus is within national markets not between them

Therefore cannot create effective single market Action needed to facilitate both types of cross-

border investment Further EU legislation necessary

Regulated Approach at EU level: TSO Responsibilities

National TSOs have national rules for building and operating their networks. We need European rules

A ‘European Grid Code’ must have:– European security standards, especially at borders– Joint system planning arrangements– Provision for co-operation between TSOs for operation of

the networks and emergency arrangements– Proper oversight

Do we need a “European Centre for Energy Networks” organisation to manage all this?– No - but greater co-ordination is required through eg. GIE

Regulated Approach at EU level: Regulators’ Responsibilities

National Regulators to look at the interests of European consumers not just national consumers

Regulators need to ensure that TSOs have certainty about the return on their cross border investments, just like national ones

Costs and risks need to be allocated fairly for cross border investments. The Inter-TSO Compensation Mechanism (ITC) goes some way to achieving this in electricity. But what about gas?

Proper unbundling remains an essential prerequisite for an efficient European (or even national) grid.

Do we need a European regulator? Probably not - but greater co-ordination is required through eg. ERGEG+?

Contract Approach at EU level: Guidelines

Europe’s gas supplies depend on ‘merchant’ investment in pipes and LNG infrastructure to bring gas to Europe’s borders

Long term contracts need a framework so investors can rely on them without precluding competition eg. consistent principles for TPA exemptions

Guidelines should be developed Recent case law should be enforced (Decision C-

17/03)

Summary

Infrastructure investment central to single energy market , and therefore to meeting political drivers

Current legislative framework not creating environment for investment

Both “regulated” and “contract” investment necessary at EU level

But requires new legislation (on TSOs and Regulators) and guidelines (on contracts) to balance certainty with competition

Promoting choice and value for all gas and electricity customers