Price Regulations in Energy Markets Dr. Okan YARDIMCI March 15, Energy Policy Research Center Bilkent s Energy Lectures

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2 Education (B.Sc) Petroleum and Natural Gas Eng. (METU) (MBA) Business Management (Atılım U.) 2008 (Executive P.) Public Utilities (Michigan State U.) (LL.M.) Law (Penn State U.) (Ph.D.) Finance (Hacettepe U.) Work Experience 2002 Intern, TPAO (NOC of Turkey) 2003 Intern, Perenco (IOC) Reservoir Engineer, Perenco -Cont. Energy Expert, Energy Market Regulatory Authority, Turkey Other Part-time METU, Hacettepe (energy - economics, regulation, finance, law) Community, Vienna Interests; economics of regulation, tariffs, contracts, international business transactions, global energy markets, shale gas, Turkish energy market, oil and natural gas prices, finance, energy law, international law, economy of law, arbitration, negotiation

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4 Competition and Regulation Consepts in Modern Economic Systems Classical Economics Invisible hand, laissez faire Keynesian Economics Government interventions, overregulations Neoliberalism Unbundling, privatization, liberalisation in the EU, Deregulation in the USA? What About a Special Approach for the Energy Industry? John Tirole (market power and regulation, sectoral differences) Stiglitz (American style socialism)

5 Unbundling of Vertical Integrated Structures Production Transmission Distribution Storage Wholesale Retail Basic Terms Natural Monopol Account Unbundling Physical Unbundling Legal Unbundling What about horizontal integration? competition within the field or competition for the field Problem of forecastable rents, problem of windfalls

6 Case Study: Reshaping of the Turkish Natural Gas Market BOTAŞ, before the market law LNG Facility Industry Distribution Imported Gas BOTAŞ Residential Power Domestic Gas State owned comp. BOTAŞ was the monopoly on; q Import & Wholesale, q Transmission, q Distribution, q Storage q Sale + Determination of wholesale prices, retail prices, connection fees

7 SUPPLY MARKETING CONSUMPTION Import Export Wholesale Eligible Customers CNG Domestic Prod. Distribution TSO Storage Non-Eligible Customers

8 Natural Gas Tariffs in Turkey Transmission & Dispatch Control Wholesale Storage Distribution Connection (non-eligible customers) Connection (eligible customers) Regulated tariffs Price is determined by the parties

9 Natural Gas Distribution Sector 6 ilde 7 adet dağıtım şirketi 4 adet belediye iştiraki + 2 adet BOTAŞ ın işlettiği 1 adet özel şirket (Bahçeşehirgaz) KIRKLARELİ BARTIN KASTAMONU KOCAELİ SİNOP ZONGULDAK EDİRNE TEKİRDAĞ SAKARYA ARTVİN KARABÜK ARDAHAN İSTANBUL SAMSUN DÜZCE RİZE YALOVA ORDU TRAHABZON BOLU ÇANKIRI AMASYA GİRESUN ÇORUM TOKAT GÜMÜŞHANE ÇANAKKALE KARS BURSA BİLECİK BAYBURT IĞDIR ANKARA ERZURUM BALIKESİR KIRIKKALE AĞRI ESKİŞEHİR YOZGAT ERZİNCAN SİVAS KÜTAHYA KIRŞEHİR TUNCELİ BİNGÖL MANİSA AFYON MUŞ UŞAK NEVŞEHİR KAYSERİ MALATYA ELAZIĞ VAN İZMİR BİTLİS AKSARAY ISPARTA KONYA DİYARBAKIR AYDIN DENİZLİ NİĞDE KAHRAMANMARAŞ BATMAN SİİRT ADIYAMAN HAKKARİ BURDUR ŞIRNAK MUĞLA MARDİN ADANA KARAMAN OSMANİYE ŞANLIURFA ANTALYA GAZİANTEP KİLİS İÇEL HATAY 77 ilde 69 adet dağıtım şirketi faaliyet gösteriyor 68 adet özel şirket 1 adet belediye iştiraki (İGDAŞ) Dağıtım lisansı tamamlanmış olup yakın zamanda gaz arzının başlanması beklenmektedir. KIRKLARELİ TEKİRDAĞ EDİRNE ÇANAKKALE BALIKESİR 2004 İZMİR 2005 MANİSA AYDIN 2009 İSTANBUL 1992 YALOVA 2005 MUĞLA 2011 BURSA 1992 UŞAK 2003 DENİZLİ KÜTAHYA 2004 KOCAELİ 1992 BİLECİK BURDUR SAKARYA 2002 AFYON BARTIN 2015 ZONGULDAK DÜZCE 2005 ESKİŞEHİR 1992 ISPARTA ANTALYA 2007 BOLU 2014 KARABÜK 2008 ANKARA 1988 KONYA 2004 KASTAMONU 2007 ÇANKIRI 2007 KIRIKKALE 2004 KIRŞEHİR 2004 AKSARAY 2004 KARAMAN İÇEL 2005 NEVŞEHİR NİĞDE SİNOP ÇORUM 2004 YOZGAT SAMSUN 2004 AMASYA 2008 TOKAT 2008 HATAY 2011 SİVAS 2004 ORDU 2007 GİRESUN 2010 ERZİNCAN 2008 TUNCELİ KAYSERİ ELAZIĞ 2004 MALATYA BİTLİS 2007 KAHRAMANMARAŞ ADIYAMAN 2007 ADANA 2008 OSMANİYE ŞANLIURFA 2008 GAZİANTEP KİLİS TRABZON 2008 RİZE 2008 GÜMÜŞHANE BAYBURT BİNGÖL ARTVİN ERZURUM 2004 MUŞ DİYARBAKIR SİİRT 2007 BATMAN MARDİN ARDAHAN KARS AĞRI ŞIRNAK IĞDIR VAN 2007 HAKKARİ Evsel doğal gaz kullanımının başlangıç yılı

10 Competition vs Monopol price regulation competition no competition or natural monopoly

11 Competition vs Unregulated Monopol Price Fiyat Pc Fr A B Supply Arz Demand Talep Price Pm Pc Consumer Surplus (Area Above Pm) Wealth Transfer (passes from the consumer to the producer) (producer surplus) Deadweight Loss Marginal Cost (MC) Demand Mr Qc Quantity Miktar Qm Qc Marginal Revenue Quantity

12 Unregulated Monopol P AvC MgC Consummer surplus P M Producer surplus P=AvC AvC P=MgC MgC MgR D Q M Q C Q B Q MgR =MgC Maximizes producer surplus (Sells Q M at P M ) Source : Training Notes, Advanced Training Course: Price Regulation & Tariffs, ERRA.

13 Regulated Monopol (P=MgC) P AvC MgC P AvC MgC P M P M P=AvC AvC AvC P=AvC AvC P=MgC MgR D MgC P=MgC MgR D MgC Q M Q C Q B Q Q M Q C Q B Q Consumer surplus P=MgC Producer loss Maximizes social welfare Maximizes consumer surplus (does not assure financial viability of the regulated company) Source : Training Notes, Optimization Advanced problem: Training Max Course: W (social Price welfare) Regulation & Tariffs, ERRA.

14 Regulated Monopol (P=AvC) P AvC MgC Consumer surplus P M Producer surplus = 0 P=AvC Social welfare = Consumer surplus AvC P=MgC MgR D MgC Q M Q C Q B Q P=AvC Acccounting solution (assures financial viability of the regulated company) Source : Training Notes, Advanced Training Course: Price Regulation & Tariffs, ERRA.

15 Efficiency? Productive Efficiency Allocative Efficiency Dynamic Efficiency Sullivan, E. T., Hovenkamp, H., Shelanski, H. A. (2014). Antitrust Law, Policy and Procedure: Cases, Materials, Problems, Sixth Edition. LexisNexis. Pareto Efficiency no one can be made better off without making another worse off Stiglitz

16 What About Service Quality? Alternative-1: Your electricity bill will be 100 TL/month in a good service quality Efficiency Alternative-2: Your electricity bill will be 50 TL/month 5 hours/week power cut, 2 hours waiting in the line in order to pay the bill Service Quality

17 Tariff = Revenue Requirement / Consumption Revenue requirement Tariff Setting RR = (RAB X WACC) + D + OPEX *Alternatives of RAB Calculations 1- Original cost valuation, historic Regulatory Asset Base* cost or historic value 2- Reproduction cost 3- Replacement cost 4- Stock value 5- Privatization value Cost-plus regulation Aka; Rate of Return (ROR) regulation Incentive regulation Fair / Reasonable Rate of Return (WACC) Price-cap regulation (Aka; RPI-X Revenue-cap regulation Yardstick competition Consumption Forecast Tariff Design P 1 = P 0 (1 + inflation X)

18 Revenue Cap Transmission (Natural Gas) Corrections Revenue Difference Correction Investment Difference Correction Cost Difference Correction Efficiency Factor Investment (Asset Value) Average RAB Correction Mechanism + + OPEX Depreciation Return Revenue Requirement Source : Kamil Yalçın HATİPOĞLU s Presentation Quality Factor (not applied) Tariff Update by CPI

19 fair rate of return? Risk of Creditors DEBT Risk Free Rate + Debt Risk Premium Rf + ( Spread ) + Risk of Shareholders EQUITY Risk Free Rate + Equity Risk Premium Rf + ( βe x Market Risk Premium ) Source : Kamil Yalçın HATİPOĞLU s Presentation

20 Risicare vs Gain You have 10 million TL, and 12 alternatives Which one is your choice? 1) put it under your pillow 10 million TL remains same 2) lend your money to the government interest rate: 11% 3) lend your money to the bank interest rate: 13% 4) buy 10 houses rent fee: 3000 TL/month/house 5) own a distribution company (gas or electricity) license fee: 5 million TL, WACC: 13% (reel and before tax), price cap method 6) operate a pump station initial investment: 8 million TL, margin of the last year: from +4% to +10% 7) invest in stock exchange last year s gain: 15%, the year before it was -10% Increasing risk 8) operate a wholesale company (electricity or natural gas) license fee: 0.5 million TL, margin of the last year: from -5% to +25% Increasing gain? 9) construct a hotel if it goes well IRR is 35%, if not it is 5% 10) drill a production well (oil or gas) drilling cost: 3 million TL, success ratio:1/2, expected production if succeed: 20 bbls/day 11) drill an exploration well (oil or gas) license fee: 1 million TL, drilling cost: 4 million TL, success ratio:1/6, e.p.: 100 bbls/day 12) gamble one shot - 50% bankruptcy, 50% 20 million TL

21 The Efficient Frontier M ) put it under your pillow 2) lend your money to the government 3) lend your money to the bank 4) buy 10 houses 5) own a distribution company (gas or electricity) 6) operate a pump station 7) invest in stock exchange 8) operate a wholesale company (electricity or natural gas) 9) construct a hotel 10) drill a production well (oil/gas) 11) drill an exploration well (oil/gas) 12) 1

22 Risk Free Rates in Turkey (10-year treasury bonds)

23 Main principles of tariff structure Tariffs Other Principles Transparency in the methodology, so that all employed criteria & procedures are made public Stability in the adopted methodology, so that the concerned agents have the least possible regulatory uncertainty. Simplicity in the methodology & its implementation, as far as possible Non-discrimination among equal parties Cost reflective prices should be applied. Costs not directly related to market operations shall not be included. Cross subsidies shall not be allowed Source : Okan YARDIMCI s Training Notes, Advanced Training Course: Price Regulation & Tariffs, ERRA, Budapest.

24 THANK YOU! Bilkent s Energy 101 Series okan.yardimci@bilkent.edu.tr

25 Bilkent s Energy 101 Series

26 Bilkent s Energy 101 Series