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IIIIIIIIIIIIIIIIIIIIlrfJd -111 ItJll/0VSAID Eastern Europe Regional EnergyBfficiency ProjectRegulatory Reform And Energy SectorRestructuring ContractIMPLEMENTING ENERGY REGULATIONIN POLANDOctober 21 thru 24, 1996, Jachranka PolandPrepared forUnited States Agency for International DevelopmentProject Office - ENI/EURProject No 180-0030Under ContractRegulatory Reform And Energy Sector Restructuring In Central AndEastern Europe And The 8alticsContract No - Onal Consultmg GroupI

------------------Pract icesImple ment mg Energ y Regu lation m Polan d Conc epts andSponsored by USAIDJachranka, October 21-24, 1996Final Training Schedule Page 1OctobQctob er 21. Mond ay1530Bus departure PSE HQ - Warsaw, Mysla 216 30-17 30 Jachranka checkInationorientatlonand onent) Chris Turner (BechteIiUSAID)) AndrzeJ Plerzak (MolT)17 30-17 45 Welcome17 45-18 15 Introduction WhoISWho, Program and Goalsation of Polish Energy IndustriesRegulation15-19 00 Key Issues for Regul18 15-1919 00Agnleszka SosulskaAgmeRuss Brown) Mirek Duda) AndrzeJ SzablewsklWelcoming Reception and DinnerOctob er 22. Tuesd ay8 00-9 00Breakfast9 00-12 30Regulators' Powers and Duties 1900-1 000\ atory Approaches OverviewRegulRegulatory-Economic Regulation-Technical Regulation-EnVironmental Regulation-Consumer ProtectionKarl McDermott

------------------Implementmg Energy Regulation m Poland Concepts and PracticesSponsored by USAIDJachranka October 21-24, 1996Final Training Schedule Page 2Octobe[October 22, Tuesday (cont.)(coot.)1000-1230What Do the Regulatory AuthoritiesAuthOrities Do? Examples- Determine regulations- Ensure compliance wIthWIth laws and regulations- Promote/protect competition, regulate monopOlies- Assess performance of Industry- Mediate disputes- Grant licences and concession permits) Karl McDermott--USA) Jon Stern--Other Countnes1230-1430 Lunch14 30-15 45 PricePnce Regulation 1, PricingPnclng Arrangements In Various CountriesJon Stern1600-17 30 Regulators' powers and Duties 2Panel1800Boundaries between Polley, Regulation and Management- PoliticalPohtlcal Context of Regulation- Institutional Arrangements and the Political and Legal Context- ASSigning Functions between MInistriesMlnlstnes and Regulators- Utility ViewpOInt on BoundariesBoundanes Predictability Y.§. FleXibilityFlexibilityDinner19 00-20 30 Begulators' Powers and Duties 3Panel Regulatory Process Case Studies1) Competition Y.§. Monopoly2) Impacts of EU Membership on Polish RegulationQuestionsWhat IS the Role of the Regulator?How do Stakeholders PartiCipate? What are their Perspectives?How does the Regulator Resolve Conflicts?(,JModerator ChriSChris Turner) Karl McDermott) John Gulliver) Jon SternModerator Tom Simpson) Karl McDermott (Regulator)) Michael Prior (ERG)) Jon Stern (Economist)) AndrzeJ Szablewskl (Poland)) Mirek Duda (Poland)) John Gulliver (Lawyer)

------------------Implementmg Energy Regulation m Poland Concepts and PracticesSponsored by USAIDJachranka October 21-24, 1996Final Training Schedule Page 3October 23. Wednesday800-9008 00-9 00Breakfast900-11 00Case Study. Privatization and Regulatory Reform In Hungary- What Happened- Powers and Duties of Regulator- Organisation and Structure of the Hunganan Energy Office- Lessons for Poland (Questions & DISCUSSion)11 15-12 30 Price Regulation 2. Key IssuesIndustry Sectors and Price RegulationDefinition of CostsEstimating Revenue ReqUirements (Including Investment)The Time DimenSion Forward or BackwardAlternative Approaches- Rate of Return- Pnce Cap- Benchmarking, Standard Costs- Combinations12 30-14 00 Lunch, ) John Gulliver) Cathy Conners) ERA Working Group Chairpersons) Chns Turner) Jon Stern

------------------Implementing Energy RegulationInPoland Concepts and PracticesSponsored by USAIDJachranka, October 21-24, 1996Final Training Schedule Page 4October 23, Wednesday (cont.)14 00-15 30 Price Regulation 3. More Key Issues) Jon Stern) ChriS TurnerTariff Transltlonlng- When the Prices are Too Low or Too High (and for Whom?)- When the SubSidies are "Hidden"- When the Costs are "Questionable"Inter-Sector Price Distortions- EffiCient Pricing and PolitiCS- Price of Imported Gas1545-1800 Price Begulatlon 4. WorkshopPrice Regulation and the Implications for Utility Management- CommerCial Operations of Utilities- Regulated Unregulated BUSiness Units- Effects of Incentives on Management BehaVior- Price Cycling- Cost-based versus market-based rates- Regulation of the market- Implications for Demand-side management1830 DinnerModerator Cathy Connors) Jon Stern) Waldemar Ochnlo (T&D Ass'n)) Mirek Duda) Tom Simpson) Karl McDermott) ChriS Turner) AndrzeJ Szablewskl

------------------Implementmg Energy Regulation m Poland Concepts and PracticesSponsored by USAIDJachranka, October 21-24, 1996Final Training Schedule Page 5October 24. Thursday800-900900-11 30BreakfastOrgamsatlon and Structure of the Regulatory Authonty In the U,Sand ElsewhereRelations of Regulatory Authonty- With Regulated Compames- With other Governmental Institutions- With Non-Governmental InstitutionsInternal Orgamsatlon of RegUlatory Authontles- by function- by Industry- matrix11 45-13 15 FaCIlitated DISCUSSion, What Will Work for Poland?13 15,G""'Moderator Russ BrownPerspectives on the Regulatory Process m Poland- Polish Energy Law- Update on Process to Establish Regulatory AuthOrity) Mirek Duda) AndrzeJ SzablewsklPanel--F aClhtated DISCUSSion- What can ERA do?- How do we get there?- Key transItion/policy Issues) Karl McDermott) AndrzeJ Szablewskl) ChriS Turner) Working Group ChairsClosmg Remarks1330-1400 Lunch,1400Karl McDermottBus Departure for WarsawPeter Amato (USAID)

IIIIIIIIIIIIIIIIIII- .f)I\\\J \\ I'(\ \ LL -\( \.'\/ ?\\ REGULATION APPROACHES OVERVIEWIMPLEl\1ENTING ENERGY REGULATION INPOLAND:CONCEPTS AND PRACTICESKARL A. MCDERM:OTrCO:MMISSIONERILLINOIS COMMERCE COMMISSION1

IIIIIIIIIIIIIIIIIII ECONOMIC REGULATION COSTS AND PRICES Natural monopoly characteristics Methods of pricing cost of service value of servicePrice discrinlination issues

IIIIIIIIIIIIIIIIIII TRADmONAL REGULATION Public Interest Standard Equllibriwn Principle/Static Analysis Prudent costs of service Totality Principle TC TR no single issue ratemakingTest year principle normalized Obligation to serve Cost causality principle Collective service principle Principle of non . discrimination

IIIIIIIIIIIIIIIIIII TRADITIONAL REGULATION (CONT'D) Incentives created by regulatory lag T\vo part process that is performedsimultaneously. Determine the total prudent costs and setRevenue Requirement equal to this amount.SEE FIGURE 1 The cross-hatched area theoreticallyrepresents the total cost of production.TC QQ So the total revenues that a firm requiresis equal to the total costs.TR TC What is included in the total costs?

IIII.J TR TC [RB-D] RORIIIIIIIIIIIIIIIITRADITIONAL REGULATION (CONT'D) OE d T - OSSRB Ratebase Total historic Cost of CapitalconstructionD Accumulated DepreciationROR Rate of returnOE cost of borrowed funds Operating expenses wages fuel costs, etc.d annual depreciationT Taxes paid by utilityoss off systenl sales The total revenues are generally allocated tovarious customer classes through the use of costallocation studies.

IIIIIIIIIIIIIIIIIII TRADITIONAL REGULATION (CONT'D) Typically three general classes of customers: Industrial Residential Commercial Study the timing of their consumption to see whocauses plants to be built. Exwnine total usage of each class.- ------------- -- ---- - ----The second part of the process involves setting the prices Equity-efficiency conflictSEE FIGURE 2 If ,ve price at p ATe we are being fair tothe utility but not efficient.

--'IIIIIIIIIIIIIIIIIII--- -- TRADmONAL REGULATION (CONT'D) If we price at p Me we achieve an emcientallocation and use of resources but the firmloses money.How do we balance these interests? 1\vo (multi) part rates. A fIXed charge to cover fIXed costs A variable charge per unit ofconsumption equal to the marginalcost.\ Block priclllg Real time pricing (TOD)

IIIIIIIIIIIIIIIIIII d) b ). Ijcr.rn-8fe.u]J1 a -c' -0 ""'I ,

------------------Figure 2Equity-Efficiency ConflictPnce - PATe:\"erage T(\tal CostPI -l'Aargmal CostLosso-v,DemandQQA'TCQ.c

- --IIIIIIIIIIIIIIIIIIIIf PROFITABILITY ASSESSMENT\' Regulation establishes a "fair rate-or-return"for the regulated company. A fair rate-of-return is a level of profit thatwould just keep the entrepreneur willing tomaintain his or her investment in thecOlnpany. Thus, a fair rate-of-return must match theopportunity costs of the next best investmentof equal risk. In the United States, we use the returns onstocks of conlpanies with comparable risk as aproxy to estimate the allowed profit for autility. This level of profit is not guaranteed. Oncethe prices have been set, if costs rise, thecOInpany's actual profit may fall and if costsfalI actual profits rise. The company bas theincentive to reduce and control costs.

[email protected]\ \, WHY SET THE ALLOWED RATE OF RETURN QUALTO THE COST OF CAPITALThe basic notion here is that if the allowedrate of return is set equal to the utility's costof capital then the market value and bookvalue of the utility should be equal. Considerthe following simplified example. IIIIIIIIIIIIIII)(1) MV PV(2) PV Ilr(3) I (BV)ROR(4) MV «BV)ROR)/rIf r ROR then(5) MV BVwhere: MV nlarket valuePV present value of an assetI income of a firmr cost of capitalROR allowed returnBV book value of company assets

IIIIIIIIIIIIIIIIIIIr\ 'I1 I I SOCIAL CONSIDERATION FOR PRICINGTRANSITIONS Gradual movement to 100% of cost standard. l\1inimize cross-subsidies uneconolnic bypass predatory pricingsubsidies via lump-sunl payments, not throughpricing decisions.

IIIIr DYNAMIC PROBLEMS IIIIIIIIIIIIIIIInflation Fuel Adjustment Clause Construction work in progressExcess Capacity and Cancellations Forecasting problem and the obligation toserve ERAMPricing Issues violates single issueMarginal costRiders Violates single issue restrictionI

- --IIIIIIIIIIIIIIIIIII-/' DYNAMIC INCENTIVES Performance Based Regulation Benchnlarklyardstick Sharing mechanisms Price CAP formulas .,. ).0

IIIIIIIIIIIIIIIIIIIr.I{l .-0'vREGULATOR'S POWERS AND DU1'IESI")lIt:\{\ \'r, \.'-('. Il'I, I('/'\ I\f, \c,./ \)LJII -1I ''{L J(,.( IIL'iC'I \ ,ItIMPLEMENTING ENERGY REGULATION IN"POLAND:CONCEPTS AND PRACTICESIIIIi:IIKARL A. MCDERMOTTC01\1l\1ISSIONERILLIN"OIS COl\1MERCE COlv.tMISSIONI, .,'-rI , ,, l1"'\Ii! ,Tt.1fI,rh\. 1r. ,tI L1 "\O""h"----- ,:. --1--------

IIIIIIIIIIIIIIIIIII WHAT DOES THE REGULATORYAUTHORITY DO? The ICC regulates investor-owned companiesthat provide the public withtelecommunications, electricity, natural gas,water, and sewer utilities. The ComnIission is responsible under Dlinoislaw for ensuring the citizens of DIinois safe,efficient, reliable, and uninterrupted utilityservice at reasonable prices. In exchange forthis, utilities are given the opportunity toearn a reasonable profit. The ICC has five nlembers, olle of whom isdesigllated Chairman by the Governor. EachCODUllissioner is appointed by the Governorand confirmed by Illinois Senate for a fiveyear term.

-- ---- -IIIIIIIIIIIIIIIIIII-\IV d(\.} c.r\ \I ClAA- \ r t I(OJ\"r\.,,, 'Ot ,-,' 'c. v C.-',.'\I\!. 2\,\c.1 .), ,'\ ?N M \ ("I,\\-,,, . 1'-"\{ D\ljDETERMINE REGULATIONS AND ENSURECOMPLIANCE WITH LAWS ANDREGULATIONS Administration and management of thetechnical, professional, and support staff of297, is the responsibility of the executivedirector who is hired by the collectiveCommission. The professional Staff conducts hearingsinvolving utilities' rates, audits of operations,investigating customer complaints, assistingin the planning 9-1-1 systems, and long-rangeenergy planning. The ICC's authority to regulate rates is notunlimited but before making changes mustconsider the effects of any changes bothconsumers and the utility.'cfJ1-

IIIIIIIIIIIIIIIIIII-- -- --. REGULATE PRICES Balance between economic efficiency andfairness to customers and stockholders. P Me and recovery of fIXed costs.ASSESSING INDUSTRY PERFORMANCE Commission receives quarterly reports on thefmancial performance of each utility. If the company overearns then theCommission can call the company in for a ratedecrease.:MEDIATE DISPUTES Commission has a complaint process whereterritorial boundary disputes or othercomplaints regarding service provided betweenutilities can be resolved.

IIIIIIIIIIIIIIIIIII GRANT LICENSES AND CONCESSIONPERMITS In the electric and gas industries we havetraditionally granted franchises to a utility forthe monopoly right to service customers in aspecific territory. Today, the situation is changing. In thetelecommunications industry, entry is allowedfor any company that Call show managerial,technical and fmancial ability to servecustomers. In the gas industry, we have allowed thirdparty marketing companies to offer service ocustomers directly. Once again, you man! VYV7L Jimpose minimum standards on these compames. Retail wheeling is the next step in tIle electricindustry and the same conditions will likely beimposed.

IIIIIIIIIIIIIIIIIII HOW DOES THE REGULATORY BODY DOTHE JOB? CONDUCT PROCEEDINGS Under law, a utility may not increaserates until it receives approval from theICC. Rate Cases must be decided within 11months.SEE FIGURE 4 Disputes among the parties usuallyrevolve around four issues. The utility's rate base - this includesthe amount of money invested toprovide utility service and the capitalrequirements of the company . The utility's expellSes - these are thenormal operating expenses of theutility for a twelve month period.

IIIIIIIIIIIIIIIIIII HOW DOES THE REGULATORY BODY DOTHE JOB? (CONT'D) The utility's rate of return - this isdetermined by the fair rate of returnon investment. The utility's rate design