Regulatory Incentives for Investments in Electricity Networks - CRNI ...

Drivers" that will adjust the revenue restriction depending on whether there are significant
unexpected changes to the level of generation connecting in different parts of the system. This
uses a system of "Unit Cost Allowances" (UCA) that will provide £m (million pounds) for
incremental capacity changes of "Y" MW. The UCA is set with reference to the likely level of
investment needed reflecting the balance of generation and demand in the zone.
5.2 Quality Incentive Schemes
Capital costs generally form a substantial part of the firm’s total costs and investment decisions
have a significant impact on the network’s quality. Assuring that investments are undertaken at
least costs and deliver an adequate quality level can generate significant benefits to society. The
ability to effectively measure the performance of investment proposals for both price and quality
is therefore an important regulatory task.
Regulators have developed different methods to encourage quality of supply. The traditional
method is based on quality performance standards. Standards put a floor on the performance
level of the company measured by selected quality indicators. Violation of the standard can lead
to a fine or tariff rebate. Examples of such quality performance standards refer to customer
minutes lost, percentage of customers with an outage, response to customer requests and
complaints.
Quality incentive schemes can be considered an extension of a quality performance standard.
Alternatively, a standard can be considered as a special case of a quality incentive scheme.
Under quality incentive schemes the company’s performance is compared to some target defined
for a certain quality indicator (e.g. reliability measured by SAIDI or energy not supplied) or a
combination of indicators. Deviations from the target result in either a penalty or a reward.
5.3 Cost of Capital
Regulated service providers compete for finance with companies operating in competitive
markets and thus rely on the same financial market conditions. Equity and debt finance will only
be available to utilities who agree to credit conditions posed to firms that operate in competitive
industries and have a comparable credit ranking. Equity finance will only be available if
profitability can be expected that covers the risk free rate of interest (i.e. yield of long term
credible government bonds) and a risk premium.
Given the capital-intensive nature of electricity networks, the return on asset accounts a
significant share of the allowed revenue. As relatively small changes to the rate of return can
have a significant impact on the total revenue requirement and investment behaviour of the
companies, it is essential that the regulator sets the rate of return at a level that reflects an
adequate commercial return for the regulated companies. The Weighted Average Cost of Capital
(WACC) is a commonly used method for determining a return on an asset base. It is generally set
equal to the sum of the cost of each individual component of the capital structure weighted by its
share. 19
19 The WACC calculation will look different depending on how taxes are treated in the revenue requirements. A
post-tax WACC is defined as the average rate of return needed to provide an appropriate return to investors in the
14