Discussion Papers

Marcus Stronzik

Incentive Regulation and the Return on Equity
IRIN working paper for working package: Advancing incentive regulation with respect to smart grids

No. 357 / Juli 2011

(full version only available in German)


Concerning electricity networks, smart grids are regarded as one of the key new technologies to cope with future challenges caused by an increasing share of electricity generated by renewable energy sources. Thus, with regard to the design of regulatory framework conditions, the question of how to address technological progress right is getting increasingly important. In Germany, since the beginning of the year 2009, an incentive regulation is in place that puts a cap on revenues of network operators. In this working paper, we analyse quantitatively whether the corresponding ordinance, the so-called Anreizregulierungsverordnung (ARegV), is well designed to incentivize the necessary investments into smart grids.

Therefore, we have developed a model for network operators that extends existing approaches by innovations. As smart grids encompass a bunch of various measures, we distinguish between three general investment categories. While pure replacement investments serve as a kind of benchmark throughout the analyses, process innovations are modeled as measures, reducing future operating costs. The third category are product innovations characterized by capital-intensive investments.

While the ARegV is well-suited for pure replacement investments without leading to major distortions, there seems to be some shortcomings concerning innovations. Since revenues are based on individual costs of network operators, the possibility of earning extra profits is restricted to one regulatory period (5 years). This shortcoming might by overcome by introducing yardsticking as revenues are no longer tied to operator’s own costs.

Product innovations are associated with costs (e.g. lagged approval of capital expenditures regarding the revenue cap, reduced efficiency scores through benchmarking) and various benefits (e.g. extra revenues through quality improvements, reduced investment needs). Costs tend to arise earlier than benefits leading to reduced innovation incentives. Nonetheless, the current regulatory framework already tackles many of these benefits associated with smart grid investments.

Currently it is less clear how investments into smart grids will actually change cost structures of network operation. Therefore, we suggest a two-step approach to address the mentioned shortcomings. First, costs of demonstration projects should be covered through conventional research funding procedures to gather better information regarding cost implications. Second, regulation should be modified according to these insights. Without a better understanding of actual cost implications of smart grids, a shift of the regulatory regime would become a rather hazardous action.

Discussion Paper is available for download.

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