The main tools of incentive regulation in Germany

Cost assessment – determining the base level of costs

The starting point for setting the revenue caps and, in turn, the network charges is based on each network operator's actual costs. Prior to the start of a regulatory period, the regulatory authorities determine the base level used to set the revenue cap. This is done by means of a cost examination carried out in accordance with the provisions of the network charges ordinances. All network operators – regardless of their size – are subject to these cost examinations. The base level determined applies for the whole of a regulatory period. Each cost examination takes place in the last but one calendar year before a new regulatory period begins. It is based on the operators' annual financial statements for the last full financial year, which is referred to in the Incentive Regulation Ordinance (ARegV) as the "base year". This is the only way to ensure that the cost examinations are based on reliable business data, but it also means that each revenue cap is set on the basis of two-year old cost data (frequently referred to as a t‑2 time lag).

Return on investment with conditions

Anyone investing in a business enterprise expects a return on the capital employed that is competitive and reflects the industry-specific risks. This return is usually regulated through the market depending on each particular branch of industry and the general level of interest rates. If the balance between the risk of investment and potential earnings is not right, no investments will be made. However, since network operators – by virtue of their natural monopoly – are not subject to these market mechanisms but still need to make vital investments in infrastructure, the rate of return on equity is determined by the regulator. The Bundesnetzagentur calculates a rate of return on capital employed for each regulatory period that reflects the risks involved and the current conditions in the financial markets.

Efficiency benchmarking

In a conventional economic sector, competition incentivizes companies to operate efficiently. Since network operators do not face competition, it is the task of incentive regulation to "simulate" competition and to provide incentives for efficiency gains.

The cost efficiency of network operators can be determined only by comparing companies with each other and not by looking at the costs of just one company on its own. That is why the calculation of regulated revenues is supplemented by efficiency benchmarking. The Bundesnetzagentur carries out its national efficiency benchmarking on the basis of the assessed costs before the start of each new regulatory period. The benchmarking takes place separately for electricity and gas, as well as for distribution system operators and transmission system operators. Key here is that a total cost benchmarking approach is adopted that takes equal account of capital and operating costs.

The benchmarking does not take into account any costs that a network operator cannot control, such as costs for the use of the upstream network. Section 11 of the Incentive Regulation Ordinance (ARegV) lists the costs that are deemed to be non-controllable.

A network operator's efficiency cannot be determined solely on the basis of the absolute level of the operator's costs. Rather, the costs recognised as necessary for network operation need to be assessed in relation to the operator's supply obligations. For instance, an operator may well be operating extremely efficiently even though the operator's network charges are higher than others' – it is simply that the operator's circumstances are different. This is why efficiency benchmarking determines each operator's relative cost efficiency compared to other operators, taking into account the individual supply tasks. The network operators are compared only with each other. The benchmark is always an existing energy network operator and not a company operating in an actual competitive sector such as the automobile industry.

The distribution system operators' individual supply obligations are taken into account by using what are known as structural parameters such as

the number of exit and metering points,
the length of underground and overhead lines,
the annual peak load, and
the area served.

The services of distribution system operators involved in connecting renewable power plants to the network are also taken into account in efficiency benchmarking.

As a result of the efficiency benchmarking, an individual efficiency level is determined for each network operator. A list of operators and their efficiency levels is published on the Bundesnetzagentur's website. The overall results of the efficiency benchmarking procedures are set out below.

Efficiency benchmarking of distribution system operators

Only a minority of electricity and gas distribution system operators are actually subject to efficiency benchmarking.

Electricity distribution system operators with fewer than 30,000 customers and gas distribution system operators with fewer than 15,000 customers may choose to participate in what is known as the "simplified procedure" and are then not subject to efficiency benchmarking. Instead, a general efficiency level is determined that is applicable to all these operators. The Incentive Regulation Ordinance set the efficiency level for the first regulatory period for operators participating in the simplified procedure at 87.5%. From the second regulatory period onwards, the efficiency level is the weighted average of all efficiency levels determined in the national efficiency benchmarking of distribution system operators for gas and electricity DSO's, respectively.

In 2012 efficiency benchmarking for the second regulatory period was carried out for a total of 186 gas distribution system operators participating in the standard procedure. In 2013 efficiency benchmarking was carried out for 179 electricity distribution system operators.

Efficiency benchmarking of electricity transmission system operators

The individual efficiency levels of the four electricity transmission system operators were determined in accordance with section 22(1) of the Incentive Regulation Ordinance (ARegV) on the basis of an international efficiency benchmarking. The Bundesnetzagentur was required to carry out efficiency benchmarking including transmission system operators from other Member States of the European Union before the beginning of the second regulatory period. An average efficiency level of 99% was determined for the German transmission system operators, taking specific national circumstances into account. This was an improvement of 1.6 percentage points in the avarage relative efficiency level compared to the first regulatory period.

Efficiency benchmarking of gas transmission system operators

National efficiency benchmarking of twelve gas transmission system operators was carried out to determine the efficiency levels for the second regulatory period. All except one operator – with an efficiency of 95% – achieved an efficiency level of 100%.

Setting the revenue caps

The revenue cap for each operator is set on the basis of the operator's base level of costs and its efficiency level.

The base level costs are divided into

permanently non-controllable costs and
generally controllable costs.

The efficiency level is applied to the generally controllable costs to create a block of efficient and a block of inefficient controllable costs. The operator is required to gradually reduce only the inefficient controllable costs over the course of a regulatory period.

The regulatory authority issues an official notice stating the revenues allowed in each year of the regulatory period; this marks the end of this step of the process.

The level of the approved revenues is not generally adjusted. The system does, however, provide flexibility to react appropriately to changes for instance in the permanently non-controllable costs. If there is a change in one of the non-controllable cost items during a regulatory period, the revenue cap can be adjusted.

Adjustment of the revenue caps for expansion investments

The budget resulting from this set revenue cap at the network operator's disposal also includes returns for the purpose of financing necessary investments through write-downs on capital assets. The network operator is free to use these funds as they see fit. Such funds, for example, can be reinvested in equipment to be replaced, be used in measures for operational management or be distributed as profit. The Incentive Regulation Ordinance (ARegV) does not require operators to reinvest the funds in replacement measures. ARegV does, however, place funds for internal financing at the disposal of network operators through the above-mentioned mechanism.

If an operator has a stable network structure and still has positive depreciation for equipment, replacement investments within the regulatory period can be financed from what is known as the "base amount" without the revenue cap being directly adjusted and without the operator having any disadvantages on its return on equity. If, by contrast, an operator's supply obligations change significantly, involving investments in network expansion or restructuring, it must also be possible for the operator to have the revenue cap adjusted in the course of the regulatory period. Otherwise, new assets would only be assessed in the next cost assessment, and the network operator would only be able to refinance the capital costs resulting from expansion investment in the following regulatory period. In this case the returns from the revenue cap may not be sufficient to cover the operator's new investments. Hence to take account of extraordinary expenditure that does not fall under a network operator's regular operations, the Ordinance provides for the investment measure for gas and electricity transmission system operators and 110 kV DSOs and the expansion factor for distribution network operators. Both instruments allow network operators to get an adjusted revenue cap in order to cover the costs of expansion investments already during the regulatory period.

Offsetting volume fluctuations through the regulatory account

The regulatory account was originally set up to balance out forecast uncertainties owing to volume fluctuations caused mainly by weather conditions. Since network operators base their network charges on forecasts of future energy sales volumes, which in turn are influenced by a variety of factors (for example: temperature, economic activity), there are frequently differences between the revenue generated and the revenue cap. These differences become apparent at the end of each year and are entered into the so-called regulatory account for the five-year period. This relieves the regulated operators of the volume risk. Operators with fluctuating sales volumes can distribute their network costs over the actually sold volumes. In the fifth and final year of each regulatory period, the balance for the previous four years is established and taken into account in the revenue caps for the following regulatory period. The balance is offset evenly over the new regulatory period in the form of additions to or deductions from the revenue cap. The regulatory account is also intended as a tool to avoid large fluctuations in network charges and thus increase predictability and planning reliability for businesses and network users.

Quality regulation

Price, cost and revenue regulation – however necessary – must not compromise the security of energy supply. Rules aiming to ensure the quality of supply are therefore a key part of the incentive-based regulatory regime. There is a general risk that network operators do not invest in their networks or do not carry out other measures to maintain or improve quality of supply, in order to save costs. To counter this, the Energy Act (EnWG) and the Incentive Regulation Ordinance (ARegV) provide for the introduction of quality regulation through a quality element in the formula for setting the revenue caps. As a result, operators whose networks have had above-average quality levels in past years will have an amount added to the cap, while operators whose networks had comparatively poor quality levels will have amounts deducted (bonus/penalty system).

Quality of supply is determined using three criteria:

network reliability
network performance
service quality

A fourth criterion which is not attributed to quality of supply but which influences it to some extent is technical security of supply. Under the Incentive Regulation Ordinance only two of these four criteria – network reliability and network performance – are used in quality regulation. The quality element is currently determined by calculating network reliability indicators based on supply interruptions longer than three minutes. Network operators participating in the simplified procedure are excluded from the calculations. There is currently no quality regulation for gas supply network operators.

The main tools of in­cen­tive reg­u­la­tion in Ger­many