Incentive-based energy regulation: what it is and who stands to benefit


Why is the RAB regulation introduced in the Ukrainian energy sector and how will it affect the infrastructure?  

The Ukrainian energy system, much of which was created in the 60-80swas poorly maintained at the time of the country’s independence restoration. The lack of investmentin development and modernization during the 1990s worsened the situation significantly. 

The industry was stabilized in the early 2000s when the government held the first transparent privatization tenders for the sale of oblenergos (regional energy distribution companies) (shadow “privatization” took place in the 1990s through artificial debt mechanisms and other informal schemes).   

New owners of oblenergos were slow in investing their funds in developmentbut used them rather as “cash cows”.   

This attitude towards energy companies remains to this day: investments in other sectors of the economy, where a quick return of capital is guaranteed, are more attractive for owners, but the same can’t be said for electricity networks 

The funds received through the distribution tariff (from electricity consumers) were and are the source of very small investments in fixed assetsOf course, these resources were not even enough to maintain the current state of networks, so they continued to deteriorate.  

It was impossible to radically increase tariff revenues, as the government restrained the growth of electricity prices, subsidizing other sectors of the economy and the population. As a result, the energy companies’ equipment is depreciated 70%.   

Attempts to reform 

In 2012-2013, it became obvious to everyone that the existing policy would result in further degradation of Ukraine’s UES networks while leading to the reduced quality of electricity supply to consumersSince then, the National Energy and Utilities Regulatory Commission (NEURC) has begun to develop a regulatory framework for the transition to so-called RAB regulation. 

RAB is a regulatory asset base. The concept is known in Ukraine as “incentive-based regulation”. RAB-regulation is the tariff design based on long-term (3-5 years) tariff regulation aimed at encouraging investment in the construction and modernization of electricity networks, as well as the cost-effectiveness of electricity distribution companies. 

The first attempt to introduce RAB regulation took place in 2017 when a package of regulatory acts governing this aspect of energy companies’ activities was finally developed.  

Then, the NEURC approved the Resolution No.972 of 27/07/2017 and set a 12.5% rate of return on the regulatory asset base. The first decisions on the transition of oblenergos to incentive-based tariff design were to be made in April 2018.      

Here we should understand the following aspect. In addition to the rate of return, the key tariff design parameter in incentive-based regulation is the same asset base implied in the RAB abbreviationie the monetary value of the company’s fixed assets used in its main activity.      

Assets are conditionally divided into the “old” (ie created before the transition to incentive-based regulation) and the new ones (after the transition).  

To introduce RAB-regulation, the energy distribution companies conducted an asset valuationaccording to which the value of oblenergos (in dollars) was 2-8 times higher than the price paid for these companies by owners during privatization  

Given the high asset base of energy distribution companies and the approved rate of return (12.5%), the increase in retail electricity prices as a result of the reform would be from 10 to 25%, which provoked outrage among industry experts, consumers, and the government. Therefore, the reform has not been implemented in this form.  

In 2020, the NEURC resumed work on the introduction of RAB regulation and proposed another approach: the 1% rate of return on the regulatory asset base for “old” assets and 15% rate for “new” ones.  

Almost immediately, the media launched a campaign to criticize this approach. The authors of these materials, who can hardly be suspected of being unbiased, were inspired almost simultaneously and provided almost the same arguments  

They emotionally argued that if the regulator did not make equal the rate of return on old and new assets, the energy industry would collapse, consumers would be left without energy, and “all would be lost”. 

That is, the owners have not invested their funds in the development and maintenance of networks for twenty years, but everything was fine, and now everything will collapse without the desired rate of return for financial and industrial groups.  

I would like to respond to these panic materials as follows: the main principle of RAB regulation is to encourage energy company owners to invest in electricity networks’ equipment. 

Once again: incentives to invest own or borrowed funds. The owners of oblenergos imagine RAB regulation as follows: raising funds from consumers at a rate of 6-8-10…%, investing them in equipment, and then, probably, raising funds from the same consumers at an even higher rate of return. Great business! 

In general, investments in infrastructure companies are super reliable, especially if these companies are market monopolies. They are even more reliable than a deposit in some Swiss bank. However, which bank has such interest rates? 

Another argument of a high rate of return supporters is the rather manipulative statement that the funds received will be used to develop infrastructure in “prospective areas” and this will reduce the cost of connection for new consumers. 

At first glance, it sounds very nice, but the devil is always in the details. 

First, who will determine the “prospects” of certain areas, and will new network facilities suddenly appear in the areas desired for businessmen close to the companies’ owners or heads? 

Second, the basic principle of everyone pays for their own stuff is violated, ie the portion of the cost to connect new consumers will be put to existing ones, which, given the already high electricity prices for industry, is unlikely to please businesses and have a good impact on the investment climate. 

It should also be understood that the consumption structure has changed dramatically in recent decades: hundreds of settlements have disappeared, a large number of industrial consumers have stopped or significantly reduced their activities, the networks of oncepowerful energy hubs are almost not required now. 

It is neither technically nor economically feasible to charge for the maintenance of networks that no one needs. On the contrary, it is necessary to assess the need to maintain such networks and include them in the asset base. 

As a result of consultations, the NEURC made some concessions but retained the separate rate of return principle: 3% for “old” assets and 16.74% for “new” ones. But these concessions for financial and industrial groups impose even more responsibility on the NEURC in terms of strict control over companies’ compliance with the requirements for improving the quality of services provided to consumers. 

However, I think this war is far from over. The owners of energy distribution companies will try to achieve their goals under various circumstances.     

I can only wish the regulator to continue using its balanced approach in this issue and remember that the basic principle of such companies in the world sounds like “a resource supplier exists for consumers”, not the other way around.