The Swedish Energy Markets Inspectorate (Ei) has regulated Swedish electricity and gas networks using revenue caps since 2012 and 2015 respectively. The regulation has undergone several changes since its inception, partly following complaints from the regulated companies. The calculation of capital costs and the regulatory WACC used to set the revenue caps have been particularly controversial.
Historically, the calculation of regulatory capital costs has been based on a capacity replacement approach. This means that the capital base is valued based on the cost of building the grid facilities at current prices, rather than the historical investment cost (investment cost approach). The capacity replacement approach risks resulting in a systematic over- or under-return for network owners if the price index used to value the capital base deviates from general inflation. To reduce this risk, Ei plans to switch to using an investment cost approach. The conversion will take place using the historical investment cost adjusted for general inflation as the basis for a network’s capital base. By doing so, the current regulatory approach, which uses a real regulatory WACC, can be preserved.
Ei further proposes that the initial value of the capital base at the transition to a new regulatory period should be based on the principle of value consistency. This means that the closing balance according to the historical method will be used as the initial value in the next. The alternative would have been to use a so-called method-consistent transition, where the capital base is calculated as if it had been subject to the new method in the past. A method-consistent transition is less predictable and entails higher administrative costs than adopting a value-consistent approach. The proposed changes have been sent out for consultation and are scheduled to come into force in 2028 (electricity) and 2027 (gas) at the start of the new regulatory periods.
The proposed changes raise several fundamental and practical questions that THEMA has investigated on behalf of Ei. THEMA’s report contains a comprehensive theoretical and empirical analysis of the characteristics of different approaches to calculating capital costs and the consequences for network companies, customers and regulators when changing methods during the operational life of the regulated assets. The main focus has been on linear methods in which capital costs reflect depreciation and returns cover the depreciated value of the capital. The empirical analyses conducted were based on a complete dataset for Swedish power and gas network companies. Our work also includes a discussion of the relationship between capital costs and other elements of regulation, including the setting of the regulatory WACC and the choice of benchmarking method.
