d e z ri o h ut A e r u os Report No: ACS4845 cl Dis . c Republic of Armenia: bli u P Power Sector Tariff Study d e z . ri o h ut A e JUNE 2013 r u s o cl . s Di c bli u P Artur Kochnakyan d e riz Ani Balabanyan o h ut Pedro Antmann A e Caterina Ruggeri Laderchi r u s clo Anne Olivier s Di Lauren Pierce c bli u Denzel Hankinson P d e z ri o h ut A e r u s o cl s Di c bli u ECSEG P EUROPE AND CENTRAL ASIA . Standard Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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Table of Contents Executive Summary i 1 Introduction 1 1.1 Definition of Key Terms 2 1.2 Overview of Regulatory Framework for Tariff Setting 2 2 Cost-Recovery Tariffs: Short-Run 9 2.1 Average Cost of Service: Actual versus Cost-Recovery 9 2.2 Why Tariffs Do Not Cover the Cost of Service in the Short- Run 11 2.3 Additional Concerns about Cost-Recovery Tariffs 14 3 Impact of New Investments on Tariffs 16 3.1 Average Cost of Service 16 3.2 Average Residential Tariffs 19 4 Marginal Cost-Based Tariff Structure 21 4.1 Proposed Tariff Structure 21 4.2 How Does the Proposed Tariff Structure Differ from the Current Tariff Structure? 25 5 Social Impact of Higher Tariffs 31 5.1 Affordability under Current Electricity Tariffs 31 5.2 Impact of Higher Electricity Tariffs 32 6 Transitioning to Higher, Marginal-Cost Based Tariffs 35 6.1 Options for Subsidization 35 6.2 Options for Mitigating Rate Shock 42 7 Conclusions and Recommendations 49 Appendices Appendix A : Estimating Revenue Requirement—Key Assumptions and Results 52 Appendix B : Estimating Marginal Costs and Determining Marginal Cost- Based Tariffs 78 Tables Table 1.1: Definition of Key Terms 2 Table 1.2: End-User Tariffs, VAT inclusive 8 Table 2.1: Sector Revenue Shortfall resulting from Tariffs that are below Cost-Recovery 10 Table 2.2: Actual versus Cost-Recovery Tariffs for Individual Companies 11 Table 2.3: Impact of Waiving Depreciation and Profit for State-Owned Companies 12 Table 2.4: Current ANPP Tariff versus Tariff with Full Decommissioning and Life Extension Costs 13 Table 3.1: Average Cost of Service and Revenue Requirement under Different Generation Scenarios 17 Table 4.1: Proposed Marginal Cost-Based Tariff Structure for All Customer Classes, 2013 22 Table 4.2: Impact of Tariff Structure on Monthly Bills for All Customer Classes 23 Table 4.3: Marginal Cost-Based Tariff under Different Generation Scenarios, 2021 (VAT inclusive) 24 Table 6.1: Subsidy Delivery Options 38 Table 6.2: Comparison of Subsidy Options in terms of Economic Distortion 39 Table 6.3: Comparison of Subsidy Options in terms of Costs 40 Table 6.4: Comparison of Subsidy Options in terms of Targeting 41 Table 6.5: Comparison of Subsidy Options in terms of Coverage 42 Table 6.6: NPV of Transition Subsidy at Different Levels of Tariff Increase 46 Table 7.1: Comparison of Electricity Subsidy Delivery Options 51 Figures Figure 1.1: Tariff Setting Process 3 Figure 1.2: Percentage of Revenue Collected from Each Customer Class, 2007-2011 8 Figure 2.1: Average End-User Tariff v. Average Cost of Service under Different Scenarios 10 Figure 2.2: Actual Feed-In Tariffs versus Tariffs Calculated based on Tariff Methodology for Small HPPs 14 Figure 3.1: Average Cost of Service under Different Generation Scenarios, 2021 (including VAT) 16 Figure 3.2: Average Cost of Service under Different Generation Scenarios, 2012-2030 18 Figure 3.3: Average Residential Tariff under Different Generation Scenarios, 2021 20 Figure 4.1: Percent Change in Monthly Bills under Proposed Tariff Structure 23 Figure 4.2: Monthly Bills in Winter and Summer under Different Generation Scenarios 24 Figure 4.3: Average Annual Electricity Expenditure under Different Generation Scenarios 25 Figure 4.4: Typical Day Average Hourly Marginal Costs per kWh, 2013- 2017 28 Figure 4.5: Customer-related Costs as a Percentage of Marginal Cost Revenue by Customer Class, 2013 29 Figure 4.6: Comparison of Class Revenue Allocation under Current Tariff versus EPMC 30 Figure 5.1: Patterns of energy use, source of heating by region (2010) 32 Figure 5.2: Energy and electricity poverty (percentage of population), by region 32 Figure 5.3: Simulated poverty impact of electricity price increase on energy poor households, for different 2021 scenarios 33 Figure 5.4: Simulated poverty impact of electricity price increase by Family Benefit program status, for different 2021 scenarios 34 Figure 6.1: Examples of How CWIP Avoids Rate Shock for Two Nuclear Scenarios 44 Figure 6.2: Example of Average Cost-Recovery Tariff versus Transition Tariff 46 Boxes Box 1.1: Tariff Methodologies for Generation, Transmission and Distribution 6 Box 1.2: Feed-In Tariff Methodology for Renewable Energy Generation 7 Box 2.1: Gas-Electricity Swap with Iran 15 Box 4.1: Using Marginal Costs to Determine the Tariff Structure 21 Abbreviations AMD Armenian Dram currency ANPP Armenia Nuclear Power Plant CCGT Combined Cycle Gas Turbine CIS Commonwealth of Independent States CWIP Construction Work in Progress EE Energy Efficiency ENA Electricity Network Armenia EPMC Equal Percentage of Marginal Cost FB Family Benefit program FERC Federal Energy Regulatory Commission GAAP Generally Accepted Accounting Principles HPP Hydropower Plant HVEN High Voltage Electric Networks IASB International Accounting Standards Board IFRS International Financial Reporting Standards kV kilovolts kWh Kilowatt hour MW Megawatt PFBP Poverty Family Benefit Program PSRC Public Services Regulatory Commission RE Renewable Energy R2E2 Renewable Energy and Energy Efficiency Fund RR Revenue Requirement tcm Thousand cubic meter TPP Thermal Power Plant VAT Value-added tax WACC Weighted Average Cost of Capital Executive Summary Armenia has a Regulatory reform underlies many achievements in Armenia’s strong power sector. A strong regulatory framework, which includes a regulatory long-standing commitment to cost-recovery tariffs, has attracted track-record in substantial private sector participation to the sector. As a result, the power reliability, service quality and the efficiency of sector operations sector… improved. In recent years, however, increasing cost of electricity service and the Government’s concern about affordability has led to a departure from cost-recovery tariffs. … but, in recent A combination of factors has led to rising costs per kWh of years, tariff electricity consumption. The cost of natural gas accounts on increases have average for 8-10 percent of the cost of service, and will likely not kept pace increase as the import price of natural gas from Russia continues with rising costs to rise. Moreover, as a result of the global financial crisis, the Armenian dram depreciated against the US dollar by 30 percent. The depreciation proved costly for many companies, particularly thermal power plants (TPPs), because gas payments and some debt service are denominated in US dollars. The crisis also affected consumption, which fell 7.4 percent in 2009. The drop in consumption increased the average cost of electricity per kWh as fixed costs had to be spread over fewer kWh of sales. The The Government has taken steps to mitigate increases in the cost Government of service in order to maintain affordability. Some actions have tried to benefited consumers without harming the financial sustainability maintain of the sector. The gas-electricity swap with Iran has allowed affordable Armenia to take advantage of excess capacity during off-peak tariffs, hours and trade this for natural gas, which is needed to run the however, some more expensive TPPs to meet peak demand. measures have Other government measures, however, have sought to maintain hurt financial affordability at the expense of the financial sustainability of state- performance of owned power companies, including: the sector  Under-recovery of capital costs for state-owned plants. The Government has waived the depreciation charge and return on assets for state-owned power companies  Lack of adjustment for inflation. The allowance for wages, material, repair, and various other costs in each company’s tariff has remained constant since 2009, despite 19 percent cumulative inflation over that period.  Under-recovery of decommissioning charges. The tariff for the Armenia Nuclear Power Plant (ANPP) does not adequately cover the cost of decommissioning. i Average residential tariffs, equal to AMD 28.8/kWh or US$0.074/ kWh, are roughly 13 percent below the efficient cost of service as result of the above measures. Large Armenia needs a large baseload plant by 2021 to replace the ANPP investments are and two old gas-fired TPPs, Hrazdan TPP and Yerevan TPP, when needed in the they are retired. The Government plans to build a new 1,100 MW sector, which nuclear plant, but has yet to mobilize financing for the plant. Plans will significantly to tap into Armenia’s renewable energy resources, including small- increase and medium-sized hydropower plants (HPPs), wind, and revenue geothermal, can help to fill the gap, but will not be sufficient to requirements replace the ANPP. The only other viable baseload alternative for Armenia would be a large, gas-fired TPP. Ongoing investment is also needed to rehabilitate Armenia’s aging transmission and distribution networks. Thus, beginning in 2021, roughly AMD 78- 373 billion (1-5 percent of estimated 2021 GDP) will be needed in additional sector revenue annually to cover the cost of supply. The share of generation in total sector revenue will increase from roughly 60 percent in 2012 to 75-90 percent in 2021 as a result of the required investments. Large tariff Large tariff increases will be needed to cover the revenue increases will requirement with new investments. To allow for full cost- be needed to recovery, end-user tariffs would need to increase 70–270 percent finance those depending on the investment scenario, with the largest increase investments expected if a new nuclear plus some renewable energy plants are constructed with commercial financing. The figure below shows 2021 marginal cost-based tariff levels under the different investment scenarios. ii The tariff The tariff structure does not reflect the marginal cost of serving structure is different customer classes. This provides distorted price signals to suboptimal customers, leading to inefficient consumption, particularly during high cost winter peak hours when Armenia’s expensive TPPs must operate to meet demand. Presented below are the deviations from marginal cost based tariff setting principles:  Seasonality. Armenia does not have a seasonal tariff, despite the fact that winter marginal costs are significantly higher than summer marginal costs.  Time of use. The differential between peak and off-peak, or day and night, tariffs does not reflect the difference in the marginal cost of service during those two periods.  Fixed charges. Armenia does not have a fixed component in the monthly bill despite the fact that there are significant customer-related (and demand-related) costs of service, which are not driven by kWh consumed.  Voltage levels. Allocation of revenue to different customer classes does not reflect the differences in the marginal cost of serving different voltage levels. As a result, non-residential customers have cross-subsidized residential consumption. Marginal cost- A marginal cost-based tariff structure would include a seasonal based tariffs component and fixed component to better reflect how will improve incremental costs are incurred. It would also improve the revenue efficiency allocation to customer classes to remove existing cross-subsidies and contribute to increased energy efficiency. The table below compares the existing end-user tariff structure to the marginal cost-based proposed tariff structure. Residential 0.4 kV 6 (10) kV 35+ kV Current Tariff (AMD/kWh) Day 30 30 25 21 Night 20 20 17 17 Marginal Cost-Based Tariff (AMD/customer/month) Monthly Marginal Customer- 2,551 7,365 120,805 718,610 Related Cost Combined Marginal Energy (AMD/kWh) and Capacity Costs Winter peak 35.8 35.8 34 23.2 Winter off-peak 9.7 9.7 9.4 8.8 Summer peak 5.2 5.2 5 4.7 Summer off-peak 2.9 2.9 2.8 2.6 iii Many Many households will struggle to afford electricity at tariffs that households will cover the cost of new generation and reflect marginal costs. Tariff struggle to pay hikes could result in 1–8 percent increase in poverty compared to electricity bills if the baseline for 2021.1 Electricity poverty would increase 2–5 the critical percent depending on the investment scenario, with a heavier investments are burden on the poorest households. Armenia’s targeted social made assistance program, known as the Poverty Family Benefit Program (PFBP), helps to reduce poverty among vulnerable households. However, current allocations under the PFBP would not be sufficient to protect its beneficiaries from poverty. The figure below shows the increases in poverty levels as a result of the tariff increase for FB and non-FB beneficiaries. Transition The PSRC can reduce the sudden impact of tariff increases by mechanisms employing mechanisms to help transition to marginal cost-based can cushion the tariffs. These transition mechanisms could include: sudden impact  Regulatory accounting methods to smooth out the increase in of tariff the revenue requirement. New investments can cause a large increases one-time increase in the revenue requirement. However, regulatory mechanisms, such as Construction Works in Progress (CWIP) or creation of a regulatory asset can be used to help “smooth out” the increase in the revenue requirement over several years in order to avoid rate shock. The figure below shows how CWIP would help smooth out the increase in average tariffs for one of the generation scenarios.  Modified approach to revenue allocation. In developing a marginal cost-based tariff, economic efficiency requires recovery of costs from, or allocation of revenue to, customers in proportion to their marginal cost revenues.2 Residential 1 Baseline poverty incidence is the poverty incidence that would be expected in 2021 if tariffs remain at constant 2010 prices. 2 “Marginal cost revenues” are the sum of the marginal generation, transmission, and distribution costs associated with serving an additional kWh of energy, kW of demand, or customer, multiplied by the class’ kWh, kW and number of customers. iv