Explanatory_Notes_to_Action_Plan_for_Liberalization_of_the_Power_Market_of_the_Republic_of_Armenia_July_2017_Eng.docx

EXPLANATORY NOTES

to ACTION PLAN for Liberalization of the Power Market of the Republic of Armenia

INTRODUCTION

The Action Plan for Liberalization of the Power Market of the Republic of Armenia and Enhancing Cross-Border Trade (hereinafter, the Plan) takes into consideration the RoA Government Protocol Decision No. 29-11 dated July 29, 2016, with the intention of coordinating the process of power market liberalization and the implementation of activities promoting cross-border trade.

Armenia’s current electricity market model (EMM) was established in 2004 and is based on a “single buyer (seller)” model, in which the power distribution licensee reserves the right to buy electricity from generators on the wholesale market and sell it to customers. Both wholesale and retail sections of the market are fully regulated, as well as the import and export. In most developed and developing countries, power markets are already liberalized and are oriented toward a fully competitive market structure.

The RoA Energy Law was adopted in 2001. It requires extensive revisions to adequately address the challenges in the sector and the development of applicable solutions on a legislative level. The law needs to clarify the state policy principles and delineate jurisdictions for various government agencies and other entities operating in the sector. It should indicate requirements for the future structure of the power market and recommend incentives for the system’s stable development.

To liberalize the power market, transition to a new market design that increases wholesale and retail market efficiencies is necessary. At the same time, promotion of cross-border trade will augment certain elements of competitiveness in the domestic market.

The current power market of Armenia is based on the forecasted annual volumes of generation and consumption. Market participants do not bear responsibility for deviations from the defined volumes. This procedure increases risks and price volatility because actual volumes always differ from forecasted volumes of generation. The resulting financial imbalance is covered by future tariffs for end-users. These risks also include the cost of balancing such risks by the entity holding the distribution license. This regulatory construct negatively impacts the power system’s economic efficiency. Thus, to improve efficiency, the new market model should be based on contemporary trade rules. It should operate on the basis of electricity offers and bids received from market participants. It should also create mechanisms that place responsibility on market participants and give them opportunities to manage them.

Current tariff regulation is primarily based on “rate of profit regulation,” recalculating tariffs each year for utilities and service-providing entities. This principle does not create sufficient incentives for regulated entities to increase operational efficiency and attract investments. Supply tariffs are differentiated according to voltage levels and daytime/ nighttime usage, and do not adequately ensure targeted distribution of the cost of electricity and system power expenses. There are separate energy and capacity charges defined for generating plants; however, they are not applied to any specific customer group. At the same time, consumer-designated nighttime and daytime tariffs do not accurately reflect the generation prices for those periods. This tariff structure negatively impacts financial flows. These gaps within the current tariff regulation system can best be cured through the application of new market and regulatory approaches.

To improve incentives and efficiencies, the Plan’s primary objectives are the transition from a fully regulated EMM to a new liberalized model, implementation of contemporary trade rules, further improvement of the tariff structure, and promotion of cross-border trade. Priority issues include the protection of domestic consumers and sharing of responsibilities among market participants.

Main Objectives of the Action Plan

The Action Plan includes the following objectives:

Transition to hourly electricity trades as a mechanism to increase efficiency of the power system operation.

Implementation of optimal dispatch scheduling of the power system, based on demand and supply applications of market participants.

Transition to a mechanism whereby market participants and end-users are responsible for balancing risks incurred due to the difference between actual and forecasted consumption volumes.

Adoption of a model that creates new opportunities for cross-border trade.

Implementation of new mechanisms for protection of domestic consumers.

Improvement of the investment environment.

To successfully reach these objectives, the following steps are required:

Amend the RoA Energy Law and respective regulations consistent with those international best practices that help clarify the jurisdiction of government agencies and entities operating in the sector.

Develop the concept of a new Electricity Market Model (EMM).

Develop the concept of new Electricity Trade Mechanisms (ETMs).

Based on EMM and ETM concepts, develop new power market rules and, before 2020, transition to a new market model and new trade mechanisms.

Revise the existing tariff methodology.

Primary changes in the ROA ENergy Law

The RoA Energy Law will be revised in two stages. During the first stage, amendments will be introduced to the law that modernize the legal regulations and eliminate the existing barriers to gradual market liberalization. Amendments to the RoA Law on State Duty, aimed at changing the rates of state duties in compliance with the new types of licensed activities, will also be introduced.

Based on this work and any issues arising from it, new Energy Law will be developed at the second stage. These revisions will also take into consideration adoption of new sectoral laws for separate areas of the Energy sector.

At this point, the necessary amendments to the RoA Energy Law include, at minimum:

Clarifying functions of the RoA MOEINR and PSRC;

Introducing provisions on power market gradual liberalization;

Unbundling distribution and supply functions through the establishment of separate licenses and development of a regulatory framework for each;

Clarifying and broadening the authorities of the System and Market Operators;

Regulating export and import operations without issuance of licenses;

Introducing new types of licensing and regulations for electricity wholesale trade implementation; and, Introducing provisions guaranteeing nondiscriminatory access for third parties, including new grid connections and access to infrastructures.

Primary changes in the Power Market Model

The existing Armenian power market is fully regulated, with the distributor acting as a single buyer and seller. Distribution and supply are not unbundled and there is no Market Operator. Large consumers do not have access to the wholesale market. There are no wholesale traders and retail market suppliers. To liberalize Armenia’ power market by opening these market elements, a new efficient market model that will include abovementioned market participants is required.

Changes to the EMM should enable an orderly transition from the “single buyer (seller)” model to a liberalized market model that includes the following outcomes:

Establishment of a Market Operator Expansion of a System Operator authorities Participation of large consumers in the wholesale power market Participation of suppliers in the power market Participation of traders in the wholesale power market Considering the above, the concept of a new Electricity Market Model (EMM) will need to be developed and verified, providing market participants with the authorities presented below.

Establishment of the Market Operator Establishment of a Market Operator is a priority for further development of the power market and enhancement of power trade. The Settlement Center is already operating within the market structure as a licensee providing services to the market and already has a modern automated system of electricity metering. It is well positioned for the PSRC, in cooperation with the MOEINR, to transform it into the Market Operator. The PSRC can make this change through granting the Settlement Center a new license, assigning it Power Market Operator status. The PSRC will also authorize the new Market Operator to organize new trade functions on the wholesale and retail electricity markets (WREMs), including, but not limited to, the following:

Organization and further development of the WREM;

Registration of WREM participants;

Registration and management of power purchase and sale applications submitted by WREM participants;

Metering and invoicing of electricity purchased and sold on the WREM;

Organizing trade with neighboring WREMs.

While recalculating the cost of services rendered through the Settlement Center Closed Joint Stock Company (CJSC), the PSRC will include additional funds to ensure fulfillment of the Settlement Center’s new competencies.

The Market Operator, in cooperation with the System Operator, may introduce additional mechanisms that further develop the domestic market, and increase cooperation with the regional power markets.

Expansion of the System Operator Authorities To ensure successful implementation of new functions provided under the Market Rules and Grid Code, the System Operator’s authorities should be expanded. In this regard, the PSRC, together with the MOEINR, will amend the Power System Operator license conditions, expanding the authorities for implementation of new functions provided under the Market Rules and Grid Code. The PSRC will also allow the System Operator to recover additional funds as part of its cost of service, to enable it to fulfill its new functions.

Entrance of Large Consumers to the Market Currently, all consumers buy electricity through the distribution network. The entrance of large consumers into the wholesale power market will allow consumers to buy electricity directly from the generators, paying PSRC-established tariffs for transportation of power through the distribution or transmission networks. Large consumers will be able to participate in system planning. They will pay separately for energy and capacity, which provides an opportunity to garner additional economic profits, both for the system and for their own operations.

Participation of Suppliers in the Market Unbundling of supply and distribution functions is critical to the creation of a competitive market. The suppliers are participants in the wholesale and retail power markets. They buy electricity on the wholesale market and sell it to consumers in the retail market. Suppliers do not possess any section of the distribution network; their function is to ensure connection between wholesale and retail markets.

Currently, only the entity holding the distribution operation license has the right to perform the supply function, using the same distribution license. After unbundling of supply and distribution functions, the Electric Networks of Armenia CJSC will be allowed to continue performing both supply and distribution operations. For this purpose, the company will be issued two licenses, establishing separate accounting systems for each function. At that time, other companies may begin offering competing power supply service by obtaining a corresponding license. As a result, the gradual entry of new suppliers into the power market will create a competitive environment in the retail market.

Participation of traders in the Wholesale Market Including traders (entities implementing electricity wholesale trade) in the wholesale market will increase efficiencies and help to harmonize trade both within the domestic wholesale market and with neighboring power markets. Traders’ operations are limited exclusively to this level of trade; they do not participate in the retail market.

Establishing traders as an institution in Armenia’s power market and endowing them with the authority to conduct export and import activities will be critical to the successful development of cross-border trade relations.

Primary CHANGES in the Electricity Trade Mechanism Transitioning domestic markets to a fully competitive model will also create mutually beneficial trade opportunities with neighboring countries. A new market structure includes transition to an hourly market that enhances electricity sector operation, more efficient allocation of responsibilities between market participants, protection of domestic consumers, and creation of an enabling environment for investors. To meet these tests, the new ETMs should provide transition to an hourly market and outline the following:

Annual planning for tariff-setting purposes Capacity Market Direct Contracts Market Day-ahead Market Balancing Market Ancillary Services Armenia’s power plants include an array of different types with a wide range of production prices. Full liberalization is therefore not realistic, since tight supplies may lead to unacceptable increase of prices on the wholesale and retail markets. To avoid these increases, tariff regulation mechanisms should, for the most part, remain in effect. At the same time, power importers will be able to participate in market operations, creating a certain level of competitiveness and deterring price increases. It will become possible to export excess electricity surplus at unregulated prices, providing generators with a new revenue source.

For greatest efficiency, the ETMs should also focus on responsibility-sharing mechanisms among market participants taking into consideration below presented general description.

Annual Planning for Tariff-Setting Purposes Annual planning assists in developing a balance of the power system aimed at covering forecasted demand for electricity through the least costly generating capacities, while taking into account the system’s reliability and safety indicators.

Based on market participants’ offers and demands, the System Operator in cooperation with Market Operator will develop the annual balance of the power system based on daily load shapes. Using the annual balance, the PSRC will calculate and approve the tariffs for the next settlement period.

Those power plants whose capacities were not included in the annual balance will be free to generate electricity and sell it to any entity on the domestic market at non-regulated prices or to export it.

Capacity Market The capacity market’s primary goal is to ensure the availability of a group of effective generating plants, which, at any given moment, can satisfy electricity demand while maintaining system reliability and safety. The capacity market will create opportunities to avoid a capacity deficit, both short and long term, and will give power plant operators the responsibility of ensuring that their generating capacities are fully operational.

The task of establishing a capacity market within Armenia’s power market is partially resolved since, for large power plants, the tariff already provides two separate rates - energy and capacity.

To implement new ETMs, the mechanisms for planning and regulation will remain unchanged. However, for planning purposes, the System Operator will take into account not only the distributor’s applications but also those of large consumers. Following the principle of annual planning for the capacity market, large consumers will need to apply for differentiated rates for energy and capacity. Capacities ordered by the System Operator will be proportionally allocated in advance between the buyers. Corresponding annual contracts will be signed with them. Payments for the ordered capacities will continue to be implemented each month, per current practice.

BILATERAL CONTRACTS Market The purpose of Bilateral Contracts Market (BCM) is to define the values and amounts of demand and supply of electricity for the following month. The BCM will be comprised of two sections - regulated and liberalized. The “take or pay” principle will be applied in these sections.

In the regulated segment, bilateral contracts are signed between the market participants with prices not exceeding the regulated tariffs. During the first step toward the power market’s liberalization the bilateral contracts signed in the BCM’s regulated segment will not completely cover the forecasted demand - the portion has been estimated at 85 to 95 percent. The final size of the proportion is defined prior to the approval of the ETM, while minimizing the risks of occurrence of surpluses to the buyers on the wholesale market for normal regime of operation. Even if such situations still occur, the buyers will sell the surplus of electricity on the DAM at prices not exceeding the regulated tariffs. The part of electricity demand not covered on the BCM will be traded on the DAM.

At the same time, in order to cover the demand for electricity, several regulatory approaches could be applied on the generation side. In particular, the demand could be covered by committing the entire volume of output of individual power plants or, a certain portion of it, mindful of seasonal and hourly differences and import-export opportunities.

Under the BCM’s liberalized section, the generating plants will receive the right to sell any surplus electricity not required under the regulated BCM or to export it at free contractual prices.

Market participants’ bids for demand and supply of electricity on the BCM will be submitted to the Market Operator. The Market Operator will coordinate with the System Operator for development of optimal dispatch load schedules and congestion management. Based on the monthly electricity balance approved by the System Operator, the Market Operator will coordinate the process of signing bilateral contracts between the market participants for the following month.

To develop the full set of mechanisms to cover electricity demand and supply and define proportions, prior to the approval of ETMs, corresponding software must be developed. In addition, all possible situations must be modeled, and multifunctional calculations implemented. Based on modeling results, Market Rules will be developed and approved.

Day-Ahead Market The Day-Ahead Market (DAM)’s purpose is to cover the electricity demand not satisfied on the BCM, taking into account possible differences in BCM versus DAM planning.

Each day, market participants will submit their offers/bids for the next day to the Market Operator. The Market Operator, in cooperation with the System Operator, will apply the principle of economic dispatch and coordinate the process of executing power purchase transactions for the next day between market participants that will include consideration of the bilateral contracts signed under the BCM.

Transactions between DAM participants will also comply with the “take or pay” principle. Contrary to the BCM, in the DAM generators have the opportunity to sell electricity at prices higher than the regulated prices. At the first stage, because of the absence of excess supply and the significant differences among power plant tariffs, it will be necessary to restrict that amount eligible for unregulated sale (e.g., by five to 15 percent). This correlation will be based on modeling results. However, even this limited tariff liberalization will provide an opportunity for the generating plants to cover risks associated with inflation, currency, and other market risks that were not considered while calculating the tariffs. It will also help to promote new investments.

The importers and those power plants that were not included (or only partially included) in the annual balance can also participate on the DAM. This environment will enable a certain level of competitiveness. Sellers will be allowed to export all electricity that the DAM does not require. Export mechanisms will mostly depend on cross-border trade rules, mutually agreed with the neighboring countries.

Balancing Market The purpose of the balancing market is to provide a mechanism for assigning responsibility for power purchase transactions and for deviations of the actual volumes from those commitments.

As a result of deviations between the actual and forecasted volumes of generation, the actual prices of electricity generation will differ to a certain extent from the prices of transactions signed on the DAM. Each party to a transaction bears responsibility for such deviations. Such individual responsibility avoids the situation when a financial imbalance must be covered via end-user tariffs. This mechanism will also allow increasing protection for end-users and small business interests.

Responsibility measures should be defined based on the modeling results prior to the ETM approval and should be reflected in the Market Rules.

Ancillary Services The purpose of ancillary services is to ensure power supply of a quality defined by the power system’s safety and reliability indicators.

The ancillary services in Armenia’s power system are not considered as separate types of services. The System Operator fee or capacity and electricity charges of generation units cover ancillary services but they do not ensure adequate targeting.

Market participants provide the following types of ancillary services:

Frequency and power flow regulation Balancing Voltage regulation Energy system rehabilitation in case of system blackout Separation of ancillary services will increase market participants’ responsibility and revenue, improve efficiency, and better target expenses for the installations used to provide these services.

The System Operator will be compensated for system dispatch and other ancillary services provided, with corresponding expenses included in payments for dispatch services.

Primary Changes in Tariff Regulations

Implementation of tariff regulation in Armenia’s power system is based on the principle “rate of profit regulation.” Currently, the PSRC recalculates the tariffs annually for all entities and service providers of the system. Where financial returns are insufficient, it also recalculates the power supply tariffs for consumers. The “rate of profit regulation” principle does not create sufficient incentives for regulated entities to improve long-term accounting and investment efficiencies. This principle needs to be gradually amended by making a transition to longer models by applying relevant incentive mechanisms.

Where voltage levels and daytime and nighttime hours differentiate power supply tariffs, targeted distribution of the cost of electricity and system expenses is inexact and inadequate. There are separate energy and capacity charges defined for generating plants; however, they are not applied to any customer group. At the same time the nighttime and daytime tariffs that apply to customers do not reflect the generation prices for the afore-mentioned time periods. Large consumers purchase electricity from the distribution network at average, regulated prices only. Thus, they do not have incentives to increase the efficiency of their consumption structure, which would help restrict the growth of generation costs and decrease the average weighted price of electricity purchase. For example, they are not encouraged to consume less when electricity is more expensive, or to consume more when there is a surplus of electricity in the power system.

To resolve this issue, research into new principles of cost and investment allocations between the tariffs for various voltages is essential, as is the development of relevant tariff methodology. Further improvement is also needed in mechanisms for calculating the defined values of the distribution network margin. The efficiency of the daytime and nighttime tariffs should also be studied from the perspective of their values and the hours of application. It is also important to consider the issue of setting seasonal tariffs and to differentiate them according to other time periods, such as peak hours, or under-loaded night hours.

Prate of return of power plants and service providers is limited to eight percent after taxation. This level of return does not allow state companies to attract loans without RoA government guarantees, even for implementation of long-term projects. Thus, state companies operating in the sector remain unattractive for investors. Therefore, to attract investment, it is essential to modestly increase the profit rate applied to these companies.

Transition to the New Market Model and Perspective Development

Improvement of the existing market structure is a lengthy and gradual process. It is necessary to perform comprehensive research and work to ensure a phased and smooth transition from the existing market to the new market model. New tools that help implement electronic market control are also essential, as is the need to develop network rules—first, for the temporary market and later, for the new fundamental model.

The RoA MOEINR and PSRC have already initiated development of the Grid Code, implementation of which will present all market-related technical regulations in one unified document. The market trade rules, which are presented in fragmentary form in various PSRC documents, should also be consolidated into one unified document. The first step toward improved documentation is obtaining approval of the temporary market rules of trade. These rules would contain the package of documents permitting direct sale of electricity from cogeneration plants and renewable power plants to industrial and commercial customers. This package may also address other opportunities of market liberalization during the transition period. Within the framework of temporary rules, the following should be defined:

For the development of new WREM rules, the Market Operator, using the software package for optimal structure modeling, will implement corresponding calculations. The Market Operator should also develop, in cooperation with the System Operator and market participants, the new Armenian EMM and ETM concepts and submit them to the MOEINR and PSRC for approval. The new EMM and ETM concepts should, at minimum:

At the next step, the Market Operator would run the software package selected for the EMM and ETM implementation and operate it for a short time in simulation mode, i.e., without financial obligations to market participants. During that period of time, the market participants will have an opportunity to increase their abilities to operate successfully after transition to the new EMM.

The complete transition to the new model will be implemented after approval of new market rules coordinated between the PSRC and MOEINR.

After transition to the new EMM is complete, and based on lessons learned from both domestic and external market experience, it will be appropriate to prepare new 10- year development program for the Armenian power system. The System Operator in cooperation with the MOEINR, PSRC, and other state bodies and interested parties, including market participants, will design this 10-year development program.

Acronyms

DSO Entity possessing the Electricity Distribution Services License

EMM Electricity Market Model

EMO Entity possessing the Electricity Sector Market Operator service provision license

ESO Entity possessing the Electricity Sector System Operator service provision license

ETM Electricity Trade Mechanism

PSRC Public Services Regulatory Commission

RoA MOEINR Ministry of Energy Infrastructures and Natural Resources of the Republic of Armenia

WREM Wholesale and Retail Electricity MarketU.S. Agency for International Development 1300 Pennsylvania Avenue, NW Washington, DC 20523 Tel: (202) 712-0000 Fax: (202) 216-3524 www.usaid.gov