Table 1

Table 2

Operator Profiles

The Portuguese electricity market comprises one TSO, Redes Energeticas Nacionais SGPS (REN), and one main DSO, Energia de Portugal (EDP) through E-REDES - Distribuiçao de Eletricidade.

The Portuguese gas market is operated by REN and split into three fully owned subsidiaries: REN Gasodutos (gas TSO); REN Atlantico (operates and owns the liquefied natural gas terminal); and REN Armazenagem (operates and owns the storage facilities). Distribution is managed by Galp Gás Natural Distribuição (GGND), the main operator, and REN Portgas Distribuiçao (fully owned by REN).

Table 3

Assessment Factors

Regulatory stability: Four-year period is providing adequate predictability

We view the Portuguese regulatory framework as supportive, given its track record of consistency and stability since its creation in 1999 for the electricity framework, and in 2008 for the gas framework.

Since 2020, the gas tariff regulatory period has been extended to four years from three, while the electricity period was extraordinarily extended by one year until 2021 following the COVID-19 crisis. Definitive extension to a four-year period for electricity is still pending approval from the regulator, ERSE. We view this timeframe as providing sufficient stability for the Portuguese operators, and more aligned with other European frameworks. The remuneration formula remains consistent from one period to another, with the main principles and components unchanged since 2009. The annual indexation to the 10-year Portuguese government bond of the weighted average cost of capital (WACC) resulting in yearly changes of the regulatory rate of return (RoR) is a relative weakness compared with other European frameworks. However, we consider that this source of volatility, correlated to volatility in the financial environment, is affecting the financial stability more than the regulatory stability of the framework.

Tariff setting: Detailed and transparent with full cost recovery

The regulator ERSE sets tariffs in advance each year based on estimated consumption and consultations with actors before a final decision. The approval of the tariff code is preceded by a public consultation and an opinion from ERSE's tariff board, except for the yearly tariff approval that is only submitted to ERSE's Tariff Council, on a confidential basis. ERSE's tariff-setting process, including its timeframe, is also defined in the code, providing full transparency to all stakeholders.

The allowed revenues are calculated based on the information sent annually by the regulated companies, real audited data, and estimated data. At the beginning of each regulatory period, the companies send their cost forecasts for the entire new regulation period. Regarding investments, in addition to the analysis of the values sent by the companies each year, ERSE considers the development and investment plan prepared every two years by each sector's transmission and distribution network operators. In these cases, ERSE must also carry out a public consultation and, in accordance with the result, issue its opinion for subsequent approval by the government.

A regulated asset base (RAB)-based model

The regulations allow operators to recover their capital and operational costs in a comprehensive and stable manner, and timely parameter reviews ensure that the regulation is adequate.

• The regulated asset base (RAB) is updated annually with periodic revisions of capital expenditure (capex) and depreciation and amortization (D&A).
• The RoR on RAB is calculated through the WACC method, and ERSE sets a pretax nominal rate at the beginning of each regulatory period. The WACC is indexed each year to the evolution of the 10-year Portugal treasury bond yield, since the bonds reflect the ability of the central government--and to an extent, the companies--to raise money in the financial markets. A cap and a floor are set to frame the volatility of the financial environment. In year N+2, ERSE calculates the final RoR considering actual bond yield, and the respective adjustment is computed into the allowed revenue calculation.
• Work-in-progress projects are remunerated once in operation and transferred to the final asset base.
• Operators are allowed to recover the annual depreciation amount for regulated assets.
• Regulatory D&A is calculated applying a straight-line depreciation approach to the initial asset base using a different regulatory lifetime for each asset composing the RAB.

According to ERSE, the asset life for gas-regulated distribution assets averages 30 years; for electricity transmission, 30 years; and for electricity distribution, 20 years, based on annual tax depreciation, all being comparable with other European regulations. But the real average remaining life of the existing network is 15-20 years, which means the infrastructure is fairly new compared with that of other European markets.

Chart 2

Table 4 shows the regulated rates of return (RoR) set for the current regulatory period.

Table 4

Chart 3

Chart 4

Tight operating costs control and incentive mechanisms

The Portuguese framework entails a high level of control over operating costs, which we view as a strong incentive for operators to continuously improve their cost efficiency.

In the gas sector, operating expenditure (opex) is based on a price cap for transmission and a revenue cap for the distribution operations, the cap being linked to the connection points (75%) and energy distributed (25%). For low-voltage electricity distribution activities, a price-cap method has applied to all costs based on a total expenditure approach since 2018, and ERSE might apply this in the next gas regulatory period, starting 2024.

Efficiency factors on operating costs have been in place for the past 10 years, to incentivize the distribution and transmission networks to achieve higher cost efficiencies. The efficiency factor is differentiated by company, depending on the number of delivery points and volume distributed, among other variables. The efficiency factor applied to operating costs stands at 1.5% for the electricity TSO, between 2.0% and 3.0% for the gas TSO and storage, and at 2% for DSOs, which compares unfavorably with other European regulatory frameworks where there are lower or no efficiency factors. However, Portuguese grid operators have a sound track record of reducing costs in line with targets, and the continuing ability to do so, in our view.

Specifically, for electricity transmission, a capex efficiency mechanism is in place, whereby a premium (75 basis points) is allocated if the TSO, REN, is able to achieve capex costs below a reference level determined by the regulator (assets post-2009).

Financial stability: Relatively strong based on full cost recovery despite tariff deviations

For both the electricity and gas sectors, companies are able to recover their allowed revenue, albeit with a time lag.

There is a significant level of protection against volume risk and noncontrollable costs. The companies are not exposed to volume or commodity prices. Additionally, opex is updated annually with inflation, and this inflation rate is included in the calculation for WACC for only the first regulatory year.

However, we consider that the tariff deviation--that is, the cash flow deviation arising from the difference between actual and budgeted payments, which is recovered over the subsequent two years of the regulatory cycle--constitutes one of the main weaknesses of the Portuguese framework, compared with shorter recovery periods in other EU jurisdictions. The remuneration on the recovery of the tariff deviations that arise from the differences between estimated and actual demand is calculated from the Euro Interbank Offered Rate (EURIBOR) ) plus a spread in the previous two years. While no tariff deficit accrues to power and gas grid operators, as was the case in Spain between 2008-2014, tariff deviations induce inherent cash flow volatility.

Another relative weakness of the Portuguese framework is that it does not allow the pass-through of all expenses, creating some exposure to fiscal pressures. This is the case of the Energy Sector Extraordinary Contribution (CESE) tax, imposed since 2014 to Portuguese regulated networks by the central government. With the COVID-19 pandemic, the tax was not levied in 2020, as was our initial assumption in 2019, hindering the profitability of grid operators. While we recognize that this is not a regulatory-driven tax, it remains an extraordinary tax levy with no pass-through into regulated tariff.

Regulator's independence: Strong, fully independent from any public or private interests

ERSE enjoys political independence, and from the first regulatory period we have seen no evidence of government interference. The regulator has also demonstrated its independence within the legal framework under a period of duress, including during the 2012 bail-out of Portugal. The regulator interacts in an open and transparent way with the regulated players through the publication of consultation papers well ahead of the scheduled regulatory revision. ERSE presents its tariff proposals to the tariff council, an independent body with representatives of the various gas and electricity system stakeholders; the Ministry of Environment and Energy Transition sets the energy policies and their implementation; and the Direçao Geral de Energia e Geologia (DGEG) designs policies on energy and geological resources.