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Finland’s Electricity Transmission And Distribution Regulatory Frameworks: Very Supportive

Table 1

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The Finnish electricity market: Largely decarbonized but dependent on imports

Finland is a relatively large net importer of electricity, importing about 18% of its total consumption, on average, in 2020. The main sources of electricity generation in Finland are hydro power (representing 25%) nuclear (35%), followed by biomass (15%), wind (10%) and fossil fuel (15%). We expect fossil generation to be phased out before 2035, as Finland has pledged to become carbon neutral by 2035by adding more nuclear and wind generation to the mix. This will also increase its energy self-sufficiency. The construction of nuclear plant Olkiluoto 3 (1,600-megawatt capacity), expected to be commissioned in 2022, is likely to transform the supply/demand dynamics, although will not sufficiently solve the net deficit.

Chart 1

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Operator Profiles

The Finnish Energy Authority regulates power and gas network operators across the country. Independent from the government, it implements the principles of the new Finnish Electricity Market Act (EMA) but also determines allowed returns. The first period of formal and active regulation started in 2005, with the latest EMA rules enacted from 2016.

Fingrid Oyj (AA-/Stable/A-1+) is Finland's sole power transmission system operator (TSO). The network--comprising 14,300 kilometers (km) of high voltage power lines--transmits 75% of Finnish electricity a year.

In contrast, Finland's distribution market is highly fragmented, with about 80 market participants. Of these Caruna Networks Oy (BBB+/Stable) owns 21.3% of the network and accounts for 18.9% of total customers; Elenia Verkko Oyj (senior secured debt rating: BBB+/Stable) owns 17.5% of the network with 11.9% of customers.

Assessment Factors

Regulatory stability: Stable and transparent frameworks since 2005

We believe the frameworks relating to the Finnish power market exhibit a high degree of regulatory stability. The Finnish Energy Authority has regulated the market under the EMA since it was enacted in 2005, with only minor adjustments since then. In our view, the amendments to the DSO framework suggested by the government in the latest bill are marginal; they are balanced and will not significantly affect distribution system operators' (DSOs) metrics. The framework is very transparent, with clear guidelines, assumptions, calculations, and rationales that are available on the regulator's website and through public consultations.

Since 2008, the length of regulatory periods has been four years. However, since November 2015, DSOs can apply the same method to compute the regulated rate of return for two consecutive regulatory periods (2016-2019/2020-2023), increasing the predictability of the framework.

Chart 2

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In September 2013, the EMA was updated to include targets for security of supply as extreme weather conditions have historically caused significant outages in Finland. One way that DSOs can ensure supply is by weatherproofing the network by moving cabling underground instead of having it overhead. The EMA targets for security of supply must be met by 2028, which, in our view, allows for stable and high remuneration at least until that year. The EMA also stipulates that power needs to be restored within six hours in zoned areas (urban) and 36 hours outside zoned areas following a storm-related power failure. The security of supply goal was for 50% of a DSO's cables to be moved underground in 2019 (Caruna and Elenia met the target, as well as half of unrated DSOs), with 75% targeted in 2023, and 100% in 2028. However, several DSOs requested an extension to the Energy Authority to fulfil its obligations, including underground cabling targets, with one of the reasons cited being that the cost of underground cabling is passed on to end-consumers leading to tariff increases. In June 2019, the Energy Authority granted two DSOs until the end of 2032 to fulfil these obligations, and until the end of 2036 for a further eight DSOs.

Following new regulatory methods in 2016, the regulator implemented modifications resulting in a higher weighted-average cost of capital (WACC) and stronger cost-recoverability, as an incentive for DSOs to invest and weather-proof the network. From 2016, the WACC has been linked to the higher of either the 10-year average rate or the previous year's (April-September) average of the Finnish government's 10-year bond. For the current regulatory period that started 2020, the regulatory WACC parameter calculation and method will remain the same, however some of the parameters were updated, for example the debt premium was adjusted to 1.26% from 1.40%. The risk-free rate is reset annually. WACC for 2021 is 5.35% and 4.52% for DSO and TSO respectively, compared with 5.73 and 4.89% during 2020. Despite the WACC reduction and downward trend, the level is higher than in other countries with similar sovereign credit quality. We believe the framework continues to be supportive and allows for very good cost recoverability.

Tariff setting method allows for swift cost recovery, except weather-related extraordinary costs, which are recovered with delay via the quality and efficiency incentive.

The Finnish framework follows a regulatory asset base (RAB)-led revenue-cap model under which incentives include efficiency, quality, innovation, investment, and security of supply. Reasonable return and regulatory depreciation create over 50% of the allowed return and are mainly affected by investments, capital expenditure (capex) outperformance, regulatory unit prices, and changes to WACC. Direct costs, which represent about 20% of allowed income, are considered as pass-through items, include transmission costs and distribution losses. Operational costs represent about 20% of allowed income, and depend on the company's historical performance and efficiency. We also view positively that the regulation limits volume risk for the DSOs and the TSO as the regulation allows for rapid recovery through tariff adjustments.

Reasonable return: the amount derived by multiplying the regulatory asset base by WACC. The WACC is determined according to an Energy Authority-approved formula applicable to both the TSO and DSOs and published on the regulator's website before the start of the upcoming regulatory period. The formula stipulates that:

  • Regulatory capital includes all annual investments in the network and its net present value is updated annually.
  • The parameters of WACC are fixed for the regulatory period, except for the risk-free rate, which is updated annually.

Economies of scale allow for unit price list outperformance.  Finland has about 80 DSOs of significantly varying sizes, but all companies are subject to the same regulation. This creates an opportunity to outperform the price list when investing; mainly larger companies could invest at a lower price than the unit price list, and therefore add a greater value to its RAB than the actual investment.

Chart 3

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Chart 4

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Incentives are provided to Finnish networks subject to a cap.  Once the allowed return is defined, it is compared with the realized adjusted profit from network operations including the incentives effects. The aim of Finnish networks is to equalize both side of the formula; in case allowed return is higher than realized profit, the network operator can increase tariffs in the upcoming year, currently up to 15% after taxes, over 12-rolling months. On the other hand, were profits to exceed reasonable return, the surplus would have to be returned to customers through lower tariffs.

The WACC covers all operational costs except those that fall under incentives embedded in the regulation. If certain costs are below the regulator's target, operators receive an incentive payment, subject to an upper limit or cap linked to the allowed regulatory return. If the costs exceed the target, then they face losses. Also, despite facing significant storms and snow, Finnish regulation doesn't allow for full coverage of costs following extraordinary weather conditions.

The TSO and DSOs all have four incentives: investment, quality, efficiency, and innovation. Only DSOs have a security of supply incentive. Details of the incentives:

  • Investment: Aimed to help DSOs invest in network replacement, it arises from the difference between investments calculated with unit prices and the cost of realized investments Though the change in unit price is supposed to take place in 2024, we expect it to occur beforehand, upon EMA updates.
  • Quality: Also known as regulatory outage costs, this is based on the amount and length of outages and compared with the reference level. The quality incentive is limited to 15% of the allowed regulatory return for DSOs and 3% for Fingrid.
  • Efficiency: Derived from both a general efficiency target and a company-specific efficiency target for the DSOs established by the regulator. It cannot be higher than 20% of the reasonable return for that specific year. For the TSO Fingrid, it is +/-5% of reasonable return.
  • Innovation: A maximum of 1% of all DSOs' revenues can be treated as research and development costs and will be reimbursed in allowed returns.

We note that the 2013 version of the EMA introduced the security-of-supply incentive for DSOs in 2016, which we expect will be removed from 2022. This incentive aims to help DSOs make invest in extensive replacement and carry out significant maintenance works to secure supply during extreme weather conditions. However, following the minimum requirements of the security of supply, and since networks can set tariffs independently without pre-approval from the regulator, 2016 saw a large increase in tariffs of Finnish DSOs. After this, in 2017, a cap on tariff increases was introduced at 15% over a rolling 12-month period. We believe the cap will be decreased to 8% once parliament votes for the EMA update. In our view, it won't affect Finnish DSOs as their historical average annual tariff increase has been well below this level, and together with lower WACC, the tariff increase should naturally decrease.

Financial stability: Supportive, despite weakness regarding recovery of extraordinary costs

In our view, although Finnish regulation supports operators' financial stability, the frameworks' flexibility is somewhat limited. This is because it does not define circumstances in which operators' costs would be deemed extraordinary and therefore treated as costs they can pass through to the end users. As such, if a utility suffers from the effects of an unusually severe storm, there is no guarantee that it could recover all the associated costs. We believe that in exceptional cases, the regulator would classify storm-related costs as pass-through items. That said, we have no track record of such intervention in recent years as there have been limited outage-related costs following the increase in underground cabling as per the 2013 EMA. Due to security of supply investments, severe storm-related costs have declined in recent years.

The frameworks provide for timely cost recovery because there is no restriction on how often a utility can change its tariffs, as long as it gives customers 30 days' notice and it is below the 15% annual cap over 12 months.

Congestion revenue for the TSO can be material but is not included in our adjusted EBITDA.  Congestion income is generated when there is insufficient transmission capacity between the bidding zones of an electricity exchange that lead to price differences between the zones. The difference are divided equally between the TSO operators, negative prices cannot occur. Congestion income received by a grid owner must be used for the purposes stated in EU Regulation 2019/943, Article 19: to guarantee the actual availability of the allocated capacity, and maintain or increase interconnection capacities through network investments. The change in the regulation governing Fingrid's grid pricing led the company to start including congestion income received after Jan. 1, 2016 in its accounting for transparency. Congestion income has varied greatly in the past few years. During the period 2016-2020 this income fell as low as €26 million, but in 2020 peaked at €147 million, representing about 110% of Fingrid's capex for the year.

Congestion income is not included in allowed income for the TSO and therefore not included in S&P Global Ratings-adjusted EBITDA. We treat congestion income as working capital--as we do cash flows--because it has limited restrictions and because it tends to be used for capex over an investment cycle, that is, amounts do not accrue over a longer period. Additionally, we view the regulatory treatment of congestion as credit positive for TSO regulation, as Fingrid has the opportunity to use these funds to make investments, which will not increase Fingrid's RAB (or balance sheet). However, the company is entitled to recover regulatory depreciation of those investments.

Delayed remuneration for assets entering into operations.  Another minor weakness for the TSO's activities, in our view, is that the frameworks do not fully support operators' capex during construction. Although work in progress that has been capitalized on the balance sheet would earn a return, a completed investment project forms part of the operator's regulatory capital from the beginning of the following year and therefore does not earn a return for the first calendar year of operation. In the framework methodology, the TSO is allowed to earn a return on book-valued assets under construction until the component is in operation. The component in operation is included into RAB when it is reported to the regulator.

We see a low risk that the regulator would disallow an operator's capital costs, however. The regulator does not preapprove operators' capital investments. Rather, the operators submit their long-term development plans (currently for 2014-2028) to the regulator for approval as stipulated in the EMA. We understand that the TSO can amend its capex plan without consent of the regulator. In our view this flexibility is an advantage as the capex plan could be amended, at least to some extent, if needed.

Regulator's independence: Legally assured

We believe the Finnish regulator has historically exhibited a high degree of independence and insulation from the government, as its role is enshrined in law. We have seen limited risk of political intervention, given the Finnish government's generally hands-off approach. However, the current potential amendments to the EMA could reduce our view of regulator's independence, especially if changes to networks are material and hastily implemented in the middle of the regulatory period. Furthermore, utilities can take disputes to the Market/ Court, which has a record of ruling in their favor if it believes the framework has not been fair to the regulated utilities.

This report does not constitute a rating action.

Primary Credit Analyst:Daniel Annas, Stockholm +46 (8) 4405925;
daniel.annas@spglobal.com
Secondary Contacts:Per Karlsson, Stockholm + 46 84 40 5927;
per.karlsson@spglobal.com
Emeline Vinot, Paris + 33 014 075 2569;
emeline.vinot@spglobal.com

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