Common cost allocation in Icelandic combined heat and power

Abstract

This paper finds that arrangements – designed chiefly to ensure against cross subsidy between regulated heat markets and the competitive electricity market by operators of Icelandic Combined Heat and Power (CHP) plant – do not necessarily secure their objective of precluding cross subsidy. Furthermore, arrangements have not supported implementation of some satisfactory solutions, contravening principles of good regulation. Existing arrangements have therefore been the source of protracted disagreement between authorities and CHP owners, with some CHP owners appearing to have ignored (at least elements of) regulations. Absent reform this is likely to continue to drain resource, and provide limited clarity and confidence that price outcomes are free of cross subsidy.The paper presents evidence suggesting that the chosen cost allocation of Orkuveita Reykjavikur (OR) has secured cross-subsidy free pricing in 2018. This is consistent with heat consumers being unable to obtain lower prices elsewhere, including from a hypothetical efficient entrant providing heat with a stand-alone plant. OR´s 2018 allocation saw synergies of co-production expressed in both heat and electricity vectors in 2018. Benefits of OR´s decision to invest in combined heat and power – rather than stand-alone plant – are estimated in the region of around 1 billion ISK per year.The paper identifies issues in the regulatory framework, and proposes a light touch reform. These seek to facilitate implementation of cost allocations that comply with cross-subsidy free pricing, and to provide greater confidence that allocations that do not comply will be addressed. It also notes potential for differences in regulatory arrangements to distort the playing field for heat investment in favour of stand-alone plant over CHP, which if unaddressed, could impede realisation of significant cost synergies of co-production. In the longer term, attention might fruitfully be applied to the potential for removing obstacles to competition in heat generation in the capital area. If feasible, this would address the rationale for regulatory intervention in common cost and allow the market to ensure against cross subsidy.This abstract has been redacted to protect confidentiality of firm specific sensitive information.