Benchmarking and efficiency mechanisms

1. Benchmarking and efficiency mechanisms Stephen Clark - A/GM Connections & Development Transend Networks

2. Challenges of regulation “Network performance, especially by the transmission companies, is good. However, we consider that the Regulator’s concern to reduce costs to consumers should now be tempered by a greater emphasis on ensuring that electricity network owners have the financial resources necessary to secure a viable long-term electricity supply.” House of Commons Trade and Industry Committee, March 2004, Resilience of the National Electricity Network,Third Report of Session 2003–04, Vol 1

3. Shared objectives • Deliver the right services at the right price • Reward prudent investment – do not expose companies to revaluation risk • Provide incentives to improve performance – in relation to cost and service • Set “fair” allowances for opex and capex • Share efficiency gains “fairly” between shareholders and customers • Minimise cost of regulation

4. Holistic approach required • Objectives unlikely to be met if: • Significant uncertainty regarding the regulator’s approach or outcomes • Weak incentive for better performance • Opex and capex allowances are not set fairly • Sharing of gains is not fair • Processes are unworkable or impractical • Regulation drives business decisions

5. Benchmarking & incentive mechanisms • Important aspects of regime • Establish “fair” opex and capex allowance • Establish “fair” sharing of cost efficiency and service performance gains • But • Cannot be divorced from asset valuation and WACC issues • Danger if regulatory approach treats each “topic” as separate

6. Role of benchmarking….so far • Simplistic benchmarking as part of the evidence for setting opex and capex allowances • Opex benchmarking based on • ITOMS • Historic costs • Simple ratio analysis • Partial recognition that capex is more difficult to benchmark, and incentive issues are more complex to resolve

7. Effective benchmarking • To be effective, need set of peers • Distribution lends itself more easily to benchmarking • International models offer limited benchmarks for Australian transmission • ACCC Discussion Paper (page 61) cautions: "a substantial component of the differences in cost observations between firms are due to legitimate or ‘uncontrollable’ differences in factors which affect the level of costs incurred by the firms”

8. ACCC recognition • ACCC identifies TNSP differences: • Nature, range, volume, quality of services • Price of inputs • Governmental regulations • Number, density, load factor and size-distribution of customers [and generators] • Environmental factors • Age and quality of capital stock

9. Benchmarking non-peers • Would require sophisticated analysis to normalise • Proper consideration of explanatory factors • Implies more intrusive regulation => Most effective Australian TNSP benchmark likely to be against own performance • same influences on efficient costs (eg nature, range, volume, quality of service etc) => Well-designed incentive mechanisms: allow benchmarking against own performance over time

10. Incentive mechanisms…so far • “Glide path” opex incentive mechanisms flagged in the DRP • Limited application of capex efficiency to date (Powerlink) • No clear system for application • No distinction between cost and scope changes • No clear models in recent revenue cap decisions => Companies cannot respond to incentives that only reveal themselves after the event

11. Incentive mechanisms… the future • Should be: • Clearly explained at the outset • Well designed, well understood, consistent over time • able to recognise externally-imposed capex and opex cost-drivers • Equitable - fair sharing of gains • Unobtrusive/light-handed

12. ESC’s incentive mechanism • Scheme appears to have good incentive properties provided cost allowances are set appropriately in the first place • Future opex allowances based on efficient costs being “revealed” • Capex profiling important (this may introduce distortions?) • Recognition of external unpredictable factors that may affect cost performance Note: Transend would not sign up to an ESC-type scheme based on its present revenue cap allowances

13. Suggested way forward • Benchmarking - useful if organisation performance benchmarked against true peers • In Australia, vastly different networks and operational environment =>most effective benchmarking for revenue-setting is against organisation’s own performance • Well-designed incentive mechanisms allow companies to benchmark against selves over time • ESC and ESCOSA models - starting point for further analysis?

14. Principles for future incentive regulation • Scheme should be • Well-designed, well-understood, consistent over time • Able to recognise externally imposed capex and opex cost-drivers • Equitable - fair sharing of gains • Unobtrusive • TNSP option to “sign up” to scheme • Where allowances are set properly and incentive mechanisms well-designed - win/win situation for all: • a viable long-term electricity supply