Reform of capital expenditure regulation

1. Reform of capital expenditure regulation Bruce Mountain MountainAssociates MountainAssociates

2. Content • Review of the current capex regulatory contract • Description • Incentive properties • Administrative requirements • Is there a better way - how could we think about this? • The ACCC’s suggested “ex-ante cap” approach: description, questions & answers MountainAssociates

3. Current regulatory contract: Description • Commission’s Code obligations: • Economic incentives for efficient investment. • Commission’s Draft Regulatory Principles • Step 1: Determine capex forecast and set revenue cap accordingly. Capex forecast is only “ball-park” estimate of “efficient” investment; • Step 2: Assess prudency of actual expenditure at end of regulatory period based on “good industry practice”. Roll-in “efficient” investment into RAB. “Ex-post” optimisation MountainAssociates

4. Current regulatory contract: Incentive properties • But will threat of ex-post optimisation cause TNSPs to invest efficiently … • what if optimisation threat isn’t credible – would TNSPs still invest efficiently? • what if optimisation threat is credible – surely TNSPs would seek regulatory consent before undertaking major investments? (In which case, is an ex-post regime sustainable?) MountainAssociates

5. Current regulatory contract: Incentive properties • Also, does existing regime only offer a stick (i.e. no carrot) to TNSPs: • if actual capex < forecast capex: risk that regulator will take away part of the “underspend”; • if actual capex > forecast capex: risk that regulator will make them absorb part of the “overspend”. MountainAssociates

6. Current regulatory contract: Administrative requirements • What needs to be done to assess the prudency of past investments? • Assess whether bona fide need for investment; • Assess whether most efficient project chosen; • Assess whether most efficient project delivered. • The assessment must only take account of what the TNSP knew (or should have known) at the time it invested. MountainAssociates

7. Current regulatory contract: Administrative requirements • What does this mean in practice? • From 1999 to 2004, TransGrid invested in more than 60 separate transmission augmentation projects and hundreds more replacement, IT, and “support the business” projects. Each project should be assessed. • Prudency judgements requires that regulator can credibly “second guess” TNSP decisions. This means capability in transmission planning & engineering; environmental and local planning regulations; the ability to judge what corporate entities could be expected to achieve etc. Ex-post assessments are inevitably highly intrusive, subjective, time consuming (for both regulator and TNSP) and expensive. MountainAssociates

8. Developing and evaluating alternative regulatory contracts: variables for consideration • Ex-ante vs ex-post • Project-specific vs basket • Variable price vs fixed price MountainAssociates

9. A range of possible capex regulatory contracts Basket of projects Ofgem UK DTe Holland NVE Norway Ofwat US Public Utility Commissions (PUCs) Ofgem Individual projects VENCorp VENCorp “Variable price” contract “Fixed price” contract MountainAssociates

10. Evaluating alternative regulatory contracts Intrusiveness Strength of efficiency incentive Administrative requirements Decision variables Information asymmetry Predictability Impact on service standards & reliability Regulatory failure Uncertainty – regulatory risk MountainAssociates

11. The ACCC’s suggested direction for capex regulatory contract Basket of projects Ofgem UK DTe Holland NVE Norway ACCC’s current suggestion Ofwat US Public Utility Commissions (PUCs) Ofgem Individual projects VENCorp VENCorp “Variable price” contract “Fixed price” contract MountainAssociates

12. What’s the difference between the ACCC’s current suggestion and the existing regulatory contract? MountainAssociates

13. Q&A on the Commission’s suggested direction for reform • What if demand much higher than expected - setting a fixed cap places reliability and service at risk? • Conversely, if the cap too high, TNSPs profit at expense of customers? • Why is suggested arrangement less intrusive than the existing arrangement – both require assessment of efficiency? MountainAssociates

14. Q&A on the Commission’s suggested direction for reform • New arrangement provides no incentive for efficiency – why not simply investing in all the “marginal” projects first and then simply come back to ACCC for more money? • Existing ex-post approach provides stronger customer protection because the ACCC retains the power to optimise? MountainAssociates

15. Q&A on the Commission’s suggested direction for reform • Project-specific approach means the Commission can apply stronger efficiency incentive than it can with a “basket of projects” approach? • Shouldn’t ACCC simply exclude all large and uncertain projects from “ex-ante cap” – this would allow a more accurate specification of the cap and greater protection for consumers? MountainAssociates

16. The last word … “A regulator is supposed to take the punch bowl away before the party gets out of hand. The impact of its actions is blunted if it waits until the miscreants are numb with remorse before bursting into the room and issuing fire and brimstone denunciations.” Financial Review editorial on APRA’s report into the NAB. MountainAssociates