ACCC Forum on Draft Statement of Principles for Transmission Regulation – New Investment

1. ACCC Forum on Draft Statement of Principles for Transmission Regulation – New Investment Roman Domanski Executive Director Energy Users Association of Australia Melbourne, 2nd April 2004

2. Contents • Setting of Capex • Basis for new and replacement investment • “Ex ante Cap” approach • Regulatory Test • Service standards • Investment in new technology

3. Setting Capex • ACCC’s preferred position to adopt Regulatory Test when assessing & reviewing capex program. • But, evidence suggests that TNSPs seek to increase short-term profitability by cutting costs below revenue benchmarks, including by reducing and putting off capex as long as possible.

4. Setting Capex • No mention in Discussion Paper of observed CAPEX ‘spending habits’ of TNSPs based on 4 regulatory reviews conducted since of 1999. • Comparing forecast & actual CAPEX undertaken routinely by UK regulators to assess prudency of past & efficiency of future CAPEX • Clear that regulated companies always seek to increase profit by reducing costs below revenue benchmarks • TransGrid reporting actual CAPEX spending some $155.1m (or 13%) above that forecast in 1999/2000 due to “unforeseen” circumstances • ACCC will need to assess if this is “prudent” and TransGrid’s forecasting skills are up to the mark

5. Setting Capex • ACCC needs to confirm it will treat differences between forecast & actual CAPEX in a symmetrical manner when it is rolled into the regulated asset base • TNSPs permitted to retain benefits of ‘out-performing’ revenue benchmarks, which include benefits from under-spending CAPEX • Where ‘required’ to over-spend CAPEX, they should only be entitled to roll-in efficient actual CAPEX and not be ‘compensated’ for ‘holding costs’ associated with over-spent amount

6. Setting Capex • Jurisdictional regulators have required NSPs to ‘wear the cost’ of depreciation and return on CAPEX over-spend even where over-spent amount deemed ‘prudent’ or ‘efficient’ • Symmetrical treatment of CAPEX efficiency gains provides clear incentive for TNSPs to focus attention on accurate forecasting, on mechanisms to achieve most efficient outcomes and is consistent with competitive markets

7. Strategic Behavior • Incentive for regulated companies to overstate forecast costs (and under-forecast sales) • If forecasts accepted by regulators, the companies are able to increase profits by achieving lower than forecast actual costs (or higher prices) and then claim this as an ‘efficiency gain’, which it clearly is not • ACCC does not mention how it will deal with ‘strategic behaviour’, widely recognised as a major negative feature of ‘incentive regulation’

8. Evidence of Strategic Behavior • Evidence of how it occurs presented in submission • Regulated companies reduce CAPEX early in regulatory period as profits increase by delaying CAPEX • Substantially overstate CAPEX in forecasts, regulators ‘prune’ back forecasts and companies generally still ‘out-perform’ the regulators’ benchmarks • CAPEX spending rises towards end of regulatory period as companies react to the looming prospect of actual CAPEX being rolled into the asset base and address need to construct assets deferred earlier • Exposes end user to higher costs, lower reliability

9. UK Approach • UK regulators make judgements on efficient level of CAPEX based on technical and econometric analysis of actual and forecast expenditure • Rely on profit maximisation incentives to produce efficient outcomes • Where they have provided substantially increased CAPEX, have generally only required utilities to publish information comparing actuals& forecasts • Used this information to inform their judgements on efficiency and ‘strategic’ behaviour at next reset. • EUAA would prefer that SRP moved closer to UK

10. ACCC’s Approach & End Users • Strong evidence that "incentives" in incentive regulation don’t work as intended • If TNSPs can increase profitability by changing forecast spending, they will • Eg, finding lower cost ways of delivering same OUTPUT and deferring CAPEX as long as possible • ACCC's proposals will not bring regulation of TNSPs anywhere near to "incentives" in UK  • UK regime focuses almost entirely on "incentives" for NGC to ensure "value" to users • Regulatory Test, even in modified form, still focused on inputs

11. ACCC’s Approach & End Users • If ACCC really wants to move closer to UK model,must shift focus from analysis of inputs to "incentives" to deliver efficient inputs and concentrate analysis of inputs on how effective inputs have been in delivering "efficient" output • Should improve analysis of forecast inputs (ex-ante) to ensure rewardsfrom "strategic behaviour" minimised • No evidence that end users well served by current arrangements

12. Ex Post v’s Ex Ante Assessment • ACCC proposes to subject TNSPs’ execution of Regulatory Testto ex-ante and ex-post reviews so as to evaluate whether or not TNSPs actual CAPEX is ‘prudent’ and forecast CAPEX ‘efficient’ • This seems to be micro-managing TNSPs’ CAPEX or even putting pressure on them to spend CAPEX because it has been approved • Could shift responsibility for investment decisions away from TNSPs who are in best position to make such decisions • Reduce incentives for CAPEX efficiency savings

13. Comments on Regulatory Test • Focuses attention on "satisfying the regulator", rather than focussing TNSPs on achieving outcomes that deliver efficient services to users • No such thing in UK or in distribution • No evidence that this hasn’t delivered more effective outcomes to users than RT • If ACCC got the incentives right, couldn’t we get rid of RT? • If it stays it should be altered to focus on benefits to those that pay (end users) and limiting appeal rights

14. Service Standards • Basis for delivery of reliable and competitive energy to end users (who pay TUoS) • Linked to need for capex • Current regime next to useless • ACCC has been sitting on issue for too long • Now a process in place, but will it deliver anything useful to end users? • Seems to be bogged down and in need of more leadership/direction • Not good enough to offer ‘creeping incremetalism’ to end users

15. New Technology & Innovation • Becoming more apparent that ‘incentive’ regulation in Australia not material in fostering technological change & innovation by NSPs • No incentive to ‘modernise’ the grid • eg, measure behavior in real time, use devices and information to control power flows, upgrades to pump more juice through, produce and store power closer to consumers, demand management initiatives • Regulators need to pay more attention to this • Create incentives for TNSPs to be more innovative in delivering power more reliably and economically