Tariff control of pipes & wires utilities – where is it heading??

Tariff control of pipes & wires utilities – where is it heading?? Phil Caffyn, Utility Consultants Ltd www.utilityconsultants.co.nz Please read disclaimer on second page

Disclaimer • This presentation has been prepared for the sole purpose of the NZIGE Spring Technical Seminar 2006 and is not to be relied upon by event participants or any other person as professional advice. • This presentation has been compiled by Utility Consultants Ltd at the request of the NZIGE. Neither the NZIGE, its officers or their employers take any responsibility for the factual accuracy of this presentation or for any views, opinions or biases in the content of this presentation. • Utility Consultants Ltd as the author of this presentation shall not be liable in any way whatsoever for any action or failure to act based on the content of this presentation. www.utilityconsultants.co.nz

Author’s note • Between the time this presentation was drafted in mid-September 2006 and delivered on 19 October 2006 the dispute between Vector and the Commerce Commission seemed to take a turn for the better. • Accordingly some of the views expressed in this presentation may need to be “softened”. • While this is obviously awkward from a presentation point of view, it is pleasing from an industry point of view. www.utilityconsultants.co.nz

Theme of this conference is “the burning issues” – the cover photos on the conference brochure strongly depict the upstream aspects of gas supply (which I profess to know little about), so the subject of my presentation is the tariff control of midstream and downstream infrastructure which really burns me up. • Warning – I get rather passionate about tariff control !! • Format of this presentation is to examine key issues and trends in two specific areas of tariff control… • First area is the quantifying of the “building block” components that are typically used to regulate pipes & wires utilities. • Second area is the broader issues & trends that are impacting on the way building block components will be thought about and quantified. www.utilityconsultants.co.nz

Building block component #1WACC www.utilityconsultants.co.nz

Issues & concerns… • Current WACC thinking based heavily on Capital Asset Pricing Model (CAPM) with its dependence on equity beta. • Classical regulatory thinking took (and in many areas still takes) the view that a pipes & wires utility should have an equity beta less than the “market as a whole” like about 0.75 to 0.8. Very recent work by the AEMC suggests that equity betas could be as high as 1.0 for a high voltage electricity transmission grid indicating that a pipes & wires utility could be just as risky as any other investment. • Theoretical approach to CAPM usually includes efficiencies that would normally only be available to very large utilities like annual S&P rating and access to the US debt markets. • Doesn’t seem to allow for real world inefficiencies that are often deemed to be systematic risks (and therefore should be diversified away by an efficient portfolio) which in fact are unsystematic and cannot be easily diversified away – transaction costs, imperfect information, irreversibility and the finite resources of investing firms. www.utilityconsultants.co.nz

Going back about 4 years a WACC of about 5.2% to 5.5% post-tax was used to set tariff controls (and figures around this level are still being used in sectors such as the Victorian water). • Other recent regulatory thinking is about 7.35% nominal post-tax in NZ, about 7.57% in Australia (Moomba – Sydney Pipeline) and about 8.5% for the Queensland electricity distributors. • Jumping to the industry side of the table, recent events have revealed target post-tax returns of about 9.24% (Unison), 9.6% (Vector) and 9.9% (APT). • Observed that utilities estimates of WACC are about 2.25% to 2.5% higher than the WACC that regulators adopt – supported by a brief web search. Possible that this margin might increase if capital markets or rating agencies perceive regulatory risk to be increasing. • Research at the ISCR within the last 2 years or so suggests this gap might even be as high as 4%. www.utilityconsultants.co.nz

Trends… • Although allowable WACC’s are increasing it appears only to keep pace with an increasing risk-free rate - no obvious sign that the observed 2.25% to 2.5% gap is closing (or will close any time soon). • Queensland electricity and EirGrid may prove to be exceptions as their “WACC gap” seems to be only about 1%. • Will be interesting to see what becomes of the AEMC’s view that equity beta could be as high as 1.0. www.utilityconsultants.co.nz

Building block component #2CapEx www.utilityconsultants.co.nz

Issues & concerns… • On-going presence of ex-post efficiency tests continues to add at least some uncertainty to all CapEx. • Experience indicates that some regulators believe most if not all CapEx is firstly justified and secondly efficiently procured (and hence does not need to be excluded from the asset base after the fact), but there seems to be a lingering unwillingness to abolish ex-post efficiency tests and remove the associated investment uncertainty. • Recognition of the impending “wall of wire” doesn’t yet seem widespread enough. • Lack of deep insight that the risks of under-investment are significantly different from over-investment. www.utilityconsultants.co.nz

Trends… • Seems unlikely that any safe-harboring of CapEx will occur, so the threat of future exclusion will probably always remain even though it is hardly ever used. • Recognition of the “wall of wire” is increasing but apparently in response to blackouts rather than through consideration of the industry’s submissions. • Recognition of the asymmetry of under-investment and over-investment is increasing, but again seemingly in response to blackouts rather than through being persuaded by the industry’s submissions. www.utilityconsultants.co.nz

Building block component #3Valuation www.utilityconsultants.co.nz

Issues & concerns… • Adherence to centrally-mandated unit costs (despite a stated preference for market-based valuations in accordance with FRS-3). • In particular a reluctance to allow a utility to adopt the acquisition value of an asset in accordance with FRS-3 (or the reasonable expectations of the owners - a point bought out by the ACT in APT’s appeal of the ACCC’s determination in regard to the Moomba – Sydney Pipeline). • Reluctance to acknowledge actual legacy costs – seems to be a preference for taking “low” rather than “mid-point” estimates. • Proposed indexing of standard costs seemed unnecessarily complex and also seemed to miss the point of correctly capturing price movements of key inputs. This was identified as a key barrier to year-on-year indexing of the proposed Historical Cost method. www.utilityconsultants.co.nz

Lack of safe-harboring of CapEx into the valuation base will always create at least some investment uncertainty. • Current valuation methodologies often ignore the incremental nature of investment over time and consequently may optimise out assets that were fully justified when built but may now be less than fully utilised due to factors such as changing demand. • Retention of optimisation (and the associated investment uncertainty it creates) despite the low level of optimisation actually occurring in the industry (about 1% of replacement cost) and the robust ex-ante efficiency tests already in place. • Continued use of the Economic Value test for uneconomic lines despite an obligation to supply. www.utilityconsultants.co.nz

Trends… • Expect centrally-mandated unit costs to prevail, although there may be some increases. Possible that some sort of indexing may be introduced but this may be unwieldy and complicated. • Any sort of safe-harboring would seem unlikely so all investments are likely to always be exposed to at least some risk of future exclusion from the valuation base. • The “snap-shot in time” approach to valuation seems likely to prevail meaning that efficient incremental legacy investments may be deemed inefficient when considered now. www.utilityconsultants.co.nz

Building block component #4OpEx www.utilityconsultants.co.nz

Issues & concerns… • Allowed OpEx in recent determinations seems consistently lower than that sought by the applicants – seems that utilities are expected to achieve the most favorable costs across all parameters (“efficient frontier cost”). • Pleasing to note that OFWAT has correctly identified many OpEx issues and taken steps to correctly incentivise the implementation of these issues in the current (2005 – 2010) price control, and particularly allowing pass-through of externalities. • Pleasing to also note the ACT’s conclusion in the Moomba – Adelaide Pipeline that the ACCC were unreasonable in adopting the lowest of a range of values when no clear reason existed for not choosing the mid point of the range of values. www.utilityconsultants.co.nz

Trends… • Hard to know whether other regulators will follow OFWAT’s good example (and the view taken by the ACT) – would seem unlikely. www.utilityconsultants.co.nz

Building block component #5Depreciation & asset life www.utilityconsultants.co.nz

Issues & concerns… • Disparity of actual asset lives with standard ODV or ODRC lives leading to under or over-recovery of renewal funding. Some examples exist of drainage assets in NZ that are 2x their standard life (and about 5x in the UK) but conversely there are also electricity assets supplying consumers that may only have a short life such as mines and forestry. • Removal of accelerated depreciation provision in Australia which made off-shore investments more preferable (although this was apparently off-set by a recent budget provision that allowed significantly shorter lives). • Trends… • Seems unlikely that actual asset lives (or the life of predominant consumers) will be used to calculate more realistic depreciation rates so the possibility of under-recovery of short-lived assets may always remain. www.utilityconsultants.co.nz

Issues & trends #1Increasing emphasis on security www.utilityconsultants.co.nz

Initial emphasis of tariff control was on reducing short-term prices for consumers – certainly in the home of incentive regulation (UK) some rather stiff P0’s were imposed eg. OFGEM imposed P0’s of 25% in 1995 and again in 2000. • Apparent exception to this was the recognition of security of gas supply as a public policy objective as part of the privatisation of the Dampier – Bunbury Pipeline which was in 1997 - 1998. • Seems to have been a very mixed bag of investment over the period 1990 to 2005… • At least some reinvestment in the UK, but it is unclear if this kept pace with asset deterioration. • Virtually none in Queensland or NSW (high demand growth at the expense of renewals). • Isolated patches of investment in NZ. www.utilityconsultants.co.nz

Things started to fall apart in what seems to be two reasonably well defined tranches… • Black-outs around 1997 to 1999 in Auckland, Melbourne and Buenos Aires. • Black-outs around 2003 to 2004 in Ohio & Pennsylvania, London, parts of Italy, and south-east Queensland. • Key point to note is that several of these black-outs were unlikely to be related to a lack of reinvestment – seem to be more related to thermal over-load, protection mal-operation etc. • However it seems likely that the London, Queensland and possibly the Buenos Aires black-outs did stem from a lack of reinvestment (much to the delight of the anti-privatisation brigade). • Regardless of the real causes these black-outs seem to have prompted a step change in regulatory thinking from “reducing tariffs” to “improving security” in some jurisdictions. www.utilityconsultants.co.nz

Of course we now have the added complication of the bow-wave of (electricity) renewals which adds a further dimension to an already very complex process. • This new-found emphasis on security is evident in the recent electricity lines tariff determinations in the UK, NSW and Queensland which have allowed modest or even negative P0 and X in many cases (although still less than what was sought by the applicants). • Queensland EDSD report well worth reading. www.energy.qld.gov.au/independent_report.cfm (underscore between the independent and the report) www.utilityconsultants.co.nz

Issues & trends #2Adherence to theoretical models www.utilityconsultants.co.nz

Strict adherence to theoretical models despite considerable practical evidence to the contrary remains a concern. • Theoretical calculation of WACC components is obviously one of these areas. • Number of Australian gas pipeline appeal rulings and court decisions that strongly suggest adherence to strict theoretical models is wrong and that adequate weight must be given to real world factors – recognition that real pipes & wires markets fall short of the purely competitive markets upon which such theoretical constructs rely. • However it would seem that a bias for theoretical answers is likely to remain. www.utilityconsultants.co.nz

Issues & trends #3Subsidising public policy outcomes www.utilityconsultants.co.nz

We’ve already examined security of supply as a public policy outcome, and broadly observed an emerging willingness to allow additional CapEx to improve security. • Many other areas in which utilities are directed to create public policy outcomes that benefit classes of persons other than consumers… • Public safety. • Amenity value. • Avoiding electrical interference. • Providing comparative data. • Implementing renewable energy policies. www.utilityconsultants.co.nz

Utilities are generally expected to absorb many of the costs of creating these outcomes, but in all fairness consumers of utility services tend to overlap into the “other classes of persons” which benefit. • A major concern is the increasing expectation that electric utilities will assist in implementing renewables policies but with little mention of compensating shareholders when non-commercial decisions are made. www.utilityconsultants.co.nz

Issues & trends #4Treatment of stranded costs www.utilityconsultants.co.nz

Difficulty occurs when previously approved recoveries of stranded costs are curtailed leaving utilities without recompense for sunk costs – significant in Italy a few years ago when ENEL was left holding €6.3b of stranded costs after the government curtailed its recovery mechanism. • Key issue going forward for stranding is therefore not so much the cause of stranding but whether the policy and regulatory regimes will allocate those costs to those who have benefited (usually either consumers or the wider community – not usually shareholders). www.utilityconsultants.co.nz

Issues & trends #5Treatment of efficiency gains www.utilityconsultants.co.nz

First issue is the recognition of the gradual exhausting of efficiency gains – current thinking seems to range from expecting continued efficiencies well into the future to recognising the exhaustion of gains somewhere just beyond the present control period. • Next issue is the allocation of any efficiency gains that may arise (two quite contrasting view points)… • Pleasing that OFWAT did move beyond allowing efficiency gains to be kept only to the end of the control period – allowing the gains to be kept for 5 years regardless of when during the control period they were implemented was a huge step forward for incentivising efficiency gains (part of North West Water’s acquisition of NORWEB). • Converse position has been suggested in which consumers should expect to share in up-side gains but be fully insulated from any down-side losses. www.utilityconsultants.co.nz

Issues & trends #6Correctly incentivising CapEx www.utilityconsultants.co.nz

Having approved increased tariffs to fund the projected increases in CapEx, the key concern for regulators now is to ensure that utilities are correctly incentivised to actually spend. • This will include many of the issues we have already discussed – realistic WACC, safe-harboring of CapEx, fair allocation of the rewards of out-performing cost and efficiency targets etc. • Apart from OFWAT it seems that the above issues have not been sufficiently thought through to correctly incentivise CapEx – possible that allowing utilities to gather additional funds will be seen as the sole issue (which has purportedly been fully addressed through increased tariffs) rather than only the first of two issues. www.utilityconsultants.co.nz

Issues & trends #7Regulatory treatment of equity www.utilityconsultants.co.nz

Many determinations to date seem to have treated shareholders equity as being subordinate to debt (which in the strictest financial terms it is). • This feature was exploited as the “first loss” principle when the UK water industry was privatised in the late 1980’s to accommodate the industry’s largely unknown CapEx requirements – there was a clear expectation that shareholders equity would bear the impact of any unknowns (which were presumably losses). • This first loss principle became known as the “equity cushion” which strongly suggests that equity was regarded as expendable. • Similar view on equity (capped up-side gains but unlimited down-side losses) was hinted at in the NZ toll roads bill that was proposed a few years ago. www.utilityconsultants.co.nz

This equity cushion principle became clearer when Railtrack PLC and British Energy PLC both went for a burton and just about all shareholders equity was lost. • It therefore seems very clear that equity is viewed asymmetrically, and this shows no signs of changing. www.utilityconsultants.co.nz

Issues & trends #8Capital structure www.utilityconsultants.co.nz

Some rather conflicting views here… • On one hand OFWAT has previously stated that capital structure is a matter for individual utilities to decide. • On the other hand OFWAT has also expressed an expectation that an equity cushion will exist, and furthermore expressed a view that the formation of the debt-funded mutual Glas Cymru to own Welsh Water should not become the norm. www.utilityconsultants.co.nz

Issues & trends #9Access to capital markets www.utilityconsultants.co.nz

Access to capital is obviously important for all asset-intensive industries however current WACC thinking is probably not facilitating such access. • Pleasing to note that one of OFWAT’s three stated reasons behind their comment “it would be unwise ... for customers to expect real term reductions in bills” in putting together the current price control was to maintain appropriate interest cover ratios to ensure continued access to capital markets – especially important in the context of Glas Cymru. • Given the level of debt funding that exists in the NZ gas sector this could be problematic. www.utilityconsultants.co.nz

Where is it heading?? www.utilityconsultants.co.nz

Really good thinking embodied in many of the OFWAT determinations to date (only a few minor concerns). • Also been some really good stuff in some of the ACT appeal decisions. • A few promising signals emerging from the QCA (in regard to WACC) and the ESC (in particular the recognition that “the relationship between network expenditure and service performance is neither precise nor limited to the short term”). • However if the ultimate measure of the robustness of regulatory thinking is the level of reinvestment in networks it seems that regulatory thinking as a whole might well be getting it more wrong than right. www.utilityconsultants.co.nz

So where is it heading… www.utilityconsultants.co.nz

Contact me for more info. www.utilityconsultants.co.nz

Phone (07) 854-6541 • Mobile (021) 606-670 • Email phil@utilityconsultants.co.nz • Skype philcaffyn • Web www.utilityconsultants.co.nz • Subscribe to “Pipes & Wires” (email me) • Subscribe to “WACCWatch” (email me) • Subscribe to “RegulatoryRoundup” (email me) www.utilityconsultants.co.nz

Glossary of abbreviations www.utilityconsultants.co.nz

OFWAT – Office of water regulation www.ofwat.gov.uk • ESC – Essential services commission www.esc.vic.gov.au • AEMC – Australian Energy Markets Commission www.aemc.gov.au • S&P – Standard & Poors www.standardandpoors.com • EirGrid – EirGrid PLC www.eirgrid.com • APT – Australian Pipeline Trust www.pipelinetrust.com.au • ISCR – Institute for the Study of Competition and Regulation www.iscr.org.nz • ACT – Australian Competition Tribunal www.australia.gov.au • ACCC – Australian Competition & Consumer Commission www.accc.gov.au • OFGEM – Office of gas & electricity markets www.ofgem.gov.uk • ENEL – Ente Nazionale per l’Energia Elettrica www.enel.it • NORWEB – North Western Electricity Board www.uuplc.co.uk • Glas Cymru – Glas Cymru Cyfyngedig www.glascymru.com • QCA – Queensland Competition Authority www.qca.org.au www.utilityconsultants.co.nz

Tariff control of pipes & wires utilities – where is it heading??