Economic regulation of electricity and gas network businesses

1. Economic regulation of electricity and gas network businesses Mark Feather, Acting Executive Director 23 November 2011

2. Background • January 2009 – economic regulation of distributors transferred to AER • October 2010 – final determination on revenues for Victorian electricity distributors 2011-15 (first under NER) • Victorian Government concerned that outcomes not consistent with interests of consumers • Made several submissions to process • Intervened in Tribunal proceedings

3. Key issues and concerns • NER too prescriptive • objective was to provide greater investor certainty • experience indicates that consumer interests not appropriately protected • AER not taking jurisdictional circumstances into consideration • particularly different incentives on public versus private businesses • Merits review process − concern that process does not balance the interests of consumers with networks.

4. NER too prescriptive • Prescription can bring regulatory certainty • But excessive prescription has downsides: • limits the ability of the regulator to innovate and develop the regulatory framework in a dynamic manner to promote efficient behaviour and protect consumers (e.g with respect to incentive schemes) • can lead to sub-optimal and erroneous outcomes. • Examples include: • Treatment of related party margins under the NER • Treatment of side constraints between price control periods in Victoria • Closure of Victorian S-factor regime and transition to Service Target Performance Incentive scheme • DB recovery of transmission costs

5. NER too prescriptive – related party margins • Unjustified related party margins removed from capex forecasts by AER • However, AER determined that it had to roll unjustified related party margins into RAB • based on interpretation of NER • AER’s final determination states that: The apparent requirement for the AER to automatically roll into the RAB all amounts characterised as capex creates an incentive for DNSPs to enter into related party contracts and seek outcomes contrary to the efficiency objectives of the regulatory framework. • Could lead to significant costs being imposed on Victorian consumers in the future

6. NER too prescriptive – related party margins • Victorian Government appealed AER decision to the Tribunal • Perverse incentive for networks to contract for related party services at fees unrelated to cost of providing those services • Victoria sought alternative interpretation of NER • Awaiting Tribunal Decision • Rule change proposal • Clarifies that related party margins can be excluded from RAB • Victorian Governmentsupports the amendments

7. Jurisdictional differences - Regulatory vs actual depreciation • NER provides AER with discretion to apply actual or forecast (regulatory) depreciation to RAB • discretion provided as different approaches have been applied historically across jurisdictions • Actual depreciation is based on actual capex • Forecast depreciation is based on forecast capex • In practical terms: • RAB = Opening balance + capex – depreciation - disposals • Under forecast depreciation if network underspends relative to capex forecasts, it’s depreciation will be higher and the RAB will be lower – consumers pay less

8. Jurisdictional differences – regulatory vs actual depreciation • In Victoria forecast depreciation used by ESC • AER Vic EDPR decision – applied actual depreciation • national consistency, noting that NER prescribe actual depreciation for transmission businesses • AER view that actual depreciation will lead to capex efficiencies • Victorian Government appealed decision • Regulatory depreciation provides strong incentives on networks not to over-forecast • Relevant to privately owned Victorian DBs which generally underspend relative to forecast • Actual depreciation will increase incentives for over-forecasting and lead to a larger RAB

9. Jurisdictional differences – regulatory vs actual depreciation • Rule change proposal • provides AER with discretion to use actual or forecast depreciation for transmission businesses • proposal recognises that apply a nationally consistent (“actual depreciation”) approach may not be appropriate • Rule change supports Victorian Government’s arguments • Victorian Government supports proposal

10. Merits review – issues and concerns • NER provides for a merits review • allows businesses to ‘cherry pick’ issues for appeal • difficult for parties other than businesses and AER to participate • asymmetric process creates outcomes that favour only the businesses • is this consistent with the long term interests of consumers under the NGO and NEO? • commentators raising concerns (Garnaut, IPART, consumer groups) • Victorian Government shares these concerns

11. Merits review – issues and concerns • SCER proposing to bring forward review of merits review framework • Terms of Reference under development by officials • Regulatory accountability important • Does the existing framework balance the interests of networks and consumers? • Is a narrower judicial review framework sufficient?

12. Merits review – international developments Ofgem appeal mechanisms are being amended to meet EU requirements There will be an ability to appeal individual elements of a determination, but with scope for wider review if the individual element is considered to have a wider impact. The Government response to consultation states: “[A]s price control decisions are essentially a package of balancing measures, there is the potential that upholding an appeal on a single element could have a knock-on effect on other elements of the package and upset the balance of the price control mechanism as a whole. The appeal body would therefore have discretion to consider additional elements or the whole package of the price control decision if the evidence submitted shows that reviewing individual elements is likely to upset the balance of the whole package.” Source: Implementation of the EU Third Internal Energy Package Government Response, para 2.23

13. Merits review • Example 1 – appeal of Victorian decision on debt risk premium • only businesses and AER participating in process • Victorian Government observing given impact on consumers • no party arguing for consumer interests • Example 2 – expenditure allowances • key driver of significantly increased network prices • only businesses and AER able to effectively participate in process • Victorian Government not well positioned to appeal

14. Rule change proposals • Expenditure allowances • remove requirement for AER to accept or reject businesses’ expenditure proposals • allow AER to determine efficient and prudent level of expenditure to meet objectives • Less reliance on “bottom up” approach, under which AER faces significant information asymmetries • Enables more reliance on benchmarking, comparative regulation • In principle, a better balance of network and consumer interests

15. Rolling capex overspends into RAB • To increase incentive to not overspend, AER has proposed that only 60% of capex overspends are rolled into RAB. • Risks creating perverse incentives • provides a stronger incentive to over forecast • privatised businesses will not overspend, even where expenditure is efficient and prudent • Potential detrimental impact on service levels • AER changes relating to pass through events and contingent projects unlikely to address concerns

16. Conclusion • Victorian Government supports changes to NER to ensure consumers’ interests are protected • Victorian Government supports NER changes in relation to: • related party margins • regulatory vs actual depreciation • review of expenditure proposals • Victorian Government has concerns with proposal to restrict rolling capex overspends into RAB