Rules change to balance network and consumer concerns

By Andrew Reeves, Chairman Australian Energy Regulator

For many years Australia enjoyed relatively stable energy prices in real terms. However, this situation has changed markedly, as network prices have increased substantially in the past two-to-three years, leading to significant retail price increases.

There are a number of reasons for this; fundamentally there is a need to spend money on the networks to meet strong growth in demand, to provide services to new connections and to replace ageing equipment to maintain reliability. However, having approved the revenues of almost all of the electricity network businesses under the current regulatory framework, the Australian Energy Regulator (AER) is concerned that the rules that govern network regulation do not strike an appropriate balance between the interests of network business and those of consumers.

The current regulatory regime was designed to ‘lock-in’ much of the process of economic regulation. When the rules were written in 2006, network businesses felt the former arrangements did not give the assurance of returns needed to guarantee investment and support strong growth. The AER considers that the rules now not only hard-wire a process, but also deny the regulator the discretion to make an unbiased estimate of efficient costs, leading to customers paying more than necessary. While certainty for investment remains a key consideration today, it is equally important that only necessary and efficient investment be paid for by customers.

The 2006 rules produce a systemic bias towards inflated allowances for capital and operating expenditure. This is due to the limitations that are placed on the regulator’s response to the proposal from the business.

The network businesses currently have an incentive to propose estimates that are at or exceed the limits of what ‘reasonably reflects’ required capital and operating expenditure. The proposals are accompanied by copious amounts of detail and substantial engineering justification. Since the rules require that the regulator’s response be based on the business’ proposal, the regulator must counter the detailed engineering-based assessments before it is able to amend the forecast.

Further, the regulator can only amend the proposal to bring it back into a range of what could be considered to ‘reasonably reflect’ a forecast of efficient costs. So while we have been able to amend proposals to some degree, the outcome does not provide a central estimate of efficient costs, or even one which would conservatively provide ‘at least’ efficient costs. Instead, the outcome is one which is biased in favour of the service provider and can lead to excessive payment by users.

The rules can provide an incentive for firms to over-invest in the networks. The current rules require that all actual capital expenditure, including expenditure which is greater than the forecast, be automatically rolled into the asset base at the start of the next regulatory period. The over-expenditure is then paid for by customers for the rest of the life of the investment, whether or not the expenditure is efficient or necessary. Previous overspending has led to significant step changes in prices for consumers at the start of the current regulatory period.

The other significant contributor to price increases has been the process for setting the rate of return that businesses receive on their assets. At present, the AER must use three different processes to determine the weighted average cost of capital to apply to network businesses. Our experience has shown that each of these three models is imperfect. For example, while in electricity transmission, our five-yearly cost of capital statement is binding on the regulator and transmission businesses. The other two models, however, require the assessment of a large amount of material for each reset process, either in determining the parameters themselves or determining whether there is ‘persuasive evidence’ to depart from the cost of capital statement.

The rules also overly constrain the assessment of the cost of debt. The regulator is effectively locked into using a 10-year corporate bond as the benchmark for the cost of debt, but it is not possible to reliably estimate this cost due to the limited use of such long-dated corporate bonds in Australia. We are therefore obliged to make an assessment of financing costs using a methodology that no longer reflects actual debt-financing practices.

We recognise that there is no perfect solution to this problem. Drawing on our experiences, we are currently considering amendments that balance the intuitive appeal of allowing flexibility to deal with changes in financial markets that might occur within a period, with the need for stability in those factors, which are long-term financial market averages.

So what would an improved rules framework look like?

In summary, we will be proposing changes to the rules to enable a robust forecast of efficient costs to be determined, with strong incentives to organise capital expenditure programs to not overspend that allowance. We will also propose streamlining the processes for determining the cost of capital and ensure that it properly reflects the cost of funds and actual debt financing practices of network businesses.

We will be submitting the rule change proposal to the Australian Energy Market Commission during the third quarter of 2011. This timing is to ensure that it would be possible to have an amended set of rules in place for the next round of revenue resets (starting with the NSW and ACT networks).

The rule change proposal seeks to restore the balance of the regime to better meet the national energy objective: to promote efficient investment in and efficient operation and use of energy services for the long-term interests of energy consumers.