AER Better Regulation Reform Program Update July 2013 A Fair - - PowerPoint PPT Presentation

AER Better Regulation Reform Program Update July 2013

A Fair Return to Consumers

Presentation on AER Issues Papers to Consumer Roundtable 23 July Bev Hughson, Darach Energy Consulting Services

Today’s Acronyms

• ACT

Australian Competition Tribunal (Tribunal)

• AEMC

Australian Energy Market Commission

• AER

Australian Energy Regulator

• CAPM

Capital Asset Pricing Model

• FM

Foundation Model

• MRP

Market Risk Premium

• NEL/NGL

National Electricity (Gas) Law

• NER/NGR

National Electricity (Gas) Rules

• NSP

Network Service Provider

• RAB

Regulatory Asset Base

• RPP

Regulatory Pricing Principles

• RoD

Return on Debt

• RoE

Return on Equity

• RoR

Rate of Return

• STPIS

Service Target Performance Incentive Scheme

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Multi Factor Productivity (MFP) Growth by Industry

Source: Productivity Commission, An Overview of Australia’s productivity performance, November 2012

Network Regulatory Frameworks – current status

• Better Regulation program – Development of Guidelines
• Rate of Return Guideline
• Expenditure Forecast Assessment Guideline
• Expenditure Incentive Guideline
• Confidentiality and Shared Assets Guidelines
• NSP Engagement Guideline
• Power of Choice
• Demand management embedded generation
• Investment test for distribution (RIT-D)
• AER’s Stakeholder Engagement Framework
• Establishment of National Consumer Advocacy Panel & Consumer Challenge

Panel

• Reform of the Tribunal through changes to the NEL & NGL
• Productivity Commission Final Report on Network Regulatory Frameworks &

Government’s response

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Network Regulatory Frameworks –

• ther relevant developments
• AER’s Stakeholder Engagement Framework
• National Consumer Advocacy Panel & Consumer Challenge Panel
• SCER’s reform of the Australian Competition Tribunal through

changes to the NEL & NGL

• Productivity Commission’s Final Report on Network Regulatory

Frameworks & Government’s response

• AEMC’s National Frameworks for Network Reliability

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AER Guidelines: Approach & Timetable

• General Approach to the Guidelines:
• Relatively short Guideline setting out how AER proposes to conduct

reviews

• Detailed Explanatory Statement setting out AER’s
• Guidelines not mandatory (except Confidentiality), but NSP or AER

required to provide reasons for varying from Guideline.

• Some key dates:
• 9 August
• Expenditure Assessment & Incentive Draft Guidelines
• Confidentiality & Shared Asset Draft Guidelines
• Mid-August
• Rate of Return Draft Guideline
• Supporting Papers on Risk and Benchmark Efficient Firm
• 22 August – AER meeting with consumer groups
• Mid–September – Response to Guidelines
• 29 November – Final Guidelines

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Network Revenue building blocks & the AER Guidelines

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Expenditure Assessment Guideline Expenditure Incentive Guideline Expenditure Incentive Guideline Rate of Return Guideline Expenditure Assessment Guideline

RATE OF RETURN GUIDELINE

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Rate of Return – a key area of regulatory failure

• Past AER determinations delivered rates of return well in excess of actual

cost of capital:

• Immediate cost to consumers in higher network prices
• Long-term costs through inefficient capital investment
• Main source of disputes taken to Tribunal
• Multiple reasons for failure
• Rules put onus of proof on the regulator that NSP proposal ‘unreasonable’
• Lack of confidence by the regulator in using their discretion
• Compounded by conservative, legalistic approach of the ACT
• Methodological and data gaps, e.g.
• Restricted use of benchmarking, reliance on historical performance
• Limited financial market information (e.g. on bond markets)
• Emphasis on ‘on the day’ view of costs (create volatility)
• GFC made forecasting harder than ever

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Assets & investment in the NEM (excluding retail)

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Asset Value (circa 2010) Estimated Average Annual investment (Note (a)) Investment Rate (Investment /assets) Share of Total Assets Share of Total Investments Contribution to Electricity Price (2010- 11) $ billion 2011 prices $ billion 2011 prices % % % % Generation 40.0 1.2 3.0 39.0 12.1 34.5 Transmission 16.7 1.5 8.9 16.3 14.9 7.7 Distribution 45.8 7.2 15.8 44.7 73.0 37.3 Total for above components 102.4 9.9 9.7 100.0 100.0 79.5

Source: Adapted from the Productivity Commission, Electricity Network Regulatory Frameworks Inquiry Final Report, p 98.

Balance is retail costs, RET, FIT & other green (excluding carbon) Note (a): based on average yearly investment for the current 5-year regulatory period

AER’s RoR Guideline development has involved significant stakeholder inputs!

• New Rules require
• the AER to develop the Guidelines having regard to a range of relevant

methods, financial models, market data and other evidence

• Consult with stakeholders in the development of the Guidelines
• AER developed a set of principles to assess alternative approaches
• Numerous consultations with stakeholders & others
• Issues Paper
• Consultation Paper
• ACCC staff reports
• Expert Reports on Risk
• Multiple working group meetings
• Meetings with stakeholder groups
• A sound consultation process will be important in any appeal to ACT?

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AER’s Overall RoR Assessment Framework

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Regulatory Determinations

Rate of return Guidelines

Rate of return objective 3 yearly reviews

Estimating methods Financial Models

NEO, NGO, RPP

Market data Other evidence

Set out how AER proposes to take into account

New Rules give priority to the NEO and NGO in decision making New Rules introduce the RRO; to guide the AER New Rules require the AER to develop RoR Guidelines having regard to a wide variety of models & other information. NSPs’ Proposals and AER’s Determinations should be based on the Guideline, alternative approaches must be justified as in the long term interests

• f consumers.

RoR Guideline must be reviewed within 3 years

Source: AER Rate of Return Consultation Paper, May 2013, page 11

The AER’s latest proposal: RoD

• Move to a Trailing Average (TA) approach (vs ‘on the day’)
• Use of Commonwealth Government bonds for risk free rate;

Bloomberg’s fair value yield curve for MRP

• Annual ‘mechanistic’ updating of RoD based on updated market data
• n bond yields
• However, AER still considering details of the TA approach
• Term of the bond yield curves
• Preference for using 7 year period – best aligns with NSP practice
• However, alternative of 5 years still under consideration
• Transitional arrangements?
• Benefits & Risks of AER’s approach for consumers
• TA approach generally provides more certainty for consumers
• Annual updating – less stability within regulatory period, more certainty

between regulatory periods

• Approach generally overcompensates NSP’s (but less than before?)

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AER’s Estimate Cost of Debt & Cost of Equity (2010 to 2013)

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Cut off point for trailing average cost of debt?

The AER’s latest proposal for RoE

• Return on Equity (RoE): the “Foundation Model” (FM) approach
• Identify and evaluate different approaches against criteria
• Select the ‘foundation model’ &
• Calculate a feasible range and point estimate for FM parameters
• Review other models and data points:
• Use to inform the foundation model parameters?
• Use to assess the overall RoE?
• Distill all information into a single point estimate of RoE
• Likely outcome in the Draft Guideline:
• Sharpe-Linter CAPM is the ‘Foundation Model’ (ticked most criteria boxes)
• Black Scholes CAPM inform parameter estimates (beta)
• Dividend Growth Model inform parameter estimates (MRP)
• Other models/market data used to inform or cross check overall RoE
• Note: Fama-French model “under consideration” – code for NO.

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Benefits & challenges of RoE approach

• Benefits of the AER proposed approach to RoR Guideline:
• Based on consistent set of criteria to assess different approaches
• Using the S-L CAPM as the foundation model provides some consistency &

builds on established regulatory theory & practice

• Provides for explicit treatment of [relative] ‘priced’ investor risk
• Uses other models/information in a more transparent way, eg:
• To inform the FM parameters of overall RoE
• To guide the AER within a range set by the FM
• Acknowledges decision-making requires the exercise of regulatory

judgment – not purely quantitative analysis

• Reduces (but not eliminates) opportunities for NSPs to ‘cherry pick’

preferred model(s) or weighting of these models

• Will the AER’s judgment be challenged in the Tribunal?
• Will it deliver more appropriate outcomes than current method?

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Envestra: 3 year Total Return

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Total Shareholder Return (average annual rate) 1yr 3yr 5yr 10yr 35.2% 37.2% 20.5% 9.4%

EXPENDITURE INCENTIVE GUIDELINE

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New & more comprehensive incentive sharing schemes required

• Current incentive schemes not delivering improved performance
• Rules require AER to develop Guideline covering:
• Enhanced operating expenditure incentive scheme (EBSS)
• New incentive scheme for capital expenditure (CESS)

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Source: AER Expenditure Incentives Scheme Issues Paper, p v.

AER’s current view…

• Capital Expenditure Incentives
• Focus on ex-ante incentives
• But include ex-post incentives as additional check on excess capex
• Asymmetrical penalties & rewards– the stick is bigger than the carrot
• Operating Cost Incentives
• Preference for using ‘revealed costs’ as the base year cost
• But place for using benchmarked costs as the base
• Symmetrical – the stick and carrot are about the same
• Consumer preferences
• Asymmetrical incentives – why should consumers pay for overspend?
• Use benchmark costs where possible, rather than revealed costs
• Encourage NSPs to use transparent regulatory mechanisms to manage

unexpected costs and forecast error (pass through

• Minimise gaming opportunities by NSPs (back-loading, substitution…)
• Must develop parallel performance quality measures & targets (STPIS)

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EXPENDITURE ASSESSMENT

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Expenditure Assessment Guideline

• AER has found it difficult to challenge NSPs forecasts for operating and

capital expenditures

• Reliance on ‘revealed costs’ – but assumes NSP already efficient!
• Limited benchmarking against efficient performance standard
• Expenditure Assessment Guideline designed to demonstrate how AER

will assess expenditure proposals in the future

• Variety of techniques to be included, but not prescriptive
• Governance review
• Project / sample review
• Predictive modelling
• Trend analysis
• Economic benchmarking
• Category benchmarking
• Must be consistent with the incentive scheme & annual performance

reporting

• Expected to evolve over time – greater reliance on benchmarks

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Reforming the Appeals Process

• SCER released its recommendations from the Limited Merits Regime

Review (conducted in late 2012) in June 2013

• Addresses some of the main concerns with the appeals process & the

decisions of the ACT.

• Will (?) provide support to the AER in exercising their regulatory

judgment & more opportunity for consumer engagement.

• In very brief:
• In applying for review of AER’s decision, an NSP must make a prima facie

case that addressing this would lead to materially preferable outcomes in the long-term interests of consumers.

• Tribunal must consider if overall outcome of the review (taking account of

all the interrelationships) delivers a materially preferable outcome in the long-term interests of consumers.

• Concern with ‘cultural’ change required for success of reform
• Tribunal to consult with consumers ….

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