Analyst’s corner: Is “better regulation” dead on arrival?

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Networks are waging a fierce war with regulators over how much spending they can pass on to consumers. The competition tribunal appears to have decided that higher prices are in the longer term interests of consumers.

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Outside of PV, wind, climate change, the ageing thermal fleet in NSW and Victoria, the potential closure of Portland Smelter and lithium storage, what’s the biggest issue facing electricity consumers today?

We think it might be the future, or lack of future, of the Australian Energy Regulator’s “Better Regulation” program.

Settle in with a beverage of your choice if you’re new to this story because there’s a bit of history, a touch of “realpolitik” and some underlying structural dilemmas.

Before getting to the story, though, let’s look at what’s at stake. Issues decided by the Australian Competition Tribunal, if not changed on judicial review, will impact the entire electricity and for that matter the gas industry. But it’s instructive to look at Ausgrid, the most valuable asset in the NEM.

Ausgrid’s final proposal for electricity total cumulative revenue in the five years ended 30 June 2019 was for revenue of $9.8 billion, and the regulator’s final decision was for $6.6 billion. Based on the final decision, average electricity prices would fall by $165 per year (or about 8%).

The following chart contrasts an index (FY14=1) of nominal electricity prices. The chart shows that if Ausgrid’s proposal prevails, then electricity prices will go up over the next 12 months.

Screen Shot 2016-04-08 at 2.17.20 PM

An extremely simplistic view of the difference between what Ausgrid wants and what the AER was going to allow in terms of the value of Ausgrid, as estimated at 12X 2017 ebitda, is shown below:

rsz_screen_shot_2016-04-08_at_21724_pm

It’s important to understand that part of the difference is specific to how much opex NSW distributors in general, and Ausgrid in particular, should be allowed; and part of it is due a difference of opinion about what a fair return on debt is.

The return on debt issue will apply to every regulated business in Australia. The regulated asset base of all the electricity distribution and transmission assets in the NEM is about $70 billion, and the notional regulatory debt against that at 60% is about $41 billion.

rsz_1screen_shot_2016-04-08_at_21735_pm

Very, very broadly, if all electricity distribution and transmission assets in the NEM were to have an interest cost of 7.98% (what Ausgrid and the other NSW distributors are looking for) as compared to the 6.4% that the AER proposed to allow in year-one of the transition, the difference is about $0.6 billion per year of higher costs to consumers.

That is an extreme way of looking at the data, but shows what’s at stake.

The broader issues

We think the ACT decision, and indeed the entire process, shows the issues in the regulated model.

Is a regulated monopoly the right way to manage electricity distribution and transmission? Should distribution be integrated with retail and generation as the boundaries become blurred? Is the legalistic process producing timely and reasonable decisions for all the parties involved?

The vast majority of media discussion is about generation and retailing, but a massive amount of value is tied up in electricity distribution and transmission, where owners of the business essentially lead a charmed life.

Provided the ACT can be persuaded to agree with them, and it often does, returns continue irrespective of demand, cost, consumer preferences or anything else. These characteristics tend to make them popular with investors looking for predictable income streams.

Background

You don’t need the memory of an elephant to recall that electricity prices in most states, but particularly NSW and Queensland, rose rapidly over five years to 2013. They rose so much it became a political issue.

Analysis clearly showed that customer bills went up because (i) network and transmission costs per MWh increased dramatically, (ii) environmental costs increased (principally the carbon tax, but also costs of feed-in tariffs, RECs and SRECs). (iii) consumption pre-customer fell, meaning that fixed investment costs had to be spread over a thinner base.

In NSW, the estimate was that the average customer bill increased from about $1250 to about $2000 over the three years between 2010 and 2013, and about $450 of that increase was due to higher network costs.

Putting on your “energiewende” hat, higher costs for grid-delivered electricity might actually be a “good” thing, because it provides a higher opportunity cost for rooftop PV and storage and incentivises energy efficiency. i.e. Prices work as intended.

Still, consumers and governments were unhappy and many people wanted to understand why it was that transmission and distribution use of system costs [UOS] had risen so much.

At this point we have to side track briefly into how UOS costs are set. Networks are regarded as monopoly-like, and so they are regulated by the Australian Energy Regulator [AER].

A network earns revenue based on the size of its regulated asset base [RAB] together with allowances for costs including depreciation tax and open.

The regulated utility submits a proposal once every five years. The regulator generally modifies that [draft decision], the utility submits a revised proposal and the regulator then makes a “final decision”. Except it is mostly not final, because the regulated utility can and does appeal aspects to the Australian Competition Tribunal [ACT]. Even the ACT’s decision, as we shall see, is not always the end of the story.

In response to network prices going up so much, despite falling consumption, two main things happened:

  1. The AER committed to a “better regulation” program. The main financial impact of “better regulation” was a change to the method for calculating the allowed return on debt used to finance the business. The change was from calculating a debt cost based on interest rates at the time of the determination to calculating interest costs based on a 10-year trailing average. However, in a twist which has big impacts for consumers, the AER wanted a 10-year transition to the 10-year trailing average. Although they didn’t say this, the reason most likely is that historic interest rates were much higher than rates today, so a 10-year trailing average takes into account interest rates all the way back to 2005.
  2. The Federal and State Governments jointly, via the Standing Committee on Energy and Resources [SCER] commissioned a review of the appeal process to the ACT . The main faults of the appeal process were seen to be:
    • Unduly legalistic
    • Cherry picking. The utility would pick one or more aspects of the decision it was unhappy with where it thought it could win. It would take those grounds to appeal and be awarded higher revenue if it won and no penalty for losing. All upside no downside.

The eventual outcome or the review was a change in the grounds of appeal. As we read it at the time: “prospective applicants will also be required to establish a prima facie case that addressing the original error would lead to a materially preferable outcome in the long-term interests of consumers.” However the legislation that was eventually passed didn’t mention the consumer. Instead it referred to a “materially preferable NEO decision”

As luck would have it, the first decisions made by the AER under its “better regulation period” were for the NSW distribution assets for the 2014-2019. Decisions about NSW assets were of critical importance because (i) The assets are the largest block of regulated electricity assets in Australia, (ii) NSW distribution assets were widely regarded as the least efficient in the country and indeed the State Government had been so dissatisfied it had put them under one consolidated management team, (iii) The owner of the assets, the NSW Government, planned and still plans to sell a majority stake in Ausgrid and Endeavour to fund its very worthy “Rebuild NSW” plan.

As discussed above, the draft and final decisions of the AER were a bombshell for the NSW distributors, no previous ruling had come within cooee of reducing revenue by one-third.

Normally, the two sides get closer through the revised proposal and final decision but, in this case, the gap was never capable of being bridged to either party’s satisfaction and so off they went to the ACT.

In late February 2016, after months of legal process, hearings and submissions by experts, the ACT handed down its 1230 paragraph decision. The decision was essentially a comprehensive victory for the networks. Specifically, the Tribunal ruled the AER had (i) erred in regard to its opex allowances and (ii) had also erred in the manner in which it calculated interest costs. The only small victory for the AER was that due to the changes in the appeal legislation the ACT could only remit the decision back to the AER to be remade.

In prior regulatory cases the AER seemed to take the ACT’s decision as the last word, but in this case the AER has appealed to the Federal Court for a review of the ACT’s decisions.

From this analyst’s point of view it is hard to see how the ACT’s decisions are going to produce materially better outcomes for consumers as they will clearly result in higher prices to consumers than the AER’s decision would have produced.

Moreover, the entire appeal process seems to have had a legal  focus where the technical rights and wrongs of the AER’s methods were the only issues in point. Essentially, the ACT conclusion was that higher prices were in the longer term interests of consumers. Para 1220 of the decision stated:

“In that way, the AER will better identify the appropriate revenue during the current regulatory control period of those entities to achieve the level of quality, safety reliability and security of supply of electricity and of the national electricity system in the long-term interest of consumers, and be in a better position then to also address the desirability of consumers not paying more than is necessary over the long term for those services.

The ACT, in our opinion, has adopted a view that if it determined that a reviewable error had been made, then that in itself was sufficient to justify a view that a remake of the decision would produce a materially better outcome for consumers.  We wonder if that really is the case.

David Leitch was a Utility Analyst for leading investment banks over the past 30 years. The views expressed are his own.

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6 Comments
  1. JeffJL 4 years ago

    With the Federal government recently borrowing money at below CPI (just over 2%), perhaps it should buy the distribution business and charge the 6.4%. Debt is paid for three fold and consumers get cheaper power.

    • neroden 4 years ago

      Absolutely. Why not? Transmission and generation is a natural monopoly like the roads and the railways and should be owned and run by the elected government.

      • Brunel 4 years ago

        The international airports should be owned by the state they are in, so SYD airport should be owned by the NSW government for the benefit of the people of NSW.

  2. Farmer Dave 4 years ago

    Who designed this regulatory system? Were they industry insiders by any chance? How on earth did they get away with designing a system in which the networks have a guaranteed return on their capital employed, with no skin in the game if they make poor decisions?

  3. neroden 4 years ago

    As a result of this sort of giveaway to the grid operators, the off-grid market in Australia looks more and more promising.

  4. Peter Grant 4 years ago

    Thanks for an informative and timely article David. I don’t feel quite so pessimistic about WA joining the national system now.

    The regulatory test omission of ‘consumer interest’ is disheartening but not a surprise, let’s hope the courts may reset the priorities that government has let drift. Energy may be one of the worse examples but so much of the Australian economy is riven with well positioned oligopolies successfully screwing the public (banking, retail, beverages, to say nothing of mining interests setting their own tax rates…), so much for the ACT!

    This is a complex regulatory system and you rightly question, it’s fitness for purpose given technological changes and this and past suboptimal outcomes. The AER appeal to the federal court seems a positive way to go though, perhaps (without knowing the particular grounds) a higher court might display less capture by the well funded voices of vested interests than the ACT. This is a good news story from the AER thanks for telling it.

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