24 July 2013

In a speech at the Energy Networks Association's (ENA) Regualtion Seminar, AER Chairman, Andrew Reeves highlighted key work the AER is undertaking in developing its approach to network regulation.

Transcript

Thank you to the ENA for the invitation to participate in your Regulation Seminar today.

At last year’s seminar, I presented on the topic of ‘Changes in the World of Regulation’. In this presentation, I focused on longer term issues, giving my perspectives on where regulation of the Australian energy sector may head in the next 10 to 15 years. I noted that the next big phase of reform will occur at the customer end of the grid, where we will increasingly see competition between self generation, demand management and grid services, with the end consumer as an active agent in this choice.

I also emphasised some of the challenges on the horizon in implementing this reform. In particular, I noted the quality of engagement with energy consumers was an area where the NEM did lag behind some other markets, and was an area where we needed to get better.

Clearly there has been a significant amount of water pass under the bridge in the past year. Rising energy prices have led to a continuing national debate around whether the market has been functioning efficiently and what could be done to the market to make it work better.

Over 2012, there were reviews across the full spectrum of regulation. These included:

  • a wholesale review of the rules that set out how network prices are determined, which was initiated by the rule changes lodged by the AER
  • a review of the effectiveness of the process for reviewing the AER’s regulatory decisions
  • a review of the effectiveness of the Australian Competition Tribunal as the review body,
  • reviews of how reliability standards are set,
  • reviews of how the demand side can be better incorporated into the market, and
  • a range of reviews considering how the long term interests of consumers can be better integrated with the regulatory process.

The overall thrust of these reforms is summed up in the title of SCER’s report to the December COAG meeting – Putting Consumers First.

In some areas, these reforms are still very much a work in progress. For example, the proposed changes to the rules to empower the demand side arising from the Power of Choice review are still to be submitted to the rule making body, the AEMC. Key related issues around network tariff design are still to be resolved.

In other areas, changes are well advanced. For example, changes to the process for reviewing the AER’s decisions are now at the draft legislation stage. If implemented, these changes will ensure that merits review allows appropriate review of AER decision making, but also ensure that merits review better reflects the long term interest of consumers.

Today, however, I would like to focus on the reforms that the AER is directly responsible for implementing. In particular, I would like to share with you the work the AER has been undertaking to develop our approach to energy regulation under the Better Regulation Program.

As we all know, while there have been a range of reasons for recent price increases, network costs have been a significant contributor to price increases in all states. The factors driving these increased network costs include the need to replace ageing equipment and, at the time many determinations were made, strong growth in demand and higher costs of finance in the post-GFC environment.

However, weaknesses in the regulatory framework, that is the rules that the AER had to apply in regulating network prices, also played their part.

The rules were developed in 2006, following 10 years of strong economic growth and at a time where there were serious concerns in Australia about the adequacy of investment in critical infrastructure in energy, in ports, and in transport, to support continued growth. Also, the external environment, including financial markets, had been stable for a relatively prolonged period. In this environment, it was decided to ‘lock in’ key elements of the rules to provide greater investment certainty.

It turned out that this stability wasn’t going to continue and rules that had been written to suit more stable conditions were no longer appropriate in trying to meet the challenges of the increasingly dynamic energy market.

While the rules created a favourable environment for investment – certainly we have witnessed historically high levels of investment – in our view the balance of cost and service was not given sufficient attention.

Our concerns were such that in 2011 we submitted proposals to the AEMC to address issues with the regulatory framework. The AEMC’s final rules, released in November last year, set out a framework for the balanced assessment of the need to allow for the ongoing efficient investment required to ensure a continued reliable energy supply, with the need to minimise costs to consumers.

Briefly, the key reforms to the rules include:

  • changes to the approach for setting rates of return which allow the setting of overall rates that more accurately reflect actual financing practices;
  • changes to the approach for setting expenditure allowances to enable a ‘top down’ assessment of a business’s efficient expenditure needs, including the use of comparator or benchmark data
  • changes to incentive arrangements to prevent businesses from receiving a return on inefficient overinvestment, and
  • changes to consultation arrangements designed to promote more effective consumer engagement

The AEMC passed the implementation of these changes back to the AER and in December last year, we initiated the Better Regulation Program to draw together these important reforms and our other work in developing our regulatory processes and systems.  The scope of our Better Regulation Reform Program is extensive and includes our developing guidelines on a range of key regulatory issues – including how we calculate the allowed return on assets, assess expenditure proposals, encourage efficient spending by businesses, and engage consumers in the regulatory process.  Many of you in the audience today have been actively participating in this work. When we are finished, it will come close to being a complete manual of AER network regulation. That in itself brings transparency and certainty to the regulatory process.

We appreciate that the reforms to the rules provide the AER with greater discretion in how to determine a business’s efficient investment needs and appropriate rates of return. We also, however, appreciate that this additional discretion needs to be applied judiciously to maintain investor and consumer confidence in the regulatory process.

There are a number of key principles that are the foundation of our Better Regulation program.

First, the need to encourage necessary and efficient investment. This is enshrined in the National Electricity and Gas Objectives and in the Revenue and Pricing Principles. We believe that by providing certainty, our Better Regulation Program will support necessary and efficient investment.

A second key driver is that where possible our economic regulation should be incentive based. While not all businesses have responded to commercial incentives in the past, the rules have a strong emphasis on providing incentives for efficient investment. The Expenditure Incentives Guidelines that we are currently developing will be a core part of the incentive based regulatory regime.  These will reward efficiency, allow customers to share in the benefits of efficiency, and penalise inefficient investment.

A third key driver is that the guidelines should be the product of extensive consultation and engagement.

This work developing the guidelines is at an important juncture – with some draft guidelines already released and the rest to be released very shortly.  The development of the draft guidelines, through our initial discussions, issues papers, workshops and bilateral discussions really has been a forum for the competition of ideas and the explanatory statements that will accompany the draft guidelines describe how these matters have been developed.

I would now like to focus on some of these key workstreams and the issues that are arising.

Let me first discuss the rate of return framework. The AER is required under the new rules to develop a guideline setting out how it will approach the assessment of the rate of return. It is fair to say that the rate of return guideline poses more challenges than other guidelines, partly because the return on investment is such a significant component of the overall revenue allowance.

There were a range of problems with the approach to setting the rate of return under the old rules. The rules were prescriptive, that is, they set out in some detail the approach that regulators should adopt, on the notion that certainty of process was necessary for a stable investment climate.

This prescription led to a range of problems:

  • “Mechanical” outcomes that failed to take into account the “bigger picture”. We were required to determine the overall rate of return by estimating and bringing together individual components. Nothing allowed us to consider the overall outcome and whether it was appropriate.
  • There were different rate of return frameworks for electricity distribution, electricity transmission and gas. These different frameworks resulted in different estimates of the cost of capital for each sector for no good reason.
  • The old rules primarily relied on the application of one estimation method—the “Sharpe CAPM”. The AER could not take into account other relevant information.
  • The AER could not readily adjust its approach to account for changing market circumstances. This was particularly a problem with the estimation of the cost of debt, where we were locked into assessing a type of bond that was no longer traded following the GFC. The prescriptive approach set out in the Rules locked the AER into setting the cost of capital in a way that did not reflect changing business practices of capital raising. As a result, the allowances for the cost of debt were much higher than the market costs which network businesses actually face.
  • Estimates of the cost of capital were based on a short sampling period. This led to substantial movements in the cost of capital from one decision to the next in response to financial market volatility. For example, our recent Victorian gas decisions allowed a rate of return of a bit more than7 per cent. For some decisions, such as the NSW electricity network decisions made in 2009, the rate of return exceeded 10 per cent. There were examples where the allowances for the rate of return varied substantially (by more than a percentage point) within a few months.

The new framework specifically addresses the weaknesses of the old rate of return regime.

First, the focus of the new rules is on the AER providing an overall rate of return that corresponds with the efficient financing costs of a benchmark efficient business. This allows us to consider the rate of return holistically rather than as an aggregation of individual components.

Second, under the new rules there is consistency of approach, with a common rate of return framework applying across electricity distribution, electricity transmission and gas.

Third, under the new rules, we can consider a broader range of material. In the guidelines, we will set out the information we intend to take into account, and our approach in bringing it together to formulate our estimate of the rate of return.

Fourth, under the new rules, we have a greater ability to respond to changing market conditions. We are required to publish our rate of return guideline every three years. We can update the guideline to account for advances in finance theory or fundamental shifts in market circumstances.

Finally, we have been considering the merits of setting the rate of return by reference to a hypothetical portfolio of current debt, with annual updates of the cost of portion of the portfolio.  This would give a closer reflection of financing costs and lessen the mismatch between the regulatory allowance and market rates.  It would reduce the quantum of the step change adjustments we have seen at recent resets.

We have been considering views on these and other approaches in developing our draft guideline, which will be released for comment in August.

The second major workstream I’d like to touch on is the expenditure assessments workstream. We are developing an expenditure assessments guideline to support the shift under the new rules to a more holistic expenditure assessment framework, with a stronger focus on benchmarking.  

The previous rules restricted the AER’s ability to make holistic assessments of how much investment was efficient or necessary. This was because the rules placed a heavy reliance on the networks’ expenditure proposals, including a presumption that they be accepted if found to be reasonable, and if found otherwise, a requirement on the AER to make the minimum adjustment necessary for the proposal to be acceptable under the Rule assessment criteria.

Under the new framework, where deficiencies are found in the spending proposals of businesses, the AER will now be better able to scrutinise the capital and operating expenditure proposals submitted by network businesses, and reject excessive cost forecasts.  As I said before, as an economic regulator the AER has a strong preference for incentive regulation, whereby the businesses are rewarded if they perform efficiently, and those efficiency gains are then shared with consumers.  However, we will also be able to draw on our own benchmarking and other analysis to form a view on efficient costs, rather than being limited to deviations from the proposal from the network business.

This rule change was important to ensure that the AER is unambiguously able to apply benchmarking techniques to estimate efficient expenditure for all network businesses. It is the AER’s intention to undertake benchmarking of network businesses against their peers at both the high level (through economic benchmarking) and at the more detailed category analysis level (which allows a ‘bottom up’ assessment of the relatively efficiency of work practices). This should allow the AER to better examine the overall relative efficiency of businesses. We have been holding workshops to develop the mechanics of cost benchmarking and determine how benchmarking will be used in regulating network revenues. The importance of the AER’s benchmarking work was also recognised in the Budget, with the AER being provided with additional resources from 1 July this year to expand our benchmarking capability.

The draft expenditure assessments guideline will also be released in August. It will outline the types of assessments we will undertake in determining expenditure allowances and the information we will require from network businesses to facilitate those assessments. This will provide the networks with more certainty on the methods the AER will employ at the time of a regulatory reset and will also assist the AER in undertaking more effective assessments of expenditure proposals.

Finally, the rules now require us to publish annual benchmarking reports, beginning in September 2014.  The purpose of these reports is to describe, in reasonably plain language, the relative efficiency of each electricity network business in providing services. These reports will be a useful tool for consumers to engage in the regulatory process and will play an important role in increasing the transparency and accountability of network businesses.

The third major workstream I’d like to focus on is the expenditure incentives workstream. We are developing an expenditure incentives guideline to provide stronger incentives for efficient investment.

Under the previous rules there were limited incentives for firms to improve their capital expenditure efficiency - all capital expenditure regardless of its efficiency was rolled into the regulatory asset base and provided a return for the business for the remaining life of the asset.

The new framework introduces new regulatory tools, so the AER can provide incentives to promote more efficient investment spending. This includes the ability to implement a capital expenditure sharing scheme.  Under this scheme, businesses and consumers will share the financial impact of a capital expenditure overspend or underspend. This means that consumers will not fund all of a business’s overspend, and a business will not keep all the benefits of an underspend.

A further tool designed to promote efficient investment is the requirement on the AER to carry out an ex post review of capital expenditure if the AER forecast of efficient expenditure is breached. Under the new rules, network businesses will carry the risk that inefficient expenditure may be excluded from the regulated asset base, and they will be denied the return on that inefficient expenditure.

The AER’s draft capital expenditure incentives guideline will be released in August. It will set out the details of the capital expenditure sharing scheme and our proposed approach to ex-post reviews. 

The final major workstream I’d like to touch on deals with consumer engagement.

The complexity of the energy market and the regulatory processes that make up much of the AER’s work have made it difficult for consumers, or even their representatives, to participate meaningfully. This has led to reduced consumer confidence in the energy market, its regulation and the outcomes it has delivered.

A key area of focus for recent energy market reforms has been on increased consumer participation and engagement. This is a new focus – for the first time, there is a regulatory requirement for network businesses to consult with their consumers in the development of their regulatory proposal and the AER is now required to take into account this consultation when considering the proposal.  If the National Electricity Law includes the long term interest of consumers in its objective, it makes very good sense that the views of consumers are deliberately considered during the development of the network business’s regulatory proposal.

Earlier this month we released a draft service provider consumer engagement guideline. It sets out our expectations for consumer engagement by network businesses. This guideline aims to assist network businesses to engage systematically, consistently and strategically with consumers on significant issues, to better align the provision of services with the long term interest of consumers.

There are also a range of reforms to regulatory process and practice designed to facilitate improved consumer engagement. There is now more time allowed in the regulatory process for stakeholders to prepare submissions and put their views forward. There is more emphasis on consumer-focused written documents, including AER issues papers and requirements on the businesses to include overview papers with a consumer focus.

We have taken up the  challenge to deliver more consumer focused material. It has required us to adopt a different mindset and change the way in which some key messages are delivered. Our recent decisions, such as the Victorian gas distribution decision, are a much easier read than our earlier work,  and we are devoting significant attention to this style of communication as part of our effort to improve consumer engagement. 

There is also a broader suite of engagement initiatives designed to give consumers a greater voice and empowerment in the regulatory process.

We have established a consumer reference group. We recognise how difficult it is for consumers to engage in complex guideline development processes that are a part of our Better Regulation Reform Program. The consumer reference group is designed to make it easier for consumer representative groups to have input into the Better Regulation Reform Program, by engaging in discussion with staff and the Board and without necessarily writing formal submissions.

We have also established the Consumer Challenge Panel. This was a key component of the Council of Australian Governments’ energy reform agenda from December 2012. We recently appointed thirteen members to the Challenge Panel for an initial three year term.  The Panel will help the AER examine spending proposals from a consumer perspective. Members of the panel will provide advice on whether spending proposals from network businesses are justified in terms of the services to be delivered to consumers and whether they are in their long term interests.

Further areas for engagement with consumers include the establishment of a National Energy Consumer Advocacy Body. SCER recently gave in principle support for the establishment of the Advocacy Body in July 2014.

While there has been a strong focus on improved consumer engagement, the AER has been mindful of the need to effectively engage with all key stakeholders in developing our approach to regulation under the new rules.

Certainly, this has been the most exhaustive consultation process we have ever undertaken. We have been consulting with network businesses, investors and consumers through papers and submissions, through workshops, and through face to face meetings to develop these guidelines.

We have been encouraged by the open engagement and constructive dialogue we have had with network businesses and other parties in the guideline development process.  We think in many regards that our engagement and exchange with network businesses has been rather better than it has been previously.

Clearly, the challenge for us all will be to continue with this constructive engagement as we consult on our draft guidelines and move towards final guidelines later in the year.

One final area I’d like to touch on concerns demand side participation. While the AER has a demand side response workstream under our Better Regulation Program, some key work has to sit on the backburner until the changes to the rules arising from the AEMC’s Power of Choice review are implemented.

This work is a fundamental part of market reforms going forward. The growth of solar PV, electric vehicles and storage have significant implications for the grid and consumers. One key issue that is already emerging, driven by the growth of solar PV, concerns the distribution of network costs under current tariff design. We are already seeing some governments giving thought and some network businesses exploring ways to address issues around the mismatch between network pricing and network usage. These key issues of tariff design, such as the mix of fixed and variable charges and time and demand- based pricing , remain a key reform imperative. It is important that regulation in this area keeps pace with broader market developments.  It is particularly important that the need for such reform is communicated early and often to allow users time to adjust to necessary changes in pricing structures. 

To conclude my presentation, I would like to quote from Ergon Energy’s latest annual report:  

"Ergon Energy recognises that the rising price of electricity is a concern for our customers….

We are committed to doing everything we can to positively affect the price our customers pay for electricity – whether this is by managing electricity demand during peak times to make better use of our assets or reducing our own costs through business efficiency and improvements.

At the same time we know we have to keep pace with the growing demand for electricity and that our customers expect to have a safe and reliable electricity supply.

It’s about finding the balance and working together to find smarter, more efficient waysto ensure a bright future for regional Queensland."

I think this quote captures much of what I have been discussing today.

The quote highlights the importance of engagement with consumers. Energy prices are a concern for consumers in all states. Having an informed conversation with consumers about key market issues is critical if we are to earn back some of the consumer trust that has been lost in recent times.

The quote also refers to the importance of finding the balance between reliability and price. The reforms to the regulatory framework and our Better Regulation program are designed to achieve a balance by providing ongoing regulatory certainty for investors to undertake investment that is required, while also ensuring that consumers pay no more than necessary for a secure and reliable electricity supply.

We believe this can help establish a better and more efficient energy sector – one that delivers in the long term interests of consumers.