23 April 2013

In a speech to CEDA in Melbourne, the Australian Energy Regulator Chairman, Andrew Reeves highlighted the importance of recent energy market reforms in improving outcomes for energy consumers.

Transcript

Thank you to CEDA for the invitation to participate in the second energy series seminar today. The important matters of how monopoly industries are regulated, the level of investment in energy infrastructure and how much consumers ought to pay for a safe and reliable supply of energy have come under the spotlight for all consumers, and certainly has been a focus of the AER’s work in recent times.

There is no getting away from the fact that rising energy prices have put financial strain on consumers and public scrutiny on the market as a whole – policy makers, regulators and network businesses have all been under the spotlight.

Nationally, there has been a great deal of discussion around whether the market been functioning efficiently and what could be done to the market to make it more efficient – and many of you would have seen late last year, at the December 2012 COAG meeting, the Prime Minister announced, in her terms, ‘the most comprehensive package of reforms to Australia’s electricity markets in more than a decade.’

This energy reform package has both immediate and longer term implications for the work of the AER, for the work of the other energy market institutions – the AEMC and AEMO – and for the energy market itself.
Over the last 12 months, there have been reviews across the full spectrum of regulation. These reviews have covered:

  • a wholesale review of the rules that set out how network prices are determined, initiated by the AER
  • a review of how they’ve been applied,
  • a review of the effectiveness of the ACT as the review body,
  • how reliability standards are set and the role of jurisdictions,
  • how the underlying drivers of cost might be addressed,
  • a spotlight on the efficiency of public and private NSPs
  • how the long term interests of consumers can be better integrated with the regulatory process.

Better energy regulation, better investment decisions and better consumer engagement will result in a more efficient sector. Today I would like to touch on the significance of these energy market reforms and share what the AER has been doing in the areas of energy regulation and stakeholder engagement to make the sector more efficient.

There have been a range of reasons for recent price increases, but the rising costs of the electricity poles and wires that transport energy to customers have been the main contributor to price increases in all states. The factors driving these increased network costs include the need to replace ageing equipment and meet peak demand and, at the time the determinations were made, higher cost of finance in the post-GFC environment.

Firstly, on the issue of peak demand – it is important to remember that the determinations were made against a backdrop of strong growth in demand, particularly from residential air conditioning, and from new connections from the housing boom. Energy networks are engineered with sufficient capacity to meet peak demand, which typically occurs on days of extreme weather. Around 20-30% of the $60 billion of electricity network capacity in the NEM is idle 99% of the time. While this capacity is drawn on for less than 90 hours a year, the associated network charges are carried by energy consumers.

Secondly, while we consider much of the investment included legitimate costs to replace ageing assets and maintain infrastructure that was largely built in the 1970s, there are questions about whether the magnitude of the increase in expenditure was balanced against the cost to consumers and the value of reliability.

Further, there were weaknesses in the regulatory framework. That is, the rules that set out how the AER must regulate prices have led to price increases beyond what has been necessary for a safe and reliable supply.

For some time now, the AER has held concerns about how well the energy market was working for consumers and whether consumers were paying too much for a safe and reliable energy supply.

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. The rules were, in our view, deliberately set to create a favourable environment for investment but in doing so, the balance of cost and service was not given sufficient attention. If the rules were intended to promote investment, they certainly have delivered that - energy network investment in the current five year regulatory cycle is running at historically high levels - over $7 billion has been forecast for electricity transmission networks, $36 billion for electricity distribution networks and $3 billion in gas distribution.

Our experience under the rules framework and our concerns were such that in 2011we submitted proposals to the AEMC to address issues with the regulatory framework. The areas we saw needed attention were:

  • to improve how the rate of return was set
  • to improve how the forecasts of capital and operating expenditure were set
  • to improve incentives for network businesses to manage their expenditure and strive for efficiency
  • to improve the regulatory process to ensure greater consumer involvement.

Let me first address the rate of return framework – the return on investment makes up approximately 50-60% of revenue needs for network businesses. The rules for the electricity networks 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. Such a strategy may have been appropriate in the light of the 10 years or so of established regulatory practice, and in an era of consistent economic growth, but they were clearly not appropriate with the disruption of financial markets that came with the GFC. The prescriptive approach locked the AER into setting the cost of capital in a way that provided certainty of process, but 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.

Under the new framework, the AER is required to develop a guideline setting out how it will approach the assessment of the rate of return. It must meet an objective to deliver a return that is, in the words of the rules, ‘commensurate with the efficient financing costs of a benchmark efficient entity with a similar degree of risk in respect of the provision of reference services’. The publication of this guideline will provide certainty for investors and the ability for the AER to set the rate of return on a ‘determination by determination’ basis for all network businesses. This will allow the AER to better respond to changes in financial market conditions and financial practices.

Under the previous rules there were three different approaches to setting the rate of return – one for gas pipelines, one for electricity transmission and one for electricity distribution. Under the new arrangements, there will be one guideline and we are consulting extensively with consumers, the network businesses, investors and financiers on its development.

The second change to the framework I’d like to touch on is a more holistic expenditure assessment framework. As I mentioned earlier, there has been a need for increased spending on energy networks. However, 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. This restriction in the framework led to consumers paying more than necessary for a safe and reliable energy supply.

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. We will 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 change is important to ensure that the AER is unambiguously able to apply the outputs benchmarking techniques to estimate efficient expenditure for all network businesses.

There is a new requirement on the AER to publish expenditure assessment guidelines, as well as annual benchmarking reports. This will also assist the AER in undertaking more effective assessments of expenditure proposals. The AER will be providing consumers and the network businesses regular information on the relative efficiency of the businesses, as well as providing the networks more certainty on the methods the AER will employ at the time of a regulatory reset. Both measures are expected to streamline the process of expenditure assessments by focusing attention on comparative efficiency and matters that are more material.

The third element of the new framework I would like to discuss are the provisions that 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 stronger incentives for businesses to keep expenditure within the allowance, as the AER is required to carry out an ex post review of capital expenditure. Now network businesses carry the risk that inefficient over expenditure may be excluded from the regulated asset base, and they will be denied the return on that inefficient expenditure.

As a package, we consider the new regulatory framework now allows the AER to make a more balanced assessment of the level of efficient investment required for a reliable and safe energy supply.

As part of these changes in the framework, the AER is required to develop a series of guidelines setting out how it proposes to approach its assessment. We are working with our stakeholders, that is, consumer groups and network businesses, to develop a series of guidelines that clearly set out our approach to regulation under the new rules. The scope of our Better Regulation Reform Program is extensive - covering issues from how we assess expenditure proposals, calculate the allowed return on assets, encourage efficient spending by businesses and allocate costs, to how we engage consumers in the regulatory process.
This work will be completed by November this year, so that it can be applied to the next round of regulatory determinations which commence in early 2014.

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. This is an important tool in increasing the accountability of network businesses to the community they serve. The businesses should be accountable to their customers, and they owe their customers an explanation of the reason for expenditure and the reliability outcomes they intend to achieve.

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. It is difficult for the regulator to be confident that a business’s proposal will deliver the services that consumers want, if consumers don’t have a real opportunity to affect that proposal.

Changes both to the rules framework and to the AER's processes are a part of making the energy market work better for consumers. In essence, the initiatives underway are intended to promote an interactive process in which consumers, the AER and network businesses are all involved in ensuring the services that are valued by consumers are the ones that are provided.

A number of new strategies to engage with consumers are also being developed.

  • We have established a Consumer Reference Group to make it easier for consumer representative groups to have input into the Better Regulation Reform Program.
  • We are also in the process of establishing the Consumer Challenge Panel to provide expert advice during the AER’s assessment of energy network businesses’ regulatory proposals. It is designed to ensure that consumers’ views, particularly those of residential and small business consumers, are properly considered by the AER throughout regulatory processes,
  • I also mentioned earlier, that we are developing benchmarking reports, so consumers can assess how their network business is performing in comparison to others.
  • Further areas for engagement with consumers include the establishment of a National Energy Consumer Advocacy Body which is currently being considered by government.

Taken together, all of the measures I’ve discussed today – a new regulatory framework and better consumer engagement will deliver a better and more efficient energy sector.