2 July 2015
In a speech at the 2015 Committee for Economic Development of Australia Conference in Sydney, AER Chair Paula Conboy discussed recent network tariff reforms.
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Introduction
Good afternoon. And thanks to CEDA for the invitation to speak with you today.
The issue of network tariffs and network tariff reform is certainly a very topical one in Australia at present. Discussions around the future direction of energy markets and views on the part that customers and various technologies should, or should not, be playing in these markets have led to interesting discussions over network tariff reform.
You may not be surprised to hear that these issues are also very topical in overseas markets. I recently attended an international forum of regulators. What was clear is that market participants, regulators and policy makers worldwide are grappling with the reality that due to technological change in energy markets, the role of networks in those markets is rapidly changing. Other regulators are asking the same questions as we are here in Australia. How do we make sure that our electricity markets and our regulatory arrangements are sufficiently flexible and resilient to respond to this consumer-driven technological change?
There was unanimous agreement among regulators that we need to start with ensuring that we have got the fundamentals right.
I think in Australia we are ahead of the curve when it comes to reforming the electricity market in a way that contributes to the long term interests of consumers. Through the policy directions set by the COAG Energy Council, AEMC’s Power of Choice reform package and the AER’s Better Regulation Program we are considering the implications of new technologies and business models and making incremental changes to the regulatory frameworks to prepare for these changes. They set us on a good path to ensuring we get the fundamentals right.
Perhaps one of the most significant of the fundamentals to get right is network pricing – and reforms to make network pricing more cost reflective. Much of the focus here has been about having appropriate network pricing rules. Certainly the AEMC’s recent changes to the network pricing rules help in this regard. But also critical in ensuring that we get network pricing right is to ensure that the implementation of more cost reflective tariffs is handled well.
My presentation will focus on both the changes to the rules and the implementation challenges associated with the shift to more cost reflective network pricing.
What are the changes to the rules?
In November last year, the AEMC finalised a rule setting out a new process and new timeframes for setting network tariffs to improve certainty, timeliness and transparency for consumers and retailers.
It is important to note that this rule does not change the framework for setting the total amount of revenue that the network businesses can recover from consumers. This rule deals with the next step and outlines how the network tariffs that apply to individual consumers are to be determined.
Under the final rule, distribution businesses will need to submit their initial tariff structures to the AER by the latter part of 2015. Network tariffs based on these new rules will take effect no later than 2017. Many distribution businesses have already started consulting with retailers and consumers on the network tariffs they propose to apply.
The Consumer Utilities Advocacy Centre recently published a report to help consumers, consumer advocates and consumer groups engage with electricity distribution businesses and policy makers in their development and implementation of cost reflective tariffs.
While the rules previously required that network tariffs should have regard to efficient costs, under the new rules there is now a more explicit requirement for tariffs to be structured efficiently and to demonstrably move toward greater reflection of the underlying drivers of network costs.
For example, the new pricing principles contain:
an overarching objective for tariffs to reflect efficient costs of service delivery
a requirement for tariffs to be based on the long run marginal cost of providing services to the customers assigned to that tariff, and
a requirement for tariffs to be structured with regard to the time and location varying nature of network cost drivers.
The benefits and costs of cost reflective pricing were considered in depth through the AEMC’s rule change and I don’t propose to elaborate too much on them here.
Suffice to say, cost reflective network prices will allow consumers to compare the value they place on using the network with the costs of using it. If consumers choose to use electricity in ways that reduce network costs, for example by using less power at peak times when the network usage is at its highest, they should be rewarded through lower electricity costs through their retail bills.
In the long term, reductions in peak demand result in lower overall network expenditure, with benefits passed through to all consumers.
While much focus has been on this shift towards cost reflective network tariffs, there are a range of other features in the rule change package that are in some respects more important.
The new rules require distribution businesses for the first time to set out their intended tariff structures for the regulatory period in a Tariff Structure Statement. The Tariff Structure Statement must include:
The tariff classes into which consumers are to be divided during the relevant regulatory control period. This involves grouping customers that have similar characteristics together. So for example residential, small business and large businesses customers might be grouped into separate tariff classes.
The policies and procedures the distribution business will apply when assigning consumers to tariffs or reassigning consumers from one tariff to another. For example, large customers at less than 1,000 volts might be assigned to large customer connection low voltage; large customers between 1,000 volts and 22,000 volts would be assigned to tariff class large customer connection high voltage
The structures for each proposed tariff. For example, these can include one or more of a fixed charge, consumption charge and a demand charge component
The charging parameters for each proposed tariff. Specific characteristics to the tariffs could be defined, such as the time periods that apply or minimum charge levels
A description of the approach that the distribution business will take in setting each tariff in each pricing proposal of the distribution business during the relevant regulatory control period. So, how did they arrive at calculating the appropriate tariff in each tariff class.
The Tariff Structure Statement must also be accompanied by a separate indicative pricing schedule that sets out the indicative price levels for each tariff included in the Tariff Structure Statement.
These requirements provide greater transparency around tariff setting. Customers and retailers have greater insight into how distribution businesses arrive at their tariffs, how they operate and their underlying rationale.
Further, stakeholders will have greater certainty than they have currently, as distribution businesses will be bound to the structures in their Tariff Structure Statements for the regulatory period. If they wish to change their structures, they must submit a revised statement to the AER for approval. This certainty provides customers and retailers with greater ability to understand and respond to the network tariffs.
Two other important features in the rule change package are the introduction of a specific consumer impact principle and the requirement for businesses to describe how they have engaged with customers and retailers in developing the proposed Tariff Structure Statements. These principles place an obligation on distribution businesses to consider the impacts of network tariff changes on consumers when determining how to transition consumers to more cost reflective tariffs. In practice, this is likely to require distribution businesses to gradually transition to more cost reflective tariffs. The principle also requires distribution businesses to set tariff structures that are reasonably capable of being understood by customers.
These requirements for distribution businesses to engage with customers and retailers, to consider the impacts of their tariffs on customers and to set network prices that customers can understand helps manage the transition to cost reflective network prices. It provides customers with a better ability to meaningfully respond to network prices.
Implications of the rule changes
The reform package is designed to provide distributors with ownership of their tariff approaches and provide them with flexibility to innovate. Distributors play the key role in driving this reform.
Indeed distributors are best placed to consult and develop prices that best suit the particular circumstances of their network and their customers.
And the success of these reforms will depend in no small part on how well distribution businesses engage with retailers and their customers.
The AEMC argues that the intention of this consultation is to stimulate discussion between distribution businesses, retailers and consumers so that distribution businesses have the information to develop more robust and suitable tariff structures that retailers can implement and consumers can understand and respond to.
This requires genuine, meaningful engagement between distributors and retailers and customers. In other words, the consultation process must provide retailers and consumers with a real opportunity to provide meaningful input into the development of network tariffs, rather than the current process whereby retailers and consumers are merely informed of proposed network tariff structures.
The Victorian distribution companies are currently in this phase of the process, which is still ongoing. As we understand it, a number have set up customer councils, pricing workshops and other forums as well as bilateral discussions with customers and retailers. These have focussed on the significance and relevance of tariff transitions in minimising customer impacts. For example, they have tested trade-offs with customers in how they should balance the pricing principles of moving towards more cost reflective tariffs but in a way that takes account of customer impacts. This feedback would be useful in informing the business on the rate of transition that is seen as appropriate.
Another factor highlighting the importance of this engagement is that household customers do not see network tariffs directly, but rather pay them to the extent that retailers pass them on. It will therefore be critical for there to be a dialogue between distribution businesses and retailers to understand how retailers are likely to pass on changes in network tariffs.
Without this engagement, there is a real risk of lack of ‘buy in’ to the reforms by retailers and consumers.
So what’s the AER’s role in all this?
While it is industry that must take ownership and drive these reforms, the reform package also creates new responsibilities for the AER. We will now have a role, and the rules set out a process, in reviewing the structures of distribution tariffs in Tariff Structure Statements.
This role will include reviewing whether tariff structures are moving towards cost reflectivity. In this, we’ll need to review issues such as how distributors arrived at their expectations of forward looking costs caused by changes in demand (increases or decreases), the rationale for how customers are allocated to different groups and tariff structures (including their approach to determining network cost causation), and how distributors propose to recover costs that are sunk and not determined by changes in demand.
We also need to review whether tariff structures are managing consumer impacts. As part of this we’ll need to review how distributors considered the impacts on customers of changes in tariffs from one year to the next or over what time-period is this transition to occur. We will need to review a distribution business’s engagement with consumers and retailers in coming to a view on these aspects.
This raises the question of how the AER intends to undertake these responsibilities.
The rules make clear that the AER’s role is more of a compliance one. Our role is not to do an in-depth review of the structures developed by distribution businesses, but rather it is to review whether the Tariff Structure Statement complies with the rules or not. Our role will be to oversee whether these approaches are moving toward the goals set out in the pricing rules. In essence, this is about ensuring that distribution businesses are moving towards cost reflectivity, but in a considered and measured way.
This process involves more comprehensive assessment and consultation of how proposed tariff structures are consistent with the cost principles. The process also provides for an open and transparent review and approval. The process for considering Tariff Structure Statements will normally occur during a revenue reset but as a transitional measure will be undertaken by the AER for almost all distribution networks over the next 12-18 months.
It’s also important to note that the rules require that the AER must approve a distribution business’s proposed Tariff Structure Statement unless the AER is reasonably satisfied that the proposed Tariff Structure Statement does not comply with the requirements of the rules. This underscores the compliance nature of our Tariff Structure Statement review role. If a Tariff Structure Statement (or part of it) does not comply with the rules we can point out where it is non-compliant and ask the business to address the non-compliance, but that is very different from substituting our own Tariff Structure Statement for that proposed by the distribution business.
Again, this underscores that the distribution businesses are in the best position to develop pricing structures that best suit the characteristics of their networks and customers.
Concluding remarks
The recent changes to the rules for setting network tariffs are a significant reform. One of the important features of these rules is the implementation of more cost reflective network pricing. These new rules also outline a new process and new timeframes for setting network prices to improve certainty, timeliness and transparency for consumers and retailers. Together these reforms help promote a market where customer choices (and the benefits and costs of these choices that customers make) drive outcomes in the market.
I certainly share the ENA's call that networks should be given the flexibility to design appropriate, more cost reflective network tariffs in consultation with their customers, stakeholders and with the oversight of the regulator. By providing customers and investors with certainty, these efforts have an important part to play in securing the benefits of network tariff reform. If we all do our part, cost reflective pricing will be a success from all perspectives.