Final
Decision

Access Arrangement by Transmission Pipelines
Australia Pty Ltd and Transmission Pipelines Australia
(Assets) Pty Ltd for the Principal Transmission System

Access Arrangement by Transmission Pipelines
Australia Pty Ltd and Transmission Pipelines Australia
(Assets) Pty Ltd for the Western Transmission System

Access Arrangement by Victorian Energy Networks
Corporation for the Principal Transmission System

Date:  6 October 1998

	File No:	Commissioners:
	CR97/159	Fels
		Asher
		Shogren
		Tamblyn

Contents
Contents	
Abbreviations	
Glossary	
Executive summary	
1. 	Introduction	
2. 	Background	
3. 	Broad issues in the final access arrangements assessment	
3.1 	Rate of return	
3.2 	Incentive regulation	
3.3 	Initial capital base	
4. 	Conclusion	
5. 	Final Decision	
6. 	Proposed amendments	
1. 	Introduction	
1.1 	Structure of the Victorian gas industry	
1.2 	The access arrangements	
1.3 	The Commission’s assessment of the access arrangements	
2. 	Broad issues	
2.1 	Introduction	
2.2 	Market carriage and interstate trade	
2.2.1 	Services and policies under each model	
2.2.2 	Interstate trade	
2.2.3 	Compatibility of trading arrangements between States	
2.2.4 	Pricing and the InterConnect	
2.2.5 	Overall assessment	
2.3 	Existing contractual rights	
3. 	Reference tariffs	
3.1 	Overall reference tariff methodology	
3.1.1 	Victorian Access Code requirements	
3.1.2 	TPA’s Access Arrangements for the PTS and WTS	
3.2 	The initial capital base	
3.2.1 	Victorian Access Code requirements	
3.2.2 	TPA’s Access Arrangements for the PTS and WTS	
3.3 	New facilities investment and capital redundancy	
3.3.1 	Victorian Access Code requirements	
3.3.2 	TPA’s Access Arrangements for the PTS and WTS	
3.4 	Depreciation and inflation indexation of the asset base	
3.4.1 	Victorian Access Code requirements	
3.4.2 	TPA’s Access Arrangements for the PTS and WTS	
3.5 	Rate of return	
3.5.1 	Victorian Access Code requirements	
3.5.2 	TPA’s Access Arrangements for the PTS and WTS	
3.6 	Operations and maintenance costs and working capital	
3.6.1 	Victorian Access Code requirements	
3.6.2 	TPA’s Access Arrangements for the PTS and WTS	
3.7 	Forecast revenue	
3.7.1 	Victorian Access Code requirements	
3.7.2 	TPA’s Access Arrangements for the PTS and WTS	
3.7.3 	VENCorp’s Access Arrangement for the PTS	
3.8 	Cost allocation and tariff setting	
3.8.1 	Victorian Access Code requirements	
3.8.2 	TPA’s Access Arrangements for the PTS and WTS	
3.8.3 	VENCorp’s Access Arrangement for the PTS	
3.9 	Tariff path and incentive structure	
3.9.1 	Victorian Access Code requirements	
3.9.2 	TPA’s Access Arrangements for the PTS and WTS	
3.9.3 	VENCorp’s Access Arrangement for the PTS	
3.10 	Assessment of reference tariffs and reference tariff policy	
3.10.1 	Victorian Access Code requirements	
3.10.2 	TPA’s Access Arrangements for the PTS and WTS	
3.10.3 	VENCorp’s Access Arrangement for the PTS	
4. 	Other mandatory elements	
4.1 	Access Arrangement	
4.1.1 	Victorian Access Code requirements	
4.1.2 	TPA’s Access Arrangements for the PTS and WTS	
4.1.3 	VENCorp’s Access Arrangement for the PTS	
4.2 	Services policy	
4.2.1 	Victorian Access Code requirements	
4.2.2 	TPA’s Access Arrangements for the PTS and WTS	
4.2.3 	VENCorp’s Access Arrangement for the PTS	
4.3 	Terms and conditions	
4.3.1 	Victorian Access Code requirements	
4.3.2 	TPA’s Access Arrangements for the PTS and WTS	
4.3.3 	VENCorp’s Access Arrangement for the PTS	
4.4 	Capacity management policy	
4.4.1 	Victorian Access Code requirements	
4.4.2 	TPA’s Access Arrangements for the PTS and WTS	
4.4.3 	VENCorp’s Access Arrangement for the PTS	
4.5 	Trading policy	
4.5.1 	Victorian Access Code requirements	
4.5.2 	TPA’s Access Arrangements for the PTS and WTS	
4.5.3 	VENCorp’s Access Arrangement for the PTS	
4.6 	Queuing policy	
4.6.1 	Victorian Access Code requirements	
4.6.2 	TPA’s Access Arrangements for the PTS and WTS	
4.6.3 	VENCorp’s Access Arrangement for the PTS	
4.7 	Extensions and expansions policy	
4.7.1 	Victorian Access Code requirements	
4.7.2 	TPA’s Access Arrangements for the PTS and WTS	
4.7.3 	VENCorp’s Access Arrangement for the PTS	
4.8 	Review and expiry of the Access Arrangement	
4.8.1 	Victorian Access Code requirements	
4.8.2 	TPA’s Access Arrangements for the PTS and WTS	
4.8.3 	VENCorp’s Access Arrangement for the PTS	
4.9 	Information provision	
4.9.1 	Victorian Access Code requirements	
4.9.2 	TPA’s Access Arrangements for the PTS and WTS	
4.9.3 	VENCorp’s Access Arrangement for the PTS	
4.10 	Key performance indicators	
5. 	Final Decision	
5.1 	TPA and TPAA’s Access Arrangement for the PTS	
5.2 	TPA and TPAA’s Access Arrangement for the WTS	
5.3 	VENCorp’s Access Arrangement for the PTS	
Appendix A:	Interested parties consulted by the Commission	
Appendix B:	Submissions	
Appendix C:	Attachment A of the Victorian Access Code	
Appendix D:	Explanation of EPD model	
Appendix E:	The implications of regulatory returns driven by a pre-tax 
real WACC	

Abbreviations
AAI	Access Arrangement Information	
ABS	Australian Bureau of Statistics	
ACA	Australian Cogeneration Association	
ACCC	Australian Competition and Consumer Commission 	
ACI	ACI (Packaging Group) Operations Pty Ltd	
ACM	Australian Chamber of Manufactures	
AGL	The Australian Gas Light Company	
AGUG	Australian Gas Users’ Group	
Amcor	Amcor Ltd	
BCA	Business Council of Australia	
BHPP	BHP Petroleum Pty Ltd	
Boral	Boral Energy Holdings Limited	
CAPM	Capital Asset Pricing Model	
CCA	Current Cost Accounting	
CoAG	Council of Australian Governments	
Coastal	Coastal Gas Australia Pty Ltd	
CitiPower	CitiPower Pty	
CLCV	Consumer Law Centre of Victoria Limited	
Commission	Australian Competition and Consumer Commission	
Commonwealth Bank	Commonwealth Bank of Australia 	
CPI	Consumer Price Index	
CSFB	CS First Boston	
CTM	Custody Transfer Meter	
DAC	Depreciated Actual Cost	
DORC	Depreciated Optimised Replacement Cost	
DRC	Depreciated Replacement Cost	
EAG	Energy Action Group	
EAPL	East Australian Pipeline Limited	
EAPM	East Australian Pipeline Marketing Pty Limited	
Ecogen	Ecogen Energy	
Energy 21	Energy 21 Pty Ltd	
Envestra	Envestra Pty Limited	
EoD Linepack	End of Day Linepack	
EPD	Energy Projects Division, Department of Treasury & Finance (Victoria)	
Esso	Esso Australia Resources Ltd	
FATT	Forecast Average Transmission Tariff	
GFCV	The Gas and Fuel Corporation of Victoria	
GHD	Gutteridge, Haskins and Davey Pty Limited	
GJ	Gigajoule (equal to one thousand million Joules)	
GSA	Gas Sales Agreement	
GTC	Gas Transmission Corporation (the predecessor of TPA)	
GTSO	Gas Transmission System Operator	
HCA	Historical Cost Accounting	
IPA	Institute of Public Affairs Ltd	
IPART	Independent Pricing and Regulatory Tribunal of NSW	
IRR	Internal Rate of Return	
ISO	Independent System Operator	
KPIs	Key Performance Indicators	
LNG	Liquefied Natural Gas	
LTBR	Long Term Bond Rate	
MATT	Maximum Average Transmission Tariff	
MDQ	Maximum Daily Quantity of gas (in GJ)	
MEE	Modern Engineering Equivalent	
MRP	Market Risk Premium	
MSOR	The Victorian Gas Industry Market and System Operation Rules	
Multinet	Multinet Energy Pty Ltd	
National Access Code	National Third Party Access Code for Natural Gas Pipeline Systems	
NCC	National Competition Council	
Nova Gas	Nova Gas Australia Pty Limited	
NPV	Net Present Value	
ODRC	Optimised Depreciated Replacement Cost (same as DORC)	
ORC	Optimised Replacement Cost	
ORG	Office of the Regulator-General (Victoria)	
O&M	Operations & Maintenance Costs	
PCS	Project Consultancy Services Pty Limited	
PJ	Petajoule (equal to 1 000 000 GJ)	
PTS	Principal Transmission System	
RC	Replacement Cost	
RL	Remaining Life	
Santos	Santos Ltd	
SKM	Sinclair Knight Merz Pty Ltd	
SEA	Service Envelope Agreement	
SRC	Standard Replacement Cost	
Stratus	Stratus (Gas) Pty Ltd	
SWP	South-West Pipeline	
Tariff Order	Victorian Gas Industry Tariff Order	
TEP	Tax Equivalent Payments	
Texas Utilities	Texas Utilities Australia Pty Ltd	
TJ	Terajoule (equal to 1 000 GJ)	
TPA	Transmission Pipelines Australia Pty Ltd (provider of transmission services) 	
TPAA	Transmission Pipelines Australia (Assets) Pty Ltd (transmission assets owner) 	
TUoS	Transmission Use of System (charges)	
UGS	Underground Storage	
VENCorp	Victorian Energy Networks Corporation (a statutory company - operator of Victoria’s gas transmission system)	
VENCorp P/L	Victorian Energy Networks Corporation Pty Ltd	
Victorian Access Code	Victorian Third Party Access Code for Natural Gas Pipeline Systems	
VPX	Victorian Power Exchange	
WACC 	Weighted Average Cost of Capital	
Westar	Westar (Gas) Pty Ltd	
WTS	Western Transmission System	

Glossary
Ancillary payments	Additional payments made to market participants to compensate when transmission constraints or surprises result in them being disadvantaged by a uniform, daily market price	
Augmentation	The process of upgrading the capacity or service potential of a transmission (or a distribution) pipeline (also referred to as expansion)	
Authorised MDQ	In respect of a customer, the maximum daily quantity of gas, expressed in GJ/day, which is authorised by VENCorp to be withdrawn by or on behalf of that customer. MDQ is also used to describe a notional allocation by VENCorp to market participants for the purpose of calculating uplift payments when congestion of the system occurs 	
Backhaul	A transport service which notionally transports gas between two points in the opposite direction to actual gas flow	
Bypass	The construction of a pipeline to avoid the existing transmission or distribution system or part thereof	
Capacity charge	In a market carriage system: a charge levied on gas throughput on days of peak usage.  In a contract carriage system: a charge levied on transport capacity actually reserved regardless of actual gas throughput	
City gate	Transition point from high pressure transmission pipelines to distribution network	
Commodity charge	A charge levied on the quantity of actual gas transported through the system	
Contract carriage	The service provider normally manages the system by requiring users to enter into contracts that specify a quantity of service, which a user may trade with another user.  Charges are normally based, at least in part, on the quantity specified in the contract	
Covered pipeline	Pipeline to which the provisions of the Victorian Access Code apply	
CPI-X	In TPA’s Access Arrangements, CPI-X is part of the formula used to achieve a constant change, over the years of a regulatory period, in the average revenue cap.  See price control formula 	
Distribution	The transport of gas over a combination of high pressure and low pressure pipelines from a city gate to various customers’ usage points 	
Excluded transmission services	Regulated services that are not considered to be amenable to formula-based price controls	
Extension	Extending a pipeline to provide supply of gas to areas not supplied with gas prior to extending the pipeline	
Expansion	see augmentation	
Firm transport	In a contract carriage system: a transport service which guarantees to provide transportation of gas up to the contracted or reserved level every day of the year	
Hub	A ‘balancing point’ which separates injection and withdrawal services, chosen to be located at the Pakenham offtake	
Initial access arrangement period	From 1 December 1997 to 31 December 2002	
Injection	The physical injection of gas into the gas transmission system	
InterConnect	The pipeline connecting the existing TPA system at Barnawatha (Victoria) to the EAPL transmission system at Wagga Wagga (NSW) 	
Interruptible transport	A transport service which does not guarantee to provide gas at the requested levels every day of the year	
K factor	An adjustment in the price control formula for product mix variations between forecast volumes and actual volumes achieved	
Load factor	The ratio between average yearly load and peak daily load	
Market carriage	A capacity management system whereby the service provider does not normally require users to commit to a certain amount of quantity under contract.  Instead, charges are normally based on a user’s actual usage of the system 	
Matched injection	Where equal quantities of gas are injected upstream of the hub and withdrawn by a customer also upstream of the hub (so that the hub is not on the physical link between the injection and withdrawal points)	
Matched withdrawal	Where equal quantities of gas are injected downstream from the hub and withdrawn by a customer also downstream from the hub (so that the hub is not on the physical link between the injection and withdrawal points)	
Nomination	A nomination by a market participant in respect of a quantity of gas to be injected into or withdrawn from the transmission system on a gas day	
Peak period	The period of 1 June to 30 September each year	
Price capping	A form of price regulation that ensures that weighted average price increase in a given year does not exceed the percentage increase in the CPI, less some predetermined factor (CPI-X)	
Price control formula	The formula (described in schedule 5 of the Tariff Order) which controls the yearly increase in the maximum average tariff which TPA is allowed to recover.  It is equal to the initial average tariff, reweighted for forecast volumes, and then increased by a CPI-X factor.  The result is then adjusted by a K (correction) factor for differences in the product mix between actual volumes and those previously forecast 	
Reference service	According to the Victorian Access Code, ‘reference service’ means a service which is specified in an access arrangement and in respect of which a reference tariff has been specified in that access arrangement.  The three reference services in TPA’s Access Arrangements are: transmission injection service, transmission delivery service and LNG system security 	
Revenue capping	A form of price regulation where revenue is constrained.  In TPA’s Access Arrangements, average revenue is capped 	
Ring fencing	A form of accounting separation of different functions of the same organisation where a free interchange of information between two functional areas is not desirable	
Service Envelope Agreement	An agreement between VENCorp and TPA whereby TPA agrees to provide certain gas transportation facilities to VENCorp	
Service provider	A person who owns or operates the whole or any part of a pipeline	
Shipper	Also called trader, merchant or broker.  Agents which purchase gas or pipeline capacity for on-sale to others	
Spot market	A market administered by VENCorp to facilitate the physical balancing through trading of gas where gas is bought and sold at a variable price	
Take-or-pay	A contractual obligation on the part of the purchaser to pay for a certain quantity irrespective of whether the quantity is used	
Tariff D customer	A customer who consumes more than 10 TJ/year or more than 10 GJ in any hour.  This customer is metered daily	
Tariff V customer	Any customer who is not a tariff D customer.  This customer is not metered daily 	
Transmission	Long haul transportation of gas via high pressure pipelines	
Transmission delivery 
tariff D	A tariff which applies to a transmission withdrawal service to a transmission delivery zone, and comprises a transmission volume tariff component, in $/GJ for GJs of gas withdrawn in the anytime period, and a transmission demand tariff component, in $/GJ for 5 day withdrawal MDQ	
Transmission delivery 
tariff V	A tariff which applies to a transmission withdrawal service and comprises transmission volume tariff components	
Transmission injection tariff	A tariff which applies to a transmission injection service and comprising a transmission demand tariff component in $/GJ for 5 day injection MDQ	
Withdrawal	The physical withdrawal of gas from the gas transmission system 	

Executive summary
1.	Introduction
The Australian Competition & Consumer Commission (Commission) has completed its assessment of the three access arrangements which were submitted to it on 3 November 1997 by the Energy Projects Division of the Victorian Department of Treasury and Finance (EPD).
The Commission’s assessment has been conducted in accordance with the requirements of the Victorian Third Party Access Code for Natural Gas Pipeline Systems.  The Commission notes that the assessment has been undertaken in the context of broader reforms to the gas industry in Victoria and in the Australian economy more generally.  The issues have been many and complex, particularly in view of the market carriage system being introduced in Victoria.
Of all the issues raised during the public consultation process, the rate of return is the issue which has generated the most interest.  In light of significant re-examination of the applicant’s initial proposal and the Draft Decision, the Commission has, while retaining a pre-tax Weighted Average Cost of Capital (WACC) approach, revised its figures, and believes that given:
•	the risk profile of the assets;
•	analysis of financial indicators arising from the Commission’s WACC decision; and 
•	the incentive mechanisms provided for by the access arrangements;
a pre-tax real WACC of 7.75 per cent is appropriate for the first regulatory period.  The Commission calculates this is equivalent to a nominal post-tax return on equity of 13.2 per cent.
In considering the WACC it needs to be recognised that network assets are natural monopolies with the potential, in the absence of regulation, for owners of such assets to earn monopoly profits above what could be expected in a competitive, commercial environment.  A cornerstone of the reform process is that third party access pricing should replicate a competitive market.  The purpose of setting a regulatory rate of return and asset base is to determine appropriate reference tariffs for third party access.  The objective of the regulator in setting the rate of return is to strike a rate that eliminates excessive monopoly profits, but at the same time does not discourage investment.  The regulator is also required to balance the competing interests of the service provider and those of end users.  
Effective regulation is, therefore, that which passes on to final consumers efficiency gains while providing effective incentives to the service provider to maximise efficiency.  The Commission believes that the return on capital arrived at in this Final Decision, when incorporated with the amendments proposed, provides for access arrangements which achieve the broader regulatory objectives of effective regulation.  
Moreover it should be remembered that the rate of return is only one issue and needs to be considered in light of the regulatory framework being introduced.  Other issues such as incentive mechanisms, valuation of assets, depreciation and non-capital costs also impact significantly on the overall returns available to the service provider and final costs to users.
Overall, the Commission believes that the package of reforms initiated by the Victorian government is likely to produce benefits to consumers.  This is due to the greater potential for efficiency benefits in terms of improved utilisation of infrastructure and capital than is allowed for under the current regime and to the improved scope for competitive supply of gas in both upstream and downstream markets.  Efficiency benefits are also expected from greatly improved price transparency in trading of the commodity and the purchase of transmission services that should flow from the reform process and the access arrangements.  
A list of the amendments required to be incorporated in the revised access arrangements in order for the access arrangements to be approved is contained at the back of this Executive Summary.
2.	Background
The proposed access arrangements need to be considered in the broader context of structural and regulatory reforms to the Victorian gas industry initiated by the Victorian Government to foster competition.  Those reforms include the restructuring of the State-owned monopoly into separate transmission, distribution and retailing businesses ahead of their likely privatisation, and the progressive introduction of contestability into the gas market.  
The successful introduction of competitive reforms to the gas industry is seen as vital to providing incentives to participants at all functional operating levels to improve the efficiency of their production, resource allocation and investment decisions, and to minimise costs.  This is also the aim of the process initiated nationally by the Council of Australian Governments (CoAG) in February 1994 to introduce the necessary reforms to develop a framework for ‘free and fair trade in natural gas’.
These benefits will not be limited to the gas industry alone, as gas provides an important input into many Australian industries, influencing their ability to compete both domestically and internationally.  Benefits are likely to be distributed broadly throughout the economy, through lower input costs to Australian industry, lower prices to final customers, and more efficient use of resources.  The Commission appreciates that regulatory and public policy reform of the gas market is vital to Australia’s ability to capitalise upon growing international and domestic demand, and to capture its natural advantage as a low cost energy supplier.
Further, as part of the package of reforms the Victorian Government has introduced a market carriage capacity management system for the transmission pipelines in place of the more traditional contract carriage system (a description of the comparative systems is at section 2.2 of this Final Decision).  Applications for authorisation of the Market System and Operations Rules – which underpin the market carriage system – were lodged with the Commission on 22 December 1997.  The Commission’s Determination of this matter granting authorisation was released on 19 August 1998.
In coming to its Final Decision on the proposed access arrangements the Commission has undertaken an extensive public consultation process.  In addition to the information provided by the applicant, the Commission sought input from a wide range of interested parties and consultants – first in relation to the proposed access arrangements themselves and then in relation to the Commission’s Draft Decision.  The Commission also held public forums in July to discuss its Draft Decision on the proposed access arrangements and authorisation of the market rules.  A one-day conference was devoted solely to discussing rate of return issues.
3.	Broad issues in the final access arrangements assessment
Key aspects of the Commission’s Final Decision are those relating to:
•	the rate of return;
•	incentive mechanisms; and 
•	the initial capital base.
Other important matters are discussed further in the main body of this decision.
3.1	Rate of return
Of all the issues contained in the Commission’s Draft Decision the weighted average cost of capital (WACC) generated the most discussion among interested parties and the service provider.  It is not surprising that the WACC has been so prominent, as it is a critical parameter in determining the service provider’s target revenues and hence reference tariffs for third party access.  In fact, the regulatory rate of return accounts for around half of the regulated target revenue allowed the service provider.
The Commission’s Draft Decision identified a range within which individual parameters, and ultimately the WACC itself, was likely to fall.  A pre-tax real WACC of 7 per cent was put forward in the draft as an appropriate return on the assets under consideration.  
There was a range of responses to the Commission’s release of the 7 per cent figure.  In the main, business users and consumer groups felt that the figure was reasonable, if not a little high given the current investment climate and bond yields.  At the other extreme a number of utilities, private and government owned, and infrastructure investment advisers expressed concern at what they perceived as too low a return.  In addition, potential vendors, such as state governments, also requested the Commission reconsider its decision in light of the potential impact on sales of infrastructure assets.  There was also a number of interested parties which took the view that the methodology employed by the Commission was sound and that the figure of 7 per cent was in the range of an appropriate outcome but towards the lower end of that range.
Those who felt that the figure was too high argued that it should be viewed in conjunction with:
•	the current cost accounting (CCA) capital base adjustment and CPI adjusted price path which effectively inflation-proofs the service provider;
•	the possibility of higher returns than those implied in the regulatory decision due to the incentive mechanisms which allow the service provider to keep rewards from improved efficiency, market growth and managed capital investment strategies to the extent that these may exceed the forecasts implied in the regulated incentive based price levels (see 3.2 of this Executive Summary);
•	the acceptance by the regulator of a Depreciated Optimised Replacement Cost (DORC) for the initial capital base; and
•	the consideration that the Commission is obliged to arrive at a price level that would reflect outcomes likely in a competitive market, even if pre-existing prices contained elements of monopoly rent.
Those who regarded the figure as being too low alleged that it:
•	discouraged future investment, in Victoria and nationally, in natural gas pipeline infrastructure; 
•	discouraged potential purchasers of the existing assets and jeopardised the Victorian Government’s privatisation plans, and 
•	failed to take into account the full range of risks facing a transmission pipeline owner.  
The Commission does consider that the undue emphasis on the real pre-tax return caused some confusion, as many commentators were more familiar with a nominal after-tax return on equity.  For example, many public commentaries suggesting the pre-tax 7 per cent real was too low, did not include any comment on, or reference to, the nominal after-tax return on equity which was implicit in the decision.
The Commission considers it appropriate to reconsider the parameters and risk profile used in its earlier WACC determination taking into account the numerous submissions received on this matter.  In doing so the Commission has determined that a pre-tax real rate of return of 7.75 per cent is appropriate for the assets being assessed (see Table 1 below).  
Table 1:	WACC estimates
CAPM Parameter	TPA Proposal (from original submission)	ACCC Draft Decision	ACCC Final Decision	
Post-Tax Nominal Return on Equity	14.19	11.2	13.2	
Post-Tax Nominal WACC	8.34	6.0	6.9	
Post-Tax Real WACC	5.18	4.2	4.3	
Pre-Tax Nominal WACC	13.02	8.5	10.7	
Pre-Tax Real	9.73	7.0	7.75	
Note: A full discussion of the rate of return is contained in section 3.2 of the Final Decision.

The main factors accounting for the difference between the Commission’s proposed rate of return in its Final and Draft Decisions are:
•	an updating of interest rate assumptions and debt margins; 
•	use of the statutory tax rate; and 
•	re-examination of the risk profile represented in a higher asset beta. 
Regarding interest rates, the Victorian Access Code requires that the rate of return should be commensurate with prevailing conditions in the market for funds and the risk involved in delivering the services.  The original access arrangements submitted by EPD chose a nominal risk free rate of 8 per cent based on a 12 month historical average of the 10 year bond rate, plus a 45 basis points margin.  The Commission argues that this figure is significantly higher than justified in the present low interest rate climate.  In contrast to the applicant, the Commission has calculated a nominal risk free rate of 6 per cent.
In determining the real risk free rate to apply in the CAPM/WACC formulation, the Commission points to the use of indexed bonds as being the most relevant and direct market indicator for real interest rates.  The Commission has taken an eight week average for an equivalent five year bond to arrive at a real interest rate of 3.4 per cent, a slight reduction form its previous figure of 3.66 per cent.  This compares with the applicant’s real risk free interest rate of 4.85 per cent which once again is not supportable in the current climate.  It should be noted that in the proposed CCA framework, the model is relatively insensitive to the term of the bond and to the expected inflation rate used.
In regard to the cost of debt, the Commission has accepted evidence which points to an increase in margins arising from recent upheavals and uncertainty in global markets.  In arriving at a debt margin over the nominal risk free rate of 120 basis points, the Commission has chosen a figure at the higher end of the plausible range, recognising as with the increased beta that there are risks inherent in the industry which may have been unrecognised in the draft decision.
Converting a post-tax return to a real pre-tax return requires an assumption of the way in which tax obligations should be assessed.  The applicant proposed the use of the corporate tax rate.  However, to the extent that the effective tax rate is lower than the corporate rate, use of the corporate rate in the equation will result in an achieved return to the network owner in excess of the regulated rate of return.
The difficulty of estimating an effective tax rate was an issue raised at the public forum.  The Commission acknowledges that its approach in the Draft Decision has limitations as it effectively requires the Commission to estimate the network owner’s long term future tax liabilities (given the long economic life of gas pipelines).  In light of this criticism the Commission has reconsidered this parameter and has decided to adopt the statutory tax rate in place of its previous estimate of the effective tax rate, although it is recognised that both are subject to a level of uncertainty over the longer term.
The profile of the tax payments over the life of the assets gives rise to a deferred tax liability in the early years of the network’s operations which must be paid out of future cash flows.  It needs to be understood that there is an implicit contract inherent in any regulatory regime.  This so-called regulatory contract is based on the rights, responsibilities, understandings and obligations embedded in the particular regulatory arrangements.  It is this implied regulatory contract which determines to a great extent the nature of the on-going relationship between the service provider and the regulator and within which future regulatory decisions will be undertaken.  In agreeing to the use of the statutory tax rate the Commission wishes to emphasise the implications for the regulatory contract.
The presence of these quite significant free cash flows gives rise to higher actual post-tax rates of return than may be supposed under the headline return used in determining the target revenues.  While Australian law and accounting standards determine the extent to which dividends may be paid out to shareholders from certain reserves the service provider is not limited in its investment alternatives in regard to this cash.  Over the life of the asset this post-tax return will be reduced as the tax liability is crystallised and cash has to be appropriated in order for the liability to be satisfied.  It is incumbent on the service provider to manage the assets and the financial affairs of the pipeline in such a manner that these future tax liabilities are taken into account within the regulatory framework and not be considered likely to be reimbursed when payable.  (This issue is discussed further in section 3.5 of this Final Decision.)
The risk that investors may be rewarded with less than the post-tax market cost of capital in later years is inherent to the service provider’s chosen pre-tax WACC model and the use of the statutory lifetime tax profile and will not be compensated for in future regulatory periods when the post tax return falls.
The Commission has decided to use the statutory tax rate as the effective tax rate for the purpose of estimating the cost of capital.  However, for the reasons identified above the Commission approach in dealing with this issue will be considered further in other matters in which this issue may arise, including the forth coming Statement of Regulatory Intent.
Comments on the Commission’s revised WACC
For its Final Decision the Commission also reconsidered its assessment of the risk profile of the transmission business.  
Two types of risk can be distinguished.  The first is market risk – also known as systematic or non-diversifiable risk.  This risk cannot be eliminated by an investor holding a portfolio of stocks.  The second is the risk unique to a firm and can be diversified by an investor holding a portfolio of stocks.  The CAPM approach includes an estimate of market risk, the equity beta, but not of unique risk.  
The perceived omission of an allowance for the unique risk of the network owner was seen by some interested parties as a deficiency in the access arrangements.  It was felt that the target revenue stream proposed by the applicant was that which would be expected to be earned under normal conditions.  Interested parties argued that an allowance for unforeseen events that may curtail supply and result in a temporary loss of revenue to the network owner should be made, a pertinent example being the recent Longford plant explosion.  It was considered that although the probability of such an event occurring may be extremely slight, arguably it should not be ignored and rational investors would take this into account when assessing the required return on their capital investment.  Hence, it has been suggested that the rate of return to the network owner should be increased to compensate for the risk or, alternatively, that insurance costs should be included in the cash flows.
In light of these arguments the Commission has reconsidered the risk profile of the business and reflected this in its consideration of the parameter values.  Moreover, the Commission accepts that the service provider under the regulatory regime proposed for the Victorian gas transmission pipelines may face greater risk than an overseas gas utility governed by rate of return regulation.  The reason for this is the potentially greater volatility of returns associated with the incentive mechanism.
While it is theoretically sound to include these unique risks in the cash flows they are extremely difficult to quantify in any meaningful way.  In reality, while diversifiable and insurable, the risk tends to be self insured in the commercial world and often accounted for through adjustments to the cost of capital.
The presence of this risk supports the view that the cost of capital actually lies at the higher end of the particular risk continuum.  This has been recognised in the Commission’s choice of an asset beta in the upper end of the range as it is largely through the asset beta that risk is recognised and effectively brought into the framework for determining the cost of capital.
However, in considering the revised WACC a number of features of the Victorian transmission system and market design were taken into consideration by the Commission, including:
•	the captive and relatively broad nature of the market acts to limit volume risk over the longer term, although catastrophic risk remains, as evidenced in the recent Longford explosion;
•	the Victorian system is a ‘mature’ pipeline system which allows the adoption of a market carriage model, which generally limits the chance of bypass and stranded asset risk;
•	traditionally pipelines are owned and operated by a single entity.  In the case of Victorian transmission system, the owner (TPA) and operator (VENCorp) are separate entities.  There are provisions throughout the MSOR which limit the liability of VENCorp, its administrative bodies, and their agents and employees for acts and omissions performed in good faith.  This change in structure entails a reduction in the risk profile of TPA when compared with other pipeline systems; and
•	the proposed regulatory framework shields the service provider from inflation risk ‑ which is a major concern for any long term investment, particularly where that investment is based on ‘heavy’ borrowing.  The Victorian arrangements provide for an inflation adjustable regulatory asset base and CPI-X adjustment for tariffs between reviews.
Arguments have been put forward it support a much higher cost of capital on the grounds that the Commission’s cost of capital range may discourage purchasers of network assets, impede new investment and impact negatively on other infrastructure investments in electricity, water, transport etc.  In each case critical elements of the regulatory framework may be different, as well as technology and industry specific risk factors. 
The Commission, as do the National and Victorian Codes, recognises that greenfields investments carry significant market and construction risks which are not inherent in existing assets.  New pipelines in particular will be assessed quite differently in terms of overall risk than the well established Victorian system.  In addition both Codes provide for a tender process whereby a rate of return is determined competitively, automatically taking account of any special risks that may be associated with a ‘greenfields’ project.  
Regarding the argument that the regulated rate of return will discourage purchasers of the network assets, it is interesting to note recent cases of the sale of other infrastructure assets, such as Victorian electricity distributors and the Dampier to Bunbury gas pipeline.  Allgas, Powernet, United Energy and Envestra provide similar examples.  These cases suggest that the purchasers – after taking account of synergies with other segments of their businesses –have been prepared to invest at implied returns which at least in the short term appear to be below those proposed in this Final Decision.  On the basis of market evidence such as this, there is little reason to expect that if the Victorian gas transmission pipeline is sold, the purchase price may not be well in excess of the regulatory value of the capital base.
It is also to be appreciated that the WACC proposed by the Commission relates to a particular class of assets, whose risk profile the Commission has assessed.  The arguments for the proposed WACC are irrelevant for new ‘greenfields’ investment and other infrastructure industries.  Such investments will be considered on their merits and the rate of return will be established in accordance with the associated risks and type of asset.
The revised WACC will result in a reduction in proposed revenue for TPA, which will in turn result in reference tariffs that are on average lower than those proposed by the service provider.  In order to satisfy itself of the continued profitability of the business the Commission examined the financial and business profile of TPA.  This analysis indicates that TPA is financially in a strong position.  
Thus in light of all these factors the Commission is firmly of the view that the 7.75 per cent real pre-tax WACC, which the Commission calculates is equivalent to 13.2 per cent nominal after-tax return on equity, balances the interests of consumers while providing the service provider with appropriate returns, incentives and rewards.
3.2	Incentive regulation
It needs to be appreciated that the Commission is not imposing rate of return regulation on the owners of the Victorian pipelines i.e. a regime in which any profits in excess of the regulated return must be passed onto consumers in the form of lower tariffs and, on the other hand, any increases in unit costs can be passed through to consumers in higher tariffs.  Such a regime does little to encourage efficiency improvements and indeed may encourage inefficiencies in the form of ‘gold-plating’ of assets and reduction in the incentive to grow the business.
The regulatory framework being put in place in the Victorian gas industry is incentive-based regulation that will allow owners to earn potentially higher returns than the regulatory rate of return.  This is fundamental to the Victorian gas access arrangements.  The incentives work in a number of ways:
•	first, the incentives encourage growth in the market.  Any additional revenue earned by the facility owner during the first five years from higher volumes than those forecast will be added straight to the owner’s profit;
•	second, the incentives encourage the service provider to improve efficiency by reducing operating costs.  Again, any difference between actual and forecast costs will flow to the bottom line; and
•	third, the incentives encourage reductions in capital costs.  The access arrangements allow tariffs to be based on forecast capital costs.  In the event that the owner can deliver the same level of service at a lower capital cost than that forecast – dynamic efficiency in other words – the owner will receive the benefit.
All these components of the incentive mechanism mean that the facility owner has the potential to earn a rate of return greater than the regulated rate of return.  Such returns are the result of efficiency improvements, rational investment and market growth and do not impose any additional burden on customers.
3.3	Initial capital base
Target revenue depends not only on the rate of return, but the value of the assets to which the rate of return applies.  DORC represents the upper limit to the value of the initial capital base under the Victorian Access Code, with depreciated actual – or historical – cost (DAC) being the lower limit. 
The Commission accepts that a fair value for the initial capital base is $363 million.  This value is based on a written down value of DORC of $347 million and land, buildings and other assets totalling $16.5 million.
The Victorian Access Code lists several factors that the regulator should consider in determining the value of the initial capital base with the DORC methodology normally providing an upper limit to that valuation.  As the regulator, the Commission is required to take into account the legitimate interests of the owner and the public interest, including economic efficiency, as well as the interests of users.  That there is no economically ‘right’ method to apply to valuation in every circumstance suggests that equity as well as economic considerations are relevant.  
A number of informational shortcomings made a thorough assessment of the historic value of the transmission asset base difficult, particularly because the pipeline services in question were, for the greater part of their existence, part of the integrated business of the Gas and Fuel Corporation of Victoria.
The Commission has settled on a fair value of $363 million as it is considered the most appropriate on this occasion.  The Commission emphasises that this is not an endorsement of the DORC methodology under all circumstances and is not to be taken as a precedent.
4.	Conclusion
The Commission believes that there are a number of outstanding issues relating to the CAPM/WACC framework which need to be widely debated.  To this end the Commission will be using its Statement of Regulatory Intent currently being prepared as one vehicle by which these matters may be raised in the broader commercial community.  
The issues include the problems associated with choosing between effective and statutory tax rates; the conversion issue and implications for the most appropriate WACC and cash flow equivalents; and the validity of the pre-tax model in contrast to a post tax formulation.  These issues are discussed further in the body of this report and its appendices.
The Commission concludes that the proposed rate of return and the required amendments, if implemented, will satisfy the requirements of the Victorian Code and will justify acceptance of the service providers’ access arrangements.
5.	Final Decision
TPA and TPAA’s Access Arrangement for the PTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve TPA and TPAA’s access arrangement for the PTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.
TPA and TPAA’s Access Arrangement for the WTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve TPA and TPAA’s access arrangement for the WTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.
VENCorp’s Access Arrangement for the PTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve VENCorp’s access arrangement for the PTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.
6.	Proposed amendments
2.1	In order for TPA’s Access Arrangements for the PTS and WTS and VENCorp’s Access Arrangement for the PTS to be approved, the following provision must be included in the access arrangements: 
Notwithstanding anything to the contrary contained in this Access Arrangement, no provision in this Access Arrangement deprives any person of a contractual right in existence prior to 3 November 1997 other than an exclusivity right which arose on or after 30 March 1995.	
3.1	In order for TPA’s Access Arrangements for PTS and WTS to be approved, the inflation index referred to throughout the Access Arrangements must be based on the CPI (All Groups - weighted average of eight capital cities).	
3.2	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, the adjustment of the initial capital base valuation for the period 1 July 1997 to 1 January 1998 (or, if appropriate, the commencement of Access Arrangements) must be based on actual changes in the CPI over the period rather than the 3 per cent per annum rate in the proposed Access Arrangements.	

3.3	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, clause 9.2(d) of the Tariff Order must be amended to allow the Commission, at the commencement of the subsequent regulatory period, to review, and if necessary to adjust, the asset base for wholly or partially redundant assets.	
3.4	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved: 
(i)	the WACC estimates and associated parameters forming part of the Access Arrangements should be amended to more accurately reflect the current financial market settings.  In particular, the pre-tax real WACC should be set at 7.75 per cent and the associated inflation assumption set at 2.5 per cent; and 
(ii)	the target revenues and forecast revenues should be based on these new parameters, including the X factor, and applied in the derivation of individual tariffs.	
3.5	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the operational costs component of the target revenues contained in the access arrangements must be reduced by an amount equal to 0.5 per cent per year (cumulative) for years two to five of the initial regulatory period.	
3.6	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the forecast return on working capital, for each year of the initial regulatory period, must be recalculated using the WACC consistent with amendment 3.4.	
3.7	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the return on, and of, TPA’s indirect assets must be apportioned between reference and excluded services on the basis of the forecast revenue for those services or on some other basis agreed with the Commission.	
3.8	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, either: 
(i)	the service envelope agreement must incorporate an obligation on TPA to provide the Corio loop and the Brooklyn compressor upgrade (or equivalent); or 
(ii)	the Corio loop and Brooklyn compressor capital expenditure must be removed from the capital base and the tariff calculations.	
3.9	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must amend the forecast injection at Longford in the tariff model from 970 TJ/day to 990 TJ/day.	
3.10	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the Murray Valley tariff must be calculated using a proportion of yearly costs similar to the proportion of the year for which the pipeline was commissioned.	
3.11	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, clauses 5.2.2(a)(2) and 5.2.3(a)(2) of the MSOR must be amended by inserting the words ‘and the Regulator’ after ‘Participant’.	
3.12	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the price control formula must be amended so that: 
(i)	the average transmission tariff (ATT) calculation and the K factor adjustment use the volumes forecast in the Access Arrangements (rather than those revised forecasts given to the Commission with an application for altered tariffs prior to the start of each new regulatory year); and
(ii)	the MATT allows, for volumes in the previous year resulting from augmentation not forecast in this Access Arrangement, the recovery of revenue based on the relevant zones’ tariffs rather than the MATT for that previous year.	
3.13	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the Tariff Order must be adjusted so that it is clear that clause 9.2(i) does not apply to TPA.	
3.14	In order for VENCorp’s Access Arrangement for the PTS to be approved, clause 2.5 of the MSOR must be amended to the following effect:
(1)	Consultation on proposed market fees:
(i)	VENCorp, before submitting a statement to the Regulator in accordance with clause 6.1(a)(2) of the Tariff Order, must prepare a report setting out:
(a)	for that regulatory year:
-	the budgeted expenditures and revenues; 
-	the services for which a market fee is proposed; and
-	in respect of each service, the proposed market fees;
(b)	how the proposed market fees were derived, including:
-	the method used to determine each fee; and
-	VENCorp’s estimated cost to provide each service;
(c)	other fees in existence which are appropriate for comparison purposes; and
(d)	an assessment of the extent to which the proposed market fees comply with the principles set out in section 8.1 of the Victorian Access Code.
(ii)	A copy of the report must be provided to:
	(a)	the Regulator upon completion of the report; and
	(b)	participants and other interested persons upon request.
(iii)	Interested persons must have at least 10 business days after the release of the report to make submissions to VENCorp.
(iv)	VENCorp must consider any submissions received by the specified date.
(v)	VENCorp must compile a second report which summarises:
	(a)	the consultation process; and
	(b)	any oral or written submissions received by VENCorp. 
(vi)	A copy of the second report must be provided to the Regulator when VENCorp submits its annual statement to the Regulator. 
(2)	Financial Statements:
(i)	Two months after the end of each financial year, VENCorp must publish a report setting out: 
(a)	its budgeted and actual expenditures and revenues for the previous financial year; 
(b)	its budgeted and actual expenditures and revenues for the previous financial year in respect of each of VENCorp’s activities/functions, including:
-	system security; 
-	collection, storage and processing of metering data and billing and settlement of market transactions; 
-	costs of operating the dispute resolution function; and 
-	the funding requirements of the participant compensation fund; and 
(c)	an explanation of any significant variations between budgeted and actual expenditures and revenues.
(ii)	A copy of the report must be provided to:
(a)	the Regulator upon completion of the report; and
(b)	participants and other interested persons upon request.	
3.15	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must develop and include in the Access Arrangements a reference tariff policy as required in section 3.7 of the Victorian Access Code.	
3.16	In order for VENCorp’s Access Arrangement for the PTS to be approved, VENCorp must develop and include in the Access Arrangement a reference tariff policy as required in section 3.7 of the Victorian Access Code.	
4.1	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must clearly specify the terms and conditions of access to the PTS and WTS in a guide for users and in the Access Arrangement.	
4.2	In order for TPA’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect: 
(i)	The references to the pipeline operating agreement (clause 5.4.1(d)), TUoS agreement (clause 5.4.1(e)) and transmission connection agreement (clause 5.4.1(f)) must be deleted.
(ii)	TPA must undertake to make the PTS (including any extensions or expansions that are to be treated as part of the PTS) available to VENCorp in accordance with its obligations under the TPA Service Envelope Agreement.	
4.3	In order for TPA’s Access Arrangement for the WTS to be approved, amendments must be made to the following effect:
(i)	The references to the transmission services agreement (clause 5.4.1(c)) and the transmission connection agreement (clause 5.4.1(d)) must be deleted and replaced by pro-forma agreements attached, as an appendix, to the access arrangement.
(ii)	The pro-forma agreements can only be changed by following the procedure in section 2 of the Victorian Access Code.
(iii)	Any transmission service or connection agreement entered into between TPA and a user or prospective user must be consistent with the pro-forma transmission service or connection agreement (as amended in accordance with section 2 of the Victorian Access Code).	
4.4	In order for TPA’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	Subject to paragraph (ii) below, a reference to the MSOR in the access arrangement is a reference to the MSOR as amended from time to time.
(ii)	In the event that the MSOR becomes subject to an exemption under section 51(1) of the Trade Practices Act 1974 (Cth), any amendment to, or supplementation or replacement of, the MSOR will, to the extent to which the MSOR is part of the access arrangement, constitute a change for the purposes of the Victorian Access Code and will not be effective to change the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.	
4.5	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, amendments must be made to the following effect:
(i)	For the purposes of the access arrangement, a reference to the ‘Tariff Order’ is a reference to the Tariff Order as in force from time to time subject to paragraph (ii) below.
(ii)	Any change to reference tariffs will not be incorporated in the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.
(iii)	If the access arrangement specifies a charge for connection to, and the use of, the transmission pipeline, that is inconsistent with the Tariff Order, then the access arrangement prevails to the extent of the inconsistency.	
4.6	In order for VENCorp’s Access Arrangement for the PTS to be approved, VENCorp must clearly specify the terms and conditions of access to the PTS in a guide for users and in the Access Arrangement.	
4.7	In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	A pro-forma gas transportation agreement must be attached, as an appendix, to the access arrangement.
(ii)	The pro-form gas transportation agreement can only be changed by following the procedure in section 2 of the Victorian Access Code.
(iii)	Any gas transportation agreement entered into between VENCorp and a User must be consistent with the pro-form gas transportation agreement (as amended in accordance with section 2 of the Victorian Access Code).	
4.8	In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	Subject to paragraph (ii) below, a reference to the MSOR in the access arrangement is a reference to the MSOR as amended from time to time.
(ii)	If the MSOR becomes subject to an exemption under section 51(1) of the Trade Practices Act 1974 (Cth), any amendment to, or supplementation or replacement of, the MSOR will constitute a change for the purposes of the Victorian Access Code and will not be effective to change the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.	
4.9	In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	For the purposes of the access arrangement, a reference to the ‘Tariff Order’ is a reference to the Tariff Order as in force from time to time subject to paragraph (ii) below.
(ii)	Any change to reference tariffs will not be incorporated in the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.
(iii)	If the access arrangement specifies a charge for connection to, and the use of, the transmission pipeline, that is inconsistent with the Tariff Order, then the access arrangement prevails to the extent of the inconsistency.	
4.10	In order for VENCorp’s Access Arrangement for the PTS to be approved, the procedures for the initial allocation of authorised MDQ must be attached, as an appendix, to VENCorp’s Access Arrangement.	
4.11	In order for VENCorp’s Access Arrangement for the PTS to be approved, the finalised queuing policy for the PTS must be incorporated in VENCorp’s Access Arrangement.	
4.12	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, amendments to the extensions/expansions policies must be made to the following effect:
Coverage
1.	If the extension or expansion to the PTS/WTS is to come into service on or after the commencement of the access arrangement:
(i)	Prior to the extension or expansion coming into service, the service provider must notify the Commission of the extension or expansion.
(ii)	Subject to paragraph (1)(iii) below, the extension or expansion will automatically be treated as part of the covered pipeline upon the extension or expansion coming into service.
(iii)	An extension will not be treated as part of the covered pipeline through the operation of the extensions/expansions policy if:
(a)	the extension is a ‘significant extension’;
(b)	the service provider elects not to treat the extension as part of the covered pipeline; and
(c)	the service provider notifies the Commission of its election prior to the extension coming into service.
(iv)	A ‘significant extension’ means an extension that:
(a)	is at least 10 kilometres in length; or
(b)	costs at least $5 million.
2.	If the extension or expansion to the PTS/WTS comes into service prior to the commencement of the access arrangement, the extension or expansion is to be treated as part of the covered pipeline upon the commencement of the access arrangement.
Note:	Under paragraph 2 above, the natural gas pipeline, owned by TPA, extending from Barnawatha (Vic) to Culcairn (NSW) is to be treated as part of the PTS upon commencement of the access arrangement.
Effect of extension/expansion on reference tariffs
3.	The extensions/expansions policy, insofar as it specifies how the extension or expansion will affect reference tariffs, must be consistent with Chapter 8 of the Victorian Access Code.  In particular:
(i)	The amount of the cost of the new facility that can be included in the capital base must be determined in accordance with section 8.16 of the Victorian Access Code.
(ii)	The portion of the new facilities investment that cannot be included in the capital base may be:
(a)	included in a speculative investment fund in accordance with section 8.19 of the Victorian Access Code;
(b)	recovered by a capital contribution a user agrees to pay TPA which may be assumed to be a surcharge; and
(c)	recovered by a surcharge approved by the Commission in accordance with section 8.25 of the Victorian Access Code.
Submissions to vary an access arrangement
4.	The treatment of an extension or expansion as part of the PTS/WTS as a consequence of the operation of the extensions/expansions policy is not a change to the access arrangement.
5.	Reference tariffs cannot be changed unless the procedure in section 2 of the Victorian Access Code is followed.
6.	A surcharge is not a change to the access arrangement.  However, in accordance with section 8.25 of the Victorian Access Code, for the purposes of public consultation, a notice to impose a surcharge is to be treated as if it were a proposed revision to the access arrangement submitted under section 2.28.	
4.13	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, the revisions submission date must be amended to 31 March 2002.	
4.14	In order for VENCorp’s Access Arrangement for the PTS to be approved, the revisions submission date must be amended to 31 March 2002.	

1.	Introduction
On 3 November 1997 the Energy Projects Division of the Victorian Department of Treasury and Finance (EPD) submitted proposed access arrangements and access arrangement information for the Victorian natural gas transmission system to the Australian Competition and Consumer Commission (the Commission) for approval under the Victorian Third Party Access Code for Natural Gas Pipeline Systems (the Victorian Access Code).  
The reforms in Victoria are far wider in scope than the introduction of these access arrangements for gas transmission pipelines.  The wider reforms which have occurred or are proposed in Victoria include the introduction of new market arrangements for gas (including a market carriage capacity management system), the restructuring of a vertically integrated State owned business into three gas retailers, three gas distributors, one transmission business and an independent system operator, and the progressive introduction of contestability into the gas market.
The access arrangements describe the policies and basic terms and conditions on which the service providers will make access to the transmission pipelines available to third parties.
Three separate gas transmission access arrangements were submitted by EPD to the Commission for approval on behalf of: 
•	Transmission Pipelines Australia Pty Ltd (TPA) and Transmission Pipelines Australia (Assets) Pty Ltd (TPAA) for the Principal Transmission System (PTS);
•	TPA and TPAA for the Western Transmission System (WTS); and 
•	Victorian Energy Networks Corporation (VENCorp) for the PTS.
In addition, as part of the overall restructuring of the Victorian natural gas industry, VENCorp and Gas Services Business lodged applications for authorisation under Part VII of the Trade Practices Act 1974 with the Commission.  These applications are for authorisation of the proposed Market and System Operations Rules (MSOR) and a generic gas service performance contract respectively.  The Commission’s decisions to approve the applications for authorisation subject to certain conditions being met were issued on 19 August 1998.  An application for review of the MSOR authorisation was lodged at the Australian Competition Tribunal on 9 September 1998.
EPD has lodged access arrangements and access arrangements information relating to the three gas distribution businesses (Westar (Gas) Pty Ltd (Westar), Stratus (Gas) Pty Ltd (Stratus) and Multinet Energy Pty Ltd (Multinet)) with the Victorian Office of the Regulator-General (the ORG).  The ORG’s assessment of the distribution arrangements is also according to the principles set out in the Victorian Access Code.  Where practical, the Commission and the ORG have coordinated their consultation, assessment and approval processes for these arrangements.
The Commission’s assessment of the access arrangements lodged with it has been conducted in accordance with the requirements set out in the Victorian Access Code and has been based on information provided by EPD, consultants and interested parties.  This document sets out the Commission’s final decisions and related amendments under section 2.16 of the Victorian Access Code for TPA’s access arrangements and VENCorp’s access arrangement.
Although the three access arrangements constitute separate applications for approval, the Commission’s final decision on each access arrangement has been reported within a single document.  In view of the degree of commonality between the assessment of TPA’s Access Arrangements for the PTS and WTS, the discussion of the Commission’s final decisions on these access arrangements has been reported collectively, with the exception of those areas in which divergence has necessitated separate considerations.
This introduction: 
•	sets out the ownership and operator structure for the Victorian gas transmission access arrangements; 
•	describes the proposed structure of the Victorian gas industry; 
•	outlines the Commission’s role in assessing and approving access arrangements under the Victorian Access Code; 
•	sets out the Commission’s assessment of the proposed access arrangements; and 
•	outlines the process for submission and approval of revised access arrangements.
The remainder of this Final Decision discusses: 
•	the issues of market carriage, contract carriage and interstate trade (chapter 2);
•	the Commission’s analysis of the determination of reference tariffs (chapter 3);
•	the assessment of the access arrangements in terms of the other mandatory elements in the Victorian Access Code (chapter 4); and
•	chapter 5 sets out the Commission’s final decisions. 
In addition, a number of appendixes are included: 
•	parties consulted by the Commission (appendix A); 
•	submissions received (appendix B); 
•	attachment A of the Victorian Access Code (appendix C); 
•	an explanation of the EPD model (appendix D); and
The Commission has identified amendments to the proposed access arrangements that must be incorporated in the revised access arrangements for them to be approved.  These required amendments are set out in the relevant sections in this document and in the Executive Summary.  
1.1	Structure of the Victorian gas industry
The proposed structure of Victoria’s gas industry is described in the EPD paper, The Gas Market For The Future (November 1997).  Under the proposal, the market will comprise: 
•	the PTS, supplied by the Esso/BHPP joint venture under an agreement negotiated with the Victorian Government, which currently supplies over 98 per cent of the total demand for natural gas in Victoria;
•	the physically separate WTS, which is supplied by Cultus Petroleum;
•	a gas transmission business comprising TPA (the service provider) and TPAA (the asset owner) which together own and maintain the transmission assets and provide gas transmission services;
•	VENCorp, established as a statutory gas company under the Gas Industry Act 1994 (Vic), is to operate the transmission system and administer the arrangements in accordance with the MSOR;
•	three gas distribution companies (Westar, Stratus and Multinet) with associated asset owning companies; and
•	three gas retailers (Kinetik Energy Pty Ltd, Energy 21 Pty Ltd (Energy 21), and Ikon Energy Pty Ltd). 
Under the proposed structure, the natural monopoly components (the transmission and distribution system pipelines) are separated from the contestable component (retail supply).  VENCorp will link several components together by, amongst other things, managing the wholesale market to ensure there is balance between demand and supply of gas.  Esso/BHPP’s position as the sole supplier to the PTS is expected to diminish as supply competition is made possible through the development of the InterConnect linking the NSW and Victorian transmission systems, the linking of the WTS and PTS and the development of the underground storage facility.
The relevant legislation and documents regulating the Victorian gas transmission industry are: 
•	the Gas Industry Act 1994 (as amended);
•	the Victorian Access Code;
•	Orders in Council made pursuant to those Acts, including the Victorian Gas Industry Tariff Order (Tariff Order), made under the Gas Industry Act 1994;
•	licences issued by the ORG pursuant to the Gas Industry Act 1994; and 
•	various rules which the legislation and licences require the licensees to observe.
The Victorian and National Access Codes
The Victorian Government introduced the Victorian Access Code in advance of the National Third Party Access Code for Natural Gas Pipeline Systems (the National Access Code) to expedite the reform process and the associated restructuring of the Victorian natural gas systems at the transmission, distribution and retail levels.  The Victorian Access Code as made by Order in Council, dated 9 December 1997, largely mirrors the National Access Code, which is expected to supersede it.  The Victorian Government has subsequently made a number of change to the Victorian Access Code, some of which further differentiate it from the National Code.  The Commission understands that, while the Victorian Government has the power to make further changes, and that these will bind its decision making under the Victorian Access Code, it is concerned that changes may be inconsistent with the National Access Code. 
Although the National Access Code was agreed to by all Heads of Government on 7 November 1997 as part of the National Gas Pipelines Access Agreement, it will not come into effect in Victoria until its access legislation has been enacted.  The Commission understands that under the agreement Victoria will enact its legislation by the end of December 1998, and within 30 days it will submit its access regime to the National Competition Council (NCC) for certification.  The NCC must then undertake a process involving public consultation which leads to a recommendation to the Commonwealth Treasurer who decides whether or not to certify the regime as effective.  The Victorian Minister may appeal to the Australian Competition Tribunal within 21 days of the Commonwealth Treasurer’s decision.  
The objective of the Victorian Access Code is to establish a framework for third party access to natural gas transmission pipelines that: 
•	facilitates the development and operation of Victorian and national markets for natural gas;
•	prevents abuse of monopoly power;
•	promotes competitive markets for natural gas in which customers may choose suppliers, including producers, retailers and traders;
•	provides rights of access to natural gas pipelines on conditions that are fair and reasonable for both service providers and users; and
•	provides for resolution of disputes.
The owner or operator of a pipeline that is covered under the Victorian Access Code is required to lodge an access arrangement with the relevant regulator.  The access arrangement is similar in many respects to an undertaking under Part IIIA of the Trade Practices Act and is designed to allow the owner or operator of the covered pipeline to develop its own tariffs and other terms and conditions under which access will be made available, subject to the requirements of the Victorian Access Code.
The Victorian Access Code requires that the relevant regulator seeks comments on the access arrangement both before and after it issues a draft decision in which it proposes to approve or not approve the access arrangement.  Where necessary, the relevant regulator may specify amendments which it will require to be made to the access arrangement before it will be approved. Under certain circumstances, the relevant regulator must draft and approve its own access arrangement.
Division 1 of Part 4B of the Gas Industry Act 1994 provides for the establishment of the Victorian Access Code.  Division 4 provides for administrative review of certain regulatory decisions made under the Victorian Access Code.
Important features of the Victorian Access Code are: 
•	coverage - the mechanism by which pipelines (including distribution systems) become subject to the Victorian Access Code; 
•	reliance on an up-front access arrangement outlining services and reference tariffs applicable to a covered pipeline; 
•	pricing principles; 
•	ring fencing requirements; 
•	information disclosure requirements; 
•	binding arbitration where there is a dispute; and
•	specific timelines for all processes. 
The aim of the Victorian Access Code is to provide sufficient prescription so as to reduce substantially the number of likely arbitrations, while providing sufficient flexibility for the parties to negotiate contracts within an appropriate framework. 
Victorian Gas Industry Tariff Order
The Victorian Gas Industry Tariff Order (Tariff Order) is a Victorian Order in Council under the Gas Industry Act 1994 that will regulate the tariffs for certain regulated services provided by TPA, VENCorp, the distributors and the franchise retailers.  Chapter 3 of this Final Decision assesses the proposed transmission reference tariffs for conformity with the requirements of the Victorian Access Code.
The regulated services are referred to as tariffed services and are defined in the Tariff Order in chapter 10.  Chapter 6 of the Tariff Order sets out procedures for changing tariffs and prices, including the requirement for approval by the Commission. 
Chapter 2 regulates the prices of transmission services provided by TPA.  The Tariff Order specifies initial tariffs for these services and the basis for variation of the tariffs over the initial access arrangement period to 31 December 2002.
Chapter 5 regulates the prices of services provided by VENCorp.  The Tariff Order sets out the tariffs for the first year of the access arrangement period while in subsequent years VENCorp’s tariffs must be approved by the Commission.
The Tariff Order also regulates the prices which TPA and VENCorp can charge for some of their regulated services referred to as ‘excluded services’, for which formula based controls are not appropriate.  Initial prices for some excluded services are listed in the Tariff Order.  The Tariff Order otherwise regulates prices for excluded services on the basis that they must be ‘fair and reasonable’ and consistent with the requirements of the Victorian Access Code.  Any services offered which are not tariffed services or excluded services are ‘competitive services’ and these are not regulated by the Tariff Order or the Victorian Access Code.
An important issue for the Commission has been the legal structure of the access arrangements.  The amendments incorporate by reference a number of external regulations, such as the Tariff Order and the MSOR.  Both these instruments can be varied by the Victorian Government outside the operations of the Victorian Access Code.  The  Victorian Access Code allows for the inclusion of external documents in an access arrangement.  However, the Commission is concerned that the use of external documents may create confusion and difficulties in understanding the access arrangements. The Commission is also concerned to ensure that ongoing amendments to external documents do not bring the arrangements into conflict with either this decision or the Victorian Access Code.  In view of these concerns, the Commission has proposed a number of amendments to clarify the role of external documents and to ensure continued compliance with the principles and other criteria set out in the Victorian Access Code.
Access arrangement period and regulatory review
The Tariff Order regulates transmission tariffs and prices for scheduled excluded services for the regulatory period from 11 December 1997 to 31 December 2002.  This timing is consistent with the common revisions commencement date of 1 January 2003 specified in the three proposed access arrangements.  At the end of the access arrangement period the Commission must determine the price control arrangements which will apply to the transmission tariffs for the subsequent access arrangement period of five years.
The Tariff Order provides guidance for the regulator in terms of the regulatory review.  This includes the use of CPI-X price paths and ensuring a fair sharing of efficiency gains between TPA and customers.  The procedures for making the decision to regulate transmission tariffs in the subsequent access arrangement period of five years are set out in clauses 1.6 and 9.2 of the Tariff Order.
Annual tariff reviews
Chapter 6 of the Tariff Order provides that, prior to each year (other than the first year) of the initial five year access arrangement period, TPA must submit its proposed tariffs to the Commission for approval in terms of consistency with the formulae in the Tariff Order.
The TPA price control formula comprises an average revenue control and a tariff rebalancing control which applies a cap to the price movements for each individual tariff.  The X factor proposed for the CPI-X formula for TPA in the initial access arrangement period is 3.4 per cent and the Y factor rebalancing control for TPA is ‑2.4 per cent.  This would result in individual tariff price changes being capped annually at the increase in the Consumer Price Index (CPI) less 2.4 per cent.
As well as prior to the regulatory year, alterations to tariffs may be requested any time during the regulatory year.  In both cases, the Commission has 20 business days in which to respond (or it is taken to have approved the proposed tariff variation).  Chapter 6 of the Tariff Order sets out the rules relating to when approval can and can not be given.  Similarly, the Commission has 20 business days in which to approve or otherwise a proposed new tariff or a proposed closure of a tariff.
1.2	The access arrangements
As stated above, three access arrangements have been lodged with the Commission for approval.  Separate access arrangements have been submitted by TPA for the gas transmission services provided by the PTS and WTS as these are currently physically separate pipelines which operate under different capacity management systems, and so require individual access arrangements. 
The VENCorp access arrangement relates to VENCorp’s role as independent system operator of the PTS in which it has responsibility for the transmission control, market management and liquefied natural gas (LNG) system security functions under a market carriage capacity management system.  In contrast, the WTS will be operated as a contract carriage pipeline and as such VENCorp’s role will be confined to transmission control.  It is proposed that should the WTS become physically connected with the PTS in the future, the WTS will be designated as a market carriage pipeline and the WTS access arrangement be amended accordingly.  
Section 2 of the Victorian Access Code specifies that the service provider is required to establish an access arrangement and submit it to the regulator for approval.  The service provider is defined as ‘a person who owns (whether legally or equitably) or operates the whole or any part of a pipeline’.   
Although TPAA as the pipeline owner and VENCorp as the pipeline operator are both service providers as defined under the Victorian Access Code, neither TPA nor TPAA will directly provide services to users or prospective users.  Under the proposed arrangements, TPAA will lease its pipeline assets to TPA and TPA will make tariffed transmission services available to VENCorp as user of the PTS under the Service Envelope Agreement.  VENCorp will then provide services to other users of the PTS in accordance with the MSOR.  Users will be required to enter into a Gas Transportation Deed with VENCorp, under which they will agree to pay certain market fees to VENCorp.  VENCorp will then direct them to pay the transmission charges (charged by TPA to VENCorp) directly to TPA in return for the services performed by VENCorp for the users.  From a practical perspective, VENCorp may be considered to be the real service provider.  
Section 9.2 of the Victorian Access Code provides that where there is more than one service provider in relation to a covered pipeline, one being the owner and another the operator, responsibility for complying with the Victorian Access Code is allocated among them by their access arrangements, or their access arrangement information.  Accordingly, each service provider is responsible only for complying with the obligations allocated to it.
The Commission notes that the TPA and VENCorp access arrangements appear ambiguous with respect to some aspects of the allocation of the service providers’ respective responsibilities.  The Commission has taken this factor into account when considering comments from interested parties.  The Commission has proposed a number of amendments to the access arrangements to more clearly specify the terms and conditions of access.
1.3	The Commission’s assessment of the access arrangements
Under section 2.24 of the Victorian Access Code the Commission may approve a proposed access arrangement only if it is satisfied that it contains the required elements and satisfies the principles set out in sections 3.1 to 3.22 of the Victorian Access Code.  An access arrangement cannot be opposed on the sole basis that it does not address a matter which is not required under section 3 of the Victorian Access Code.
The minimum elements required in an access arrangement are set out in section 2 of the Victorian Access Code.  In combination, these elements aim to ensure that users and prospective users are able to gain access to the services offered by the service provider, consistent with the Competition Principles Agreement signed by the Council of Australian Governments (CoAG) on 11 April 1995.  The Commission’s assessment of the minimum elements of the access arrangements is discussed in chapters 3 and 4 of this Final Decision.  This Final Decision does not examine other obligations on the service providers under the Victorian Access Code which are not germane to the current assessment.  These include requirements relating to ring fencing arrangements, approval of affiliate contracts and dispute resolution.  The Commission will monitor compliance with these provisions as appropriate once the access arrangements come into effect.  
The reference tariff principles in section 8 of the Victorian Access Code are discussed in chapter 3 of this Final Decision.  These principles balance the requirement that a service provider can earn a commercial rate of return on its assets while providing access to its services, with the need to provide the right efficiency based incentives so that service providers are encouraged to pursue productivity gains, and that the benefits gained are shared with consumers.
Submissions and consultations
On 3 November 1997 the EPD submitted the proposed access arrangements to the Commission for approval.  The Commission has since consulted widely with interested parties and experts throughout its assessment of the access arrangements, leading to these final decisions.  This process has included: 
•	The Commission began consulting with interested parties prior to releasing its Issues Paper in December 1997.  The Commission subsequently received written submissions from 28 interested parties regarding the proposed access arrangements. 
•	In response to concerns raised about the novelty of the proposed market carriage model (for the PTS) and the complexity of the overall reform package, the EPD provided additional submissions and additional access arrangement information in March 1998.  In light of this additional material, the Commission invited further submissions from interested parties and extended the deadline for assessment of the proposed arrangements. 
•	On 28 May 1998 the Commission issued its Draft Decision under section 2.13(b) of the Victorian Access Code in which  it proposed not to approve each of the three access arrangements in their then current form, and identified amendments it proposed be made in order for the access arrangements to be approved.  The Commission invited submissions from interested parties on the draft decisions (up until 17 June 1998). 
•	The Commission held a public forum in Melbourne (with a video link to Sydney) on 3 July 1998 (in conjunction with the ORG) on issues related to the weighted average cost of capital (WACC) and a second on 7 July 1998 on other issues relating to the draft decisions.  The Commission invited further submissions from interested parties, and extended the period for receipt of written submissions until 21 July 1998.  The Commission also extended the deadline for assessment of the proposed arrangements to 2 September 1998, and later to 2 November 1998. 
•	The Commission has received 71 written submissions regarding the Draft Decision from 49 interested parties. 
•	The Commission has received 10 written submissions from EPD regarding the Draft Decision, the forums and issues raised by other parties. 
Final decisions
EPD has chosen not to submit revised access arrangements for approval by the Commission (under s 2.16(c) of the Victorian Access Code) prior to release of its final decisions.  EPD has instead indicated its intention to respond to the Commission’s anticipated section 2.16(b) final decisions by then submitting revised access arrangements incorporating all required amendments by the specified date.  Since publication of its Draft Decision, the Commission has liaised with EPD in developing revised access arrangements that should satisfactorily incorporate the amendments required by the Commission’s final decisions.
The Commission has now assessed the three access arrangements in terms of the requirements of the Victorian Access Code, taking into consideration all submissions received and other information available to it.  Pursuant to section 2.16(b) of the Victorian Access Code:
•	the Commission’s final decision in each case is to not approve the access arrangement as proposed; 
•	this document provides the reasons for these decisions and states the amendments (or nature of the amendments) which would have to be made to the access arrangements in order for the Commission to approve them; and
•	the date by which revised access arrangements must be submitted is 2 November 1998.
The Commission must issue a ‘further final decision’ (under section 2.19 of the Victorian Access Code) that it approves a revised access arrangement provided that the revised access arrangement is submitted by the specified date, and that the Commission is satisfied it incorporates the amendments it specified when setting out its ‘first final decision’ (under section 2.16(b)).
If the service provider does not submit a revised access arrangement by the required date, or submits a revised access arrangement which the Commission is not satisfied incorporates amendments it specified in the final decision, the Commission must draft and approve its own access arrangement (section 2.20(a) of the Victorian Access Code).  Such a decision is subject to merits review under the Gas Industry Act 1994.
The proposed date of release of the Commission’s final decision on the revised access arrangements, pursuant to section 2.19 of the Victorian Access Code (should the Commission decide to approve the arrangements), is 2 November 1998.  The date of effect for the access arrangements will be subject to the outcome of this decision and will be notified to interested parties.

2.	Broad issues
2.1	Introduction
This chapter examines a number of broad issues that have been raised by interested parties which they consider are grounds for the Commission to not approve the proposed access arrangements.  They are: the adoption of the market carriage capacity management system, and the related issue of the potential impact of the proposed arrangements on interstate trade; and whether any provisions of the access arrangements would deprive a person of prior contractual rights.
2.2	Market carriage and interstate trade
This section provides an assessment, in terms of the guiding principles and other criteria of the Victorian Access Code, of the market carriage model proposed by EPD.  It also notes issues raised by interested parties regarding the choice by EPD of a market carriage model in preference to a more traditional contract carriage market.  Primarily these issues relate to:
•	the adequacy or otherwise of services and policies that are being offered by the service provider under a market carriage model; and 
•	the impact of the adoption of the proposed arrangements on interstate trade.
Table 2.1 below highlights the primary differences between the contract carriage and market carriage models as defined in the Victorian Access Code.  
Table 2.1:  Distinction between contract carriage and market carriage
Contract Carriage	Market Carriage	
•	the service provider normally manages its ability to provide services primarily by requiring users to use no more than the quantity of service specified in a contract;	•	the service provider does not normally manage its ability to provide services primarily by requiring users to use no more than the quantity of service specified in a contract;	
•	users normally are required to enter into a contract that specifies a quantity of service;	•	users are normally not required to enter a contract that specifies a quantity of service;	
•	charges for use of a service normally are based at least in part upon the quantity of service specified in a contract; and	•	charges for use of services are normally based on actual usage of services; and	
•	a user normally has the right to trade its right to obtain a service to another user.	•	a user normally does not have a right to trade its right to obtain a service to another user.	
Source:	Victorian Access Code, section 9.9.
From the above definition it is obvious that market carriage can be practically implemented in a number of ways.  The Victorian market carriage model therefore represents an interpretation of the above definition.  
EPD has summarised the Victorian market carriage approach to transportation capacity as follows:
•	VENCorp and TPA will enter into and maintain a service envelope agreement (SEA), which defines the level of transportation capacity to be provided by TPA under its Access arrangement.  This will need to meet the requirements of the existing authorised large customers, plus anticipated load growth amongst small (tariff V) customers;
•	small (tariff V) customers will receive a authorised maximum daily quantity of gas (MDQ) for whatever they actually use, and prior to commencement of the spot market, there will be an initial allocation of authorised MDQ to existing large (tariff D) customers;
•	where a party subsequently negotiates with and pays TPA to augment the pipeline, it will receive an additional MDQ authorisation commensurate with the agreed increase in the service envelope attributable to that augmentation;
•	where transmission constraints give rise to ancillary payments being made, uplift charges are allocated in such a way as to penalise those parties who have contributed to the cause of those constraints (for example, using gas in excess of their authorised MDQ) - this being the mechanism by which the market carriage model provides the holders of authorised MDQ with financially firm transportation rights; and
•	if a transmission constraint is sufficiently serious to result in a requirement for the interruption of gas supplies, then wherever practicable, VENCorp will seek to curtail customers using gas without, or above, their authorised MDQ before curtailing authorised customers - providing such authorised gas users with physically firm rights.
EPD contends that market carriage facilitates operation of the pool and helps promote retail competition.
2.2.1	Services and policies under each model
Victorian Access Code requirements
Section 3.10 of the Victorian Access Code requires that an access arrangement must include a statement that the covered pipeline is either a contract carriage pipeline or a market carriage pipeline.  This election in turn determines the types of services offered and policies necessary to meet the requirements of the Victorian Access Code.
The regulator may not oppose an access arrangement solely because the service provider proposes to offer a market carriage regime.  The regulator is bound by section 2.24 to approve or not approve an access arrangement according to whether the regulator is satisfied that the access arrangement contains the elements and satisfies the principles set out in sections 3.1 to 3.22.  Section 2.24 specifies the factors that the regulator must take into account in making its decision.
Key issues raised by interested parties
Comments from interested parties ranged between preference for market carriage (Ecogen Energy and Texas Utilities Australia Pty Ltd (Texas Utilities)) and advocacy of the contract carriage model (BHP Petroleum Pty Ltd (BHPP), Esso Australia Resources Ltd (Esso), Business Council of Australia (BCA), and Energy Action Group (EAG)).  Other interested parties are broadly in support of the market carriage model although they have concerns over some elements. 
Ecogen Energy (Ecogen) considers that entry and exit by participants is far easier with market carriage, and that contract carriage tends to support the status quo by locking-in participants through long-term contractual arrangements.  Texas Utilities expects that the market carriage system with its proposed allocation of authorised MDQ will provide retailers and customers with a degree of certainty of access to transmission services similar to that which would be expected under a contract carriage system. 
Opponents of the proposed model have expressed concern at what they see as novel, untried and complex market arrangements, in particular the market carriage capacity management system.  For example, EAG states that the proposed market carriage model and the wholesale gas market structures have not been tried in this format in any other gas markets and the concepts have been developed largely on the basis of theoretical economic modelling.  It has also been argued that features of the proposed arrangement are inconsistent with the traditional model used elsewhere, and with the principles of the National Access Code.  Many parties expressed concern about rights to transportation capacity under the proposal, including whether individual users would see their rights diminish.
A number of parties have argued that the requirements of the Victorian Access Code are not met because the services policy does not include provision for specific services (such as firmness of service and capacity trading) which they submit are required by a major segment of the market.  While clearly preferring contract carriage, BHPP proposed that an alternative hybrid model might form an acceptable compromise.
In response to the Commission’s Draft Decision which concluded that the proposed market carriage system is consistent with the Victorian Access Code, BHPP has restated its view that the access arrangements do not comply with Victorian Access Code requirements, in particular section 3.8 concerning the adequate specification of services.  BHPP also submits that there are sufficient grounds for the Commission to compel the service provider ‘ ... under section 3.5(b) to provide firm service at a predefined price’.
Commission’s assessment
The Commission understands that it cannot oppose an access arrangement solely on the basis that a market carriage model is proposed, but must assess the proposal in terms of section 2.24 of the Victorian Access Code.  The Commission’s assessment of issues raised in relation to the proposed market carriage model is provided as part of its assessment of the individual mandatory elements of the access arrangements for the PTS under chapters 3 and 4 of this Final Decision (refer in particular sections 3.10 (Reference tariffs), 4.2 (Services policy), 4.3 (Terms and conditions) and 4.4 (Capacity management policy).  In summary, the Commission notes that:
•	the Victorian Access Code requires that a covered pipeline be either a contract carriage pipeline or a market carriage pipeline (see section 4.4);
•	EPD has argued that a hybrid model (which permits for the simultaneous operation of a contract carriage system and a market carriage system) would be impractical and might disadvantage certain market participants (see section 4.2); 
•	the choice of market carriage over contract carriage has implications for the type of services offered to users and prospective users (see Table 2.1), with some parties arguing that market carriage does not provide the firmness of service they require.  Of particular concern is the charging of uplift payments and the potential volatility this creates in the total charges paid by users;
•	retailers and potential retailers are likely to seek market carriage services because these services permit access to the network without the rigidity associated with traditional take-or-pay contracts (see section 4.2).  This is particularly important as retailers’ customer bases become less certain through contestability and because of the existing full allocation of PTS capacity;
•	the Ernst & Young report to VENCorp on the initial allocation of MDQ and the public process undertaken by VENCorp have allayed the majority of concerns raised concerning the charging of uplift payments, and the potential volatility this creates in the total charges paid by users (see section 4.3); and
•	users who do not wish to manage the risk associated with the spot market and uplift payments may contract with retailers (or brokers) who will bear the risk on their behalf.  The Commission anticipates that only a few end users will negotiate directly with the service provider with most entering contracts with retailers. 
The Commission has examined issues raised in submissions and understands the concerns raised.  The Commission accepts that the concepts and processes developed may be novel and complex to those newly exposed to them.  However, experience in the electricity market has shown that market participants quickly become familiar with operating in a new environment.
2.2.2	Interstate trade
In the context of assessing the proposed arrangements a fundamental issue in relation to interstate trade is the compatibility of trading arrangements between States – the application of market carriage in Victoria and a contract carriage system in NSW.
A number of interested parties submit that where a pipeline system based on market carriage in one State links with one based on contract carriage in another State it is likely that incompatibilities between the two systems will inhibit interstate trade in gas.  It is also claimed by some interested parties that this is inconsistent with the Competition Principles Agreement signed by CoAG for free and fair trade in gas and the development of an integrated gas market in south eastern Australia.
A further matter raised in submissions is the pricing of transport services for the InterConnect linking the NSW and Victorian transmission systems.  The InterConnect was commissioned on 12 August 1998 and links the existing East Australian Pipeline Ltd (EAPL) system at Wagga Wagga to TPA’s system.  Some submissions expressed concern that TPA’s segment of the InterConnect is not currently covered under either the Victorian Access Code or the National Access Code.
2.2.3	Compatibility of trading arrangements between States
Service provider’s proposal
EPD submits that the proposed market carriage model will not be a barrier to interstate trade.  In response to concerns raised by interested parties, in particular BHPP, it states:
The Access Arrangement guarantees that BHP (or any other party) can inject gas at Longford and withdraw gas from anywhere in the system, including at the interconnection with NSW, even on critical days.  To obtain this physically-firm service, BHP pays the required transmission charges (which it can contract with TPA for on a long term basis); cashes out its imbalances each month, and pays its share of the uplift that assures that gas will be physically available to those willing to pay for it.  If BHP ensures that its customers remain within their authorised MDQ then BHP will not pay a significant share of the uplift (where the total uplift is already expected to be insignificant as these will be met largely by unauthorised users).  If BHP does not wish to manage these risks it will be able to contract with competing middlemen (retailers or brokers) who will deal with these arrangements and take the risk of spot imbalances and occasional uplift payments on its behalf.
EPD states that volatility in uplift charges will rarely occur as the system becomes constrained in the short term only on two or three days per year.  The cost is likely to be in the order of only $100 000 per day across the entire market, and such risk could be insured against.  TPA will establish a subsidiary to provide risk management in the short term until congestion pricing and transmission rights are in place.  
Most of the likely gas flows from NSW into Victoria would be at peak times to meet gas demand in northern Victoria.  While this trade presents the shipper with the problem that the timing of the peaks is uncertain, EPD notes that this problem would also exist in a contract carriage system where penalties would exist for failure to ship or if parties exceed their MDQ.  The EAPL system has larger spare capacity and greater linepack flexibility than the PTS which EPD states should mean more stable spot prices.
Key issues raised by interested parties
A number of interested parties expressed concerns in their submissions that the proposed market carriage system would inhibit trade with States or Territories operating on a contract carriage system, and so lessen the prospect of effective interstate competition.  BHPP suggested that resultant incompatibilities would be less likely to inhibit inflows to Victoria than outflows.  In addition, it was submitted that uplift payments due to congestion on the PTS would lead to volatile tariffs which were seen as likely to impede trade.
Conversely, Texas Utilities considers that interstate trade will not be affected by the adoption of the market carriage system in Victoria:
Experience in the United States indicates that it is possible for market participants operating under different regulatory scenarios to negotiate access to adjoining systems in spite of those regulatory models.
BHPP has raised concerns in response to the Commission’s Draft Decision relating to both the availability of hedges against uplift charges and the existence and operation of administrative procedures by EAPL and VENCorp to ensure the removal of barriers to interstate trade.
Commission’s assessment 
The Commission firmly believes that interconnection of the south east Australian gas market is vital to creating competition upstream and in order to deliver benefits to consumers in terms of lower prices.  Interconnection can also enhance security of supply.  The Victorian arrangements are designed to cater for multiple injection points, and the development of alternative sources of supply will be important if the Victorian Government’s forecast that demand will exceed supply in the next few years proves correct.
The Commission has considered issues raised by interested parties in submissions, including BHPP’s concerns that interstate trade (in particular, gas sales out of Victoria) could be hampered, and also concerns relating to the availability of hedges against uplift charges and the existence and operation of administrative procedures by EAPL and VENCorp.
The Commission notes that the InterConnect was commissioned on 12 August 1998 and that it may take some time for various arrangements and facilities to be developed.  The implementation of administrative procedures designed to ensure efficiency and commercial viability of interstate trade arrangements is in the interests of VENCorp and EAPL.
The Access arrangements provide for 5 PJ per year of gas to be guaranteed as firm service because TPA will establish a subsidiary to provide risk management.  TPA has requested MDQ to cover this 5 PJ in order to cover its financial exposure to uplift payments.  
The Commission noted in its Determination on the MSOR that even though there is a common gas transportation model in North America, the details of carriage on each pipeline are different, but this has not stopped gas markets from developing.  Hence, the Commission considers that interstate trade will not be adversely affected by the different market systems in Victoria and other States.
2.2.4	Pricing and the InterConnect
Service provider’s proposal
EPD did not include the InterConnect in the proposed Access arrangements.  EPD contended that the InterConnect would not have natural monopoly characteristics since it would be subject to significant competition, and so it should not be a covered pipeline.
Following the Commission’s Draft Decision, which noted the importance of effective access to the InterConnect, EPD has advised the Commission that it proposes to include the InterConnect in the PTS access arrangements.  This will be achieved soon after the access arrangements come into effect through TPA’s extensions/expansions policy for the PTS (see also section 4.7 for further discussion).
Key issues raised by interested parties
The Australian Gas Light Company (AGL), Santos Ltd (Santos) and EAPL expressed concern that the InterConnect was not proposed to be covered under the National Access Code or the Victorian Access Code.  They consider that as InterConnect tariffs are critical for interstate trade growth, it is vital that the issue of pricing be resolved as soon as possible.  In addition, AGL and EAPL expressed concern that the InterConnect would be priced incrementally and that this would pose a barrier to interstate trade.
Subsequent to the release of the Commission’s Draft Decision, a number of parties have expressed concerns relating to amendments proposed to ensure coverage of the InterConnect (refer section 4.7 of this document).
Commission’s assessment 
As noted earlier, the Commission is of the view that interconnection of the south east Australian gas market is vital to creating competition upstream and in order to deliver benefits to consumers in terms of lower prices.  However, the Commission has noted the concerns of parties relating to the amendments proposed in its Draft Decision.  These concerns have been addressed in section 4.7 of this Final Decision.
EPD has advised the Commission that, once the access arrangements come into effect, TPA will submit proposed revisions to its PTS access arrangement under section 2.28 of the Victorian Access Code in order to include the InterConnect in the access arrangement under its extensions/expansions policy.
Chapter 2 of the Victorian Access Code sets out the procedures the Commission must follow when assessing proposed revisions to an access arrangement.  A full public consultation process is required to be undertaken when the proposed changes are material.  This provision would allow interested parties the opportunity to present analysis and argument on matters such as InterConnect pricing to be taken into account in the Commission’s assessment.  This assessment would be carried out in terms of the requirements of the Victorian Access Code and TPA’s extensions/expansions policy.
2.2.5	Overall assessment
While there has been considerable debate on the merits of Victoria’s proposed market carriage model in comparison to the standard contract carriage model, the Commission’s role is not to rule in favour of one model over the other, or to demonstrate that one model is superior to an alternative regime.  Rather than adjudicate between models as some interested parties have suggested, the role of the Commission is to assess the proposed Access arrangements in terms of the criteria set out in the Victorian Access Code as described in chapter 1 of this Final Decision.
The Commission’s assessment is that the Victorian market carriage model is consistent with the Victorian Access Code’s guiding principles and criteria.  It also considers that interstate trade is unlikely to be adversely affected by the different systems in Victoria and other States. 
2.3	Existing contractual rights
Victorian Access Code requirements
Section 2.25 of the Victorian Access Code provides: 
The Relevant Regulator must not approve an Access Arrangement ... any provision of which would, if applied, deprive any person of a contractual right in existence prior to the date the proposed Access Arrangement was submitted ... .
Service providers’ proposal
Clause 4 in the access arrangements proposed by TPA for the PTS and WTS and by VENCorp for the PTS states: ‘No provision in this Access Arrangement deprives any person of a contractual right which was in existence prior to the date on which this Access Arrangement is submitted to the Regulator’. 
Key issues raised by interested parties
BHPP, in its submission of 12 January 1998, stated that BHPP/Esso have existing contractual rights under several agreements and that it was not clear how the proposals accommodated these rights.  BHPP subsequently identified, in confidential submissions, provisions of the MSOR that it considered would deprive BHPP/Esso of pre-existing rights under its contract with GASCOR (the Gas Sales Agreement (GSA)).
EPD, in response to BHPP’s submissions, stated, in confidential submissions, that there was no contractual override of the GSA by the MSOR. 
Commission’s assessment
The Commission considers that the proposed access arrangements, when applied, will not breach section 2.25 of the Victorian Access Code.  
The MSOR forms part of the access arrangements proposed for the PTS.  However, if the MSOR is inconsistent with BHPP/Esso’s contractual rights, then these rights would be varied or terminated upon the MSOR being established by order of the Victorian Governor in Council under subsection 48N(1) of the Gas Industry Act 1994 (Victoria).  Consequently, the operation of the access arrangements for the PTS could not be said to deprive BHPP/Esso of any contractual rights.  
Nevertheless, the Commission notes EPD’s assurance that there is no contractual override of the GSA by the MSOR and EPD’s commitment to discuss this matter further with both BHPP and the Commission, particularly the issue of whether the MSOR should include a general savings clause.  
In addition, the Commission requires the following amendment to be made to the access arrangements.  
Amendment 2.1
In order for TPA’s Access Arrangements for the PTS and WTS and VENCorp’s Access Arrangement for the PTS to be approved, the following provision must be included in the access arrangements: 
Notwithstanding anything to the contrary contained in this Access Arrangement, no provision in this Access Arrangement deprives any person of a contractual right in existence prior to 3 November 1997 other than an exclusivity right which arose on or after 30 March 1995. 

3.	Reference tariffs
Introduction
The Victorian Access Code specifies a set of Mandatory Elements with which an access arrangement must comply.  
In addition to the respective access arrangements and access arrangement information, EPD has provided the Commission with several spreadsheet files which contain the model for construction of individual tariffs from forecasts of cost data.
Structure
This chapter assesses compliance of the proposed reference tariffs for the three access arrangements (where applicable) using the structure below, taking into account specific requirements of the Victorian Access Code, proposals by the service providers, and submissions from interested parties under the following headings:
3.1	Overall reference tariff methodology
3.2	The initial capital base
3.3	New facilities investment and capital redundancy
3.4	Depreciation and inflation indexation of the asset base
3.5	Rate of return
3.6	Operations and maintenance costs and working capital
3.7	Forecast revenue
3.8	Cost allocation and tariff setting
3.9	Tariff path and incentive structure
3.10	Assessment of reference tariffs and reference tariff policy.
Section 3.1 is introductory and covers both TPA and VENCorp.  Sections 3.2 - 3.6 will discuss the TPA access arrangements only.  As VENCorp is a not-for-profit organisation with minimal assets which does not require a return on assets, consideration of the issues in these sections are largely irrelevant.  Discussion of all VENCorp’s costs will occur in section 3.7.  Thus, sections 3.7 - 3.10 will be divided into an assessment of the TPA access arrangements and the VENCorp access arrangement. 
3.1	Overall reference tariff methodology
3.1.1	Victorian Access Code requirements
Section 8 of the Victorian Access Code establishes the principles which must be followed in the establishment of reference tariffs.  The reference tariff policy and all reference tariffs should be designed to achieve the following objectives (section 8.1 of the Victorian Access Code):
(a)	providing the service provider with the opportunity to earn a stream of revenue that recovers the efficient costs of delivering the reference service over the expected life of the assets used in delivering that service;
(b)	replicating the outcome of a competitive market;
(c)	ensuring the safe and reliable operation of the pipeline;
(d)	not distorting investment decisions in pipeline transportation systems or in upstream and downstream industries;
(e)	efficiency in the level and structure of the reference tariff; and
(f)	providing an incentive to the service provider to reduce costs and to develop the market for reference services and other services.
To the extent that there may be conflict between the application of these objectives, the Commission has the responsibility to determine how they may be best reconciled.  In addition, there are a number of matters on which the Commission must be satisfied before it can approve a reference tariff (section 8.2), including:
(a)	the revenue to be generated from the sales (or forecast sales) of all services over the access arrangement period (the Total Revenue) should be established consistently with the principles and according to one of the methodologies contained in this section 8;
(b)	to the extent that the covered pipeline is used to provide a number of services, that portion of total revenue that a reference tariff is designed to recover (which may be based upon forecasts) is calculated consistently with the principles contained in this section 8;
(c) 	a reference tariff (which may be based upon forecasts) is designed so that the portion of total revenue to be recovered from a reference service (referred to in paragraph (b)) is recovered from the users of that reference service consistently with the principles contained in this section 8;
(d)	incentive mechanisms are incorporated into the reference tariff wherever the relevant regulator considers appropriate and such incentive mechanisms are consistent with the principles contained in this section 8; and
(e)	any forecasts required in setting the reference tariff represent best estimates arrived at on a reasonable basis.
These factors are mandatory requirements on the Commission.  In addition, the Victorian Access Code specifies principles and requirements for each of these factors which are a mixture of mandatory requirements on the Commission and principles which provide the Commission with different levels of discretion.  Furthermore, the Victorian Access Code provides the Commission with a limited ability to approve ‘principles’ (fixed principles) in an access arrangement that will constrain its decisions at future reviews.  The Victorian Access Code, however, only permits fixed principles to be included if they meet certain principles in section 8.48 in the code.
Nevertheless, within these parameters, the reference tariff principles are designed to provide sufficient flexibility so that the reference tariff policy can be designed to meet the specific needs of each pipeline system.  The overarching requirement is that when reference tariffs are determined and reviewed, they should be based on the efficient cost (or anticipated efficient cost) of providing the reference services. 
The principles also require that, where appropriate, reference tariffs be designed to provide the service provider with the ability to earn greater profits (or less profits) than anticipated between reviews if it outperforms (or under-performs) against the benchmarks that were adopted in setting the reference tariffs.  The intention is that, to the extent possible, service providers be given a market-based incentive to improve efficiency and to promote efficient growth of the gas market (an incentive mechanism).
Section 8 of the Victorian Access Code provides extensive guidance on the methodology to be used in establishing reference tariffs and their adjustment over time.  Reference will be made to the relevant parts of section 8, where appropriate in the following sections, when considering the basis for the reference tariffs proposed in the access arrangements.
Reference tariffs are to be set on the basis that sales of all services provided by the service provider (or are forecast to deliver) a certain amount of revenue (total revenue) over the period for which the reference tariffs remain in effect (the reference tariff period).
The reference tariff principles of the Victorian Access Code (section 8.4) permit a choice of three methodologies for determining the total revenue:
•	Cost of service: where the total revenue is set to recover ‘costs’ with those costs to be calculated on the basis of a return (rate of return) on the value of the assets that form the covered pipeline (capital base), depreciation on the capital base (depreciation) and the operating, maintenance and other non-capital costs (non-capital costs) incurred in delivering all services.
•	IRR: where the total revenue is set to provide an acceptable internal rate of return (IRR) for the covered pipeline on the basis of forecast costs and sales.
•	NPV: where the total revenue is set to deliver a net present value (NPV) for the covered pipeline (on the basis of forecast costs and sales) equal to zero, using an acceptable discount rate.
While these methodologies are different ways of assessing the total revenue, their outcomes should be consistent (for example, it is possible to express any NPV calculation in terms of a cost of service calculation by the choice of an appropriate depreciation schedule).  In addition (section 8.5), other methodologies that can be translated into one of these forms are acceptable (such as a method that provides a real rate of return on an inflation-indexed capital base).  The possibility of combining a ‘price-path’ approach with cost of service based on forecast costs is also noted.
3.1.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA has provided access arrangements which specify initial tariffs for the tariffed transmission services and initial prices for scheduled excluded transmission services.  It specifies the principles, procedures and formulae for altering these tariffs and prices, closing services and introducing new services.  It also provides guidance for the Commission’s assessment of price determinations for the subsequent regulatory period. 
TPA has adopted the cost of service model (allowed for in section 8.3(b) of the Victorian Access Code) with a three stage approach (Access Arrangement Information section 1.6) to establish reference tariffs for the initial regulatory period covering the period from 1 December 1997 to 30 December 2002.  This model includes the following steps: 
Step 1: Set target revenue
A target revenue figure is calculated for each year of the initial regulatory period.  These are based on forecasts of costs comprising a nominated return on capital invested, depreciation of the capital base, operation and maintenance expenses.  Proposed capital investments are also integrated into these forecasts.
Further analysis of the methodologies involved in developing target revenues are considered below.  The Depreciated Optimised Replacement Cost (DORC) methodology applied to existing assets is used to establish the initial capital base.  These estimates and the approach used are discussed in section 3.2  of this Final Decision.  Changes to the regulatory capital base over time are considered in sections 3.3  (New facilities investment and capital redundancy) and 3.4  (Depreciation and inflation) below.  The proposed rate of return or WACC to be applied to estimate the cost of capital (or return on investment) is reviewed in section 3.5.  Other costs are discussed in section 3.6. In section 3.7 of this Final Decision, these elements are brought together and actual forecasts of target revenues are considered.  This section also considers the adjustments which are made to revenue forecasts as a result of seeking a smooth transition in average tariffs over time. 
Step 2: Set year 1 tariffs
The target revenue for the first year is disaggregated between services and then within services between capacity and commodity.  These figures are then allocated to each off-take and injection point.  The tariff methodology provides the basis for setting each tariffed transmission service at each location on the transmission system such that:
(a)	at forecast demand, TPA will recover target revenue for year 1; and
(b)	users contribute an appropriate share of the cost of the assets and services which are used in providing the relevant tariffed transmission service (cost reflectivity).
The total price charged to customers for transmission of gas is broken into three components such that each customer is charged:  
•	an injection tariff, on the volume of gas injected on its behalf on the five peak injection days;
•	a capacity delivery tariff.  Tariff D customers (who have meters which read daily volumes) are charged on the gas delivered on the five days of highest system demand.  Tariff V customers (who do not have daily meters) are charged on their consumption from June to September; and 
•	a commodity delivery tariff charged on all gas delivered throughout the year.
The tariff methodology for establishing individual tariff components by type and location of service are considered in detail in section 3.8 below.
Step 3: Set formulae for tariff and revenue adjustment from year to year
Formulae are set out in the Tariff Order which govern the average tariff revenue from tariffed transmission services that can be recovered in the next year, given the average revenue achieved in the previous year and also the maximum amount that individual tariffs can be adjusted from one year to the next.  The stated objectives of these formulae are to:
(a)	achieve a clear overall price path that recovers target revenue over the five year period and ensure real gains to customers; 
(b)	create incentives to grow usage where an increase or decrease in total volumes of gas delivered leads to an increase or decrease in total revenue; 
(c)	encourage efficiency gains, particularly capital efficiency; and 
(d)	be consistent with light handed regulation. 
These aspects of reference tariffs are considered in section 3.9 below.
Within this framework the service provider has proposed that target revenue be calculated so as to provide a real rate of return (that is, a real WACC) on an asset base that is indexed for inflation.  Depreciation forming part of the cost base is also indexed for inflation.  Consistent with this approach, the capital base and any new facilities investment is indexed for actual inflation for the purposes of setting the capital base at the commencement of the next regulatory period.  TPA refers to this inflation adjustment of asset values as a CCA approach.  
Key issues raised by interested parties
Submissions were generally supportive of a cost based approach to the establishment of tariffs.  However, many submissions suggested that the proposed reference tariff methodology had shortcomings which meant that cost reflectivity was not achieved.  Generally, such criticisms focussed on specific aspects of the approach and are summarised where appropriate in the sections below.  
Commission’s assessment
The cost of service approach, as a general approach, seems to be non-controversial and is consistent with the Victorian Access Code.  In fact TPA has combined the cost of service approach with a tariff path price approach.  Reference tariffs are determined in advance for the access arrangement period to follow a path that is forecast to deliver a revenue stream consistent with forecast costs of service, but provide for adjustments to account for some subsequent events on an annual basis and others at the commencement of the next regulatory period.  Such a combined approach is given by way of example in section 8.3 of the Victorian Access Code.
However, TPA’s use of a CCA framework in its proposal does not, on the face of it, comply with any of the methodologies provided for in section 8.4 of the Victorian Access Code.  It may, nevertheless, be acceptable under section 8.5 which permits other methodologies to be used provided they can be expressed in terms of the permitted methodologies.  The Commission considers this to be case with the current proposal.  The equivalence is recognised by noting:
•	that the application of a real rate of return to an asset base (and depreciation) which is inflated over time is theoretically equivalent to a historical cost accounting (HCA) approach where the nominal rate of return is applied to an asset base with values and associated depreciation based on historical costs;
•	the practical difference is that the time profile of tariff revenues under the CCA approach is flattened relative to the historical cost approach; and
•	it can be demonstrated that the CCA revenue profile is identical to using the historical accounting valuation for assets and a nominal rate of return but with a non-linear depreciation schedule.  This non-linear depreciation schedule is the residual obtained after deducting the stream of nominal rate of return on the historical asset base from the combined return and depreciation under the CCA approach.  
The Commission also notes that the methodology adopted by TPA results in the capital base at the commencement of each access arrangement period being equal to the present value of future returns to those assets (calculated at the rate of return).
In terms of future regulatory period, however, the Commission notes that the Victorian Access Code requires that the capital base be determined mechanically, adjusted only for depreciation, new facilities investment and redundant capital (section 8.9).  Therefore, in order for the methodology proposed by TPA to be consistent with the requirements of the Victorian Access Code, the appropriate formula for determining the capital base at the commencement of the next access arrangement period is:
Capital base = initial capital base (indexed) - depreciation (indexed) + new facilities investment (indexed) - redundant capital
The Commission notes that the Victorian Access Code does not provide scope to revalue the existing assets outside of what is permitted by this formula.
There remains an issue as to what should be the basis for the proposed inflation index used in the CCA framework.  TPA has proposed the CPI compiled by the Australian Bureau of Statistics (ABS) for the city of Melbourne.  The Commission acknowledges that a general price index needs to be chosen, but it should be one which reflects the difference between real rates of return and nominal rates of return as perceived by financial markets.  In this context the CPI may not be the ideal index.  
Firstly, its orientation means that it is over sensitive to some consumer oriented costs such as specific taxes on goods and prices of products and services which may have only marginal relevance to general financial conditions.  At the same time factors relevant to business oriented costs may be somewhat muted.  Secondly, the selection of a Melbourne based index is unnecessarily narrow given the financial markets oriented requirement of the index.  
An Australia-wide based CPI is less likely to be as susceptible to fluctuations of a spurious nature in this context.  Notwithstanding, the Commission acknowledges the advantage of using a well recognised index like the CPI and understands that the ABS is developing an experimental variation of the CPI to reflect the ‘underlying rate of inflation’ in a way which may be better suited for this application.  Unfortunately, an official index of this type will not be available in the near term and the Commission considers that the CPI (All Groups - weighted average of eight capital cities) is the best available compromise.  Further support for the use of this index is its use as the basis for adjusting the value of treasury capital indexed bonds.
The Commission considers that the overall cost of service approach proposed by the service provider meets the requirements of sections 8.3 and 8.4 of the Victorian Access Code.
However, this does not imply that the Commission agrees with the values assigned to the different components of total revenue or the allocation of costs for the purpose of deriving specific reference tariffs.  Such issues are dealt with individually within subsequent sections of this chapter.  
Amendment 3.1
	In order for TPA’s Access Arrangements for PTS and WTS to be approved, the inflation index referred to throughout the Access Arrangements must be based on the CPI (All Groups - weighted average of eight capital cities). 

3.2	The initial capital base
3.2.1	Victorian Access Code requirements
The Victorian Access Code requires the regulator to approve a value for an existing pipeline (an initial capital base) as part of the first access arrangement for that pipeline.  The value that is assigned to the existing assets is then treated under the Victorian Access Code as a historical cost that is carried forward mechanically to future regulatory periods (and adjusted only for depreciation, new capital expenditure and, where appropriate redundant assets).  The initial capital base, therefore, is the present value of expected future returns to the existing assets (evaluated using the regulated WACC).
The initial capital base has a significant effect on the value of the businesses.  Indeed, providing all bidders are rational, any difference between the sale price for a business and the capital base could be explained by the market employing a different WACC, some buyers being able to achieve cost saving synergies with their existing businesses or through buyers having different beliefs about future market growth and opportunities.
In addition, the initial capital base will have a significant effect on the level of tariffs over a considerable period given the long life of assets.
The Victorian Access Code (sections 8.11 and 8.10 (a) and (b)) requires that normally the value of the initial capital base should not fall outside the range of depreciated actual cost (DAC) and DORC.  In establishing the initial capital base, the Victorian Access Code (section 8.10) also requires the Commission to consider: 
•	other well recognised asset valuation methodologies (section 8.10(c)) and the advantages and disadvantages of these methodologies (section 8.10(d));
•	international best practice and the impact on the international competitiveness of energy consuming industries (section 8.10(e));
•	the basis on which tariffs have been (or appear to have been) set in the past, the economic depreciation of the covered pipeline, and the historical returns to the service provider from the covered pipeline (section 8.10(f));
•	the reasonable expectations of persons under the regulatory regime that applied to the pipeline prior to the commencement of the Victorian Access Code (section 8.10(g));
•	the impact on the economically efficient utilisation of gas resources (section 8.10(h));
•	the comparability with the cost structure of new pipelines that may compete with the pipeline in question (for example, a pipeline that may by-pass some or all of the pipeline in question) (section 8.10(i));
•	the price paid for any asset recently purchased by the service provider and the circumstances of that purchase (section 8.10(j)); and
•	any other matters considered relevant (section 8.10(k)).
In addition, the Commission is guided by the objectives in section 8.1, of which the following are particularly relevant:
•	replicating the outcome of a competitive market;
•	ensuring the safe and reliable operation of the pipeline;
•	not distorting investment decisions in pipeline transportation systems or in upstream and downstream industries; and
•	efficiency in the level and structure of the reference tariff.
As noted above, the regulator’s decision over the valuation of existing assets is clearly quarantined from the valuation of new investment.  Sections 8.12 and 8.15 of the Victorian Access Code provide that new pipelines and additions to an existing pipeline are valued at their actual cost.
3.2.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA employed consultants Gutteridge, Haskins and Davey Pty Limited (GDH) to determine the valuation of transmission system assets on the basis of DORC (section 8.11).  This valuation involved three stages:
•	Optimisation – determine the optimal configuration and sizing of pipeline assets;
•	Replacement costs – a modern engineering equivalent (MEE) is established for each asset in the optimised system and a standard replacement cost (SRC) established; and
•	Depreciate those assets (straight line) using the standard economic life (SEL) of each asset together with an estimate of the remaining life (RL) of each asset.  For example if the standard economic life of an asset is 40 years and its remaining life is ten years, the asset would be depreciated to 25 per cent of the replacement cost of the MEE.
SRCs are calculated on the basis that ‘brownfields conditions’ exist, that is, all existing infrastructure (e.g. roads, footpaths and other services) is in place and the replacement of Transmission System assets would therefore need to allow for such features.
Minimum remaining lives are assumed for each asset type so that if an asset is still working at the end of its economic life it is attributed a minimum remaining life of five years.
On this basis, TPA claims the effect of optimisation was to reduce replacement cost valuations of system assets as at 1 July 1997 by nine per cent, from $642 million to $585 million.  Depreciation reduced the optimised asset valuation further to $357 million.  EPD made a policy decision to reduce this valuation further, mainly in respect of assets on the WTS to limit what it considered undesirable network price differentials.  In essence EPD considered tariffs would be unacceptably high using the proposed tariff setting procedure in  conjunction with the initial DORC valuation for WTS assets.  Reducing the DORC valuations was the mechanism used to achieve the desired tariff level without compromising the overall approach to the establishment of tariffs.  Further aspects of this adjustment are discussed in section 3.7 below.
Non-system assets (mainly land and buildings) are not included in the above figures.  Land and buildings were valued at the lower of market and depreciated replacement value ($14.3 million) and other assets at book value ($2.4 million).
Table 3.1 summarises the valuation figures and shows adjustments made to arrive at the proposed DORC valuation and includes several historical valuations for comparison purposes.
New assets are based on forecast capital expenditure required to meet forecast growth.  TPA has no obligation to incur this capital expenditure: thus there is an incentive to find cheaper options.
These figures have been updated to 1 January 1998 taking account of depreciation, forecast inflation and capital expenditure for the period 1 July 1997 to 31 December 1998.  It is these updated figures which have been used as the initial capital base for the Access Arrangements and for determining target revenues.  
Table 3.1:	Valuations of TPA’s assets ($ million) 
Valuation Methodology	PTS	WTS	Total	
Replacement Costs (RC)	615.7	26.8		642.5	
Depreciated Replacement Cost (DRC)	390.7	24.3		415.0	
Optimised Replacement Cost (ORC)	557.8	26.8		584.6	
Depreciated Optimised Replacement Cost (DORC)	332.9	24.3		357.2	
Adjusted DORC (Policy Reasons)	331.7	15.3		347.0	
Land and buildings (lesser of market value and DRC) 				14.3	
Other assets (book value)				2.4	
Total Capital Base				363.7	
Estimated Historical Actual Cost (AC)a				287.8	
Estimated Depreciated Actual Cost (DAC)b				185.9	
Estimated CCA Valuationc				381.9	
Notes:	(a)	TPA, Access Arrangement Information, Supplementary Information, 6 March 1998. 
(b)	While no DAC valuation for TPA pipeline assets is available from historical accounts this estimate which assumes the same proportional depreciation in moving from AC to DAC as for RC to DRC is likely to be a reasonable approximation.
(c)	Letter from EPD to Commission and the ORG, 15 April 1998.
Submissions by interested parties
The main concerns raised by the submissions prior to, and following the release of the Draft Decision are as follows:
•	DORC valuation generally results in excessive asset values, and that the Victorian Access Code treats DORC as one extreme, with DAC setting the other extreme, and with values in between to be considered;
•	the DORC valuation methodology is subjective and arbitrary;
•	that international best practice as demonstrated in North America uses historical cost values;
•	that the outcomes of a competitive market generally reflect historical cost values;
•	that long term users have already paid for the depreciation of the existing system and therefore the use of a DORC methodology means that the assets will be valued upwards and recovering the depreciation from users again; and
•	that DORC does not provide the correct economic signals, as the correct economic signals would not recover any sunk costs on a forward looking basis.
In addition, there were a number of statements to the effect that the objective is to determine a fair and reasonable valuation of the existing assets.
There were a number of public submissions after the release of the Draft Decision on the analysis of historical returns as required by section 8.10(f) of the Code.  Specific comments included:
•	it is questionable whether any useful information can be gathered from analysing historical returns given data problems and the large number of assumptions that need to be made;
•	that some of the assumptions made in the ORG’s analysis, which was relied on in the Commission Draft Decision, are open to challenge - and that plausible changes to these assumptions will deliver different (substantially lower) results; and
•	the cut‑off date for the ORG analysis missed out the Petroleum Resources Rent Tax settlement which would increase the fair written down value.
The particular issues are discussed more fully in the discussion of section 8.10(f) of this statement of reasons.
The arguments that the service provider made in support of the adjusted DORC valuations prior to and following the release of the Draft Decision include the following:
•	it was not possible to estimate DAC from the available data, and therefore that methodology did not provide a certain asset value and DORC provided a practical starting point;
•	recorded historical estimates are sensitive to varying accounting policies over time and would incorporate inconsistencies including dubious assumptions about past recovery of asset costs.
•	the use of modern engineering equivalent asset values and the optimisation of the systems resulted in the benefits of technological change to be passed on, and for users to be insulated from the costs of excess assets;
•	the optimisation process ensures that redundant or oversized assets are not included in the capital base and are not paid for by users.  By comparison, the service provider notes that historical based costs would undervalue the asset and distort user’s choices in using the pipeline.
•	DORC is likely to provide better economic signals and is more likely to replicate the outcome of a competitive market.  Hence it provides a sound economic basis for determining fair and economically efficient tariffs; and
•	DORC recognises the valuable investment made in building the asset base over many years.
In addition, EPD quoted a number of other precedents for the use of DORC (or deprival value), which include the Commission for determining telecommunications access charges, the guidelines for asset valuation published by the Steering Committee on National Performance Monitoring of Government Trading Enterprises, and the Standing Committee of the Agriculture and Resource Management Council of Australia and New Zealand Water Industry Asset Valuation Draft Guidelines.
Commission’s considerations
For a new access arrangement being applied to an existing pipeline system the Victorian Access Code (section 8.10) provides for methodological flexibility for asset valuation with DAC normally offering valuations at the lower end and DORC the upper of the acceptable range.  This may reflect a recognition in the Victorian Access Code that for an existing pipeline being brought into an access regime there is no economically ‘right’ valuation for the purpose of tariff determination and market determined approaches will involve a circular analysis.  
The applicant has proposed a written down value of DORC, and a number of issues arise in considering the validity of this valuation methodology for determining the initial capital base for the establishment of tariffs.  One is whether the DORC valuation is the appropriate one given the historical perspective, the nature of the pipeline and the proposed basis for establishment of tariffs.  In considering this, the Commission has also had regard to other possible approaches to asset valuation.  This reflects the scope provided under the Victorian Access Code and the consequent obligation on the regulator to exercise judgement in determining an appropriate asset value which can be best reconciled with other criteria in the Victorian Access Code.  The Commission has also sought to obtain a DAC valuation alternative by auditing actual cost figures and deriving an estimate for the DAC. 
In determining the appropriate asset valuation, given that economic theory does not provide an unambiguous answer, regard to notions of fair treatment and the effects on the different interest groups affected by the pricing approach to the recovery of sunk assets need to be taken into account.  The factors in section 8.10 of the Victorian Access Code direct the regulator towards this analysis.
The valuation methodology and economic theory
Economic theory notes that in the short run efficiency is achieved with pricing based on marginal costs, but with prices rising where congestion arises to signal resource scarcity.  That is, efficient prices should encourage usage to the point where the marginal user is prepared to pay the short-run marginal cost of supply and the cost of any additional augmentation that may be required.  Pipeline infrastructure has a high proportion of fixed costs, such that pricing on the basis of marginal cost will not provide sufficient revenue to permit the business to recover its capital costs and be viable in the longer term.  
On the basis of economic efficiency, an existing asset should earn at least the return in its next best use.  For pipeline assets, which have few if any alternative uses, this will be satisfied at the assets scrap value, noting that this value could be very low.  However, such an approach could have an adverse effect on future investment in regulated pipeline infrastructure (as discussed below).The constraint at the upper end is the value that can be maintained before the end-users either by-pass the system or seek an alternative fuel source.  In relation to the former, by-pass will become possible whenever prices reflect the cost of an efficient new entrant.  
Thus, for sunk assets, economics only provides a range for the revenue constraint, and therefore for the value of the assets, between the scrap value and the by-pass value.  
This discussion assumes, however, that the treatment of existing assets can be separated from the treatment of new assets.  One consideration for dynamic efficiency is that the price set for existing assets may influence the expectations of investors as to the regulator’s treatment of future investment.  While the Victorian Access Code clearly separates the treatment of existing assets from new assets, industry participants are likely to see the regulator’s treatment of existing assets as setting a precedent for how it will exercise its (generally wide) discretion when making other decisions under the Victorian Access Code in the future.  Therefore, opportunistic behaviour by the regulator with respect to existing assets may dampen the incentives for investment in the industry.
The merits of alternative valuation methodologies (s8.10 (a),(b),(c) and (d))
In addition to the DAC and DORC methodologies mentioned in the Victorian Access Code, a valuation based on CCA principles, as being proposed in the Access Arrangements for adjusting the capital base over time, is a readily available alternative in this instance.  Such a valuation ($382m) is included in the Table 3.1 above.  However, since it exceeds the DORC valuation, even if that value was thought to be appropriate the Victorian Access Code would require it at least be reduced to the DORC valuation.
As noted above, economic theory does not provide an unambiguous answer as to the most appropriate asset valuation methodology.  That said, however, the two methodologies that are listed in the Victorian Access Code, DORC and DAC, have a number of advantages and disadvantages that will be discussed in turn.
The DORC methodology has theoretical economic attraction for a number of reasons.  First, regulators often look to competitive or contestable markets for guidance on efficient decision rules for regulating natural monopoly markets.  Such comparisons can provide a number of guiding principles for a range of complex regulatory problems.  In addition, the establishment of broadly symmetrical pricing and incentive structures across regulated and unregulated markets has intuitive appeal on general resource allocation grounds.  It is noted in this regard that one of the objectives for reference tariffs is to replicate the outcomes of a competitive market (section 8.1(b)).
Second, the maintenance of reference tariffs over time at a level that is consistent with a DORC asset valuation may act to reduce shocks to reference tariffs as the replacement of assets becomes necessary (noting that the Victorian Access Code requires that the full replacement cost of assets be included into the capital base).  It is also arguable that, as actual systems comprise of assets of varying vintages with different service lives, the variations in prices may be muted in practice whatever valuation methodology is adopted. 
Third, unlike the statements made in some of the submissions, DORC valuations are based on a competitive concept.  A return on replacement cost is the maximum that a monopoly firm could earn in a perfectly contestable market.  However, it is noted that the concept of contestability relates to a particular form of competition, which may not be applicable to the evaluation of sunk assets for regulatory purposes.  
Lastly, any value that is in excess of DORC may produce reference tariffs that will expose the service provider to being by-passed.  While the significant entry and exit costs that characterise gas transmission make large scale duplication of the existing system unlikely, by-pass will become more likely at the edges of the system.  Moreover, to the extent that parts of the system are by-passed, some of this cost inevitably gets absorbed by the remaining customers who do not have by-pass options.
Another justification for DORC setting the upper limit to valuations comes from what a DORC valuation actually is attempting to measure.  This is the maximum price that a firm would be prepared to pay for ‘second hand’ assets with their remaining service potential, higher operating costs, and (old) technology given the alternative of installing new assets which embody the latest technology, generally have lower operating costs, and which will have a greater remaining service potential.  Therefore, if prices reflect a value that is in excess of DORC, then users would be better off were the existing system scrapped and replaced by new assets.  Similarly, if assets are sold for prices above the DORC valuation, then this implies that scarce investment funds are being inefficiently: in this case, it would have been a more efficient use of investment funds for the existing assets to be scrapped and a duplicate system installed.
The main argument in favour of a DAC valuation is that if tariffs were set on a cost of service basis in the past, then the book value of the assets - the DAC valuation - would be consistent with all parties’ expectations of the value of the assets at that point in time.  It also follows that any valuation in excess of DAC would lead to an unexpected windfall to the pipeline owner.
The difficulty with old and previously integrated systems, however, is in determining how tariffs for the market as a whole were set in the past and the extent to which those tariffs have already recovered the capital costs from past users.  The ORG has attempted to estimate the historical returns to the former Gas and Fuel Corporation of Victoria (GFCV) to test whether the conditions for the DAC valuation hold.  This is discussed below (in the context of the discussion of section 8.10(f) of the Code).
The second advantage that normally is advanced for a DAC valuation is that this valuation provides an auditable value, that it is objectively observable, a ‘hard number’.  This, however, would not appear to provide much of a justification for accepting a value that appears unreasonable to all parties.  In addition, regardless of how the initial Capital Base is determined, it becomes fixed as soon as the Access Arrangement is accepted, and thereafter is objectively observable.
Another advantage advanced for DAC is that this valuation provides an auditable value, that is an objectively observable.  However, DAC valuations of existing assets are also arbitrary.  Where the investment is sunk, there is no economic reason why a DAC valuation will be better or worse than any other valuation that exceeds scrap value.  Similarly, a limitation of DORC valuations are that they can be arbitrary.  Many of the problems with DORC valuations are raised in the paper by Johnstone and Wells.  In either case, regardless of how the initial capital base is determined, it becomes fixed as soon as the Access Arrangement is accepted, and thereafter is objectively observable.  
A major difficulty with the use of a DAC valuation for the purpose of these access arrangements is a practical one.  Because the business originally integrated transmission, distribution and gas retailing together as part of the GFCV’s operations, there are no separate records of depreciation just for TPA assets.  In addition, the business has in recent years used a CCA approach for accounting purposes.  This means that a verifiable DAC valuation is not available.  While a reasonable estimate of a DAC can be made and included in Table 3.1, it does not facilitate the assignment of associated capital costs to different users to provide for cost reflectivity as required by the Victorian Access Code.  The DORC approach assigns values to specific assets and it is at this micro level that many of the economic advantages of the DORC methodology emerge in the structuring of tariffs for different users.  As discussed elsewhere, the Victorian Access Code effectively requires a DAC valuation for future reviews but the starting point for this will be based on the valuation set by this determination.
The Commission considers that no single asset valuation methodology will provide the answer that is appropriate in all cases.  In particular, even though DORC has the advantages discussed above, the Commission does not consider that this could be justified where this resulted in TPA earning windfall profits and/or existing users facing higher transportation charges.  As will be apparent in the discussion to follow, the Commission also notes that the claimed ‘fairness’ of DAC assumes a certain methodology for setting tariffs in the past, which may or may not be the case.
The Commission therefore considers that it is essential to look at a number of indicators to test the implications for the viability of the businesses, the tariffs charged to end-users, and the impact on competition and efficiency in related markets of any asset valuation methodology that might be feasible within the framework of the Victorian Access Code.  In particular, the Commission notes that its decision must have regard to both ‘the legitimate business interests of the service provider’ (section 2.24(b)(i)) and ‘the interests of users and prospective users’ (section 2.24(b)(vi)).  Section 8.10 lists a number of factors directed towards testing the implications of the asset valuation on all relevant parties.  These are considered further below.
Best practice and the impact on energy consuming industries (s8.10(e))
The Commission considers that this factor may require the regulator to determine benchmarks for transportation tariffs, both for overseas companies and for other domestic pipelines.  It suggests that one objective for determining the initial capital base is that it produce tariffs that are consistent with best practice transportation tariffs.  That said, however, the use of the word ‘comparable’ suggests that it is legitimate for tariffs to reflect costs differences that may arise from factors such as the terrain, customer type and density, and the distance of transportation.  In this context, strict benchmark comparisons are difficult to obtain.  For the purpose of this determination the Commission considers that the optimisation and the current (efficient) prices being assigned to assets as part of the DORC procedure and subsequently endorsed by independent consulting engineers has essentially covered this criteria.
The basis on which tariffs appear to have been set in the past and historical returns (s8.10(f)) and the reasonable expectations of persons under the regulatory regime that applied to the pipeline prior to the commencement of the Victorian Access Code (section 8.10(g))
A number of submitters have argued that the tariffs they paid in the past resulted in much of the existing infrastructure having been paid for, so that a low valuation, such as that likely to be provided by DAC, is now justified for its remaining economic life. This factor requires the Commission to try to make an effort to ‘unravel the past’ and form a view as to whether these claims are justified.  In addition these clauses also require the Commission to also look forward, particularly in regard to 8.10 (g).
These particular two clauses are part of a number of clauses which are designed to ensure a reasonable balance of interest between the Service Provider and the users or prospective users.  Box 3.1 below indicates some of the key issues in looking at past performance to make judgements on asset valuation. 
Box 3.1:	Past pricing and the initial asset valuation relevant to 8.10(f)&(g) of the Victorian Access Code 

Consider the example of two identical pipelines, A and B (both built 20 years ago with 20 years life remaining) and now being brought into the regulatory framework of the Victorian Access Code.  Each had an initial cost of $1 000m, at a time when the Post-Tax Nominal Cost of Capital was nine per cent. Over the 20 years, there has been no new capital expenditure and inflation has remained steady at four per cent.  All costs associated with the efficient running the system are identical for each pipeline.  The only difference in the operation of the two pipeline systems has been pricing policy, which in the case of pipeline A has permitted annual net cash flows after tax of $100m per year, and in the case of B has permitted annual net cash flows of $88m per year. 
The question is, how should the Initial Capital Value of each pipeline be established with the introduction of the Victorian Access Code?  Is DORC or DAC the more appropriate methodology and is the same methodology appropriate to each?  If past returns are to be taken into account then it is fairly clear that a different methodology could apply in each case.  If the regulator is seeking to set a (residual) valuation which is fair to the pipeline owner and consistent with reasonable commercial expectations, then the valuation to be put on the pipeline is that which allows the pipeline owner to have achieved the nine per cent return anticipated when the pipeline was built.  On this basis, the residual value of pipeline A would be $500m (in this case its DAC valuation, assuming straight line depreciation), and the residual value of pipeline B would be $1 096m.  In case B the residual value is double the DAC valuation and close to the original undepreciated cost of the pipeline.  With four per cent inflation it also corresponds to the depreciated value of the pipeline in a current cost accounting (CCA) framework.  In the absence of technological change and other factors that may lead to optimising pipeline changes if it were built today, this would also correspond the present DORC valuation.
This illustration shows that a DAC valuation may be appropriate in one instance in terms of the Victorian Access Code and the DORC valuation in another.  In a broad range of situations an intermediate value may be more appropriate.  Of course actual returns may be outside these ranges which could suggest residual value estimates either below DAC or above DORC, however, the Victorian Access Code would call for the DAC or DORC limits, as appropriate, to be applied in such cases.
For existing pipelines, where transmission prices were not previously regulated, there could be a general presumption that the pipeline owner would be a profit maximiser (with relatively high tariffs) suggesting a DAC valuation as being appropriate.  Exceptions to this may include a pipeline initially sized with the expectation of market growth but with low volumes initially so that a commercial return will not be achieved if the residual value is set at DAC at this point in time.  Another important group of possible exceptions are government owned pipelines.  Prior to the 1990’s Australian Governments have not always sought a commercial return on infrastructure.  Where that has been the case, application of the above analysis may suggest a valuation well above DAC for many such assets.  
When related to actual cases, these comments suggest that IPART’s concerns with the DORC valuation in relation to AGL’s NSW pipeline assets may be well founded while a DORC valuation in other circumstances (e.g. the Moomba to Sydney pipeline previously owned by the Commonwealth Pipeline Authority or the Victorian transmission pipeline assets now owned by the TPA) may be acceptable.  However, in all cases the more appropriate valuation methodology needs to be confirmed by examining the historical financial records relating to the pipeline assets in question.	

For the purpose of the present determination there are a number of informational shortcomings in considering the past which make a thorough assessment of these issues difficult.  The transmission services were only separated from distribution in December 1994 with the formation of Gas Transmission Corporation (GTC) (subsequently TPA) and this makes past analysis of TPA difficult.  In addition, the accounting information which is used in the analysis has been subject to multiple changes in classifications over the period from 1957/58. The analysis below also assumes that the conclusions about the whole (GFCV) apply to the parts (TPA). 
As suggested in Box 3.1 above, the twofold difference in Table 3.1 between the estimated valuations based on DAC and DORC does not, by itself, mean that a DORC valuation is inappropriate as the initial valuation of the capital base.  When much of the infrastructure was built the cost of capital was, at times, much higher than now.  If a CCA approach had been employed throughout the period it is quite conceivable that the present valuation of assets on this basis could be as high as the present DORC based valuation.  The crucial factor is whether returns on the pipeline in the past have been in line with the cost of capital prevailing at the time new investments were being committed.
•	In a bid to evaluate the fair value of existing GFCV assets the ORG undertook a modelling exercise to evaluate section 8.10(g) of the Code i.e. the basis on which tariffs appear to have been set in the past and historical returns.
•	It is noted at the outset that this analysis of historical returns has little justification in terms of economic theory, which is concerned with creating the incentives for efficient forward‑looking decision making rather than with unravelling the past.
•	However, the Code requires a broader perspective to be taken when determining the value of existing assets, in effect determining a reasonable balance of interest between the Service Provider and Users and Prospective Users (section 2.24(b)(i) and section 2.24(b)(vi)).  The Commission interprets the Code as implying that this is one of a number of possible alternative indicators of the reasonable balance of interests.
The Commission presented the results of the ORG’s analysis of the historical returns to the assets of the former GFCV in its Draft Decision.  That analysis in effect involved determining the implied ‘return of capital’ to the asset owner since 1957/58 to 1996/97 after a reasonable return on assets had been earned.  The ‘economic’ written down value was then calculated as the opening book value of the assets, plus capital expenditure undertaken, less the implied ‘return of capital’.
It is the Commission’s  view that there are a number of difficulties with this analysis.  Most importantly, the exercise involved the estimation of returns for just one part of an integrated entity to be assessed.  This required a number of plausible - but not necessarily correct - assumptions to be made.  In addition, a number of adjustments for known problems were made.  One adjustment was to impute a ‘commercial’ price of natural gas (for the period since about 1970) to ensure that rents due to the low gas price are classed as gas rents.  The imputation of a ‘commercial’ price for a commodity where there are no international or national market benchmarks is arbitrary at best.  Lastly, the data sources used in the analysis – the published financial accounts – have been subject to multiple changes in classifications of costs and revenues and changes of accounting policy, all of which reduces the accuracy of the analysis.
The results of this analysis as published in the Commission’s Draft Decision, identified a range of between $1.3 billion and $11.3 billion as the fair economic written down value obtained depending on the assumptions made about what a ‘reasonable’ rate of return over the period was, and what a reasonable commercial natural gas price was.
There were a number of criticisms levelled on the assumptions made in this analysis, in particular in a paper prepared for BHPP.  It presented analysis of the fair written down value which suggested a value of about $1130 million which is closer to the DAC value of the assets.  While the methodology adopted in this analysis was very similar, there were two points of departure in the assumptions:
•	first, the analysis was commenced from 1970 (using the book value of assets as the fair written down value at that time), this being around the time from which natural gas began to flow (prior to this the gas systems reticulated manufactured gas); and
•	second, a different assumption about the ‘commercial’ cost of natural gas for the period since 1970, which was to use the Cooper Basin well-head price.
The first of these changes explains most of the difference between the ORG and BHPP’s analysis.  A major rationale advanced for the difference in the starting date was that during the era of manufactured gas, the system was not very profitable, and that there were substantially extraordinary costs incurred in the conversion to natural gas which should not be classed as a pipeline cost.  In addition, a number of other public submissions noted that this analysis assumes that all historical investment in GFCV was efficient and profit motivated - which has been argued not to have been the case.
On balance the Commission accepts that there is merit in the claims the some of the under‑recovery prior to 1970 should not be treated as an under‑recovery from the pipeline operations.  That said, however, it is noted that the distribution systems in place prior to 1970 continued to be used after the era of natural gas, and much is understood to still be used today.  Thus, it is not clear by how much the assumed under‑recovery prior to 1970 should be reduced.  In addition, even on the analysis presented by BHPP, an increase in the assumption about what is a ‘reasonable’ rate of return by 1 percentage point (which would still only bring the assumed nominal pre‑tax weighted average cost of capital to the Government long term bond rate plus 3 per cent) increases the estimate of the fair written down value to a value closer to the DORC values than the DAC values.  The Commission considers that the arbitrariness of many of the assumptions necessary in this analysis, and the range of possible answers available from equally plausible assumptions implies that the analysis does not provide any useful information for the purposes of determining the initial Capital Base.
Thus, the Commission has considered the ‘the basis on which Tariffs have been (or appear to have been) set in the past, the economic depreciation of the Covered Pipeline, and the historical returns to the Service Provider from the Covered Pipeline’ as required by the Code.  However, for the reasons given above, the Commission does not consider that this provides a sound basis for making inferences about the proposed initial Capital Base.
The criterion in section 8.10(g) would appear to imply that the regulator should try to avoid creating significant ‘shocks’ for either the Service Provider or the Users through the determination of the initial Capital Base, having regard to the features and implications of the previous regulatory arrangements.  This would suggest that with the introduction of a new regulatory regime, both sides should have an expectation of fair treatment and to not have previous expectations based on the administration of the previous regulatory regime altered unreasonably.  Nevertheless, the Commission considers that, where there is evidence that the Service Provider had been earning excessive returns in the past, it is reasonable to expect that these would be wound back at least to the level that would be consistent with a DORC valuation and appropriate regard for the legitimate interests of Users.
One indicator of the reasonable expectations of the various parties is to compare the revenue stream attributable to the transportation function of the former GFCV with the revenue stream that will flow to the transportation functions (the three distribution businesses and TPA) under the proposed initial Capital Base (using the ORG’s preferred Rate of Return of 7.75 per cent).  In particular, this analysis would indicate the extent to which Users would be paying more or less for transportation than they reasonably could have expected had the regulatory regime remained unchanged.
Analysis was undertaken by the ORG and, on reasonable assumptions, this indicated that the proposed initial Capital Base was consistent with a revenue stream that is significantly below the revenue stream that was attributable to transportation in the former GFCV.
In addition, it was noted that the Victorian Government has made a policy decision that no customer should suffer an upward tariff shock at the time of contestability.  In response to this, the initial Capital Base incorporates a reduction in the full DORC value where the application of the full DORC value may have resulted in tariff shock.  While this policy applies in respect of the projected price for the combined gas and transportation service and not just transportation, it is reasonable to infer that this implies that the projected transportation price in the future should not exceed that which would have existed in the absence of the change of the regulatory regime.
These indicators would suggest that the adjusted DORC valuations as proposed (and using the Commission’s preferred Rate of Return) is likely to produce a revenue stream which would be below the ‘no change’ revenue stream, consistent with what all parties could reasonably expect prior to the commencement of the Code.
It is noted that this analysis has been done for all of the assets of the former GFCV which is now disaggregated into Multinet, Westar, Stratus and TPA.  However, the Commission considers that it is reasonable to infer that, if the value of the assets as a whole is reasonable, then the valuation of each of the parts also is reasonable.
The impact on the economically efficient utilisation of gas resources (s 8.10(h))
This factor directs the regulator to look at whether the valuation methodology that is selected is consistent with providing the price signals which result in incentives for the efficient development and use of gas resources available to the Victorian market. 
As noted earlier, economic principles do not provide clear guidance on the valuation of sunk assets from the perspective of economic efficiency.  They do however suggest that irrespective of their evaluation sunk costs should be recovered in a manner that distorts the behaviour of system users and operators as little as possible.
The Commission considers that this objective can be met if reference tariffs are determined efficiently so that end users pay a price reflecting the true cost of using transportation.  On this issue, an appropriate allocation of costs (associated with the overall valuation, whatever that may be) to specific users or services is perhaps more important than the overall valuation.  In this context, as noted earlier, the establishment of the DORC valuation, which is derived by examining individual assets, facilitates the allocation of costs to specific users.  To the extent that the DORC valuation achieves overall price levels reflective of long run costs, the potential for efficient allocation of gas resources will be further enhanced.  
The comparability with the cost structure of new pipelines that may compete with the pipeline in question (e.g. a pipeline that may by-pass some or all of the pipeline in question) (s 8.10(i))
This factor suggests that the asset valuation methodology chosen should not leave TPA open to uneconomic by-pass (i.e. not justified on the basis of stand alone cost of entry).  As noted above, this suggests that the valuation should not be in excess of the DORC valuation.
The price paid for any asset recently purchased by the service provider and the circumstances of that purchase (s 8.10(j))
This factor allows a regulator to have regard to the price that may have been paid for a pipeline in a recent sale.  This factor would appear to be a variant on section 8.10(g), and suggests in effect that fairness dictates that the service provider’s legitimate expectations at the time of the sale be respected.  The regulator is also required, however, to have regard to the circumstances of the sale, and is under no compulsion to accept the sale price of an asset as the regulatory asset base.
In Victoria, the transfer of the transmission assets from GFCV to TPA could be interpreted as a ‘sale’.  However, the Commission considers that even if this was interpreted as a sale, then it would not be considered to be an arms length transaction, and so does not yield any information that should be taken into account for the purposes of this criterion.
Any other factors the relevant regulator considers relevant (s 8.10(k))
The Government ownership of TPA and planned privatisation introduces another factor for the Commission to consider.  There is no distinction between government and privately owned pipeline systems in the Victorian Access Code and therefore any revenue raising objectives associated with mooted privatisation of TPA assets cannot be taken into account in assessing the asset valuation or other aspects of the determination.  However, to the extent that the Victorian population are not only the beneficiaries of revenues raised from any asset sales, but also benefit from less costly pipeline system services (both past and in the future), there is a limited degree of comfort in the valuation placed on TPA assets in that the overall fairness or public interest are unlikely to be seriously compromised. 
The DORC valuation procedure
Given that the Victorian Access Code nominates DORC as one of the valuation bounds, there is still a need to check that technical aspects of the valuation and any necessary assumptions are appropriate.  To assist the Commission in this, a consultant was engaged to ‘desk check’ the basis for the DORC valuation.
The Commission considers that the philosophical arguments for DORC and its associated efficiency properties require a focus on forward looking replacement costs associated with continued operation of the pipeline.  Only then do the DORC valuations provide a valid indicator for estimating long run marginal costs which are important in deriving economically efficient tariff structures.  Here there is some tension between a valuation based on recreating an asset ‘from scratch’ and a valuation linked to actual replacement or refurbishment which may be somewhat less costly.  The former being relevant to the likely cost of a new entrant and by-pass considerations, the latter to long run costs associated with the operation of the pipeline. 
For these reasons issues of particular interest are the optimisation and valuation assumptions.  It is questionable whether the ‘brown fields’ assumption is universally appropriate for estimating replacement cost.  For example, rather than estimate the cost of locating an asset where existing extensive infrastructure needs to be disrupted an alternative route may be less costly.  Similarly, if rather than replacing a pipeline at the end of its useful life, it can be refurbished at a fraction of replacement cost then the refurbishment cost may be more appropriate than the replacement cost, since the asset is unlikely to actually be replaced.  The best example of this is the ‘goldlining’ of old ‘fully depreciated’ reticulation systems which it is a major issue in respect of distribution networks.  However, it is not clear that factors having such a significant impact on valuation are also relevant for transmission.  In addition, the ‘optimisation’ assumptions may compensate for a lower refurbishment based cost approved.  
Sinclair Knight Merz Pty Ltd (SKM), commissioned to ‘desk check’ the DORC valuation being proposed as the basis for the initial Capital Asset base, came up with a valuation about nine to 12 per cent higher than that indicated by TPA.  Neither Gutteridge, Haskins and Davey Pty Ltd (GHD) nor SKM considered replacement costs in terms of measures to extend the useful life of existing assets rather than a ‘from scratch’ installation.  However, to the extent that the Access Arrangement will be based on the lower of the two valuations the Commission has no justification for altering the DORC valuation proposed.  It is also noted that TPA made some reductions to the DORC valuation mainly in relation to the WTS system to achieve tariffs which were more in line with Government policy.  The Commission accepts that such a change is the prerogative of the service provider and will not require any further adjustment.
Updating the DORC valuation for introduction to the regulatory framework 
The CCA adjustment update of the DORC valuation from 30 June 1997 to 1 January 1998, the start of the regulatory period, assumed an inflation rate of 3.0 per cent per annum.  In fact, the CPI declined marginally over this period.  The Commission considers an adjustment for inflation over this period, consistent with actual inflation, would be more appropriate.  The Access Arrangements are unlikely to commence until late 1998 but the Commission recognises that target revenues will need to be based on annual projections and a requirement to update the valuation to say August 1998 may be largely immaterial.
Overall conclusion
After considering the criteria in the Victorian Access Code for assessing the valuation for the initial capital base, the Commission considers that a fair value for the initial asset base is $363.7 million.  The Commission believes that this value provides an appropriate balance of the interests of the various stakeholders under the Victorian Access Code assessment criteria.  
The Commission points out that implications should not drawn from this Decision for other access arrangements as each access arrangement will be considered on a case-by-case basis, recognising the economic arguments for and against the various valuation methodologies.
Further, the Commission’s decision on the valuation of existing assets is clearly quarantined from the valuation of new investment.  Section 8.12 of the Code provides that new pipelines (section 8.12) and additions to an existing pipeline (section 8.15) are valued at their actual cost. 
Amendment 3.2
In order for TPA’s Access Arrangements for the PTS and WTS to be approved, the adjustment of the initial capital base valuation for the period 1 July 1997 to 1 January 1998 (or, if appropriate, the commencement of Access Arrangements) must be based on actual changes in the CPI over the period rather than the 3 per cent per annum rate in the proposed Access Arrangements. 

3.3	New facilities investment and capital redundancy
3.3.1	Victorian Access Code requirements
Once the value of the initial capital base is established, the capital base for each subsequent period is determined as the value of the capital base at the start of the preceding period, plus new facilities investment (or recoverable portion), less depreciation for the preceding period, less redundant capital (section 8.14 of the Victorian Access Code).  
New facilities investment
The Victorian Access Code (sections 8.15-8.16) allows for the capital base to be increased to recognise additional costs incurred in constructing new facilities for the purpose of providing services.  The amount of the increase is the actual capital cost provided that the investment is prudent in terms of efficiency, in accordance with accepted good industry practice and is designed to achieve the lowest possible cost of delivering services.  
Furthermore, if the incremental revenue is not expected to exceed the cost of the investment, the service provider (and/or users) must satisfy the relevant regulator that the new facility has system wide benefits (justifying a higher tariff for all users), or that the new facility is necessary to maintain the safety, integrity or contracted capacity of services.
To the extent that the investment does not meet such criteria or is speculative in character, the augmentation of the capital base needs to be correspondingly reduced.  
Reference tariffs may be determined on the basis of forecast investment (section 8.20 of the Victorian Access Code) during the access arrangement period provided that such investment is reasonably expected to pass the requirements noted above when the investment is forecast to occur.  However, the inclusion of forecasts does not imply that the criteria contained in section 8.16 of the Victorian Access Code have been satisfied.  
The relevant regulator may reserve its judgment until the time that the investment is undertaken or at the next review.  The Victorian Access Code (section 8.22) also notes that the reference tariff policy should specify how discrepancies between forecast and actual investment are to be reflected in the capital base at the commencement of the next regulatory period (so as to meet the objectives of section 8.1 of the Victorian Access Code). 
Capital redundancy
Section 8.27 of the Victorian Access Code stipulates that a reference tariff policy may include a mechanism that will remove from the capital base at the commencement of the next period, an amount which:
•	ensures that assets which cease to contribute to the delivery of services are not reflected in the capital base; and 
•	share costs associated with a decline in sales volume between the service provider and users. 
Before approving such a mechanism, the regulator must consider the potential uncertainty and its effect on the service provider, users and prospective users.
Where redundant assets subsequently contribute to or enhance the provision of services, the Victorian Access Code (section 8.28) allows them to be added back to the capital base as if they were new facilities investment and subject to the associated criteria for inclusion of such expenditure in the capital base.
3.3.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
New facilities investment
Within a regulatory period forecast capital expenditures that are needed to meet forecast growth in demand in reference services are rolled into the capital base for the purpose of establishing reference tariffs.  Investments over the initial five year period are estimated to be $60.7m.  While the TPA is not obliged to undertake these forecast investments, there is an obligation to deliver the services associated with the augmentation, possibly in a less costly manner. 
New facilities investment (extensions and expansions) may be added to the capital base when they occur, subject to certain provisions which closely parallel the requirements of the Victorian Access Code.  Where a prudent investment does not satisfy the roll-in test (that is meet the necessary roll-in conditions) the short-fall may, instead of being added to the capital base, be held as speculative investment fund (section 8.19 of the Victorian Access Code) or recovered through a surcharge/capital contribution levied on incremental users (section 8.25 of the Victorian Access Code). 
Redundant assets
The Tariff Order states (clause 9.2(d)) that the asset base for the subsequent regulatory period is the asset base at the start of the initial period adjusted for inflation, depreciation additions and disposals.  No reference is made in the formula regarding the removal of redundant assets.
Commission’s assessment
New facilities investment
As the provisions in the access arrangements for adding new investments into the capital base follow the Victorian Access Code closely there is no need for additional comment on this aspect of capital base augmentation from the perspective of acceptability of the approach.
Capital redundancy
Of concern to the Commission is the omission of redundant assets from the formula which calculates the asset base at the start of the subsequent regulatory period and the potential this has for users to pay for assets that have ceased, or substantially ceased, to contribute to the delivery of services.  
Amendment 3.3
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, clause 9.2(d) of the Tariff Order must be amended to allow the Commission, at the commencement of the subsequent regulatory period, to review, and if necessary to adjust, the asset base for wholly or partially redundant assets.  

3.4	Depreciation and inflation indexation of the asset base
3.4.1	Victorian Access Code requirements
Under the cost of service approach proposed by TPA, depreciation of the capital base represents one element of costs used in the establishment of reference tariffs.  Each asset or group of assets must be assigned a depreciation schedule designed (following section 8.33 of the Victorian Access Code) so that:
•	the impact on reference tariffs is consistent with the efficient growth of the market for the related services;
•	depreciation occurs over the life of the asset(s) with progressive adjustments where appropriate to reflect changes in expected economic lives; while
•	ensuring that the asset is depreciated only once and that total accumulated depreciation will not exceed the valuation of the asset when initially incorporated in the capital base.
Although there is no specific provision in the Victorian Access Code to allow for adjustments to the asset base for inflation, some flexibility is allowed in the method used to calculate revenue.  Section 8.5 permits any methodology to be used provided it can be expressed in terms of one of the methodologies described in section 8.4 of the Victorian Access Code.
3.4.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Since the access arrangement proposes a CCA framework for establishing target revenues the capital base is notionally re-valued in line with price inflation on an annual basis.  Using the re-valued figures in conjunction with a real rate of return to establish capital costs effectively provides the same overall investment return as using unadjusted capital values with an equivalent nominal rate of return, but results in a more level tariff profile over time than alternative approaches. 
Depreciation of system assets uses the straight-line method based on standard asset lives.  However, in line with the CCA approach, depreciation costs are also adjusted to reflect revaluations in line with an inflation index.
While these adjustments to the capital base are described in the TPA Access Arrangement Information document for the purpose of deriving target revenues over the initial five year regulatory period, the same CCA approach is specified for the establishment of the initial capital base for the start of second regulatory period.  That is the 1 January 1998 capital base is the starting point with adjustments made for depreciation, new investment and actual inflation that has occurred between that date and 1 January 2003. 
Commission’s assessment
While the depreciation costs are consistent with the CCA framework they are not, at face value, consistent with section 8.33(d) of the Victorian Access Code which requires that an asset is depreciated only once.  This provision is clearly satisfied from a CCA perspective but the relevant section of the Victorian Access Code goes on to note: 
... the sum of the Depreciation that is attributable to any asset or group of assets over the life of those assets is equivalent to the value of that asset or group of assets at the time at which the value of that asset or group of assets was first included in the Capital Base... 
Since depreciation costs are linked to an inflation index in the CCA approach, the sum of depreciation costs will not equate to the initial value of the assets when they were first introduced to the capital base.  The Commission would argue that the key word in the qualification is ‘equivalent’ since it is necessary to inflate the depreciation to achieve the same overall return as would be achieved using an equivalent non-indexed accounting framework (for example, a nominal rate of return in combination with valuations and depreciation based on historical costs). 
The CCA approach can also be viewed as a mechanism to achieve the equivalent of a non-linear depreciation schedule over time with depreciation costs unindexed for inflation, but again giving an equivalent rate of return.  In this instance, the inflation part of the depreciation cost simply gets relabelled as part of the cost of capital associated with an asset value, which, as a consequence of the relabelling, is not being depreciated as fast.  Such an interpretation is fully compliant with the letter of the Victorian Access Code and generates identical tariffs.  As a consequence, the Commission considers that the CCA depreciation approach proposed is fully consistent with the Victorian Access Code requirements.
The TPA tariff methodology uses a real rate of return in conjunction with asset valuations linked to a CCA approach where simple inflation index adjustments are made annually to the capital base.  For target revenue estimates, forecasts of inflation are used but in establishing the capital base for the start of the second regulatory period, actual inflation estimates will be applied.  The apparent inconsistency is resolved through the CPI-X price-cap which leads to tariff level changes appropriate to actual inflation rather than forecast inflation.
The only stage in which the DORC methodology is used within the proposed access arrangement is to establish the initial capital base.  All subsequent adjustments to the capital base are no different to what would occur with a valuation based on actual costs using the CCA approach.  
The Commission is favourably inclined towards the CCA approach which yields fairly level tariffs over time because of the economic efficiency advantages identified by EPD.  
3.5	Rate of return
3.5.1	Victorian Access Code requirements
The Victorian Access Code (sections 8.30-8.31) states that the rate of return used should provide a return which is commensurate with prevailing conditions in the market for funds and the commercial risk associated with the provision of reference services.  As an example, it suggests using a weighted average of the returns applicable to each type of capital (equity, debt and any other source of funds) with such returns determined on the basis of a well accepted financial model such as the capital asset pricing model (CAPM).  The financing structure assumed should also reflect standard industry structures.
3.5.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA has proposed a rate of return based on WACC using CAPM benchmark comparisons to establish the cost of equity and historical interest rates to establish the cost of debt.  The WACC calculations also take account of dividend imputation which is relevant under the Australian tax system.  In the context of the TPA proposal, where a current cost accounting approach to asset valuation is used, the real rate of return becomes the critical parameter.  This in turn requires any inflation rate assumption (implicit in WACC proposals) to be specified.  The WACC figures proposed by EPD are based on a report prepared by CS First Boston (CSFB).
The underlying parameters, equations and other assumptions used within the CAPM framework to develop the proposed post-tax nominal WACC and other WACC derivatives are summarised below. 

Table 3.2:	Parameter settings used in TPA WACC calculations
Parameter	Value 	Rationale Given by TPA/Formula	
Gearing (D/V) - where 
V = debt(D)+equity (E)	60%	Based on comparable entities, noting high gearing of Victorian electricity distributors	
Risk Free Rate of Return (rf )	8.00%	Based on twelve month range of 6.1% - 8.2% for Sep 2009 bonds plus a premium for the 30-60 year economic life of the assets.	
Market risk premium1 (rm - rf )	6.5 %	Range of 6-7% represents the generally accepted range in the corporate finance industry.	
Corporate Tax Rate (T)	36.0%	Current Statutory Rate	
Cost of Debt ( rd )	8.75%	0.75% above rf  to provide for risk premium and lender margin (claim of 60-90 basis points for similar debt).	
Gamma (  )- the assumed utilisation of franking credits by shareholders	25%	Estimate based on future possible ownership structure (given government intentions to privatise) with adjustment to capture effect of low dividend pay-out ratio.	
Asset Beta ( a )
	0.45	Based on CSFB’s report where estimated e’s of other gas companies (mainly overseas) used to provide benchmark comparisons are adjusted for different gearing ratios plus a term to reflect debt risk.  
a = e E/V +   d D/V  	
Debt Beta2 ( d )	0.12	Calculated from assumed rf, rd and market risk premium.   d = (re -  rf ) / ( rm -  rf)	
Equity Beta ( e )	0.95	Derived from Asset Beta, Debt Beta, debt/equity and corporate tax rate assumptions. 
e = a - ( a - d ) D/E 	
Expected Return on Equity (re )	14.19%	CAPM formula   re = rf  + e ( rm -  rf)	
Inflation ( f )	3%	Considered reasonable assumption for initial tariff setting period.	
Post-Tax Nominal WACC r0	8.34%	re [(1-T)/(1-T(1-))].E/V+ rd (1-T).D/V	
Post-Tax Real WACC rr0	5.18%	(1+r0 ) / (1+f) -1	
Pre-Tax Nominal WACC r1	13.02%	r0  / (1-T)	
Pre-Tax Real WACC rr1	9.73%	 (1+ r0 / (1-T))/(1+f) -1	
Source:	TPA Access Arrangement Information, pp. 16-18. 
Notes:	(1)	In the context of the model used, it is implicit that rm is a partially grossed up figure which takes account of the value of imputation credits to the overall market.
	(2)	Not reported in publicly available access arrangement documentation.
As indicated in the table, the post-tax nominal WACC is defined by the formula proposed by Officer:  

As noted in Table 3.2 above the pre-tax nominal WACC is assumed to be obtained by grossing up the post-tax estimate on the basis of the corporate tax rate.  The real WACC estimates make a further adjustment for the assumed rate of inflation. 
Key issues raised by interested parties
Prior to the Draft Decision there were relatively few submissions dealing with WACC related issues.  However, the Draft Decision gave rise to considerable public debate over the appropriate level of the WACC to be used within the proposed regulatory framework and the way its value should be determined.  The Commission and the ORG held a joint public forum specifically to provide interested parties an opportunity to comment on the issues concerning the regulators’ draft decisions on WACC.  The views and arguments put at that forum and in subsequent submissions are too extensive to consider individually as part of this document.  Nevertheless, the key issues are covered below as part of the Commission’s considerations in finalising its assessment of the WACC for the present access arrangements. 
It was clear from the debate that many of the interested parties, including financial market commentators, were not familiar with the real pre-tax WACC required for the proposed regulatory framework.  In some cases, comments expressed arose from comparisons made between the headline number of the Draft Decision of seven per cent and other market rates of return such as the nominal rates of return on equity, rather than the comparable rates of return implied by the seven per cent real pre-tax WACC.  These concerns were largely discounted by the Commission in the Final Decision for this reason. 
Commission’s assessment
The WACC is a critical element of pricing principles since it determines the prospective profitability of the service provider.  Its value should be set on the basis of financial market benchmarks taking into account the level of commercial risk involved in establishing the service infrastructure.  If it is too low, the service provider would not expect to be able to recover the efficient (and fair) costs of service provision and perhaps, more importantly, may not have adequate incentive to augment facilities when appropriate.  If it is too high, the service provider would have a strong incentive for over-capitalisation and the opportunity to derive monopoly rents.  Such issues are directly relevant to the reference tariff objectives established in section 8.1 of the Victorian Access Code. 
In the Draft Decision the Commission drew on expert advice from Professor Kevin Davis of Melbourne University to assist in its assessment of the WACC proposal.  In its Final Decision the Commission has been further informed in its assessment and decision making process by a large number of submissions from interested parties, financial market experts and commentators addressing matters relating to the CAPM/WACC framework.
In the main, the issues raised by interested parties focused on the financial parameters relevant to the CAPM approach and used to derive the WACC.  However, there were also concerns raised over the use of the real pre-tax WACC approach and the formulae used to determine its value.  These concerns related to both the formulae proposed by EPD and the subsequent modifications proposed by the Commission.  The nature of the formula problems are discussed below in the context of the CAPM/WACC parameter settings.  The key parameters relevant to this analysis are:
•	the risk free interest rate (rf ), the real risk free rate (rrf ) and by implication the anticipated rate of inflation (f) and the interest rate applicable to debt (rd );
•	the market risk premium (MRP);
•	the likely utilisation of imputation credits ();
•	the effective tax rate (Te);
•	the likely level of debt funding (D/V); and
•	the equity beta (e) relevant to the stand-alone operation within the proposed regulatory framework.
Despite agreement on some issues it is clear that the values assigned to the financial parameters remain contentious and warrant discussion in some detail since they form the basis for determining the rate of return that will be permitted on the regulated assets.
Interest rates and inflation
The Victorian Access Code (section 8.30) states that the rate of return should be ‘commensurate with prevailing conditions in the market for funds’.  The Commission interprets this as implying that all information for deriving the rate of return should be as up-to-date as possible at the time the access arrangements come into effect.  In the case of interest rates and inflation expectations for which parameters are set by the financial markets on a daily basis and are readily determined, there seems little justification for using historical data.  This point was supported by Davis and in a number of submissions made prior to the Draft Decision.
This view reflects the fact that the relevant WACC for regulatory purposes should be a forward looking concept that indicates the minimum expected commercial return necessary to underwrite any new facilities investment required to provide the reference services, while taking account of the commercial (and regulatory) risks involved.
The interest rates and inflation estimates relevant to the setting of the WACC are shown below in Table 3.3.
Table 3.3:	Current financial market interest rates and inflation expectations1
 
Financial Indicator	Average Value (per cent pa)
Dec 97-May 98	Value at
15/5/98	Value at
25/9/98	Average of last 8 weeks	
5 Year Gov Bond Rate	5.44	5.40	4.84	5.35	
10 Year Gov Bond Rate	5.71	5.69	5.16	5.53	
Indexed Bonds (August 2005 series) 	3.74	3.65	3.30	3.42	
Indexed Bonds (August 2010 series) 	3.71	3.63	3.28	3.40	
Indexed Bonds (August 2015 series) 	3.68	3.61	3.26	3.38	
Indexed Bonds (August 2020 series) 	3.64	3.59	3.24	3.36	
Estimated 5 year real rate2	3.75	3.66	3.31	3.43	
Estimated 10 year real rate2	3.73	3.64	3.29	3.41	
Implied 5 year inflation expectation3	1.62	1.68	1.48	1.85	
Implied 10 year inflation expectation3	1.91	1.98	1.81	2.04	
Notes:	(1)	Based on the average weekly closing quotes from 5 December 1997 to 25 September 1998 as published in The Australian Financial Review.
	(2)	Interpolations based on indexed bond figures.
	(3)	Inferred by comparing nominal and real interest rates over the corresponding period. 
The risk free rate
TPA states that ‘the ideal proxy for the risk free rate would be the yield on a default risk-free bond with the same maturity as TPA’s assets’.  To reflect this approach, the risk free rate assumed by CSFB in the estimation of the WACC is eight per cent.  This is based on a 12 month (August 1996 to August 1997) historical average ten year bond rate augmented by 45 basis points (the observed premium of 30 year US Treasury Bonds over their ten year maturity counterparts) to proxy the interest rate on a 30 year maturity Australian Government bond rate. 
While the Commission acknowledges that the yield on Government Bonds provides an estimate of the risk free rate, it does not agree with CSFB’s proposal for a number of reasons.  First, the CAPM model on which the WACC is based is a one period model and the interest rate benchmarks implicit in the model are correspondingly short-term.  
Second, rarely does initial debt funding for such investments extend beyond ten to 15 years and in any event, as noted by the Commonwealth Bank of Australia (Commonwealth Bank), it is likely that interest swaps would be re-set on a five yearly basis.  
Third, the temporal structure of cash flows means that the bulk of a project’s costs are recovered well in advance of the technical life of the assets.  
Fourth, even where a long term cost of capital is appropriate to the valuation of long-lived assets, it does not follow that it is appropriate for pricing decisions in the short run when the asset values are annually adjusted for inflation (thus removing a need for an inflation risk premium) and the allowable cost of capital can be revised at each review (to adjust for long term changes in market perceptions). 
The Commission accepts arguments in submissions and those of Professor Davis that neither very long term interest rates nor historical interest rates are appropriate to the estimation of the WACC relevant to TPA assets.   This view was also endorsed by a significant number of commentators and submissions following the WACC forum. 
Taking this position  requires a significant revision of the access arrangement since the proposed 8.0 per cent for the risk free rate compares with current five and ten year bond rates of around 4.8 and 5.2 per cent.  The Commission considers that the term associated with the risk free rate should coincide with the five year period until the next review.
The Commission is aware that there can be short term spurious movements in the relevant interest rates.  This recently happened at the end of August 1998 when the five year bond rate rapidly escalated to over six per cent but within two weeks had moved back onto its trend path more than one full per cent lower.  At the time these movements occur it is often difficult to assess whether the change will be sustained. 
To minimise the impact of such events on the Commission’s decision an average of the last eight weeks will be used rather than adopt the ‘on the day’ rate for regulatory purposes.  The use of such a short term average in the present circumstances is reasonable and does not materially compromise the requirement of the Victorian Access Code that the financial parameters should reflect current market conditions.  The eight week average of the five year Government bond rate to the week ending 25 September 1998 was 5.35 per cent. 
It is probably worth noting that for practical purposes, within the CCA framework proposed, the choice of very long (for example, 30 years) or shorter term (five or ten years) interest rates is largely immaterial since it is the real interest rates that matter.  As the difference between long and short term real interest rates (indexed bond rates) is just six basis points (see Table 3.3 above), there will be only minor differences in the real WACC estimates regardless of the maturity.  The Commission is of the view that the CSFB figure does not reflect current market conditions and is inconsistent with the inflation assumption subsequently applied.  
Inflation assumptions and the real risk free rate
While the inflation rate is not an explicit parameter in the basic WACC estimation, it is an inherent aspect of the risk free rate and cost of debt parameters.  Also it is fundamental to deriving real rates of return which are used in the target revenue calculations and in making current cost accounting adjustments to the asset values on an annual basis.  CSFB have assumed an annual rate of inflation of three per cent over the initial five year price setting period.  In considering this figure, the Commission was concerned that it was not consistent with the historically based estimates of the risk free rate and cost of debt used.  The effect of choosing a rate of inflation lower than that prevailing in the corresponding historical period meant that the real rate of return proposed for establishment of tariff levels is excessive.  Similarly, when current interest rates are used as the basis for the risk free rate and cost of debt, it is still important that the inflation forecast be reviewed for consistency.  
An indication of the inflation rate anticipated by financial markets and corresponding to the interest figures is provided by the difference in the normal bond rates and inflation indexed bonds for the same term.  The indexed bond series have maturity dates which do not correspond to current five or ten year bond rates but the corresponding figures are readily derived by interpolation and are shown in the Table 3.3 above.  These figures represent the real risk free rate corresponding to the current nominal risk free rate (based on the five year bond yield) and indicate that the current expectations of inflation over the initial regulatory period are 1.85 per cent.  
The implied inflation rate expectation differs from current official forecasts of 2.5 per cent.  This may simply reflect a different time horizon under consideration.  However, a choice needs to be made for the purpose of forecasting target revenues in nominal terms and establishing reference tariffs within the regulatory framework. 
The Commission has chosen to use the 2.5 per cent official forecast as the benchmark assumption.  This choice is not critical since the framework is driven by real rather than nominal rates of interest.  However, it is important that current real interest rates are used in conjunction with this forecast and the nominal rates deduced so that consistency is maintained.  Indexed bonds provide the only direct market indicators for real interest rates and provide the basis for the real rates in the context of this decision.  The real rate with an equivalent of a five year term, shown in Table 3.3 above, has averaged 3.4 per cent over the eight weeks to 25 September 1998.  
This figure in combination with the 2.5 per cent inflation assumption, for consistency, requires a nominal risk free rate of 6.0 per cent to be used in the derivation of the WACC. 
Cost of debt
CSFB suggested that the appropriate margin for the cost of debt is around 60-90 basis points above the relevant risk free rate with a nominated value of 75 basis points.  Although the Commission has no concerns with a margin of this magnitude, when combined with the risk free rate proposed by CSFB, the cost of debt of 8.75 per cent is well above average market rates.  This provides strong support for the alternative risk free rate proposals discussed above. 
The lending margin is basically an empirical matter.  Not only will it vary with the credit rating of the company and its chosen level of gearing, it may also depend on the aggressiveness of lenders for financing the project at the time funds are being raised.  Prior to the Draft Decision, Westpac suggest that, for a service provider with an A- credit rating and gearing of around 60 per cent, the likely margin would be 85 to 100 basis points above the five year Commonwealth bond rate.  The Commonwealth Bank suggest that for gearing of 70 per cent, a 100 basis points margin is indicative of the likely range.  BHPP assumed a margin of 79 basis points.  In the Draft Decision the Commission proposed a debt margin of 80 basis points.  However, since that time there is evidence that margins may have increased due to the growing uncertainties in global financial markets.  For this reason the Commission has decided to increase the assumed debt margin to 120 basis points.  This figure is towards the top end of a range of 100 to 125 basis points suggested by Macquarie Risk Advisory Services in a consultancy commissioned by the ORG.  
The 120 point margin in combination with the yield on a five year nominal risk free rate of six per cent suggests a nominal cost of debt figure of 7.2 per cent for use in the WACC estimation.  The corresponding real cost of debt is 4.6 per cent.  
The market risk premium
The market risk premium is a parameter in the CAPM model which together with the risk free rate and firm specific beta determine the expected return on equity in the business.  CSFB proposed 6.5 per cent for the market risk premium given that the conventionally accepted value has been six to seven per cent under the classical tax system.  Davis suggests that this may not be in keeping with a forward looking CAPM framework favoured by the Commission.  For example, the more stable inflationary environment now prevailing may mean that the relevant market risk premium is less than has been observed over recent years.  Also following the introduction of imputation, the premium, as measured in the conventional way, would have fallen to reflect the additional value of franking credits.  However, a ‘partially grossed up’ premium is appropriate within the WACC model and with such adjustment the six to seven per cent range may still be acceptable.  
Davis also notes that this range is too high to be consistent with reasonable estimates of risk aversion and derives alternative figures based on a dividend growth model.  With this approach he estimates a range of between 4.5-7.0 per cent for the market risk premium.  Officer also provides support for the view that the MRP may be trending downward.  Despite these claims of a falling trend, six to seven per cent is still the ‘conventional market wisdom’ favoured by many financial analysts in view of the year to year volatility.
On balance the Commission believes the lower end of the probable range should be reduced, giving a range from 4.5 to 7.5 per cent and, along with Davis, has chosen to use a mid-value of six per cent as the market risk premium for the purpose of estimating WACC
Level of debt funding
CSFB has assumed that the proportion of debt funding applicable to TPA will be 60 per cent based on purchases of utilities in the electricity sector.  While actual debt is at the discretion of the private sector purchaser of TPA, the Commission considers that the nature of regulation proposed for TPA means there is relatively low commercial risk and the gearing for the company could be correspondingly high without adverse credit consequences as suggested in the Australian Cogeneration Association (ACA) submission.  Even if, as expected, gearing following privatisation exceeds 60 per cent of the regulatory asset value, cashflows will be sufficient to facilitate a substantial reduction within the initial regulatory period.  The market value of TPA, when sold, may be significantly higher than the regulatory asset value.  If this is the case, the gearing in the regulatory context could be quite high while the gearing with respect to market capitalisation remains relatively modest.
While the Commission acknowledges that higher figures have been proposed by other parties on the basis of what has happened with the sale of electricity assets to foreign buyers, using that as a guide may not be consistent with the approach espoused below in Box 3.2 on ownership considerations. Nevertheless, the submissions from the banks and BHPP express a strong expectation of gearing between 60 and 70 per cent.
The Commission notes that the Modigliani-Miller theorem suggests that the relevant cost of capital should be invariant over a broad range of gearing possibilities.  The proposed WACC formulation also has this property and therefore the gearing assumption used is not a critical one.  
For the purpose of deriving the WACC the Commission considers the 60 per cent assumption of CSFB to be reasonable. 
Role of imputation credits and gamma estimation
The availability of tax imputation credits requires a modification to the standard WACC/CAPM model to reflect the value to shareholders of tax credits associated with share dividends.  In this revised model the rate of utilisation of tax credits, , becomes a significant parameter.  The analysis of imputation credits and its impact on assessed costs of capital in Australia is a developing field and some issues remain contentious.  While the formula used to derive the post-tax nominal WACC as indicated in the Access Arrangement Information seems appropriate, the value used for  appears questionably low.  Davis has suggested a figure of 50 per cent or above is more appropriate than the 25 per cent assumed by TPA.  This change reflects his views that downward revisions proposed by CSFB to the 50 to 90 per cent estimates for Australian firms (based on dividend drop-off studies) were overdone.  He noted:
•	a 20 to 30 per cent reduction to reflect foreign ownership was unnecessary since the figures obtained in the studies were already influenced by foreign ownership;
•	the assumption that pay-out ratios would be comparable to overseas companies is inconsistent with the incentive for high pay-out ratios under the Australian imputation tax system;
•	this has been compounded by an excessive adjustment to  to reflect the impact of less than 100 per cent pay-out ratios; and
•	reducing the  is also likely to require compensating adjustments to the return on equity (re ) calculation and these have not been made.
Accordingly, the Commission believes that values in the range 50 to 90 per cent suggested by dividend drop-off studies (which examine the change in share price after going ex-dividend) provides a reasonable guide.  Values in this range would also be consistent with the Commission’s preferred approach for foreign ownership adjustments covered in the boxed discussion below and should accommodate the concerns raised on this issue in the Carlton and United Breweries Limited and ACI (Packaging Group) Operations Pty Ltd (ACI) submissions.
However, as discussed below, the deferral of tax (through accelerated depreciation) also defers imputation credits giving them diminished value in the hands of shareholders.  Using the adjustments to  recommended by Davis for less than a 100 per cent pay-out ratio, and a stylised model of cash flows, the discounted value of credits relative to their nominal value suggests a modified range for  of between 40 and 70 per cent based on the drop-off studies and a middle value of 55 per cent.  In view of the fact that there are likely to be other tax concessions not considered in their analysis a somewhat reduced range of between 40 and 60 per cent may be more appropriate.  The mid-value of this range not only coincides with Davis’ nominated value but also with what has been proposed in the Westpac and BHPP submissions on WACC.  While there was lively debate on this issue at the public forum on WACC and in subsequent submissions, there was strong support for a  of 50 per cent.  The Commission remains of the view that a  of 50 per cent is the appropriate assumption for calculating the WACC.
Tax status of the owner
The tax position of the potential owner may raise questions as to the validity of the approach being adopted for the development of the WACC.  For example, an overseas owner may not be able to take advantage of imputation credits although this could be offset to a greater or lesser degree by the more generous taxation treatment available to some overseas (for example, US) investors for the goodwill component of any purchase price.  There is also the more general question of the taxation status of the business and whether it will pay dividends at all and the effective tax rate of the corporate entity during the regulatory period under consideration.  The Commission’s approach to such issues is considered further in Box 3.2 below.
Box 3.2:	The impact on WACC parameters of ownership 
There has been considerable debate over whether weight should be given to the possibility of foreign ownership of the business and the implications this would have for the  to be used in the WACC estimation.  The Commission considers this debate to be somewhat misguided.  For example, if the possibility of foreign ownership is used to moderate the value of , it would seem also appropriate to modify other parameters such as the gearing, the perceived beta values and the effective tax rate on the same basis.  Clearly, the different perceptions, tax treatment and opportunities are major factors which could lead a foreign purchaser to value the business more (or less) highly than an Australian operator. So although a foreign firm may not be able to take advantage of imputation credits, the business could be counter cyclical to its domestic operations and therefore provide shareholder benefits in other ways (effectively the foreign firm perceives a lower beta).  This in turn, may mean that optimal leverage is also higher for the foreign firm.  Such effects may be amplified if the foreign firm is able to derive more generous tax depreciation concessions than an Australian owner. 
The approach the Commission would prefer is to assume the operator is Australian owned with the WACC parameters determined accordingly.  The alternative of assuming foreign ownership (say a US investor) may also be methodologically sound, but is less feasible given the difficulty of assessing the relevant WACC parameters.  If there is a concern that a foreign owner is able to justify a higher purchase price for the assets, that is not a regulatory issue.  Similarly, the prospect that a foreign owner may, after exhausting its own tax concessions, sell to an Australian owner which then takes advantage of the imputation credits that typically accumulate after the other tax concessions have been exhausted, is not an issue relevant to regulation. 
With an Australian owner assumption used to derive the benchmark WACC, the Commission will seek to ensure parameter values are chosen to reflect this situation.  Such an approach suggests an estimate of  towards the high end of ranges discussed by commentators. 
Just as the Commission considers it appropriate to abstract from foreign ownership, it is also appropriate to abstract from complexities introduced by special circumstances (for example, accumulated tax losses, accumulated imputation credits etc) of an Australian purchaser. Accordingly, the effective tax rate assumed to apply to the regulated facility should reflect the tax treatment available to a stand-alone Australian firm. 
Similarly, the Commission will abstract from government ownership and develop WACC estimates based on private ownership.	

Effective tax rates
Even assuming a stand-alone Australian owned operation, the difference between the tax depreciation rates and economic depreciation rates means there is a more rapid payback of capital and a considerable deferral of any tax liabilities associated with the project.  These serve to improve early cashflows to the investment and improve the internal rate of return of the project above that indicated by the assumed WACC parameters.  This effect may be interpreted as an effective tax rate for the return on equity (Te) which is less than the statutory rate assumed by CSFB for the CAPM/WACC framework.  
In the derivation of the CAPM/WACC equations the tax rate used is not usually identified but it is clear from the context that the effective tax rate (Te) could be used in place of the corporate tax rate (T) in the relevant formula for calculating the post and pre-tax rates of return on equity. 
However, use of this rate in the CAPM framework is problematic as the effect on cash flows is not easily integrated into the single period CAPM framework.  While a number of commentators, including Davis, BHPP, and several banks all acknowledge that an effective tax rate is appropriate, and may be well below the statutory rate, they all avoid the issue of how it may be integrated into the CAPM framework.  Instead they suggest that the tax rate effects are best handled in the valuation of post tax cash flows.  Nevertheless, an effective tax rate approach was used in the Draft Decision where cash flow models were used to estimate the reduction in effective tax rate due to tax depreciation exceeding the economic depreciation.  The effective tax rate for return on equity used was 25 per cent.  
However, this approach was criticised at the WACC public forum on the grounds that it was not sensible to attempt to make estimates of the effective tax rate over the life of assets those lives ranged from 30 to 50 years.  This is partly due to the fact that such calculations are sensitive to assumptions regarding maintenance of the effective tax regime, inflation and the depreciable value of the assets for tax purposes.  Since there is considerable uncertainty over these parameters beyond a short time horizon, it was suggested that the statutory rate be used rather than a lower effective tax rate.  Although even the statutory tax rate may be subject to similar uncertainties, the Commission has used it in this regulatory decision.
Use of the statutory tax rate within the WACC formulae, by its effect, implies a decision on an issue surrounding the value of the asset base for tax purposes in the hands of the Government, under the Tax Equivalent Payments (TEP) arrangements, and the value of TPA assets in the hands of a private purchaser.  It has been argued to the Commission that there is a potential‘ tax wedge’ arising from the transfer from public to private hands.  The Commission considers this to be an issue requiring further investigation and will be one of a number of matters considered in future Issues Papers, such as the Statement of Regulatory Intent.
While the use of an effective tax rate set at the corporate tax rate of 36 per cent is accepted on this occasion, the Commission has also noted and explored the preferred approach of financial experts and academics.  At the WACC forum a number of experts (Officer, Hathaway and Davis) argued that their preferred regulatory approach was to avoid the use of a pre-tax WACC altogether.  Subsequent discussions with these experts suggested how this could be done, by using a post-tax WACC directly available from CAPM estimates to reflect the return on assets and capturing the impact of taxes in the cashflows.  Such taxes would simply then be added, along with other costs such as operations and maintenance (O&M), to calculate target revenues for the business.  Such an approach avoids the need for a special conversion formula, discussed later, and handles tax in a very transparent way.
The post-tax approach also addresses another perceived problem inherent in the use of the real pre-tax approach.  This relates to the return incorporating a fixed allowance for tax liabilities.  This means that in the early years the business receives returns in excess of those suggested by CAPM to cover future, but uncertain, tax liabilities.  In later years, the revenues may be insufficient to cover tax liabilities while still achieving equity returns demanded by financial markets.  This feature of the real pre-tax approach is illustrated in Figure 3.1 below.  The allowance in target revenues for tax obligations is indicated by the straight line identified as the ‘statutory rate’.  Actual tax obligations (relative to economic income) are reflected in the curved line.  The average effective rate of tax is shown to be below the statutory rate because of the time value of the tax concessions.
Figure 3.1:	Stylised taxation profile of a regulated gas business

The consequences for after tax returns is shown in Figure 3.2.  The after tax returns are initially above those that would be indicated by the market determined post-tax WACC but once the accelerated depreciated allowances were exhausted the returns achieve would fall below this level.  Such a pattern of returns may place strains on the regulatory contract implied by the proposed framework driven by a real pre-tax rate of return.  This is because the business will very likely claim in the later years it is not receiving the returns commensurate with those required by the market and needs additional compensation through higher tariffs.  In such circumstances the regulator in terms of its obligations under the Victorian Access Code will only be able to respond by noting that such compensation has already been provided during the early years of the assets operations. 
The fact that the post-tax approach assesses tax obligations on an ‘as you go’ basis avoids both the need to calculate a long term effective tax rate and problems generated by post-tax returns diverging from market rates over time.  As far as the business is concerned the post-tax approach would remove any risks associated with future tax liabilities and provide a return that was always commensurate with market requirements.  However, the business would lose the benefit of early free cash flows that may be attractive to some owners.  
The consequences of the pre-tax approach and its implications for the effective tax rate are reviewed in more detail within Appendix E, together with the post-tax alternatives.  
Figure 3.2:	Actual and ‘market’ post-tax return, long term average tax rate

The Commission sees benefits in a post-tax approach but also notes there are still a number of complex issues that are difficult to resolve.  The Commission recognises the need to subject such an alternative to widespread examination by experts and other interested parties in a public process.
As a consequence the Commission is reluctant to change the proposed approach without further work.  The Commission intends to pursue this and a number of related issues further, including in the context of its Statement of Regulatory Intent.  
Beta estimation and the treatment of risk
The Draft Decision noted a number of concerns with the derivation of the equity beta (e) proposed by EPD.  Accordingly, the Commission reduced the asset beta to 0.35 from the proposed 0.45 and the equity beta from 0.95 to 0.85.
EPD and others have claimed there is a significant asymmetry in the diversifiable risks faced by the service provider, and this should be reflected in a higher return available, either through a notional addition to cashflows or a higher beta.  This is an empirical matter.  Many commentators have drawn attention to downside risks, such as those associated with the recent Longford disaster, but comparatively little assessment has been made of upside benefits, including those available as a result of the incentive based arrangements operating in the regulatory framework. 
Under normal CAPM assumptions the equity beta is meant to reflect only market related or non-diversifiable risks  However, it was suggested that an allowance for unique (diversifiable) risks could be accommodated by increasing the value of beta instead of providing a specific allowance in the cash flows. 
An increase in the equity beta would only be justified if there were a downside bias in the unique risks faced by the business.  Arguing for such a bias the applicant noted the possibility of by-pass or redundancy of assets and the uninsured risks faced by the business.  
On the first of these the Commission could find little evidence that such stranded asset risks were significant in the context of the Victorian pipeline system.  The way reduced utilisation would be handled under the regulatory arrangements would also tend to ameliorate any adverse impact of demand reductions.
On the issue of potentially insurable risks, EPD submitted a commissioned a report which attempted to quantify the notional insurance premiums that may be associated with self-insurance.  Had the calculation of such premiums been credible there would have been a reasonable case for the inclusion of a corresponding allowance in the target revenue calculation.  The Commission believes that the claims were not justified, not necessarily because of the high values placed on certain types of disaster, but because of the suggestion that a company such as TPA with proposed equity capital of around $150 million can credibly self-insure for a loss of, say, $1 billion.  When the upper limit of $150 million is placed on such insurance claims the total value of the notional insurance premium reduces markedly. 
On the basis of evidence presented, the Commission was not convinced that there were significant downside risks that outweighed potential upside benefits which would be on top of profits implied by the target revenue calculations.  Nevertheless, the Commission does acknowledge that all of these risks are difficult to quantify.  Accordingly it has adopted the suggestion of financial experts at the WACC forum, that they are taken account of by choosing beta estimates towards the top end of the plausible range.  
In determining the beta pertinent to TPA, submissions have suggested that regulatory arrangements which are based on revenue caps or price caps are inherently more risky than the US rate of return regulation which provided the main source of benchmark firms for beta determination.  As a consequence, EPD has suggested higher beta assumptions than it originally proposed would be appropriate.  The asset beta range for Transco in the UK, which is subject to a similar regulatory regime to TPA, was assessed by the Monopolies and Mergers Commission 1997 price review as being between 0.45 and 0.60. 
In addition, it was suggested that the ‘newness’ of the regulatory framework introduced perceived uncertainties on the part of investors which should be taken into account in setting the cost of capital via the beta value assumption. 
The Commission accepts these considerations as being relevant and has acknowledged that commensurate increase in the beta estimates may be appropriate.  The asset beta (equity beta) has been increased from 0.35 (0.85) to 0.55 (1.20).  Given that the risks are compensated for by the higher beta which leads to a higher rate of return, it would be difficult to justify additional compensation should one of these risk events materialise and impose additional costs on the service provider.  
The real pre-tax WACC conversion formula
The Commission believes that it has identified a potential problem with the formula proposed by EPD to derive the real pre-tax WACC from the CAPM input assumptions.  This was first highlighted when the cash flows resulting from EPD’s real pre-tax WACC of 9.73 per cent were simulated.  The nominal post-tax return on equity implied by those cash flows was 17.8 per cent, considerably in excess of the 14.2 per cent used as the basis for deriving the WACC.  This was partly attributable to the faster rate of tax depreciation relative to economic depreciation.  
However, even when the tax depreciation was set to be the same as the economic depreciation, the discrepancy remained, with the implied nominal post-tax return on equity equal to 15.7 per cent, still well above the 14.2 per cent used as the basis for setting the real pre-tax WACC.  
Even when used in the context of very simple stylised models this discrepancy remained, highlighting a deficiency in the real pre-tax conversion formula.  Closer examination of the formulae proposed by EPD showed no problems for the WACC formulae expressed in nominal terms.  The error was introduced in the conversion to the real pre-tax equivalent WACC required to set target revenues.  EPD’s approach was to start with the nominal post-tax WACC then gross-up for taxation and in a second step adjust for inflation to give a real pre-tax number.  Such an approach is only valid for a regulatory framework which uses a nominal pre-tax WACC applied to a regulatory asset base which is not adjusted for inflation. 
In a report commissioned by the ORG, Macquarie Risk Advisory Services suggested that reversing the order of the transformation, that is, adjust for inflation first and gross up for tax second, provides the correct conversion where a real rate of return is applied to an asset base which is adjusted for inflation.  This is easily demonstrated to be correct for a simple analytical model and in a simple cash flow model.  However, in a more realistic context involving debt where there is an interplay between the tax on equity and the debt shield which is sensitive to inflation, simulations show again, that the pre-tax real WACC obtained is incorrect.  In this case the bias is opposite to that obtained using EPD’s transformation. 
The level of bias in each case depends on the assumptions used concerning the real cost of debt, the gearing, the utilisation of imputation credits and, in particular, the rate of inflation.  Given this uncertainty associated with the conversion formulae, the Commission has sought to resolve the issue by adopting a less mechanistic approach.  This is discussed further below. 
Recalculation of rates of return 
The Commission considers the above concerns over CSFB’s assumptions used to derive WACC and the conversion formula used warrant a re-calculation of proposed real pre-tax WACC and the resultant target revenues used to set tariff levels.  To assist in the development of an alternative WACC, Table 3.4 summarises the parameter values proposed by TPA, the Draft Decision and this Final Decision.  
Table 3.4:	Comparison of WACC parameters used by TPA and ACCC values
CAPM Parameter	TPA Proposal 	ACCC Draft Decision	ACCC Final Decision	
Real Risk Free Rate (rrf ) %	4.85	3.66	3.43	
Expected Inflation Rate (f) %	3.00	1.68	2.50	
Nominal Risk Free Rate (rf ) %	8.00	5.40	6.00	
Cost of debt margin (over rf ) %	0.75	0.80	1.20	
Cost of debt(rd ) %	8.75	6.20	7.20	
Real cost of debt (rrd ) %	5.58	4.45	4.60	
Market Risk Premium (rm-rf ) %	6.50	6.00	6.00	
Corporate Tax Rate (T) %	36	36	36	
Effective Tax Rate (Te) %	36	25	36	
Usage of Imput. Credits () %	25	50	50	
Debt Funding (D/V) %	60	60	60	
Debt Beta (d ) (a)	0.12	0.06	0.12	
Asset Beta (a )	0.45	0.35	0.55	
Equity Beta (e) (b)	0.95	0.85	1.20	
Nominal Cost of Equityc re = rf+e (rm-rf) %	14.19	10.5	13.2	
Real Cost of Equityc rre = (1 + re)/(1 + f) - 1 %	10.9	8.7	10.4	
Notes:	(a)	The applicant calculated the d as (rd-rf)/(rm-rf) but this assumes banks’ costs are zero.  To deduce the d on a similar basis the Commission has assumed that bank costs account for about 50 basis points of the debt margin so that d = (rd-rf - 0.50)/(rm-rf)
(b)	In the Draft Decision the Commission adopted the formula proposed in Davis’ paper
a [1+(1-(1-)T) D/E] but now considers the Monkhouse formula more appropriate since it reflects an assumption of an active debt policy aimed at maintaining a specific gearing ratio as assumed in the regulatory model.  The Monkhouse formula e = a +(a -d )(1-rd/(1+rd)T) D/E is in fact quite close in numerical terms to the formula originally used by CSFB  e = a + (a - d  ) D/E. 
(c)	These estimates of return on equity are derived from the CAPM model and associated parameters.  As noted in the text, the outcome in actual cash flows will exceed these numbers where the EPD formula is used as the basis for the pre-tax real WACC.  10.5 is consistent with the above parameters, although the Draft Decision’s 7 per cent equated to a nominal cost of equity of 11.2. 
While the CAPM/WACC framework provides a well recognised theoretical framework to establish the cost of capital, there is less than full agreement on the precise magnitude of the various financial parameters which need to be applied (as evidenced by the range of parameter values suggested by different commentators).  The variability of WACC estimates flowing from uncertainty in the underlying parameter assumptions was explored in the Draft Decision.  However, such an exercise is considered of limited value for the purpose of the Final Decision.  The Commission has given careful consideration to the value that should be assigned to TPA given the nature of its business and current financial circumstances.  Accordingly, the parameter values used are those considered most appropriate.  Mostly these fall near the middle of a narrow range based on the information available, however a few, such as the equity beta and the margin on debt, have been chosen to give TPA the benefit of associated uncertainty.  
As discussed previously, there is some question as to the appropriate formula to be used to determine the real pre-tax WACC.  Hence Table 3.5 below shows the results of the alternative formulae which have been proposed.  
Table 3.5:	WACC estimates based on parameters given in Table 3.4 and Commission decisions
CAPM Parameter	TPA Proposal 	ACCC Draft Decision	ACCC Final Decision	
Nominal Cost of Equity re = rf+e (rm-rf) %	14.19	11.2	13.2	
Post-Tax Nominal WACC (r0) %
re [(1-Te)/(1-Te(1-))].E/V + rd (1-T).D/V	8.34	6.0	6.9	
Post-Tax  Real WACC  (rr0) %
(1+r0 ) / (1+f) -1	5.18	4.2	4.3	
Pre-Tax Nominal WACC (pr0) %
=re /(1-Te(1-)).E/V +rd .D/V	13.02	8.5	10.7	
Pre-Tax Real WACC  (prr0) % = (1+ pr0)/(1+f) -1
(applicant transformation)	9.73	6.7	8.0	
Pre-Tax Real WACC  (prr0) % = rr0/(1-T)
(reverse transformation)	8.09	6.0	6.7	
Pre-Tax Real WACC  (prr0) %
Commission Decision	na	7.0	7.75	

Given the uncertainty represented by the conversion formula, the Commission has decided to focus primarily on the nominal return on equity which comes directly from the parameters in Table 3.3 and the post-tax nominal WACC.  There is broad agreement among experts and commentators about how these are to be calculated from the basic input parameter assumptions.
To obtain the pre-tax real WACC, the Commission has used computer models which simulate the cash flows emanating from the regulatory framework.  The value is chosen so that the cashflows indicated by the model are consistent with the nominal return on equity of 13.2 per cent (and the post-tax nominal WACC of 6.9 per cent) indicated by the CAPM model based on parameters identified as being appropriate to TPA within this regulatory period.
The value of the real pre-tax WACC consistent with these outcomes is 7.75 per cent, which is between the values suggested by EPD and Macquarie (reverse) transformation formulae.
The inter-play between the assumed tax arrangements, tax depreciation, economic depreciation, the mix of asset classes, level of debt (and how it is funded) and the assumed inflation rates are all known to alter the conversion relationship. 
Given this dependence, however, it is important to note what assumptions have been made to arrive at the 7.75 per cent outcome.  The model used is strictly in line with the regulatory framework proposed and asset values, capital expenditures, and lives are as specified in the access arrangement.  Other costs and financial parameters are as specified in this Final Decision.  
This includes the effective tax rate assumption.  Rather than recognise the accelerated depreciation allowances available under the Australian taxation system the depreciation for tax purposes has been assumed to be identical with economic depreciation recognised by the regulatory framework.  This is analogous to assuming an effective tax rate of 36 per cent within a conversion formula.  The reasons for adopting such an assumption were discussed previously in the context of WACC parameter settings.  
While 13.2 per cent is the expected post-tax return on equity under the assumptions of the regulatory framework, this is a long term expectation.  In reality, returns will vary from year to year and can be expected to exceed this benchmark under the incentive provisions of the access arrangement.  
It should also be re-iterated that, under the real pre-tax regulatory framework where there is a provision for future tax liabilities in the revenue streams, actual post-tax returns to equity will be initially much higher than 13.2 per cent.  However, when the bulk of available accelerated depreciation tax provisions are exhausted, the achieved return on equity can be expected to fall below the 13.2 per cent.  This is a feature of the real pre-tax approach, as discussed earlier.  This result must be recognised as part of the implied regulatory contract underpinning the proposed access arrangements.  The implication is that the lower future return cannot be used, at that time, to argue for an increase in the rate of return.  To permit such a change would amount to double dipping since the business has already been compensated in earlier years.  The key WACC decisions relevant to the setting of tariffs are the value of the real pre-tax WACC and the value of inflation.  
These are shown in amendment 3.4 below.  With respect to the inflation assumption it is noted that the first year of the regulatory period is now more than half over.  Hence the actual inflation rate should be applied to the June quarter since the number is known.  The 2.5 per cent inflation may be then applied to obtain the forecast for 1998 as a whole.  This figure is 2.0 per cent.  Since first year target revenues for the base from which future year revenues are projected it is important that the target revenues for the first year of the regulatory period reflect, as closely as possible, actual costs.  To achieve this the inflation forecast for 1998 should be set at 2.0 per cent and subsequent years at 2.5 per cent.
Amendment 3.4
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved: 
(i)	the WACC estimates and associated parameters forming part of the Access Arrangements should be amended to more accurately reflect the current financial market settings.  In particular, the pre-tax real WACC should be set at 7.75 per cent and the associated inflation assumption set at 2.5 per cent; and 
(ii)	the target revenues and forecast revenues should be based on these new parameters, including the X factor, and applied in the derivation of individual tariffs. 

Concluding comments on the WACC and the nature of the Regulatory Contract
Since the WACC has been established on the basis of a CAPM framework, the regulatory return, by definition, does not incorporate any significant level of monopoly rents.  This is seen as important in the context of the micro-economic objectives of the Victorian Access Code.
Notwithstanding this, many commentators have tried to argue that the market will require a WACC considerably above the 7.75 per cent figure.  Such comments generally reflect confusion on how the real pre-tax WACC should be interpreted.  The number is in fact a real return and the benefit available from the inflation adjustment of the asset base needs to be accounted for before it is compared with the normal indicators available from financial markets.  The best guide for comparison purposes is the post-tax return on equity of 13.2 per cent.  This is directly comparable to the corresponding numbers implied by companies listed on the Australian share market.
Indeed, there were several commentators of note at the WACC forum and in subsequent submissions who endorsed such a rate of return as being appropriate.  For example, Mr Timms of AMP Asset Management (Infrastructure) stated at the forum that a target return on equity in the range of 12 to 13 per cent nominal was appropriate in the present inflationary environment.  Michael Thompson, Vice President of the Investment Banking Division of Merrill Lynch made a similar statement.
Further support for the proposed level of return is suggested by the prospective earnings, relative to their observed market value of energy infrastructure which have been recently sold or listed on the Australian Stock Exchange.  Two studies contained in a submission from the Australian Gas Users’ Group (AGUG) suggest that the relevant WACC may be around 7 per cent or less.  The companies analysed in this instance were Envestra Limited which was recently floated on the Stock Exchange and Powernet Victoria recently acquired by GPU.
Having resolved that that regulatory WACC is fair and reasonable, it is useful to reiterate the nature of the regulatory contract implied by the access arrangements in conjunction with the Victorian Access Code.
First it needs to be noted that the framework is not rate-of-return regulation.  The incentive based mechanisms forming part of the framework permit the business to achieve returns in excess of the nominated WACC through efficiency improvements, innovation and market growth.
At the same time, there are certain obligations forming part of the regulatory contract that limit the scope for what could be best described as 'double dipping'.  These have previously been clarified but a brief summary is useful at this point.  They include:
•	recognition that the equity beta has been set at a relatively high level to compensate for a range of risks facing the service provider.  These include potentially insurable risks, the prospect of stranded assets and regulatory risk.  Therefore, the service provider will be limited in terms of extra compensation at a later stage to the extent it incurs costs associated with these risks;
•	the provision for future tax liabilities implicit in revenues associated with the real pre-tax regulatory framework.  Should future revenues appear inadequate to achieve a market rate of return while meeting the then current tax liabilities, there would be little or no justification for a compensating increase in tariffs at that stage.
•	finally, the Victorian Access Code requires the WACC parameter settings to be reset at each review to be consistent with financial market conditions at the time.  Should this prove detrimental to the business there may be scope for adjustments to alleviate problems but, in general, these will be limited to the provisions identified in the Code.
While these provisions may appear restrictive, they are equally likely to work to the advantage of the service provider as against it.  The reverse side to the points made above is that the regulator can not capriciously make rulings to claw-back gains made by the service provider should events prove more favourable than expected.  
3.6	Operations and maintenance costs and working capital
3.6.1	Victorian Access Code requirements
The Victorian Access Code (sections 8.36 and 8.37) allows for recovery of the operating, maintenance and other non-capital costs that would be incurred by a prudent service provider acting efficiently.  
Attachment A to the Victorian Access Code (see Appendix C to this Final Decision) requires the disclosure in the access arrangement information of costs (including wages and salaries; rental equipment; gas used in operations; materials and supply; and corporate) with some disaggregation by zones, services or categories of assets, unless the disclosure would be unduly harmful to the legitimate business interests of the service provider, user or prospective user.
3.6.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Total forecast O&M costs, for both the PTS and WTS, for the years 1998 - 2002 are $19.5 million, $19.6 million, $19.4 million, $19.1 million, $19.2 million respectively.  While TPA has sought to reflect efficiency savings in its forecast of O&M costs, EPD has assumed additional efficiency savings. 
In supplementary information to the Access Arrangement Information, EPD provided forecast costs for the five years of the initial regulatory period disaggregated into 12 cost categories and with data for Murray Valley stated separately.  These data indicate that ‘labour’ and ‘outside services’ each account for about one third of total O&M costs.  Separate figures are also given for the ‘administration’ and ‘marketing’ contained in the totals.  The data (net of Murray Valley) are also disaggregated into nine pricing zones.
Key issues raised by interested parties
Various submissions noted that O&M expenses had not been disaggregated as required under Attachment A of the Victorian Access Code.  Those interested parties considered that, therefore, they were unable to comment other than to call for more information.  Upon the release of the supplementary information, the Commission requested further industry comment by 27 March 1998.  
Concerns were raised that the absolute level of forecast costs appeared to be too high.  BHPP submitted that GTC’s 1996 costs were $20.6 million.  Of this, LNG system security ($1.38 million) and transmission system control ($4.5 million) will now be performed by VENCorp.  Also TPA will operate 1 600 km of pipeline whereas GTC operated and maintained 2 200 km.  BHPP expects this reduction in pipeline length to result in a proportional reduction in O&M costs (to the extent that O&M costs are not fixed) of approximately $5 million.  Consequently, it believes O&M costs of $9.8 million are more appropriate.  
In response to these comments EPD states that costs are largely fixed and that the reduction in staff associated with the reduction of pipeline length resulted in a saving of $1.2 million rather than the $5 million suggested by BHPP.  Further, there are additional costs that will be incurred by TPA in 1998 which were not incurred by GTC in 1996.  A reconciliation of GTC’s 1996 costs to the forecast 1998 TPA costs was submitted.  
Commission's assessment
TPA’s starting point for forecast O&M costs is the GTC 1997 Corporate Plan (which includes GTC’s expected productivity savings).  Costs relating to VENCorp activities are removed and the remaining costs allocated to TPA activities.  Total TPA O&M costs (not including compressor fuel costs) are forecast to be $24.3 million in 1998, rising to $25.4 million in 2002.  
Costs not associated with reference services were then removed.  The Commission has no reason to believe that the methodology for the allocation of costs between reference services and other TPA services is unreasonable. 
Finally, the total remaining costs were reduced by EPD by an expected ‘productivity factor’.  This factor is in addition to GTC’s expected productivity savings built into its forecasts.  The productivity improvement factor by which EPD reduced TPA’s forecast revenue for each of the five years 1998 - 2002 is 0.77, 2.56, 4.31, 6.10 and 7.73 per cent respectively.  This is equivalent to a cumulative reduction of 1.5 per cent per year.  This results in the total forecast operational costs tabled in the Access Arrangement Information and noted above (in service provider’s proposal).  A more detailed explanation of this process can be found in Appendix D.  
Two industry accepted benchmarks for O&M costs are cost per pipeline length and cost per volume transmitted.  O&M costs per 1 000 km in 1998 is forecast to be $16 million, which compares unfavourably with other Australian transmission pipelines which have costs in the range of $9.0-12.8 million/1 000 km.  TPA’s forecast O&M costs of $0.13/GJ compares favourably with these same pipelines which have a range of $0.15-0.20/GJ.  Both measures compare unfavourably with GTC’s figures for 1995/96 of $9.4 million/1 000 km and $0.09/GJ respectively.  However, these figures must be viewed in the light of the structure and size of the Victorian transmission system.
The Commission has reviewed the cost forecasts and has no reason to believe that the forecast levels for 1998 are excessive.  Discussions with TPA about the methodology employed in GTC’s forecasting indicate that a significant proportion of costs forecast for 1998 were known costs based on existing contracts, while labour costs were based on assumptions which have subsequently proved to be accurate.  The Commission has noted BHPP’s analysis but has identified no basis for concluding that EPD’s response to BHPP’s comments is unreasonable.
However, the Commission considers that the level of productivity savings implied in the level of total costs forecast of just over $19 million for each of the next five years does not appear to incorporate productivity savings of the level that could be expected from a government enterprise that is about to be privatised.  It notes that EPD has required TPA to achieve efficiencies of one and a half per cent per year on top of those incorporated in GTC’s forecasts and that EPD claims that the corporatisation of GTC realised many of those efficiencies.  Notwithstanding this, the Commission believes that greater efficiency savings are likely to be available in the future and was factored into its overall assessment of the proposed access arrangements and the proposed amendments.  
The TPA forecasts are based on an inflation forecast of three per cent.  However, as noted in section 3.5 above, the Commission considers an inflation rate of 2.5 per cent to be a more appropriate forecast.  To be consistent, the forecast O&M costs should reflect this change.  That is, they should increase from 1998 by 0.5 percentage points less than that proposed in the Access Arrangement Information.  
Amendment 3.5
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the operational costs component of the target revenues contained in the access arrangements must be reduced by an amount equal to 0.5 per cent per year (cumulative) for years two to five of the initial regulatory period.  

A return on net working capital is also included in the tariff calculations which is separate from the O&M cost.  Calculated using pre-tax nominal WACC (of 13.02 per cent) the amount in the access arrangement for 1998 is $520 000.  This required return implies the level of working capital is $4 million (though this is not stated anywhere in the Access Arrangement Information).  The Commission notes that there is no forecast working capital for the distribution businesses.  However, the level of working capital implied in the return forecast does not appear unreasonable to the Commission.  The forecast return will need to be reduced in line with the reduction in WACC required in section 3.5. EPD has accepted this amendment.  It has also indicated that the basis of determining the working capital will be revised in the light of more recent information to hand.  
Amendment 3.6
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the forecast return on working capital, for each year of the initial regulatory period, must be recalculated using the WACC consistent with amendment 3.4. 

In conclusion, the Commission is satisfied that the allocation of operating, maintenance and other non-capital costs between tariffed services and non-tariffed services has been made appropriately.  With the amendments proposed adopted in the revised access arrangements, the Commission is of the view that the forecast revenue will allow for the recovery of the operating, maintenance and other non-capital costs that would be incurred by a prudent service provider acting efficiently.  
3.7	Forecast revenue 
3.7.1	Victorian Access Code requirements
Three methodologies are set out in the Victorian Access Code (section 8.4) for determining total revenue: cost of service; IRR; and NPV.  The service provider has proposed the cost of service model.  This provides that the total revenue recovers costs, which are calculated on the basis of a rate of return on asset values, depreciation of the asset base, plus the operating, maintenance and other non-capital costs incurred in delivering all services.
3.7.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
The ‘target revenue’ for each of the five years of the initial regulatory period is the sum of all the forecast costs (as described above) for each year.
To create a smooth pricing path, EPD has proposed that the average unit revenue ($/GJ) in each year after the first year should increase by the formula CPI-X.  For each year after the first year, the average unit revenue multiplied by the forecast total anytime volume of gas consumed will give a ‘forecast revenue’.  X is initially set so that the NPV of this forecast revenue stream is equal to the NPV of the target revenue stream.  X is then adjusted to a level that EPD states will represent best practice for a similar company.  This process gives an X of 3.4 per cent.  The NPV of the forecast revenue stream is materially the same as the NPV of the target revenue.  The target revenues and forecast revenues for the five year regulatory period are set out in Table 3.6 below. 
Table 3.6:	Target and forecast revenue for TPA
Year ending 31 December 	1998	1999	2000	2001	2002	
Target revenue ($m)	70.2	72.2	74.8	77.1	77.3	
Forecast revenue ($m)	68.1	74.8	75.9	75.8	74.6	
Source:	TPA Access Arrangement Information, p. 21. 
	Letter from EPD to Commission, 29 April 1998. 
Note:	The forecast revenue in the Access Arrangement Information was incorrectly calculated.  EPD’s letter contained the correct forecasts which are reproduced in the table.  The forecast revenue is simply an expression of the revenue which is forecast to result from the tariffs calculated in the tariff model.  This correction does not change target revenue, the initial tariffs or the price path set out in the Access Arrangement Information and the Tariff Order.  
Key issues raised by interested parties
CitiPower Pty (CitiPower) states that the forecast $70.2 million for TPA’s costs and revenue requirements appears reasonable.  As noted in the above sections, BHPP argues that costs should be significantly less.
Commission's assessment
The Commission considers the desire for a smooth pricing path within the initial regulatory period to be reasonable and does not oppose the substitution of the target revenue stream with a forecast revenue stream of the same (or less) NPV.
As indicated in Table 3.7 below, the recommendations in this Final Decision, will reduce target revenues by around 13 per cent (equivalent to revenues of $12 million in 1998).  It should be noted that comparisons of changes beyond 1998 are exaggerated by the different inflation assumptions.  Since revenues are adjusted annually based on actual inflation, the 13 per cent difference observed for 1998 is also indicative of the difference in future years.  These changes in target revenues will also require a re-calculation of the X factor used in the adjustment of tariffs over time.  However, initial estimates suggest the X will not change from 3.4 per cent as proposed by EPD.  
The cumulative impact on target revenues of the recommended changes in the access arrangement proposals relating to the establishment of the costs of providing the reference services are summarised in Table 3.7 below.
Table 3.7:	Target revenue estimates resulting from recommended changes to cost of service calculations ($m)
Year Ending December 	1998	1999	2000	2001	2002	
TPA proposal	70.2	72.2	74.8	77.1	77.3	
Actual inflation adjustment of DORC to 1  January 1998	69.5	71.5	74.1	76.4	76.5	
Reduce inflation assumption from 3.0 per cent to 2.0 per cent for 1998 and 2.5 per cent thereafter	68.9	70.7	73.0	75.0	74.9	
Adjust O&M for different inflation assumption	68.9	70.6	72.8	74.7	74.5	
Reduce pre-tax real WACC to 7.75 per cent	61.3	62.8	64.6	66.3	66.1	
Adjust for a proportion of indirect assets to be recovered by non-reference services	60.9	62.4	64.3	65.9	65.7	
Source:	Commission calculations.  
Financial Indicator Analysis
To assess the implications of the total revenue for the credit-worthiness of the transmission business, the Commission has produced the range of financial indicators that credit rating agencies normally use to undertake such assessments.  However, considerable care is required in making inter-company comparisons since the risk factors, optimal leverage and taxation position are important commercial considerations.  As such the financial ratios which are appropriate for one company may not be appropriate for another.  In constructing and interpreting these indicators, the Commission has sought advice from IPART which uses these and other financial indicators extensively to set regulated price paths.
The financial indicators that were considered by the Commission and the ranges applicable to utilities are those which were provided by Standards and Poor’s Ratings Group to the NSW Treasury.  In interpreting these ratios, the Commission considers that a credit rating above ‘A’ would be considered to be an indicator of sufficient credit worthiness to ensure the financial viability of this type of business, noting that the NSW Treasury has adopted a minimum target of an A rating for its government trading enterprises.  Table 3.8 below shows, for different categories of business risk, the range of each indicator that is consistent with an ‘A’ credit rating, as well as the indicators for the categories above and below ‘A’. 
Table 3.8:	Standard and Poor’s credit rating indicators
Utility Business Risk Profile	Funds Flow Interest Cover	Funds Flow Net Debt Pay Back	Internal Financing Ratio	
	AA	A	BBB	AA	A	BBB	AA	A	BBB	
Excellent	3.25	2.75	1.50	6.0	9.0	12.0	70	60	40	
Above Average	3.50	3.00	2.00	5.0	7.0	9.0	80	70	50	
Average	4.00	3.25	2.50	4.0	5.5	7.0	100	90	55	
Below Average	4.25	3.50	3.00	4.0	5.5	7.0	100	100	75	
Vulnerable	X	4.00	3.50	X	4.0	6.0	X	100+	90	
As TPA has just been formed and does not as yet have a commercial financing structure, the Commission has adopted assumptions about the balance sheet of the business to construct a meaningful test of the revenue stream that its view on total revenue would imply.  In general, the Commission has used assumptions used within a model of accounts supplied by EPD.  This includes assumptions on the rate of debt/equity ratios, the rate of debt pay-back and dividend policies which may not be appropriate under all scenarios or those adopted by the company.  Nevertheless, it forms a reasonable basis for estimating the financial indicators. The particular assumptions adopted are:
•	the market value of the transmission business is the capital base;
•	the business commences the access arrangements period with 70 per cent debt which reduces by a constant amount (provided funds are available); and
•	the cost of debt is the same as assumed by the rate of return calculation relevant to each scenario.
Table 3.9 below shows the relevant financial indicators for TPA over the access arrangement period that is implied by the projected total revenue that was proposed by TPA, as well as those implied by the projected target revenue following the changes to the access arrangements recommended by the Commission.  
In interpreting these ratios, the Commission considers that TPA has a risk profile which is between above-average and excellent given the likely stability of earnings and lack of competitors for the services being provided.  
In comparing the financial indicators pertinent to Standard and Poor’s credit rating criteria, it is noted that the impact on the indicators of the Commission’s recommended changes are relatively minor.  This is partly due to the fact that the interest rate on debt assumption partly offsets the more generous pre-tax real WACC assumption.  It should be noted that the assumed inflation rate will have only a minor impact on the financial indicators.  Indeed, because tariffs are linked to actual inflation in the regulatory framework rather than forecast inflation, the financial ratios will tend to be preserved in a broad range of economic settings.
Table 3.9:	IPART financial indicators calculated for TPA under EPD proposal and ACCC recommended changes (AGL figures are included for comparison)
Company	AGL	TPA 
EPD proposal	TPA 
ACCC changes	
Financial indicator	av.  1996 & 1997	5 years av.	5 years av.	
Funds flow adequacy (%)	103.1	82.5	78.5	
Funds flow interest cover (times)	9.8	2.6	2.6	
Funds flow net debt pay back (years)	1.5	8.6	10.5	
Internal financing ratio (%)	108.5	123.2	118.9	
Pre-tax interest cover (times)	6.8	2.0	1.9	
Total debt percentage (gearing %)	28.4	66.6	66.8	
PATBI to funds employed (%)	13.4(a)	9.6	7.5	
PBIT to revenue (%)	21.1	57.0	50.2	
PBITD to revenue (%)	27.7	74.4	70.4	
PBIT to funds employed %	17.6(a)	11.8	9.0	
EBIT on operating assets %	12.4(a)	11.0	8.4	
Notes:	(a) These figures are not strictly comparable to TPA figures since the funds employed relate to a balance sheet value rather than stock market capitalisation and the operating assets are book values rather than the value of the assets for regulatory purposes.
	Financial indicators formulae: 
Funds flow adequacy		(profit after tax + depreciation)/(dividends + capex)
Funds flow interest cover		(profit after tax + depreciation + interest + tax)/interest
Funds flow net debt pay back	(total debt - cash)/(profit after tax + depreciation)
Internal financing ratio		(profit after tax + depreciation - dividends)/capex
Pre-tax interest cover 		(profit before interest and taxes)/interest
Total debt ratio			(total debt)/(total debt + total equity)
PATBI to funds employed		(profit after tax + interest)/(total debt + total equity)
PBIT to revenue			(profit before interest and taxes)/target revenue
PBITD to revenue		(PBIT + depreciation)/target revenue
PBIT to funds employed		PBIT/(total debt + total equity)
EBIT on operating assets		EBIT/average total assets
The rating is not uniform across the Standard and Poor’s related indicators.  The funds flow interest cover is very close to the A rating in each case and the funds flow net debt pay back is between A and BBB.  The internal financing ratio clearly has an AA rating in each case.  Nevertheless, on balance the analysis suggests that TPA would have an A or A- credit rating under both the EPD scenario and under the Commission’s revised scenario.  This is reinforced, given the high gearing of 70 per cent assumed in the EPD model.  At the mid-range gearing ratio of 60 per cent assumed in the WACC formulation the first two indicators which are heavily influenced by the level of debt would move closer to the A ratings.  The ratings suggest that the required amendments of the Commission will not adversely compromise the financial viability of TPA nor its ability to raise finance for ongoing investment. 
This conclusion provides a degree of comfort with the rate of return requirement being set by the Commission in this decision.  It should be noted that the financial indicators are irrelevant as a check on the value assigned to the initial capital base.  This is because the financial indicators depend on the rate of return, but as ratios they are relatively insensitive to the value of the asset base.  In a sense, alternative valuations in the short to medium term represent only a re-scaling of the size of the business.
Macquarie Bank financial analysis
The Commission engaged the Macquarie Bank to independently assess the cash flows associated with TPA under the Commission’s regulatory framework.  It has developed a model which is not constrained and thus allows a more realistic appraisal of the business over the longer term.  The model captures the need for ongoing replacement investment and extends the cash flow modelling over the full life-cycle of the pipeline system (50 years).  However, in other respects the Macquarie Bank analysis of the credit worthiness of TPA under the regulatory arrangements proposed, closely parallels that given above.  In particular, it uses Standard and Poor’s two dimensional indicative credit rating framework for global power companies which they summarise in the following matrix.  
	Weak	A	BBB	BB	
Financial Profile	Average	AA	A	BBB	
	Strong	AAA	AA	A	
		Strong	Average	Weak	
		Business Profile	

Macquarie’s business risk assessment of TPA uses a qualitative approach taking account of such factors as likely volatility of earnings, gearing, regulatory environment, market stability and the susceptibility of TPA markets to competition.  The financial risk assessment is quantitatively based using the same Standard and Poor’s ratios considered earlier but calculated using Macquarie’s own cash flow model.
In both assessments Macquarie drew comparisons with utilities in the electricity sector as benchmarks relevant to Australian financial markets. 
Macquarie summarised the conclusions as follows:
We believe that TPA's business profile is likely to be predominantly the same as GPU Powernet and slightly stronger than the currently rated Victorian electricity distribution companies.
The financial profile based on the benchmark capital structure of 60% debt to net assets suggests that TPA will be significantly stronger than the 74% geared GPU Powernet and on par with the similarly geared electricity companies.
External factors aside, there is no reason to believe that the benchmark structure would be unable to attract at least a “BBB” long-term rating with an “A” being realistically achievable.
These conclusions by Macquarie provide independent confirmation of the Commission’s own analysis. 
3.7.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
VENCorp incurs costs in four areas of activity and these are listed below with the forecast cost for 1998/99.  Primarily they relate to the PTS operations.  WTS related costs consist solely of transmission control ($0.1 million of the figure below), though this will change when the WTS is connected to the PTS.
Table 3.10:	Forecast VENCorp costs for 1998/99
Activity	$ million	
Transmission Control	4.5	
Third Party Access	4.8	
Operation of the Spot Market	2.8	
LNG System Security	1.4	
Total	13.5	
Source:	VENCorp Access Arrangement Information, Supplementary Information, 6 March 1998, p. 2. 
More detailed forecast cost disaggregation for the next four years is contained in Attachment 1 to the supplementary Access Arrangement Information.
Key issues raised by interested parties
ACI states that additional costs will necessarily be incurred in moving to a market-based system and expresses no significant concerns related to VENCorp’s operating costs, so long as these are benchmarked and carefully controlled.  
The ACA considers that the $12.1 million is an excessive cost burden which does not reflect the ‘real’ value of VENCorp services.  Coastal Gas Australia Pty Ltd (Coastal) supported this argument stating that VENCorp’s costs are excessive compared to the costs which would be incurred if TPA operated its system.
Commission's assessment
A large part of the costs (44 per cent) is accounted for by management of gas flow and system security which is normally provided by the pipeline owner or operator and was previously carried out by GTC.  Third party access costs are the nominations, scheduling, metering and settlement costs associated with dealing with multiple retailers.  Spot market costs relate to market clearing logic including the determination of the spot price, management of constraints, monitoring of prudential requirements and determining and settling spot market imbalances.  
Assessment of these costs is difficult for the Commission, especially those which are part of the new gas market system in Victoria.  The Commission currently has no evidence to suggest that the level is unreasonable but will continue to monitor these costs closely.  VENCorp is required to submit its yearly budgets to the Commission for consideration.
Coastal’s assertion, that the management of the system would be more cost effective if undertaken by TPA rather than VENCorp, is outside the scope of this assessment of the access arrangement. 
3.8	Cost allocation and tariff setting
3.8.1	Victorian Access Code requirements
The Victorian Access Code (section 8.38) requires that reference tariffs should recover costs directly attributable to the reference service and a fair and reasonable share of joint costs.  It also requires (section 8.42) that a particular user’s share of revenue to be recovered also follows these principles.
3.8.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
EPD states that the proposed tariffs: are consistent with the Victorian Access Code; are cost reflective; give efficient pricing signals; recover allowed revenue; and give price stability.
The calculation of tariffs proceeds in three main stages which are summarised below.  These stages are described in more detail in the remaining clauses of this section. 
(a)	The target revenue is allocated between the different services provided in earning this revenue.  These services are: transmission injection service, transmission delivery service and matched flows.  These services are described in the Tariff Order.
(b)	The target revenue for each service is then further allocated between revenue that should be recovered at peak only (‘capacity-driven’ costs) and those to be recovered throughout the year (‘commodity-driven’ costs).  These costs are allocated to each offtake point and injection point (as appropriate) across the Transmission System.
(c)	Using the forecast levels of utilisation of each service, the total revenue to be recovered at each location is converted to a $/GJ tariff such that, if the outturn is in line with the forecast, the planned costs will be recovered at each location, and the overall target revenue will be recovered.
Costs are allocated between:
•	injection and delivery 
Rather than paying for transportation as such, a user will pay for injection and delivery.  Injection costs are those associated with transportation to the ‘hub’ (at the Pakenham off-take) and delivery costs are those associated with transportation from the hub.  Purchases from the pool would involve no injection charge.  This allows flexibility to purchase from different sources.  Shippers who do not require gas to go through the hub are given a discount for ‘matched injection’;
•	locational specific and common 
Common costs include corporate overhead and systems operation and are spread across all users through a ‘postage stamp’ charge.  Locational costs include operational costs for pipelines and compressors, and capital.  There are 24 geographically defined asset groups (categorised as either injection or delivery) which are classified by physical characteristics.  A user’s charge depends on the number of asset groups involved in transporting that user’s gas; and
•	capacity (charged on volumes transported at peak times) and commodity (charged on volumes transported at all times).
This methodology reflects the users’ physical use of the system which is intended to be a proxy for long-run incremental costs.  The PTS has 106 off-take points grouped into 52 delivery locations (or points).  Reference tariffs are set for eight pricing (or delivery) zones, based on the volume and demand-weighted average of the delivery point allocated costs within each defined zone. 
A flow diagram of the transmission tariff pricing methodology is shown in Diagram 3.1 below. 
Diagram 3.1:	Transmission tariff pricing methodology 
	
Source:	TPA Access Arrangement Information p. 25.
Note:	The peak demand tariff is paid by tariff D (demand-metered) customers and the peak volume tariff is paid by tariff V (volume-metered) customers.  Tariff D and tariff V customers are as defined for distribution charging.
Non-system assets include land and buildings.  System assets include pipelines, regulators, compressors and odourizing plants.  Non-system O&M costs are costs applying to non-system assets as well as administration and management and the cost of odourant.  
Locational costs are allocated to 24 asset groups, which are defined physically (for example, by changes in pipeline diameter).  Peak locational cost pools (for capital related costs) are allocated on the basis of ORC (this reflects the ‘service potential’ of the asset, with users of newer parts of the system not ‘unfairly’ penalised).  Pipeline O&M costs are allocated by pipeline length.  Compressor O&M costs are allocated on fuel gas usage by the stations.
Transportation assets used from Longford to Pakenham determine the target revenue for injection.  Within an asset group, costs are based on demand/volume and distance to each delivery point (including gas flowing right through that asset group).  Through costs from upstream are allocated to delivery points on demand/volume basis only.
For pricing, the 52 delivery points are divided into eight zones.  These have been chosen to provide a reduced set of tariffs but maintain material cost of supply differences.  
Other pipelines that may be connected to the system later will pay tariffs specific to their connection point.  This recognises that the loads at these points could distort the zonal average to be passed through to end users.  
Due to the variable nature of planned expenditure and gas flows, tariffs can fluctuate materially.  Therefore they have been ‘levelised’.  As explained previously (in section 3.7.2), a NPV of the five years of costs is calculated.  A 1998 tariff is then calculated so that when it is increased or decreased by CPI-X it will give a revenue stream with the same NPV.  
Locational anytime and common anytime costs are combined into one anytime tariff as they are charged on the same basis (anytime volume).  The basis for transmission use of system (TUoS) is shown in Table 3.11 below.
Table 3.11:	Transmission use of system charges
	Delivery service 
tariff D customers	Delivery service 
tariff V customers	Injection service	
Peak charge	Actual gas delivered on the five days of highest system demand over the peak period (June to September): ‘Peak Demand’	Actual gas delivered over the peak period (June to September): ‘Peak Volume’	Actual gas injected on the five peak Longford injection days over the peak period (June to September): ‘Peak Injection’ 	
Anytime delivery charge	Actual gas delivered over the calendar year	Actual gas delivered over the calendar year	Not charged for injection	
Source:	TPA Access Arrangement Information, p. 32. 
Consistent with the above, PTS customers’ charges are computed on the five peak days at each supply point and WTS customers’ charges are computed on the five peak days of the WTS.  
The 5 peak day criteria is based on historical demand characteristics.  The analysis carried out indicated that for most years there was a noticeable change in load for between 4 and 6 days and the remaining winter days.  Also the LNG facility under ‘normal’ forecast winter conditions can supply effectively over 5 days.  Therefore, a 5 day criteria was selected.  
While charges are based on the customers’ characteristics, it is retailers who will be charged TUoS (according to the types of customers they supply).
Customers upstream from the hub receive a reduction in injection charge for any matched injection.  Similarly, where gas is injected downstream from the hub (for example, a shipper buys from the InterConnect) a lower delivery price is paid for matched delivery.  This customer pays no injection charge and, if in North Hume (the zone adjacent to the InterConnect), pays half the withdrawal charge.  
The WTS is one of the 24 asset groups, and one of the eight pricing zones, in the PTS tariff model.  As such, the tariffs calculated for the WTS are allocated a share of TPA’s total depreciation and return for both direct and indirect assets in the same way as for the PTS.  Both locational and common O&M costs are identified separately for PTS and WTS and charged to the appropriate system.  
As the WTS is not part of the spot market arrangements a simplified tariff structure is possible and no injection charge is applied. 
EPD provided the Commission with the electronic model (consisting of over a dozen spreadsheets) used to calculate the tariffs.  Although part of the model contains some confidential data, other data are contained in the Access Arrangement Information or have been released by EPD subsequent to the initial Access Arrangement Information.  EPD’s tariff model is described in some detail in Appendix D.
Key issues raised by interested parties
A number of interested parties stated that EPD did not provide sufficient information for them to assess whether the target revenue and/or tariffs were reasonable and that there was insufficient data for them to replicate the calculation of the tariffs.  However, as outlined in section 4.9.2 of the Final Decision the Commission does not believe that data to this level of dis-aggregation is required by the Victorian Access Code as it only requires that interested parties are able to ‘understand the derivation of the elements in the proposed access arrangement’ - not necessarily to be able to duplicate the tariff calculations.  
Capacity:commodity split
The main focus of submissions was the proportion of costs which will be recovered by capacity tariffs and the proportion to be recovered by commodity tariffs.  Various submissions considered the proposed 70:30 apportionment to under-price peak winter delivery and over price off-peak delivery.  These interested parties stated that they would prefer instead an allocation of around 95:5, with a number of submissions considering compressor fuel to be the only cost that should be recovered by the volume charge.  BHPP claims that the short run marginal cost for off-peak periods is effectively zero and that pricing above this marginal cost leads to a loss of consumer surplus.  
Santos took a contrary view, claiming ‘it would be more appropriate if off-peak supply bore the cost of facilities optimised for that off-peak rate.  It would then be appropriate for peak users to bear the incremental cost between peak and off-peak rates’.  Santos also stated that the linking of capacity charges to the system use on only five days is not cost reflective.  It suggested that use of 20-30 days for peak would reduce potential manipulation of the system.  
Furthermore, Santos argues that a shipper’s ability to avoid peak charges by not shipping in winter means that shipper will be subsidised by winter shippers.  In this context, its concerns are similar to the ACA which claims the current allocation favours poor load factor customers at the expense of high load factor customers like cogenerators.  
EPD acknowledges that a capacity:commodity split based on fixed/variable costs may result in a split range between 80:20 and 100:0.  It notes, however, that splits outside this range are not unknown and cites the example of ‘the United Kingdom National Transmission System (which) currently has a split of 55:45 for charges calculated from 1 October 1996’.
Capital expenditure
The other major issue raised is whether capital expenditure associated with the expansion of the system’s capacity should be rolled into the tariff.  A number of submissions considered either that inadequate justification had been provided for the roll-in of the Corio loop, or that it would result in inappropriate pricing signals.  
Other issues
Concern was raised that the use of ORC for cost allocation, rather than DORC, would make users of older parts of the system (which have been depreciated) subsidise those using newer parts of the system (with resulting higher depreciation).  
There was some concern that the final price to the user is not completely fixed.  It was noted that users are unable to know their transmission costs because they will not know which days are peak days until after the event.  
The likelihood of transportation of gas across the InterConnect into NSW was questioned unless there is an allocation of MDQ to the InterConnect by which the risk of uplift would be alleviated.  EPD has responded to this by indicating that a review of the MDQ allocation will be conducted which will address these concerns.  The Commission has been advised that this review was completed in September 1998 but the report was not provided to the Commission prior to the release of this paper.
Santos submitted that the discount available to NSW (backhaul) gas (no injection charge, and 50 per cent discount on withdrawal for North Hume) is inadequate and does not reflect the use of pipelines.
Western Transmission System
CitiPower offers the only comments specifically on WTS cost allocation or tariffs.  It stated:
The write down of the Western System results in lower tariffs than would otherwise apply. The lower tariffs may result in higher consumption and demand for further transmission capacity, the cost of which will effectively be subsidised by the write down. It appears that the write down brings the ratio of ODRC to ORC of the Western System into line with that of the Principal System and is consistent with the non-age-related allocation of costs in the Principal System. If the two systems were treated as one, Western System would be allocated costs close to the written down value, however in this case the other costs would be carried by the Principal System. The TPA Information document does not fully explain the reasoning behind the write down.   
Commission's assessment
The reference services proposed by TPA are defined in clause 3.1 of the access arrangement (quoted above in the service provider’s proposal).  This section states that the services relevant to the target revenue are: transmission injection service, transmission delivery service and matched flows.  However, the glossary in the Tariff Order (where items are defined) indicates that matched flows is not properly seen as a reference service.  The Commission understands that TPA is offering three reference services in relation to the proposed access arrangements: transmission injection service and transmission delivery service (both of which are tariffed transmission services) and LNG system security (which is a scheduled excluded transmission service).  Discussions with EPD confirm this view.
Major issues arising from EPD’s chosen tariff methodology include the basis of cost allocation, the treatment of new capital expenditure, the cost reflectivity of the pricing zones and the forecast volumes.  These issues are discussed below.  
Cost allocation
In assessing this issue, the Commission must take account of the following:  whether the proposed tariffs reflect costs directly attributable to the reference services and an appropriate share of TPA’s joint costs; and whether each user’s share of revenue reflects costs directly attributable to that user plus an appropriate share of joint costs.  
Very few costs can be attributed to any individual user.  Almost all pipelines are used by more than one customer, as are all compressors and odourant facilities.  O&M costs are mostly related to the running of the system and are thus also joint costs.  This then raises questions as to whether these costs have been shared appropriately.
Depreciation and return on direct assets are allocated to each asset group on the basis of each asset group’s ORC.  EPD states: 
The apportionment has been based on ORC so that users are charged in relation to the service potential of the assets.  By using the ORC, the age of the individual system assets become irrelevant and users of newer parts of the system are not ‘unfairly’ penalised.  This becomes a key issue as the assets are depreciated and refurbished/replaced.
Use of the ORC will smooth out variations in the allocation of costs over time (eventually flowing through to tariffs); this will produce greater future price stability and will remove any charge-related interest that users might otherwise have in TPA’s replacement decisions.
The Commission agrees with this approach.  Over the long term, ‘expired’ assets will be replaced.  Allocation of costs on the basis of ORC will give tariffs which better reflect long run incremental costs for all users.  A number of submissions by interested parties (when discussing market vs. contract carriage) emphasised the need for certainty.  Stable pricing is a major contributor to certainty.  Allocation of costs by ORC will avoid major price shocks which would flow from the renewing of assets.  
Locational O&M costs are allocated to asset groups on the basis of the length of the pipeline in the asset group (ignoring whether small or large diameter).  Pipeline O&M costs typically relate to a number of activities.  The O&M costs applicable to any part of a transmission system’s pipeline depend on length (size of undertaking), age (more maintenance and corrosion problems associated with increasing age) and location if access is a major problem (either due to high population density or remoteness).  O&M costs would also vary with diameter but to a lesser extent.  The Commission considers that, for the sake of simplicity, the allocation of O&M costs on the basis of pipeline length alone is a reasonable approach to cost allocation for TPA’s pipelines.  
Common O&M costs, and return and depreciation on indirect assets, are not distance based.  They are allocated solely on volume.  All of the return and depreciation on indirect assets has been allocated to reference services.  However, all the indirect assets of TPA are relevant to all TPA’s activities (both reference and excluded services).  The Victorian Access Code requires that these costs therefore be apportioned to both categories of service.  
Amendment 3.7
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the return on, and of, TPA’s indirect assets must be apportioned between reference and excluded services on the basis of the forecast revenue for those services or on some other basis agreed with the Commission.  

Tariffs are based on users making a contribution to the costs associated with each asset group through which the user’s gas is transported.  Consequently contribution to revenue increases as users are further away from the source of gas at Longford.  
All tariffs are based on the volume of gas transported for a user with one tariff being allocated on all gas transported during the year and two tariffs being allocated on gas transported on peak days or period.  As such, all tariffs are variable and have no fixed component.  While the peak charge closely parallels the capacity charge under a contract carriage system it provides for greater flexibility for users who can reduce their costs by reducing peak usage.  
The allocation of forecast costs to the tariffs as described above results in $46.3 million being recovered in capacity (peak) charges and $22.5 million in commodity (anytime) charges in 1998.  The ratio of this recovery is 67:33 per cent.  This is forecast to increase to 70:30 in 2002.  
Some submissions by interested parties called for more costs to be allocated to the capacity charge.  If compressor gas is the only cost feeding into the commodity charge, as advocated by some submissions, the split would be 98:2 as the gas costs are only $1.1m out of $68.8m for 1998.  
Other submissions claim that it is unreasonable that users who are able to avoid purchases in peak times will pay substantially less than those who can/will not.  However, the same submissions proposed an increase in the capacity charge, which would exacerbate this ‘unreasonableness’.  The only way these two positions could be harmonised is if the capacity charge was based on MDQ and not peak gas actually transported.  
In response to the comment by BHPP that there will be a loss of consumer surplus if non-peak volumes are priced above marginal cost, EPD points out that there will be a loss of consumer surplus if either component (peak or non-peak) of TPA’s services is priced above marginal cost.  Also, pricing of both components at marginal cost will raise insufficient revenue to cover total costs.  This is the standard problem of natural monopoly pricing.  Thus the question is how much fixed costs (not directly associated with capacity) to allocate to non-peak pricing.  The answer is largely a matter of judgement as there is no right or wrong answer on the basis of the nature of the costs.  The decision could be based on the appropriateness of the pricing signals that will be sent by the resulting tariff.  
The Commission accepts the proportion of revenue recovered by capacity and commodity charges as proposed.  It does, however, take note of the untried nature of the market carriage system, and considers it appropriate to reconsider this issue in the review at the end of the first regulatory period. 
Various submissions pointed out that the tariff structure would advantage those customers who were interrupted on peak days and those who were counter-cyclical, shifting costs onto those who use gas mainly in the winter or fairly constantly throughout the year.  This feature is considered by the Commission to be one of the advantages of the tariff structure.  It requires customers to pay in proportion to their contribution to the maximum capacity demanded from the system and gives an incentive for users to minimise their usage on days of peak demand.  Indeed the pricing structure is the feature which provides incentives for best utilisation of pipeline infrastructure.  To the extent that users avoid peak times, the pressure on system capacity (and enhancements) is diminished.  Efficient use of the assets is encouraged.  
Some submissions expressed concern that tariff V customers and tariff D customers will be charged on a completely different basis which they believe is non-cost reflective, that is, tariff V customers according to their June-September volume and tariff D customers on 5 peak day volumes.  However, in total, costs are allocated to both groups on the same basis of MDQ.  Thus, the two classes of customer are each required to contribute their appropriate portion of the target revenue.  The different tariff structure reflects the fact that metering is not available to determine usage on the five peak days for individual tariff V customers and that therefore an alternative is necessary.
Western Transmission System’s tariffs
As noted above (section 3.2), EPD made a policy decision to reduce the DORC of the WTS assets to limit what it considered to be undesirable network price differentials.  The model was adjusted so that all tariffs other than for the WTS were unchanged by this revision. 
However, it remains that users on the PTS pay for some of the costs associated with the WTS.  This is due to the methodology of the EPD tariff model (discussed above) which calculates depreciation and return on DORC but, for direct assets, allocates them to asset groups on the basis of ORC.  Accordingly, as has been pointed out in some submissions, consumers who use older, more depreciated pipelines will contribute to the recovery of costs associated with newer pipelines.  Thus users in some price zones will contribute to revenue associated with assets used by consumers in other price zones.  The WTS happens to be a zone favoured by this approach (at present).  As also noted above, the Commission agrees with cost allocation based on ORC.  
New capital expenditure
The only significant new capital expenditure included in the tariffs is the Brooklyn-Corio loop.  This loop will increase the capacity of this line thus allowing supply from the proposed underground storage (UGS) at Paaratte through the proposed south-west pipeline (SWP) of up to 250 TJ/day capacity.  TPA argues that this is necessary as forecast peak demand cannot be supplied solely from Longford after the year 2000.  TPA considers the Brooklyn-Corio loop the cheapest and most likely alternative (compared to looping the Longford-Dandenong line and looping the Barnawatha-Wollert line for supply from Moomba).  
EPD claims that the anticipated incremental revenue of at least $5 million is greater than the expected annual cost of $4 million.  However, further cost and revenue information supplied does not, in the Commission’s opinion, support the claim that the project passes the ‘economic feasibility’ test required by section 8.16(b)(i) of the Victorian Access Code which, if passed, would allow the cost to be incorporated into TPA’s capital base.
EPD has also argued that the project passes the ‘system-wide benefits’ test of section 8.16(b)(ii) of the Victorian Access Code which also would allow the cost to be incorporated into TPA’s capital base.  The loop (in association with the UGS and SWP) will reduce Esso/BHPP’s market power in peak periods by providing an alternative source of supply.  This increase in competition should result in lower supply prices.  The ability to supply gas from the south west of the state will also encourage the development of new fields in that area.  Finally, the provision of another source of supply will increase system security for the PTS and WTS.  The Commission considers these factors offer significant system-wide benefits.  It is satisfied that these benefits justify the higher reference tariffs that will result from including this expenditure in the capital base.  
If the UGS project does not go ahead and the loop therefore does not go ahead, EPD contends that TPA will need to undertake another more expensive alternative.  However, the Victorian Government is committed to the development of the UGS (see Gas source section below). The Access Arrangement Information (section 5.3) makes it clear that ‘TPA and VENCorp will agree as to the amount of pipeline capacity that TPA will provide to VENCorp under certain variable conditions.  This agreement, the Service Envelope Agreement, will establish TPA’s obligations’.  Currently an interim SEA is in place and a more substantial SEA is being negotiated by the parties.  Neither the interim nor the draft agreement state an amount of pipeline capacity and neither place an obligation on TPA to provide any expansion of the TPA system.  
Thus, TPA can fulfil its obligations as currently expressed without undertaking the Corio loop expenditure (or any of the more expensive alternatives).  If the Corio loop did not go ahead, it is possible that TPA would reap a windfall gain of up to $4 million for each of the last two years of the initial regulatory period.  The mechanism which would allow this is meant to provide TPA with an incentive to find the most efficient way to provide the necessary capacity and not meant to facilitate a windfall gain for non provision.
A similar concern exists in regard to the capital expenditure forecast for the Brooklyn Compressor Station upgrade which is also based on increased deliverability past 2000.  
Amendment 3.8
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, either: 
(i)	the service envelope agreement must incorporate an obligation on TPA to provide the Corio loop and the Brooklyn compressor upgrade (or equivalent); or 
(ii)	the Corio loop and Brooklyn compressor capital expenditure must be removed from the capital base and the tariff calculations.  

Gas source
The Victorian Government supports the development of underground storage as a competitive source of peak gas for Victorian users.  ‘The Government intends to sell the UGS assets together with an obligation to provide retailers with peak day deliverability (at a level less than UGS capacity) for a period of some five to seven years commencing in 2001.’  On this basis TPA forecasts that 250 TJ/day of peak gas will be supplied from the UGS from 2001.  
Recipients of gas from UGS are assumed (in the tariff model) to be users in the Calder price zone and the western section of the Metro zone.  Other sources of peak gas are or could potentially be the spot market, NSW via the InterConnect, direct from BHPP at Longford, and LNG.  On the basis of discussions held with EPD, and further confidential information supplied, the Commission considers the peak sourcing assumptions in the tariff model to be reasonable.  
The UGS is unlikely to be the physical source of most of the off-peak (anytime) gas consumed by users in Calder and western Metro pricing zones.  The majority of each user’s gas will still be purchased from GASCOR and come from Longford.  However the model assumes (for the sake of simplification) that all gas used by the Calder and western Metro zones will be sourced from UGS.  The proposed anytime tariffs for the Calder zone will therefore be lower than a tariff which assumes sourcing from Longford while the anytime tariffs for most other zones will be higher.  It is unclear whether the Metro tariff is higher or lower.  However the difference between the proposed tariffs and alternative tariffs is likely to be very small.
A major argument for not including greater sophistication in the tariff model is that there is no solid basis on which to forecast non-peak volumes to be sourced from the UGS.  Thus the increased complexity in the model would not be matched by increased accuracy in revenue allocation.  The review in 2002 may be a more appropriate time in which to take this source into account for the anytime tariff calculation.  At that stage there is expected to be historical data for a year which will greatly aid forecasting.  
EPD has informed the Commission that the maximum delivery capability of the PTS is now considered to be 990 TJ/day: an increase from the 970 TJ/day noted in section 5.2 of the Access Arrangement Information.  The Commission considers that this increase should be reflected in the calculation of the reference tariffs.  EPD has advised the Commission that it accepts this amendment and will revise the access arrangements accordingly.  This should result in a slightly lower injection tariff.
Amendment 3.9
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must amend the forecast injection at Longford in the tariff model from 970 TJ/day to 990 TJ/day.  

Volume
The Commission believes that overall, the volumes forecast are at an acceptable level.  The Commission has been aided by analysis undertaken for a consultancy commissioned by the ORG on forecast demand which questioned the methodology of TPA’s forecasts.  Its conclusions were, however, that the issues identified are not immediately material to total market volumes.  In its Draft Decision on the distribution access arrangements, the ORG proposed an amendment to the methodology used to derive the demand forecasts.  In response, EPD submitted two further demand forecasts.  The nature of one is limited.  The other forecasts total demand to be higher than the demand forecast in the access arrangement.  However, the difference between this forecast and the access arrangement is less than three per cent.  The Commission considers that the variations between the three demand forecasts fall within an acceptable range for forecasts and sees no reason to require revisions to the forecast submitted in the access arrangement.  
TPA’s forecast volume for the InterConnect is 5 PJ per year flowing from south to north.  While the capacity of the InterConnect itself will be much greater, TPA considers 5 PJ to be the maximum physical increase the PTS can accommodate before augmentation is needed.  Also, the current system structure in Victoria and NSW means that, physically, gas cannot be pumped into the Moomba-Sydney pipeline at Young during winter due to the pressure in the Moomba-Sydney pipeline.  Accordingly TPA is only able to physically deliver to NSW the amount of gas consumed by users on the line which branches south from Young, which is 17 TJ/day (which represents 5 PJ/year assuming an 80 per cent load factor).
The general expectation expressed by industry is that the physical flow of gas will be from south to north.  However, AGL has contracted to sell 5 PJ/year of gas into Victoria (to Energy 21), thus requiring a virtual flow of gas from north to south.  It would appear, therefore, that up to 10 PJ a year could be contracted for transportation north through the InterConnect.  On this basis, in its Draft Decision, the Commission proposed that reference tariffs be based on forecast volumes for the InterConnect of 10 PJ per year. 
However, EPD has indicated that there are several conditions that could inhibit this occurring: Energy 21 could decide to redirect its 5 PJ to Sydney; as the extra 5 PJ would not currently receive an MDQ authorisation, ‘firm’ supply can not be offered and there is no demand for interruptable supply; and TPA is vulnerable to swaps.  It argues, therefore, that a forecast for the InterConnect of 5 PJ/year, rather than 10 PJ/year, is more appropriate.  
The Commission considers EPD’s argument to be valid.  It is possible that Energy 21 could request under the MSOR, and receive from VENCorp, an allocation of authorised MDQ on the basis of injecting gas from NSW.  In this case Energy 21 could arrange with another shipper to use Energy 21’s unused MDQ to ‘firmly’ transport gas to NSW.  However, the likely physical result of this exercise would be for Energy 21 to redirect its NSW gas to NSW customers and to supply its Victorian customers with the other shipper’s Longford sourced gas.  If this happened, VENCorp would be aware only of Energy 21 transporting Longford gas.  TPA’s revenue would be no different from the situation where Energy 21 had no contract to purchase NSW gas.  
The Tariff Order (clause 6.1(h)) allows the Commission (with respect to volumes forecast to flow interstate) to approve TPA’s current forecast now and substitute a revised forecast (when approving tariffs for the next regulatory year) to determine the maximum average transmission tariff (MATT) to be used in calculating the K factor.  This removes the potential for TPA to ‘game’ the Commission with regard to forecast InterConnect volumes.  With this in mind, and considering the arguments put forward by EPD, the Commission accepts the forecast volumes for the InterConnect as contained in the access arrangement.  The Commission will consider these interstate issues further when assessing the next access arrangement, at which time historical data will be available.  
Each year will see a recalculation of tariffs, increasing by CPI-X but also adjusting, for actual volumes achieved, through the K factor.  At that time the Commission will be able to reject revised forecasts if it considers them unreasonable.  The Commission’s expertise in this area will grow over time as actual data on performance become available.
In its Draft Decision, the Commission proposed an amendment (A3.10) for a reduction in the withdrawal tariffs that will apply to gas sourced from NSW.  This was based on the understanding that if gas was sourced from NSW it would be matched by the transportation of gas from Longford into NSW.  Thus, TPA would gain its required revenue from the transportation of Victorian sourced gas and any revenue charged on NSW sourced gas would be above requirements.  It was proposed that this amount be reduced so that the windfall to TPA would be less.  
However, as noted above, this transportation is unlikely.  If it does occur notionally, it would most likely occur as swaps between market participants of which VENCorp would be unaware and TPA would not gain any extra revenue.  If for some reason Energy 21 was not able to arrange for the transportation of 5 PJ north into NSW then TPA’s revenue from Victorian sourced gas would decrease and it would need the full withdrawal tariffs to be applied to the withdrawal of the NSW sourced gas for it to recover its target revenue.  Thus, the Commission considers it not appropriate to require the amendment to the withdrawal tariffs for NSW sourced gas as proposed in the Draft Decision.  
Model audit
At various points in the calculation of tariffs, the methodology described by TPA in its access arrangement, and detailed in Attachment D, has not been followed exactly.  Rather it has been simplified to reduce the overall complexity.  For example, where a small proportion of an asset zone is used for delivery downstream, none of its costs have been fed into the tariffs for those downstream users.
The Commission considers that this simplifying of the model is not likely to produce significantly different tariffs to those which would be produced under a more complex and accurate model.  Indeed any differences would be lost in the final averaging of the tariffs for the 24 asset zones into tariffs for the eight pricing zones.
Murray Valley
The Murray Valley incremental tariff has been calculated separately on cost data for this region only.  This is in keeping with TPA’s stated approach of calculating incremental tariffs for new infrastructure.  The model assumes that gas flows in 1998 will be approximately one fifth of those in subsequent years.  However, it also includes return on and of capital for half of 1998 and O&M costs for a full year.  The Commission considers this to be inconsistent and it results in the proposed tariffs being higher than appropriate.  
Amendment 3.10
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the Murray Valley tariff must be calculated using a proportion of yearly costs similar to the proportion of the year for which the pipeline was commissioned. 

Conclusion
The Commission is of the view that the chosen methodology is appropriate for the allocation of costs for TPA’s pipelines.  The tariff model, with the amendments proposed above, appears to allocate costs to users on the chosen bases.  At the final stage in the process, tariffs are averaged into eight pricing zones in order to present a relatively simple set of tariffs and to group users together to the extent that potential changes in usage by some customers will be unlikely to significantly affect tariffs.  This averaging will necessarily mean that some users will pay more, and some less, than they would have if there had been a greater number of pricing zones.  However, overall the Commission is of the view that, after implementation of the proposed amendments, the tariffs will recover from each user a fair and reasonable share of costs.  
3.8.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
Some of VENCorp’s tariffs are the result of certain costs directly allocated to the relevant users and others are allocated to customers according to their capacity to bear the costs.  
There will be approximately 110 custody transfer meters (CTMs) in the PTS and approximately 700 tariff D meters.  One million dollars of VENCorp costs are assessed to relate to data handling functions.  VENCorp believes reading and processing data from CTMs is more complex than from tariff D meters and has consequently constructed two different tariffs.  The tariff of $7/day for CTMs is the same as the Victorian Power Exchange’s (VPX) wholesale meter fee (VENCorp considers the function of these two types of meters to be similar).  
VPX has 3 000 meters similar to VENCorp’s 700 tariff D meters.  VENCorp has escalated VPX’s charge of $1.60/meter by 50 per cent to reflect the lower efficiencies of reading a smaller number of meters.  This produces a tariff for tariff D customers of $2.40/day.  This charge is expected to minimise the possible distortion arising from fully recovering costs in this tariff.  These tariffs produce an under-recovery of $109 000 which is recovered in other charges.
The registration fee (for each market participant) is set at $30/day based on previous work done in the electricity industry.  Fees on the three retailers will recover $32 850.  
The LNG system security costs ($1.4 million per year) are allocated on total forecast injected volumes.  
System control costs associated with the WTS are $88 000.  These will be recovered by a commodity charge of 2.82 cents/GJ common to both tariff V and tariff D customers in that system.  
The balance of costs ($11.1 million of ‘common costs’) is to be recovered by a commodity charge on PTS users.  VENCorp notes that the proportion of injection volumes between tariff V and tariff D customers is 50.9:49.1.  However it has chosen to allocate 78 per cent of common costs to tariff V customers resulting in a tariff for tariff V customers of 7.64 cents/GJ and for tariff D a tariff of 3.08 cents/GJ.  The reason for this allocation is that it produces charges which match customers’ ability to pay, minimises distortions in usage and results in VENCorp charges being about one per cent of total delivered costs to users.
Also note that where possible VENCorp costs have been allocated on a cost reflective basis. VENCorp common costs (being costs not readily allocated on a cost reflective basis) have in general been allocated in such a way as to ensure that total VENCorp charges do not exceed 1% of total delivered energy costs for any customer except in the cases of customers with low price elasticity, in which case the 1% may be exceeded as there will be no significant consequential distortion in usage.  Where specific beneficiaries of VENCorp services are identifiable, the costs are allocated directly to those beneficiaries.  An example of the latter is data reading.
Key issues raised by interested parties
Various submissions said insufficient detail has been given to understand the derivation of tariffs.  These concerns have been reduced by the release of supplementary information by EPD.  
BHPP notes that all users will bear the cost of all VENCorp’s services, whether or not they use all the services, and calls for VENCorp’s services to be optional so that customers only pay for those services they use.  Submissions questioned the basis on which VENCorp’s costs are allocated and the fact that there is no cap on the costs that VENCorp can recover.
The ACA states that a high proportion of costs are allocated on a volume basis such that high load factor customers will subsidise poor load factor customers.  It states that costs should be allocated on ‘anytime maximum demand’ to reflect customers’ use of VENCorp services.
Commission's assessment
VENCorp has identified $1 million as directly attributable to the cost of reading customers’ meters.  It therefore seeks to recover these costs appropriately through a fixed daily charge as the costs are independent of volumes.  It notes that the reading of CTMs is more complicated than the reading of tariff D customer meters and that therefore the appropriate tariff will be higher.  As it does not have cost data disaggregated between the two types of meters, any decision on the tariff levels will be somewhat arbitrary.  Given this, the Commission does not consider it inappropriate for VENCorp to model the tariffs on the structure existing in the electricity industry, adjusted with regard to different user groups’ ability to pay.  As in other areas, the Commission expects that tariffs will be adjusted to reflect the costs incurred as soon as reliable data become available.
To recover the $11.1 million of ‘common costs’, VENCorp bundles the costs of system operation, spot market operation and end of day linepack (EoD linepack) operation into the one set of tariffs based on customer volumes.  This structure is not strictly cost reflective as not all users of the transmission system will be users of the other two markets and those who are users of the other two market services may use those services in different proportions to their total system usage.  
However, all users benefit from the operation of the spot market as it is likely to result in increased utilisation of the system.  This reduces the need for system expansion which may otherwise result in increased tariffs.
Further, it would be extremely difficult and somewhat arbitrary at this stage to establish a unit price for VENCorp services related to the spot market and EoD linepack as there is little indication of the volumes that will flow in these markets.  Thus, the Commission considers recovering the costs of the spot market operation and EoD linepack operation from all market participants to be appropriate at this time with a move to recovery from spot market participants when volumes are somewhat more certain.  
The proposed tariffs are not uniform with tariff V customers paying more than twice as much per gigajoule as tariff D customers.  The economic justification for this is Ramsay pricing which provides a way of covering costs by charging a premium above marginal cost in proportion to a customer’s willingness to pay.  
The marginal cost of VENCorp’s customers will be zero since VENCorp will undertake essentially the same common expenditure irrespective of the load factor in the pipeline.  The appropriate collection of the $11.1 million of common costs will need to be covered by the Ramsay ‘premia’.  A reasonable proxy for willingness to pay is the actual cost of delivered gas to the user and it is on this basis that tariff V customers pay more than tariff D customers.  
VENCorp has constructed the tariffs so that for most users the total charge payable to VENCorp will be about one per cent of that user’s total cost of delivered gas.  VENCorp believes that this pricing will not distort consumption decisions.  While not a fixed charge, the charge approximates what might be imposed under a Ramsay pricing rule and therefore meets economic efficiency criteria.
Thus, in summary, the Commission accepts the proposed tariffs which will be subject to review again in May 1999.  The Commission expects that for subsequent regulatory years, the proposed tariffs will be more cost reflective to the extent that the available data facilitate.
3.9	Tariff path and incentive structure
3.9.1	Victorian Access Code requirements
The Victorian Access Code (section 8.3) allows discretion in choosing the way in which the reference tariff may be varied.  For example, it may be designed on the basis of a ‘price path’ approach (with no adjustments yearly), a ‘cost of service’ approach (adjusted for actual outcomes) or variations/combinations of these approaches.
The Victorian Access Code (section 8.44) states that the reference tariff should, where the Commission considers appropriate, contain a mechanism to enable TPA to retain some, or all, of the returns which exceed the expected level, particularly where these increased returns are due to TPA’s efforts.  This incentive mechanism should give the service provider an incentive to increase sales volumes, minimise costs, develop new services, and undertake only prudent investment (section 8.46).  It should also ensure that users gain from increased efficiency, innovation and volume of sales.  
The Victorian Access Code (sections 8.47 - 8.48) provides that certain principles (any structural elements but not market variables) may be fixed at the time of a review.  Regard must be had to the interests of the service provider and users.  
3.9.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Price formula for this regulatory period
EPD has chosen an average revenue yield control rather than a revenue cap or price cap.  In the first year the tariffs are set as described in section 3.8.2 above. In subsequent years, average tariffs will increase according to a CPI-X formula.  For the initial regulatory period X is 3.4 per cent.  
The average revenue allowable in any year is the MATT.  For each year after the first year, the MATT is the sum of the average transmission tariffs (by customer class and transmission pricing zone) in the first regulatory year, escalated by CPI-X and re-weighed for forecast volumes.  It is then adjusted by a correction factor (K).  To prevent distortion from inaccurate volume forecasts for gas to interconnected pipelines the Commission has a limited right to retrospectively adjust MATT.  
K is intended to correct for the differences in weighting between actual charging parameters and pricing zones, and the weightings forecast when the tariffs were approved.  The correction factor has two components, dealing with the difference between forecast and estimate volumes (Ka) and the difference between estimates and actual volumes (Kb).  Each individual tariff component is also capped by CPI+Y to protect customers from substantial movements in tariff components or major tariff rebalancing.  Y has been set at ‑2.4 per cent.  
The Commission can reject the revised forecasts, presented each year by TPA as part of TPA’s statement of proposed tariffs for the next regulatory year, if the Commission considers them unsatisfactory.  This facility is intended to serve as a protection against gaming.
With average revenue capped, TPA has an incentive to reduce operational and maintenance expenditure, reduce capital expenditure and increase the total volume of gas transported.  
Price formula for future regulatory periods
The access arrangements propose five year regulatory periods with a review at the end of each period.  They propose that a revision of the access arrangements be submitted by 30 June 2002 with the new arrangements to commence on 1 January 2003.  Clause 9.1(b) of the Tariff Order determines this subsequent regulatory period to be five years.  
Chapter 1 of the Tariff Order applies to all future tariff reviews by the Commission.  Clause 1.6(b) allows the Commission to regulate prices in any manner it considers appropriate, while having regard to the following factors (contained in Clause 1.6(c)):
(1)	the cost of supplying services;
(2)	the return on assets in the gas industry;
(3)	relevant benchmarks for prices, costs and return;
(4)	the financial implications of the determination; and 
(5)	any other factors it considers relevant.
Clause 9.2 of the Tariff Order places limits on the Commission in its determination of the tariffs to apply in the subsequent (that is, the second) regulatory period.  In summary, clause 9.2 of the Tariff Order (with the relevant sub-clauses noted) states that the Commission is to:
(a)(b)	use a CPI-X approach (not rate of return regulation) where only one X factor applies without revision for the entire subsequent regulatory period;
(c)(d)	in setting the X factor, apply a weighted average return which is commensurate with prevailing conditions in the market for investments having a similar nature and degree of business risks as those faced by TPA.  The fixed asset base is to be the fixed asset base for TPA at the start of the initial regulatory period, that is the value specified in its access arrangements, adjusted to take account of inflation since 1 July 1997, depreciation, additions and disposals;
(e)	have regard to the public policy adjustments to TPA’s fixed asset base which are identified in its access arrangements and which are designed to protect the interests of consumers;
(f)(m)(l)	ensure a fair sharing between TPA and its customers of the benefits achieved through efficiency gains, if, in the initial regulatory period TPA has achieved efficiencies greater than the value implied by the value X in the CPI-X formula in the initial regulatory period.  With respect to this the Commission may issue a statement of regulatory intent.  This fair sharing may take place over more than one regulatory period; 
(g)	take into account in the first year of the subsequent regulatory period the correction factor for the difference between forecast and actual quantities in the last year of the initial regulatory period; 
(h)	have regard to costs; benchmarks for prices, costs and returns on assets; and the level of executive remuneration by reference to benchmarks; and 
(i)	if a tariff is not cost reflective at the end of the initial regulatory period, facilitate a smooth transition to cost reflectivity of tariffs over time. 
Subsections (j) and (k) apply only to distribution tariffs and therefore are not relevant in the Commission’s current assessment of the Victorian transmission access arrangements.
Key issues raised by interested parties
Support was expressed for allowing the carry-over of efficiency savings achieved in the current regulatory period into the next regulatory period to provide appropriate incentives.  However, concern was also expressed, due to the difficulty of the task, over whether the regulated entity should be required to demonstrate how its actions were responsible for the savings, before the regulator allows the carry-over.
Commission’s assessment
As noted in the access arrangement, TPA has an incentive to increase profits by reducing operational and maintenance expenditure, reducing capital expenditure and increasing the total volume of gas transported.  
The target revenue is not affected by changes in costs.  Consequently, any reduction in costs will result in an increase in TPA’s profit.  Consumers are expected to benefit in the subsequent regulatory period as a result of lower forecast costs for that period.
Any changes in total volumes (either revised forecasts or those actually achieved) compared to the forecasts in the tariff model will not alter the average revenue TPA is allowed to collect.  Consequently, TPA has a strong incentive to grow the total market as the extra revenue generated throughout the regulatory period will result in an increase in profit.  Consumers will benefit indirectly as the higher volumes used in the subsequent regulatory period will result in lower tariffs from that time on.  
Any reduction in capital expenditure from the forecast will also result in increased returns for TPA.  This offers an incentive to TPA to choose the most cost efficient method of achieving the system enhancements from the forecast capital expenditure.  As discussed in the previous section, the Commission considers this incentive to be reasonable as long as TPA is required (by the SEA or some other means) to provide the capacity increase which is currently forecast to flow from the projects included in the tariff model.  
Price control formula 
There are other incentives for certain behaviour introduced by the Tariff Order which are created by the mechanisms which determine the relationships between three sets of parameters:
•	tariff: injection, withdrawal and anytime;
•	customer: tariff V and tariff D;
•	location: the location of each price zone.
Pricing is uneven between the parameters in each set.  Consequently, any change in the proportions of parameters in any set could lead to a change in revenue for TPA.  The price control formula (schedule 5 of the Tariff Order) holds the parameter mix in the first set constant while allowing some changes to the second and third.  These are discussed below.
As already noted, forecast volumes for the five years of the regulatory period have been presented in the access arrangement and feed into the tariff calculations.  In November each year revised forecasts for the next year, estimate forecasts for the current year and actual volumes for the previous year will be provided to the Commission.  At this time tariffs for the next year will be calculated using the price control formula.  
The use of average withdrawal revenues in the price control formula, which are held constant for the whole regulatory period, lock in the forecast capacity:commodity (peak/off peak) ratio used in the tariff model.  Thus any change in load factor will not change the average revenue TPA is allowed to recover.  TPA will benefit from any improvements in load factors in that a more efficient use of the system will allow greater volumes (and thus greater revenues) to be achieved before system enhancement becomes necessary.  As total demand grows, customers will benefit in subsequent regulatory periods.
The Commission’s understanding of the nature of the benefit to TPA of improvements in load factors at the time of completing the Draft Decision led the Commission to propose an amendment (A3.13 in the Draft Decision) that the K factor calculation reflect changes between forecast and actual load factors.  Further discussion with TPA has clarified the Commission’s understanding and thus reduced its concerns.  As a result, the Commission considers that the amendment previously contemplated is now inappropriate.
When the customer and location parameter mixes in actual sales differ from that forecast, the average revenue collected may also differ due to the different tariffs which apply to each parameter.  For example, if a greater proportion of actual sales are to tariff V customers (as they would be in a relatively cold winter) then the average revenue collected will be greater than the forecast average revenue as the average tariff for tariff V customers is greater than for tariff D customers.  However, the revenue requirements of TPA will not have altered.  The K factor is calculated so that any extra (less) revenue collected in the previous year due to the actual parameter mix being different to that in the revised forecast is removed from (added to) the revenue requirements for the next year.  Thus there is no lasting effect on the average revenue achieved by TPA from actual parameter mix changes.  
By contrast, any changes in parameter mix between the initial forecast volumes in the access arrangement and the revised forecast volumes is not corrected for.  This is due to the MATT for each regulatory year being based on the average transmission tariff of the first year re-weighted for the revised volumes forecast just prior to the regulatory year.  As a result, for example, a once-off forecast increase (in the revised forecast compared to the forecast in the access arrangement) in the proportion of tariff V customers will lead to a once-off increase in revenue, irrespective of whether that forecast is achieved.  A permanent actual increase in the proportion of tariff V customers will lead to a permanent increase in revenue (through the increase in the forecast mix) from the time of the change in forecast mix irrespective of whether this anticipates or responds to the actual change.  
Accordingly, TPA has a strong incentive to increase the forecast volumes for high tariff customers relative to forecasts for low tariff customers.  For any given zone, tariff V customers are higher tariff customers compared to tariff D customers.  Customers in high tariff pricing zones, which are those furthest from Longford, are high tariff customers compared to customers in low tariff pricing zones, which are those closer to Longford, including Metro.  
It would appear that the only incentive TPA has to actually change the parameter mix (as opposed to forecasting a change) would be to justify the forecast of an even bigger change in subsequent years.  Again, the Commission considers it is unclear from the Access Arrangement Information and subsequent EPD submissions how TPA would be able to significantly affect the parameter mix.
There are two safeguards provided to the Commission within the access arrangement which will help counteract this potential gaming.  First, no individual tariff can be increased more than one percentage point higher than the allowed increase in average tariffs.  If there is substantial gaming which results in the calculation of a significantly large K factor, TPA may not be able to consume the complete K factor by tariff increases in that year.
Second, the Commission is able to reject forecasts it finds unsatisfactory.  Each year VENCorp will receive independent forecast volumes from both retailers and TPA and will subsequently produce its own forecast for the following year by November.  VENCorp’s forecasts would greatly assist the Commission in its assessment of TPA’s forecasts.  Accordingly, the Commission will require the following amendment to the access arrangements.
Amendment 3.11
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, clauses 5.2.2(a)(2) and 5.2.3(a)(2) of the MSOR must be amended by inserting the words ‘and the Regulator’ after ‘Participant’.  

It is doubtful that the re-weighting mechanism in the price control formula would result in a net benefit.  It gives TPA an incentive to promote actual changes in the parameter mix to high tariff parameters.  However TPA’s incentive to increase overall volumes is a greater incentive for it to promote growth, irrespective of where, or for which type of customer, that increase in volumes may arise.  The incentive to game the Commission in its forecasts, resulting in higher tariffs to customers, may be significant.  
The Access Arrangement Information does not offer any reason for the re-weighting that enables this gaming opportunity.  Also, the incentive to favour some customers over others would appear to be contrary to the intention of section 8.46(a) of the Victorian Access Code which states that incentive mechanisms should avoid artificially favouring the sale of one service (used here in a broader sense than ‘reference service’) over another.  The Commission therefore does not accept the proposed price control formula.  
To remove this gaming opportunity, the Commission believes the price control formula should compare actual volumes to those forecast in the access arrangement rather than the revised forecasts produced prior to each regulatory year.  
One effect of this requirement is to allow TPA to recover the average tariff for each extra gigajoule of gas transported (rather than the tariff of the relevant zone).  This removes the incentive for TPA to favour one zone over another.  However it also removes the incentive for TPA to augment the system where the unit cost of augmentation is greater than the average tariff but less than the particular zone tariff.  To remove this undesirable effect, the Commission will require amendment to the price control formula to allow TPA to recover the tariff for the relevant zone on all gas transportation associated with augmentation. 
Amendment 3.12
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the price control formula must be amended so that: 
(i)	the average transmission tariff (ATT) calculation and the K factor adjustment use the volumes forecast in the Access Arrangements (rather than those revised forecasts given to the Commission with an application for altered tariffs prior to the start of each new regulatory year); and
(ii)	the MATT allows, for volumes in the previous year resulting from augmentation not forecast in this Access Arrangement, the recovery of revenue based on the relevant zones’ tariffs rather than the MATT for that previous year.

Each year’s forecast average transmission tariff (FATT), which must be below the approved MATT, will (as proposed in the access arrangement) be calculated using the revised forecast at the beginning of the regulatory year.  This provides no gaming opportunity as the forecast will simply determine the timing of the changes to tariffs resulting from the price control formula.  
In the Draft Decision, the Commission proposed an amendment to the Tariff Order which would allow the Commission time to receive and consider VENCorp’s forecasts each year (as a check against TPA’s forecast volumes) before the Commission was required to decide on TPA’s proposed tariffs for a regulatory year.  In the light of the fact that, with the above amendment, TPA’s forecasts do not affect the final outcome of the price control formula, the Commission considers this amendment unnecessary and has not included it in this Final Decision.
Productivity savings 
As noted above, the X in the CPI-X formula is not a productivity component.  Rather it is the solution to the question of what yearly adjustment to make to tariffs so that there is a smooth progression from the tariffs constructed for the first year of the initial regulatory period (while preserving the NPV of the target revenue stream for the initial regulatory period).
With regards to the sharing of productivity benefits in the first regulatory period, consumers benefit immediately from the savings imposed by EPD and those forecast by TPA, whether they occur or not, and TPA will benefit from any further savings in the initial regulatory period.  The proposed tariffs are based on these savings and the Tariff Order locks the tariffs into a set price path that will not be affected by costs or sales volumes in the initial regulatory period.
The proportion in which productivity benefits (and other factors which lead to returns in the initial regulatory period in excess of those implied by the WACC) are shared between users and TPA in the subsequent regulatory period will be determined by the Commission at the tariff review.  The limits on the Commission in this regard are discussed below.  
Regulatory lock-in
For future regulatory periods clause 1.6 of the Tariff Order regulates the Commission’s price determinations.  In addition, clause 9.2 of the Tariff Order further defines and limits the scope of the Commission’s price determination for the subsequent regulatory period.  The intent of clause 9.2 is to guide the Commission on how productivity savings from the initial regulatory period are to be shared in the subsequent period and the structure of the tariff path in that period.
The Commission accepts the requirements of clause 1.6 of the Tariff Order.  They are very general and propose nothing more than what a prudent regulator would undertake in assessing TPA’s tariffs.
The Tariff Order (clause 9.2(f)) requires the Commission to ensure a fair sharing between TPA and its customers of the benefits achieved through efficiency gains which are greater than the value implied by X in the CPI-X formula.  Clauses 9.2(a) and (b) require the tariffs in the subsequent regulatory period to be expressed in a CPI-X formula with only one X factor for the entire subsequent regulatory period.  This means that the average tariff path over the five years of the regulatory period is to be a straight line (as proposed for the first regulatory period).  However, clause 9.2 leaves it up to the Commission to determine the starting point and the end point for the subsequent regulatory period’s tariffs.  This flexibility enables the Commission to ensure that users gain from increased efficiency, innovation and growth in volumes (section 8.46(e) of the Victorian Access Code).  
It is possible that TPA will, in the first regulatory period, achieve returns greater than those implied by the WACC used in calculating the target revenue.  These ‘excess’ returns may occur for a number of possible reasons including: volumes achieved are greater than those forecast; costs are less than forecast; capital expenditure is less than forecast; etc.  In some cases the reason for the excess return will be due to the efforts of TPA and in other cases it will be no more than a ‘windfall’ gain by TPA.  The Commission understands that the Tariff Order (as discussed in the above paragraph) will allow the Commission full discretion as to which parts of these excess returns are to be shared between TPA and customers, and which parts are to be wholly transferred to customers at the beginning of the subsequent regulatory period.  
In the context of this freedom afforded to the Commission, clause 9.2(i) of the Tariff Order may potentially cause some confusion.  It could be interpreted by some to require that the smooth price path of the subsequent regulatory period begins with the tariffs applicable in the last year of the initial regulatory period (thus negating some of the Commission’s freedom described in the above paragraph).  The Commission understands (from discussions with EPD staff) that the intention of clause 9.2(i) is to isolate consumers from ‘rate shock’ which they might otherwise experience in the rebalancing of various distribution tariffs to cost reflectivity.  It is not intended to have any consequences for transmission tariffs.  Accordingly, the Commission considers that clause 9.2(i) should not apply to TPA.
Amendment 3.13
	In order for the TPA’s Access Arrangements for the PTS and WTS to be approved, the Tariff Order must be adjusted so that it is clear that clause 9.2(i) does not apply to TPA.  

The Commission will expect TPA, as part of its submission to the Commission’s review of tariffs, to identify the source of any excess returns in the initial regulatory period and to present supporting arguments for the portion of the excess return from which it claims it should continue to benefit.  
Clause 9.2 (d) of the Tariff Order also effectively requires that the tariffs are based on the asset base determined for the start of the initial regulatory period adjusted for inflation, depreciation, additions and disposals.  Any ‘mistake’ in the construction of the tariff base which may subsequently become apparent would thus be locked in.  The Commission considers that it is appropriate that redundant assets should be removed from the capital base.  An appropriate amendment has been proposed in section 3.3 above to address this issue. 
The Commission notes that clause 9.2(h)(3) of the Tariff Order requires the Commission, in its review of tariffs, to consider the level of executive remuneration provided by TPA compared to the private sector.  This is intended to meet industry concern that there are no controls over operational costs, with special reference to executive salary abuses in the UK. 
The Commission considers the other requirements of clause 9.2 of the Tariff Order to be reasonable and acceptable and in line with the Victorian Access Code.
Conclusion
The proposed tariff structure and price control formula give TPA incentives to decrease costs, increase market demand and reduce capital expenditure.  The price control formula also seeks to introduce other ‘incentives’ which largely consist of mechanisms which expose TPA to potential revenue increases (and decreases) on the basis of changes in market attributes for which it is unlikely to be responsible.  As well, these attributes give TPA incentives to game the Commission.  The Commission does not agree with the introduction of these incentives and consequently has proposed that these be removed from the formula.
One factor in constructing the appropriate incentives for TPA is the extent to which TPA will be allowed to keep returns in excess of those implied by the WACC, both in the initial regulatory period and any continuing benefit in the subsequent regulatory period.  The Commission proposes to avoid any restrictions on its ability to act as it considers most appropriate at the time.  The Commission notes that the Tariff Order seeks to place few limits on it and accepts those limits with modification.
3.9.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
EPD has stated:
The organisational form selected by EPD for VENCorp is intended to be a not-for-profit entity.  This has the advantage that the system operator is not required to earn a profit which in itself might create difficulties for a body, at least initially, that is meant to be a neutral and impartial system operator and is a monopoly.  
The board of VENCorp, which includes industry representatives, has the ability to establish incentive arrangements with management in order to limit costs and achieve other desired objectives related to, e.g. safety, reliability, the efficiency of metering and settlement activities etc.  EPD consider that the VENCorp board is in a better position than EPD, or a regulator, would be to define the appropriate balance between costs, risk management and the quality of other services that VENCorp is expected to deliver (such as safety, reliability and metering and settlement services). 
EPD considers it desirable to rely initially on a high level of disclosure of VENCorp’s activities and costs and a light handed regulatory approach so as to provide VENCorp, under the oversight of its board, flexibility to carry out its functions.  Over time and as experience develops, there is no reason why such incentives as suggested by BHP could not be incorporated in the Access Arrangements should it be considered necessary although the issues of appropriately capitalising VENCorp to bear the risk created by the incentive arrangements would need to be considered. 
Under the Gas Industry (Amendment) Act 1998, provision has been made for the transfer of the functions of the statutory corporation VENCorp to Victorian Energy Networks Corporation Pty Ltd (VENCorp P/L).  VENCorp P/L will have private industry shareholders and directors as well as independent directors and a Chairman (appointed by the Victorian Treasurer) with the power of veto over board decisions.  This will ensure that VENCorp P/L cannot be captured by sectional industry interests.
Key issues raised by interested parties
Some submissions have raised the concern that there is no incentive for VENCorp to be efficient.  For example, BHPP stated:
It appears that VENCorp’s revenue requirement will not be subject to any effective regulatory oversight.  (The reliance on a Board to provide cost control is completely inadequate.  No Board could be constituted and administered in a way that would effectively represent the diverse interests of gas industry players.)  This is particularly worrisome given that VENCorp’s costs may well be much higher than projected given the experience of ISOs generally.
There appear to be no ‘incentive’ features to VENCorp’s tariffs.  Each year VENCorp will give the regulator its projected cost service and its projected tariffs.  The regulator appears to have broad scope to review these tariffs, though it is worrisome that the regulator has no explicit mandate to hold VENCorp to any prudence standards or cost control standards (Tariff Order, p. 8).
Nova Gas Australia Pty Limited (Nova Gas) also states that the total pass-through of costs does not make VENCorp accountable and gives it no incentives to control costs.  Retailers, who are able to pass through all VENCorp costs, may prefer VENCorp to reduce the risks faced by retailers rather than to minimise VENCorp’s costs of operation.  
Commission's assessment
The proposed VENCorp tariffs are calculated to recover all relevant forecast costs for 1998/99.  In the month prior to each subsequent year the tariffs are to be recalculated to recover forecast costs for that year after adjustment for the difference between actual costs and revenue in the preceding year.  Thus it is clear that VENCorp has no financial incentive to reduce costs.
EPD considers that industry participation on the board of VENCorp will impose an adequate restraint on costs.  Some industry participants are sceptical of this and have suggested that the Commission should exercise some form of control over VENCorp.  However, given that VENCorp is a not-for-profit organisation with no outside funding there is no scope for the Commission to impose cost control.  In addition, the underlying policy supporting both the Victorian and National Access Codes is premised on the relevant regulator(s) maintaining as light-handed an approach as possible in the performance of its duties.
The Commission understands industry’s concerns expressed in submissions that there is limited incentive for VENCorp to operate efficiently.  There are few avenues available for the introduction of incentives to a non-profit organisation, though the Commission believes industry participation on the board of VENCorp will provide some discipline. 
The Commission has attempted to counter this concern by opening VENCorp operations to greater public scrutiny.  The Commission approved the applications for authorisation of the MSOR on the condition (among others) that VENCorp consults with industry over its proposed fees each year and report on this to the Commission, and that after the end of each year VENCorp reports to industry on its actual performance against what was forecast in the budget.  This is contained in condition C7.1 of the ACCC Determination.  The Commission proposes the same amendments to the MSOR for the purposes of this Final Decision.  The amendment below replicates C7.1 of the authorisation.  Version 2.1 of the MSOR (dated 3 September 1998) incorporates this condition.
Amendment 3.14
	In order for VENCorp’s Access Arrangement for the PTS to be approved, clause 2.5 of the MSOR must be amended to the following effect:
	(1)	Consultation on proposed market fees:
(i)	VENCorp, before submitting a statement to the Regulator in accordance with clause 6.1(a)(2) of the Tariff Order, must prepare a report setting out:
(a)	for that regulatory year:
-	the budgeted expenditures and revenues; 
-	the services for which a market fee is proposed; and
-	in respect of each service, the proposed market fees;
(b)	how the proposed market fees were derived, including:
-	the method used to determine each fee; and
-	VENCorp’s estimated cost to provide each service;
(c)	other fees in existence which are appropriate for comparison purposes; and
(d)	an assessment of the extent to which the proposed market fees comply with the principles set out in section 8.1 of the Victorian Access Code.
(ii)	A copy of the report must be provided to:
	(a)	the Regulator upon completion of the report; and
	(b)	participants and other interested persons upon request.
(iii)	Interested persons must have at least 10 business days after the release of the report to make submissions to VENCorp.
(iv)	VENCorp must consider any submissions received by the specified date.
(v)	VENCorp must compile a second report which summarises:
	(a)	the consultation process; and
	(b)	any oral or written submissions received by VENCorp. 
(vi)	A copy of the second report must be provided to the Regulator when VENCorp submits its annual statement to the Regulator. 
(2)	Financial Statements:
(i)	Two months after the end of each financial year, VENCorp must publish a report setting out: 
(a)	its budgeted and actual expenditures and revenues for the previous financial year; 
(b)	its budgeted and actual expenditures and revenues for the previous financial year in respect of each of VENCorp’s activities/functions, including:
-	system security; 
-	collection, storage and processing of metering data and billing and settlement of market transactions; 
-	costs of operating the dispute resolution function; and 
-	the funding requirements of the participant compensation fund; and 
(c)	an explanation of any significant variations between budgeted and actual expenditures and revenues.
(ii)	A copy of the report must be provided to:
(a)	the Regulator upon completion of the report; and
(b)	participants and other interested persons upon request.

It should also be noted that if VENCorp’s costs increase too much (as some industry participants fear in the light of the experience in the electricity industry) it could change the detriment/public benefit assessment in the Authorisation and result in a reconsideration of the Authorisation.  It is the Commission’s intention to monitor VENCorp’s costs closely in line with industry concerns.
3.10	Assessment of reference tariffs and reference tariff policy
3.10.1	Victorian Access Code requirements
Section 3.7 of the Victorian Access Code requires an access arrangement to include a policy describing the principles that are to be used to determine a reference tariff (a reference tariff policy).  This reference tariff policy must, in the Commission’s opinion, comply with the reference tariff principles in section 8 of the Victorian Access Code.
The general objectives for a reference tariff and certain factors about which the relevant regulator must be satisfied before approving a reference tariff are set out in section 8 of the Victorian Access Code. 
Section 8.1 of the Victorian Access Code requires reference tariffs to be designed with the objectives of: recovery of efficient costs; replication of a competitive market; ensuring the safe and reliable operation of the pipeline; efficient investment decisions; efficiency of the tariff structure; and incentives to reduce costs and develop market.
Before approving a proposed reference tariff, the relevant regulator must be satisfied (pursuant to section 8.2 of the Victorian Access Code) that the service provider has complied with the methodologies and principles contained throughout section 8 of the Victorian Access Code. 
3.10.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Clause 5.3.4 of the access arrangement states that the principles used to determine the reference tariffs are defined in section 4 of the Access Arrangement Information.  Clause 5.3.4 also refers to mechanisms and formulae in the Tariff Order and to the extensions/expansions policy.  
Section 3.2(a) of the Access Arrangement Information lists the following five ‘pricing principles’:
(1)	Consistency with the Victorian Access Code.  TPA listed the six objectives contained in section 8.1 of the Victorian Access Code;
(2)	Cost reflectivity.  Costs are allocated to users according to their use of assets and benefit received from operation; 
(3)	Efficient pricing signals.  Tariffs are priced at a level commensurate with the long run marginal cost of providing that service.  This provides appropriate signals to users and developers of gas sources;  
(4)	Recovery of allowed revenue.  The average revenue regulation aims to allow TPA a reasonable return on assets, whilst providing tariff stability for users and incentives on TPA to improve operational efficiency; and 
(5)	Price stability.  Tariffed prices at each off-take should be stable.  This is consistent with providing long-run pricing signals.
Key issues raised by interested parties
Most of the comments from interested parties relevant to the assessment of reference tariffs have already been considered under previous sections in this Final Decision.  However, there has been general scepticism expressed about the efficiency aspects of the access arrangements which warrant further comment.  For example, BHPP states that users will not be able to make efficient decisions as ‘the true cost of peak usage is unknowable’, and the EAG states:  
The major group of customers creating the peak load demand, the franchised Tariff V customers are excluded from pricing signals by both the glide path approach and the uniform tariff in place until the first five year pricing review to be completed by until 2002. The glide path approach again ameliorates rate shock for another 5 years. 
How can the proponents of the market changes expect consumers to adjust their demand to reduce consumption if the event has occurred a month or so ago. This issue is exacerbated by the imposition of a glide path ensures that the major pricing signals are masked from the most significant source of constraint, deemed consumers.
Commission's assessment
From the information provided by EPD, the Commissions considers that it is unclear what constitutes TPA’s reference tariff policy.  There is no reference to a ‘reference tariff policy’ in either TPA’s access arrangements or the Access Arrangement Information.  Section 3.2(a) of TPA’s Access Arrangement Information lists general ‘pricing principles’ while clause 5.3.4 of its access arrangement identifies quite different and specific mechanisms and formulae as the ‘principles used to determine the reference tariffs’.  Consequently, the Commission concludes that no reference tariff policy has been included in the access arrangements.
Amendment 3.15
	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must develop and include in the Access Arrangements a reference tariff policy as required in section 3.7 of the Victorian Access Code. 

The Commission’s assessment of the reference tariffs in the TPA’s Access Arrangements for the PTS and WTS pursuant to the Victorian Access Code has been made throughout the discussion in this chapter so far.  The following discussion draws together the Commission’s conclusions within the framework of the introductory sections (8.1 and 8.2) of the Victorian Access Code’s section on reference tariffs.
Section 8.1 objectives
Recovery by the service provider of efficient costs associated with the provision of reference services (8.1(a)) 
The Commission has taken considerable care (in section 3.5 of the Final Decision) to ensure that the proposed rate of return (WACC) (as amended by the Commission’s proposals) will provide the service provider with a commercial return on its investments.  The outcome of the CAPM/WACC framework adopted for this purpose was supported by the credit rating analysis of TPA carried out by both the Commission and Macquarie Risk Advisory Services (section 3.7 of the Final Decision).  
The requirement within the access arrangements for new investment to be retained in the regulatory asset base only if it conforms to set prudency requirements (section 3.3 of the Final Decision) will ensure that the relationship between commercial returns and efficient investment will be maintained over time.  Complementary to the determination of this analysis is the way other costs have been scrutinised and amendments required to the access arrangements, where necessary, to ensure that forecast costs being incorporated into the tariffs reflect efficient costs likely to be incurred during the regulatory period (section 3.6.2).  Subject to the required amendments being made to the access arrangements the Commission considers that reference tariffs will provide the service provider with the opportunity to earn a stream of revenue which recovers efficient costs associated with the reference services.
Replicating the outcome of a competitive market (8.1(b))  
Given that the provision of the reference services is a natural monopoly the question is how this counter-factual objective can be achieved.  The setting of the rate of return based on a value commensurate with commercial returns achieved by similar operations against their stock market valuations (the CAPM framework) means that the scope for monopoly profits is strictly limited.  Accordingly, the returns achieved are expected to be similar to those achieved by a firm facing similar commercial risks operating in a competitive environment.  
The return will be based on only those assets necessary to deliver the services required.  This is achieved through the optimising process in the valuation of assets.  
The reference tariffs will also allow TPA to achieve a return in excess of a normal return from increased efficiencies and growth in sales, as occurs in a competitive market.  However, over time, as in a competitive market, this benefit will pass onto customers.  
While pricing reflective of efficient costs is also a feature of competitive markets it is achieved at the level of individual services, thereby ensuring price structures which achieve an efficient allocation of resources among users.  Such an efficient structuring of tariffs in these access arrangements is achieved by ensuring that individual reference tariffs are based on an allocation of costs which reflect both current and long run costs of providing the reference service in question (section 3.8 of the Final Decision).  
Ensuring the safe and reliable operation of the pipeline (8.1(c)) 
The reference tariffs are based on costs forecast as being necessary for the safe and reliable operation of the pipeline.  Each tariff review is an opportunity for TPA to increase its revenue if the safety and reliability of the pipeline demands it.  Other factors which will tend to preserve the integrity of the system include the contractual arrangements that TPA has with VENCorp to maintain the service envelope and the need by TPA to satisfy commercial markets that its assets are well maintained and operated efficiently.
Not distorting investment decisions in pipeline transmission systems or in upstream or downstream industries (8.1(d)) 
Efficient investment decisions upstream and downstream will be facilitated by pricing based on an allocation of costs to users which approximates long run costs of service provision (section 3.8.2 of the Final Decision).  Inter-temporal investment distortions are minimised by the levelising process which is intended to present stable prices over the regulatory period and the CCA framework which avoids tariffs which increase or diminish markedly over time.  EPD has argued that for TPA to undertake efficient levels of system expansion it needs to recover all the revenue it receives from charging the tariff applicable to the zone where demand is satisfied by the relevant system expansion.  This aspect of the access arrangement will remain unchanged by the Commission’s amendments.  
While the WACC selected by the Commission is towards the high end of the nominated range (section 3.5 of the Final Decision) this is considered unlikely to encourage over investment because of the redundancy provisions which have been introduced into the access arrangements (section 3.3 of the Final Decision).  
The risk of inefficient investment by another pipeliner seeking to bypass the system is minimised by the upper limit, DORC valuation, placed on assets by the Victorian Access Code which would tend to create pricing which makes such ventures commercially unviable (section 3.2 of the Final Decision).  To the extent that new markets may emerge, the additional volumes will, as a result of the regulatory framework, lead to lower tariffs for all users sharing the same infrastructure.  This will maintain the price advantage of the incumbent with the access arrangement providing for competition in related markets both upstream and downstream.  The Commission is satisfied that the reference tariffs will not distort pipeline investment decisions or investment decisions in related markets.  
Efficiency in the level and structure of the reference tariff(s) (8.1(e))  
The efficiency of reference tariff structures has been already noted above.  However, some additional comments that relate to the market carriage arrangements are also warranted.  The structure of the tariffs is efficient in that users who purchase gas from the spot market pay for transportation only from the hub.  However, the tariffs are inefficient in that they will require the same payment from users irrespective of the source of that user’s gas.  
This problem is considered relatively small and hard to correct without historical volume data.  A more efficient structure may be contemplated in the next tariff review.  
The Commission considers that the price signals transmitted from TPA’s tariffs will be seen by retailers and a few large users.  Tariff V customers will be charged by retailers and retailers may well construct tariffs that transmit appropriate pricing signals.  
The major advantage of the market carriage system which does not seem to be appreciated in the comments of BHPP and EAG above, is that it is not the specific price signals on five peak days which is important.  Rather, it is the general incentive for those users with discretion in the volumes they demand to reduce those volumes throughout periods of high demand, not just on the five days which would otherwise lead to peak demand.  Such behaviour, has the potential to enhance the efficient use of the pipeline with benefits emerging for both customers and the pipeline operator. 
Incentives for the service provider to reduce costs and expand the market (8.1(f))  
As noted in section 3.9.2 above, the Commission considers that the proposed tariffs and price control mechanism give TPA incentives to increase sales volumes, minimise costs and develop new services.  While, the service provider reaps most of the benefits of such developments in the initial regulatory period, the benefits of increased efficiency, innovation and volume of sales will flow to users in subsequent regulatory periods.
The Commission is satisfied that, with the suggested changes to the proposed access arrangements, the reference tariffs and the proposed tariff adjustment process are generally designed to achieve the objectives stated in section 8.1 of the Victorian Access Code.
Section 8.2 factors
Section 8.2 of the Victorian Access Code lists five factors on which the Commission must be satisfied in determining whether to approve the reference tariffs.  These are assessed below.
Total revenue to be consistent with the principles and one of the methodologies contained in section 8 of the Victorian Access Code (8.2(a))  
The Commission considers that the total target revenue in the proposed access arrangements is based on a tariff setting procedure involving assumptions which are inconsistent with certain aspects of the Victorian Access Code.  Accordingly, the Commission has proposed amendments which would reduce the total revenue by approximately 13 per cent and improve the allocation of costs for forming reference tariffs (sections 3.5, 3.6 and 3.7 of the Final Decision).  The Commission is of the view that the proposed amendments in this Final Decision are consistent with the principles contained in section 8 of the Victorian Access Code. 
The proportion of total revenue that any one reference tariff is designed to recover is calculated consistent with the principles of section 8 of the Victorian Access Code (8.2(b))  
The Commission is satisfied that, with the amendments proposed, the allocation of operating, maintenance and other non-capital costs between tariffed services and non-tariffed services will be appropriate (section 3.8 of the Final Decision).  The Commission’s proposed amendment to the allocation of return on, and of, capital will result in reference tariffs covering an appropriate share of joint costs.  The Commission is satisfied that the allocation of costs between reference services is also consistent with the principles of section 8 of the Victorian Access Code.  
The proportion of total revenue recovered from users of a service is calculated consistent with the principles of section 8 of the Victorian Access Code (8.2(c))  
The Commission conducted a detailed review of the computer models used to allocate costs to specific tariffs by user group and by zone to ensure that such allocations were in compliance with, and were likely to meet, the objectives of the Victorian Access Code (section 3.8 of the Final Decision).  The Commission considers that, after implementation of the proposed amendments, the tariffs will recover from each user a fair and reasonable share of costs.  
Incentive mechanisms are incorporated consistent with the principles of section 8 of the Victorian Access Code (8.2(d))  
Incentive mechanisms are incorporated into the reference tariffs and the mechanisms for adjusting tariffs over time (section 3.9 of the Final Decision).  Essentially, the incentives emerge from a combination of access arrangement provisions and the opportunity to achieve above normal returns as outlined above in the discussion of incentives.
Forecasts are best estimates (8.2(e))  
The Commission considers the O&M costs forecast for 1998 in the Access Arrangement Information to be reasonable.  Even after requiring a reduction of 0.5 per cent in the subsequent years (see section 3.6.2 above) to accommodate the modified inflation assumption, the Commission considers that the forecasts may not reflect all the efficiency savings that could be expected.  The Commission has taken this into account in its overall assessment of the access arrangements and does not consider that the forecast O&M costs need to be further revised.  The Commission is aware of the ORG’s consultancy on demand forecasts which questions the methodology but identified no material change in the overall figures.  While sharing some of its reservations, the Commission considers that the forecasts are adequate for their purposes in the tariff calculations.  
The Commission has considered EPD’s forecast capital expenditure of $60 million over the five years of the initial regulatory period contained in the Access Arrangement Information.  This is based on a consultant’s evaluation and contrasts with GTC’s planning forecast of approximately $500 million capital expenditure.  With the proposed amendments previously noted, the Commission is of the view that these forecasts represent best estimates arrived at on a reasonable basis.
Pass through of tariff reductions
The Commission considers that the implementation of the amendments required by this Final Decision will lead to reference tariffs which meet the requirements of the Victorian Access Code.  However, for the objectives of the Victorian Access Code to be met, it will be important for all users to be exposed to the full impact of these changes.  At present, the prices for natural gas to many customers are set according to legislated retail tariff caps.  Therefore, in this context, the Commission considers it important that the Victorian Government reduce the legislated retail tariff caps to fully reflect any reduction in transmission tariffs resulting from the access arrangements.
3.10.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
EPD has, for the majority of VENCorp’s costs, chosen an ‘end-use customer bearable methodology’.  VENCorp’s costs are estimated to be about one per cent of retailers’ costs in the Victorian gas industry.  One of VENCorp’s charging principles is that VENCorp’s charges should be around one per cent of delivered energy costs for most customers.  This generally ‘means that higher-use customers must be levied a lower average $/GJ rate than low-use customers’.  If charges materially exceed one per cent, it will be for a customer segment which has a low price elasticity.
In its Access Arrangement Information, VENCorp lists the tariff design objectives of section 8.1 of the Victorian Access Code.  It also gives (in section 3.3(a)) the following set of guiding principles by which cost allocation methodologies and the resulting tariffs are to be tested:
(1)	allocate VENCorp costs to end-use customer groups on a commercially reasonable and economically efficient basis;
(2)	allocate costs so as not to distort potential investment decisions in pipeline and end-user facilities;
(3)	provide incentives to grow the gas market;  
(4)	costs must be simple to understand and implement; and
(5)	as far as possible, allocation should be cost reflective.
In the Supplementary Information of 6 March 1998, VENCorp provided another set of guiding principles used in constructing tariffs:
•	they must be simple to understand and implement;
•	VENCorp charges should be around one per cent of total delivered energy costs for most customers; and
•	where charges exceed the one per cent guideline, this should be for customer segments with low price elasticity.
Key issues raised by interested parties
Submissions noted that VENCorp’s charges result in customers paying for all VENCorp’s services even if they do not use them.
Commission's assessment
From the information provided by EPD the Commission considers that it is unclear what constitutes VENCorp’s reference tariff policy.  There is no reference to a ‘reference tariff policy’ in VENCorp’s Access Arrangement Information even though the access arrangement (clause 5.3.4) indicates there will be.  Section 3.2(a) of VENCorp’s Access Arrangement Information summarised section 8.1 of the Victorian Access Code.  The Access Arrangement Information lists one set of guiding principles and the Supplementary Access Arrangement Information lists another.  Consequently, the Commission concludes that no reference tariff policy has been included in the access arrangement.
Amendment 3.16
	In order for VENCorp’s Access Arrangement for the PTS to be approved, VENCorp must develop and include in the Access Arrangement a reference tariff policy as required in section 3.7 of the Victorian Access Code.

Section 8.1 objectives
While the proposed reference tariffs for VENCorp, on their own (see below), may not appear to achieve all of the objectives of section 8.1 of the Victorian Access Code, the Commission considers that the VENCorp access arrangement cannot be assessed in isolation from the other reforms in the Victorian gas industry.  Specifically, the VENCorp access arrangement should be considered alongside the proposed TPA access arrangements.  This holistic approach is contemplated by section 9.2 of the Victorian Access Code.  
Within most gas industry structures, the TPA and VENCorp functions would be undertaken by the one entity.  EPD considers that the proposed market carriage system will function better with the pipeline operator being independent of the pipeline owner.  The Commission accepts this proposition (see section 4.2 below) and considers it is reasonable to expect the objectives of the Victorian Access Code to be satisfied by the combination of the two access arrangements.
Recovery by the service provider of efficient costs associated with the provision of reference services (8.1(a))  
Full cost recovery leaves open the likelihood of inefficiencies.  Alternatively, the non-profit nature of VENCorp will mean that any over-recovery of costs will automatically be passed back to customers in the following financial year and industry representation on the board of VENCorp is expected to result in some control of costs.  The Commission has proposed amendments which will open VENCorp to greater public scrutiny.  These factors should help minimise inefficiencies.  If significant problems do occur, the reassessment of the access arrangement in 2002 will afford an opportunity to adopt a structure which, in the light of experience, is more appropriate.
Replicating the outcome of a competitive market (8.1(b))  
VENCorp is a not-for-profit operation and therefore many of the features which may otherwise require scrutiny become irrelevant.  The remaining factors pertinent to replication of a competitive market are efficiency and cost-reflective pricing.  These aspects are considered further below.
Ensuring the safe and reliable operation of the pipeline (8.1(c)) 
The fact that VENCorp’s revenue is based on full cost recovery means that the safe and reliable operation of the pipeline should not be threatened by cost considerations on its part.  To the extent that the safe and reliable operation of the pipeline depend on TPA, VENCorp will, through its SEA with TPA, be able to require pre-determined levels of safety and reliability.
Not distorting investment decisions in pipeline transmission systems or in upstream or downstream industries (8.1(d))  
These tariffs are not likely to distort investment decisions in upstream or downstream industries as by their design they will only contribute one per cent to most users’ costs.  Charges greater than one per cent of total costs will only be levied on users with low price elasticity and even then such costs will remain only a small component of their overall cost of gas.
Efficiency in the level and structure of the reference tariff(s) (8.1(e)  
Some of VENCorp’s charges are cost reflective (as discussed in section 3.8.3 above).  The majority of charges to customers, though, do not reflect the costs incurred by those customers but are charged, as VENCorp states, on ability to pay and the basis of VENCorp charges being one per cent of retailers’ costs.  There are no clear cut economic answers to VENCorp’s pricing.  The Commission considers that using a ‘customer bearable methodology’ in line with Ramsay pricing is likely to be less distorting than some alternatives.  In this context the efficiency criteria is preferred to an allocation of costs on some kind of pro rata basis or the same price for all.
Incentives for the service provider to reduce costs and expand the market (8.1(f)) 
As already noted in section 3.9.3, the structure of VENCorp as a not-for-profit entity removes the possibility of incorporating incentive mechanisms into the tariff structure.  However, considering TPA and VENCorp together, the market will benefit from a transmission service provider having an incentive to grow the market.  Further, most of the costs associated with transmission will be related to cost reduction incentives (VENCorp costs are one seventh of all transmission costs).
Thus, the Commission considers that the objectives of the Victorian Access Code have largely been met by the proposed VENCorp tariffs.  In the cases where an objective has not been met, this is the result of the limitations of VENCorp being a separate entity to TPA and the Commission considers the failure to achieve these objectives to be outweighed by the advantages of the pipeline operator being separate from the pipeline owner.  
Section 8.2 factors
The costs of several services are bundled together into one tariff which results in a tariff which does not initially appear to satisfy the Victorian Access Code’s requirement (section 8.38) that users pay for the services they receive.  However, the Commission is of the view that given the structure of VENCorp and given that historical data are not yet available for its operations, tariffs more accurately reflecting users’ costs are not technically feasible at this time.  
Although section 8.2 of the Victorian Access Code notes factors on which the Commission must be satisfied, there is no rational basis for assessing whether the criteria are met or not, given that there is no actual market for VENCorp services.  Therefore, the Commission has chosen to not apply a literal interpretation of section 8.2.  Rather, the Commission has focussed on the need for VENCorp services to facilitate the operation of access arrangements proposed by TPA and the efficient operation of the market for gas.  In this broader context, the structure of VENCorp and its tariffs may be considered acceptable as an integral part of an efficient gas market.  To the extent that the segments of the gas market meet the section 8.2 criteria, the Commission has no reason to reject the VENCorp access arrangement on the basis that it does not meet the section 8.2 criteria.
4.	Other mandatory elements
As noted in chapter 3, the Victorian Access Code specifies a set of mandatory elements with which an access arrangement must comply.  Chapter 3 reported the Commission’s assessment of reference tariffs and reference tariff policy.  This chapter assesses each of the other mandatory elements for the PTS and WTS as listed below for conformance with the Victorian Access Code.  These are:
•	a services policy that must contain at least one service that is likely to be sought by a significant part of the market;
•	terms and conditions on which the service provider will supply each reference service;
•	a capacity management policy to state whether the covered pipeline is a market carriage or contract carriage pipeline;
•	a trading policy which refers to the trading of capacity.  This is not consistent with a market carriage pipeline, such as the PTS.  However, some issues arise in this case of capacity rights trading in a multi zone context.  A trading policy is relevant for the WTS as it has been designated a contract carriage pipeline by the service provider;
•	a queuing policy which defines the priority that users and prospective users have to negotiate capacity where there is insufficient capacity on the pipeline;
•	an extensions/expansions policy which determines whether an extension or expansion of a covered pipeline is or is not to be treated as part of the covered pipeline for the purposes of the Victorian Access Code; and
•	a review date by which revisions to the access arrangements must be submitted and a date on which the access arrangements are intended to commence.
In addition, compliance with the information provision requirements pursuant to section 2.6 of the Victorian Access Code is assessed. 
The Victorian Access Code requirements are summarised for each mandatory element followed by an outline of the service provider’s proposal, the key issues raised by interested parties throughout the public consultation process, and the Commission’s assessment.  This is followed, where relevant, by amendments which must be incorporated in the revised access arrangements in order for them to be approved. 
As noted earlier (in section 1.2), the TPA and VENCorp access arrangements appear ambiguous with respect to some aspects of the allocation of the service providers’ respective responsibilities.  The Commission has taken this factor into account when considering comments from interested parties.  It also needs to be borne in mind when interpreting some of the issues and assessments discussed in this chapter.  
4.1	Access Arrangement
4.1.1	Victorian Access Code requirements
The Victorian Access Code requires that an access arrangement be in writing, and that it may specify regulatory instruments with which the service provider will comply (section 3.1).  The service provider must have sufficient rights for it to be able to deliver its services in accordance with its access arrangement (section 3.2).
4.1.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA has submitted its proposed access arrangements in writing specifying that it will comply with the Victorian Access Code, the MSOR (PTS only) and the Tariff Order.  TPA has submitted that it has sufficient rights in respect of the PTS and the WTS (including under the Pipelines Act 1967, Gas Industry Act 1994 and (in relation to TPA) the lease between it and TPA Assets) to make available its services in accordance with the access arrangements.
Key issues raised by interested parties
No material concerns have been raised about compliance with sections 3.1 and 3.2 of the Victorian Access Code.
Commission’s assessment
The Commission is unaware of any material non-compliance with sections 3.1 and 3.2 of the Victorian Access Code.
4.1.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
VENCorp has submitted its proposed access arrangement in writing specifying that it will comply with the Victorian Access Code, the MSOR and the Tariff Order (where applicable).  VENCorp has submitted that, upon establishment it will have sufficient rights in respect of the PTS (including under the Pipelines Act 1967, Gas Industry Act 1994 and the operations agreement between it and TPA) to make available its services in accordance with the access arrangement.
Key issues raised by interested parties
No material concerns have been raised about compliance with sections 3.1 and 3.2 of the Victorian Access Code.
Commission’s assessment
The Commission is unaware of any material non-compliance with sections 3.1 and 3.2 of the Victorian Access Code.
4.2	Services policy
4.2.1	Victorian Access Code requirements
Sections 3.3 and 3.4 of the Victorian Access Code require an access arrangement to include a services policy which must include a description of one or more services that the service provider will make available to users and prospective users.  The policy must contain one or more services which are likely to be sought by a significant part of the market and any service, or services, that in the relevant regulator’s opinion should be included in the services policy.
To the extent that is practicable and reasonable, a service provider should make available only those elements of a service required by users and prospective users and apply a separate tariff for each element if this is requested.
4.2.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPAA, as owner of both the PTS and WTS, will lease the PTS and WTS to TPA under a short term operating lease, thereby enabling TPA to offer the services described in these access arrangements. 
TPA states in its Access Arrangements for the PTS and the WTS that it will offer tariffed transmission services, excluded transmission services and competitive transmission services to users or prospective users of the PTS and WTS.  Tariffed and excluded transmission services will be made available at the reference tariffs and in accordance with the reference tariff policies (clause 5.3).  Reference services will be made on the terms and conditions described in clause 5.4.
TPA advises that these services are defined in chapter 10 of the Tariff Order and are described more fully in the description of TPA’s service envelope in the relevant clauses of the access arrangements.  The Tariff Order defines the tariffed transmission services (transmission injection service and transmission delivery service), specifies the initial tariffs for these services, and the basis for variation of the tariffs over the regulatory period.  It also regulates the prices of excluded transmission services, which are services that are not considered to be amenable to formula-based price controls.  The Tariff Order lists initial prices for scheduled excluded services, and regulates prices for non-scheduled excluded services on the basis that such prices are required to be ‘fair and reasonable’ consistent with the requirements of the Victorian Access Code.  Any services offered by TPA which are not tariffed transmission services or excluded transmission services are competitive transmission services, whose prices are not regulated by the Tariff Order or the Victorian Access Code.  Chapter 3 of the Final Decision assesses the proposed reference tariffs for tariffed transmission services.
EPD has provided an explanation of the proposed arrangements relevant to the services policy:
The Victorian Access Arrangement unbundles and efficiently prices the basic services provided by a pipeline – the service of taking gas in at one time and place and delivering gas at another time and place – so that Market Participants and middlemen (for example retailers and brokers) competing to serve those participants can bundle these basic services with other services to create a range of products final consumers may want.  The Access Arrangement does not try to provide every product Market Participants or final consumers might want to have, but only to provide the basic unbundled components that allow others to assemble the products they or their customers want.  This is consistent with other competitive markets being developed in previously monopolistic infrastructure industries such as electricity and telecommunications.
Key issues raised by interested parties
Some interested parties, including AGL, East Australian Pipeline Marketing Pty Limited (EAPM), the Australian Gas Users’ Group (AGUG), BHPP, Esso and Amcor Ltd (Amcor), raised concerns in their submissions about the adequacy of the services policy being offered for the PTS for reasons mainly associated with the choice of the market carriage model.  In particular, parties were concerned that long-term firm contracts for delivered gas did not appear to be available.  The parties considered that such services are sought by a significant part of the market and could be included in the services policy subject to the regulator’s discretion, and as such TPA’s services policy for the PTS fails to comply with the principles set out in section 3.4 of the Victorian Access Code. 
In relation to the WTS access arrangement, no concerns have been raised by interested parties about compliance with sections 3.3 and 3.4 of the Victorian Access Code.  
Commission’s assessment 
The Commission notes that retailers and potential retailers are likely to seek the market carriage services being offered for the PTS because these services allow access to the system without the rigidities of traditional take-or-pay contracts.  This flexibility will become increasingly important as retailers’ customer bases become less certain through contestability and the existing full allocation of TPA’s capacity.  The Commission also notes that the reference services have been unbundled.  
Some interested parties have contended that traditional ‘firm’ contract carriage services should be made available because they are likely to be sought by a significant part of the market.  The Commission has the power to require that a services policy include any service or services that the Commission considers should be included (section 3.4(a)(ii) of the Victorian Access Code).  
While the Commission is aware of these users’ stated preferences, it is concerned that provision of contract carriage services on a market carriage system may cause undue complexity.  EPD has argued that these types of arrangements might disadvantage certain market participants.  The Commission also notes that contract carriage services are not generally available under the market carriage model chosen for the PTS and may be incompatible.  
The Commission considers that the services policies as included in TPA’s Access Arrangements for the PTS and WTS, meet the requirements set out in sections 3.3 and 3.4 of the Victorian Access Code.  
4.2.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
VENCorp states in its access arrangement that it will offer tariffed VENCorp services and competitive VENCorp transmission services to users or prospective users of the PTS, as set out in the Gas Industry Act 1994 and the MSOR, in order to operate the transmission system and operate and administer the spot market.  It will make available the tariffed VENCorp services at the reference tariffs and in accordance with the reference tariff policy (Tariff Order clause 5.3).  VENCorp will make the reference services available on the terms and conditions described in clause 5.4 of its access arrangement.   
Key issues raised by interested parties
The comments made by interested parties concerning TPA’s services policy for the PTS and WTS are also relevant for VENCorp.  In addition, some interested parties have contended that they would prefer not to use VENCorp’s services and so should not have to pay for them.  For example, both BHPP and Esso contend that some users will incur unnecessary costs as the use of VENCorp’s services will be imposed on all market participants whether or not they require them.
Commission’s assessment 
In considering the question of whether users would be obliged to purchase VENCorp services for which some parties suggest they have no need, the Commission notes that the PTS would require certain system operations regardless of the capacity management system.  It seems likely that an independent system operator is a pre-requisite for a market carriage pipeline and that it would be impractical to allocate network costs on the basis of users’ stated preferences.  The related issue of whether the tariffs paid by users of VENCorp services comply with the reference tariff principles and other Victorian Access Code requirements is addressed in chapter 3 of the Final Decision.
The Commission considers that the services policy included in VENCorp’s access arrangement meets the requirements set out in sections 3.3 and 3.4 of the Victorian Access Code.  
4.3	Terms and conditions 
4.3.1	Victorian Access Code requirements
Section 3.8 of the Victorian Access Code requires an access arrangement to include the terms and conditions on which a service provider will supply each reference service.  To be approved, these terms and conditions must be considered reasonable by the regulator. 
Where applicable, and to the extent legally possible, the terms and conditions for part of a covered pipeline situated outside Victoria must conform with the Victorian Access Code and must not differentiate between the terms and conditions of that part of the pipeline within Victoria merely because they are located in different jurisdictions.
4.3.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
The terms and conditions of the proposed access arrangements for PTS and WTS relate to the provision of services by TPA and TPAA only.  A separate access arrangement has been submitted by VENCorp regarding the terms and conditions of services supplied by VENCorp for the PTS.  
The access arrangements for the PTS and WTS state that the terms and conditions under which each reference service will be supplied are set out in the following documents: 
•	Victorian Access Code;
•	MSOR (for the PTS only);
•	Tariff Order;
•	Pipeline Operating Agreement (for the PTS only); 
•	TUoS agreement (for the PTS only); 
•	transmission connection agreement; and 
•	transmission services agreement (for the WTS only).  
EPD has advised the Commission that a single document containing all the terms and conditions is not required by the Victorian Access Code.  EPD states that a list referring to the documents which include the terms and conditions is sufficient.  In relation to the MSOR, EPD has stated that all of the MSOR are terms and conditions to ‘the whole of the extent they apply to the market participant in question’ and that the extent of application to a particular market participant can be determined from the MSOR themselves.  Similarly, all of the Tariff Order is claimed to contain terms and conditions.  
The Commission has been provided with four agreements on a confidential basis.  These are: 
•	Pipeline Systems Deed; 
•	Western Transmission System Agreement (in draft form); 
•	Transmission-Westar Distribution System Connection Agreement; and
•	TUoS and LNG Services Agreement.  
EPD has stated that all key documents have been provided and are complete.  It considers that the disclosure of details has been sufficient and complies with the Victorian Access Code.  
The services policies for the PTS and WTS identify three services that are provided by TPA.  These are: tariffed transmission services; excluded transmission services; and competitive transmission services.  The WTS services policy also states that VENCorp will provide tariffed transmission services for the WTS on behalf of TPA.  Although these services have been identified in the access arrangements, terms and conditions have not been provided for each individual service.  Instead, the terms and conditions have been presented to apply to the reference services as a group.  
The access arrangements state that the terms and conditions on which access is provided do not differ according to the location of the pipeline.  The PTS access arrangement states in clause 5.4.3 that it is anticipated that an identical access arrangement for the PTS will be submitted in NSW once the Gas Pipeline Access Law takes effect in that state.  
Key issues raised by interested parties
There have been two key issues raised in submissions relating to terms and conditions.  The first is that there has not been a clear identification of the terms and conditions in the access arrangements.  According to the BCA this makes an assessment of the impact of the arrangements on business difficult.  
BHPP has raised a number of concerns relating to this area.  Firstly, that there is no single document where the terms and conditions of service can be accessed.  In addition, the transmission agreements referred to in the access arrangements and the MSOR have not been available to interested parties to review.  BHPP also claims that the Tariff Order does not contain terms and conditions although it has been named as a document where such information is contained.  
In a subsequent submission, BHPP asserts: 
... by failing to define key elements such as the method by which authorised MDQ will be allocated, the level of service which VENCorp will seek to provide, the likely availability, cost and firmness of capacity for new or expanding users, the total cost of commercially firm transportation, and the definition and allocation method for Transmission Rights, the Access Arrangements fail to define the Reference Service that is being provided.  BHPP submits that the ACCC should not and cannot approve the Access Arrangements until these most fundamental elements of the service provided have been defined and debated.  
By having a number of elements incomplete, BHPP contends that the Victorian Access Code requirement for the service provider to provide terms and conditions in an access arrangement is not met.  
The second issue relates to the external documents that have been identified in the access arrangements as containing terms and conditions.  BHPP states that: 
... it is inappropriate for the access arrangements to incorporate by reference external documents which may be amended other than in accordance with the National Access Code.  
BHPP does not accept claims by EPD that sections 3.1 and 9.7 of the Victorian Access Code support the service provider's use of external documents and notes that the National Code does not contain equivalent sections.  BHPP claims that the incorporation of external documents in the access arrangements ‘appears to be contrary to section 2.49 of the National Access Code’.  
Commission’s assessment
The concept of terms and conditions is a contractual one and as such does not sit well with the proposed market carriage model for the PTS.  In a contract carriage market system it would be expected that the terms and conditions of access would be available in a single contractual document.  However, the Commission acknowledges that in the case of market carriage this format may not always be the most suitable.  
Nonetheless, the Commission is concerned that the access arrangements do not clearly identify the relevant terms and conditions.  This may cause difficulty in determining what elements of the external documents listed in the access arrangements are terms and conditions applicable to TPA in relation to the PTS and WTS.  The Commission also considers it is unlikely that all of the details contained in the external documents would be terms and conditions.  While the use of external documents is not a matter that would render the entire access arrangements invalid, the current circumstances may create a situation where the access arrangements are unworkable.  In that case, the Commission would find it difficult to conclude that the terms and conditions are reasonable and that the access arrangements meet the Victorian Access Code requirements.  
The Commission has raised the issue of supplying the terms and conditions in one document with EPD.  Proposed Amendment A4.1 of the Draft Decision required TPA to clarify the terms and conditions and make them available in the access arrangements and a users guide.  This amendment remains relevant. 
Amendment 4.1
	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, TPA must clearly specify the terms and conditions of access to the PTS and WTS in a guide for users and in the Access Arrangement.  

The Commission considers that all relevant documents should be provided to the Commission (and, in general, the public) on submitting an access arrangement for approval.  A full and proper assessment of an access arrangement can only be made if interested parties and the Commission have the opportunity to review all related items.  The Commission notes that in considering the Access Undertaking proposed by AGL for its NSW distribution network, IPART required AGL to provide a standard contract with their information package.  The Commission considers that it is important that the information currently contained in the confidential documents be publicly available as far as practicable as this will enhance the capacity of users and prospective users to form their own views as to compliance of the access arrangements with the Victorian Access Code.  Proposed Amendment A4.2 of the Draft Decision required TPA to develop pro forma documents so that information in the confidential agreements could be made public.  The Commission considers that this remains a relevant amendment to the access arrangements and that the pro forma document must be attached to the relevant access arrangements.  
The transmission agreements presently identified in the access arrangements will be replaced with pro forma agreements and attached to the access arrangements.  The Commission is of the view that any changes to these documents should use the procedure in section 2 of the Victorian Access Code.  The Commission considers that users and potential users would benefit from this fact being clarified in the terms and conditions of the WTS access arrangement.  
Amendment 4.2
In order for TPA’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect: 
(i)	The references to the pipeline operating agreement (clause 5.4.1(d)), TUoS agreement (clause 5.4.1(e)) and transmission connection agreement (clause 5.4.1(f)) must be deleted.
(ii)	TPA must undertake to make the PTS (including any extensions or expansions that are to be treated as part of the PTS) available to VENCorp in accordance with its obligations under the TPA Service Envelope Agreement.

Amendment 4.3
In order for TPA’s Access Arrangement for the WTS to be approved, amendments must be made to the following effect:
(i)	The references to the transmission services agreement (clause 5.4.1(c)) and the transmission connection agreement (clause 5.4.1(d)) must be deleted and replaced by pro-forma agreements attached, as an appendix, to the access arrangement.
(ii)	The pro-forma agreements can only be changed by following the procedure in section 2 of the Victorian Access Code.
(iii)	Any transmission service or connection agreement entered into between TPA and a user or prospective user must be consistent with the pro-forma transmission service or connection agreement (as amended in accordance with section 2 of the Victorian Access Code).

TPA has provided some aspects of its access arrangements, in particular the terms and conditions, in external documents.  The Commission understands that the use of external documents in this manner is permitted under the Victorian Access Code.  However, the Commission is concerned that this use of external documents may create confusion and difficulties for the regulator and interested parties to understand the access arrangements. As a result of this concern the Draft Decision proposed two amendments - A4.3 and A4.4.  The first required that all amendments to any of the identified external documents would only be validly added to the access arrangement through the use of the change process set out in section 2 of the Victorian Access Code.  The latter amendment supported the first by stating that changes to the external documents would trigger an obligation on the part of TPA to submit revisions to the relevant access arrangement under section 2 of the Victorian Access Code.  
The Commission has considered this issue further since the release of the Draft Decision.  The external documents can be separated into two groups - the transmission agreements and the regulatory instruments.  The previous discussion and amendments concerned the transmission agreements for the PTS and WTS.  The remaining discussion deals with the regulatory instruments.  
Clause 5.1 of the PTS access arrangement identifies three regulatory instruments that TPA will comply with - the Victorian Access Code, the MSOR and the Tariff Order.  These instruments have also been identified as containing terms and conditions.  However, the Commission understands from EPD that as a result of the Proposed Amendment A4.1 of the Draft Decision, the Victorian Access Code will no longer be identified as containing terms and conditions.  In addition, the relevant sections of the MSOR and Tariff Order will be identified in the access arrangements.  
With these amendments to the PTS and WTS access arrangements in mind, the Commission has considered the appropriate change process for the MSOR and Tariff Order.  The MSOR contains its own change process in Chapter 8.  This process requires VENCorp to present proposed changes to the MSOR (that it or other parties have initiated) to the Commission.  The Commission is then required to determine whether the proposed change impacts on the authorisation of the MSOR or any of the access arrangements.  The Commission considers that this is a suitable process under which the MSOR can evolve over time.  
However, the Commission is concerned that this process may not remain in its current form.  In particular, in the situation where the MSOR becomes subject to an exemption to the Trade Practices Act under s.51(1) of that Act.  If this occasion were to arise then the Commission considers that the most appropriate method of changing the MSOR for the purposes of the access arrangements would be to use the section 2 change process of the Victorian Access Code.  Accordingly, the following amendment is required to be made to TPA’s Access Arrangement for the PTS.  
Amendment 4.4
In order for TPA’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	Subject to paragraph (ii) below, a reference to the MSOR in the access arrangement is a reference to the MSOR as amended from time to time.
(ii)	In the event that the MSOR becomes subject to an exemption under section 51(1) of the Trade Practices Act 1974 (Cth), any amendment to, or supplementation or replacement of, the MSOR will, to the extent to which the MSOR is part of the access arrangement, constitute a change for the purposes of the Victorian Access Code and will not be effective to change the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.

The Tariff Order also contains a change process in Chapter 6.  However, this process does not relate to changes in the Tariff Order itself but rather changes to the tariffs.  That is, altering, closing and introduction of tariffs.  However, to provide certainty in regard to the relevant tariffs the Commission considers that changes to the tariffs should only be incorporated in the access arrangements through the change process set out in section 2 of the Victorian Access Code.  Consequently, the Commission requires an amendment to TPA’s Access Arrangements for the PTS and WTS.  
Amendment 4.5
In order for TPA’s Access Arrangements for the PTS and WTS to be approved, amendments must be made to the following effect:
(i)	For the purposes of the access arrangement, a reference to the ‘Tariff Order’ is a reference to the Tariff Order as in force from time to time subject to paragraph (ii) below.
(ii)	Any change to reference tariffs will not be incorporated in the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.
(iii)	If the access arrangement specifies a charge for connection to, and the use of, the transmission pipeline, that is inconsistent with the Tariff Order, then the access arrangement prevails to the extent of the inconsistency.

Section 3.9 of the Victorian Access Code does not permit discrimination between portions of the pipeline system located in different jurisdictions on the basis of their location.  It appears that the access arrangements do comply with this section of the Victorian Access Code.  At present there are no transmission pipelines covered by these access arrangements which lie outside Victoria.  However, upon commencement of the PTS access arrangement, TPA’s portion of the InterConnect will be treated as part of the PTS.  
Subject to all the issues identified in this section, the Commission considers that the terms and conditions for access to the PTS and WTS appear to be reasonable.  
4.3.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal 
This access arrangement has been submitted in conjunction with TPA’s Access Arrangement for the PTS.  Access to services performed by VENCorp in relation to the PTS are only available through this particular access arrangement which sets out the terms and conditions on which such services will be provided.  The services provided by VENCorp on behalf of TPA for the WTS are covered by TPA’s Access Arrangement for the WTS.  
VENCorp’s access arrangement states that the terms and conditions relating to the provision of reference services are set out in the MSOR and the Tariff Order.  The services policy for VENCorp identifies two services - tariffed VENCorp services and competitive VENCorp services.  As with the TPA access arrangements, the terms and conditions have been presented to apply to VENCorp services as a group.  According to clause 1.2.1 of the MSOR, tariffed transmission services for VENCorp include:
•	operation of the transmission system and the market;
•	publication and maintenance of a register of market participants;
•	development and updating of system security guidelines;
•	consideration of the likely costs of compliance for the procedures it develops under the MSOR; and 
•	compliance with requirements and obligations set out in the MSOR.  
While VENCorp’s access arrangement states that the terms and conditions are contained in the MSOR, not all of the procedures and policies identified in the MSOR have been developed.  The MSOR gives VENCorp some discretion in the development of these procedures.  The MSOR also contains requirements for VENCorp to develop guidelines and procedures in consultation with market participants and/or in accordance with the MSOR.  These details must then be published.  
One of the areas that provides VENCorp with discretion in policy making is the initial allocation of authorised MDQ.  Clause 5.3.2(a) of the MSOR requires that VENCorp allocates authorised MDQ for: 
•	all customers who withdraw gas at tariff V withdrawal to the extent of any such withdrawals; and
•	all tariff D customers on the basis of past and/or existing contractual arrangements, or on some other basis that VENCorp considers appropriate.  
VENCorp has recently completed a project to determine an appropriate initial allocation of authorised MDQ to customers.  This work, which commenced in January 1998, was undertaken under the guidance of an industry representative steering committee.  The consultant's recommendations were presented at seminars held in May and June 1998.  VENCorp then engaged an independent review panel to review each of the 70 submissions received and propose a final allocation prior to market commencement.  The Commission has been advised that the independent review panel made its final recommendations to the VENCorp Board in September 1998 but no details have been provided to the Commission prior to release of this document.
Like TPA’s Access Arrangement for the PTS, this access arrangement states that the terms and conditions on which access is provided do not differ according to the location of the pipeline.  
Key issues raised by interested parties 
Two key issues have been raised in submissions in relation to the terms and conditions in VENCorp’s access arrangement.  The first concerns the level of discretion that is provided to VENCorp.  AGL states that the level of discretion given to VENCorp in the MSOR is high and questions whether that results in a satisfactory level of disclosure of terms and conditions under the Victorian Access Code.
BHPP also comments on this matter, stating: 
... BHPP acknowledges that these missing pieces [including development of a queuing policy] are not as fundamental to the service as issues such as MDQ allocation.  We perhaps even would acknowledge that it would be difficult to argue that any single one of these pieces being missing would constitute a failure to define the service being offered.  We would contend quite strongly, however, that by having so many elements of the Access Arrangement terms and conditions not defined, the Access Arrangement itself fails the requirement of Section 3.8 of the Code.  
Of the areas that VENCorp has discretion over, the initial allocation of authorised MDQ has attracted the most interest.  A number of interested parties raised the following concerns:
•	Not accepting the recommendation of the Ernst & Young report that tariff V customers have a set MDQ (in the same way as tariff D customers) will result in the long term erosion of transport rights to large customers and expose them unequally to uplift costs which will not be borne by the customer class causing the problem;
•	VENCorp has not addressed the issue of transferability of MDQ rights;
•	The current MDQ proposal will prevent companies with multiple sites making rational decisions to amalgamate or relocate sites in their endeavours to improve their operational efficiencies and competitiveness; and
•	Allocation of each site with its actual MDQ will result in aggregate MDQ significantly exceeding pipeline capacity.  Conversely, if pipeline capacity is used as the basis, then tariff D customers will be allocated an MDQ well below their needs, resulting in them consistently having to pay uplift.  The proposal to subsequently issue transmission rights will further exacerbate this problem as they will have a trading value.  
GasAdvice states that the authorised MDQ quantities which have been provisionally allocated for each site, whilst equivalent to the existing contractual arrangement, are substantially below current site gas usage levels.  It suggests that the MDQ allocation process needs to be conscious of both current and future operating modes of the various gas users throughout the system. 
Commission’s assessment 
The Commission’s views on the adequacy of the provision of the terms and conditions in relation to the PTS and WTS for TPA can be found earlier in this section.  These comments apply equally to VENCorp in relation to its access arrangement.  In addition, the previous discussion and amendments relating to external documents are also relevant to VENCorp’s access arrangement.  Consequently, the following amendments are required by the Commission prior to the approval of VENCorp’s Access Arrangement for the PTS.  
Amendment 4.6
	In order for VENCorp’s Access Arrangement for the PTS to be approved, VENCorp must clearly specify the terms and conditions of access to the PTS in a guide for users and in the Access Arrangement.  

Amendment 4.7
In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	A pro-forma gas transportation agreement must be attached, as an appendix, to the access arrangement.
(ii)	The pro-form gas transportation agreement can only be changed by following the procedure in section 2 of the Victorian Access Code.
(iii)	Any gas transportation agreement entered into between VENCorp and a User must be consistent with the pro-form gas transportation agreement (as amended in accordance with section 2 of the Victorian Access Code).

Amendment 4.8
In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	Subject to paragraph (ii) below, a reference to the MSOR in the access arrangement is a reference to the MSOR as amended from time to time.
(ii)	If the MSOR becomes subject to an exemption under section 51(1) of the Trade Practices Act 1974 (Cth), any amendment to, or supplementation or replacement of, the MSOR will constitute a change for the purposes of the Victorian Access Code and will not be effective to change the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.

Amendment 4.9
In order for VENCorp’s Access Arrangement for the PTS to be approved, amendments must be made to the following effect:
(i)	For the purposes of the access arrangements, a reference to the ‘Tariff Order’ is a reference to the Tariff Order as in force from time to time subject to paragraph (ii) below.
(ii)	Any change to reference tariffs will not be incorporated in the access arrangement unless and until the procedure in section 2 of the Victorian Access Code is followed.

(iii)	If the access arrangement specifies a charge for connection to, and the use of, the transmission pipeline, that is inconsistent with the Tariff Order, then the access arrangement prevails to the extent of the inconsistency.

In addition, the Commission has considered the concerns raised in submissions regarding incomplete elements of the terms and conditions and the consequential discretion given to VENCorp in the development of these elements.  The Commission is also mindful that it should not approve an access arrangement when there are material items in that arrangement that are incomplete.  At the time of releasing its Draft Decision the element raising most concern was the initial allocation of authorised MDQ as it was considered to be material to VENCorp’s access arrangement.  
The Commission considers that the subsequent Ernst & Young report to VENCorp on the initial allocation of authorised MDQ and the public process undertaken by VENCorp have allayed the majority of concerns raised by interested parties.  However, the Commission remains of the view that the procedures regarding the initial allocation of authorised MDQ should be included in the VENCorp access arrangement.  Accordingly, the Commission requires the following amendment. 
Amendment 4.10
	In order for VENCorp’s Access Arrangement for the PTS to be approved, the procedures for the initial allocation of authorised MDQ must be attached, as an appendix, to VENCorp’s Access Arrangement.  

However, one remaining issue raised in submissions that VENCorp has not adequately addressed is the allocation of uplift between tariff D and tariff V customers.  The Commission has been informed by VENCorp that it has made an in-principle decision to remove the automatic authorisation of tariff V customers.  The materiality of this issue will not be known until the arrangements are in place.  Therefore, condition C8.3 of the authorisation of the MSOR has required that the automatic authorisation of tariff V customers be reviewed one year after market commencement.  
A number of other elements of VENCorp’s terms and conditions were also identified in submissions as being incomplete.  However, the Commission considers that these elements do not warrant further amendments to VENCorp’s access arrangement.  Consequently, the terms and conditions in VENCorp’s access arrangement may be considered to be reasonable despite some items remaining incomplete at the time of approving the access arrangement.  However, the Commission urges that these elements be finalised as soon as practicable.  
4.4	Capacity management policy 
4.4.1	Victorian Access Code requirements
Section 3.10 of the Victorian Access Code requires an access arrangement to include a statement that the covered pipeline is either a contract carriage pipeline or a market carriage pipeline.
4.4.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA has provided statements that the PTS is a market carriage pipeline and the WTS is a contract carriage pipeline.  However, the WTS may be reclassified as a market carriage pipeline in the future.  
Key issues raised by interested parties
While some parties supported the choice of a market carriage model for the PTS, others raised a number of concerns as to its complexity, novelty and impact on interstate trade.  As an alternative, BHPP has proposed a hybrid market and contract carriage model.  
BHPP also raised concerns about what it considered to be inadequate details in the capacity management policy in section 1 of the Access Arrangement Information.  
Commission’s assessment 
The concerns raised by interested parties are addressed in the context of the Commission’s consideration of the market carriage model in chapter 2 and relevant sections of this Final  Decision. 
The Victorian Access Code requires no more than a statement that the covered pipeline is either a market carriage or a contract carriage pipeline.  As the access arrangements include a statement that the PTS is a market carriage pipeline and the WTS a contract carriage pipeline, they satisfy section 3.10 of the Victorian Access Code.
4.4.3	VENCorp’s Access Arrangement for the PTS
VENCorp’s access arrangement also includes a statement that the PTS is a market carriage pipeline.  Consequently, the access arrangement complies with section 3.10 of the Victorian Access Code. 
The comments made by interested parties concerning the adoption of the market carriage model in regard to the PTS have been noted above in the discussion on TPA’s access arrangements.  
4.5	Trading policy
4.5.1	Victorian Access Code requirements
If a pipeline is a contract carriage pipeline, the access arrangement must include a trading policy which explains the rights of a user to trade its right to obtain a service to another person.  The trading policy must, inter alia, allow a user to transfer capacity:
•	without the service provider’s consent, if the obligations and terms under the contract between the user and the service provider remain unaltered by the transfer; and
•	with the service provider’s consent in any other case.  Consent may be withheld only on reasonable commercial or technical grounds.  The trading policy must specify conditions under which consent will be granted and any conditions attaching to that consent.  
4.5.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
The Victorian Access Code does not require a market carriage pipeline such as the PTS to have a trading policy, and none has been proposed.  However, clause 5.3 of the MSOR and the associated summary document discuss, inter alia, transfer of authorised MDQ.  Authorised MDQ is not generally tradeable under the initial single zone model.  An exception is where a party has entered into an agreement with TPA to augment the system.
However, the WTS must have a trading policy as it is a contract carriage pipeline.  It is proposed that, in certain circumstances, a user may transfer or assign all or part of any capacity in the WTS which it has reserved pursuant to a contract between it and the TPA (contracted capacity) as set out in clauses 5.6.2 and 5.6.4 of the access arrangement.  
Under the proposed trading policy, TPA will not unreasonably withhold its consent to any changes requested to the existing contract which: are commercially and technically feasible; do not interfere with TPA’s ability to satisfy its obligations to other users; and do not adversely affect the operational control of the system by VENCorp.
Clause 5.6.7 of the WTS access arrangement deals with any request by a transferee to change a delivery point or receipt point defined in an existing contract between TPA and the user.  Under the proposal, the tariff payable by the user will be adjusted upwards, if appropriate.  
Key issues raised by interested parties
Submissions from interested parties have raised concerns about the proposals relating to trading of capacity in respect of the PTS.  Ecogen considers that the trading of authorised MDQ is unclear and questions whether, in the event of a sale of assets by a gas customer, the MDQ allocated to the business would be transferable as a right.   In addition, while BHPP acknowledges that a trading policy is not required for market carriage systems, it considers that it ‘ ... is a very important component of efficiency on contract-based gas transmission systems and hence must be a part of the Commission’s evaluation of market carriage’.  
Two problems with the trading policy proposed for the WTS have been identified by BHPP.  First, TPA can block a capacity trade on the grounds that it would ‘adversely affect the operational control of the system by VENCorp’.  BHPP suggests that ‘ ... this is a very loose clause, prone to subjective interpretation’ and considers  that it is not clear how a regulator would be able to constrain TPA’s and VENCorp’s scope to block capacity trade.  Second, BHPP states that there is no discussion on how transferred capacity is to be defined.  For example, it is not clear whether a contract is specific to unique injection and delivery points, in which case it could be traded only if the buyer wished to use the same points.  
Commission’s assessment 
The Commission notes that the PTS does not require a trading policy to meet the minimum requirements of the Victorian Access Code as it is a market carriage pipeline.  However, the Commission has considered the services and polices that are generally available under both a market and contract carriage model in chapter 2 of this Final  Decision.  In that context the Commission also notes that the Victorian Access Code at section 2.24 states: 
... The Relevant Regulator must not refuse to approve a proposed Access Arrangement solely for the reason that the proposed Access Arrangement does not address a matter that sections 3.1 to 3.22 do not require an Access Arrangement to address. ... 
It has been suggested that the service provider could block a trade in capacity on the WTS to further its own commercial interests.  The Commission notes that the WTS access arrangement provides that a service provider will not unreasonably withhold its consent, and that a user denied capacity trade has the option to refer the matter for arbitration under the dispute resolution mechanism set out in section 6 of the Victorian Access Code.
Regarding the issue of defining capacity for the purposes of trading capacity, under clause 5.6.7 of the WTS access arrangement, TPA will deal with any request by a transferee to change a delivery point or receipt point defined in an existing contract between TPA and the user under the queuing policy (which is set out in clause 5.7).  The tariff payable by the user will be adjusted upwards, if appropriate.  This differs from the ‘example of reasonableness’ given in section 3.13(b) of the Victorian Access Code where the service provider would receive the same amount of revenue that it would have received before the change.  
However, the Commission notes that changing a delivery point or receipt point may involve additional costs to the service provider (for example, moving the delivery point downstream).  If this is the case, it may be in the legitimate business interests of the service provider to recover these costs.  In other cases, a reduction in haulage distance may not lead to any significant reduction in the service provider’s costs as the service provider has already incurred expenditure to configure its capacity to meet the user’s original needs.
The Commission considers that the trading policy in the access arrangement for the WTS accords with the Victorian Access Code.  No concerns have been raised by users of the WTS regarding this provision of the access arrangement.  
4.5.3	VENCorp’s Access Arrangement for the PTS
VENCorp has not proposed a trading policy in its access arrangement for the PTS.  As with the TPA’s Access Arrangement for the PTS, the Commission considers that VENCorp does not require a trading policy to meet the minimum requirements of the Victorian Access Code as the PTS is a market carriage pipeline.
4.6	Queuing policy 
4.6.1	Victorian Access Code requirements
Sections 3.14 to 3.17 set out the Victorian Access Code’s requirements for a queuing policy.  An access arrangement must include a queuing policy for determining the priority given to users and prospective users for obtaining access to a covered pipeline and for seeking dispute resolution (under section 6 of the Victorian Access Code).  
The policy must: set out sufficient detail to enable users and prospective users to understand in advance how it will operate; accommodate, to the extent reasonably possible, the legitimate business interests of the service provider, users and prospective users; and, to the extent reasonably possible, generate economically efficient outcomes. 
4.6.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Responsibility for administering the queuing policy for the PTS is allocated to VENCorp and is discussed in VENCorp’s Access Arrangement for the PTS.
TPA’s proposed queuing policy for the WTS is described in clauses 5.7.1-5.7.9 of the WTS access arrangement.  It addresses how a prospective user obtains access to existing capacity, both in the case where there is spare capacity and in the case where there is potential to expand capacity.  Furthermore, it sets out the process by which TPA will: administer requests by a prospective user seeking access (the applicant); and determine the priority that a prospective user has, as against any another prospective user, to the services offered in this access arrangement and the developable capacity of the pipeline.  Applications will be dealt with on a first-come first-serve basis.
The WTS queuing policy also sets out the application procedure, evaluation policy, response to applicant, response from applicant, dispute procedure, amended offers and applicant obligations.  Clause 5.7.3 of the WTS access arrangement stipulates that an applicant will obtain access to the queue by completing an application form and paying a prescribed fee. 
Under the applicant obligations (clause 5.7.9 of the WTS access arrangement), TPA will not make any commitments to capital expenditure on a proposed project until an enhanced facilities agreement has been executed.  Under clause 5.7.5 of the WTS access arrangement, an excluded service charge will be borne by an applicant to recover the incremental costs to add capacity under an enhanced facilities agreement.  The enhanced facilities agreement will provide that, in the event that an applicant terminates an executed contract, the applicant will be obligated to reimburse TPA for all expenditure incurred on the facilities under construction to meet the obligations under that contract, or if the service has commenced, to reimburse TPA with the depreciated asset value of that facility.  
Key issues raised by interested parties 
No submissions regarding the queuing policy for the WTS were received from users of the WTS.  However, BHPP has criticised the proposed queuing policy on two grounds.
First, BHPP states that a weakness in the evaluation process of the queuing policy is that it requires TPA to make a unilateral and subjective assessment of available capacity.  In order to decide how much capacity is available for new contracts, TPA must guess how much capacity demand growth there will be from holders of existing contracts.  Second, BHPP considers that it is a weakness of the WTS queuing policy that the contract carriage system will disappear when the WTS and PTS are integrated.  BHPP contends that contractual rights on the WTS are therefore seriously constrained to the point of being meaningless. 
Commission’s assessment 
The queuing policy proposed by TPA for the WTS sets out mechanisms for processing requests for service where spare capacity is available but inadequate to satisfy all users and potential users.  It defines the priority that prospective users have to negotiate for access.
The Commission notes the issues raised by BHPP.  However, the Commission understands that current and expected future excess capacity of the WTS pipeline mean that it is unlikely that capacity will be constrained and that there is little likelihood in practice that a queue will eventuate on the WTS.  Consequently, the Commission considers that the queuing policy for the WTS meets the requirements set out in sections 3.14 to 3.17 of the Victorian Access Code.  
4.6.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
EPD has advised that consistent with section 9.2(c) of the Victorian Access Code, responsibility for complying with the obligation imposed by sections 3.14 to 3.17 of the Victorian Access Code is allocated to VENCorp with respect to the PTS. 
VENCorp states in its access arrangement for the PTS that its queuing policy is described in the MSOR.  Clause 5.3.4 of the MSOR provides that, in the event that there is insufficient available authorised MDQ to satisfy the requirements of all customers or prospective customers who have requested an allocation of authorised MDQ, VENCorp must conduct an auction amongst all customers or prospective customers from whom it has received requests for authorised MDQ.  It must allocate the available authorised MDQ to the customer or prospective customer who offers the highest amount for that authorised MDQ and that allocation of authorised MDQ will be effective in respect of a delivery point at which that customer or prospective customer withdraws gas. 
Specifically, clause 5.3.4(h) of the MSOR states ‘ ... the principles and procedures VENCorp develops and applies to effect an allocation of available authorised MDQ, comprise the queuing policy of VENCorp as required under the Access Code’.
Clause 5.3.4(g) provides that all monies received by VENCorp as a result of allocating authorised MDQ under clause 5.3.4(e) are to be used by VENCorp to offset its costs for the next financial year calculated in accordance with the Tariff Order. 
EPD has advised that the initial allocation of MDQ is likely to entail the allocation of all available MDQ and hence there will be no opportunity in the short term for VENCorp to allocate spare capacity by auction.  The concerns raised by interested parties on the procedures for the initial allocation of MDQ are discussed in the terms and conditions section of this document and in the Commission’s Determination of the MSOR.  
In response to the Commission’s Draft Decision which proposed that the queuing policy be finalised and included in the revised access arrangement, EPD agreed to finalise VENCorp’s queuing policy.  EPD provided the Commission with a draft copy of the queuing procedures on 17 June 1998.  The Commission was subsequently advised by EPD that it had not received any comments from interested parties on the draft procedures and that it proposed that VENCorp will formally adopt them as its queuing policy.  
The proposed auction process is summarised as follows: 
Register of MDQ applications
VENCorp will establish and maintain a formal register for all applications for new or additional MDQ allocations under MSOR clauses 5.3.4(d) and 5.3.4(e)(2).  The register will contain the date of the application, quantity requested, customer’s name and postal address and of the authorised agent, if applicable.  VENCorp will formally provide to the customer (and authorised agent, if applicable) acknowledgment of the receipt of its application.  
Auction process
When additional capacity is made available, VENCorp will conduct an open auction of the whole of that capacity and to allocate that capacity in order of highest bids received.  The auction is open only to persons registered with VENCorp.  During the ten day auction period, a person may bid or alter a bid once on each day.  Bids and re-bids received by the end of the tenth business day shall form the basis of VENCorp’s allocations of MDQ.  
Key issues raised  by interested parties
Several interested parties, including BHPP, AGL, Amcor, EAG, the Consumer Law Centre of Victoria Limited (CLCV) and BCA raised concerns about the proposed queuing policy for the PTS in their submissions.  Central themes were dissatisfaction with the level of detail provided, and costs and uncertainty associated with the auction process.  The major issues raised were:
•	there is no information as to what conditions will qualify users or prospective users to participate in an auction, how the auction will be conducted, when it will take place and its frequency;
•	the queuing policy proposed under clause 5.3.4 of the MSOR is inadequate to meet the Victorian Access Code’s requirements and the MSOR are excessively vague about how the queuing policy will operate; and
•	the auctioning of spare capacity could mean that the cost of a reference service would be greater than the reference tariff and it will add to consumer costs.  
The Institute of Public Affairs Ltd (IPA) supports the proposed policy.  It argues that an auction based system provides an incentive for service providers to augment the capacity and allows those people who value the service most highly to actually obtain it.  
BHPP argues that the queuing policy cannot be assessed by the regulator until the principles and procedures have been promulgated by VENCorp.  Both BHPP and BCA support the Commission’s proposal that the queuing policy for the PTS should be finalised before the revised access arrangement is approved.  
Commission’s assessment 
The purpose of a queuing policy is to allocate spare capacity where there is insufficient capacity to satisfy the needs of all users and potential users who have requested capacity.  
The Commission noted in its Draft Decision the concerns expressed in submissions about the adoption of an auction (instead of a traditional, literal ‘first come, first served’ queue) and about the amount of detail then available on the principles and procedures governing the auction process.
In principle, the Commission sees merit in the concept of an auction process rather than a queue and notes the IPA’s support for it.  Queuing can be an inefficient way of allocating scarce resources.  An auction provides a market mechanism which is more likely to lead to an efficient allocation of the potentially scarce and valuable spare capacity of the pipelines.  An auction can deliver a competitive outcome in that the market value of connection may be determined.  While successful bidders would in effect pay more than the reference tariff for a service, the additional amount would reflect the value they place on gaining access to the system.  Any revenues raised through the auction process will be used to offset VENCorp costs in the subsequent financial year and will benefit users as a whole.
Although some parties raised some concerns about the use of an auction, the Commission notes that no material concerns have been raised by interested parties on the details of VENCorp’s proposed auction process.  The Commission is satisfied that the EPD’s proposed approach of adopting the draft auction policy as the formal queuing policy and incorporating it in VENCorp’s revised access arrangement addresses its concerns.  
In the Draft Decision, the Commission Proposed Amendment A4.10 which required VENCorp to finalise the procedures for the initial allocation of MDQ.  This is now discussed under terms and conditions in section 4.3 of this document.
Amendment 4.11
	In order for VENCorp’s Access Arrangement for the PTS to be approved, the finalised queuing policy for the PTS must be incorporated in VENCorp’s Access Arrangement.  

4.7	Extensions and expansions policy
4.7.1	Victorian Access Code requirements
Section 3.18 of the Victorian Access Code requires an access arrangement to have an extensions/expansions policy.  The policy is to set out the methodology to assess whether any extension or expansion of the system will be treated as part of the covered pipeline.  A service provider is also required to specify the impact on reference tariffs of including an extension or expansion with the covered pipeline.  In addition, an extensions/expansions policy must outline under what conditions the service provider will fund new facilities and provide a description of those new facilities. 
4.7.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
Clauses 5.7 of the PTS access arrangement and 5.8 of the WTS access arrangement set out the extensions/expansions policies for TPA.  These two policies have the same effect.  Firstly, extensions or expansions that are included in the service envelope are covered by the access arrangements and are rolled-in to the reference tariffs.  
Alternatively, TPA must seek Commission approval to include in the access arrangements any extensions and expansions which it proposes be included and are currently outside the service envelope.  If the Commission agrees that a particular new facility should be included in the service envelope, and hence the access arrangement, the project may be rolled-in to the capital base.  
If the Commission does not agree to allow a revision of the access arrangement to include a new facility then the cost of the project is to be recovered as an excluded service.  Excluded services are subject to regulation to the extent that they are ‘fair and reasonable’ in the view of the Commission.  TPA is not required to seek Commission approval if it decides to exclude an extension or augmentation from the access arrangement. 
Clause 5.7.4 of the PTS access arrangement (and clause 5.8.4 of the WTS access arrangement) specify that TPA must provide access arrangement information in two cases.  Firstly, where TPA is proposing to apply a surcharge on the basis that a new facility has system wide benefits and, secondly, where the extension in question will result in a material change to the covered pipeline.  
However, if an application to review an access arrangement will not result in changes to reference tariffs, the Commission has the discretion to dispense with the requirement that TPA produce access arrangement information relating to that extension or expansion.  The Commission also has the discretion to make a decision without public consultation.  
Generally, extensions and expansions will not result in changes to reference tariffs for reference services under clauses 5.7.3(e) and 5.8.3(e) of the PTS and WTS access arrangements.  However, this is subject to the Commission approving a surcharge for a new facilities investment that is considered to provide system wide benefits under clause 5.7.3(f) of the PTS access arrangement (or clause 5.8.3(f) of the WTS access arrangement).  
Subject to clauses 5.7.3(a) to (f) of the PTS access arrangement (and clauses 5.8.3(a) to (f) of the WTS access arrangement), the principles stated in sections 8.15 to 8.19 of the Victorian Access Code will apply to new facilities investment by TPA.  Specifically, the following apply: 
•	an investment should not exceed that which would be carried out by a prudent service provider (see also section 8.16(a) of Victorian Access Code); 
•	the present value of the incremental tariff revenue from the investment should exceed the investment costs (this is referred to as the roll-in test, see section 8.16(b)(i) of the Victorian Access Code).  Alternatively, the regulator is to be satisfied that the investment produces system-wide benefits that would justify a ‘surcharge’ which would result in TPA meeting the roll-in test; 
•	if the roll-in test is not met, the shortfall may:
•	be held as a speculative investment fund (as specified under section 8.19 of the Victorian Access Code); or 
•	be recovered as a surcharge (as allowed under section 8.19(a) of the Victorian Access Code) or a capital contribution from incremental users; 
•	new facilities investment may be added to the capital base when there is a review of reference tariffs for the upcoming regulatory period or at the approval of a variation to the access arrangement.  
Thus, as provided under section 8.18 of the Victorian Access Code, and specified by clause 5.3.4 of the access arrangements, the extensions/expansions policies do allow TPA to undertake new facilities investment even if the requirements of section 8.16 of the Victorian Access Code are not met.  In addition, under section 8.19 of the Victorian Access Code, the reference tariff policies provide that the balance of a new facilities investment may be subsequently added to the capital base of the reference tariffs (see clause 5.3.4 of the PTS and WTS access arrangements).  
TPA’s Access Arrangement Information lists its planned major capital projects.  These are:  
•	Murray Valley extension (which was subject to a competitive tender process under GTC and has an incremental tariff set in the Tariff Order);
•	Brooklyn-Corio project (which is considered to meet the system-wide benefits criteria of the Victorian Access Code);
•	automation of compressor stations;
•	minor capital expenditure on the pipeline and compressor stations to cover ongoing load growth; and 
•	non-system capital expenditure to meet information technology requirements.  
While these are all listed in TPA’s Access Arrangement Information, only the Murray Valley project is included in the service envelope.  The Murray Valley system will have an incremental charge while the other items listed above are rolled-in to the reference tariffs.  Prior to the release of the Draft Decision, it was anticipated that TPA would establish an incremental tariff for the Barnawatha to Culcairn portion of the InterConnect.  However, the Commission has since been advised by EPD that TPA will submit a revision to the PTS access arrangement for the inclusion of the InterConnect to the PTS.  
The extensions/expansions policy also outlines the relationship between the Tariff Order and the service envelope agreement.  The Tariff Order limits TPA’s transmission services to those provided from the existing and forecast assets specified in the Access Arrangement Information.  These services are provided according to the set geographical parameters such as area code details and the established service standards.  
Key issues raised by interested parties
BHPP has argued that the extensions/expansions policy provided in the access arrangement is 
...defective and should be revised, consistent with providing contract carriage choices on TPA. ... That is, the policy should ring-fence new investment costs to be charged to those who create the demand for that new capacity.  
There appear to be two reasons for BHPP taking this view.  The first is the level of discretion the policy provides to TPA.  BHPP claims that the present policy for the PTS provides TPA with complete discretion as to what investment projects will be rolled-in to the reference tariffs and consequently, is inefficient.  In addition, the access arrangement allows for the Commission to consult only with TPA when considering a submission to vary the access arrangement in relation to extensions and expansions.  BHPP prefers that this process be open to all market participants regardless of the impact on reference tariffs.
The second area of concern relates to the level of pipeline competition possible under the proposed access arrangements.  BHPP claims that in enabling roll-in to occur, the access arrangements allow incumbent pipelines to subsidise new projects with existing customers.  BHPP considers this makes it ‘virtually impossible for new pipeline companies to enter the market’.  Thus, BHPP is of the view that the potential areas of competition in relation to extensions and expansions which exist have not been addressed by the access arrangement.  
However, concerns have also been raised regarding the Commission’s proposals in the Draft Decision and their impact on pipeline competition.  Project Consultancy Services (PCS) has commented on the level of the WACC and its impact on extensions and expansions.  PCS suggests that the WACC proposed by the Commission ‘may result in a situation where the injection of maintenance capital and expansion capital cannot be justified’.  In addition, PCS claims the incumbent will be sheltered from competition from new entrants seeking to extend or expand the system.  Coastal asserts that Proposed Amendment A4.11 ‘will inhibit the construction of additional facilities causing detriment to the consumers’.  The ACA has also suggested that the arrangement of the extensions/expansions policy under Proposed Amendment A4.11 would not be efficient and would constrain commercial behaviour.  
Submissions received on extensions/expansions policy have also commented on the InterConnect.  EAPL is concerned that the InterConnect is not included in the service envelope and hence the PTS access arrangement.  AGL also raised its concern regarding the initial proposal from EPD that the InterConnect will be incrementally priced.  Like EAPL, AGL considers such a policy will become a barrier to interstate trade.  Both companies support the inclusion of the InterConnect with the PTS access arrangement.  Support for the inclusion of the InterConnect has also come from Eastern Energy and the NSW Government.  AGL has also suggested that consultation on the reasonableness of the InterConnect’s tariffs must occur before the InterConnect is included with the PTS access arrangement.  
Commission’s assessment
Under section 3.18 of the Victorian Access Code, an extensions/expansions policy must set out the method to be used in determining whether a particular extension or expansion will be included in an existing access arrangement for a covered pipeline.  An example of a method is provided in section 3.18 of the Victorian Access Code.  It indicates that the service provider may elect, with the regulator’s consent, whether to include an extension or expansion as part of a covered pipeline.  While this example may not seem like a conventional ‘method’, the PTS and WTS access arrangements have followed a similar approach.  The Commission is satisfied that the extensions/expansions policies proposed for the PTS and WTS do contain a method and meet this requirement of the Victorian Access Code.  
The access arrangements require TPA to seek approval from the Commission for an extension or expansion to be included in the existing access arrangements.  However, approval is not required for a decision to exclude an extension or expansion from an access arrangement.  The Commission does not consider that this reflects the intention of the Victorian Access Code.  As a result, the Draft Decision contained Proposed Amendment A4.11 which required all extensions and expansions to be included in the access arrangements unless the Commission considered otherwise.  EPD did not agree to this amendment as far as it applied to extensions.
EPD argued that 
... this amendment skews the market for transmission services in favour of the incumbent as, with the Regulator having the right to require roll-in in respect of every extension, other pipeline builders/owners will be deterred from bidding in competitive tenders against the incumbent.  
After further consideration of this argument, the Commission is of the view that the Proposed Amendment A4.11 may give the perception that the service provider is able to use the extensions/expansions policy as required by Proposed Amendment A4.11 to extend its monopoly and thus limit pipeline competition.  This is because Proposed Amendment A4.11 may have the effect of automatically extending the covered pipeline.  
However, the Commission does not consider it appropriate for TPA to have total discretion over the application of its access arrangements to extensions and expansions.  For significant extensions that TPA does not include in the relevant access arrangement it is possible that an access arrangement will apply to that extension through the application of section 1 of the Victorian Access Code.  That is, any third party can apply to the Victorian Treasurer for a particular pipeline to be declared as a covered pipeline.  The Commission considers that the determination of coverage of major pipelines in this manner is the most appropriate route.  
In contrast, the Commission considers that minor extensions should be incorporated in the relevant access arrangement according to the criteria set out in section 8 of the Victorian Access Code in regard to new facilities investment.  It would be inefficient, and may create regulatory uncertainty, to treat minor extensions and expansions separately from the existing system.  In addition, efficiencies will arise from the incumbent building some of the extensions and expansions to the system.  
In considering these issues, the Commission has assessed the condition proposed by the ORG in its Draft Decision in relation to extensions/expansions policy.  The Commission is of the view that methodology similar to that promoted by the ORG would be appropriate for TPA.  The methodology includes the concept of ‘significant’ extensions.  EPD has advised that a suitable test on which significance can be determined is that an extension can be considered significant if it is greater than 10 km in length or has cost more than $5 million.  The Commission is satisfied that this threshold appropriately separates minor extensions from major new facilities.  Consequently, in response to submissions from interested parties and EPD, the Commission requires the proposed extensions/expansions policy in TPA’s access arrangements be amended.  
However, the Commission considers that the proposed access arrangements did not clarify the impact of extensions and expansions on reference tariff sufficiently.  To ensure that the impact of new facilities on reference tariffs is understandable to users and prospective users the Commission considers that the access arrangements should clearly specify the impact extensions and expansions may have on reference tariffs in accordance with section 8 of the Victorian Access Code. 
Amendment 4.12
In order for TPA’s Access Arrangements for the PTS and WTS to be approved, amendments to the extensions/expansions policies must be made to the following effect:
Coverage
1.	If the extension or expansion to the PTS/WTS is to come into service on or after the commencement of the access arrangement:
(i)	Prior to the extension or expansion coming into service, the service provider must notify the Commission of the extension or expansion.
(ii)	Subject to paragraph (1)(iii) below, the extension or expansion will automatically be treated as part of the covered pipeline upon the extension or expansion coming into service.
(iii)	An extension will not be treated as part of the covered pipeline through the operation of the extensions/expansions policy if:
(a)	the extension is a ‘significant extension’;
(b)	the service provider elects not to treat the extension as part of the covered pipeline; and
(c)	the service provider notifies the Commission of its election prior to the extension coming into service.
(iv)	A ‘significant extension’ means an extension that:
(a)	is at least 10 kilometres in length; or
(b)	costs at least $5 million.
2.	If the extension or expansion to the PTS/WTS comes into service prior to the commencement of the access arrangement, the extension or expansion is to be treated as part of the covered pipeline upon the commencement of the access arrangement.
Note:	Under paragraph 2 above, the natural gas pipeline, owned by TPA, extending from Barnawatha (Vic) to Culcairn (NSW) is to be treated as part of the PTS upon commencement of the access arrangement.
Effect of extension/expansion on reference tariffs
3.	The extensions/expansions policy, insofar as it specifies how the extension or expansion will affect reference tariffs, must be consistent with Chapter 8 of the Victorian Access Code.  In particular:
(i)	The amount of the cost of the new facility that can be included in the capital base must be determined in accordance with section 8.16 of the Victorian Access Code.
(ii)	The portion of the new facilities investment that cannot be included in the capital base may be:
(a)	included in a speculative investment fund in accordance with section 8.19 of the Victorian Access Code;
(b)	recovered by a capital contribution a user agrees to pay TPA which may be assumed to be a surcharge; and
(c)	recovered by a surcharge approved by the Commission in accordance with section 8.25 of the Victorian Access Code.
Submissions to vary an access arrangement
4.	The treatment of an extension or expansion as part of the PTS/WTS as a consequence of the operation of the extensions/expansions policy is not a change to the access arrangement.
5.	Reference tariffs cannot be changed unless the procedure in section 2 of the Victorian Access Code is followed.
6.	A surcharge is not a change to the access arrangement.  However, in accordance with section 8.25 of the Victorian Access Code, for the purposes of public consultation, a notice to impose a surcharge is to be treated as if it were a proposed revision to the access arrangement submitted under section 2.28.

The Draft Decision of the Commission expressed concern that the InterConnect was not intended to be included in the PTS access arrangement in the future.  Submissions received prior to the release of the Draft Decision also expressed concern over this decision by EPD.  This resulted in the Draft Decision containing Proposed Amendment A4.12 which required the InterConnect to be included with the PTS access arrangement.  
Subsequent to the release of the Draft Decision, EPD has advised the Commission that TPA intends to include the InterConnect with the PTS access arrangement through the application of the revised extensions/expansions policy.  Consequently, the Commission expects that once the access arrangements have commenced, TPA submit proposed revisions to the reference tariffs.  A public consultation process will be undertaken by the Commission in accordance with section 2 of the Victorian Access Code to assess TPA’s proposal.  The Commission notes that under the National Access Code the consent of the NSW Minister is needed for the InterConnect to operate as a market carriage pipeline in NSW.  The consent of the NSW Minister is currently being sought.  In light of submissions from interested parties, the Commission considers that this is the most appropriate approach to consider the matters raised in relation to the InterConnect.
4.7.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal 
VENCorp’s access arrangement states: 
The Extensions/Expansions Policy for the Principal Transmission System is described in clause 5.7 of TPA’s Access Arrangement.  
Detailed comments on the extensions/expansions policy under TPA’s Access Arrangement for the PTS are located in the previous segment of this section.  
4.8	Review and expiry of the Access Arrangement
4.8.1	Victorian Access Code requirements
Section 3.19 of the Victorian Access Code requires an access arrangement to include a date upon which the service provider must submit to the regulator a revised access arrangement (revisions submission date) and a date upon which the revisions are intended to commence (revisions commencement date).  An access arrangement may also include an expiry date (section 3.22).
The regulator’s assessment of the appropriateness of the two dates under section 3.19 must include reference to the objectives contained in section 8.1 of the Victorian Access Code.  The regulator may require an amendment to the proposed access arrangement to include earlier or later dates and may also define a specific major event as a trigger which compels the service provider to submit revisions prior to the revisions submission date.
An access arrangement period accepted by the regulator may be of any duration.  However, if the period is greater than five years, the regulator must consider whether mechanisms should be included in the access arrangement to address the potential risk that forecasts, on which terms of the proposed access arrangement are based, subsequently prove to be incorrect (section 3.20).
Finally, it should be noted that the revisions commencement date is not a fixed date for the revisions to commence but is subject to variation by the regulator at the time at which it approves the revisions pursuant to section 2.48 of the Victorian Access Code.  This section states that: 
... Subject to the Gas Industry Act, revisions to an Access Arrangement come into effect on the date specified by the Relevant Regulator in its decision to approve the revisions (which date must not be earlier than either a date 14 days after the day the decision was made or ... the Revisions Commencement Date).  
4.8.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
TPA proposes that the revisions submission date will be 30 June 2002 and the revisions commencement date will be 1 January 2003 for both the PTS and WTS.
Chapter 9 of the Tariff Order supports the revisions commencement date set in clause 5.8.2 of the PTS access arrangement and clause 5.9.2 of the WTS access arrangement.  It states that the initial Tariff Order ceases on 31 December 2002 and the subsequent Tariff Order will operate for five years from 1 January 2003.  Moreover, clause 9.2 of the Tariff Order sets out a framework to guide the Commission in its decisions on the price regulation arrangements for the period 1 January 2003 to 31 December 2008, including the use of an incentive based model. 
Key issues raised by interested parties
Concerns were raised that there is insufficient information disclosed in the proposed access arrangement to know if the system would operate effectively over a five year period.  Based on these concerns, the Australian Chamber of Manufactures (ACM) suggests that a three year review period would be more appropriate at the start of the market.  
CLCV considers that: 
There is difficulty in establishing the initial appropriate cost/price path for the proposed arrangements, given that the historical information related to integrated businesses. ... A short time-frame for initial review ... would be favoured by the CLCV.  
Other submissions raised concerns that future costs have been estimated for specific businesses when there is no historical information available for those businesses on which to base the estimates and suggested that each of the businesses need to be benchmarked against similar operations overseas.  On this issue, AGUG states: 
In our view the uncertainty with the estimates is best handled by the imposition of a shorter initial review period than the five years proposed in the undertakings as this would mean that any errors that are made in year zero are not locked in for five years. 
BHPP states that section 3.20(a)(ii) lays the groundwork for a review to be held if there is a change to locational and/or hourly pricing.  
In response to the Commission's decision to change the revisions submission date to 30 March 2002, EAPM has stated that a nine month period for assessment of revisions to the 
access arrangements is too long and will be too costly.  
Commission’s assessment
TPA’s proposal for the revisions submission date is consistent with section 3.19(a) of the Victorian Access Code in that it includes a date upon which the service provider must submit revisions to the access arrangement and a date upon which those revisions are intended to commence.  
The Commission is satisfied that an initial access arrangement period of approximately five years is suitable for the present access arrangements.  It also notes that section 3.20 of the Victorian Access Code implies that an access arrangement period would generally be five years in length.  Due to the current assessment process, the initial access arrangement period for the access arrangements presently under assessment will be nearer four years than five.  In addition, EPD claims that the cost of altering the revisions commencement date would outweigh any benefits due to the increased regulatory uncertainty.  For these reasons the Commission approves the revisions commencement date of 1 January 2003. 
The revisions submission date proposed by EPD of 30 June 200 is six months prior to the proposed commencement date of the second access arrangement period.  The Commission considers that this would not allow the Commission to extend the review process under section 2.44 of the Victorian Access Code, if required, and would not provide sufficient time for TPA to respond to the decisions made by the Commission.  The Commission considers that it would be prudent to allow more than six months for the assessment and implementation of revisions as this would ensure a complete and thorough public consultation process is carried out.  
While the Commission proposed that the revisions submission date be altered to 30 March 2002 in its Draft Decision, this was inconsistent with the decision taken by the ORG.  It is therefore appropriate to have a revisions submission date of 31 March 2002.
Amendment 4.13
	In order for TPA’s Access Arrangements for the PTS and WTS to be approved, the revisions submission date must be amended to 31 March 2002.  

The BHPP submission supports the regulator defining trigger factors such as a change to locational and/or hourly pricing.  This would be possible by reference to section 3.19 of the Victorian Access Code.  
The Commission agrees that a change from a daily pricing to a multi-zone, hourly pricing model is significant.  As discussed in the Commission’s Determination of the MSOR, the change (if required by the market) to multi-zone hourly pricing will be subject to Commission scrutiny according to the established authorisation process.  In addition, the change process contained in Chapter 8 of the MSOR provides for Commission assessment of any proposed changes to the MSOR.  The Commission considers that the provisions of section 2.28 of the Victorian Access Code are sufficient to allow TPA to submit any necessary revisions to the access arrangements at the time a change to the pricing system of the spot market occurs.  Accordingly, the Commission does not consider that a trigger for review under section 3.19 of the Victorian Access Code is required for a change to a multi-zone hourly pricing model for the spot market.  
4.8.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal 
VENCorp proposes a revisions submission date of 30 June 2002 and a revisions commencement date of 1 January 2003 for the PTS.  These dates are the same as those submitted in TPA’s access arrangements.  
Commission’s assessment
As the same revisions submission date and the revisions commencement date have been nominated by each of the service providers, the issues raised in the submissions on the questions of the revisions submission and commencement dates can be regarded as relating to both the TPA and VENCorp access arrangements.  The Commission considers that it is necessary to maintain consistency between the access arrangements for TPA and VENCorp as well as between the decisions taken by the Commission and the ORG.  For this reason, the dates approved under section 3.19 of the Victorian Access Code for each of the access arrangements should be the same.  As a consequence, the Commission requires an amendment to the revisions submission date proposed in VENCorp’s access arrangement to 31 March 2002.
Amendment 4.14
	In order for VENCorp’s Access Arrangement for the PTS to be approved, the revisions submission date must be amended to 31 March 2002.  

4.9	Information provision
4.9.1	Victorian Access Code requirements
In conjunction with its proposed access arrangement, a service provider is required to submit access arrangement information, which must contain sufficient information to enable users and prospective users to understand the derivation of the elements in the proposed access arrangement and to form an opinion as to compliance of the access arrangement with the provisions of the Victorian Access Code (section 2.6). 
The access arrangement information may include any relevant information, but must at least contain the information described in Attachment A to the Victorian Access Code (section 2.7),  which is included as Appendix C to this document.  A summary is contained in Box 4.1 below.
Box 4.1:	Summary of Attachment A information
The information required is divided into six categories:
Category 1: access and pricing principles
Tariff determination methodology; cost allocation approach; and incentive structures.
Category 2: capital costs
Asset values (by, e.g. pricing zone) and valuation methodology; depreciation and asset life; committed capital works and planned capital investment (including justification for); rates of return for equity and debt; and debt/equity ratio assumed.
Category 3: operations and maintenance costs
Fixed versus variable; cost allocation between, e.g. pricing zone, and cost categories.
Category 4: overheads and marketing costs
Costs at a corporate level; regulated versus unregulated; cost allocation between, e.g. pricing zone, and cost categories.
Category 5: system capacity and volume assumptions
Description of system capabilities; map of piping system; average and peak demand; volumes; system load profiles; customer numbers.
Category 6: key performance indicators
Indicators used to justify ‘reasonably incurred’ costs.

Information included in the access arrangement information may be categorised or aggregated to the extent necessary to ensure that disclosure of the information is not, in the opinion of the relevant regulator, unduly harmful to the legitimate business interests of the service provider, a user or prospective user (section 2.8).
If the relevant regulator is not satisfied that the access arrangement meets the requirements of the Victorian Access Code, it may, of its own volition, require the service provider to make changes to the access arrangement information.  Likewise, if requested to do so by any person, the relevant regulator must review the adequacy of the access arrangement information.  However, the relevant regulator must not request information which, if released publicly, may unduly harm the legitimate interests of the service provider or users and prospective users (section 2.9).
If the relevant regulator requires the service provider to change the access arrangement information, it must specify the reasons for its decision and allow the service provider a reasonable time to make the changes and resubmit the access arrangement information.
A summary of the responsibilities of the relevant regulator and procedures to be followed are contained in Box 4.2 below.
Box 4.2:	Information disclosure - regulator’s responsibilities and procedures
1)	The regulator must decide as soon as practicable whether the access arrangement information meets the requirements of sections 2.6 and 2.7.  That is, whether the access arrangement information includes:
•	the information described in Attachment A (section 2.7); and
•	such information as in the opinion of the regulator would:
•	enable users and prospective users to understand the derivation of the elements in the proposed access arrangement; and
•	form an opinion as to the compliance of the access arrangement with the provisions of the Victorian Access Code (section 2.6).
2)	The regulator must also consider whether changes to the access arrangement information are required.  This in turn, requires the regulator to consider:
•	whether the disclosure of the information could be unduly harmful to the legitimate business interests of the parties; and thus
•	the extent to which the information needs to aggregated or categorised (or possibly excluded).
3)	In making this decision:
•	the regulator must correctly interpret sections 2.6 & 2.7;
•	take into account relevant considerations (submissions received); and
•	provide procedural fairness to the service provider and other parties.
4)	If the regulator requires the service provider to make changes to the access arrangement information, then under section 2.9, the regulator must:
•	specify the reasons for its decision; and
•	specify a reasonable time for the service provider to make the changes.
5)	When the regulator makes its draft decision and proposed amendments to the access arrangement have been released for public comment, as a requirement of procedural fairness, the regulator should consider:
•	whether parties have received sufficient information to enable them to understand and make submissions on the proposed amendments; and
•	whether amendments must also be made to the access arrangement information.	

4.9.2	TPA’s Access Arrangements for the PTS and WTS
Service provider’s proposal
While TPA submitted separate access arrangement proposals for the PTS and WTS, it submitted combined access arrangement information covering both gas transmission systems.  The access arrangement information was submitted in three stages:
•	the access arrangement information originally submitted in conjunction with the access arrangements on 3 November 1997;
•	revised supplementary information submitted on 13 March 1998; and
•	additional supplementary information submitted on 16 March 1998.
Contained in Box 4.3 below is a summary of the additional information which was appended by TPA to the original access arrangement information.
Box 4.3:	Summary of additional Access Arrangement Information
Original Information	Additional Information	
Target Revenue		
Description of the components of target revenue.	Each item quantified by pricing zone.	
Cost allocation		
Description of the methodology used to allocate costs to services.	Quantified by each service.	
Historical costs		
No details.	TPA advised that historical costs split in accordance with the new industry structure were not available.  As a proxy, the acquisition value as at 11 December 1997 (based on DORC) was submitted.	
Depreciation		
Can be deduced from asset values and economic lives of assets.	Quantified by each pricing zone.	
Planned capital expenditure		
Total annual figures provided and description of the process for determining investment requirements.	Disaggregated by asset types.  Description of and justification for planned capital expenditure provided.	
Return on assets		
Details of the components of WACC.	Quantified by each pricing zone.	
Working Capital		
No details.	Quantified by each pricing zone.	
Operations and maintenance costs		
An aggregated figure provided with a description of the costs included.	Costs disaggregated by pricing zone and cost categories.	
Key Performance Indicators		
Comparison of costs ($m/1 000 km and c/GJ) and tariffs (c/GJ) for the system as a whole with other pipelines in Australia.	Additional information provided according to pricing zone.	

The additional information submitted in March 1998 by TPA followed criticism from interested parties of the adequacy of the original information.  Although TPA agreed to release the additional information, it maintains that in its opinion the access arrangement information as originally submitted meets the requirements of the Victorian Access Code.
Key issues raised by interested parties
Interested parties who commented in their submissions on the adequacy of information disclosure were critical of certain aspects of the access arrangement information and considered the access arrangement information as originally submitted to be deficient and not to satisfy the requirements of the Victorian Access Code.  More specific issues arising from the submissions were:
•	the lack of disaggregated cost data, for example, by pricing zone and cost categories, as required by Attachment A to the Victorian Access Code;
•	depreciation was not quantified;
•	although a description of the methodologies used, for example, cost allocation methodology, was provided, the lack of quantitative data meant it was not possible to verify the implementation of those methodologies or the conclusions reached, such as the derivation of the reference tariffs;
•	details of committed capital works and capital investment, and a description of the nature and justification for planned capital investment as required by the Victorian Access Code were not provided;
•	although the target revenue required a return on net working capital, no value was given for this component of the capital base;
•	details of the historical costs of assets were lacking;
•	inadequacy of the key performance indicators.  Previous costs of the Victorian gas industry for 1995/96 and 1996/97 should have been provided to enable comparison with current costs; and
•	the withholding of the confidential reports of the consultants engaged by TPA.
On 7 January 1998 BHPP lodged a formal request under section 2.9(b) of the Victorian Access Code that the Commission consider whether in its view the Access Arrangement Information met the requirements of the Victorian Access Code.  
Following the release of additional information by TPA, on 4 March 1998 the Commission decided to extend by two months the time period for assessment of the proposed access arrangements to allow interested parties the opportunity to make further submissions in light of the additional information.
Although those parties who made additional submissions commented that the additional information addressed many of the issues identified by them as deficiencies in the original information, some criticism was still directed at the level of disclosure.  Among the issues raised were:
•	the limited amount of benchmarking undertaken by TPA to justify costs, with some parties calling on TPA to undertake an international benchmarking study;
•	in some instances additional information was sought which, in the Commission’s opinion, exceeded the minimum requirements of the Victorian Access Code.  For example, AGUG argued that TPA should provide projected financial statements; and
•	not all operational data is provided by pricing zone.  TPA has stated that the current metering equipment is inadequate to provide such data, for example, monthly throughput by zone.
Other issues raised by some interested parties as evidence of an inadequacy in information disclosure seem more related to provisions of the proposed access arrangements themselves rather than the Access Arrangement Information and are dealt with in the appropriate sections of this Final Decision.
Commission’s assessment
BHPP’s request under section 2.9(b) of the Victorian Access Code required the Commission to consider whether the Access Arrangement Information was adequate and the requirements of sections 2.6 and 2.7 had been satisfied, and whether to require the service provider to make changes to the Access Arrangement Information.
On 29 April 1998, the Commission assessed the information provided by TPA in its entirety and concluded that the original Access Arrangement Information, together with the additional information submitted, satisfied the requirements of the Victorian Access Code with respect to the proposed access arrangements as they stood at that time.  However, the Commission acknowledged that a final decision on the Access Arrangement Information could not be made then because of the potential impact on the Access Arrangement Information of any amendments to the proposed access arrangements required by the Commission in its Draft Decision. 
In its assessment of the adequacy of the Access Arrangement Information, an issue which the Commission needed to consider was the level of detail required to satisfy the condition of the Victorian Access Code that the Access Arrangement Information should contain sufficient information to allow users and prospective users to understand the derivation of the elements of the access arrangements.
Of contention is whether service providers only need to provide sufficient information to allow users and prospective users to understand the methodology used (for example, allocation of costs), or whether users and prospective users are given sufficient financial data to allow them to replicate the service provider’s tariff calculations.  It is the Commission’s opinion that the Victorian Access Code does not require the service provider to provide such information to enable users and prospective users to replicate the service provider’s tariff calculations.  
Nevertheless, the Victorian Access Code is quite explicit in that Attachment A defines the minimum information that must be submitted by the service provider.  Any other relevant information may also be submitted in addition to the Attachment A information.  Attachment A requires the provision of a broad spectrum of financial and operational data at a disaggregated level.
In many cases the information provided by a service provider in accordance with Attachment A may be sufficient to allow a user to replicate tariff calculations.  However, this may not always be the case, particularly in the more complex cases, such as the current proposals for the Victorian gas transmission systems.  Nevertheless, the supplementary information provided by the TPA contained considerable financial and operational data at an disaggregated level.
The only option for aggregating the Attachment A information, or omitting certain items, is to ensure that disclosure of the information is not, in the opinion of the relevant regulator, unduly harmful to the legitimate business interests of the service provider, a user or prospective user.  It is the Commission’s view that the onus is on the service provider to supply, in conjunction with its proposed access arrangement, all relevant access arrangement information and in the appropriate level of detail as required by Attachment A.  If the service provider considers that the information should be categorised or aggregated, or the release of any of the information may unduly harm its legitimate business interests or those of any user or prospective user, the service provider should provide compelling reasons to support its arguments.
Transparency is an important aspect of any access arrangement and the service provider is required to provide a considerable amount of data which should be sufficient, where practical, to allow market participants to make their own assessment of the reasonableness of the elements of the access arrangement, particularly the reference tariffs.  This process should aid interested parties in making submissions to the relevant regulator which in turn assists the relevant regulator in its assessment of the proposed access arrangement.
A description of the methodology applied alone is insufficient and should be accompanied by underlying financial data.  However, as the amount of information released increases, so does the risk that the legitimate interests of the service provider or users and prospective users will be jeopardised.  Therefore, the Commission will always bear this in mind when considering the release of information and will aggregate, or withhold, information if necessary.
The confidential provisions of sections 2.8, 2.9 and 7.12 of the Victorian Access Code suggest that the relevant regulator is likely to have access to more information from the service provider than other market participants.  Nevertheless, the Commission recognises that monopolies are not subject to the same commercial disciplines of a competitive market and therefore the commercial sensitivity of publicly releasing information would be less.
4.9.3	VENCorp’s Access Arrangement for the PTS
Service provider’s proposal
VENCorp submitted its Access Arrangement Information in two stages:
•	the Access Arrangement Information originally submitted in conjunction with the access arrangements on 3 November 1997; and
•	supplementary information submitted on 6 March 1998.
The additional information provided by VENCorp expands on the original information in two basic areas:
•	more disaggregated data of costs incurred; and 
•	more information of the methodology of allocating those costs to the relevant functions.
Although the original Access Arrangement Information submitted by VENCorp listed the various cost components, they were not quantified.  The supplementary information provided more detail by way of projected profit and loss statements.  Costs were also attributed to their relevant functions.
In the original Access Arrangement Information, VENCorp stated that costs are allocated in accordance with what end users could bear and based on guiding principles.  Those principles are: that allocation is done on a commercially reasonable and economically efficient basis; does not distort investment decisions; and is cost reflective.  More detail of the cost allocation process was disclosed by VENCorp in its supplementary information.  In particular, VENCorp noted that its costs should represent about one per cent of total delivered energy costs for most customers.  According to VENCorp, where the one per cent rule is exceeded, that segment has a low price elasticity and hence can bear the charges with minimal distortion in usage.
The Victorian Access Code requires that the service provider should disclose the key performance indicators which it has used to justify ‘reasonably incurred’ costs.  In this regard, VENCorp stated:
The structure being established in Victoria is novel in the gas industry.  Direct equivalents of VENCorp are not therefore available for comparison.
Key issues raised by interested parties
BHPP and AGL were critical of the Access Arrangement Information originally submitted by VENCorp.  They argued that it contained deficiencies and failed to satisfy the requirements of the Victorian Access Code.  The main criticisms were:
•	the cost allocation methodology was not fully explained;
•	costs were provided at an aggregate level and not disaggregated by cost categories; and
•	the Access Arrangement Information contained no key performance indicators.
Both BHPP and AGL were critical of the lack of detail of the method of cost allocation employed by VENCorp.  They noted in particular that costs would be on the basis of ‘end-use customer bearable methodology’, but argued that the Access Arrangement Information lacked the underlying elements defining this broad principle.
While acknowledging that VENCorp would not incur the full range of costs set out in Attachment A of the Victorian Access Code, AGL still considers that the level of data provided does not satisfy the requirements of the Victorian Access Code.  AGL pointed to the provision in the Access Arrangement Information of only two costs figures, transmission control and market management costs.
BHPP argued that the lack of detail of disaggregated costs coupled with inadequate information about the cost allocation methodology meant that ‘we simply have no way of knowing what these costs represent, how they are incurred, or whether they are appropriately allocated’.
According to BHPP, a justification for requesting information on costs at a disaggregated level is to ‘make up’ for the lack of key performance indicators (KPIs) for VENCorp’s activities.  Furthermore, BHPP disputes VENCorp’s claim that novelty of the structure of the gas industry in Victoria means that direct equivalents of VENCorp are not available for comparison purposes.  According to BHPP, BG Transco’s Network Code regime is very similar to the proposed model for the Victorian gas industry.  BHPP also suggests that comparisons could be made with independent system operators (ISOs) in electricity industries, both local and international.
Commission’s assessment
The note above on performance standards is also relevant here with the added difficulty that there is no clear equivalent to which VENCorp can be compared.  It is also important to note that VENCorp is a non-profit organisation and that any excess earnings will be returned to the industry in the following year.
4.10	Key performance indicators
The Victorian and National Access Codes identify the need for KPI’s to be disclosed by service providers to interested parties.  The Access Arrangement Information states that the objectives of providing the KPI’s is to allow interested parties to confirm that operation costs included in the target revenue are reasonable when compared to costs in other Australian gas companies; and to monitor the service provider over time to confirm the overall reasonableness of the revenue and tariff setting approach.  The Access Arrangement Information notes, however, that there have been some restrictions on the availability of relevant information, including limited publicly available information and the difficulty in comparing like with like.
The Access Arrangement Information addresses this issue with a limited range of indicators, including comparison of operating and maintenance costs against other Australian pipelines on a $m/1 000 km and cents/GJ basis and comparison of cents/GJ of transportation.
The Commission recognises the challenges in identifying KPI’s and benchmarks especially in a newly deregulated commercial environment such as the Victorian natural gas industry.  The Commission therefore intends to work closely with the service provider to establish appropriate KPI’s but in the short to medium term it will use financial indicators.  These include funds flow adequacy, funds flow interest coverage, funds flow net debt pay back, internal financing ratio, pre-tax interest coverage, total debt/total capital, PATBI/funds employed, PBIT/sales volume ($/GJ), PBIT/total revenue, PBITD/sales volume ($/GJ), PBITD/total revenue, PBIT/funds employed, operating cash flow, and EBIT/operating assets.
Furthermore, the Commission intends to use benchmarks such as load factor and energy delivered per employee which are set out by the Steering Committee on National Performance Monitoring of Government Trading Enterprises as a basis for developing non-financial indicators for TPA.  VENCorp on the other hand, is a unique body and there is therefore no point of comparison at present which may be used to develop KPI’s or benchmarks.  The Commission, however, intends to work closely with VENCorp to develop these, particularly in light of market development and experience.

5.	Final Decision
5.1	TPA and TPAA’s Access Arrangement for the PTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve TPA and TPAA’s access arrangement for the PTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.
5.2	TPA and TPAA’s Access Arrangement for the WTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve TPA and TPAA’s access arrangement for the WTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.
5.3	VENCorp’s Access Arrangement for the PTS
Pursuant to section 2.16(b) of the Victorian Access Code, the Commission does not approve VENCorp’s access arrangement for the PTS.  In order for the Commission to grant approval, the amendments (or nature of the amendments) specified in this Final Decision must be made to the access arrangement.  A revised access arrangement must be submitted to the Commission on or before 2 November 1998.

Appendix A:	Interested parties consulted by the Commission
User consultations
Amcor Ltd
Australian Gas Users Group
Business Council of Australia
Ecogen Energy
ACI Operations Pty Ltd
Broker Consultations
Exco Energy
Government Consultations
Energy Projects Division, Department of Treasury and Finance, Victoria
Producer Consultations
BHP Petroleum Pty Ltd
Network Business Consultations
East Australian Pipeline Limited
Boral Energy Holdings Limited
Retailer and Interstate Consultations
Australian Gas Light Company

Appendix B:	Submissions
The following parties made submissions in relation to the access arrangements:
Pre Draft Decision
ACI Operations Pty Ltd, 16 January 1998
Allgas Energy Ltd, 30 March 1998
Amcor Ltd, 26 January 1998, 19 March 1998
Australian Chamber of Manufactures, 30 January 1998
Australian Cogeneration Association, 17 February 1998, 9 April 1998, 22 April 1998
Australian Gas Light Company, 12 January 1998, 3 April 1998, 28 April 1998, 6 May 1998
Australian Gas Users Group, 27 January 1998, 9 April 1998
BHP Petroleum Pty Ltd, 12 January 1998, 13 February 1998, 27 March 1998, 8 April 1998
Boral Energy Holdings Limited, 13 February 1998
BTR Asia Pacific, 6 February 1998
Business Council of Australia, 2 February 1998, 15 April 1998
Carlton and United Breweries Limited, 14 January 1998
CitiPower Pty, 12 January 1998
Coastal Gas Australia Pty Ltd, 13 February 1998
Consumer Law Centre of Victoria Limited, 2 February 1998
Department of Energy (NSW), 16 January 1998
East Australian Pipeline Limited, 12 January 1998
Ecogen Energy, 12 February 1998
Energy Action Group, 27 January 1998, 30 January 1998
Energy Projects Division of the Department of Treasury and Finance (Victoria), 6 February 1998, 11 February 1998, 20 February 1998, 10 March 1998, 11 March 1998, 26 March 1998, 31 March 1998, 2 April 1998, 14 April 1998, 17 April 1998.
Esso Australia Resources Ltd, 30 January 1998
Nova Gas Australia Pty Limited, 13 February 1998
Optima Energy, 25 February 1998
Santos Ltd, 16 January 1998, 13 February 1998
South Australian Minister for Primary Industries, Natural Resources and Regional Development, 27 January 1998, 13 February 1998
South Australian Office of Energy Policy, 12 February 1998
Texas Utilities Australia Pty Ltd, 27 March 1998
Uncle Tobys Company Limited, 2 February 1998

Post Draft Decision
ACI Packaging Group, 23 June 1998
Amcor Ltd, 27 June 1998
AMP Asset Management Australia Ltd, 29 June 1998, 7 July 1998
ANZ Investment Bank, 17 June 1998
Australian Cogeneration Association, 22 July 1998
Australian Council for Infrastructure Development Limited, 19 June 1998, 10 July 1998 
Australian Gas Association, 21 June 1998
Australian Gas Light Company, 19 June 1998
Australian Gas Users Group, 10 July 1998, 21 July 1998
Australian Pipeline Industry Association Inc, 4 June 1998, 19 June 1998, 17 July 1998
Axiom Funds Management Limited, 28 July 1998
BHP, 23 June 1998
BHP Petroleum, 24 June 1998, 17 July 1998, 31 July 1998
Business Council of Australia Energy Working Group, 20 July 1998, 
CitiPower Pty, 17 July 1998
Coastal Gas Australia Pty Ltd, 17 June 1998, 17 July 1998
Commonwealth Bank, 22 June 1998, 2 July 1998
Consumer Law Centre Victoria Ltd, 6 July 1998
Credit Suisse First Boston on behalf of Energy Projects Division, 2 July 1998
East Australian Pipeline Marketing Pty Limited, 16 June 1998
Eastern Energy, 19 June 1998
Electricity Supply Association of Australia Limited, 19 June 1998
Energy Action Group, 17 July 1998
Energy Projects Division of the Department of Treasury and Finance (Victoria), 17 June 1998, 1 July 1998, 2 July 1998, 3 July 1998, 17 July 1998, 27 July 1998, 4 August 1998
Energy Users Group, 20 July 1998, 24 July 1998
Energy Users Group, Australian Gas Users Group & Australian Cogeneration Association, 2 July 1998
Envestra Limited, 19 June 1998
Epic Energy Pty Limited, 16 June 1998, 17 July 1998
Fay, Richwhite Securities Limited, 24 July 1998
Freehill, Hollingdale & Page, 16 July 1998
GasAdvice Pty Ltd on behalf of ACI Glass Packaging, Aurora Glass Fibre, Bonlac Foods, Cabot Australasia, Pilkington Australia & Unichema International, 23 July 1998
GPU PowerNet Pty Ltd, 19 June 1998
Great Southern Energy, 17 June 1998
Hastings Funds Management Limited, 18 June 1998, 18 August 1998
Incitec Ltd, 19 June 1998
Institute of Public Affairs Ltd, 17 June 1998
KPMG on behalf of Energy Projects Division, 29 July 1998
North West Shelf Gas Pty Ltd, 22 June 1998
NSW Government, 16 June 1998, 24 July 1998
NSW Treasurer, 17 June 1998
Project Consultancy Services Pty Limited, 17 July 1998
Sinclair Knight Merz, 26 June 1998
South Australian Department of Treasury and Finance, 17 June 1998
South Australian Treasurer, 17 June 1998
Texas Utilities Australia Pty Ltd, 17 July 1998
Texas Utilities Australia Pty Ltd & Eastern Energy Limited, 18 June 1998
TransGrid, 19 June 1998
United Energy & UtiliCorp United Inc, 19 June 1998
Victorian Premier, 19 June 1998
Victorian Treasurer, 17 June 1998
Western Australian Minister for Energy, 14 July 1998

Appendix C:	Attachment A of the Victorian Access Code 

ATTACHMENT A
INFORMATION DISCLOSURE BY A SERVICE PROVIDER TO INTERESTED PARTIES
Pursuant to section 2.7 the following categories of information must be included in the Access Arrangement Information.
The specific items of information listed under each category are examples of the minimum disclosure requirements applicable to that category but, pursuant to sections 2.8 and 2.9, the relevant regulator may:
•	allow some of the information disclosed to be categorised or aggregated; and
•	not require some of the specific items of information to be disclosed,
if in the relevant regulator’s opinion it is necessary in order to ensure the disclosure of the information is not unduly harmful to the legitimate business interests of the service provider or a user or prospective user.
Category 1: Information regarding access & pricing principles	
Tariff determination methodology
Cost allocation approach
Incentive structures	
Category 2: Information regarding capital costs	
Asset values for each pricing zone, service or category of asset
Information as to asset valuation methodologies - historical cost or asset valuation
Assumptions on economic life of asset for depreciation
Depreciation
Accumulated depreciation
Committed capital works and capital investment
Description of nature and justification for planned capital investment
Rates of return - on equity and on debt
Capital structure - debt/equity split assumed
Equity returns assumed - variables used in derivation
Debt costs assumed - variables used in derivation	
Category 3: Information regarding operations & maintenance	
Fixed versus variable costs
Cost allocation between zones, services or categories of asset & between regulated/ unregulated
Wages & Salaries - by pricing zone, service or category of asset
Cost of services by others including rental equipment
Gas used in operations - unaccounted for gas to be separated from compressor fuel
Materials & supply
Property taxes	
Category 4: Information regarding overheads & marketing costs	
Total service provider costs at corporate level
Allocation of costs between regulated/unregulated segments
Allocation of costs between particular zones, services or categories of asset	
Category 5: Information regarding system capacity & volume assumptions	
Description of system capabilities
Map of piping system - pipe sizes, distances and maximum delivery capability
Average daily and peak demand at ‘city gates’ defined by volume and pressure
Total annual volume delivered - existing term and expected future volumes
Annual volume across each pricing zone, service or category of asset
System load profile by month in each pricing zone, service or category of asset
Total number of customers in each pricing zone, service or category of asset	
Category 6: Information regarding key performance indicators	
Industry KPIs used by the service provider to justify ‘reasonably incurred’ costs
service provider’s KPIs for each pricing zone, service or category of asset	

Appendix D:	Explanation of EPD model
EPD provided the Commission with a computer model of its tariff calculations.  The input is various Gascor/TPA forecasts (volumes, costs) and estimates (asset values, WACC) and the output is the reference tariffs proposed in the Tariff Order.  The following is a summarised explanation of the model.  It is similar to the summary of the service provider’s Access Arrangement Information in the body of this Draft Decision but contains more detail.
Volumes
Volume forecasts, supplied by Gascor, are changed to add seller’s own use, adjust specific points which are known to be incorrect in the Gascor data and adjust for unaccounted-for-gas.  
Operations & maintenance costs
TPA’s starting point for forecast O&M costs is the GTC corporate plan.  Costs (such as labour, materials, communications, motor vehicles, etc.) are allocated to departments.  Some costs (relating to ‘Gas Control’ and ‘GTSO’) are removed as being appropriate to VENCorp.  Total O&M costs (after removal of the VENCorp costs, and not including compressor fuel costs) are $24.3 million in 1998, rising to $25.4 million in 2002.  
Each department’s costs are then allocated to one or more of 54 activities in various proportions (either based on the proportion of net labour used in those activities or on advice received).  Each of these activities’ costs is then categorised as commodity (for example, odourisation costs), distance allocation (for example, operations costs for open access pipelines), direct allocation (for example, costs for system performance/control, engineering and operations for compressors and LNG) or common (for example, costs for commercial, financial and management activities, and systems planning).  Relevant costs are also allocated between PTS and WTS on various bases as considered appropriate.  
Costs associated with the LNG system, customer delivery facilities and receipt point facilities are removed, while the cost of compressor fuel gas is added to produce a total O&M figure relevant to the reference services.  This figure is the aggregate of common costs (for both PTS and WTS), direct costs for each of the three compressors, and direct costs associated with pipelines (for both PTS and WTS).  EPD then reduced these total forecast figures by an expected productivity saving.  
Table A below shows, for each year in the initial regulatory period, the proportion of the O&M costs forecast by GTC which EPD’s model allocates to be recovered by the reference tariffs.  It also lists for each year the result of reducing this forecast by the required productivity factor.  These reduced figures are the input to the revenue allocation model from which the reference tariffs are developed (see below).  The forecast O&M costs for Murray Valley are added to these figures to derive the figures listed in the Access Arrangement Information.
Table A:	Forecast operations and maintenance costs
	1998	1999	2000	2001	2002	
	$m	$m	$m	$m	$m	
GTC forecast 	19.5	19.9	20.1	20.1	20.5	
GTC forecast less productivity factor	19.3	19.4	19.2	18.9	19.0	
Murray Valley	0.2	0.2	0.2	0.2	0.2	
AAI forecast	19.5	19.6	19.4	19.1	19.2	
	%	%	%	%	%	
Productivity Factor	0.77	2.56	4.31	6.10	7.73	
Source:	EPD model supplied to the Commission
A regulatory fee for the Commission, and an Office of Gas Safety charge, are included in the O&M costs.
Revenue allocation
Total depreciation and return figures allocated to pipelines are allocated to asset groups in proportion to each group’s pipeline ORC.  Depreciation and return for other direct assets (compressors, odourising plants and Dandenong terminal) are allocated directly to the asset group in which they reside.
The total figure for each asset group (also referred to as a zone) is split between users in that zone and users upstream in proportion to the GJ of MDQ/km relevant to each.  These are then divided by the relevant volumes to get a per GJ pass through rate and a per GJ/km zone rate.  The ‘upstream rate’ for each asset group consists of the sum of the pass through rates for each asset group between that particular asset group and the hub.  
In 2001 and 2002 these calculations assume that the take-off points in the Calder price zone and the western half of the Metro price zone receive all their gas from the UGS.  Pass-through rates are calculated on the basis that transportation is along this route.  
For asset groups 1-5 (those on the injection side of the hub) depreciation and return are split between zone and upstream as above except that the basis is the 5 day maximum demand (rather than MDQ).  These figures are divided by the pass through volume (5 day maximum) to give a per GJ rate.  The pass through rates for asset zones 1, 2 and 5 (the direct line from Longford to the Hub) are added together to get an injection rate.  The injection rate applicable to the three delivery points in asset group 1, and to asset groups 3 and 4 are a reduced proportion of the standard injection rate to reflect only the proportion of the Longford to Pakenham line used by those items.
Pipeline locational O&M costs are is allocated to asset groups in proportion to each group’s pipeline length (which totals 1330.7 km).  O&M cost for compressors are allocated directly to the asset group in which they reside.  Each asset group’s O&M cost are allocated to asset zone and up-stream using the same method as for depreciation and return except that it is based on total annual volume and not MDQ.  
Common O&M for both PTS and WTS (forecast separately) are divided by the relevant total volume to give a per GJ rate for each system.  Return and depreciation for indirect assets are divided by total volume to give a per GJ rate (there is no split between PTS and WTS).  This rate is added to the relevant common O&M rate to give a total common rate for each of PTS and WTS.
For each delivery point, each relevant asset zone rate is multiplied by each distribution volume (or volume x distance as appropriate) to derive six target revenues associated with: MDQ, locational commodity, common commodity (assets), common commodity (O&M), injection and injection discount for each distribution point.
Tariff Order
To provide an allocation between tariff D and tariff V customers an average for the initial regulatory period is used.  Volumes forecast by Gascor are allocated to price zones for each year.  The five year data is summed and the proportion of daily metered customers to total customers calculated for each price zone.
The six revenues by delivery point (listed two paragraphs above) are imported from each of the revenue allocation spreadsheets for each of the five years.  These six revenues are re-allocated to five categories.  Capacity (MDQ) revenue is split between demand and volume on the basis of the ratio of daily metered customers to non-metered customers (calculated as in the above paragraph), except for the three specific take-off points where daily metered load is assumed to be 100 per cent.  The revenue related to locational O&M, common O&M and common assets is summed into anytime volume.  Injection charge and injection discount remain unchanged.  For each tariff for each delivery point, the NPV is calculated based on a WACC of 13.02 per cent for each of the five revenue streams.  The delivery point data are aggregated into pricing zones.
For each of the five categories, for each delivery point, a tariff is calculated that, when increased by CPI-X over years 1999-2002, will produce revenues each year (when multiplied by the forecast volume) with the same NPV as the NPV calculated in the above paragraph.  These are then aggregated for each pricing zone (net of the transmission supply points) to produce zone tariffs and transmission supply points tariffs.  This approach is applied to the calculation of tariffs for peak demand, peak volume, anytime volume, injection charge and injection discount (though injection charge is the same figure for all zones and the discount applies to only two pricing zones).

Appendix E:	The implications of regulatory returns driven by a pre-tax real WACC
TPA proposed a real, pre-tax formulation of the WACC in the determining the allowed rate of return, with this estimate incorporating an allowance for the long term effective tax rate.  Both the Draft Decision and Final Decision of the Commission have also adopted the same WACC formulation.  This approach is consistent with that widely applied to date in Australia, and with that taken over the past ten years by the United Kingdom’s two energy regulators, Offer and Oftel.
The debate at the WACC forum on the Commission’s Draft Decision estimate of the effective tax rate served to highlight some fundamental problems surrounding the treatment of tax in a medium term regulatory environment.  The purpose of this section is to draw out some of those problems, and to flag the need for a review of the overall approach in order to address those problems more effectively in future regulatory arrangements. 
Weaknesses in the use of a real, pre-tax WACC
Estimating the effective tax rate
The debate over an appropriate estimate of the long term effective tax rate effectively concluded that there is no satisfactory answer to the question of what allowance should be made for the ‘cost of tax’ in determining a pre-tax rate of return for deriving a regulated revenue stream. 
Deriving a plausible estimate of the long term effective tax rate appears unachievable without resort to estimates of economic and business variables over periods so long that the original objectives of the exercise become seriously compromised.  
It is also inevitable that the rates and even the method of taxation will change over the economic life of the assets.  Using a long-term average tax rate assumption (which assumes a degree of pre‑payment of tax in respect of expected future tax liabilities) makes it complex to respond to changes to the tax law without delivering windfall gains or losses, either to the businesses or their customers.
Nevertheless, the consequence of misjudging the effective rate of tax is that investors are over or under-rewarded for the risks they bear.  The Commission’s own modeling work suggests that, once fixed payments to debt holders have been taken into account, significant errors in the allowance for tax have a disproportionate impact on after-tax returns to equity.  These errors are compounded when the time profile of tax payments is not smooth.  
The conversion problem
A second problem with the use of real, pre-tax formulation of the rate of return is the controversy over the method for converting a nominal, post-tax WACC (as observed by the market) to a real, pre-tax WACC for determining target revenues.  The objective of the ‘conversion’ exercise is relatively straightforward, that is, which of the possible approaches delivers a regulated revenue stream that provides post-tax, nominal returns in line with the original target? 
The complexities standing between the pre-tax real and post-tax nominal formulations of investor returns include the iterative relationship between the effective tax rate and the regulated revenue stream, and uncertainty associated with the rate of inflation.  By taking inflation out of the regulatory WACC, the uncertainties brought about by changes in the general price level become another element of the conversion problem. 
The Commission has undertaken extensive modeling simulations of investor returns under the two different approaches to conversion, i.e. that proposed by TPA where the post-tax nominal WACC is adjusted for tax first, and inflation second, and the alternative order of conversion proposed by Macquarie.  This work suggests strongly that neither approach is correct, and that the real answer lies with a more complex formulation in-between these two.  
The Commission’s own analysis of the conversion issue suggests that there is no unique answer to the conversion problem.  The robustness of any standard approach is limited by a restrictive assumption of one sort or another, e.g. that tax and economic depreciation are the same, or that only the real interest component of debt costs is tax deductable. 
The basic problem is to ensure that the real, pre-tax WACC will deliver the post-tax returns indicated as appropriate by financial market indicators and the CAPM model. 
Consistency between formulations of WACC and cash flows
The nature of the conversion problem and the inherent difficulty in estimating a long term effective tax rate both suggest that the attraction for regulatory purposes of a pre-tax WACC formulation may be more apparent than real. 
The main benefit generally attributed to the use of a real, pre-tax WACC is that it avoids the need for regulators to make judgements regarding a company’s financing structure, and its tax position.  By focusing on the pre-tax WACC, regulatory decisions can avoid the risk of being seen to ‘underwrite’ particular financing or taxation arrangements, leaving investors and management free to take such decisions on their own account.
However, it would appear that adopting pre-tax WACC formulation cannot absolve the regulatory process from making implicit assumptions about a businesses financing arrangements, and its tax costs.  Rather, when using a pre-tax WACC these same issues manifest themselves in a different and perhaps more complex way.
In sum, there is a choice between two broad alternatives.  Regulatory decision-making can deploy relatively simple assessments of cash flows (that is, before tax and financing) but these must be coupled with much more complex formulations of WACC.  The alternative is to use the less complex and better understood post-tax formulation of WACC, which in turn must be applied to tax- and financing-inclusive assessments of cash flows.
The time profile of tax
Once they have been privatised, the tax status of the Victorian gas businesses will be similar to that of a newly established, asset-intensive business operating under the Commonwealth tax regime.  Although the assets of the businesses are long established, the impact of the sector restructuring and their transition to commonwealth tax law implies a tax status that is very similar to a single, newly acquired asset. 
The Victorian gas businesses will enjoy large tax depreciation allowances for the first 10-20 years of operation, and can be expected to pay little or no tax during their first few years of operation.  Typically, the tax liability of the gas businesses will then rise over time.  Depending on future inflation and capital spending, taxes may rise to the point where the effective rate of tax on regulatory profits (calculated on the basis of economic depreciation) exceeds the statutory tax rate. 
Figure E.1 below shows a stylised example of the actual company tax liabilities (as a proportion of free cash flow) likely to be faced by the regulated Victorian gas businesses.  This diagram is based on some important of assumptions; namely that there is no change to the tax regime over time and that inflation runs at a constant relatively low rate throughout the life of the asset.
Figure E.1:	Stylised taxation profile of a regulated gas business

A tax profile of this sort, in combination with the application of a real, pre-tax which is invariant to the time-profile of tax payments, seems likely to give rise to a number of problems.  The financial consequences are likely to be that:
•	regulated businesses will be receiving cash from customers several years in advance of their obligation to make business tax payments to the government, although if the estimate of the long term average effective tax rate is correct, then the net present value of the two shaded areas should be identical; and
•	for any period shorter than 50 years, the expected post-tax return on assets - which provides the foundation for the original WACC estimates - will always be different from that which the regulatory WACC aimed to deliver, as illustrated in Figure E.2 below.
Figure E.2:	Actual and ‘market’ post-tax return, long term average tax rate

The above diagram shows that setting the regulated rate of return on the basis of the estimated long term average effective rate of tax is likely to provide the asset owner with returns above the post‑tax WACC in the early years.  Conversely, returns established on the basis of a long term effective tax rate will be below the post‑tax market cost of capital in the later years.  
The Commission’s modeling of the effect of setting a constant, real pre-tax WACC suggests that, over a 40 - 50 year period, the changing profile of tax payments is likely to alter the post-tax WACC by as much as 100bpts.  Naturally, post-tax returns to equity vary within a greater range, of around 200-300bpts.
It should also be noted that Corporations Law requires a business to provide for the value of any deferred income tax liability.  This is determined in each year by the difference between accounting and tax depreciation (multiplied by the tax rate).  However, this provision is necessary irrespective of whether, say, a regulated business has or has not recovered this advance amount from customers. 
Regulatory implications
This expected profile of tax payments seems likely to give rise to a number of regulatory problems:
•	the desirable objective that regulatory decisions be credible, sustainable, and replicable may be undermined by an approach which over-rewards investors in early years but under-rewards them in later years and so, by definition, is not delivering the returns implied by the original WACC estimate;
•	marginal investment decisions may be distorted, encouraging ‘gold-plating’ in early years (when post-tax returns are higher than necessary) and potentially causing under-investment when post-tax returns fall below the market requirement;
•	despite the fact that average post-tax returns may be sufficient over the long term, a regulator may face ‘moral hazard’ problems in enforcing an arrangement which rewards investors with less than the market (post‑tax) cost of capital at some time in the future on the basis that they had received above market returns at some stage in the past – today’s investors will inevitably be different from those of a decade ago; and
•	setting a post‑tax WACC on the firm’s regulatory asset value which is below the required return of existing and prospective investors goes against the basic principles of utility regulation (where prices should reflect the efficient cost of service).
It should be noted that these problems will emerge regardless of which estimate of the average rate of taxation that is used, that is, whether the statutory tax rate is used for simplicity, or a more complex estimate of the long term effective rate is attempted.
To reduce the risk of such problems emerging later in the business life cycle, a minimum requirement for successful implementation of long term tax approach adopted in this Final Decision is that the nature of the regulatory contract must clearly be understood by both investors and customers.  As the businesses mature and post-tax returns fall below the market rate, it must be recognised that investors will have been compensated by above market returns in the early years.
A need for change?
The regulatory and financial issues generated by arrangements that offer favourable tax treatment of investment during the early years of an asset life cycle are neither new nor unique to Australia, or the privatisation context.
Regulatory commissions in the United States have been addressing the above issue since firms were first permitted to adopt accelerated depreciation on capital expenditure in 1954.  Since then, two distinct approaches to the wedge between short and long term tax rates have developed in the US, both in the context of a post-tax WACC formulation. 
The first, characterised as ‘flow-through’, involves making a regulatory allowance for tax on a ‘pay as you go’ basis.  The second and now more common approach is known as ‘normalisation’.  Under the latter, revenues are collected from customers in line with the long term average rate of tax.  However, the deferred tax is treated as a free source of capital for the firm.  Accordingly, for the purposes of deriving a revenue requirement, deferred tax is deducted from a firm’s regulatory asset base until the time the tax liability falls due.
In the United Kingdom, the water industry regulator, Ofwat, has also responded to the taxation consequences of the large capital expenditure programs of the water companies. Ofwat adopts a post-tax WACC formulation, with a separate allowance for tax derived using five-year estimates of benchmark tax liabilities.  Enquiries by the Commission suggest that a range of UK commentators are beginning to call for a similar approach to be adopted by the other industry regulators. 
These same issues have also been recognised by informed commentators in Australia.  For example, in an early submission prior to the Commission’s Draft Decision, the Commonwealth Bank commented that:
... a conceptual problem [with the approach adopted by the Applicant] is that it grosses up the WACC for the maximum possible tax payable.  The corporate tax rate is currently 36%… [but] often the utilities bought on sale are geared enough to have the effective tax rate well below 36%.  It would be more fair to end users if a post-tax WACC was used and the actual tax paid by the utility on a year by year basis was simply refunded as part of the total revenue equation.  This would equate federal taxes as a cost much the same as best practice operating costs are currently treated (ie refunded). 
The Commission also sought advice from finance experts’ Professors Bob Officer and Kevin Davis, and Dr Neville Hathaway, on the relative merits of pre-and post-tax formulations of the WACC.  Putting aside the consequences for the time profile of prices and intergenerational equity, the unanimous view of the experts was that the only effective way to address the treatment of tax was to adopt a relatively simple WACC formulation, and deal with tax as an item in the cash flows. 
Conclusion
The various options for the treatment of tax reduce to two main alternatives.  The first involves the adoption of a normalisation approach, with the extent of any deferred tax treated as a free source of capital for the firm (and so deducted from its regulatory asset base).  The alternative would involve an assessment of tax costs for one regulatory period at a time, and setting the revenue requirement accordingly.  
Both approaches could allow the simultaneous adoption of a post-tax WACC formulation, with the latter being particularly compatible with more straightforward versions of WACC.  
Each option has strengths and weaknesses, not only in terms of their practicability but also in terms of their implications for the time-profile of customer prices, for intergenerational equity, and for their robustness to change. 
While this analysis and advice provided by experts has highlighted the benefits of moving away from the real, pre-tax approach, the Commission considers at this stage, more thought needs to be given to the proposed alternatives as they should be applied by Australian regulators.  This will be done in the context of statements of regulatory intent being prepared by the Commission.