Snowy Mountains Hydro-Electric Authority

Risk Position of Transmission Assets

Prepared by:  
Helen McLeod
William M Mercer
Melbourne

July 1999

CONTENTS	Page

1.	INTRODUCTION	2
2.	RATIONALE FOR EXAMINING RISK POSITION	4
3.	ASYMMETRIC RISKS	6
4.	LIABILITY RISKS	9
5.	CHANGES IN REGULATORY FRAMEWORK	11

1.	INTRODUCTION

William M. Mercer Pty Limited (Mercer) has been engaged by the Snowy Mountains Hydro-electric Authority (Snowy) to provide advice in relation to the nature and size of the commercial risks faced by Snowy with respect to its transmission assets.
The purpose of this report is to assist Snowy with its submission to the ACCC on the required revenue cap for its transmission assets over the next regulatory period, ie the five year period to 30 June 2004.
Background
Under Chapter 6 of the National Electricity Code, the ACCC is required to determine the maximum revenue a Network Service Provider can earn on its non-contestable transmission assets.
In its “Principles for Regulation of Transmission Revenues” issued on 27 May 1999, the ACCC set out its intended “building block” approach to determining maximum transmission revenue, as follows:
Maximum revenue  =  return on capital  (WACC * value of assets)
			 plus
			 return of capital  (depreciation allowance)
			 plus
			 operations & maintenance (O&M) allowance
When using this building block approach, it is important that allowance is made for the commercial risk position of the transmission assets.
This is particularly the case with respect to risk relative to other network service providers, which needs to be considered when determining the appropriate level of WACC. In addition, allowance needs to be made for:
•	Any asymmetric cash-flow risks – ie, risks which are generally not insurable and which produce financial outcomes which are not symmetrically distributed about the expected value. The most appropriate way of allowing for these risks will generally be to take them into account when setting the level of WACC; and
•	Any self-insured risks – ie, those risks where the company has chosen, for commercial reasons, not to take out insurance cover. The most appropriate way of allowing for self-insured risks is to make a specific adjustment to the O&M allowance.

Nature of Snowy’s transmission assets
Snowy’s transmission assets essentially consist of a triangle of three switching stations (Murray, Upper Tumut and Lower Tumut) connected by 232 km of 330 kV lines. Snowy also owns 58 km of 132 kV transmission lines, connecting the Guthega power station to the “triangle”, a 132 kV switching station at Munyang, and a 330/132 kV substation.
The transmission assets form a very small part of Snowy’s overall asset base, most of which consists of dams, pipelines and power stations. As at January 1999, they were valued at approximately $144 million on a replacement cost basis, compared with a total asset base valued at approximately $3.6 billion.
While Snowy’s transmission assets make up only a very small proportion of its overall asset base, they are still very critical, especially when viewed from a risk perspective. The assets form the main interconnect between the Victorian electricity network and the NSW electricity network. Any constraint on the interconnect could lead to significant, or even extreme, price differences between the NSW and Victorian regions, leading to potentially significant financial exposures for market participants.
In addition, the transmission assets are located in a remote, rugged and highly sensitive environmental area, subject to severe weather conditions, so, from an insurance perspective, can be expected to represent a relatively high risk.

2.	
RATIONALE FOR EXAMINING RISK POSITION
In this section of the report, we discuss the rationale for examining an entity’s commercial risk position when determining the required revenue cap for that entity during the next regulatory period.
Risk relative to other Network Service Providers
When determining the WACC to use for the “return on capital” building block, the level of risk relative to other network service providers (as well as network service providers relative to the market as a whole) needs to be taken into account when determining the appropriate level of equity beta.
In Snowy’s case, the network assets are in a relatively high risk position, given their physical location and their critical interconnect function. On the other hand, the risk of stranding would appear to be low, relative to other network service providers.
Asymmetric risks
The Capital Asset Pricing Model (CAPM) adopted by the ACCC to estimate the weighted average cost of capital (WACC) associated with the provision of electricity transmission services, is a widely used model for estimating the market value of an asset. In particular, CAPM provides an estimate of the appropriate discount rate to use to value the projected cash‑flows from that asset.
The regulatory use of CAPM involves a reversal of direction. Rather than taking the cash‑flows as given and using the CAPM‑determined WACC to estimate the value of the asset, the asset value is taken as given, and the WACC is then used to determine a set of cash‑flows which are consistent with that asset value. 
Applying WACC in the reverse direction in this manner produces a “benchmark” level of cash flows which, on average, can be expected to provide the required rate of return on capital. 
Actual cash flows each year will, naturally, differ from these expected levels due to random fluctuations in experience. Provided such fluctuations are symmetrically distributed around the benchmark levels, (ie sometimes they can be expected to provide higher than benchmark revenues, sometimes lower), expected cashflows over the regulatory period will be equal to the benchmark levels determined. If, however, random divergences are not symmetrically distributed (ie “asymmetric risk”), the benchmark revenue, while it may be “most likely”, will not be equal to expected revenue over the regulatory period. 
On average, therefore, an entity exposed to asymmetric revenue risks will not receive its expected cost of capital unless allowance for these risks is included. Such an allowance could be made, for example, by a specific addition or subtraction to the benchmark revenue requirement, or, more generally, through an adjustment to the level of WACC used to determine the appropriate return on capital.
Self-insured risks
There are many reasons why a company would choose to self-insure a risk rather than purchase insurance to cover it, including:
•	The insurance premium payable may be considered to be too high.  This is particularly the case for low probability events or “new” risks, where the insurance company has inadequate statistics to develop a competitive policy;
•	Insurance may simply not be available;
•	A “standard” policy, with a number of exclusions, may be available at competitive rates, and the exclusions may be considered to be manageable within the context of the company’s balance sheet.
Clearly it should be a commercial decision whether it is more cost effective to retain a risk or take out insurance to cover it.
However, within the context of a regulated revenue cap there could be clear incentives to insure all potential risks, no matter how cost inefficient, as insurance costs are clearly allowed for in the revenue cap through the O&M allowance, whereas there is no specific allowance for uninsured risks.
The simplest way to deal with this issue is to ensure that a specific allowance for any self-insured risks is included within the O&M allowance, on the same basis as if the risk were insured.

3.	
ASYMMETRIC RISKS
In this section of the report, we set out our approach to assessing the level of asymmetric risk faced by Snowy in relation to its transmission assets, and present an overview of the relevant levels of risk. 

Approach to assessing the level of risk
The assessment of risks associated with Snowy’s cash‑flows involves the following steps:
•	Identify the events which could have an impact on the cash‑flows associated with Snowy’s regulated transmission business.
•	Determine the likelihood of the identified events occurring during the regulatory period.
•	Determine the potential financial consequences associated with the relevant event. There are essentially two broad categories of financial consequences to Snowy:
–	Direct consequences –Snowy may receive less or more revenue than projected as a result of the event, or incur higher or lower costs than projected.
–	Third party consequences – an event may leave Snowy liable to claims by third parties.
•	Assess the extent to which the potential financial consequences of the identified events will ultimately be borne by Snowy. Reasons why the financial consequences of a given event may not ultimately be borne by Snowy include:
–	Snowy may be insured against the event, in which case the cost will be allowed for through the insurance premium included in the O&M allowance;
–	the regulatory regime may allow the consequences of a particular event to be passed through to end‑users (through higher or lower prices); or
–	the implications of the event may have been factored in to the forecast of cost associated with providing the regulated services, and therefore recovered through the regulated charges.
The expected cost or benefit of a particular event is then determined by the projected financial consequences to Snowy of that event multiplied by the likelihood of the event occurring during the regulatory period. 
It is important to note that “financial consequences” can be positive or negative – some “risks” can result in higher revenue or lower costs than expected, others reduce revenue or increase costs. Whether or not there are asymmetric risks associated with Snowy’s cash‑flows will depend upon the net effect of all possible events.
Identification of risks
The commercial risks to which Snowy is exposed, within the context of a regulated revenue cap, can be grouped as follows: 
•	stranded asset risks – if assets are optimised out of the asset base at the start of the next regulatory period, the regulated return allowed on them during the current regulatory period may be insufficient to cover their actual economic depreciation rate, let alone provide a return on capital;
•	forecast risks – the revenue cap is calculated based on a number of forecast assumptions (for example, in relation to capital expenditure and O&M costs). To the extent that actual experience differs from that forecast, there may be some financial exposure (or gain) within the context of Snowy’s regulated revenue cap;
•	“insurable” risks – major, unpredictable occurrences, such as damage to Snowy’s property or the risk that Snowy may be found liable under some form of legal action to a third party, can clearly have significant impact upon Snowy’s revenue requirement; and
•	regulatory uncertainty – the revenue cap is determined in advance for each regulatory period. If there are any changes in the regulatory framework during the period, the basis upon which all assumptions and calculations were made will clearly change. If the cap is not recalculated at that point, the regulated revenue may not match actual revenue requirements for a number of years.
Likelihood of occurrence
For each of the broad classes of potential risks identified above, the likelihood of occurrence within the next regulatory period can be summarised as follows:
•	stranded assets – given the highly critical location of Snowy’s transmission assets within the SE Australian transmission network, we consider the chance of asset stranding within the next 5 years to be negligible.
•	forecast risks – on the basis that any information advantage which Snowy may have is neutralised by the ACCC using independent consultants, any differences between actual and forecast experience over the regulatory period can be expected to be symmetrically distributed around zero. Thus, while we consider it inevitable that such differences will arise, we consider the chance of their having a significant financial impact upon Snowy to be insignificant.
•	“insurable” risks – given the nature of Snowy’s transmission assets, it is quite conceivable that events leading to major property damage or third-party claims could occur at any time, including within the next regulatory period.
•	regulatory uncertainty – NECA is currently conducting a pricing review for distribution and transmission services, which clearly has the potential to have significant ramifications for revenue requirements for network service providers.
Impact on Snowy
Overall, we consider the potential impact on Snowy of stranded assets or forecast differences to be negligible over the coming regulatory period.
However, “insurable” risks have the potential to create significant financial exposures and, at present, there is considerable regulatory uncertainty which could impact upon Snowy’s required revenue over the next few years.

4.	
 LIABILITY RISKS
As is demonstrated in the Table below, major transmission failures can and do occur, resulting in very significant losses.
impact of major failure incidents in the electricity industry
Date	Place	Event	Consequence (or cost if estimated)	
3/99	Mexico	Mechanical failure	3 million people without power for several hours	
2/99	Buenos Aires Argentina	Fire destroyed a transformer plant and the main cable ducts.	$US 1 billion	
1/98	Maine USA	Freezing rain downed power lines	500,000 people for several hours	
2/98	Auckland 
New Zealand	4 major power cables collapsed	$NZ 850 million	
1/98	Ontario Canada	Collapse of transmission towers	1 in 5 Canadians affected for up to 3 weeks. 66 municipalities declared a state of emergency.	
8/96	Malaysia	Power tripping	$US 88 million
	
8/96	Idaho/ Oregon USA	High tension power lines sagged close to trees causing electric arcs that shut down the power system.	Two of the largest blackouts in US history.
	
1/89	Canada	Solar activity caused a magnetic storm which resulted in a power imbalance. 	Total blackout for Quebec.	
11/65	Northeast USA	Transmission line tripping	30 million people without electricity for up to 30 hours.	

Several of the cases set out in the above Table are discussed in more detail below to highlight the kinds of supply failures which could potentially occur in relation to transmission systems.
•	Buenos Aires - a fire in a transformer plant spread to the main cable ducts, which resulted in plant and by pass operations failing. This resulted in up to 600,000 people being without power for up to 12 days. It is estimated that the Chilean licence holder could be fined up to $US100 million, whilst business groups are threatening to sue for up to $US 900 million.
•	Auckland - the four main transmission cables for Auckland failed, the first cable on 20 January 1998 and the fourth on 20 February 1998. The City was at a standstill with no power for 10 days followed by a further 6 weeks of power rationing. In total there were 66 days of power rationing, or uncertainty, caused by the failure. In total it is estimated that it cost the New Zealand economy $700 million, Mercury Energy have additional costs of $60 million to repair the system and a further $75 million in compensation.
•	Malaysia - a nationwide power breakdown for 16 hours resulted in estimated losses of RM 123 million by manufacturers along with RM 74 million in compensation and RM 22 million in lost revenue for Tenanga. Tenanga have committed themselves to a RM 5 billion upgrade program for the transmission distribution lines in the peninsula. 
Many other potential scenarios can also readily be envisaged, including for example:
•	Bush fires can cause tripping of the supply, with fires around the pylons possibly preventing the problem being fixed for a considerable time. 
•	The entire NSW network could potentially be put off line if a “three phase fault” were to occur. The network would be down for up to 6 hours once the source of the fault had been detected. The last such event occurred in 1964.

5.	CHANGES IN REGULATORY FRAMEWORK
The NECA Transmission and Distribution Pricing Review is reviewing a number of the key components of the National Electricity Code which deal with pricing by transmission service providers.
Several of the possible Code changes under review could affect the expected cash‑flows of transmission service providers. Nevertheless, we understand that there is no requirement for revenue caps for network service providers to be reviewed when changes are made to relevant Code provisions. In fact, we understand that, unless the ACCC’s revenue cap determination specifies conditions under which the cap can be reviewed mid‑term, the Code would preclude a change to it mid-term, even if the ACCC and the network service provider were in agreement about having it revised.
Accordingly, the potential changes to the Code may impose an additional burden (or deliver a benefit) on Snowy during the coming regulatory period. 
The review is wide‑ranging and has not been reviewed in detail for the purposes of this report. However, in order to illustrate the potential impact on Snowy’s revenue requirements, the following are discussed briefly below:
•	the precise form of the price control formula to be used through the period; and
•	the service standards which network service providers will be required to meet in future.
Price control formula
The precise form of the price control formula used to regulate transmission revenue will clearly have a major impact upon expected cash-flows.
For example, if over- and under-recoveries can both be carried forward to the following year, expected revenues would be equal to the revenue cap. If, on the other hand, only over-recoveries are carried forward (ie, the revenue cap is treated strictly as a “cap”, not a “benchmark”), then the expected revenue would be significantly less than the revenue cap (assuming unbiased forecasts).
Service standards
NECA is reviewing the service standards currently specified in the Code, and the ACCC also has stated its intention to specify comprehensive service standards in the Statement of Principles.
If the required standards for service are increased during the regulatory period, Snowy would suffer additional expected costs in order to meet the higher standards. These costs would not have been factored into the revenue caps.
Impact on Snowy
It is impossible to place a value on the possible asymmetric risk associated with the potential amendments to the National Electricity Code arising out of the NECA pricing review. This is because the magnitude (and even existence) of any such risk is wholly dependent on the future decisions of the relevant regulatory authorities.
The appropriate response to this risk would be for the ACCC to make a commitment in its determination to review the revenue cap if any significant changes are made to the National Electricity Code during the regulatory period, in order to leave Snowy in an economically neutral position.