AER Better Regulation Reform Program Update July 2013 A Fair - PowerPoint PPT Presentation

AER Better Regulation Reform Program Update July 2013 A Fair Return to Consumers Presentation on AER Issues Papers to Consumer Roundtable 23 July Bev Hughson, Darach Energy Consulting Services

Today ’ s Acronyms • ACT Australian Competition Tribunal (Tribunal) • AEMC Australian Energy Market Commission • AER Australian Energy Regulator • CAPM Capital Asset Pricing Model • FM Foundation Model • MRP Market Risk Premium • NEL/NGL National Electricity (Gas) Law • NER/NGR National Electricity (Gas) Rules • NSP Network Service Provider • RAB Regulatory Asset Base • RPP Regulatory Pricing Principles • RoD Return on Debt • RoE Return on Equity 2 • RoR Rate of Return • STPIS Service Target Performance Incentive Scheme

Multi Factor Productivity (MFP) Growth by Industry 3 Source: Productivity Commission, An Overview of Australia ’ s productivity performance , November 2012

Network Regulatory Frameworks – current status • Better Regulation program – Development of Guidelines • Rate of Return Guideline • Expenditure Forecast Assessment Guideline • Expenditure Incentive Guideline • Confidentiality and Shared Assets Guidelines • NSP Engagement Guideline • Power of Choice • Demand management embedded generation • Investment test for distribution (RIT-D) • AER ’ s Stakeholder Engagement Framework • Establishment of National Consumer Advocacy Panel & Consumer Challenge Panel • Reform of the Tribunal through changes to the NEL & NGL 4 • Productivity Commission Final Report on Network Regulatory Frameworks & Government ’ s response

Network Regulatory Frameworks – other relevant developments • AER ’ s Stakeholder Engagement Framework • National Consumer Advocacy Panel & Consumer Challenge Panel • SCER ’ s reform of the Australian Competition Tribunal through changes to the NEL & NGL • Productivity Commission ’ s Final Report on Network Regulatory Frameworks & Government ’ s response • AEMC ’ s National Frameworks for Network Reliability 5

AER Guidelines: Approach & Timetable • General Approach to the Guidelines: • Relatively short Guideline setting out how AER proposes to conduct reviews • Detailed Explanatory Statement setting out AER ’ s • Guidelines not mandatory (except Confidentiality), but NSP or AER required to provide reasons for varying from Guideline. • Some key dates: • 9 August • Expenditure Assessment & Incentive Draft Guidelines • Confidentiality & Shared Asset Draft Guidelines • Mid-August • Rate of Return Draft Guideline • Supporting Papers on Risk and Benchmark Efficient Firm • 22 August – AER meeting with consumer groups 6 • Mid – September – Response to Guidelines • 29 November – Final Guidelines

Network Revenue building blocks & the AER Guidelines Rate of Return Guideline Expenditure Incentive Guideline Expenditure Assessment Guideline Expenditure Assessment Guideline 7 Expenditure Incentive Guideline

RATE OF RETURN GUIDELINE 8

Rate of Return – a key area of regulatory failure • Past AER determinations delivered rates of return well in excess of actual cost of capital: • Immediate cost to consumers in higher network prices • Long-term costs through inefficient capital investment • Main source of disputes taken to Tribunal • Multiple reasons for failure • Rules put onus of proof on the regulator that NSP proposal ‘ unreasonable ’ • Lack of confidence by the regulator in using their discretion • Compounded by conservative, legalistic approach of the ACT • Methodological and data gaps, e.g. • Restricted use of benchmarking, reliance on historical performance • Limited financial market information (e.g. on bond markets) 9 • Emphasis on ‘ on the day ’ view of costs (create volatility) • GFC made forecasting harder than ever

Assets & investment in the NEM (excluding retail) Asset Value Estimated Investment Share of Total Share of Total Contribution (circa 2010) Average Rate Assets Investments to Electricity Annual (Investment Price (2010- investment /assets) 11) (Note (a)) $ billion $ billion % % % % 2011 prices 2011 prices Generation 40.0 1.2 3.0 39.0 12.1 34.5 Transmission 16.7 1.5 8.9 16.3 14.9 7.7 Distribution 45.8 7.2 15.8 44.7 73.0 37.3 Note (a): based on average yearly investment for the current 5-year regulatory period Balance is retail costs, RET, FIT & other green (excluding carbon) 10 Total for 102.4 9.9 9.7 100.0 100.0 79.5 above components Source: Adapted from the Productivity Commission, Electricity Network Regulatory Frameworks Inquiry Final Report, p 98.

AER ’ s RoR Guideline development has involved significant stakeholder inputs! • New Rules require • the AER to develop the Guidelines having regard to a range of relevant methods, financial models, market data and other evidence • Consult with stakeholders in the development of the Guidelines • AER developed a set of principles to assess alternative approaches • Numerous consultations with stakeholders & others • Issues Paper • Consultation Paper • ACCC staff reports • Expert Reports on Risk • Multiple working group meetings • Meetings with stakeholder groups 11 • A sound consultation process will be important in any appeal to ACT?

AER ’ s Overall RoR Assessment Framework New Rules give priority to the NEO, NGO, RPP NEO and NGO in decision making New Rules introduce the RRO; to guide the AER Rate of return objective Rate of return Guidelines Set out how AER proposes to take into account New Rules require the AER to develop RoR Guidelines having regard to a wide variety of models & other Estimating Financial Market data Other methods Models evidence information. NSPs ’ Proposals and AER ’ s Determinations should be based on the Regulatory Determinations Guideline, alternative approaches must be justified as in the long term interests of consumers. 12 RoR Guideline must be 3 yearly reviews reviewed within 3 years Source: AER Rate of Return Consultation Paper, May 2013, page 11

The AER ’ s latest proposal: RoD • Move to a Trailing Average (TA) approach (vs ‘ on the day ’ ) • Use of Commonwealth Government bonds for risk free rate; Bloomberg ’ s fair value yield curve for MRP • Annual ‘ mechanistic ’ updating of RoD based on updated market data on bond yields • However, AER still considering details of the TA approach • Term of the bond yield curves • Preference for using 7 year period – best aligns with NSP practice • However, alternative of 5 years still under consideration • Transitional arrangements? • Benefits & Risks of AER ’ s approach for consumers • TA approach generally provides more certainty for consumers • Annual updating – less stability within regulatory period, more certainty 13 between regulatory periods • Approach generally overcompensates NSP ’ s (but less than before?)

AER ’ s Estimate Cost of Debt & Cost of Equity (2010 to 2013) Cut off point for trailing average cost of debt? 14

The AER ’ s latest proposal for RoE • Return on Equity (RoE): the “ Foundation Model ” (FM) approach • Identify and evaluate different approaches against criteria • Select the ‘ foundation model ’ & • Calculate a feasible range and point estimate for FM parameters • Review other models and data points: • Use to inform the foundation model parameters? • Use to assess the overall RoE? • Distill all information into a single point estimate of RoE • Likely outcome in the Draft Guideline: • Sharpe-Linter CAPM is the ‘ Foundation Model ’ ( ticked most criteria boxes ) • Black Scholes CAPM inform parameter estimates (beta) • Dividend Growth Model inform parameter estimates (MRP) • Other models/market data used to inform or cross check overall RoE 15 • Note: Fama-French model “ under consideration ” – code for NO.

Benefits & challenges of RoE approach • Benefits of the AER proposed approach to RoR Guideline: • Based on consistent set of criteria to assess different approaches • Using the S-L CAPM as the foundation model provides some consistency & builds on established regulatory theory & practice • Provides for explicit treatment of [relative] ‘ priced ’ investor risk • Uses other models/information in a more transparent way, eg: • To inform the FM parameters of overall RoE • To guide the AER within a range set by the FM • Acknowledges decision-making requires the exercise of regulatory judgment – not purely quantitative analysis • Reduces (but not eliminates) opportunities for NSPs to ‘ cherry pick ’ preferred model(s) or weighting of these models • Will the AER ’ s judgment be challenged in the Tribunal? 16 • Will it deliver more appropriate outcomes than current method?

Envestra: 3 year Total Return Total Shareholder Return (average annual rate) 17 1yr 3yr 5yr 10yr 35.2% 37.2% 20.5% 9.4%

EXPENDITURE INCENTIVE GUIDELINE 18

New & more comprehensive incentive sharing schemes required • Current incentive schemes not delivering improved performance • Rules require AER to develop Guideline covering: • Enhanced operating expenditure incentive scheme (EBSS) • New incentive scheme for capital expenditure (CESS) 19 Source: AER Expenditure Incentives Scheme Issues Paper, p v.