Regulating Victorias Distribution Network Supply Finding the Right Balance

1
Regulating VictoriasDistribution Network
SupplyFinding the Right Balance
John Tamblyn Chairperson Essential Services
Commission Victoria
2
Overview

• Some historical context
• Why do we regulate network monopolies
• The challenges of infrastructure regulation
• The current policy debate
• The 2001 distribution price review
• The 2001-05 experience to date
• The ESCs approach to the 2006 price review
• Regulatory challenges beyond 2006

3
Some historical context

• NCP/Hilmer reform agenda early 1990s
• Structural reform of public utility monopolies
• Third party access to essential infrastructure
• Part IIIA and national electricity/gas codes
• 10 years of regulatory experience
• Privatisation Vic/SA public o/ship NSW/Qld
• Second round of many regulatory reviews
• Tribunal and court appeals of various decisions
• Recent policy reviews
• Questioning policy, regulation, outcomes
• Institutional reform proposals eg AER/AEMC

4
Why do we regulate infrastructure monopolies?

• Many network services provided under natural
  monopoly conditions
• Large fixed/sunk costs, economies of scale
• Duplication not privately profitable or publicly
  desirable
• Exercise of monopoly power distorts resource
  allocation, economic efficiency in the economy
• Incentive to charge more/supply less
• Distorting competition/resource use in related
  markets
• Regulation seeks to overcome this market failure
• But risk of regulatory failure v market failure
• Is the relevant market a monopoly?
• Regulation when competition is emerging?

5
Challenges of monopoly infrastructure regulation

• Objective to eliminate monopoly behaviour, poor
  cost performance, innovation disincentive
• But information asymmetry problem of regulator
• Businesses know more about costs/market
  conditions
• Regulator exposed to opposing risks
• Providing excess revenue ? monopoly outcome or
• Too little revenue ? viability/investment risks
• Regulation addresses thro incentives to reveal
  efficient costs

6
Incentive regulation of utility monopolies

• Incentive regulation aims to reward performance
• Focus is on the power of the incentive
• High powered regulation ? business bears the
  risk of changes to its cost structure
• CPI-X method decouples prices from cost for a
  period
• Reward from managing costs/penalty for not doing
  so
• Carryover ? incentive to reveal efficient costs
• Low powered regulation ? consumers bear risk of
  cost structure changes
• R of R cost pass thro has weak efficiency
  incentives

7
Current policy debates on network regulation

• 10 years on regulatory approaches under review
• Exemplified by Parer Review, PC inquiries and
  tribunal/court appeals
• Some concerns of PC (Pt 111A/Gas Code inquiries)
• Price cap regulation being wrongly applied to
  increasingly contestable markets (but this is a
  policy issue)
• Regulation has been too cost-based/intrusive
• Too much focus on ST price/service gains
• Emphasis on cost of capital has depressed returns
• Insufficient incentive for LT investment
• Increases risk to LT viability/dynamic
  competitive potential

8
Observations on the policy debate

• These are serious issues calling for appropriate
  responses
• Scope exists for both market and regulatory
  failure
• Unregulated monopolies impose costs/create
  distortions
• Regulation is costly/can distort investment
• Objective is to minimise costs/distortions and
  encourage the right rate/level of investment
• Significant investment/related market competition
  has occurred since 3rd party access adopted
• Has it been too little/too late or about right?

9
Observations on the policy debate (2)

• Regulatory errors will occur but .
• Are they normally distributed but right on
  average?
• Are they biased against investors or users?
• Empirical research needed to test alternative
  hypotheses
• PC has relied on first principles reasoning,
  anecdotal evidence and interested submissions
• Distinguish natural monopoly markets (eg
  electricity/gas distribution) from potentially
  contestable ones (eg gas transmission)
• PC seems to imply most infrastructure mkts are
  contestable and require a lighter-handed approach

10
The 2001 distribution price review

• First independent price review since
  privatisation
• Adopted Building Blocks approach, post-tax WACC
  methodology, tariff basket price control
• Improved cost and service efficiency incentives
• Targets for service quality improvement
• 5 yr efficiency carryover, S factor, GSLs
• Conservative assumptions/no efficiency claw back
• Significant Po price reductions in 2001 (9.1
  18.4) reflecting favourable 1995-2000 conditions
• Lower interest rates
• Unforecast demand growth
• Efficiency improvements

11
Victorias experience to date (1)

• Revenue greater than forecast
• Growth
• S-factor

All DB Revenue Forecast v Actual
Forecast
M
Actual
12
Victorias experience to date (2)

• Capex opex expenditure tracking below forecast
• What is the reason?
• Excessive forecasts?
• Deferred expenditure?
• Efficiency improvements?
• Other?

Forecast (m)
Actual (m)
CAPEX
OPEX
13
Victorias experience to date (3)

• Service standards are improving exceeding
  targets, although capex / opex below benchmark

14
The 2006 distribution price review

• To build on 2001 electricity/2002 gas price
  review approaches
• Maintain certainty/consistency of approach
• Introduce enhancements based on experience
• Continue building blocks methodology
• Maintain incentive power within/across periods
• Inference that 2001-2005 actual costs are
  efficient
• Given incentives to reveal efficient costs
• Permits less intrusive top down assessment of
  2006-10 expenditure forecasts
• Focus on reasons for step change from trend
• Consultation Paper No. 1 released March 2004

15
Some challenges beyond 2006 review

• Building Blocks method has shortcomings
  alternatives being examined (ESC, ACCC, URF)
• Problem of forecasting efficient
  expenditure/revenue
• Incentive for gaming eg CAPEX underspending
• Focus on firm-specific costs not industry-wide
• In principle advantages of price caps based on
  productivity indexes being examined
• Prices/incentives based on industry-wide
  performance
• Uses historical data/not forecasts
• Index not influenced by firms own actions
• Reduces information asymmetry
• But operational feasibility/data requirements ?

16
Challenges beyond 2006 (2)

• Adapting regulatory methods to markets where
  competition is emerging
• Eg gas transmission, airports, rail access,
  ports, grain handling
• Transition of AER/AEMC
• Management of a demanding timetable
• Institutional arrangements, appointments,
  resourcing
• Revision/implementation of revised regulatory
  framework
• Policy decisions/timing and resourcing of
  transfer of distribution retail
• Managing the transition of regulation over time
  (given ongoing price reviews)

17
2006 price review key milestones