Tariff control of pipes

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Tariff control of pipes

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Title: Tariff control of pipes

1
Tariff control of pipes wires utilities where
is it heading??

Phil Caffyn,
Utility Consultants Ltd
www.utilityconsultants.co.nz

Please read disclaimer on second page
2

Disclaimer
This presentation has been prepared for the sole
purpose of the NZIGE Spring Technical Seminar
2006 and is not to be relied upon by event
participants or any other person as professional
advice.
This presentation has been compiled by Utility
Consultants Ltd at the request of the NZIGE.
Neither the NZIGE, its officers or their
employers take any responsibility for the factual
accuracy of this presentation or for any views,
opinions or biases in the content of this
presentation.
Utility Consultants Ltd as the author of this
presentation shall not be liable in any way
whatsoever for any action or failure to act based
on the content of this presentation.

Authors note
Between the time this presentation was drafted in
mid-September 2006 and delivered on 19 October
2006 the dispute between Vector and the Commerce
Commission seemed to take a turn for the better.
Accordingly some of the views expressed in this
presentation may need to be softened.
While this is obviously awkward from a
presentation point of view, it is pleasing from
an industry point of view.

Theme of this conference is the burning issues
the cover photos on the conference brochure
strongly depict the upstream aspects of gas
supply (which I profess to know little about), so
the subject of my presentation is the tariff
control of midstream and downstream
infrastructure which really burns me up.
Warning I get rather passionate about tariff
control !!
Format of this presentation is to examine key
issues and trends in two specific areas of tariff
control
First area is the quantifying of the building
block components that are typically used to
regulate pipes wires utilities.
Second area is the broader issues trends that
are impacting on the way building block
components will be thought about and quantified.

5
Building block component 1WACC
6

Issues concerns
Current WACC thinking based heavily on Capital
Asset Pricing Model (CAPM) with its dependence on
equity beta.
Classical regulatory thinking took (and in many
areas still takes) the view that a pipes wires
utility should have an equity beta less than the
market as a whole like about 0.75 to 0.8. Very
recent work by the AEMC suggests that equity
betas could be as high as 1.0 for a high voltage
electricity transmission grid indicating that a
pipes wires utility could be just as risky as
any other investment.
Theoretical approach to CAPM usually includes
efficiencies that would normally only be
available to very large utilities like annual SP
rating and access to the US debt markets.
Doesnt seem to allow for real world
inefficiencies that are often deemed to be
systematic risks (and therefore should be
diversified away by an efficient portfolio) which
in fact are unsystematic and cannot be easily
diversified away transaction costs, imperfect
information, irreversibility and the finite
resources of investing firms.

Going back about 4 years a WACC of about 5.2 to
5.5 post-tax was used to set tariff controls
(and figures around this level are still being
used in sectors such as the Victorian water).
Other recent regulatory thinking is about 7.35
nominal post-tax in NZ, about 7.57 in Australia
(Moomba Sydney Pipeline) and about 8.5 for the
Queensland electricity distributors.
Jumping to the industry side of the table, recent
events have revealed target post-tax returns of
about 9.24 (Unison), 9.6 (Vector) and 9.9
(APT).
Observed that utilities estimates of WACC are
about 2.25 to 2.5 higher than the WACC that
regulators adopt supported by a brief web
search. Possible that this margin might increase
if capital markets or rating agencies perceive
regulatory risk to be increasing.
Research at the ISCR within the last 2 years or
so suggests this gap might even be as high as 4.

Trends
Although allowable WACCs are increasing it
appears only to keep pace with an increasing
risk-free rate - no obvious sign that the
observed 2.25 to 2.5 gap is closing (or will
close any time soon).
Queensland electricity and EirGrid may prove to
be exceptions as their WACC gap seems to be
only about 1.
Will be interesting to see what becomes of the
AEMCs view that equity beta could be as high as
1.0.

9
Building block component 2CapEx
10

Issues concerns
On-going presence of ex-post efficiency tests
continues to add at least some uncertainty to all
CapEx.
Experience indicates that some regulators believe
most if not all CapEx is firstly justified and
secondly efficiently procured (and hence does not
need to be excluded from the asset base after the
fact), but there seems to be a lingering
unwillingness to abolish ex-post efficiency tests
and remove the associated investment uncertainty.
Recognition of the impending wall of wire
doesnt yet seem widespread enough.
Lack of deep insight that the risks of
under-investment are significantly different from
over-investment.

Trends
Seems unlikely that any safe-harboring of CapEx
will occur, so the threat of future exclusion
will probably always remain even though it is
hardly ever used.
Recognition of the wall of wire is increasing
but apparently in response to blackouts rather
than through consideration of the industrys
submissions.
Recognition of the asymmetry of under-investment
and over-investment is increasing, but again
seemingly in response to blackouts rather than
through being persuaded by the industrys
submissions.

12
Building block component 3Valuation
13

Issues concerns
Adherence to centrally-mandated unit costs
(despite a stated preference for market-based
valuations in accordance with FRS-3).
In particular a reluctance to allow a utility to
adopt the acquisition value of an asset in
accordance with FRS-3 (or the reasonable
expectations of the owners - a point bought out
by the ACT in APTs appeal of the ACCCs
determination in regard to the Moomba Sydney
Pipeline).
Reluctance to acknowledge actual legacy costs
seems to be a preference for taking low rather
than mid-point estimates.
Proposed indexing of standard costs seemed
unnecessarily complex and also seemed to miss the
point of correctly capturing price movements of
key inputs. This was identified as a key barrier
to year-on-year indexing of the proposed
Historical Cost method.

Lack of safe-harboring of CapEx into the
valuation base will always create at least some
investment uncertainty.
Current valuation methodologies often ignore the
incremental nature of investment over time and
consequently may optimise out assets that were
fully justified when built but may now be less
than fully utilised due to factors such as
changing demand.
Retention of optimisation (and the associated
investment uncertainty it creates) despite the
low level of optimisation actually occurring in
the industry (about 1 of replacement cost) and
the robust ex-ante efficiency tests already in
place.
Continued use of the Economic Value test for
uneconomic lines despite an obligation to supply.

Trends
Expect centrally-mandated unit costs to prevail,
although there may be some increases. Possible
that some sort of indexing may be introduced but
this may be unwieldy and complicated.
Any sort of safe-harboring would seem unlikely so
all investments are likely to always be exposed
to at least some risk of future exclusion from
the valuation base.
The snap-shot in time approach to valuation
seems likely to prevail meaning that efficient
incremental legacy investments may be deemed
inefficient when considered now.

16
Building block component 4OpEx
17

Issues concerns
Allowed OpEx in recent determinations seems
consistently lower than that sought by the
applicants seems that utilities are expected to
achieve the most favorable costs across all
parameters (efficient frontier cost).
Pleasing to note that OFWAT has correctly
identified many OpEx issues and taken steps to
correctly incentivise the implementation of these
issues in the current (2005 2010) price
control, and particularly allowing pass-through
of externalities.
Pleasing to also note the ACTs conclusion in the
Moomba Adelaide Pipeline that the ACCC were
unreasonable in adopting the lowest of a range of
values when no clear reason existed for not
choosing the mid point of the range of values.

Trends
Hard to know whether other regulators will follow
OFWATs good example (and the view taken by the
ACT) would seem unlikely.

19
Building block component 5Depreciation asset
life
20

Issues concerns
Disparity of actual asset lives with standard ODV
or ODRC lives leading to under or over-recovery
of renewal funding. Some examples exist of
drainage assets in NZ that are 2x their standard
life (and about 5x in the UK) but conversely
there are also electricity assets supplying
consumers that may only have a short life such as
mines and forestry.
Removal of accelerated depreciation provision in
Australia which made off-shore investments more
preferable (although this was apparently off-set
by a recent budget provision that allowed
significantly shorter lives).
Trends
Seems unlikely that actual asset lives (or the
life of predominant consumers) will be used to
calculate more realistic depreciation rates so
the possibility of under-recovery of short-lived
assets may always remain.

21
Issues trends 1Increasing emphasis on
security
22

Initial emphasis of tariff control was on
reducing short-term prices for consumers
certainly in the home of incentive regulation
(UK) some rather stiff P0s were imposed eg.
OFGEM imposed P0s of 25 in 1995 and again in
2000.
Apparent exception to this was the recognition of
security of gas supply as a public policy
objective as part of the privatisation of the
Dampier Bunbury Pipeline which was in 1997 -
1998.
Seems to have been a very mixed bag of investment
over the period 1990 to 2005
At least some reinvestment in the UK, but it is
unclear if this kept pace with asset
deterioration.
Virtually none in Queensland or NSW (high demand
growth at the expense of renewals).
Isolated patches of investment in NZ.

Things started to fall apart in what seems to be
two reasonably well defined tranches
Black-outs around 1997 to 1999 in Auckland,
Melbourne and Buenos Aires.
Black-outs around 2003 to 2004 in Ohio
Pennsylvania, London, parts of Italy, and
south-east Queensland.
Key point to note is that several of these
black-outs were unlikely to be related to a lack
of reinvestment seem to be more related to
thermal over-load, protection mal-operation etc.
However it seems likely that the London,
Queensland and possibly the Buenos Aires
black-outs did stem from a lack of reinvestment
(much to the delight of the anti-privatisation
brigade).
Regardless of the real causes these black-outs
seem to have prompted a step change in regulatory
thinking from reducing tariffs to improving
security in some jurisdictions.

Of course we now have the added complication of
the bow-wave of (electricity) renewals which adds
a further dimension to an already very complex
process.
This new-found emphasis on security is evident in
the recent electricity lines tariff
determinations in the UK, NSW and Queensland
which have allowed modest or even negative P0 and
X in many cases (although still less than what
was sought by the applicants).
Queensland EDSD report well worth reading.
www.energy.qld.gov.au/independent_report.cfm
(underscore between the independent and the
report)

25
Issues trends 2Adherence to theoretical
models
26

Strict adherence to theoretical models despite
considerable practical evidence to the contrary
remains a concern.
Theoretical calculation of WACC components is
obviously one of these areas.
Number of Australian gas pipeline appeal rulings
and court decisions that strongly suggest
adherence to strict theoretical models is wrong
and that adequate weight must be given to real
world factors recognition that real pipes
wires markets fall short of the purely
competitive markets upon which such theoretical
constructs rely.
However it would seem that a bias for theoretical
answers is likely to remain.

27
Issues trends 3Subsidising public policy
outcomes
28

Weve already examined security of supply as a
public policy outcome, and broadly observed an
emerging willingness to allow additional CapEx to
improve security.
Many other areas in which utilities are directed
to create public policy outcomes that benefit
classes of persons other than consumers
Public safety.
Amenity value.
Avoiding electrical interference.
Providing comparative data.
Implementing renewable energy policies.

Utilities are generally expected to absorb many
of the costs of creating these outcomes, but in
all fairness consumers of utility services tend
to overlap into the other classes of persons
which benefit.
A major concern is the increasing expectation
that electric utilities will assist in
implementing renewables policies but with little
mention of compensating shareholders when
non-commercial decisions are made.

30
Issues trends 4Treatment of stranded costs
31

Difficulty occurs when previously approved
recoveries of stranded costs are curtailed
leaving utilities without recompense for sunk
costs significant in Italy a few years ago when
ENEL was left holding 6.3b of stranded costs
after the government curtailed its recovery
mechanism.
Key issue going forward for stranding is
therefore not so much the cause of stranding but
whether the policy and regulatory regimes will
allocate those costs to those who have benefited
(usually either consumers or the wider community
not usually shareholders).

32
Issues trends 5Treatment of efficiency gains
33

First issue is the recognition of the gradual
exhausting of efficiency gains current thinking
seems to range from expecting continued
efficiencies well into the future to recognising
the exhaustion of gains somewhere just beyond the
present control period.
Next issue is the allocation of any efficiency
gains that may arise (two quite contrasting view
points)
Pleasing that OFWAT did move beyond allowing
efficiency gains to be kept only to the end of
the control period allowing the gains to be
kept for 5 years regardless of when during the
control period they were implemented was a huge
step forward for incentivising efficiency gains
(part of North West Waters acquisition of
NORWEB).
Converse position has been suggested in which
consumers should expect to share in up-side gains
but be fully insulated from any down-side losses.

34
Issues trends 6Correctly incentivising CapEx
35

Having approved increased tariffs to fund the
projected increases in CapEx, the key concern for
regulators now is to ensure that utilities are
correctly incentivised to actually spend.
This will include many of the issues we have
already discussed realistic WACC,
safe-harboring of CapEx, fair allocation of the
rewards of out-performing cost and efficiency
targets etc.
Apart from OFWAT it seems that the above issues
have not been sufficiently thought through to
correctly incentivise CapEx possible that
allowing utilities to gather additional funds
will be seen as the sole issue (which has
purportedly been fully addressed through
increased tariffs) rather than only the first of
two issues.

36
Issues trends 7Regulatory treatment of equity
37

Many determinations to date seem to have treated
shareholders equity as being subordinate to debt
(which in the strictest financial terms it is).
This feature was exploited as the first loss
principle when the UK water industry was
privatised in the late 1980s to accommodate the
industrys largely unknown CapEx requirements
there was a clear expectation that shareholders
equity would bear the impact of any unknowns
(which were presumably losses).
This first loss principle became known as the
equity cushion which strongly suggests that
equity was regarded as expendable.
Similar view on equity (capped up-side gains but
unlimited down-side losses) was hinted at in the
NZ toll roads bill that was proposed a few years
ago.

This equity cushion principle became clearer when
Railtrack PLC and British Energy PLC both went
for a burton and just about all shareholders
equity was lost.
It therefore seems very clear that equity is
viewed asymmetrically, and this shows no signs of
changing.

39
Issues trends 8Capital structure
40

Some rather conflicting views here
On one hand OFWAT has previously stated that
capital structure is a matter for individual
utilities to decide.
On the other hand OFWAT has also expressed an
expectation that an equity cushion will exist,
and furthermore expressed a view that the
formation of the debt-funded mutual Glas Cymru to
own Welsh Water should not become the norm.

41
Issues trends 9Access to capital markets
42

Access to capital is obviously important for all
asset-intensive industries however current WACC
thinking is probably not facilitating such
access.
Pleasing to note that one of OFWATs three stated
reasons behind their comment it would be unwise
... for customers to expect real term reductions
in bills in putting together the current price
control was to maintain appropriate interest
cover ratios to ensure continued access to
capital markets especially important in the
context of Glas Cymru.
Given the level of debt funding that exists in
the NZ gas sector this could be problematic.

43
Where is it heading??
44

Really good thinking embodied in many of the
OFWAT determinations to date (only a few minor
concerns).
Also been some really good stuff in some of the
ACT appeal decisions.
A few promising signals emerging from the QCA (in
regard to WACC) and the ESC (in particular the
recognition that the relationship between
network expenditure and service performance is
neither precise nor limited to the short term).
However if the ultimate measure of the robustness
of regulatory thinking is the level of
reinvestment in networks it seems that regulatory
thinking as a whole might well be getting it more
wrong than right.