Australia: Energy regulators commence rate of return review processes

Competition and Market Regulation Update (Australia)
Last Updated: 28 January 2013
Article by Simon Uthmeyer, Fleur Gibbons, Leanne Hanna and Nadia Cooke

With recent changes to the rate of return provisions in the energy regulatory frameworks, 1 the Australian Energy Regulator (AER) and Economic Regulation Authority of Western Australia (ERA) (responsible for regulation of certain gas pipelines in Western Australia) are considering significant changes to the way in which they determine the allowed rate of return for electricity and gas businesses. This update highlights:

  • The key change to the regulatory framework
  • The proposed approach of the regulators as described in the AER's Rate of Return Guidelines Issues Paper, December 2012 (Issues Paper)2 and the ERA's Consultation Paper on the Guidelines for the Rate of Return for Gas Transmission and Distribution Networks, 21 December 2012 (Consultation Paper).3

Both the AER and ERA have flagged the desirability of the consistent application of rate of return methodologies across industries, service providers and regulators and thus these developments and consultation processes will have implications for other regulated businesses and their customers.

BACKGROUND

The changes to the rate of return provisions in the National Electricity Rules (NER) have resulted in increased discretion on the part of the AER. While the National Gas Rules (NGR) have always afforded the regulator a relatively high level of discretion, in practice the AER has exercised that discretion consistently with the framework set out in the NER. The new provisions also require the AER and the ERA to focus on the overall rate of return. Accordingly, the AER and ERA are considering significant changes to the way they determine the allowed rate of return for all energy businesses going forward.

Under the new NER and NGR provisions, the regulator is to determine an allowed rate of return that achieves the "allowed rate of return objective" This objective is that the rate of return "is to be commensurate with the efficient financing costs of a benchmark efficient entity with a similar degree of risk as that which applies to [the business] in respect of the provision [the relevant services]". Subject to this requirement, the allowed rate of return for a regulatory year is to be:

  • A weighted average of the return on equity for the period in which the regulatory year occurs and the return on debt for that year; and
  • Determined on a nominal vanilla basis that is consistent with the estimate of the value of imputation credits.

The regulator must also have regard to (among other things) relevant estimation methods, financial models, market data and other evidence.

The AER and the ERA are each required to publish Rate of Return Guidelines, which set out the methodologies they propose to use in estimating the allowed rate of return and the estimation methods, financial models, market data and other evidence they propose to take into account in estimating the return on equity, return on debt and the value of imputation credits. While the Guidelines are not binding, in setting the rate of return for a regulated business, the regulator must explain any departure from their Guidelines. The Issues Paper and Consultation Paper are the first steps in the AER's and ERA's consultation processes for the Rate of Return Guidelines respectively.

KEY CHANGE TO THE REGULATORY FRAMEWORK: FOCUS ON THE OVERALL RATE OF RETURN

The changes to the NER and the NGR are designed to allow, indeed they require, the regulator to focus on whether the overall rate of return meets the allowed rate of return objective.

This could have a potentially significant impact on the overall allowed rate of return. For instance, in its Issues Paper, the AER gives the example of determining the rate of return based on the traditional weighted average cost of capital (WACC) formula, adjusted on the basis of broker reports, trading multiples, financibility tests as used by the New South Wales Independent Pricing and Regulatory Tribunal and the UK Office of the Gas and Electricity Markets, estimates from other regulators and other market evidence. Whereas previously this other evidence could not be used to adjust the overall rate of return, the AER has canvassed this in its Issues Paper as one of the options available to it under the new provisions. Similarly, the ERA observes that the focus on the overall rate of return raises questions as to how the WACC methodology might be cross-checked with actual market outcomes, highlighting the range of alternative models for estimating the return on equity and market evidence, including financial metrics, which might be used to inform the overall result.

While the regulators have more discretion under this regulatory framework, there remains the overarching requirement to determine a rate of return that achieves the allowed rate of return objective. Care will be required to ensure this requirement is met. For example, things to watch include the following:

  • Both the AER and ERA are proposing to identify a series of (similar but different) principles for assessing rate of return proposals. Care will be required to ensure the principles (including evidentiary standards) do not impermissibly supplant the correct regulatory test.4 The ERA appears to be alive to this issue, querying whether it is reasonable to consider criteria when evaluating rate of return methodologies.
  • The AER is consulting on what level of detail should be included in the Rate of Return Guidelines: a prescribed approach that leads to a relatively mechanistic determination of the rate of return at the time of the regulatory decision; an outline of a flexible, judgementbased approach; or something in between. The AER queries whether "stakeholders will commit to accepting the outcomes of predictable approaches, irrespective of whether such an outcome is adverse or favourable".5 Again, care will be required to ensure the requirements of the NER and NGR, which include a requirement that the regulator determine a rate of return that achieves the allowed rate of return objective for each business at the time of the final decision, are upheld.

PROPOSED APPROACH OF THE REGULATORS

Principles for assessing rate of return

As noted, both the AER and ERA have set out possible principles for assessing rate of return proposals.

The AER's proposed principles are that the methodologies:

  • Are driven by economic principles (have a strong theoretical foundation, are fit for purpose, are internally consistent and have regard to prevailing market conditions)
  • Are supported by robust analysis (analysis that is transparent and replicable, appropriately acknowledges uncertainty and the output of which is not unduly sensitive to small changes in inputs)
  • Are implemented in accordance with best practice (uses current, reliable and relevant datasets and avoids arbitrary filtering or adjustment to the data)
  • Recognise that there may be a need to exercise regulatory judgement (promote reasoned, transparent and predictable decision-making and avoid the search for false precision)
  • Are supportive of broader regulatory aims (are consistently applied across industries, service providers, regulators and time, are comprehensible and accessible and promote simple over complex models where appropriate).

The ERA's proposed possible set of criteria are similar but with some key differences. For instance:

  • The ERA does not identify the need to exercise regulatory judgement, including the need to avoid the search for false precision. The coupling of the exercise of regulatory judgement and the need to avoid the search for false precision by the AER is concerning. As the Australian Energy Market Commission has warned, where regulatory judgement in weighing up various sources of information and evidence is required, "it is incumbent on the regulator to identify and explain clearly where and when it has made the necessary trade-offs against precision in its estimates of parameter values and the overall reasonableness of WACC estimates".6
  • The ERA does not appear to place the same emphasis on simplicity and accessibility as the AER does in its Issues Paper. In such a complex area of regulation, it is concerning that the AER may be preparing to simplify the determination of the allowed return of return without due regard to the trade-off with robustness. The current policy push for greater consumer involvement in energy regulatory reviews should not lead to preferential treatment being accorded to approaches because they are simple and accessible where more complex approaches lead to more reliable outcomes.
  • The ERA identifies an additional criteria that the methodologies are well-accepted. The ERA considers approaches which have widespread application and acceptability are more likely to enhance the credibility and acceptability of a decision.

As noted above, where principles or criteria are employed by the regulators, care will be required to ensure that the focus remains on approaches that achieve the allowed rate of return objective.

What will be revisited?

In these review processes, it appears almost all aspects of determining the rate of return are up for discussion.

The AER indicates that in the course of preparing the Rate of Return Guidelines, it will revisit:

  • The appropriate gearing ratio
  • The efficiency of other financing practices such as hedging, staggering a portfolio of debt maturities and raising finance from multiple sources
  • Whether the conceptual definition of a benchmark efficient service provider (a "pure play" regulated network business operating in Australia without parent ownership) is still appropriate
  • The estimation of the value of imputation credits (gamma)
  • The use of the Capital Asset Pricing Model (CAPM) to estimate the return on equity – the AER indicated it will consider for example reviewing several models and choosing between them or aggregating estimates from several models
  • The estimation of parameters within the CAPM
  • Whether the approach to the return on debt could better reflect the staggered debt approach that many service providers adopt
  • The continued use of the Bloomberg fair value curve by the AER in estimating the return on debt.

The ERA is also consulting on much of the above.

WHAT'S NEXT?

Submissions on the AER's Issues Paper are due by close of business 15 February 2013. The AER then intends to publish proposed Rate of Return Guidelines on 9 August 2013, with submissions in response due by 20 September 2013.

Submissions on the ERA's Consultation Paper are due by 4pm 28 February 2013. The ERA expects to publish draft Rate of Return Guidelines in June/July 2013, with submissions in response due by August/September 2013.

Final Guidelines must be published by the AER and ERA by 29 November 2013.

WHAT ELSE IS COMING IN 2013?

Changes to energy regulation more broadly are set to continue in 2013.

The AER will continue with its "Better regulation program" by consulting on a range of other guidelines, including expenditure forecast assessment guidelines, capital expenditure incentive guidelines and consumer engagement guidelines. The Council of Australian Governments has endorsed a sweeping reform agenda for the coming year, the Standing Council on Energy has released a regulatory impact statement on changes to the limited merits review regime under the National Electricity Law and National Gas Law and the Productivity Commission will finalise its review of the electricity network regulatory framework.

Contact us if you have any queries regarding either of the Rate of Return Guidelines papers or any of the forthcoming reform processes.

Footnotes

1 Changes to the rate of return provisions of the National Electricity Rules and National Gas Rules were made by the Australian Energy Market Commission in its final rule determination of 29 November 2012 Rule Determination, National Electricity Amendment (Economic Regulation of Network Service Providers) Rule, National Gas Amendment (Price and Revenue Regulation of Gas Services) Rule 2012. The rule determination is available at http://www.aemc.gov.au/electricity/rulechanges/completed/economic-regulation-of-network-serviceproviders-.html.

2 The Issues Paper is available at http://www.aer.gov.au/node/18859.

3 The Consultation Paper is available at http://www.erawa.com.au/access/gas-access/guidelines/.

4 By way of example, the Australian Tribunal Competition was found to have erred in doing this by the Full Federal Court of Australia in Telstra Corporation Limited v Australian Competition Tribunal [2009] FCAFC 23.

5 Issues Paper, p17.

6 Australian Energy Market Commission, Directions Paper, National Electricity Amendment (Economic Regulation of Network Service Providers) Rule 2012, National Gas Amendment (Price and Revenue Regulation of Gas Services) Rule 2012, 2 March 2012, p85.

© DLA Piper

This publication is intended as a general overview and discussion of the subjects dealt with. It is not intended to be, and should not used as, a substitute for taking legal advice in any specific situation. DLA Piper Australia will accept no responsibility for any actions taken or not taken on the basis of this publication.


DLA Piper Australia is part of DLA Piper, a global law firm, operating through various separate and distinct legal entities. For further information, please refer to www.dlapiper.com

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