princing network supply i

P R I C I N G F O RE L E C T R I C I T Y N E T W O R K S

A N D R E T A I L S U P P L Y

R E P O R T

V O L U M E I

I N D E P E N D E N T P R I C I N G A N D R E G U L A T O R Y T R I B U N A LO F N E W S O U T H W A L E S

I N D E P E N D E N T P R I C I N G A N D R E G U L A T O R Y T R I B U N A LO F N E W S O U T H W A L E S

P R I C I N G F O RE L E C T R I C I T Y N E T W O R K S

A N D R E T A I L S U P P L Y

R E P O R T

V O L U M E I

Rev99-5.1 June 1999

The Tribunal members for this review are:

Dr Thomas G Parry, ChairmanMr James Cox, Full time memberMs Liza Carver, Part time member

Inquiries regarding this report should be directed to:Scott Young

(02) 9290 8404 [email protected] Groom

(02) 9290 8475 [email protected]

Independent Pricing and Regulatory Tribunal of New South WalesLevel 2, 44 Market Street Sydney NSW 2000 (02) 9290 8400 Fax (02) 9290 2061

www.ipart.nsw.gov.auAll correspondence to: PO Box Q290, QVB Post Office, NSW 1230

TABLE OF CONTENTS VOLUME 1

FOREWORD I

EXECUTIVE SUMMARY III

SUMMARY OF RECOMMENDATIONS - VOLUME 1 IX

SUMMARY OF RECOMMENDATIONS VOLUME 2 XVII

GLOSSARY OF ACRONYMS AND TERMS XXV

1 INTRODUCTION 11.1 Review process 11.2 Current regulation of electricity prices 21.3 Legislative basis for this review 2

1.3.1 A report under Section 12A of the IPART Act 21.3.2 The National Electricity Code 31.3.3 Transmission 31.3.4 Distribution 41.3.5 Retail supply to franchise customers 41.3.6 IPART Act 41.3.7 Snowy Mountains Hydro-electric Authority 51.3.8 The Premiers letter 5

1.4 Structure of this report 61.5 What happens after this report? 6

2 THE NSW ELECTRICITY INDUSTRY 9

3 PRINCIPLES AND FORMS OF REGULATION FOR NETWORKS 133.1 Requirements of the National Electricity Code 133.2 Scope of regulation 14

3.2.1 Transmission 143.2.2 Distribution 14

3.3 Regulatory period 153.4 Forms of regulation 16

Unlinked approach and external benchmarking techniques 16Cost linked approach (building block approach) 17Cash flow analysis 18

3.4.1 Price or revenue caps? 18Code requirements 18Price caps 19Revenue caps 20Secondary price controls 22

3.5 Sharing the benefits of incentive regulation 223.5.1 P0 adjustment 233.5.2 Glide paths 233.5.3 Specification of the glide path 25

3.6 X factor 25

4 STANDARDS OF SERVICE 274.1 Distribution standards of service 27

4.1.1 The requirement in economic regulation for standards of service 274.1.2 Industry and customer perspectives 284.1.3 Selection criteria for standard of service indicators 294.1.4 Network and retail services 304.1.5 Distribution network service measures 31

Quality of supply 31Reliability of supply 31Customer service 32

4.1.6 Service standards regulation in NSW 32Licence conditions 32Industry Code of Practice Electricity Service Standards 32Energy Industry Ombudsman NSW 33LCAB 1998 annual report 33Current status 35

4.1.7 Performance incentives 35Tribunals response 35

4.1.8 Responding to customer preferences 38Agreed standards and minimum standards 38Regulating for increased flexibility 39

4.1.9 Conclusion 414.2 Transmission service standards 42

4.2.1 Consultants recommendations 42Network Reliability 43Network Availability 43

4.2.2 Consultants findings 444.2.3 NECA review 454.2.4 Conclusion 45

5 THE INITIAL CAPITAL BASE 475.1 Code requirements 475.2 Proposals by the network service providers 485.3 Public submissions 495.4 Valuation methodologies 50

5.4.1 Depreciated actual cost (DAC) 505.4.2 Indexed depreciated historical cost (IDHC) 515.4.3 1996 asset values rolled forward 515.4.4 Depreciated optimised replacement cost (DORC) 525.4.5 Assessment of the DORC values submitted to the Tribunal 54

GHD's valuation reports using DORC 54Easements 59

5.4.6 Optimised deprival value (ODV) 615.5 Tribunals analysis and assessment 62

Allocative efficiency 63Dynamic efficiency 64Equity 65Overall assessment 65

5.5.1 A feasible range 67

6 ROLLING FORWARD THE CAPITAL BASE 716.1 Code requirements 716.2 Submissions 72

6.2.1 Western Power 736.2.2 NSW DNSPs 73

6.3 Tribunal discussion and analysis 746.3.1 Financial versus operating capital, and indexation 746.3.2 Indexation 756.3.3 Stranded or redundant assets 766.3.4 Assets in existence and in service on 1 July 1999 786.3.5 Assets brought into existence after 1 July 1999 79

Use of actual -v- expected capital expenditure 806.3.6 Timing of recognition 816.3.7 Disposals 81

6.4 Conclusion 82

7 CAPITAL EXPENDITURE 837.1 Code requirements 837.2 Submissions 837.3 Tribunals analysis and assessment 84

7.3.1 Consultants review 84Worleys conclusions 84Co-ordination with ACCC 86Capital expenditure and asset lives 86

7.3.2 Enhanced services expenditure 877.4 Conclusion 88

8 DEPRECIATION 918.1 Code requirements 918.2 Submissions 918.3 Tribunals analysis and assessment 92

8.3.1 The importance of depreciation 928.3.2 Distinguishing between types of depreciation 92

Economic depreciation 92Period over which assets should be depreciated 92

8.3.3 Depreciation methodologies 93Straight line depreciation 93Accelerated depreciation 93Annuity depreciation 94

8.3.4 Incentive effects of depreciation policy 95Depreciation, risk and economic value 96Depreciation and replacement expenditure 97Technically depreciated versus fully written down assets 99Implications for depreciation policy 99

8.3.5 International practice 1008.3.6 Asset life and valuation adjustments 100

8.4 Conclusions 102

9 RATES OF RETURN FOR NETWORK SERVICE PROVIDERS 1059.1 Code requirements 105

9.1.1 Transmission 1059.1.2 Distribution 105

9.2 Proposals made by the network service providers 1069.3 Public submissions 1079.4 Tribunals analysis and assessment 107

9.4.1 Approaches to rate of return 1079.4.2 Practical issues associated with CAPM/WACC 108

Market risk premium 109Treatment of taxation 110Transformation of nominal post tax WACC to pre tax WACC 112Pre tax or post tax WACC 113

9.4.3 Establishing a feasible range for rate of return 113Cost of equity 114Cost of debt 114Cost of capital - a feasible range 115

9.4.4 Risk assessment of TransGrid and the six DNSPs 116Assessment of the risks faced by electricity utilities generally 116Assessment of the market risks of Advance Energy and Australian Inland Energy 118Assessment of the market risks of TransGrid 119

9.4.5 Other evidence and considerations 120Market expectations 120Regulatory return allowed by overseas regulators 121Other considerations 122

9.5 Conclusion on rate of return 122

10 EFFICIENT OPERATING AND MAINTENANCE EXPENDITURE 12510.1 Code requirements 12510.2 Submissions 12610.3 Tribunals analysis and assessment 127

Distribution 12710.3.1 London Economics study 12810.3.2 UMS summary 12910.3.3 Partial measures 131

Recent trends in productivity 131TransGrid 133

10.3.4 Productivity across the electricity industry 13310.4 Conclusions 134

11 TOTAL REVENUE REQUIREMENTS FOR DNSPS 13711.1 Introduction 13711.2 Code requirements 13711.3 Submissions 13711.4 Summary of approach 138

11.4.1 The building block approach 13811.4.2 Financial indicator analysis 13811.4.3 Integration of analysis 139

11.5 Tribunals assessment 14011.5.1 Network financial projections and modelling 14011.5.2 Retail financial projections and modelling 14011.5.3 Revenue glide path 141

11.6 Scenario testing 14211.6.1 Revenue and price path analysis 14211.6.2 Financial indicator analysis 145

Choice of financial indicators 14511.6.3 Summary 149

Analysis for total DNSPs 14911.7 Conclusions 150

Energy Australia 152Integral Energy 153NorthPower 153Great Southern Energy 154Advance Energy 154Australian Inland Energy 154

12 TOTAL REVENUE REQUIREMENT FOR TRANSGRID 15712.1 Tribunals assessment 15712.2 Scenario testing 158

12.2.1 Financial indicator analysis 16012.3 Conclusion 161

13 RETAIL SUPPLY 16313.1 IPARTs powers in relation to retail prices 163

13.1.1 The IPART Act 16313.2 How should prices be regulated? 164

13.2.1 Option 1 - placing a cap on price movements from current tariffs 16413.2.2 Option 2 setting the regulated retail margin per kWh with pass through costs 16413.2.3 Option 3 - setting the maximum total retail margin with pass through costs 16413.2.4 Option 4 introducing a mix of regulatory mechanisms 16513.2.5 Evaluation of the options 165

13.3 Which costs should retailers be permitted to pass through 166Costs associated with the purchase of energy 167Risk premium 168Network charges 169National market charges and ancillary service charges to be imposed by NEMMCO 169Costs associated with implementing greenhouse gas emission strategies imposed by thelicensing regime 170Liability for power surges 170IT costs associated with the move to full retail contestability 170Retailer of last resort obligations 171Pass through costs 171

13.4 Revenue cap or price cap? 17113.5 The appropriate level for X 17213.6 Determining the retail margin 173

13.6.1 Current margins 17313.6.2 Margins of other retailers 175

Proposals made by the franchise retailers 17613.7 Price limits and cross subsidies 17713.8 Moving to retail competition 180

14 RING FENCING AND INFORMATION REQUIREMENTS 18114.1 Ring fencing 181

14.1.1 Development of ring fencing guidelines 181National Electricity Code framework 182Guildelines of the Distribution Boundary Review Committee 183Guidelines of the National Gas Code 184Guidelines of the ACCC 185

14.1.2 IPARTs position on ring fencing 18514.2 Information requirements 185

14.2.1 Reporters and auditors 18614.3 Compliance 187

15 REGULATORY CONCERNS 18915.1 Regulatory framework 18915.2 National Electricity Code 19015.3 Contestability issues 191

ATTACHMENT 1 TERMS OF REFERENCE 193

ATTACHMENT 2 LIST OF SUBMISSIONS 197

ATTACHMENT 3 RATE OF RETURN 201

ATTACHMENT 4 PARTIAL PRODUCTIVITY MEASURES 221

ATTACHMENT 5 PRODUCTIVITY TRENDS IN ELECTRICITY 227

ATTACHMENT 6 FINANCIAL INDICATOR FORMULAE 235

ATTACHMENT 7 ENERGYAUSTRALIA PROFILE 237

ATTACHMENT 8 INTEGRAL ENERGY PROFILE 245

ATTACHMENT 9 NORTHPOWER PROFILE 253

ATTACHMENT 10 GREAT SOUTHERN ENERGY PROFILE 261

ATTACHMENT 11 ADVANCE ENERGY PROFILE 269

ATTACHMENT 12 AUSTRALIAN INLAND ENERGY PROFILE 277

ATTACHMENT 13 RETAIL CONTESTABILITY ISSUES 285

ATTACHMENT 14 NATIONAL ELECTRICITY CODE REQUIREMENTS 295

ATTACHMENT 15 SECTION 15 COMPLIANCE 301

REFERENCES 303

Foreword

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FOREWORDThis report on the NSW electricity industry is published in response to a reference from thePremier under section 12A of the Independent Pricing and Regulatory Tribunal Act 1992. Themajor focus for this report is the Tribunal's views about appropriate revenue/price paths forthe period from 1999/00 to 2003/04 for the six government-owned distribution networkservice providers (DNSPs) and their associated franchise retailers. The Tribunal alsoconsiders the NSW transmission system, even though regulation of that network will be theresponsibility of the ACCC from 1 July 1999.

The National Electricity Code (the Code) and National Electricity Law became effective inDecember 1998, facilitating the introduction of a national electricity market. NSW is the firststate to be regulated under the national framework, with the Australian Competition andConsumer Commission (ACCC) regulating its transmission services from 1 July 1999 incompliance with the Code. The Tribunal has formed its views about appropriaterevenue/price paths for the DNSPs and their associated franchise retailers with reference toboth the Code and section 15(1) of the IPART Act.

The Tribunal intends to issue a determination covering the allowed revenue requirementsfor the NSW DNSPs in late 1999 to take effect from 1 February 2000. That determination willbe based on the findings in this report, and will reflect any changes in circumstances overthe next few months and subject to further submissions and comments from stakeholders.The determination will cover network distribution services as well as services to franchiseretail customers (ie those customers that are not contestable). Until a new determination isin place, the DNSPs and franchise retailers will comply with the regulatory provisions of thecurrent determination.

Except for very large customers, a typical customer's electricity bill comprises approximately50 per cent energy and retail charges, 40 per cent distribution charges and 10 per centtransmission charges.

The Tribunal's proposals will result in real price reductions for distribution service chargesof 16 per cent on average over the next five years. Reflecting the benefits of greater volumesand rapid growth, customers of metropolitan DNSPs on average will benefit from realreductions of around 20 per cent. Because of the higher cost environment within whichrural DNSPs operate, their customers will not enjoy price reductions, but on average pricemovements will be limited to the CPI index.

The six distributors, their related franchise retailers and Transgrid are public utilities ownedand operated on behalf of the citizens of NSW by the State Government. In protecting thevalue of the DNSPs, the Tribunal has had regard to the interest of the owners for the benefitof the taxpayers and residents of the State.

NSW taxpayers will benefit from the profits and tax equivalent payments made by theDNSPs. At the same time, the Tribunal has considered electricity customers, whose interestsare best served by long-term, sustainable low network prices.

Independent Pricing and Regulatory Tribunal

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In its deliberations, the Tribunal has attempted to seek an appropriate balance of theinterests of both the owners and the users of electricity services in NSW. The outcomesproposed in this report are very much underpinned by robust growth projections(particularly in the metropolitan areas) and a declining rate of return, offset by an increase inthe value of the businesses' asset base.

The Tribunal has serious concerns about the ongoing protection of franchise retail customersbeyond the end of 2000. Although the Tribunal will continue to regulate retail prices underthe IPART Act until December 2000, it does not have any legislative powers to regulate retailprices after that date. The Code does not provide IPART with powers in relation to the retailelectricity prices, potentially leaving those customers who are not able to properly benefitfrom competition unprotected.

The Tribunal strongly recommends that the Government develop appropriate policymeasures to deal with contestability and customer protection. This will necessitate theTribunal having appropriate powers to regulate prices and other terms and conditions forcustomers who are not able to participate in a genuinely competitive market for electricityservices.

The national electricity market and its regulatory framework are in their infancy. For thisreview the Tribunal has sought to ensure that the fundamental principles on which theregulatory framework is built will provide efficient outcomes. Given the complexity andimportance of the form of regulation, there are many issues the Tribunal must addressbefore issuing its determination. The Tribunal will continue working with the DNSPs andindustry stakeholders and welcomes comments on this report.

Thomas G ParryChairmanJune 30 1999

Executive summary

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EXECUTIVE SUMMARY

Background and legislative basis for this reviewThis report into the NSW electricity industry has been prepared by the Independent Pricingand Regulatory Tribunal in response to a reference from the Premier under section 12A ofthe Independent Pricing and Regulatory Tribunal Act 1992. The focus of the report is the settingof appropriate revenue/price paths from 1999/00 to 2003/04 for the six government-owneddistribution network service providers (DNSPs) and their associated franchise retailers. Inthis report the Tribunal addresses the NSW transmission system operated by Transgrid andEnergyAustralia, even though regulatory responsibility for that network will be passed onto the Australian Competition and Consumer Commission (ACCC) from 1 July 1999.

The National Electricity Code (the Code) and National Electricity Law became effective inDecember 1998, facilitating the introduction of the national electricity market. NSW is thefirst state to be subjected to this new regulatory framework with the ACCC regulatingtransmission services in compliance with the Code. The Tribunal has formed its viewsabout appropriate revenue/price paths for the DNSPs with reference to both the Code andsection 15(1) of the IPART Act.

With the exception of very large customers, a typical customer's electricity bill comprisesapproximately 50 per cent energy and retail charges, 40 per cent distribution charges, and 10per cent transmission charges.

KEY OUTCOMESIn its deliberations, the Tribunal sought to balance the interests of the owners and the usersof NSW electricity services. The outcome proposed in this report is underpinned by robustgrowth projections (particularly for metropolitan areas) and a declining rate of return, offsetby an increase in the value of the DNSPs asset base.

Pricing outcomesIf they are implemented, the Tribunal's proposals will result in real price reductions fordistribution service of 16 per cent on average over the next five years. Due to greatervolumes and more rapid growth, customers of metropolitan DNSPs will benefit on averagefrom real reductions of around 20 per cent. Because rural DNSPs operate in a higher costenvironment, their customers will not enjoy price reductions, but on average price increaseswill be limited to increases in line with the CPI.

Cumulative real reductions in network prices over the five years from 1999/00 to 2003/04are illustrated in Table 1. These price reductions are indicative and may be altered by anumber of outstanding issues. In particular, Integral Energys prices may not fall by the full23.6 per cent due to issues associated with co-generation facilities.


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Table 1 Cumulative real reductions in network prices, 1999/00 to 2003/04

DNSP Reduction (%)EnergyAustralia 17.7Integral Energy 23.6NorthPower 0Great Southern Energy 9.1Advance Energy 0Australian Inland Energy 0Industry average 15.9

Asset values

The six distributors, their related franchise retailers and TransGrid are public utilities ownedand operated by the State Government on behalf of the citizens of NSW. The Tribunal hashad regard to the interests of the owners by seeking to protect the value of the business forthe benefit of the taxpayers and residents of the State. This is consistent with the terms ofreference for the review and the requirements of the Code.

Table 2 illustrates the Tribunals proposed asset bases for the DNSPs and TransGrid. Theseinitial capital bases are expected to deliver revenue streams sufficient to finance networkfunctions, maintain service standards and earn reasonable returns and price outcomes.

Table 2 Regulatory asset base as at 30 June 19981

DNSP System assets$m

Non-system assets$m

Initial capital base$m

EnergyAustralia 3,530 237 3,767Integral Energy 1,590 142 1,732NorthPower 784 74 858Great Southern Energy 467 47 514Advance Energy 287 16 303Australian Inland Energy 45 5 50DNSP Subtotal 6,703 521 7,224TransGrid 1,737 79 1,816Industry Total 8,440 600 9,040

The Tribunal wishes to emphasise that it made its decision on the initial capital base havingregard to the government-ownership of the DNSPs. This accords with the requirement ofthe Code which provides for the regulator to have regard to pre-existing asset valuatonpolicies for government-owned DNSPs. This decision does not bind the Tribunals futureregulatory decisions on initial capital bases for the electricity industry or any other industry.

1 Asset values are at 30 June 1998, consistent with the NSW Treasury, ODRC Valuation of Network Assets for

NSW Electricity Supply Industry. TransGrids assets are valued at 1996 roll forward amount; AustralianInland Energys assets are valued at ODV.

Executive summary

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Rate of returnIn determining revenues and prices, the cost of capital is a very significant consideration.Once decided, it is applied to the entire capital base of the utility, and to new investmentsthroughout the regulatory period.

The Tribunal recommends that a real pre tax rate of return of 7.5 per cent apply toTransGrid, EnergyAustralia, Integral Energy, NorthPower and Great Southern Energy. TheTribunal recommends that a real pre tax rate of return of 7.75 per cent should apply toAdvance Energy and Australian Inland Energy. The difference in the proposed rates ofreturn reflects differences in the assessed risk factors for the DNSPs. These real pre tax ratesof return deliver nominal post tax returns on equity of approximately 11-12 per cent.

Operating expenditureWhile the Tribunal favours a regulatory framework which encourages the DNSPs toimprove their performance, it must carefully consider the scope for efficiency gains andmake realistic assessments of costs to ensure that DNSPs have to capacity to maintain thesystem.

After considering the various studies undertaken for the Tribunal (including the capitalexpenditure review undertaken by Worleys) and the views expressed by the DNSPs andother stakeholders, the Tribunal proposes the following reductions in operating andmaintenance expenditure over the next review (to be offset by productivity improvementsand an allowance for growth):

EnergyAustralia 10 per centIntegral Energy 15 per centNorth Power 15 per centGreat Southern Energy 15 per centAdvance Energy 15 per centAustralian Inland Energy 5 per cent

The Tribunal concurs with the ACCCs view that TransGrids real operating costs shouldreduce by 7.5 per cent from the base year of 1998/99.

Protection of franchise retail customersThe Tribunal is concerned about the ongoing protection of franchise retail customers beyondthe end of 2000. Although the Tribunal will continue to regulate retail prices under theIPART Act until December 2000, it lacks the legislative power to regulate retail prices afterthat date. The Code does not provide IPART with powers to regulate retail electricity prices,potentially leaving those customers who are not able to properly benefit from competitionunprotected.

The Tribunal strongly recommends that the Government develop appropriate policymeasures to deal with contestability and customer protection. This will require IPART tohave appropriate powers to regulate prices and other terms and conditions for customerswhich are not able to participate in a genuinely competitive market for electricity services.


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Quality of supplyThe Tribunal believes that quality of service is a fundamental principle which the regulatoryframework must address. In most, if not all cases, the cost of providing a service is closelyrelated to the standard or quality of that service. Therefore, information on quality ofsupply is essential for its effective regulation.

Although conventional industry performance indicators exist, inconsistency and variationsin definitions and measurement hinder the interpretation of and reliance on these indicators.

The Tribunal supports the Governments efforts to regulate standards of service, includingdeveloping appropriate measures of standards of service. The Tribunal believes that thiswork should be given the highest priority. Once this issue is addressed the Tribunal will bein a position to integrate service quality in the economic regulation.

Environmental issuesThroughout its deliberations, the Tribunal has had regard to environmental issuesassociated with demand management. This is consistent with the requirements of the Code.In setting its form of revenue control, the Tribunal has selected a variable revenue cap,because this reduces the bias under a pure revenue cap against efficient demandmanagement options. Likewise, the progression to more cost reflective pricing assists inremoving some of the barriers to demand management options.

The Tribunal recommends clear rewards for compliance and clear penalties for failure tocomply environmental standards, including appropriate consideration of alternatives toaugmentation in network planning and emissions benchmarks. These rewards andpenalties would extend to the Tribunals assessment of the prudence of a DNSPs capitalexpenditure, including the inclusion of demand management and distributed resourceoptions in its network planning function.

The Tribunal proposes to remove the loss factor from the maximum allowable revenue(MAR) equation but include capital expenditure on losses in the asset base, subject to aprudency test.

Any premium on green pricing is excluded from the regulated retail margin, therebyremoving any constraints on selling green power.

Impacts on rural customersThrough the side constraints, the Tribunal is limiting price impacts on rural domesticcustomers. Any tariff rebalancing will need to be conducted within the boundaries of theside constraints. The Tribunal will work with the DNSPs to develop a method of assessingthe level of cross subsidies and the amount of rebalancing required.

The impact of the proposed price paths on rural and remote customers will be reflected in:

the overall level of transmission charges

locational differences in transmission prices

the overall level of distribution charges

the structure of distribution charges by customer groups and location

Executive summary

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side constraints on maximum increases in network and franchise retail charges

capital contributions policies.

The National Electricity Code Administrator (NECA) is conducting a review of networkpricing, including consideration of considering cost reflective network pricing (CRNP) amethodology that could be used to determine transmission prices. CRNP could lead tohigher transmission charges in remote regions where demand is low or declining, sendinginappropriate economic signals to certain rural and remote customers. The Tribunalbelieves that it would be inappropriate to implement the CRNP methodology in the Codeand will make representations to this effect to NECA.

Moving forwardThe Tribunal intends to issue a determination on allowed revenue requirements for theNSW DNSPs in late 1999 to take effect from 1 February 2000. Based on the findings in thisreport, the determination will reflect any changes in circumstances over the next few monthsand be subject to further submissions and comments from stakeholders. The determinationwill cover network distribution services as well as services to franchise retail until 30December 2000. Until a new determination is in place, the DNSPs and franchise retailerswill comply with the regulatory provisions of the current revenue caps.

The national electricity market and its regulatory framework are in their infancy. For thisreview the Tribunal has sought to ensure that the fundamental principles that the regulatoryframework is built on will provide efficient outcomes. Given the complexity andimportance of the form of regulation, there are a number of issues that the Tribunal willfurther consider before issuing its determination, including developing:

a framework to deal with network losses and standards of service

disclosure requirements for DNSPs

pricing principles (including transmission pricing)

the components of the revenue formula

the negotiation framework

the treatment of embedded generation

the structure and level of miscellaneous charges and monopoly fees for contestableworks.

The Tribunal welcomes comments on this report to assist in finalising its determination anddeveloping an appropriate regulatory framework for the electricity industry in NSW.


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Summary of recommendations Volume 1

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SUMMARY OF RECOMMENDATIONS - VOLUME 1

Chapter 3 Form of regulation

The Tribunal proposes defining "prescribed distribution services" as those servicesperformed by the DNSPs which are associated with, or ancillary to, access to the networkand the delivery of electricity within each DNSP's service area, with the exclusion of thoseservices which are subject to effective competition.

The Tribunal proposes issuing a 3 to 5 year determination under the IPART Act coveringdistribution. A transitional regulation will be required to deem this determination to beunder Parts D and E of chapter 6 of the Code. The Tribunal can only issue a determinationunder the IPART Act covering retail supply to franchise customers covering the period to 31December 2000.

For this report the Tribunal has adopted a building block form of cost linked regulationusing financial indicators as a means of checking the reasonableness of the outcomes.

Having considered the forms of regulation available under the Code, the Tribunal proposesa hybrid revenue cap as the most appropriate form of economic regulation for distributionnetwork service providers.

The Tribunal believes that during the next regulatory control period it is appropriate forgains and losses to be phased out according to a glide path.

The Tribunal proposes considering the net present value approach to the specification ofglide paths at the next review.

Chapter 4 Distribution standards of service

The Tribunal proposes that, as a precursor to any further consideration of reliabilityincentive mechanisms in the regulatory framework, the industry should: demonstrate that it has consistent, robust and verifiable reliability performance data

over an extended period to support the financial modelling of reliability performanceagainst potential financial impacts

demonstrate an administratively simple and effective means of ensuring that there willnot be a deterioration in service standards in problem regions

demonstrate that reliability data can be independently verified on an on-going basis publish information on its reliability performance in a manner that is meaningful and

relevant to customers.2

The Tribunal proposes that the industry identify the operating and capital costs associatedwith reliability improvements. Any service standard mechanism included in a futureregulatory period should address how to treat these costs to prevent giving the DNSPs anexcessive incentive to invest in service reliability projects.

2 This is consistent with ORGs and OFFERs practices, as well as the recommendations in the NECA

report, p 57.


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The Tribunal proposes that DNSPs and stakeholders work with the Tribunal to advanceregulatory incentive mechanisms for service standards.

In order to develop the regulatory framework to specifically include service standards, theTribunal requires: a clear specification of old and new standards of service, supported by adequate

reporting a clear delineation of the customers right to individually or collectively retain existing

standards with existing price protection satisfactory resolution of the associated pricing and social issues.

The Tribunal proposes that it work together with DNSPs and stakeholders on these issues.

The Tribunal supports efforts to establish an appropriate regulatory regime for the technicalregulation of standards of service, including appropriate measures of service standards. Itrecommends that this work be given the highest priority.

Unless reporting on the technical regulation of distribution service standards yieldsverifiable and meaningful data, the Tribunal is inclined to adopt an asymmetric form ofstandards regulation within its economic framework. Effectively, this would be based onthe view that the distributors primary business mission should be to provide a reasonablelevel of service. Failure to deliver would be subject to a form of penalty.

Chapter 5 The initial capital baseThe Tribunal proposes that a feasible range of asset values lies between the 1996 valuerolled forward and the current estimate of DORC. A valuation within this range reflects ajudgement given the terms of reference of this review, Code requirements and the Premiersletter on the reasonableness of the pricing and financial outcomes of each NSP.

The Tribunal considers that the feasible range for the asset values for the DNSPs (as at 30June 1998) lies between $5.0 billion and $7.2 billion. A feasible range for TransGrids assetvaluation is $1.8 billion to $2.1 billion.

In determining a point estimate of the initial asset value, the Tribunal has : assessed the outcomes of a number of initial capital base scenarios to ascertain the

reasonableness of the pricing and financial outcomes of each, (This assessment isdetailed in chapter 11)

had regard to Code requirements, including the recognition of pre-existing policies ofgovernments which are distribution network owners regarding asset values, revenuepaths and prices

ensured that the point estimate is consistent with the terms of reference of this review.


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The Tribunal proposes the asset values in Table 5.11 as the initial capital base forTransGrid and the DNSPs as at 30 June 1998. These initial capital bases are expected todeliver revenue streams and network price outcomes sufficient to finance network functions,maintain service standards and earn reasonable returns. (See chapter 11.)

Table 5.11 Regulatory asset base as at 30 June 1998

DNSP System assets$m

Non-system assets2$m

Initial capital base$m

EnergyAustralia1 3,530 237 3,767Integral Energy 1,590 142 1,732NorthPower 784 74 858Great Southern Energy 467 47 514Advance Energy 287 16 303Australian Inland Energy 45 5 50DNSP Subtotal 6,703 521 7,224TransGrid 1,737 79 1,816Industry Total 8,440 600 9,040

1: EnergyAustralias initial capital base includes its transmission assets.2: For the purposes of this report non-system assets do not include inventories and working capital.

Chapter 6 Rolling forward the capital baseThe Tribunal proposes that the regulatory asset base in existence at 1 July 1999 representsshareholders financial investment in the utility.

The Tribunal proposes that for the purposes of determination of revenues up to the nextreview the regulatory capital base be indexed by CPI. This is consistent with the concept offinancial capital maintenance, that is, maintaining the value of the shareholdersinvestment, at least in terms of the initial capital base for regulatory purposes.

The Tribunal proposes that indexation of the regulatory capital base be based on the actualAll Capitals CPI for each financial year of the regulatory period until the next review.

For assets in existence and in service at 1 July 1999 the Tribunal proposes to deal withstranded or redundant assets via the calculation of ODV at the next regulatory review.

The Tribunal proposes that as part of the next regulatory review an ODV will be calculatedfor each DNSP. In calculating ODV the economic value of the assets with be compared tothe current estimate of DORC, on an asset class by asset class basis.

On balance, the Tribunal proposes that subject to a prudency test, it is appropriate to rollforward the capital base on the basis of forecast capital expenditure at the start of theperiod and, at the end of the period, to adjust the regulatory capital base to take account ofactual capital expenditure. During the period the service provider would retain the returnon the difference between projected and actual expenditure.


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As with the treatment of additions to the capital base, the Tribunal proposes to recogniseany deletions from the capital base during the year in which they occur. Disposal of assetswill be recognised in the year of disposal, and will earn neither a return on capital nor areturn of capital from that year onward.

Chapter 7 Capital expenditureFor the purpose of determining prices over the next five years, the Tribunal proposes to usethe capital expenditure forecasts recommended by Worley for TransGrid and the DNSPs.

At the next review, the Tribunal will undertake a prudency study, not unlike the Worleyconsultancy conducted as part of this investigation, to define the appropriateness ofincluding capital expenditure in the regulatory asset base.

Chapter 8 DepreciationThe Tribunal proposes to adopt simple straight line depreciation as a default option for thisreview and invite NSPs to present alternative depreciation profiles at the next review.

Whilst noting that it is unlikely, the Tribunal does not wish to exclude the possibility of theregulatory stranding of assets.

For the purposes of this review, the Tribunal proposes to: allow depreciation on the initial capital base established for regulatory purposes only adopt the asset lives established in the Worley capital expenditure review. This will

ensure consistency between the capital expenditure forecast and the depreciationreflected in the calculation of the revenue requirement.

adopt depreciation schedules based on straight line depreciation methodology provide scope for alternative depreciation profiles in the future where these can assist in

managing market risks and managing variations in the prices of new investment establish net present value neutrality as an essential condition for alternative

depreciation profiles.

Chapter 9 Rates of Return for network service providersHaving considered the matters described above, the Tribunal proposes that a real pre taxrate of return of 7.5 per cent should apply to TransGrid, EnergyAustralia, Integral Energy,NorthPower and Great Southern Energy. This conclusion is consistent with a nominal posttax return on equity of approximately 11-12 per cent.3

The Tribunal proposes that a real pre tax rate of return of 7.75 per cent should apply toAdvance Energy and Australian Inland Energy. This conclusion is also consistent with anominal post tax return on equity of approximately 11-12 per cent.

3 This conversion occurs within the framework provided by CAPM/WACC. The conversion from a return

on equity is based on a cost of debt of around 6.4 per cent and a debt to equity ratio of 60 /40 per cent.The assumed gearing ratio is considered appropriate and reflects standard industry capital structures forenergy infrastructure providers. Details of the Tribunals consideration of rate of return and theunderlying parameters are provided in Attachment 3.


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The Tribunal wishes to emphasise that the above decision on the rate of return is madehaving regard to the circumstances of the DNSPs and TransGrid, the prevailing marketconditions and methodologies currently followed by market practitioners and other Stateregulators. This should not be seen as a precedent that binds the Tribunals futureregulatory decisions on rate of return.

Chapter 10 Efficient operating & maintenance expenditureThe Tribunal proposes that the relevant state regulators and their DNSPs work together todevelop a robust data set so that useful benchmarking can occur.

After considering the various studies undertaken for the Tribunal (including the capitalworks study undertaken by Worleys4) and the views expressed by TransGrid and theDNSPs, and other submissions, the Tribunal proposes the following efficiency gains inoperating and maintenance expenditure for the NSW DNSPs (from the 1998/99 base year)over five years :

Cumulative real reduction over 5 yearsbefore allowance for growth

EnergyAustralia 10 per cent reductionIntegral Energy 15 per cent reductionNorthPower 15 per cent reductionGreat Southern Energy 15 per cent reductionAdvance Energy 15 per cent reductionAustralian Inland Energy 5 per cent reduction

The Tribunal concurs with the ACCCs view that TransGrids real operating costs shouldreduce by 7.5 per cent from the base year 1998/99.

4 Worleys, 1998, Report to the Independent Pricing and Regulatory Tribunal on Capital Expenditure Review in

NSW Electricity Distribution, Sydney.


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Chapter 11 Total revenue requirementsThe Tribunal proposes the annual aggregate revenue requirements of the DNSPs as shownbelow:

Industry Total 1999/00 2000/01 2001/02 2002/03 2003/04

Regulatory asset value1 7,469 7,637 7,787 7,939 8,101

Capital expenditure 385 371 360 382 389

Depreciation 334 342 349 355 362

Return on capital base 561 574 585 596 608

Depreciation 334 342 349 355 362

Operating costs 524 527 531 535 539

Total revenue (unsmoothed) 1,419 1,443 1,465 1,486 1,509Smoothed allowed revenue 1,445 1,460 1,475 1,491 1,508

Average network price 3.04 2.99 2.95 2.91 2.871: Representing average of opening and closing regulatory asset base and comprising system and

non-system assets

Chapter 12 TransGrids revenue requirements

Tribunal has proposed a revenue path for TransGrid which is consistent with annualrevenue requirement in 2003/04 of $355 million, being made up by: an initial capital base of $1,816 million as at 30 June 1998 a rate of return of 7.5 percent capital expenditure of $705 million real reduction in operating costs of 7.5 per cent over the 5 years

Chapter 13 Retail pricesIn summary, the Tribunal proposes that retailers be allowed to pass through the followingcosts: electricity purchased via vesting contracts network charges fees imposed by NEMMCO under the National Electricity Code.

The Tribunal will develop a portfolio of contracts (including a component for residual poolexposure) which franchise retailers will be deemed to have used when purchasing electricityfrom the wholesale market. The portfolio of contracts will reflect any greenhouse emissionreduction targets imposed by the government. This will provide an incentive for retailers tominimise the cost of electricity purchased from the wholesale market.


xv

The Tribunal proposes that the form of regulation for franchise retailers be a price cap onthe retail margin allowed per kWh, adjusted over time by CPI-X.

Having considered available information, the Tribunal considers that the retail margin perkWh for franchise customers should be aligned with the margins of other retail businesses.The Tribunal proposes that retail margin of each franchise retailers be equivalent to 6.6percent of sales turnover. The retail margin is intended to cover retail supply costs plus anyprofit. The level of profitability of each business will vary, depending on its relativeefficiency. The retail margin should provide a fair and reasonable return to the ownerswhile ensuring appropriate prices for customers.

Importantly, the Tribunal recommends that the Government ensure IPART remains theprice regulator for customers who do not have a choice of retail supplier.

The Tribunal recommends that the Government ensure that IPART has the right to set asafety net price for customers who do not elect to change retailer, or do not respond to theoffers of retailers.

The Tribunal proposes that the side constraints on retail prices for franchise customers beapplied only to residential tariffs including rural residential tariffs. Increases in the bill ofany individual residential customer for the same pattern and volume of electricityconsumption may not exceed the bill for the corresponding period of the preceding year bymore than $20 or CPI whichever is the greater. Increases to the residential class as a wholemust not exceed CPI March on March All Capital CPI.

The Tribunal may need to revise the side constraints in light of the ACCCs vesting contractdecision.

Chapter 14 Ring-fencing

The Tribunal supports further development of ring-fencing guidelines, including thoroughconsultation with stakeholders. In developing these guidelines the Tribunal wishes toencourage a level playing field in the competitive sectors of the market. Concurrently withthis the Tribunal proposes to review the current accounting separation code.

Given the difficulties experienced in the current review and the improved accountingpractices being adopted by some DNSPs, the Tribunal proposes that the DNSPs,stakeholders and the Tribunal work together to develop a better information reportingpackage and regulatory accounts format.

The Tribunal supports improving the current requirements for independent verification ofthe regulatory accounts. Further, the Tribunal believes that the first duty of the auditorsand/or reporters should be to the Tribunal, although the DNSPs should be responsible forthe cost of such reporters.

Chapter 15 Regulatory concernsThe Tribunal proposes that the Government review regulatory arrangements for theelectricity supply industry with the aim of improving the regulatory and governancearrangements. In particular, priority should be given to improving the regulation of servicestandards and the development and implementation of social policy.


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The Tribunal proposes that state based regulators, in consultation with DNSPs and otherstakeholders, jointly develop proposed amendments to the Code to improve regulatorycertainty and the framework within which the regulators work.

The Tribunal proposes that Government ensure that: it is clear which organisation is responsible for overseeing and project managing the

introduction of full contestability; and NSW works with other states in an attempt to achieve a national approach to the

implementation of full contestability.

The Tribunal proposes working with the DNSPs, other stakeholders and other jurisdictionalregulators to develop pricing guidelines.

The Tribunal proposes to set miscellaneous charges and monitor charges for contestableretail services.


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SUMMARY OF RECOMMENDATIONS VOLUME 2

Chapter 2 Principles for pricingThe Tribunal proposes: to work with the DNSPs and other stakeholders to establish guidelines for information

to be disclosed in pricing information booklets to require DNSPs to publish such booklets to require that if a DNSP has not published a complying booklet, all the DNSPs network

charges should decrease or increase by a uniform percentage consistent with the DNSPsoverall CPI-X cap.

The Tribunal proposes to work with the DNSPs to develop guidelines for the allocation ofcosts and establishment of network prices which will give the distributors appropriateflexibility in pricing and enable approval requirements under the Code to be met efficiently.

The Tribunal proposes that the determination of prices and price structure and the processfor the regulation and reporting of prices should have the following objectives: economic efficiency financial sustainability competition, including in upstream and downstream industries equity environment sustainability simplicity and transparency certainty and control of the costs of regulation.

The Tribunal proposes to work with the DNSPs, other stakeholders and jurisdictionalregulators to develop guidelines which strike an appropriate balance between the objectivesof economic efficiency and the other pricing objectives.

Chapter 3 Transmission pricingBuilding upon the objectives summarised by NECA in its draft report for the Transmissionand Distribution Pricing Review, the Tribunal proposes that the determination of pricesand price structure, and the process for regulating and reporting prices should satisfy thefollowing objectives: economic efficiency financial sustainability competition, including in upstream and downstream industries equity environment sustainability simplicity and transparency certainty and control of the costs of regulation.

From the consideration of these objectives, the Tribunal has developed the criteria forpricing outlined in the previous chapter. These criteria are equally applicable totransmission pricing.

The Tribunal concludes that the current pricing methodology specified in the Code is notadequate. It is administratively complex and neither efficient nor equitable. The Tribunal


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recommends that the Government seek to ensure that the NECA review of transmissionpricing will: fully consider recent overseas innovations in transmission pricing consider the option of a ground-up review in place of revisions and refinements.

The Tribunal recommends that the current NECA review consider and provide cleardirections on the greater use of nodal pricing to value transmission services. If thisapproach is adopted, regulated network prices will not need to attempt to send locationalsignals as these will be determined in the market. Pending consideration of these issues,caution should be exercised in implementing pricing structures which result in significantvariations from existing prices.

The Tribunal supports the adoption of NECAs proposal for unbundling charges. However,ease of unbundling should not be a primary consideration in structuring transmissionnetwork charges. The Tribunal will support NECAs proposal for disclosure of transmissioncharges by requiring DNSPs to publish a booklet outlining the basis for network charging.

The Tribunal considers that EnergyAustralias proposed change would result in a moreefficient, and robust regulatory framework, while achieving the intent of the NationalElectricity Code.

Chapter 4 Impact of proposed price paths on rural and remotecustomers

The Tribunal understands the concern of many stakeholders to limit derogations from theCode. Hence, it is prepared to endorse the recalculation of TransGrids charges using thecurrent averaged approach, notwithstanding the potential impacts on regional areas.

In light of the extensive concerns that have been expressed, and NECAs proposals for therevision of the current arrangements, the Tribunal believes it would be inappropriate toimplement the arrangements for transmission pricing currently set out in the Code. Thecharges that would result are neither economically efficient nor equitable.

The Tribunal wishes to work with the DNSPs to develop a common methodology forassessing the boundaries for efficient, subsidy-free prices. At this stage it does not see astrong case for using economic or other criteria to rebalance charges of the magnitudesuggested by the regional DNSPs.

Chapter 5 Revenue formulaThe Tribunal proposes that the side constraints on network prices be applied only toresidential tariffs including rural residential tariffs. Increases in the bill of any individualresidential customer for the same pattern and volume of electricity consumption may notexceed the bill for the corresponding period of the preceding year by more than the greater ofCPI or $20. Increases to the residential class as a whole must not exceed the CPI.

As the purpose of side constraints is to protect users from price shocks, the Tribunal believesthat unders-and-overs rectification should be included in the side constraints. Anystructured mechanism for resolving the balances in the unders-and-overs account could beinhibited by the side constraints. The Tribunal wants to avoid price shocks to consumerswhere possible, yet it wants to allow the DNSPs flexibility in resolving balances in their


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unders-and-overs account. To encourage the DNSPs to address their unders-and-oversaccount balances, the Tribunal will not impose strict methodology to resolve the balances.

The Tribunal will allow the cumulative balance in the unders-and-overs accounts to becarried over into the forthcoming regulatory period.

The Tribunal proposes to adopt the following structure for the MAR formula:

MAR = [[a + bN + cM + dL ] * (1 + (CPI-X))] + Y + GST

where

N = customer numbersM = MWh salesL = circuit kilometres (rural distributors only)Y = Y2K costs, NEMMCO fees and costs of moving to full contestability ($).GST = the net impact of the GST on the business5

a = residual fixed term capturing other costs ($000)b = dollars per customerc = dollars per MWhd = dollars per circuit kilometre

CPI = the ABS March year-on-year all-groups all capitals CPI figure

The Tribunal will work closely with stakeholders to finalise the co-efficients for thisformula.

Chapter 6 NegotiationThe Tribunal proposes to revise the information disclosure requirements in its negotiationprinciples to include: disclosure of pricing methodology disclosure of planning information and processes proposed to ensure appropriate

consideration of embedded generation and demand management options.

The Tribunal supports the inclusion in the negotiation framework of a requirement toprovide information within a defined period of receiving a request for information. TheTribunal will also create a timetable for progressing negotiations between stakeholders.

The Tribunal recommends that discounts be borne by NSPs in the current period, and thatthe regulator review any discounts and roll them into the revenue base at the next review, ifthe NSPs can demonstrate that the discounts are prudent.

Subject to stakeholder consultation, the Tribunal recommends the introduction of sanctions,including the regulatory stranding of assets and deeming loads, if: existing customers bypass the system and disconnect from the system and/or new customers do not connect to the system

5 The Tribunal will engage an auditor (at the DNSPs expense) to verify the DNSPs calculation of the net

impact of the GST.


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as a result of the NSPs not advancing negotiations which would have resulted in thosecustomers connecting to the system, thus reducing the average price of connection for othercustomers.

When determining the rate of return, the Tribunal will consider the increased risk associatedwith this regulatory approach.

The Tribunal supports the inclusion in the negotiation framework of a requirement toprovide information within a defined period of receiving a request for information. TheTribunal will also create a timetable for progressing negotiations between stakeholders.

The Tribunal recommends that discounts be borne by NSPs in the current period, and thatthe regulator review any discounts and roll them into the revenue base at the next review, ifthe NSPs can demonstrate that the discounts are prudent.

Subject to stakeholder consultation, the Tribunal recommends the introduction of sanctions,including the regulatory stranding of assets and deeming loads, if: existing customers bypass the system and disconnect from the system and/or new customers do not connect to the systemas a result of the NSPs not advancing negotiations which would have resulted in thosecustomers connecting to the system, thus reducing the average price of connection for othercustomers.

When determining the rate of return, the Tribunal will consider the increased risk associatedwith this regulatory approach.

The Tribunal proposes to consult with stakeholders to enhance the negotiation framework,specifically addressing: information asymmetry and disclosure time frames for progressing negotiations revenue impacts arising from discounts incentives for NSPs to enter into negotiations other issues raised by stakeholders.

Chapter 7 Environmental issuesThe Tribunal proposes to monitor the cost of compliance with licence conditions to ensurecompliance costs passed on to customers do not exceed efficient levels.

The Tribunal recommends that clear rewards for compliance and clear penalties for failureto comply with the emissions benchmarks be developed.

The Tribunal proposes to work with Government to define a consistent set of technical andeconomic regulations which remove barriers to the provision of electricity services usingstand alone remote area power systems.

An essential feature of the Tribunals assessment of the prudence of a DNSPs capitalexpenditure is clear evidence that the DNSP has investigated demand management anddistributed resource options as a crucial part of its network planning function.

The Tribunal proposes to work with the various other regulatory agencies to develop a clearregulatory regime which provides appropriate incentives to protect the environment.


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Chapter 8 Embedded generationThe Tribunal supports the development of a framework within which the parties cannegotiate agreements. The framework would include procedural guidelines, agreedmethodologies, dispute resolution processes and standardised contract documentation.

The Tribunal proposes to continue to work with the embedded generation working group todevelop a regulatory framework for embedded generation.

The Tribunal supports the pass through of TUOS savings to embedded generators. TheTribunal proposes to work with the embedded generation working group and otherregulators to develop a consistent framework for sharing avoided TUOS charges.

The Tribunal proposes to work with other regulators to develop a consistent regulatoryframework among jurisdictions.

The Tribunal proposes to work with government to ensure that embedded generation isappropriately reflected in the demand management code of practice.

Chapter 9 Miscellaneous chargesOn the basis of the Tribunals interpretation of the IPART Act, it does not seem possible toprovide the flexibility sought by the DNSPs within regulatory periods. This decision isreinforced by the impracticality of separate determinations within regulatory periods, giventhe size and scale of income from miscellaneous charges relative to total DNSP income.

The Tribunal considers a fee-by-fee cap to be appropriate for miscellaneous electricitycharges. To prevent the proliferation of such fees, the Tribunal considers it important forapproved miscellaneous charges to form an exhaustive list.

For the purposes of this report, the Tribunal has decided to retain the current fee-by-fee capfor fees presently contained in Determination 5.3 1997.

The Tribunal proposes to work with the industry to identify network and retail charges, andto develop a framework for sharing miscellaneous charges between the networks andfranchise retailers.

The Tribunal is of the view that section 3(1) of the IPART Act is sufficiently inclusive toprovide the legal basis for regulating security deposits. This complements the consensusview of the MCWG that security deposits be regulated. The Tribunal has decided that theclearly specified and consistent terms under which security deposits are required, used andrefunded, should follow the guidelines specified by ORG in section 9 of the Supply and SaleCode.

It should be noted that the Tribunal proposes to regulate security deposits for franchiseretail customers only.

The Tribunal recommends that security deposits be applied in a manner consistent withthat established in the Victorian Electricity Industry Supply and Sale Code.


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The Tribunal considers it important that customers clearly understand the circumstancesunder which a miscellaneous charge will be levied. The list of miscellaneous charges in thenetwork and retail price schedules should therefore be accompanied by a narrative of thecircumstances in which those fees apply.

The Tribunal recommends that the electricity industry undertake to provide a greater degreeof consumer information on miscellaneous charges and security deposits.

Chapter 10 Contestable worksGiven divergent opinions regarding the appropriate level of monopoly fees, the Tribunal isof the view that a wider investigation of the costs of undertaking contestable works isrequired before new hourly fees are set.

The Tribunal proposes to work with government, DNSPs and industry participants todevelop guidelines regulating monopoly fees for contestable works.

Chapter 11 Capital contributionsThe Tribunal is not inclined to revise its current requirement that customers fund their ownconnection assets. The Tribunal will continue to work with the Capital ContributionsWorking Group and government to develop a policy acceptable to all parties.

The Tribunal supports the working groups suggestion that the concept of a net revenueconnection contribution be examined, for use in an economic assessment of connectionapplications. Taken together with a fuller investigation of network service boundaryissues, this review may provide the basis for more workable and equitable arrangements.

The Tribunal considers that the capital contributions issues are complex and far reaching.Therefore, pending the outcome of further investigations, it recommends that Determination10, 1996 as varied in Determination 5.4, 1997 should continue to apply.

Chapter 12 StreetlightingAs the customer is unable to choose its service provider, the Tribunal will continue toregulate the operating and maintenance component of streetlighting services through thenetwork revenue cap.

The Tribunal proposes to include the costs currently regulated by the SLUOS cap within theoverall DNSP network cap. Hence, the SLUOS charge will not be regulated separately fromthe overall network charges.

The Tribunal proposes to regulate the energy costs associated with streetlighting serviceswithin the overall retail cap. Hence, there will not be a separate streetlighting energy cap.This will be subsumed within the general cap on retail margins.

In summary, the Tribunal proposes that the capital, operating and maintenance costs ofstreetlighting services (previously referred to as the SLUOS component) be combined withand regulated as part of the use of network component, separately from the energy usagecomponent. The combined NUOS component would continue to be regulated within eachnetworks MAR. The energy component will be regulated within the franchise retailframework.


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The rate of return on new distributor-funded streetlighting assets will be consistent withthat set for the rest of the network business. The basis for depreciation to be applied to newdistributor-funded streetlighting assets should be consistent with the approach used for theremainder of the network business.

GreenPower sales generated from the streetlighting business should continue to be outsidethe Tribunals regulation.

Chapter 13 Distribution network lossesThe Tribunal supports the principle that the value of loss reductions should be taken intoaccount when the asset base is rolled forward in future reviews.

The Tribunal believes that economic loss management investment should not be optimisedout of the regulated asset base.

The Tribunal proposes to work with the DNSPs to develop a framework for assessing theeconomic prudence of loss management investment.


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Glossary of acronyms and terms

xxv

GLOSSARY OF ACRONYMS AND TERMSAARR Annual aggregate revenue requirements: the calculated total

annual revenue to be earned by an entity for a defined class ofservice

ABC Activity based costingABC Aerial bundled conductorsACCC Australian Competition and Consumer CommissionACTEW ACT Electricity and WaterAGL The Australian Gaslight CompanyAGSM Australian Graduate School of ManagementAIE Australian Inland EnergyAPT Arbitrage pricing theoryASX Australian Stock ExchangeBCA Business Council of AustraliaCAIDI Customer average interruption duration indexCAIFI Customer average interruption frequency indexCapex Capital expenditureCAPM Capital asset pricing modelCCA Current cost accountingCEGB Central Electricity Generating Board (UK)CIPSE Community Information Project on Sustainable EnergyCode National Electricity CodeCOAG Council of Australian GovernmentsCPI Consumer price indexCPI-X CPI minus a distributor efficiency factorCRI Centre for the Study of Regulated Industries, LondonCRNP Cost reflective network pricing: a cost allocation method which

reflects the value of assets used to provide transmission ordistribution services to network users.

CSO Community service obligation: a government subsidy foractivities undertaken by a government enterprise which would notbe undertaken as a commercial activity or would require higherprices to be commercial

CWWG Contestable Works Working GroupDAC Depreciated actual costDB Distribution businessDEA Data envelopment analysisDeprival value A value ascribed to assets which is the lower of economic value or

optimised depreciated replacement value.Derogation Modification, variation or exemption to one or more provisions of

the Code in relation to a Code Participant according to clause8.4.1(a).

DGM Dividend growth modelDLF Distribution loss factorDNO Distribution network operatorDNSP Distribution network service provider


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DORC/ODRC Depreciated optimised replacement cost: the DORC calculation isbased on the gross replacement cost of modern equivalentnetwork assets, adjusted for overdesign, overcapacity andredundant assets, less an appropriate allowance for depreciation.It measures the minimum cost of replicating the system in themost efficient way possible, given its service requirements and theage of the existing assets.

DSM Demand side managementDUOS Distribution use of systemDUOSC Distribution use of system chargeEAPA Energy Accounts Payments Assistance (Scheme)EBIT Earning before interest and taxEGWG Embedded Generation Working GroupEICG Electricity Industry Consultation GroupEION Energy Industry Ombudsman, NSWEIOV Energy Industry Ombudsman, VictoriaEPD Energy Project Division, VictoriaESI Electricity Supply IndustryETR Effective tax rateEUG Energy Users GroupFDC Fully distributed costs Franking credit gammaGas Code National Third Party Access Code for Natural Gas Pipeline

SystemsGSN Great Southern Energy Gas Networks Pty LtdGTE Government trading enterpriseGWh Gigawatt hour (one GWh=1000 megawatt hours or one million

kilowatt hours)IPART Independent Pricing and Regulatory TribunalIRR Internal rate of returnkWh Kilowatt hour (the standard unit of energy which represents the

consumption of electrical energy at the rate of one kilowatt over aperiod of one hour)

LCAB Licence Compliance Advisory BoardLRAC Long run average costLRMC Long run marginal costMAR Maximum allowable revenueMCWG Miscellaneous Charges Working GroupMFP Multifactor productivityMMC Monopolies and Mergers Commission (UK)MoEU Ministry of Energy and UtilitiesMRP Market risk premium for equityMWh Megawatt hour (one MWh=1000 kilowatt hours)NCOSS NSW Council of Social ServicesNECA National Electrical Contractors Association (NSW)NECA National Elecrticity Code AdministratorNEL National Electricity LawNEM National Electricity MarketNEMMCO National Electricity Market Management Company LtdNPV Net present valueNRV Net realisable valueNSP Network service provider

Glossary of acronyms and terms

xxvii

NUOS Network use of systemODV Optimised deprival valueOECD Organisation for Economic Cooperation and DevelopmentOFFER Office of the Electricity Regulator (UK)OFGAS Office of the Gas Regulator (UK)OFWAT Office of Water Regulator (UK)Opex Operating expenditureORC Optimised replacement costORG Office of the Regulator General, VictoriaP/E Price/earnings ratioPIAC Public Interest Advocacy CentrePJM Pennsylvania/New Jersey/MarylandQCA Queensland Competition AuthorityRAB Regulatory asset baseRAPAS Remote area power assistance schemeRAPS Remote area power systemRECs Regional Electricity Companies(UK)Ring fencing The clear separation of subsidiaries or divisions of a company that

may have competitive advantages in dealing with each other.RPI Retail price indexSAIDI System average interruption duration indexSAIFI System average interruption frequency indexSEDA Sustainable Energy Development AuthoritySLUOS Streetlighting use of systemSOC State Owned Corporations Act, 1989 (NSW)SOCs State owned corporationsSRMC Short run marginal costTFP Total factor productivityTNSP Transmission network service providerTPA Trade Practices ActTPC Trade Practices CommissionTUOS Transmission use of systemUPS Uninterruptible power supplyv Volt (the unit of electric potential or electromotive force)w Watt (a measure of the power present when a current of one

ampere flows under a pressure of one volt)WACC Weighted average cost of capitalWDV Written down value


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Introduction

1

1 INTRODUCTIONOn 16 June 1998, the Premier of New South Wales issued a Special Reference on Electricityto this Tribunal under Section 12A of the Independent Pricing and Regulatory Tribunal Act1992. Under the terms of reference, the Tribunal is to make recommendations for five yearrevenue/price paths for both the NSW transmission system (operated by TransGrid andEnergyAustralia), and the distribution system to be operated by the six government owneddistributors from 1 July 1999. The Tribunal is also to make recommendations on appropriateregulation of the franchise retail market from 1 July 1999. The Tribunal's recommendationsare to be based on the application of the National Electricity Code (the Code) and to haveregard to the matters set out in section 15(1) of the IPART Act. The objectives are to protectthe long term commercial value of the affected businesses for the benefit of the Statestaxpayers, and to protect the long term interests of the customers of those businesses.

The Terms of Reference for this review are reproduced along with the investigationadvertisement in Attachment 1 to this Report.

1.1 Review processTo assist interested parties to prepare submissions for this review, the Tribunal released anissues paper in September 1998. Submissions from TransGrid and the six distributors werereceived at the end of September 1998. Submissions were subsequently invited frominterested parties and the public.

As part of the public consultation process, the Tribunal released seven discussion paperscovering retail price regulation, forms of network regulation, incentive regulation, rollingforward the regulatory asset base, and rates of return. Attachment 2 lists the discussionpapers and submissions received. Consultant studies of capital expenditure, efficiency andbenchmarking, retail competition, and network energy loss incentives, were alsoundertaken as part of the review. Copies of the four studies can be found on the Tribunalswebsite, www.ipart.nsw.gov.au

Public hearings were held on 8 and 9 December 1998 at the Tribunals offices Level 2, 44Market Street, Sydney.

Copies of all public submissions and a transcript of the hearings are available for inspectionat the Tribunals offices, or from the Tribunals website.

As part of the Tribunals commitment to public consultation, an electricity industryconsultation group was established. Membership of this group included representatives ofthe distribution network service providers (DNSPs), the retailers, large customers,consumers and community groups. This group met regularly throughout the review. Apublic forum was held on 9 February 1999 to discuss possible forms of revenue cap for theDNSPs.

In undertaking this review, the Tribunal has worked closely with the AustralianCompetition and Consumer Commission (ACCC) to determine appropriate pricing for NSWtransmission operated by TransGrid and EnergyAustralia.


2

The Tribunal members who conducted this inquiry are:

Dr Thomas Parry, ChairmanMr James Cox, Full-time MemberMs Liza Carver, Member

1.2 Current regulation of electricity pricesSection 11 of the IPART Act requires the Tribunal to conduct investigations and makereports on:

the determination of pricing for a government monopoly service supplied by agovernment agency specified in Schedule 1 of the IPART Act; and

a periodic review of pricing policies in respect of government monopoly servicessupplied by these agencies.

Until December 1998, TransGrid and the distributors were specified in Schedule 1 of theIPART Act. IPART was thus empowered to regulate transmission, distribution, and retailsupply for franchise electricity customers.

The Tribunal's pricing determinations have fixed electricity transmission and distributioncharges for the period to 30 June 19996. A Tribunal determination regulates retail supply to30 June 1999 for customers who do not have a choice of retail supplier.7

As a result of the National Electricity (New South Wales) Act 1997, the National Electricity Law(NEL)8 was applied as a law of New South Wales. TransGrid and the NSW distributorswere deleted from Schedule 1 of the IPART Act. The effect of the NEL is that:

IPART may continue to regulate TransGrid as if it were listed in Schedule 1 of the IPARTAct until 30 June 1999; and

IPART may continue to regulate the NSW distributors as if they were listed in Schedule1 of the IPART Act until 31 December 2000.

1.3 Legislative basis for this review1.3.1 A report under Section 12A of the IPART Act

The Tribunal derives its powers to conduct this review from section 12A of the IPART Act.Section 12A requires the Tribunal to conduct investigations and make reports on any matterwith respect to pricing, industry or competition which is referred to the Tribunal by thePremier.

6 IPART determination nos 5.1, 5.2 and 5.3, 1997.7 IPART determination no 5.3, 1997.8 The National Electricity law is set out in the Schedule to the National Electricity (South Australia) Act 1996.

Introduction

3

A report made under s12A of the IPART Act is not an enforceable determination. However,the findings of a report made under section 12A may be enforced by the subsequentlegislative enactment of some or all of the reports findings or the inclusion of some or all ofthe reports findings in a section 11 or section 12 determination 9.

1.3.2 The National Electricity Code

The terms of reference require the Tribunal to base its report on the application of theNational Electricity Law and the National Electricity Code. The National Electricity Lawwhich gives the Code force of law, established the national wholesale electricity market. TheCode provides for the ACCC to be the regulator of electricity transmission in NSW from1 July 1999.

The Code also names the Tribunal as the jurisdictional regulator for electricity distributionin NSW. The Tribunal will be able to implement a price path for distribution networkservices under the Code from as early as 1 July 1999. Alternatively, a derogation in theCode10 allows the Tribunal to regulate distribution network services in NSW under theIPART Act until 30 December 200011.

To date neither the jurisdictional regulator nor the ACCC has issued a determination underthe Code.

1.3.3 Transmission

Parts B and C of chapter 6 of the Code provide for the ACCC to regulate electricitytransmission networks within NSW from 1 July 1999.

Part B of chapter 6 of the Code establishes the procedure for determining the annualaggregate revenue requirements (AARR) of each transmission network service provider.The ACCC is required to comply with:

the objectives set out in clause 6.2.2

the principles set out in clause 6.2.3

the form and mechanism of regulation as set out in clause 6.2.4.

The revenue cap must be for a regulatory control period of no less than five years12.

The requirements of the Code are outlined in volume 1 chapter 3. The Code requirestransmission use of system charges to be allocated partly using the CRNP methodology setout in part C and the remainder is to be allocated on a postage stamp basis. This section ofthe Code (like part E of chapter 6) has been the subject of an extensive review by theNational Electricity Code Administrator (NECA). NECA released a draft report on itsfindings in March 199913. This report is discussed in volume 2 chapter 3.

9 Section 12 of the IPART Act requires the Tribunal to conduct investigations and make reports to the

Premier on either of the following matters referred to the Tribunal by the Premier: the determination of pricing for a specified government monopoly service; or a periodic review of pricing policies in respect of a specified government monopoly service.

10This derogation is consistent with the NEL, which allows IPART to regulate the six distributors until 30December 2000 as if they were listed in Schedule 1 of the IPART Act.

11 ie by way of a section 11 or section 12 determination.12 National Electricity Code, clause 6.2.4(b).13 Transmission and Distribution Pricing Review, Draft Report, March 1999, NECA.


4

1.3.4 Distribution

Part D and E of chapter 6 of the Code provide for regulation of electricity distributionnetworks. Part D sets out the procedure for determining each distribution networks AARR.As with transmission, the Code does not require a particular methodology but rather thejurisdictional regulator must consider:

the range of financial and other factors set out in clause 6.10.5

the objectives set out in clause 6.10.2

the principles set out in clause 6.10.3

any national guidelines or jurisdictional rules, as provided for by clause 6.10.1.

These requirements are outlined in chapter 3 of volume 1 of this report.

In making a determination under the Code, the Tribunal will have to comply with clause6.10.7, publishing:

full and reasonable details of the basis for its decisions

details of qualitative and quantitative methodologies applied

full reasons for material judgements, options considered, and discretions exercised.

In proposing the recommendations in this report, the Tribunal has endeavoured to complywith the requirements of the Code. Attachment 14 explains how the Tribunals proposalscomply with the Code.

Clause 6.10.1 of the Electricity Code provides for national guidelines to be developed andapplied to distribution service pricing by the various jurisdictional regulators. This clausealso provides for each jurisdictional regulator to formulate guidelines and rules to apply todistribution service pricing within its jurisdiction. See chapter 1 of volume 2 of this report.

1.3.5 Retail supply to franchise customers

The Code does not provide for retail pricing to be regulated. Until December 2000, IPARTwill continue to regulate retail prices under the IPART Act. Beyond 2000, the Tribunal doesnot have any legislative sanction to regulate retail prices. Yet it seems highly likely thatthere will be franchise customers after this date. Importantly the Tribunal recommends thatGovernment ensures that IPART remains the price regulator for customers who do not havea choice of retail supplier. This issue is further discussed in chapter 13 of volume 1.

1.3.6 IPART Act

The terms of reference also requires the Tribunal to comment on the effects of the revenuepath recommendations on the matters listed in section 15(1) of the IPART Act. Attachment15 provides a summary of how the Tribunals proposals comply with section 15(1). TheTribunal must consider the matters listed in section 15(1) of the IPART Act when makingdeterminations and recommendations under the IPART Act. These matters include:

the cost of providing the services concerned

the protection of consumers from abuses of monopoly power

the appropriate rate of return on public sector assets

Introduction

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the need to achieve greater efficiency in the supply of services

the need to maintain ecologically sustainable development

the need to promote competition in the supply of the services concerned

the social impact of the determinations and recommendations

standards of quality, reliability and safety of the services concerned.

The Tribunal may also consider any other matters it considers relevant.

1.3.7 Snowy Mountains Hydro-electric Authority

The terms of reference requires the Tribunal to recommend appropriate pricing of thetransmission assets of the Snowy Mountains Hydro-electric Authority which are notified toIPART by the Treasurer as the assets proposed for transfer to TransGrid under section 14 ofthe Snowy Hydro Corporatisation Act 1997.

This report does not contain recommendations on appropriate revenue paths for SnowyMountains Hydro as:

corporatisation has been deferred

The Tribunal does not have powers to regulate Snowy under the IPART Act

Snowy is not a Code participant.

Prior to the transmission assets being transferred to TransGrid, and if the Government sowishes, the Tribunal will undertake a review and make recommendations.

1.3.8 The Premiers letter

On the 18 June 1999, the Premier wrote to the Tribunal stating:

The recent decline in rates of return offers the Tribunal an opportunity to achieve bothfurther real reductions in the prices to end-users and increases in the value of thebusinesses for the benefit of taxpayers and residents of NSW. This can be achieved byvaluing electricity networks at their optimised depreciated replacement cost (ODRC).

The nature of ownership may be relevant to the Tribunals consideration of the balanceof interests. For publicly owned utilities the beneficiaries of increases in value are theresidents and taxpayers of the state. In this regard I would note that where theGovernment owns distribution networks the National Electricity Code provides that:

The distribution service pricing regulatory regimes must seek to achieve the followingoutcomes:

(g) reasonable recognition of pre-existing policies of governments which areDistribution Network Owners regarding distribution asset values, revenuepaths and prices. (section 6.10.2)

I wish to confirm that in terms of this section of the code the pre-existing policies of thegovernment are reflected in the most recent asset valuations provided by Treasury whichinclude:


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1.

Independently determined ODRC valuations of the physical assets of the NSWdistributors (incorporating revisions to Treasury guidelines as recommendedby the independent consultants); and

2.

Replacement cost valuations of easements prepared by independentconsultants.

Adoption of these values including the replacement cost of easements would result in avery significant increase in asset values in the two largest distributors. Given the currentuncertainty in relation to the regulatory treatment of easements, I would thereforepropose that for this review the ODRC values for distributors should include easementsat actual costs, rather than replacement value. Furthermore, the asset values for ruraldistributors may need to be constrained so as to avoid real increases in network charges.

A copy of the Premiers letter is in Attachment 1 of this report.

1.4 Structure of this reportThis report is published in two volumes:

Volume 1 explains the Tribunals regulatory approach, proposes annual revenuerequirements for TransGrid and the Distribution Network Service Providers, as well asappropriate retail margins for franchise retailers

Volume 2 discusses pricing principles, transmission pricing issues, impacts of the proposedprice path on rural and remote customers, the form of the revenue cap for distribution,embedded generation, capital contributions, street lighting, and miscellaneous charges.

1.5 What happens after this report?The Tribunals current determination regulates transmission, distribution and franchiseretail supply revenues to 30 June 1999. The ACCC issued a draft determination under theCode, covering transmission revenues of TransGrid and EnergyAustralia14. This was to beimplemented from 1 July 1999. However, in June 1999 the NSW Government applied for aCode derogation to delay the implementation of the ACCC determination until 1 February2000. On 30 June 1999, the ACCC approved this derogation. As a result the current IPARTdetermination will be rolled forward but will be administered by the ACCC rather than theTribunal.

Prior to the Tribunal being in a position to issue a determination for DNSPs further work isrequired on:

the form that the distribution revenue cap should take (this is discussed in chapter 5volume 2)

pricing issues under Part E of chapter 6 of the Code (see chapter 2 volume 2)

capital contributions and contestable works (see chapters 10 and 11 volume 2).

14 ACCC, NSW and ACT transmission network revenue caps 1999/00-2003/04, Draft decision, 12 May 1999

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In the interim, the Government has passed a transitional regulation which has altered theexpiry date for the Tribunals current determination from 30 June 1999 to 1 February 2000.In effect, DNSPs and franchise retailers will be able to price tariffs in compliance with theircurrent revenue caps and side constraints.

The Tribunal will issue a new determination covering distribution and franchise retailsupply from 1 February 2000. This determination will be released by the end of 1999.

The Code requires the Tribunal to develop and publish ring fencing guidelines inconsultation with the ACCC and other regulators. Ring fencing is discussed in chapter 14 ofvolume 1 of this report. The Tribunal expects to publish ring fencing guidelines as part ofthe determination, ie by 31 December 1999.

The Code also requires guidelines for distribution pricing to be developed. The Tribunalwill work with the DNSPs, other stakeholders and jurisdictional regulators to develop theseguidelines.

Issues associated with extending retail contestability, including providing the Tribunal withregulatory powers beyond 2000 also require attention. See volume 1, chapter 13. Some ofthese issues require resolution by Government, others can be resolved by the Tribunal. TheTribunal will endeavour to expedite these matters.


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The NSW electricity Industry

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2 THE NSW ELECTRICITY INDUSTRYIn the past five years, with the introduction of generation and retail sales competition, theNSW electricity industry has undergone major structural change. This has involved:

amalgamating the previous 25 distributors into two large metropolitan and four ruraldistribution network service providers and retail supply businesses

separating the transmission and generation functions, and establishing TransGrid

splitting the generation sector into three companies: Pacific Power, Delta Electricity, andMacquarie Generation15.

In parallel with these structural changes, the Government has introduced retail andwholesale competition into the electricity industry. A national electricity market h

princing network supply i

Documents