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TheWinnersandLosersoftheMonopolyGame

HowtheQueenslandGovernmentprofits fromQueensland’sexcessiveelectricityprices

HughGrant,ExecutiveDirector,ResponseAbilityApril2018

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1 ExecutiveSummary

1.1 BackgroundQueensland’s excessive electricity prices are presenting major hardship for residential consumers anddestroyingtheinternationalcompetitivenessofQueenslandbusinesses.

Inrecentyears,theQueenslandcommunityhasbecomeincreasinglyconcernedwiththelevelsofprofitstheQueensland Government is extracting from the Queensland government-owned monopoly electricitynetworks (Energex, Ergon Energy and Powerlink Queensland) and the extent to which those profits aredrivingQueensland’sexcessiveelectricityprices.

In response to pressure from the Queensland community, Queensland’s political parties are proposingvariouspoliciesaimedatreducingtheQueenslandelectricitynetworks’excessivepricesandprofits.

ThispaperprovidesananalysisoftheprofitstheQueenslandGovernmentisextractingfromtheQueenslandnetworksandhowthoseprofitsaredrivingQueensland’sexcessiveelectricityprices,outliningthepolicyandregulatorychangesrequiredtoreducethenetworks’pricesandprofitstoefficientlevels.

1.2 Queensland’sExcessiveElectricityNetworkPricesReview after review, inquiry after inquiry, has consistently concluded that the primary driver ofQueensland’s excessive electricity prices is the excessive prices of Queensland’s monopoly electricitynetworks.

AllofthereviewsandinquirieshaveoutlinedthattheQueenslandnetworks’price increasesoverthepastdecadewereunnecessaryandhaveresultedfromthenetworksexploitingdeficienciesandloopholesinthenational regulatory framework, gaming the national regulator (the Australian Energy Regulator (AER)) tosecurerevenueallowancesofovertwicetheefficientlevels.

Over the past decade, the Queensland networks’ prices and profits have grown at the highest rates inAustralia and the Queensland Government has realised extraordinary profits from the networks’overinvestmentandinefficiencies.

1.3 TheQueenslandNetworks’ExtraordinaryProfitsOver the past five years theQueensland networks achieved annual profitmargins of up to 48%,with anaverage profit margin of 28.3%, equating to around 3-4 times the average profit margins realised bycomparableenergybusinesses.

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1.3.1 ComparisonWithTheQueenslandGovernment-OwnedGenerators’Profits

The Queensland Government’s returns from the government-owned networks contrast sharply with itsreturnsfromthegovernment-ownedgenerators.

Unlike Queensland’s monopoly networks, Queensland’s government-owned generators operate in acompetitive market that (until recently) has punished over-investment and inefficiency. As a result,Queensland’sgovernment-ownedgeneratorsincurredsignificantlossesoverthepastdecade,requiringtheQueenslandGovernmenttoinjectsignificantlevelsofequitytokeepthebusinessessolvent.

Bycontrast,Queensland’sgovernment-ownednetworkshavedeliveredveryhighprofitsineveryyearsincethey were corporatised in the 1990s. Rather than requiring equity injections, successive QueenslandGovernmentshaveactuallywithdrawnequityfromthenetworksandhavefrequentlyextractedincomefromthenetworksabovethenetworks’levelsofincomegeneration.

1.3.2 ComparisonsWithTheReturnsInOtherSectors

TheQueenslandnetworks’highprofitmarginsareresulting in theQueenslandGovernmentrealising long-termfinancialreturns(returnonequity)fromthenetworksofmanymultiplesofthereturnsbeingachievedinallothersectorsoftheAustralianeconomy.

For example, over the 15-year period to 2014, the Queensland Government’s returns from PowerlinkQueenslandamountedto:

§ 23timesthereturnsachievedbytheAustralianconstructionsector(LendLease)

§ 15.5timesthereturnsachievedbytheAustraliantelecommunicationssector(Telstra)

§ 10.5timesthereturnsachievedbytheAustralianmineralsandresourcessector(BHP)

§ 10timesthereturnsachievedbytheAustralianbankingsector(NAB)

§ 3.6timesthereturnsachievedbyAustralia’smostprofitablesupermarket(Woolworths)

NoASX100stockcameclosetoPowerlink’sreturns

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Basedonallof theavailable information, theprofitability levelsbeing realisedbyQueensland’smonopolyelectricitynetworksarethehighestofanyelectricitynetworksintheworld.

Importantly, thosereturnsarebeingrealiseddespiteQueensland’selectricitynetworksbeingamongst themostinefficientnetworksinAustralia:

§ PowerlinkQueenslandisthemostinefficienttransmissionnetworkinAustralia

§ ErgonEnergyisthesecondleastefficientdistributionnetworkinAustralia

1.4 The Queensland Government’s Unsustainable Income ExtractionsFromTheElectricityNetworks

TheQueenslandGovernmentextractsthreesourcesofincomefromtheQueenslandelectricitynetworks:

§ Dividendpayments–theQueenslandnetworkspaydividendstotheQueenslandGovernment§ Tax equivalent payments – the networks are corporatised and pay “tax equivalent” payments to the

Queenslandgovernmentatthecommonwealthcorporatetaxrate

§ Competitive neutrality fees – the networks source their debt from the Queensland Government atinterest rates below market rates. The Queensland Government charges the networks competitiveneutrality fees to reflect the difference between the interest rates charged by the government andmarketinterestrates

Despite the Queensland networks extraordinary profits, in every year over the past three years theQueenslandGovernmentextractedmoreincomefromthenetworksthanthenetworkscreated.

Overall,overthepastthreeyearstheQueenslandGovernmentextractedatotal incomeof$9billionfromtheQueenslandnetworks,equatingto167%ofthenetworks’totalprofitsovertheperiod.

Importantly, in2014/15theQueenslandGovernment’s total incomeextractionsamountedto270%of thenetworks’ profits (617% of Powerlink Queensland’s profits, 230% of Ergon Energy’s profits and 214% ofEnergex’sprofits).

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1.5 TheQueenslandGovernment’sProfitsFromTheNetworks’ChargesOverthepastthreeyears,foreverydollarQueenslandconsumerspaidinnetworkcharges,theQueenslandGovernmentcollected47centsinprofits–i.e.theQueenslandGovernmentcollecteda47%profitmarginfromtheQueenslandnetworks.

Asillustratedinthechartsoverleaf,thismeansthat:

§ For a Queensland household electricity bill with network charges of $1,000, the QueenslandGovernment’sprofitsfromthenetworksamountedto$470

§ For a Queensland small business bill with network charges of $2,000, the Queensland Government’sprofitsfromthenetworksamountedto$940

§ Fora largebusinessuserbillwithnetworkchargesof$200,000, theQueenslandGovernment’sprofitsfromthenetworksamountedto$94,000

1.6 The Transfer To National Network Regulation Has Been ACatastrophicFailure

The decision to transfer responsibility for theQueensland electricity networks’ revenue regulation to thenationalregulatoryframeworkin2006wasbasedonpromisesthatitwoulddelivermoreefficientpricesandimprovethenetworks’productivitylevels.

However, rather than delivering those promised improvements, national regulation of the Queenslandnetworks’revenueshasbeenacatastrophicfailure,resultingin:

§ AmorethandoublingoftheQueenslandnetworks’prices

§ The Queensland networks achieving extraordinary profits of many multiples of the returns beingachievedbyASX100companiesinallotherindustrysectors

§ Extraordinarylevelsofoverinvestmentandgoldplating–resultingintheQueenslandnetworks’capitalproductivitylevelsbeingthelowestinAustralia

§ Extraordinary increases in the networks’ operational costs - resulting in the Queensland networks’operationalefficiencylevelsbeingthelowestinAustralia

Althoughthedeficiencies inthenationalregulatoryframeworkapplytobothpubliclyandprivatelyownednetworks,thestategovernmentownednetworkshaveexploitedthedeficienciesandloopholestoamuchhigherdegreethantheprivatelyownednetworks.

Inessence,thenationalregulatoryframeworkwasdesignedforprivateownershipandhasbeenunabletopreventgovernmentownednetworks(withtheiraccesstolow-costfinance)fromexploitingtheincentivesforoverinvestmentandgoldplating,andprofitingfromtheirinefficiencies.

As a result, the state government ownednetworks’ prices are over twice the efficient level,whereas theprivatelyownednetworks’pricesaretypicallyaround30-40%aboveefficientlevels.

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1.7 TheQueenslandNetworks’GamingOfTheNationalRegulatorThe Queensland networks have systemically exploited various deficiencies and loopholes in the nationalregulatory framework, securing revenue allowances from the national regulator (the AER) over twice theefficientlevels:

ProfitingFromOver-InvestmentandGoldPlating

TheQueenslandnetworksreceiveguaranteedreturnsontheirregulatoryvaluations–theirregulatoryassetbases(RABs).Thosereturnsdrivethemajorityofthenetworks’revenuesandprices.

Prior to transferring to national regulation, the regulatory rules required the regulator to optimise thenetworks’ RAB valuations to reflect the efficient value of assets needed to provide the required services.Thatmeant that if the networks invested inmore capacity than required, the regulator was required toexclude thevalueof theexcesscapacity fromthenetworks’RABs, therebyensuring thatconsumerswerenotrequiredtofundexcesscapacityorinefficientinvestments.

However,whenthenetworkstransferredtonationalregulationin2006,theQueenslandGovernment(andotherstategovernments)insistedthatmajorchangesweremadetotheregulatoryrulestopreventtheregulatorfromoptimisingthenetworks’RABsandtoensurethatthenetworksreceivedguaranteedreturnsonallinvestmentsirrespectiveoftheirprudencyorefficiency.

Theremovaloftheregulator’sRABoptimisationpowerscontrastssharplywiththeregulatoryrulesinotherjurisdictions in Australia and overseas. For example, the regulatory rules that apply to Australia’s gasnetworksandtotheWesternAustralianelectricitynetworkshavealwaysrequiredtheregulatortooptimisethenetworks’RABs.

Aspredictedbynumerousstakeholders,theremovalofRABoptimisationfromtheNationalElectricityRulesincentivised extraordinary levels of over-investment by the networks, particularly by the Queenslandgovernment-ownednetworksduetotheirlowerborrowingcostsandtheadditionalpecuniarybenefitstheQueenslandGovernmentrealisesfromthenetworks’over-investment.

The Queensland networks’ levels of overinvestment were the highest in Australia and the QueenslandGovernment is continuing to profit substantially from that over-investment, as the networks continue toreceiveguaranteedreturnsonunder-utilisedandredundantassets.

ProfitingFromOperationalInefficiencies

TheQueenslandnetworksareamongsttheleastefficientnetworksintheNationalElectricityMarket(NEM).

§ PowerlinkQueenslandisthemostinefficienttransmissionnetworkintheNEM

§ ErgonEnergyisthesecondleastefficientdistributionnetworkintheNEM

TheQueenslandnetworkshavemanaged toprevent theAER fromproperly applyingbenchmarkingwhensetting their opex allowances, resulting in the AER setting their opex allowances on the basis of theirhistoricalcosts,ratherthanefficientcosts.

Asaresult,theQueenslandnetworks’totalopexallowancesovertheircurrent5-yearregulatoryperiodsare$2.25billion($450millionperannum)abovetheefficientlevel.

ProfitingFromGamingTheAER’sIncentiveSchemes

TheQueenslandnetworkshaverealisedmajorwindfallprofitsfromgamingtheAER’sincentiveschemes,bytaking advantage of information asymmetries and negotiating incentive scheme targets well above theefficientlevels.

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1.8 SuccessiveQueenslandGovernmentsHaveEnabledTheQueenslandNetworksToExploitTheNationalRegulatoryFramework

Since transferring to national regulation, theQueensland networks’ prices and profits have grown at thehighestratesinAustralia.

Successive Queensland Governments have consistently deflected the blame for the networks’ priceincreasestothe“independentnationalregulator”-i.e.theyhaveconvenientlyblamedtheAustralianEnergyregulator(AER)forthenetworks’priceincreases.

However,thenationalregulatoryframeworkandtheAER’sregulatorypowersareactuallycontrolledbythestateandterritorygovernmentsthroughtheCOAGEnergyCouncil.

ThetruthisthatsuccessiveQueenslandGovernmentshavedemonstrablyfailedtobalancetheirconflictingrolesofnetworkownerandregulatoryrulemaker.Theaddictiontothenetworks’extraordinaryprofitshasseverelycompromisedtheQueenslandGovernment’sapproachtonetworkregulationformanyyears.

SuccessiveQueenslandGovernmentshaveconsistentlychosenshort-termprofitsovereffectiveregulation,by:

§ Constraining the AER’s powers and ensuring that the regulatory rules have a strong bias towards thenetworks’financialinterestsattheexpenseofconsumers’interests;whilst

§ Ignoring the consequences of inflicting excessive prices on the Queensland community and theQueenslandeconomy

It is therefore not surprising that the Western Australian electricity network (Western Power) was soenthusiastic regarding recent proposals to transfer its revenue regulation to the national regulatoryframework, as the Western Australian regulator (the ERA) has much stronger powers than the nationalregulator(theAER).

ThispaperoutlineshowtheQueenslandGovernmenthasbeenthemostproactivestategovernmentoverthe past decade in constraining the AER’s powers and ensuring the retention of the deficiencies andloopholesintheregulatoryframeworkthatenabletheQueenslandnetworkstorealiseextraordinaryprofitsfromtheiroverinvestmentandinefficiencies.

Itexposes thehypocrisyof claimsby successiveQueenslandGovernments regarding their commitment toensuringefficientand fair electricityprices forQueenslandconsumers,providingexamplesofQueenslandGovernmentdecisionsoverthepastdecadethatdemonstratethathypocrisy,e.g.:

§ Supporting the 2006 rule changes that removed the requirement for the regulator to optimise thenetworks’regulatoryassetbases(RABs).Aspredictedbynumerousstakeholdersatthetime,thoserulechanges resulted in extraordinary levels of overinvestment and consequential price and profitabilityincreasesbytheQueenslandnetworks

§ Increasing theQueenslandreliability standards in2005withnoconsiderationof theprice increases toQueensland consumers and no consideration of the value that Queensland consumers place onreliability

§ AllowingtheQueenslandnetworkstosystemicallyuseoverblownloadforecaststogametheregulator(theAER)toprovidecapexallowanceswellinexcessoftherequiredlevels

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§ Supporting Ergon Energy’s legal challenge to theAER’s benchmarking process – a legal challenge thatresultedinNSWandACTconsumerspaying$3billionabovetheAER’srevenuedeterminationsandthatwillfurtherraiseQueensland’snetworks’prices.

§ Strongly resisting the abolition of the Limited Merits Review (LMR) process – the one-sided appealprocessthatenablesthenetworkstocontesttheAER’srevenuedeterminations.Since2008,Australianelectricity networks’ appeals through the LMR process have resulted in over $12 billion in additionalrevenuebeingpassedontoAustralianconsumers

1.9 AssessmentOfEfficientPricesForTheQueenslandNetworksThispaperprovidesdetailedestimatesofefficientrevenuesandpricesforeachQueenslandnetwork,basedon the conclusions of various independent analysts – i.e. revenues that reflect reasonable returns onefficientinvestmentsandtherecoveryofefficientcosts.

It demonstrates that the Queensland networks’ current revenues and prices are over twice the efficientlevels.

1.10 PotentialPriceReductionsFromTheQueenslandPolitical Parties’Policies

In response to pressure from the Queensland community, Queensland’s political parties are currentlyproposing various policies aimed at reducing the Queensland networks’ prices and profits. This paperprovides an assessment of those policies and the extent to which they would drive the Queenslandnetworks’pricestowardsefficientlevels.

The chart overleaf illustrates that the Queensland political parties’ proposed policies would potentiallydelivernetworkpricereductionsofupto60%.

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1.11 BusinessAsUsualisUnsustainableIt is clear fromthevariouspoliciesproposedbyQueensland’spoliticalparties that there isbroadpoliticalawarenessthatbusinessasusualisunsustainable.

TheQueenslandnetworks’excessivepricesareinflictingmajordamageontheQueenslandcommunityandtheQueenslandeconomy.

ThispaperdemonstratesthattheQueenslandnetworks’excessivepricesaredrivinganindustrydeathspiralthatwillultimatelybemuchmoredestructivetothevalueandfutureviabilityofQueensland’sgovernment-ownedenergycompaniesthantheshort-termimpactsofimplementingmoresustainableprices.

It demonstrates the irresponsibility of continuing to allow Queensland’s state budget to be so heavilydependentupontheextractionofunsustainableprofitsfromQueensland’smonopolyelectricitynetworks.

TheQueenslandcommunity isbecoming increasinglyawareof the real reason forQueensland’sexcessiveelectricitypricesandisbecomingincreasinglyvocalinlettingQueensland’spoliticalleadersknowthattheywillnolongerbeplayedasfools.

The new delicately balanced Queensland parliament provides an opportunity for the new QueenslandGovernmenttoseriouslyaddressthekeydriverofQueensland’sexcessiveelectricitypricesandreducetheQueensland state budget’s dependence on unsustainable profits from Queensland’s monopoly electricitynetworks.

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1.12 Recommendations

Recommendation1. SetTheQueenslandNetworks’PricesAtEfficientLevels

AsowneroftheQueenslandnetworks,theQueenslandgovernmenthasahighdegreeofcontrolovertheirprices.

RatherthancontinuingtoenabletheQueenslandnetworkstogamethenationalregulatorandchargepricesovertwicetheefficientlevels,theQueenslandGovernmentneedstoexercisethatcontrolandensurethatthenetworks’pricesaresetatefficientlevels.

TheAustralianEnergyRegulator(AER)setsalimitonthemaximumrevenuestheQueenslandnetworksareallowed to collect from their customers. The networks have complete autonomy regarding the actualrevenuetheycollect,aslongastheirtotalrevenuedoesnotexceedtheirmaximumrevenuecaps.

Decisionstocollectrevenuesbelowthenetworks’maximumrevenuecapsarenotunusualandhavebeenmadebyvariousnetworkowners(includingpreviousQueenslandgovernments)inrecentyears.

For example, the NSW government recently directed Essential Energy (the NSW government-owneddistributionnetwork)toset itspricesat34%belowthe levelthatEssentialEnergymanagedtogamefromthenationalregulatoryframework.

Importantly, this paper outlines that the NSW government made that direction in response to the NSWcommunity’soutragefollowingtheleakingofadocumentthatconfirmedthatEssentialEnergyhadcynicallyexploiteditsconsumers,theregulatorandtheAustralianlegalsysteminitspursuitofexcessiveprofits.

TheQueenslandcommunity isbecoming increasinglyawareof the real reason forQueensland’sexcessiveelectricitypricesandincreasinglyvocalinlettingQueensland’spoliticalleadersknowthattheywillnolongerbeplayedasfools.

The new delicately balanced Queensland parliament provides an opportunity for the new QueenslandGovernmenttoseriouslyaddressthekeydriverofQueensland’sexcessiveelectricitypricesandreducethestatebudget’sdependenceonunsustainableprofitsfromQueensland’smonopolyelectricitynetworks.

Importantly,settingtheQueenslandnetworks’revenuesatlevelsbelowtheirmaximumrevenuecapscanbeimplementedimmediatelyanddoesnotrequireanychangestothenationalregulatoryframework.

Criticsofcalls toset theQueenslandnetworks’pricesatefficient levels tendtomakeshort-sightedclaimsregardingtheimpactontheQueenslandstatebudget.Suchresponsesreflectaverynarrowandshort-termviewoftheissuesandignorethemajordamagethatQueensland’sexcessiveelectricitypricesareinflictingontheQueenslandcommunityandthestateeconomy.

SettingQueensland’selectricitypricesatefficientlevelswill:

§ Minimisefurtherhardshipforresidentialconsumers

§ RestoretheinternationalcompetitivenessandviabilityofQueenslandindustry

§ Improvethelong-termviabilityoftheQueenslandelectricitysupplychain

§ Protect the Queensland Government owned energy companies from the value destruction that willinevitablyarisefromthecontinuationofthenetworkdeathspiral

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Recommendation2. Revert ToQueenslandGovernment Controlled Regulation For TheQueenslandNetworks

AscurrentlybeingproposedbysomeQueenslandpoliticalparties, thereisaneedtoreverttoQueenslandGovernmentcontrolledrevenueregulationfortheQueenslandnetworks-asappliedpriorto2006,andascurrentlyappliestostate–ownedelectricitynetworks incomparablefederalcountries includingtheUnitedStates,CanadaandGermany.

AlthoughQueenslandGovernmentcontrollednetworkrevenueregulationwillnotbeimmunefrompoliticalinterference,thepracticalrealityisthatprovidingsinglepointaccountabilitytotheQueenslandGovernmentforthenetworks’pricesandprofitsismuchmorelikelytodeliverefficientnetworkpricesthancontinuingtoplace false hope that future state governments will progress the numerous long-overdue reforms to thedeeplyflawednationalregulatoryframework.

Queensland controlled regulation should be designed to avoid the deficiencies in the existing nationalregulatoryframeworkoutlinedwithinthisreport.

Recommendation3. ImplementFiscalControlsThatRestrictTheQueensland Government’sIncomeExtractionstoSustainableLevelsTheQueenslandGovernmentisextractingincomefromtheQueenslandnetworksatunsustainablelevels.

There is a need for stronger fiscal controls that make it more difficult for Queensland Governments toextractunsustainablelevelsofincomefromtheQueenslandnetworks.

Furthermore, the Queensland Government should cease the practice of extracting competitive neutralityfeesfromthenetworks.ThispaperdemonstratesthattheQueenslandGovernment’srationaleforextractingcompetitiveneutralityfeesfromthenetworksisbasedonaflawedapplicationoftheCompetitionPrinciplesAgreement (CPA) and that it serves no purpose, imposing unnecessary costs on Queensland consumerswhilstdeliveringnobenefits.

Recommendation4.ImplementStrengthenedOversightOfTheQueenslandNetworks

SuccessiveQueenslandGovernmentshavehada“hands-off’approachtothegovernanceoftheQueenslandgovernmentownednetworks, enabling thenetworks to exploit loopholes anddeficiencies in the nationalregulatoryframework,pursuingoutcomesthatarenotinQueenslandconsumers’long-terminterests.

TheQueenslandGovernmentneedstoimplementimprovedgovernancearrangementsfortheQueenslandnetworks toensure that theybetter reflect theQueenslandcommunities’ long-term interests.This shouldinclude:

§ Preventingthenetworksfromcollectingwindfallprofitsfromover-forecastingtheirneeds

§ MuchstrongeroversightoftheQueenslandnetworks’advocacyandlobbyingactivities–ensuringthattheyceaseopposingordelayingreformsaimedatimprovingtheirperformanceandproductivity

§ IncreasedscrutinyandtransparencyoftheQueenslandnetworks’performance

§ Settingandoverseeingcapitalandoperationalefficiency improvementprograms,withtheobjectiveofimproving the Queensland networks’ productivity from bottom-quartile to top-quartile performancewithintheshortestpossibletimeframe

§ Segregatedfinancialreportingofthenetworks’regulatedandnon-regulatedbusinessactivities

§ ImprovedtransparencyofthedirectionsbeingprovidedtotheQueenslandnetworksbytheQueenslandEnergyMinisterandQueenslandTreasury

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2 BackgroundAndPurpose

2.1 BackgroundInrecentyears,theQueenslandcommunityhasbecomeincreasinglyconcernedwiththelevelsofprofitstheQueensland government is extracting from the Queensland government-owned monopoly electricitynetworks (Energex, Ergon Energy and Powerlink Queensland) and the extent to which those profits aredrivingQueensland’sexcessiveelectricityprices.

In response to pressure from the Queensland community, Queensland’s political parties are proposingvarious policies aimed at reducing the Queensland electricity networks’ excessive prices and profits,including:

§ TheQueenslandGovernment isproposing toprovidea$50electricityownershipdividendpayment foreachQueenslandhousehold

§ The Queensland Liberal National Party (LNP) is proposing to write down the Queensland networks’regulatory asset bases (RABs) and has publicly supported the findings and recommendations of therecentGrattanInstitutestudy,whichoutlinedtheneedforRABwrite-downsofupto38%.1

§ The One Nation Party has proposed to reduce Queensland’s electricity prices by 20%, by ceasingdividendpaymentsfromtheQueenslandenergycompaniestotheQueenslandGovernment

§ The Katter’s Australian Party has proposed to revert the networks’ pricing to “recovery only” and toabolish the application of the depreciated optimised replacement cost (DORC) asset valuationmethodology (the methodology used to determine the networks’ regulatory valuations (RABs) and‘returnoncapital’allowances

§ TheQueenslandGreensPartyhasproposedtorevertthenetworksbacktonon-profitpublicauthorities,therebyremovingthenetworks’profitsfromQueenslanders’electricitybills

In addition, the Katter’s Australian Party and the Queensland Greens have proposed to deliver furthersignificant price reductions by moving from the deeply flawed national regulation to QueenslandGovernment controlled regulation, bringing back the responsibility for setting the Queensland networks’revenuestotheQueenslandGovernment.

2.2 ReportPurposeThispaperprovidesananalysisoftheprofitstheQueenslandGovernmentisextractingfromtheQueenslandnetworksandhowthoseprofitsaredrivingQueensland’sexcessiveelectricityprices.

ItoutlinesthepolicyandregulatoryimplicationsofthefindingsandprovidesrecommendationsonthepolicyandregulatorychangesrequiredtoreducetheQueenslandnetworks’pricestoefficientlevels.

1Downtothewire:AsustainableelectricitynetworkforAustralia,TechnicalSupplement,GrattanInstitute,March2018TheGrattanInstitutecalculatedarangeofRABwritedownsfortheQueenslandelectricitynetworksbasedonvariousassumptions–identifyingrequiredRABwrite-downsoffupto$2.5bn(38%)forPowerlinkQueensland,$3.9bn(33%)forEnergexand$2.8bn(26.3%)forErgonEnergy

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3 Queensland’sExcessiveElectricityPricesThe National Electricity Market (NEM) is failing to deliver efficient Queensland electricity prices due tovariousmarketandregulatoryfailures.

Queensland’s excessive electricity prices are presenting major hardship for residential consumers anddestroyingtheinternationalcompetitivenessofQueenslandbusinesses.

3.1 RecentTrendsInQueensland’sElectricityPricesThechartbelowillustratesrecenttrendsinthebreakdownofQueensland’selectricityprices.2

Figure1AverageQueenslandAnnualTariff11CostBreakdown(c/kWh)

Theabovechartillustratesthat:

§ Queensland’selectricitypricesdoubledfrom2007/08to2013/14

§ Thepricerisesoverthepastdecadehavebeenpredominantlydrivenbyincreasesinnetworkcharges,whichincreasedsix-foldfrom2004/05to2014/15,accountingforover95%ofthetotalelectricitypriceincreasesduringtheperiod

§ As a result, network charges now account for over half ofQueensland’s electricity prices,whereas in2004/05theyaccountedforaround20%

§ Bycontrast,generationandretailcostsremainedrelativelystableovertheperiod

2QueenslandProductivityCommission,ElectricityPricingIssuesPaper,October2015,Page8

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3.2 Queensland’sExcessiveNetworkPricesItiswellunderstoodthatthekeydriverofQueensland’sexcessiveelectricitypricesistheexcessivepricesofQueensland’smonopolyelectricitynetworks(Energex,ErgonEnergyandPowerlinkQueensland).

Reviewafter review, inquiryafter inquiry,hasconsistently concluded that themajorityof theQueenslandnetworks’ price increases over the past decade were unnecessary and are the result of the Queenslandnetworks exploiting deficiencies and loopholes in the National Electricity Market (NEM) regulatoryframework, gaming the national regulator (the Australian Energy Regulator (AER)) to secure revenueallowanceswellabovetheefficientlevels.3

Importantly,allofthereviewsandinquirieshaveoutlinedthattheQueenslandnetworks’pricesandprofitshave grown at the highest rates in Australia, with their owner (the Queensland Government) realisingextraordinaryprofitsfromthenetworks’overinvestmentandinefficiencies.

For example, the charts overleaf, from the current ACCC review into the drivers of Australia’s electricityprices,highlightthat increases innetworkpriceswasthedominantdriverofQueensland’selectricitypriceincreasesoverthepastdecade,andthattheincreasesintheQueenslandnetworks’priceswerethehighestinAustralia.4

TheACCCreviewalsooutlinedthatQueenslandnetworkchargesarethehighestinAustralia.5

3Forexample:ACCCRetailElectricityPricingInquiry:PreliminaryReport,16October2017AssetsorLiabilities?TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay2016SenateInquiryIntoThePerformanceandManagementofElectricityNetworkCompanies,June2015Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018VictorianElectricityDistributionBusinessesSubmissiontotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:,18thDecember2014QueenslandGovernmentIndependentReviewPanel(IRP)onNetworkCosts,FinalReport,2013ElectricityNetworkRegulatoryFrameworks:ProductivityCommissionInquiryReport,9April2013SenateSelectCommitteeonElectricityPrices:ReducingEnergyBillsandImprovingEfficiencyWrite-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandargument,CME,April2015AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,EUAA,2012Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors,EUAA,2011Shocktothesystem:Dealingwithfallingelectricitydemand,GrattanInstitute,December2013Puttingthecustomerbackinfront:Howtomakeelectricitycheaper.GrattanInstitute,December2012TheGarnautClimateChangeReviewUpdate,Paper8:TransformingtheElectricitySector,2011TheEnergyMarketDeathSpiral-RethinkingCustomerHardship,PaulSimshauserandTimNelson,2012AMPSubmissiontotheProductivityCommission-TheCapitalEfficiencyofAustralianElectricityDistributors,ResultsofaBenchmarkingStudy,November2012UtilitiesPolicy:IndependentRegulationofGovernment–OwnedMonopolies:AnOxymoron?,December20144ACCCRetailElectricityPricingInquiry:PreliminaryReport,16October2017,Page62AERBenchmarkingReportsandAERStateOfTheEnergyMarket2017Report5ACCCRetailElectricityPricingInquiry:PreliminaryReport,16October2017

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4 TheQueenslandNetworks’ExtraordinaryProfits4.1 TheQueenslandNetworks’AnnualProfitMarginsOverthepastfiveyearstheQueenslandnetworkshaveachievedannualpre-taxprofitmarginsofupto48%,withanoverallaverageannualpre-taxprofitmarginof28.3%.6

Thenetworks’averageannualprofitmarginequatestoaround3-4timestheaverageannualprofitmarginsbeingrealisedbycomparableenergybusinesses,includingtheQueenslandgovernmentownedgenerators.

Forexample,as illustrated in thechartbelow,over thepast fiveyears theDUETGroup (ownerofvariousAustralianelectricityandgasnetworks)achievedanaveragepre-taxprofitmarginof6.7%-i.e.lessthanonequarteroftheaverageprofitmarginsrealisedbytheQueenslandelectricitynetworks.7

The Queensland Government’s returns from the government-owned networks contrast sharply with itsreturnsfromthegovernment-ownedgenerators.

For example, an analysis of the profit margins being achieved by the Queensland government-ownedgenerator,CSEnergy,overthepastfiveyears,identifiesthat:8

§ CSEnergymadelossesinthreeoutofthepastfiveyears

§ CSEnergy’saveragepre-taxprofitmarginamountedto10.8%

Unlike Queensland’s monopoly networks, Queensland’s government owned generators operate in acompetitivemarketthat(untilrecently)haspunishedCSEnergyforover-investmentandinefficiency.

Consequently,Queensland’sgovernment-ownedgeneratorsincurredsignificantlossesoverthepastdecade(e.g. CS Energy’s accumulated losses in 2017 amounted to $566 million), requiring the QueenslandGovernmenttoinjectsignificantlevelsofequitytokeepthebusinesssolvent.

By contrast, as outlined in Appendix 1 of this report, theQueensland networks have delivered very highprofits in every year since they were corporatised in the 1990s. Rather than requiring equity injections,successiveQueenslandgovernmentshaveactuallywithdrawnequityfromthenetworksandhavefrequentlyextractedincomefromthenetworksabovethenetworks’levelsofincomegeneration.6QueenslandElectricityNetworks’AnnualFinancialReports7DUETGroupAnnualReports8CSEnergyAnnualReports

0%

5%

10%

15%

20%

25%

30%

QueenslandNetworks CSEnergy DUETGroup

AverageAnnualPro-itMarginsOverThePast5Years

18

*EnergexandErgonEnergyweremergedtoformEnergyQueenslandin2016(2015figurescombinedforconsistency)

0500,000

1,000,0001,500,0002,000,0002,500,0003,000,0003,500,0004,000,000

2014/15 2015/16 2016/17 2015-17Total

PowerlinkQueenslandPreTaxProQit Expenses

02,000,0004,000,0006,000,0008,000,00010,000,00012,000,00014,000,00016,000,00018,000,000

2014/15 2015/16 2016/17 2015-17Total

EnergexandErgonEnergy*PreTaxProQit Expenses

0

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15,000,000

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QueenslandNetworksTotalsPreTaxProQit Expenses

19

4.2 ComparisonWithTheReturnsInOtherSectorsAppendix1ofthisreportprovidesadetailed15-yearanalysisoftheactualfinancialreturnsbeingrealisedbytheQueenslandmonopolynetworks,comparedtothereturnsrealisedinothersectors.

It outlines that the Queensland government is realising returns (return on equity) from the Queenslandnetworksofmanymultiplesofthereturnsbeingachievedbyblue-chipcompaniesinallothersectorsoftheAustralianeconomy.

Forexample,theQueenslandGovernment’sreturnsfromPowerlinkQueenslandamountedto:9






NoASX100stockcameclosetoPowerlink’sreturns

Note–theabovechartactuallyunderstatestheQueenslandgovernment’sreturnsfromPowerlink,asitonlyincludesdividend income and does not include the other pecuniary benefits extracted by the Queensland Government -i.e.taxpaymentsandcompetitiveneutralityfees

9AssetsorLiabilities?TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay2016

0

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20

Basedonallof theavailable information, theprofitability levelsbeing realisedbyQueensland’selectricitynetworksarethehighestofanyelectricitynetworksintheworld.

Importantly, thosereturnsarebeingrealiseddespiteQueensland’selectricitynetworksbeingamongst themostinefficientnetworksinAustralia:

§ PowerlinkQueenslandisthemostinefficienttransmissionnetworkinAustralia10§ ErgonEnergyisthesecondleastefficientdistributionnetworksinAustralia11

ClearlytheQueenslandnetworks’profitsaregrosslyexcessiveandarenot inQueenslandconsumers’long-terminterest.

10Powerlink’MultilateralTotalFactorProductivity(MTFP)is5thoutofthe5NEMtransmissionnetworks-seeAER2017TransmissionBenchmarkingReport,3December201711ErgonEnergy’sMultilateralTotalFactorProductivity(MTFP)is12thoutofthe13NEMdistributionnetworks–seeAER2017DistributionBenchmarkingReport,3December2017

21

5 TheQueenslandGovernment’sIncomeFromTheNetworksThechartsbelowhighlighttheQueenslandnetworks’annualrevenuesandprofits;andtheincomeextractedfromthenetworksbytheQueenslandGovernmentoverthepastthreefinancialyears.


0

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2015 2016 2017 2015-17Total

PowerlinkQueensland

Revenue ProQits QueenslandGovernmentIncomeExtractions

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EnergexandErgonEnergy*


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QueenslandNetworksTotals


22

5.1 TheQueenslandGovernment’sUnsustainableIncomeExtractionsFromTheElectricityNetworks

TheQueenslandgovernmentextractsthreesourcesofincomefromtheQueenslandelectricitynetworks:

§ Dividendpayments–theQueenslandnetworkspaydividendstotheQueenslandGovernment

§ Tax equivalent payments – the networks are corporatised and pay “tax equivalent” payments to theQueenslandgovernmentatthecommonwealthcorporatetaxrate

§ Competitive neutrality fees – the networks source their debt from the Queensland government atinterest rates below market rates. The Queensland Government charges the networks competitiveneutrality fees to reflect the difference between the interest rates charged by the government andmarketinterestrates12

ThechartsoverleafprovideabreakdownoftheincometheQueenslandGovernmentextractedfromtheQueenslandelectricitynetworksfromtheabovesourcesoverthepastthreeyears.13

5.2 IncomeExtractionsAsAProportionOfTheNetworks’RevenuesAs illustrated intheabovecharts,overthepastthreeyearstheQueenslandGovernmentextractedatotalincomeof$9billionfromtheQueenslandnetworks.Thisequates toanaverageof47%of thenetworks’totalrevenueof$19billionoverthethree-yearperiod.

Thehighestannualincomeextractionsoccurredinthe2014/15financialyear,withextractionsequatingto:

§ 139%ofPowerlinkQueensland’srevenue

§ 87%ofErgonEnergy’srevenue

§ 61%ofEnergex’srevenue

5.3 IncomeExtractionsAsAProportionOfTheNetworks’ProfitsDespite the Queensland networks’ extraordinary profits, in every year over the past three years theQueenslandGovernmentextractedmoreincomefromthenetworksthanthenetworkscreated.

As outlined in the charts overleaf, theQueenslandGovernment’s income extractions over the past threeyearsamountedto167%ofthenetworks’pre-taxprofits.

Importantly,in2014/15,theQueenslandgovernment’sincomeextractionsamountedto:

§ 617%ofPowerlinkQueensland’spre-taxprofits

§ 230%ofErgonEnergy’spre-taxprofits

§ 214%ofEnergex’spre-taxprofits12AsoutlinedinChapter10ofthisreporttheQueenslandGovernment’srationaleforchargingcompetitiveneutralityfeestothemonopolynetworksisbasedonaflawedapplicationoftheCompetitionPrinciplesAgreement(CPA).ItservesnopurposeandsimplyimposesanunnecessarycostonQueenslandconsumerswhilstdeliveringnobenefits13AlldatawassourcedfromtheQueenslandNetworks’AnnualFinancialReportsandQueenslandGovernmentBudgetOutlookPapers.WheretheQueenslandBudgetOutlookfiguresdonotalignwiththenetworks’annualreportfigures,thenetworks’annualreportfigureshavebeenusedEnergexandErgonEnergyweremergedtoformEnergyQueenslandin2016(2015figureshavebeencombinedforconsistency)

23


0

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QldGovtIncome

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PowerlinkQueenslandProQits Dividends TaxPayments CompetitiveNeutralityFees

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EnergexandErgonEnergy*ProQits Dividends TaxPayments CompetitiveNeutralityFees

24

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TotalQldGovtIncome

QueenslandNetworksTotalsProQits Dividends TaxPayments CompetitiveNeutralityFees

25

6 The Impact Of The Queensland Government’s ProfitExtractionsOnQueenslanders’ElectricityBills

6.1 TheNetworkBusinesses’RegulatedAndNonRegulatedProfitsThe Queensland Government’s profit extractions are ultimately recovered by the network businessesthroughtheirprices.

The majority of the network businesses’ revenues are derived from the provision of regulated networkservices – i.e. revenue that is recovered from Queensland consumers as “network charges” within theirelectricitybills.

Theremainderofthenetworkbusinesses’revenuesisderivedfromtheprovisionofnon-regulatedservices.14

As the Queensland networks do not provide segregated accounts for their regulated and non-regulatedactivities, it isnotpossibletopreciselydeterminetheproportionsoftheQueenslandGovernment’sprofitsthatareextractedfromthenetworks’regulatedandnon-regulatedbusinessactivities.

However, it is well understood that the profit margins the networks are realising from their regulatedactivitiesaremuchhigherthantheprofitmarginstheyareachievingfromtheirnon-regulatedactivities.

For example, the recent audit of the Queensland energy companies’ finances by the Queensland AuditOffice, outlined that ErgonEnergy’s annual post tax profitmargins from its energy retail activities rangedfrom5.6%to10%overthepast3years,comparedtoposttaxprofitsfromthenetworksof24-28%.15

Asoutlinedthroughoutthisreport,theQueenslandnetworks’regulatedrevenuesaredeterminedwithinadeeply flawed national regulatory framework, fromwhich the networks are securing revenue allowanceswell above the efficient levels, enabling them to realise extraordinary profits of many multiples of thereturnsbeingrealisedbybusinessesinallotherindustrysectors.

It is clear that it is the extraordinary profits from the networks’ regulated activities that are enabling theQueenslandGovernmenttoextractsuchhighlevelsofprofitsfromthenetworkbusinesses.

However, in theabsenceof segregated reportingof thenetworkbusinesses’ regulatedandnon-regulatedprofits, this analysis has adopted the highly conservative assumption that the Queensland Government’sprofit extractions arebeingderived inequalproportions from thenetworks’ regulatedandnon-regulatedactivities.

Basedon the information containedwithin the aboveQueenslandAuditOffice report, it is clear that thisconservative assumption significantly understates the level of profits that are being collected fromQueenslandconsumersthroughtheirelectricitybills.

14Powerlink,EnergexandErgonEnergyprovidenon-regulatednetworkandtechnicalconsultingservices.ErgonEnergyalsoprovideselectricityretailingservicesinregionalQueensland15Energy:2016-17resultsoffinancialaudits,Report9(2017-18),QueenslandAuditOffice,February2018

26

6.2 TheQueenslandGovernment’sProfitsFromTheNetworks’Charges

Asoutlined inthepreviouschapter, foreverydollar thatQueenslandconsumerspaid fornetworkchargesover thepast threeyears, theQueenslandgovernmentcollected47cents inprofits– i.e. theQueenslandGovernmentcollecteda47%profitmarginfromtheQueenslandnetworks.

ThechartsoverleafillustratetheprofitsthattheQueenslandGovernmentcollectedfromthenetworksasaproportion of typical network charges for Queensland household, small business and large businesselectricitybills.

Theyillustratethat:

§ For a Queensland household electricity bill with network charges of $1,000, the QueenslandGovernment’sprofitsfromtheQueenslandnetworksamountedto$470

§ For a Queensland small business bill with network charges of $2,000, the Queensland Government’sprofitsfromtheQueenslandnetworksamountedto$940

§ Fora largebusinessuserbillwithnetworkchargesof$200,000, theQueenslandGovernment’sprofitsfromtheQueenslandnetworksamountedto$94,000

27

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28

7 TheAddictionOfSuccessiveQueenslandGovernmentsToTheNetworks’ExtraordinaryProfits

SuccessiveQueenslandgovernment’shavedemonstrablyfailedtobalancetheirconflictingrolesofnetworkowner and regulatory rulemaker. The addiction of Queensland governments to the electricity networks’extraordinaryprofitshasseverelycompromisedtheirapproachtoenergypolicyandnetworkregulationformanyyears.

SuccessiveQueenslandGovernmentshave consistently chosen short-termprofits over effective long-termenergypolicy,by:

§ Ensuring (through COAG) the retention of deficiencies and loopholes in the national regulatoryframeworkthatenabletheQueenslandnetworkstoachieveextraordinaryprofits;whilst

§ NotfullyconsideringtheconsequencesofinflictingexcessiveelectricitypricesonQueenslandconsumersandthestateeconomy

Having Queensland’s electricity prices driven by such extraordinary profits contradicts the claims ofsuccessiveQueenslandGovernments regarding their commitment to ensuring efficient and fair electricitypricesforQueenslandconsumers.

Examples of decisions by Queensland Governments over the past decade that demonstrate thisinconsistencyinclude:

§ Supporting the 2006 rule changes that removed the requirement for the regulator to optimise thenetworks’regulatoryassetbases(RABs).Aspredictedbynumerousstakeholdersatthetime,thoserulechanges resulted in extraordinary levels of overinvestment and consequential price and profitabilityincreasesbytheQueenslandnetworks16

§ Increasing the Queensland’s network reliability standards in 2005 with no consideration of the priceincreasestoQueenslandconsumersandnoconsiderationofthevaluethatQueenslandconsumersplaceonreliability

§ AllowingtheQueenslandnetworkstosystemicallyuseoverblownloadforecaststogametheregulator(theAER)toprovidecapexallowanceswellinexcessoftherequiredlevels

§ SupportingErgonEnergy’slegalchallengetotheAER’sbenchmarkingprocess.Thatlegalchallengewasamajor factor in the recent Australian Competition Tribunal decision that resulted in NSW and ACTconsumerspaying$3billionabovetheAER’srevenuedeterminations–adecisionthatwillhavefurtherflowoneffectsinraisingtheQueensland’snetworks’prices.17

§ Supporting the LimitedMerits Review (LMR) process – theone-sided appeal process that enables thenetworks to contest the AER’s revenue determinations. Since 2008, Australian electricity networks’appealsthroughtheLMRprocesshaveresultedinover$12billioninadditionalrevenuebeingpassedontoAustralianconsumers18

16SeeChapter8ofthisreportforanoverviewofthoserulechanges17ErgonEnergyInterventiontotheAusgrid,EndeavourEnergyandEssentialEnergyLimitedMeritsReview(LMR)AppealontheAER’s2014-19revenuedeterminationfortheNSWdistributors18TheLMRwasrecentlyabolished,despiteitsabolishmentbeingstronglyopposedbytheQueenslandGovernment

29

8 TheKeyDeficienciesInTheNationalRegulatoryFramework

8.1 TheFailureOfTheNationalRegulatoryFrameworkPrior to transferring responsibility for the settingof theQueenslandnetworks’ revenues to theAustralianEnergy Regulator (AER), the networks’ revenueswere determined byQueenslandGovernment regulatoryauthorities.19

The decision to transfer responsibility for the Queensland networks’ revenue regulation to nationalregulation in 2006 was based on promises that it would deliver more efficient prices and improve thenetworks’productivitylevels.

However, rather than delivering those promised improvements, national regulation of the Queenslandnetworks’revenuesbytheAERhasbeenacatastrophicfailure,resultingin:

§ AmorethandoublingoftheQueenslandnetworks’prices

§ The Queensland networks achieving extraordinary profits of many multiples of the returns beingachievedbyASX100companiesinallotherindustrysectors

§ Extraordinarylevelsofoverinvestmentandgoldplating–resultingintheQueenslandnetworks’capitalproductivitylevelsbeingthelowestinAustralia20

§ Extraordinary increases in the networks’ operational costs - resulting in the Queensland networks’operationalefficiencylevelsbeingthelowestinAustralia21


8.2 TheQueenslandNetworks’GamingOfTheNationalRegulatorTheQueenslandnetworks’excessivepricesandprofitsare the resultof thenetworks’ systemicgamingofthedeeplyflawednationalregulatoryframework.

The Queensland networks have systemically exploited various deficiencies and loopholes in the nationalregulatoryframework,securingrevenueallowancesfromtheAERwellabovetheefficientlevels.

ThekeyregulatoryframeworkdeficienciesexploitedbytheQueenslandnetworksarehighlightedoverleaf.

19EnergexandErgonEnergy’srevenuesweredeterminedbytheQueenslandCompetitionAuthority(QCA)PowerlinkQueensland’srevenuewaspreviouslydeterminedbytheQueenslandEnergyReformUnit(QERU)andbytheACCC20Powerlink’MultilateralTotalFactorProductivity(MTFP)Scoreis5thoutofthe5NEMtransmissionnetworks-AER2017TransmissionBenchmarkingReport,3December2017ErgonEnergy’sMultilateralTotalFactorProductivity(MTFP)Scoreis12thoutofthe13NEMdistributionnetworks–AER2017DistributionBenchmarkingReport,3December201721AERBenchmarkingReports

30

8.2.1 TheGamingOfExcessive‘ReturnOnCapital’Allowances

Australia’smonopolyelectricitynetworksreceiveguaranteedreturnsontheirregulatoryvaluations–theirregulatoryassetbases(RABs).

Ashighlightedinthediagrambelow,thosereturnsdrivethemajorityofthenetworks’revenuesandprices.

Since moving to the national regulatory framework, the Queensland networks have managed to secure‘returnoncapital’allowancesfromtheAustralianEnergyRegulator(AER)wellabovetheefficientlevels.

ThenetworkshavesecuredthoseexcessiveallowancesbyexploitingvariousdeficienciesintheAER’s‘returnoncapital’determinationprocessoutlinedbelow.

8.2.1.1 TheApplicationOfAnInappropriateAssetValuationMethodology

The networks’ RABs are effectively valued at replacement cost, using the Depreciated OptimisedReplacement Cost (DORC) valuation methodology - an asset valuation methodology that results in thehighestpossiblevaluations(andthereforeprices)ofallofthemethodologiesthatcouldbeapplied.

By contrast, theUKnetworks’ regulatory valuationswereestablishedon thebasisof theirhistorical costsresultingintheirRABsperconnectionbeinglessthanathirdoftheQueenslandnetworks’DORCvaluations.22

22Write-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandissues,CME,April2015Determiningtheregulatoryassetbaseforutilitypriceregulation,DavidMNewbery,1997

31

The decision to apply a replacement valuation methodology, rather than a cost-based valuationmethodology,wasnotjustifiedandisnotinAustralianconsumers’long-terminterests.23

8.2.1.2 TheIncentivisationOfInefficientExpenditure

The proper implementation of the DORC valuation methodology requires the regulator to optimise thenetworks’RABvaluationstoreflecttheefficientvalueofassetsneededtoprovidetherequiredservices.

Thismeans that if the networks invest inmore capacity than required, the regulator should exclude thevalueoftheexcesscapacityfromtheirRABs,therebyensuringthatconsumersarenotrequiredtofundtheexcesscapacityorinefficientinvestments.

However, when responsibility for the networks’ revenue regulation was transferred to the nationalregulatory framework in 2006, major changes to the National Electricity Rules (NER) were implemented,including:24

§ Theremovaloftherequirementfortheregulatortooptimisethenetworks’RABs,and

§ NewrulesthatensuredthatallfuturecapexincurredbythenetworkswasautomaticallyrolledintotheirRABswithoutanyprudencyorefficiencyreviews

The removalof theoptimisationandcapexprudency reviewprovisions fromtheNationalElectricityRules(NER) contrasts sharplywith the provisions containedwithin the regulatory rules in other jurisdictions inAustraliaandoverseas.

For example, the regulatory rules that apply to Australia’s gas networks and to the Western Australianelectricitynetworkshavealways required the regulator toapplyabroad rangeofoptimisationand capexprudencyreviewteststothedeterminationofthenetworks’regulatoryvaluations.25

As predicted by numerous stakeholders, the 2006 rule changes incentivised extraordinary levels of over-investment by the networks - particularly by the Queensland government-owned networks due to theirlowerborrowingcostsandtheadditionalpecuniarybenefitsthattheyrealisefromover-investment.

Importantly,theQueenslandnetworks’levelsofoverinvestmentwerethehighestinAustralia.26

23UtilityAssetValuation–AUser’sPerspective,R.Booth,16June200ReplacementCostAssetValuationandRegulationofEnergyInfrastructureTariffs,D.J.Johnstone,2003TheDORCvaluationmodelofregulatedinfrastructureassets,Johnstone,D.J.andLonergan,W,2006SubmissiontotheSenateinquiryintothePerformanceandManagementofElectricityNetworkCompanies,DJohnstone,December201424SeeforexampletheAEMCRuleChangeDetermination,NationalElectricityAmendment(EconomicRegulationofTransmissionServices),November2006TheRABsforthedistributionnetworkarespecifiedinSchedule6.2oftheNER27TheRABsforthetransmissionnetworksarespecifiedinSchedule6.2AoftheNationalElectricityRules(NER)25WesternAustraliaElectricityNetworksAccessCode2004,Clauses6.44to6.63NationalGasRulesVersion36,Clause77,Pages54-5826AssetsorLiabilities?TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay2016SenateInquiryIntoThePerformanceandManagementofElectricityNetworkCompanies,June2015VictorianElectricityDistributionBusinessesSubmissiontotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:,18thDecember2014Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018QueenslandGovernmentIndependentReviewPanel(IRP)onNetworkCosts,FinalReport,2013ElectricityNetworkRegulatoryFrameworks:ProductivityCommissionInquiryReport,9April2013SenateSelectCommitteeonElectricityPrices:ReducingEnergyBillsandImprovingEfficiencyWrite-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandargumentCME,April2015AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,EUAA,2012

32

As outlined in Appendix 2 of this report, a key factor that enabled the Queensland networks’ over-investment was their systemic over-forecasting of demand, with the networks using overblown loadforecaststogametheAERtoprovidecapexallowanceswellinexcessoftherequiredlevels.

Appendix2outlinesthattheQueenslandnetworks’demandforecastshavebeenconsistentlyoverblowntoamuchhigherdegreethanalloftheotherAustralianelectricitynetworks.

As a result, the Queensland networks expended substantially more capital than the privately ownednetworks, both in absolute terms and after normalisation for changes in network outputs such as peakdemandandenergydelivered.

Forexample,whennormalisedforchangesindemand:27

§ EnergexandErgoninvestedingrowthrelatedcapexat7timestheleveloftheVictoriandistributors

§ Powerlink Queensland invested in growth related capex at 15-20 times the rate of the Victoriantransmissionnetwork

TheQueensland networks’ over-investment has resulted in a large degree of excess system capacity andsignificant declines in their asset utilisation levels, with the networks having the lowest capital efficiencylevelsintheNationalElectricityMarket(NEM)28

Italso resulted in theQueenslandnetworks’RABsgrowingatmuchhigher rates than thenetworks in theother states. For example, theQueensland distributors’ ‘RABs per connection’ are 250%higher than theVictoriandistributors,havingincreasedfrombeing60%higherin2001.29

Anexplanationofwhytheprivatelyownednetworksrestricttheirinvestmentsandcontroltheircostsmuchmoreeffectivelythangovernment-ownednetworkswasoutlinedbytheVictorianelectricitynetworksinthesubmissions andevidence theyprovided to theSenate inquiry Into ThePerformanceandManagementofElectricityNetworkCompanies.30

AsstatedbyAlistairParkerofAusNetServiceswhenpresentingevidencetotheSenateInquiry:

“Itisjustfundamentallybecauseoftheownershipstructure.Wespendlesstogetthesameoutcomes”

“Wedobetteroverthelongrunbyspendingless,byfindingcheaperalternativestodelivergoodoutcomes”

“This is not our view: it is theAustralian Competition and Consumer Commission's (ACCC’s) view, it is theAER'sview,itistheProductivityCommission'sview,itistheEnergyUsersAssociationofAustralia'sview”

“Person after person looks at this objectively and looks at the data that is before them and findswe arecheaperandmorereliable.Iputthatdowntoourownershipstructure”

Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors,EUAA,2011Shocktothesystem:Dealingwithfallingelectricitydemand,GrattanInstitute,December2013Puttingthecustomerbackinfront:Howtomakeelectricitycheaper.GrattanInstitute,December2012TheGarnautClimateChangeReviewUpdate,Paper8:TransformingtheElectricitySector,2011TheEnergyMarketDeathSpiral-RethinkingCustomerHardship,PaulSimshauserandTimNelson,2012AMPSubmissiontotheProductivityCommission-TheCapitalEfficiencyofAustralianElectricityDistributors,ResultsofaBenchmarkingStudy,November2012UtilitiesPolicy:IndependentRegulationofGovernment–OwnedMonopolies:AnOxymoron?,December201427EUAA:AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,Oct2012EUAA:Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors28AERTransmissionandDistributionBenchmarkingReports,3December201729EUAA:AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,Oct2012EUAA:Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors30SubmissionandEvidencetotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:VictorianElectricityDistributionBusinesses,18thDecember2014

33

Asaresult,theQueenslandnetworks’returnsontheirregulatoryassetbases(RABs)drivetheirpricestoamuchhigherdegreethanalloftheotherAustralianelectricitynetworks.

For example, over the previous regulatory period, the Queensland networks’ returns on their RABsaccountedfor:31

§ 77%ofPowerlinkQueensland’srevenueallowances§ 75%ofErgonEnergy’srevenueallowances§ 74%ofEnergex’srevenueallowances

8.2.2 TheAER’sFlawed‘ReturnOnCapital’DeterminationMethodology

Toretainthenetworks’RABvaluationsatreplacementvalue,thenetworks’RABsareartificiallyinflatedeachyear(byCPI).

However, the AER’s methodology for determining the networks’ ‘return on capital’ allowances does notappropriatelydealwiththeimpactsofartificiallyinflatingthenetworks’capitalbases:

Inessence:

§ TheAER'smethodology for determining the requiredpercentage returns is basedon the returns thatinvestorsrequireontheiractualcapitalinvestments

§ However,theAERcalculatesits'returnoncapital'allowancesbymultiplyingthosepercentagereturnstoartificiallyinflatedcapitalbases

Furthermore,theAER’spercentagereturnsarebasedonthereturnsrequiredbybusinessesthatfaceassetwrite-downrisks,whereasAustralia’smonopolynetworksarespecificallyprotectedfromsuchrisks.

Those inconsistencies are resulting in the AER providing ‘return on equity’ allowances to theQueenslandnetworksof3-4timestheefficientlevels.32

8.2.3 EstimationsOfEfficientRegulatoryAssetBases(RABs)ForTheQueensland Networks

In recent years there have been numerous calls from various stakeholders for theQueensland networks’RABstoberevaluedtoefficientlevels.

ItisimportanttounderstandthatmostestimatesoftherequiredwritedownsfortheQueenslandnetworks’RABs,includingtherecentlyreleasedGrattanInstitutepaper,haveonlyactuallyestimatedthewrite-downsrequiredtoaddressthenetworks’inefficientinvestments.33

31‘Returnoncapital’plus‘returnofcapital’(depreciation)allowances32ConsumerChallengePanel(CCP2)SubmissionstotheAERonTheAER’sDraft2015-20RevenueDeterminationsforEnergexandErgonEnergy-BruceMountainandHughGrantsubmissionsConsumerChallengePanelCCP4(HughGrant)SubmissiontotheAERonTheAER’sRevenueDeterminationforPowerlinkQueensland33Seeforexample:VictorianElectricityDistributionBusinessesSubmissiontotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:,18thDecember2014Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018Puttingthecustomerbackinfront:Howtomakeelectricitycheaper.GrattanInstitute,December2012TheGarnautClimateChangeReviewUpdate,Paper8:TransformingtheElectricitySector,2011SenateInquiryIntoThePerformanceandManagementofElectricityNetworkCompanies,June2015

34

However,asoutlinedinsection8.2.1.1above,acomprehensiveassessmentofefficientRABvaluationsalsoneedstoassesstheappropriatenessofthenetworks’initial(DORC)valuations.

InMarch 2016, the author of this report performed themost comprehensive analysis and assessment ofefficient RABs for Australia’s electricity monopoly networks, quantifying the required adjustments to thenetworks’ initial (DORC based) valuations and the required adjustments to address the networks’subsequentinefficientinvestments.34

That 150-page report demonstrated that, based of highly conservative assumptions, the Queenslandnetworks’RABvaluationsareatleasttwicetheefficientlevels.

Over thepast6months, theQueenslandLiberalNationalParty (LNP)hasbeencalling for theQueenslandgovernmenttowritedowntheQueenslandnetworks’regulatoryassetbases(RABs).Forexample,theLNPhas publicly supported the findings and recommendations of the recent Grattan Institute study, whichcalculated(onthebasisofinefficientinvestmentalone)theneedforRABwrite-downsofupto38%fortheQueenslandnetworks.35

It is important to note that, as acknowledged by theGrattan Institute throughout its report, theGrattanInstitute’scalculationsoftherequiredRABwrite-downswerebasedonhighlyconservativeassumptionsthatresultedintheirrecommendedRABwrite-downsfortheQueenslandnetworksbeingmuchlowerthantheestimationsofotherindependentanalysts.36

However,itisimportanttoacknowledgethattheQueenslandLiberalNationalParty(LNP)proposaltowritedownthenetworks’RABsisthefirstsuchproposalfromadominantQueenslandpoliticalparty.

It reflectsa longoverdueacknowledgementof theunsustainabilityof continuing toallowtheQueenslandnetworks’excessiveRABstodrivetheirexcessivepricesandprofits.

Excessive‘returnoncapital’allowancesaretheprimarydriveroftheQueenslandnetworks’excessivepricesandprofitsandwillcontinuetodosountiltheabovedeficienciesareaddressed.

Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors,EUAA,2011AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,EUAA,2012SenateSelectCommitteeonElectricityPrices:ReducingEnergyBillsandImprovingEfficiencyShocktothesystem:Dealingwithfallingelectricitydemand,GrattanInstitute,December2013Write-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandissues,CME,April201534AssetsorLiabilities?:TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay201635Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,March2018TheGrattanInstitutepaperoutlinedarangeofRABwritedownsfortheQueenslandelectricitynetworksbasedonvariousassumptions.ThepapercalculatedrequiredRABwrite-downsofupto$2.5bn(38%)forPowerlinkQueensland,$3.9bn(33%)forEnergexand$2.8bn(26.3%)forErgonEnergy36TheGrattaninstitutepaperdidnotchallengethenetworks’initialDORCvaluations.Asoutlinedwithinthispaper,otherindustryanalystshaveconcludedthattheQueenslandnetworks’initialDORCvaluationswerearoundthreetimestheiractual‘historiccost’valuationsTheGrattanInstitute’smethodologyforcalculatingthenetwork’sinefficientinvestmentlevelsadoptsthesimple(contentious)assumptionthatthenetworks’RABsaredrivenbytwovariables-customernumbersandpeakdemand.TheGrattanInstitute’smethodologyappearstodoublecounttheneedforincreaseddemandpresentedbynewcustomersanddoesnotappeartoreflecttheeconomiesofscaleofnetworkinfrastructureTheGrattanInstitute’scalculatedrangeofRABwritedownsarehighlysensitivetothestudyperiodstartandenddates(moresothanotherstudies)

35

8.3 TheGamingOfExcessiveOperationalExpenditure(Opex)AllowancesTheQueenslandnetworksareamongsttheleastefficientnetworksintheNationalElectricityMarket(NEM):

§ PowerlinkQueenslandisthemostinefficienttransmissionnetworkintheNEM37

§ ErgonEnergyisthesecondleastefficientdistributionnetworksintheNEM38

TheQueenslandnetworks’ poor operational efficiency andproductivity has been the subject of extensivecriticisminnumerousreportsandreviews.39

Over the past decade, the Queensland networks have managed to prevent the AER from applyingbenchmarking when setting their opex allowances, resulting in the AER setting the networks’ opexallowancesonthebasisoftheirhistoricalcosts,ratherthanefficientcosts.40

Thisresultedinthefollowingoutcomesinthenetworks’mostrecentrevenuedeterminations:

§ The AER fully accepted Energex’s proposed opex, despite the AER’s benchmarking identifying thatEnergex’sopexis35-40%abovethebenchmarkefficientlevel

§ TheAERonlyapplieda5%reductiontoErgonEnergy’sproposedopex,despitetheAER’sbenchmarkingidentifyingtheneedforreductionsof55-60%

§ The AER fully accepted Powerlink’s proposed opex, despite the AER’s benchmarking identifying thatPowerlink’sopexisaroundtwicetheefficientlevel

Asaresult,theQueenslandelectricitynetworks’totalopexallowancesovertheircurrent5-yearregulatoryperiodsare$2.25billion($450millionperannum)abovetheefficientlevel.

37Powerlink’sMTFPisranked5thoutofthe5NEMtransmissionnetworks–seeAER2017TransmissionBenchmarkingReport,2ndDecember201738ErgonEnergyMTFPisranked12thoutofthe13NEMdistributionnetworks–seeAER2017DistributionBenchmarkingReport,2ndDecember201739Forexample:AssetsorLiabilities?TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay2016SenateInquiryIntoThePerformanceandManagementofElectricityNetworkCompanies,June2015VictorianElectricityDistributionBusinessesSubmissiontotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:,18thDecember2014QueenslandGovernmentIndependentReviewPanel(IRP)onNetworkCosts,FinalReport,2013ElectricityNetworkRegulatoryFrameworks:ProductivityCommissionInquiryReport,9April2013SenateSelectCommitteeonElectricityPrices:ReducingEnergyBillsandImprovingEfficiencyDowntothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,EUAA,2012Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors,EUAA,2011Shocktothesystem:Dealingwithfallingelectricitydemand,GrattanInstitute,December2013Puttingthecustomerbackinfront:Howtomakeelectricitycheaper.GrattanInstitute,December2012TheGarnautClimateChangeReviewUpdate,Paper8:TransformingtheElectricitySector,2011TheEnergyMarketDeathSpiral-RethinkingCustomerHardship,PaulSimshauserandTimNelson,2012Write-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandargumentCME,April2015AMPSubmissiontotheProductivityCommission-TheCapitalEfficiencyofAustralianElectricityDistributors,ResultsofaBenchmarkingStudy,November2012UtilitiesPolicy:IndependentRegulationofGovernment–OwnedMonopolies:AnOxymoron?,December201440Seeforexample,ErgonEnergyInterventiontotheAusgrid,EndeavourEnergyandEssentialEnergyLimitedMeritsReview(LMR)AppealontheAER’s2014-19revenuedeterminationfortheNSWdistributors

36

8.4 TheQueenslandNetworks’GamingOfTheAER’sIncentiveSchemesOver the past decade, the AER has implemented various incentive schemes aimed at incentivising thenetworkstoimprovetheirperformanceandefficiency.

Allofthoseschemeshavedemonstrablyfailedtomeettheirobjectives.

Rather, the Queensland networks have realised extraordinary windfall profits from gaming the variousschemes, by taking advantage of information asymmetries and negotiating incentive scheme targetswellabovetheefficientlevels.

Forexample, the chartbelowoutlines theasymmetricoutcomesof theAER’sServiceTargetPerformanceIncentiveScheme (STPIS)–underwhichPowerlinkhasachievedmajorbonuses ineveryyear,andhasnotincurredanypenaltiessincetheschemewasimplemented.41

0.00#

5.00#

10.00#

15.00#

20.00#

25.00#

2007# 2008# 2009# 2010# 2011# 2012# 2013# 2014# 2015#

Powerlink*+*STPIS*Bonuses*($M)*

37

9 BusinessAsUsualisUnsustainableQueensland’sexcessiveelectricitypricesareinflictingmajordamageontheQueenslandcommunityandtheQueenslandeconomy.

In response to the dramatic increases in electricity prices, Queensland consumers are exhausting allopportunitiestoreducetheirelectricitycosts.

In addition to reducing consumption,Queensland consumers are increasingly investing in self-generation,therebyfurtherreducingtheenergybeingdeliveredbytheQueenslandnetworks.

For example, residential consumers are increasingly investing in solar PV and battery storage systems toreduceorremovetheirrelianceongridsuppliedelectricity.

Similarly, Queensland’s industrial consumers are increasinglymoving to self-generation andQueensland’sirrigatorsarepursuinginefficienttechnologysubstitutionssuchasmovingtotheuseofdieselpumpsratherthanelectricalpumps.

Whilst these decisions are justified on the basis of current electricity prices, many of the decisions areactuallyeconomically inefficientastheyarebasedonpursuingalternativestoartificially inflatedelectricityprices.

The Queensland networks are responding by further increasing their prices to recover their guaranteedrevenuesoverareducedlevelofconsumption.

Consequently, Queensland’s excessive network prices are driving ongoing demand reductions andaccelerating the industry death spiral - i.e. as themove towards self generation increases, the burden ofpaying for the networks’ costs is being progressively placed on a reducing consumer base until thoseconsumerscannolongeraffordtostayconnectedtothenetwork.

Continuationofthe industrydeathspiralwillultimatelybemuchmoredestructivetothevalueandfutureviability of Queensland’s government-owned energy companies than the short-term impacts ofimplementingmoresustainableprices.

It is clearly irresponsible and foolhardy to continue to allow Queensland’s state budget to be so heavilydependentupontheextractionofunsustainableprofitsfromQueensland’smonopolyelectricitynetworks.

It is clear fromthevariouspoliciesproposedbyQueensland’spoliticalparties that there isbroadpoliticalawarenessthatbusinessasusualisunsustainable.

TheQueenslandcommunity isbecoming increasinglyawareof the real reason forQueensland’sexcessiveelectricitypricesandisbecomingincreasinglyvocalinlettingQueensland’spoliticalleadersknowthattheywillnolongerbeplayedasfools.


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10 PolicyAndRegulatoryImplications

10.1 TheNeedtoSetTheQueenslandNetworks’PricesAtEfficientLevelsAsowneroftheQueenslandnetworks,theQueenslandgovernmenthasahighdegreeofcontrolovertheirprices.

RatherthancontinuingtoallowtheQueenslandnetworkstogamethenationalregulatorandchargepricesovertwicetheefficientlevels,theQueenslandGovernmentneedstoexercisethatcontrolandensurethatthenetworks’pricesaresetatefficientlevels.

AsoutlinedintherecentGrattaninstitutereport,theQueenslandgovernmentneedstotakeresponsibilityandaddresstheQueenslandnetworks’excessiveprices.42

“Wefindthatfaultliespredominantlywithsuccessivestategovernments”

“Stategovernment’scan’tturnbacktheclockbuttheycanfixthemistakesofthepast.Andtheyshould,becauseiftheydon’t,consumerswillbepayingfordecadestocome”.




Importantly, theNSWgovernmentmade thatdirection in response toNSWcommunityoutrage followingthe leaking of a document that confirmed that Essential Energy cynically exploited its consumers, theregulatorandtheAustralianlegalsysteminitspursuitofexcessiveprofits.

Overthepasttwoyears,EssentialEnergyspentmillionsinlegalfees(fundedbyconsumers)securinghigherrevenuethrough legalappeals to theAustralianCompetitionTribunalandtheFederalCourt.During thoselegal battles, Essential Energy made numerous non-credible claims that lower revenues would result incatastrophicconsequencesandcompromisethesafety,securityandreliabilityofthenetwork.

However,inOctober2017,theNSWoppositionuncoveredabriefingdocumentfromEssentialEnergytotheNSWGovernmentthatstronglycontradictedthoseclaims.Inthatdocument,EssentialEnergyacknowledgedthattheextrarevenueithadrepeatedlyinsistedwasnecessarywasactuallyunnecessary,andwouldsimplyresultinsignificantadditionalprofitsforthecompany.

Asoutlinedwithinthispaper,successiveQueenslandgovernmentshavealsobeencomplicitinenablingtheQueenslandnetworkstoexploitQueenslandconsumersintheirpursuitofexcessiveprofits.


42Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018

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10.1.1 AssessmentofEfficientNetworkPrices

Efficientpricescanbedefinedas:

Pricesbasedonrevenuesthatprovidefor:

§ Reasonablereturnsonefficientinvestments;and

§ Therecoveryofefficientcosts

The charts overleaf provide an indication of the differences between the Queensland networks’ currentrevenuesandefficientrevenues.

The estimations of efficient revenues are based on the conclusions of various independent analyses andreviewsoftheQueenslandnetworks’revenuesandcosts.43

The chartsoutline thedifferent revenues thatwouldapply if thenetworkswere to remainas “forprofit”entitiesandtherevenuesthatwouldapplyifthenetworksweretoberevertedto“non-profit”entities(ascurrentlybeingproposedbysomeQueenslandpoliticalparties).

43AssetsorLiabilities?TheNeedtoApplyFairRegulatoryValuestoAustralia’sElectricityNetworks,HughGrant,5thMay2016SenateInquiryIntoThePerformanceandManagementofElectricityNetworkCompanies,June2015VictorianElectricityDistributionBusinessesSubmissiontotheSenateSelectCommitteeInquiryintotheperformanceandmanagementofelectricitynetworkcompanies:,18thDecember2014AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNEM,EUAA,2012Australia’srisingpricesanddecliningproductivity:thecontributionofitselectricitydistributors,EUAA,2011Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,25March2018Shocktothesystem:Dealingwithfallingelectricitydemand,GrattanInstitute,December2013Puttingthecustomerbackinfront:Howtomakeelectricitycheaper.GrattanInstitute,December2012TheGarnautClimateChangeReviewUpdate,Paper8:TransformingtheElectricitySector,2011TheEnergyMarketDeathSpiral-RethinkingCustomerHardship,PaulSimshauserandTimNelson,2012Write-downstoaddressthestrandedassetsofelectricitynetworksintheNationalElectricityMarket:evidenceandargumentCME,April2015AMPSubmissiontotheProductivityCommission-TheCapitalEfficiencyofAustralianElectricityDistributors,ResultsofaBenchmarkingStudy,November2012UtilitiesPolicy:IndependentRegulationofGovernment–OwnedMonopolies:AnOxymoron?,December2014ElectricityNetworkRegulatoryFrameworks:ProductivityCommissionInquiryReport,9April2013SenateSelectCommitteeonElectricityPrices:ReducingEnergyBillsandImprovingEfficiencyQueenslandGovernmentIndependentReviewPanel(IRP)onNetworkCosts,FinalReport

40

Thekeyassumptionsunderlyingtheestimatesinclude:

CurrentRevenueAllowances

The“currentrevenueallowances”reflecttheAER’saverageannualrevenueallowancesoverthenextthreefinancialyears(2017/18-2019/20)44

EfficientRevenueAllowances(ForProfitScenario)

Keyassumptionsinclude:

§ TheongoingapplicationoftheCapitalAssetPricingModel(CAPM)approach

§ Theongoingassumptionof60%/40%debt/equitygearingratios

§ AcceptanceoftheAER’s‘riskfreerate’calculations

§ Anequityriskpremium(ERP)of2%basedonamarketriskpremiumof5%andanequitybetaof0.4

§ Debtriskpremiums(DRPs)of1%belowtheAER’sapplieddebtriskpremiums

§ The estimations of efficient regulated asset bases (RABs) are based on the conclusions of variousindependentanalyststhatthenetworks’currentRABsareatleasttwicetheefficientlevels

§ The estimations of efficient opex allowances are based on the “benchmark efficient costs” as per theAER’sbenchmarkingreports45

EfficientRevenueAllowances(NotForProfitScenario)

Thekeyassumptionsareasperthe“forprofit”scenario,except:

§ Thenetworksareassumedtobe100%debtfunded

§ A debt risk premium (DRP) of 1.25% has been provided to provide an allowance for the networks’specificnon-diversifiablefinancialrisks46

§ Notaxallowancesareprovided

Thechartshighlightthat:

§ Ifthenetworksaretoremainas“forprofit“entities,theQueenslandnetworks’currentrevenuesare2.3-2.4timestheefficientlevel

§ If thenetworks are tobe reverted to “nonprofit“ entities (asproposedby someQueenslandpoliticalparties),theQueenslandnetworks’currentrevenuesarearound2.4-2.5timestheefficientlevel

44AllrevenueallowancesexcludetheAER’scalculated“additionalamountsinDUOS”-themajorityofthosecostshavebeenremovedfromtheQueenslanddistributors’revenuesaspertheQueenslandGovernment’sJune2017statebudgetannouncement–availableathttps://budget.qld.gov.au/budget-highlights/powering-queensland/45AERTransmissionsandDistributionBenchmarkingReports46Thisapproachiscommoninthedeterminationofreturnsforgovernmentownedbusinesses.Seeforexample:“EconomicRegulationinAustralia:theCaseoftheNewSouthWalesGas”.Abbot,MandXiaoyongEconomicPapers,Vol36,No.3“TheregulationofgovernmentownedelectricitydistributorsinAustralia”,BruceMountain,JournalofRegulatoryEconomics,December2017

41

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PowerlinkQueenslandReturnonCapital Depreciation Opex Tax

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EnergexReturnonCapital Depreciation Opex Tax

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QueenslandNetworksTotalReturnonCapital Depreciation Opex Tax

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10.1.2 TheQueenslandPoliticalParties’PoliciesToReduceTheNetworks’Prices

Queensland’s political parties are currently proposing various policies aimed at reducing the Queenslandnetworks’pricesandprofits.

Appendix3ofthisreportprovidesanassessmentofthosepoliciesandtheextenttowhichtheywoulddrivetheQueenslandnetworks’pricestowardsefficientlevels.

ThetablebelowhighlightstheQueenslandpoliticalparties’keypoliciesandtheestimatedpotentialnetworkpricereductionsthatwouldarisefromtheirimplementation.

PoliticalParty

PoliciesToAddressExcessiveProfits

PoliciesToDriveEfficientCosts

PotentialPriceReductions

Labor$50“electricityassetownershipdividendpayment”forQueenslandhouseholds

-

3%

LiberalNationalParty(LNP)

Write-downsofthenetworks’regulatoryassetbases(RABs)47

Appointconsumerrepresentativestothenetworks’boards

Tieexecutivebonusestopricereductions

20%

OneNationParty

20%reductionfromremovalofdividendpayments

- 20%

Katter’sAustralianParty

Implementationof“recoveryonly”pricing

AbolishmentofDORCvaluationmethodology

Reversiontostatebasedregulation

60%

QueenslandGreens

Reversiontononprofitentities

Reversion to state basedregulation 60%

47On3April2018,theLNPLeader(DebFrecklington)endorsedthefindingsandrecommendationsoftheGrattanInstitutePaper–“Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,March2018”TheGrattanInstitutepapercalculatedarangeofRABwritedownsfortheQueenslandelectricitynetworksbasedonvariousassumptions.TheestimatedpricereductionsarebasedontheGrattanInstitute’scalculatedRABwrite-downsof$2.5bn(38%)forPowerlinkQueensland,$3.9bn(33%)forEnergexand$2.8bn(26.3%)forErgonEnergy

44

Itisclearfromthevariouspoliciesproposedthatthereisabroadpoliticalawarenessthatbusinessasusualisunsustainable.

ThenewdelicatelybalancedQueenslandparliamentprovides anopportunity to seriously address the keydriverofQueensland’sexcessiveelectricitypricesandreducetheQueenslandstatebudget’sdependenceonunsustainableprofitsfromQueensland’smonopolyelectricitynetworks.

10.2 TheImpactsOfImplementingEfficientPricesOnTheQueenslandBudgetCriticsof calls to set theQueenslandnetworks’pricesatefficient levels tend tomake shortsighted claimsregardingtheimpactontheQueenslandstatebudget.

Suchresponsesreflectaverynarrowandshort-termviewofthe issuesandignorethemajordamagethatQueensland’s excessive electricity prices are inflicting on the Queensland community and the stateeconomy.

Furthermore, by acknowledging the difficulty of addressing the problem, such responses are actuallyconfirming the unsustainability of the Queensland budget’s dependence on the monopoly networks’excessiveprofits,highlightingthatthat‘businessasusual’isunsustainable.

Clearlywecannotundo themistakesof thepast,butwecanprevent them frombeing repeated in thefuture.

10.3 IsThe‘ProfitMotive’NecessaryToDeliverEfficientPrices?CriticsoftheQueenslandpoliticalparties’proposalstoreverttheQueenslandmonopolynetworksto“non-profit”entitiesarelikelytoclaimthatthe‘profitmotive’isessentialtodeliverefficientprices.

Suchcriticismsneedtobeevaluatedinlightoftheextensivecounterfactualevidence.

SinceresponsibilityfortheregulationoftheQueenslandnetworks’revenueswastransferredtothenationalregulatory framework in 2006, theQueenslandnetworks’ efficiency levels havedeclineddramatically andtheirproductivitylevelsarethelowestintheNationalElectricityMarket(NEM).

Duringthatperiod,thenetworksprofitabilitylevelsincreaseddramatically.

It is clear from the evidence that the effectiveness of the regulatory framework is a much strongerdeterminantofthenetworks’efficiencylevelsthanwhetherornottheyhaveaprofitmotive.

10.4 TheNeedForGovernment-OwnedNetworksToBeRegulated ByTheirGovernmentOwners

As demonstrated throughout this report, the transfer of the Australian networks’ revenue regulation tonationalregulation(bytheAustralianEnergyRegulator(AER))hasbeenacatastrophicfailure.

Althoughthedeficienciesinthenationalregulatoryframeworkapplytobothpubliclyandprivatelyownednetworks,itiswellunderstoodthatthepubliclyownednetworkshaveexploitedthedeficienciestoamuchhigherdegreethantheprivatelyownednetworks.

Asaresult,thestategovernment-ownednetworks’pricesareovertwicetheefficientlevel,whereastheprivatelyownednetworks’pricesarearound30-40%aboveefficientlevels.

45


Asoutlinedabove,theQueenslandGovernmenthasbeenthemostproactivestategovernmentinconstrainingtheAER’spowersandensuringtheretentionofthedeficienciesinthenationalregulatoryframework.

Over the past decade, successive Queensland governments have worked with other state governments(throughCOAG)tocreateahighlydeficientregulatoryframeworkthatinvolves:

§ Aregulatoryrulemaker(theAustralianEnergyMarketCommission(AEMC))withastrongbiastowardsthenetworkbusinesses’interestsattheexpenseofconsumers’interests,and

§ Atoothless regulator (theAustralianEnergyRegulator (AER))withanarrowlydefinedandconstrainedroleandlimitedpowers

These arrangements are unique to Australia, and have conveniently enabled successive QueenslandGovernmentstodeflecttheblameforthenetworks’priceincreasestoan“independentnationalregulator”.

It is therefore not surprising that the Western Australian electricity network, Western Power, was soenthusiastic regarding recent proposals to transfer its revenue regulation to the national regulatoryframework,astheWesternAustralianregulator(theERA)hasmuchstrongerpowersthantheAER.

As outlined within this report, some Queensland political parties are proposing to revert to QueenslandGovernmentcontrolled revenue regulation for theQueenslandnetworks,asappliedprior to2006,andascurrentlyappliestostate–ownedelectricitynetworks incomparablefederalcountries includingtheUnitedStates,CanadaandGermany.

AlthoughQueenslandGovernmentcontrollednetworkrevenueregulationwillnotbeimmunefrompoliticalinterference,thepracticalrealityisthatprovidingsinglepointaccountabilitytotheQueenslandgovernmentforthenetworks’pricesandprofitsismuchmorelikelytodeliverefficientnetworkpricesthancontinuingtoplace false hope that future state governments will progress the numerous long-overdue reforms to thedeeplyflawednationalregulatoryframework.

10.5 The Need To Restrict The Queensland Government’s IncomeExtractionsToSustainableLevels

As outlined throughout this report, successiveQueensland governments have extracted income from theQueenslandnetworksatunsustainablelevels.ThereisaneedforstrongerfiscalcontrolsthatmakeitmoredifficultforfutureQueenslandGovernmentstoextractunsustainablelevelsofincomefromtheQueenslandnetworks.

TheunsustainabilityoftheQueenslandgovernment’sincomeextractionswashighlightedintheQueenslandAuditOffice’s(QAO)recentauditoftheQueenslandenergycompanies’2015-17finances.AsstatedbytheQueenslandAuditOffice:48

TheQueenslandGovernmentcontinuestorequireadividendof100percentofenergynetprofitsaftertaxfor all entities except CS Energy. During the last two years, a mixture of net profit after tax and specialdividendshavebeenpaid to the stategovernmentusing cashandadditionalborrowings, through realisedaccumulated earnings and unrealised asset revaluation reserves. While this continues, there is a risk ofdepletingcashandreserves,resultinginalimitedabilitytofundfuturedividendswithincreaseddebt.”

48Energy:2016-17resultsoffinancialaudits,Report9(2017-18),QueenslandAuditOffice,February2018

46

Furthermore,futureQueenslandGovernmentsshouldceasethepracticeofextractingcompetitiveneutralityfeesfromthenetworks.

The Queensland Government’s rationale for extracting competitive neutrality fees from the networks isbasedonaflawedapplicationoftheCompetitionPrinciplesAgreement(CPA).

TheCPAisintendedtoapplytogovernment-ownedentitiesthatoperateincompetitiveindustries.However,the Queensland networks are monopoly businesses that have no competitors. Consequently, extractingcompetitive neutrality fees from the Queensland networks serves no purpose and simply imposesunnecessarycostsonQueenslandconsumerswhilstdeliveringnobenefits.

10.6 TheNeedForImprovedOversightOfTheQueenslandNetworksSuccessiveQueenslandGovernmentshavehada“hands-off’approachtothegovernanceoftheQueenslandnetworks.

This lackofoversighthasresultedintheQueenslandnetworksexploiting loopholesanddeficiencies inthenational regulatory framework, pursuing outcomes that are not in Queensland consumers’ long-terminterests.

There is a need formuch stronger oversight of theQueensland network businesses, to ensure that theiractionsbetterreflectQueenslandconsumers’long-terminterests.

In May 2016, the Queensland Productivity Commission (QPC) made a number of recommendations forimprovementstotheGOCshareholderoversightrole,aimedatensuringthattheQueenslandnetworksareheldmoreaccountablefortheirperformanceandefficiency.

DespitetheQueenslandGovernmentstatingthat itacceptedmostof thoserecommendations, there isnoevidencethatanyimprovementstothegovernanceoftheQueenslandnetworkshavebeenprogressedoverthepast2years.

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11 RecommendationsRecommendation1. SetTheQueenslandNetworks’PricesAtEfficientLevels

AsowneroftheQueenslandnetworks,theQueenslandgovernmenthasahighdegreeofcontrolovertheirprices.

RatherthancontinuingtoenabletheQueenslandnetworkstogamethenationalregulatorandchargepricesovertwicetheefficientlevels,theQueenslandGovernmentneedstoexercisethatcontrolandensurethatthenetworks’pricesaresetatefficientlevels.




Importantly, this paper outlines that the NSW government made that direction in response to the NSWcommunity’soutragefollowingtheleakingofadocumentthatconfirmedthatEssentialEnergyhadcynicallyexploiteditsconsumers,theregulatorandtheAustralianlegalsysteminitspursuitofexcessiveprofits.


The new delicately balanced Queensland parliament provides an opportunity for the new QueenslandGovernmenttoseriouslyaddressthekeydriverofQueensland’sexcessiveelectricitypricesandreducethestatebudget’sdependenceonunsustainableprofitsfromQueensland’smonopolyelectricitynetworks.

Importantly,settingtheQueenslandnetworks’revenuesatlevelsbelowtheirmaximumrevenuecapscanbeimplementedimmediatelyanddoesnotrequireanychangestothenationalregulatoryframework.

Criticsofcalls toset theQueenslandnetworks’pricesatefficient levels tendtomakeshort-sightedclaimsregardingtheimpactontheQueenslandstatebudget.Suchresponsesreflectaverynarrowandshort-termviewoftheissuesandignorethemajordamagethatQueensland’sexcessiveelectricitypricesareinflictingontheQueenslandcommunityandthestateeconomy.

SettingQueensland’selectricitypricesatefficientlevelswill:

§ Minimisefurtherhardshipforresidentialconsumers

§ RestoretheinternationalcompetitivenessandviabilityofQueenslandindustry

§ Improvethelong-termviabilityoftheQueenslandelectricitysupplychain

§ Protect the Queensland Government owned energy companies from the value destruction that willinevitablyarisefromthecontinuationofthenetworkdeathspiral

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Recommendation2. Revert ToQueenslandGovernment Controlled Regulation For TheQueenslandNetworks

AscurrentlybeingproposedbysomeQueenslandpoliticalparties, thereisaneedtoreverttoQueenslandGovernmentcontrolledrevenueregulationfortheQueenslandnetworks-asappliedpriorto2006,andascurrentlyappliestostate–ownedelectricitynetworksincomparablefederalcountries.

AlthoughQueenslandGovernmentcontrollednetworkrevenueregulationwillnotbeimmunefrompoliticalinterference,thepracticalrealityisthatprovidingsinglepointaccountabilitytotheQueenslandGovernmentforthenetworks’pricesandprofitsismuchmorelikelytodeliverefficientnetworkpricesthancontinuingtoplace false hope that future state governments will progress the numerous long-overdue reforms to thedeeplyflawednationalregulatoryframework.

Queensland controlled regulation should be designed to avoid the deficiencies in the existing nationalregulatoryframeworkoutlinedwithinthisreport.

Recommendation3. ImplementFiscalControlsThatRestrictTheQueensland Government’sIncomeExtractionstoSustainableLevelsTheQueenslandGovernmentisextractingincomefromtheQueenslandnetworksatunsustainablelevels.

ThereisaneedforstrongerfiscalcontrolsthatmakeitmoredifficultforfutureQueenslandGovernmentstoextractunsustainablelevelsofincomefromtheQueenslandnetworks.

Furthermore, the Queensland Government should cease the practice of extracting competitive neutralityfeesfromthenetworks.ThispaperdemonstratesthattheQueenslandGovernment’srationaleforextractingcompetitiveneutralityfeesfromthenetworksisbasedonaflawedapplicationoftheCompetitionPrinciplesAgreement (CPA) and that it serves no purpose, imposing unnecessary costs on Queensland consumerswhilstdeliveringnobenefits.

Recommendation4.ImplementStrengthenedOversightOfTheQueenslandNetworks

SuccessiveQueenslandGovernmentshavehada“hands-off’approachtothegovernanceoftheQueenslandgovernmentownednetworks, enabling thenetworks to exploit loopholes anddeficiencies in the nationalregulatoryframework,pursuingoutcomesthatarenotinQueenslandconsumers’long-terminterests.

TheQueenslandGovernmentneedstoimplementimprovedgovernancearrangementsfortheQueenslandnetworks toensure that theybetter reflect theQueenslandcommunities’ long-term interests.This shouldinclude:

§ Preventingthenetworksfromcollectingwindfallprofitsfromover-forecastingtheirneeds

§ MuchstrongeroversightoftheQueenslandnetworks’advocacyandlobbyingactivities–ensuringthattheyceaseopposingordelayingreformsaimedatimprovingtheirperformanceandproductivity

§ IncreasedscrutinyandtransparencyoftheQueenslandnetworks’performance

§ Settingandoverseeingcapitalandoperationalefficiency improvementprograms,withtheobjectiveofimproving the Queensland networks’ productivity from bottom-quartile to top-quartile performancewithintheshortestpossibletimeframe

§ Segregatedfinancialreportingofthenetworks’regulatedandnon-regulatedbusinessactivities

§ ImprovedtransparencyofthedirectionsbeingprovidedtotheQueenslandnetworksbytheQueenslandEnergyMinisterandQueenslandTreasury

49

Appendix1 AnalysisOfTheQueenslandNetworks’Profitability

This appendix provides a detailed analysis of the actual financial returns realised by two Queenslandnetworks(PowerlinkQueenslandandEnergex)overthe15-yearperiod1999/00-2013/14.

11.1 Definitions,DataSourcesAndCalculationsThe profitability analysis involved the calculation of the two key returns that investors realise from theirequityinvestments:

§ AnnualIncome–calculatedastheannual%returnonshareholderequity

§ GrowthinShareholderEquity–calculatedasthegrowthinshareholderequityoverthe15yearperiod

Therearetworecognisedmethodsforexpressingshareholderequity:

BookValue-calculatedasthesumofshareholdercontributionsplusretainedearning;and

Marketvalue–calculatedassharemarketvaluationlessdebt

Bothofthosedefinitionsareappropriate,dependentuponthecontextoftheiruse.

Thisprofitabilityanalysisusesbothofthosemethodsasfollows:

AnnualReturnOnEquityCalculations

The Annual Return on Equity is the ratio (expressed in % terms) of the annual profit achieved by thebusiness,dividedbytheequityinvestment,i.e.:

ReturnonEquity=NetProfitAfterTax(NPAT) ShareholderEquity

Theprofitabilityanalysisuses the“bookvalue”definitionofequitywhencalculating theannual returnonequitylevels–i.e.thedefinitionusedbyallAustralianbusinessesoutsideoftheenergynetworksectorwhencalculatingtheirannualreturnonequitylevels.

Note-the“bookvalue”ofequityissometimesreferredtoas"shareholdercontribution”.49

Usingthebookvalue(orshareholdercontribution)definitionensuresthattheannualreturnsontheactualequityinvestedbythebusinessesarecomparedonan"applesforapples"basis.

Importantly, the return on equity calculations do not include the other pecuniary benefits that theQueenslandGovernment realises from its investment in the networks (i.e. tax payments and competitiveneutralityfees)

GrowthInShareholderEquityCalculations

The growth in shareholder equity is calculated using the "market value” definition ofequity (i.e. businessvalue less debt) – i.e. the definition commonly used by all Australian businesses outside of the energynetworksectorwhencalculatingtheirchangesinshareholdervalue.

49IntheQueenslandnetworks’financialreportsthisisthesumofthenetworks’“sharecapital”and“retainedearnings”

50

Again, using that definition ensures that changes in shareholder value are compared on an “apples forapples”basis.

All data (e.g.NPAT, share capital and retainedearnings)was takendirectly fromPowerlink andEnergex’sauditedannualfinancialreportsovertheanalysisperiod.

11.2 TheNetworks’ActualReturnOnEquityThechartsoverleafillustratethetrendsintheQueensland’selectricitynetworks’profits,shareholderequityandactual‘returnonequity’levelsoverthe2000-2014period.

Theyhighlightthat:

§ Powerlink Queensland achieved actual ‘return on equity’ levels of 18% to 75%, which amounted to1.5-8.1timestheAER’stheoreticalreturnonequitylevels

§ Energexachievedactual‘returnonequity’levelsof10.5%to148%,whichamountedtoupto13.5timestheAER’stheoreticalreturnonequitylevels

§ Bycomparison,mostASX50companiesstruggledtoachieveannual‘returnonequity’levelsof5%overthatperiod

§ Overthepast15yearstheQueenslandnetworks’annualprofitshavegrownstronglywithmajorspikesinsomeyears

§ Atnotimeoverthepast15yearshavethenetworksexperiencedlowprofitsorlosses(unlikeallotherbusinessesoftheirsize)

§ The networks consistently extracted very high dividend levels, with dividend payout ratios averagingaround90%-i.e.theyhavereinvestedminimalamountsofretainedearningsintothebusiness

§ Bycontrast,ASX50businessestypicallyreinvestover50%oftheirearnings

§ Thenetworks’extraordinarygrowthlevelshavebeenpredominantlyfundedbydebt,e.g.:

o PowerlinkQueensland’sRABgrewfourfoldwithnochangetoitssharecapitalof$401million

o Energex’s RAB grew fourfold whilst Energex reduced its invested equity’ by $175 million (from$921millionto$746million)

§ FundingsuchlevelsofgrowththroughdebtwouldbeimpossibleforbusinessesthatoperateinanyothersectoroftheAustralianeconomy

§ Thecommercialconstraintsthatapplytoallotherbusinesseswouldrequiresignificant levelsofequityinjectiontofundsuchgrowthlevels

§ ThisdemonstratestheuniquenessofthenationalregulatoryframeworkandhowitisdisconnectedfromthecommercialrealitiesfacedbybusinessesinallothersectorsoftheAustralianeconomy

51

0

100

200

300

400

500

600

200020012002200320042005200620072008200920102011201220132014

PowerlinkNetProfitTrends

NetProQitAfterTax(NPAT) Dividends

0100200300400500600700800900

20012002200320042005200620072008200920102011201220132014

PowerlinkShareholderEquityTrendsShareCapital RetainedEarnings

0%10%20%30%40%50%60%70%80%

20012002200320042005200620072008200920102011201220132014

PowerlinkReturnonEquity

ActualReturnonEquity AERTheoreticalReturnonEquity

52

020040060080010001200140016001800

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EnergexNetPro-itTrends

NetProQitAfterTax Dividends

0

500

1000

1500

2000

2500

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EnergexShareholderEquityTrends

ShareCapital RetainedEarnings

0%20%40%60%80%100%120%140%160%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

EnergexReturnOnEquity

ActualReturnOnEquity AERTheoreticalReturnOnEquity

53

11.3 GrowthInShareholderEquityWithAustralia’selectricitynetworksachievingsuchextraordinaryreturns, it isnotsurprisingthat investorsare queuing up to purchase them when they come up for sale, paying well in excess of the networks’regulatoryvaluations.

11.3.1 RecentElectricityNetworkSaleValuationsInrecentyears,theNSWGovernmentsolditselectricitynetworksatsalepriceswellabovetheirregulatoryvaluations.

Forexample, inNovember2015,theNSWtransmissionnetwork(TransGrid),wassoldfor$10.3billion–asale price that amounted to 165% of TransGrid’s regulatory asset base (RAB) value. Similarly, the NSWgovernmentsoldEndeavourEnergyinMay2017for169%ofitsRABvalue.

Importantly,duringtheirrecentrevenuedeterminations,theNSWnetworksmademanyassertionsthattheAER’s approach to determining their ‘return on equity’ allowances would not enable them to recoverefficientfinancingcostsortoattractequityinvestors–claimingthatitwouldresult inlowerinvestmentinthenetworksandsignificantincreasesintheirfinancingrisks.

TheextraordinarysalespricesachievedbytheNSWnetworksmakeamockeryofthoseclaims.

As all informed investors and industry analysts are aware, the statements that Australia’s electricitynetworks make to regulators, policy makers and consumers are very different to their statements toinvestors.

Forexample,areviewoftheSparkInfrastructureequityinvestmentprospectusfortheTransGridpurchaseoutlineswhyinvestorsarequeuinguptopaysuchlargepremiumsabovethenetworks’regulatoryvalues.50

InformedinvestorsandindustryanalystswerenotintheleastsurprisedthatTransGridsoldfor165%ofitsregulatory valuation, as they know that the AER is currently providing investors with ‘return on equity’allowancesofaround3-4timesthelevelthattheyactuallyrequiretoinvestinthenetworks.51

ThesalepricesoftheNSWnetworksprovideaverystrongindicationofthemarketvalueoftheQueenslandelectricity networks. A RAB multiple of 165% was used in the estimates of the Queensland networks’businessvalues.

11.4 TheQueenslandNetworks’TotalReturns The charts overleaf illustrate the total returns (income plus growth in shareholder equity) that theQueenslandgovernmenthasaccrued from its investments inPowerlinkQueenslandandEnergexover the15-yearperiod.

Theyillustratethat:

§ TheQueenslandGovernment’s $401million equity investment in PowerlinkQueensland accrued totalreturnsofaround$9.4billion–i.e.23timestheequityinvestment

§ TheQueenslandGovernment’s average equity investment of $814million in Energex over the periodaccruedtotalreturnsof$17.8billion-i.e.22timestheequityinvestment

It is important tonote that theQueenslandnetworksareunlikely tohaveactually investedtheir reported“sharecapital”.Consequently,thenetworks’actual‘returnonequity’ratiosarelikelytobehigherthantheaboveratios.52

50SparkInfrastructure-EquityInvestmentinTransGridandEquityRaising,25November201551AssetsorLiabilities–TheNeedToApplyFairRegulatoryValuesToAustralia’sElectricityNetworks,HughGrant,5May201652Asabove

54

§ ShareholderEquityiscalculatedasCurrentBusinessValuelessCurrentDebt§ CurrentBusinessValuehasbeencalculatedas165%ofRAB,aspertherecentTransGridsale

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

EquityInvestment Returns

PowerlinkQueenslandReturnonInvestmentOverThePast15Years

ShareholderEquity

Dividends

0

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4000

6000

8000

10000

12000

14000

16000

18000

20000

EquityInvestment Returns

EnergexReturnonInvestmentOverThePast15Years

ShareholderEquity

Dividends

55

11.5 ComparingTheQueenslandNetworks’ReturnsWithRealWorldReturns

TheseareclearlyextraordinaryreturnsandrepresentmanymultiplesofthereturnsthatwereachievedbyAustralia’sbestperformingASX100entitiesovertheperiod.

For example, the chart below compares the returns that theQueenslandgovernment is realising from itsequityinvestmentinPowerlinkwiththereturnsthatitwouldhavebeenachievedifithadinvestedthesameequityinbluechipstocksinothersectorsoftheAustralianeconomy.

It illustrates that over the past 15 years, the Queensland government’s equity investment in PowerlinkQueenslandaccruedtotalreturnsof:






NoASX100stockcameclosetoPowerlink’sreturns.

Note–theabovechartactuallyunderstatesPowerlink’sreturns,as:§ ItdoesnotincludetheotherpecuniarybenefitsthattheQueenslandGovernmenthasrealisedfromitsinvestment

inPowerlink(taxpaymentsandcompetitiveneutralityfees)§ TheQueenslandgovernmentisunlikelytohaveactuallyinvestedthereported“sharecapital”levels.53Importantly, those returns are being realised despite Powerlink being the most inefficient transmissionnetworkintheNationalElectricityMarket(NEM).ClearlythosereturnsaregrosslyexcessiveandarenotinQueenslandconsumers’long-terminterest.53AssetsorLiabilities–TheNeedToApplyFairRegulatoryValuesToAustralia’sElectricityNetworks,HughGrant,5May2016

01,0002,0003,0004,0005,0006,0007,0008,0009,00010,000




56

Appendix2 TheQueenslandNetworks’SystemicOver-Estimationof LoadGrowthAkeydriveroftheQueenslandnetworks’over-investmenthasbeenthenetworks’systemicover-forecastingofdemand.

Overthepastdecade,theQueenslandnetworks’demandforecastshavebeensignificantlyoverblown.

Importantly, theQueenslandnetworks’haveconsistentlyover-forecasted their systemdemand toamuchhigherdegreethanthenetworksinallotherstates.

Thiswas highlighted by theQueensland Government Independent Review Panel on Network Costs, whichstatedthat:54

§ “Another factor contributing to the escalation in capital programs has been the consistent over-estimationofdemandbytheNSPs

§ “The Panel also notes that the current revenue cap control mechanism places volume risk oncustomers”

§ “Wheredemandisover-estimated,capitalprogramswillbeexcesstorequirementsandnetworktariffstocustomerswillincreaseduringtheregulatorycontrolperiodtoensuretheNSPsareabletorecovertheallowablerevenue”

Powerlink’sOver-ForecastingRecordThe chart below, from the EUAA study into the demand forecasting records of Australia’s transmissionnetworks, highlights that over the 2006-2012 period, Powerlink’s level of over-forecastingwas four timeshigherthantheVictorianover-forecastinglevel.55

54QueenslandGovernmentIndependentReviewPanel(IRP)onNetworkCosts,FinalReport55AcomparisonofoutcomesdeliveredbyelectricitytransmissionnetworkserviceprovidersintheNationalElectricityMarket,EUAA2012

57

The table below outlines the differences between Powerlink’s 2013/14 peak demand forecasts and theactualpeakdemandthateventuated(justtwoyearsaftertheforecasts).56

2013/14MediumForecast(MW)

2013/14Actual PeakDemand(MW)

Difference

RevenueProposal

10%POE

50%POE

10,907

10,500

7,500

7,500

45%overestimate

40%overestimate

Powerlinkwasrewardedwith‘windfallprofits’ofaround$300millionduringthe2012-17regulatoryperiodforits“forecastingerrors”,asitsrevenueallowancesincludedreturnsoncapitalforforecastcapexthatitdidnotincur.57

EnergexandErgonEnergy’sOver-ForecastingRecordSimilarly, the demand forecasts used by the Queensland distributors to justify their record-high capexallowances for the 2010-15 regulatory period were also dramatically overblown. Rather than increasingsignificantly,aspredictedby thedistributors,peakdemandandenergydeliveredbothreducedduring theperiod.

Asoutlined inthetableoverleaf, theQueenslanddistributorsover-estimatedtheirpeakdemandforecastsby33.2-41.4%,andover-estimatedtheirenergydeliveredforecastsby14.2-25.2%.58

2015 Forecasts 2015 Actuals Difference

Energex - Peak Demand

- Energy Delivered

5,940 MW

24,042 GWhrs

4,200 MW

21,055 GWhrs

41.4 % over-estimation

14.2% over-estimation

Ergon - Peak Demand

- Energy Delivered

3,330 MW

16,874 GWhrs

2,500 MW

13,496 GWhrs

33.2% over-estimation

25.2 % over-estimation

Asaresult,theQueenslanddistributorswererewardedwith‘windfallprofits’ofaround$1billionforthoseforecasting errors, as their 2010-15 revenue allowances included returns and depreciation on capex thattheydidnotincur.59

56AERConsumerChallengePanelCCP6(HughGrant)submissiontotheAERonPowerlinkQueensland’s2017-22RevenueProposal57AERConsumerChallengePanelCCP6(HughGrant)submissiontotheAERonPowerlinkQueensland’s2017-22RevenueProposal“ElectricitybillsupinQueenslandbecauseofPowerlinkoverspend”,CourierMailArticle,5thDec,201158AERConsumerChallengePanelCCP2(HughGrant)SubmissiontotheAERonEnergexandErgon2015-20RevenueProposals,P1859AERConsumerChallengePanelCCP2(HughGrant)SubmissiontotheAERonEnergexandErgon2015-20RevenueProposals,P19

58

Appendix3 AssessmentOfPotentialPriceReductionsArising FromTheQueenslandPoliticalParties’PoliciesOver the past year Queensland’s political parties have proposed various policies aimed at reducing theQueenslandnetworks’pricesandprofits.

ThisappendixprovidesacritiqueoftheQueenslandpoliticalparties’currentpoliciesandtheextenttowhichtheywoulddrivetheQueenslandnetworks’pricestowardsefficientlevels.

The table below summarises the Queensland political parties’ key policies and the estimated potentialnetworkpricereductionsthatwouldarisefromtheirimplementation.

PoliticalParty

PoliciesToAddressExcessiveProfits

PoliciesToDriveEfficientCosts

PotentialPriceReductions

QldGovernment$50“electricityassetownershipdividendpayment”forQueenslandhouseholds

-

3%

LiberalNationalParty(LNP)

Write-downoftheQueenslandnetworks’regulatoryassetbases(RABs)60

Appointconsumerrepresentativestothenetworks’boards

Tieexecutivebonusestopricereductions

20%

OneNationParty

20%reductionfromremovalofdividendpayments

- 20%


Implementationof“recoveryonly”pricing

AbolishmentofDORCvaluationmethodology

Reversiontostatebasedregulation

60%

QueenslandGreens

Reversiontononprofitentities

Reversion to statebasedregulation 60%

60

On3April2018,theLNPLeader(DebFrecklington)endorsedthefindingsandrecommendationsoftheGrattanInstitutePaper–“Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,March2018”TheGrattanInstitutepapercalculatedarangeofRABwritedownsfortheQueenslandelectricitynetworksbasedonvariousassumptions.TheestimatedpricereductionsarebasedontheGrattanInstitute’scalculatedRABwrite-downsof$2.5bn(38%)forPowerlinkQueensland,$3.9bn(33%)forEnergexand$2.8bn(26.3%)forErgonEnergy

59

Theassumptionsunderlyingtheestimatedpriceimpactsareasfollows:

QueenslandGovernmentPolicies

In relation to addressing the networks’ excessive profits, the Queensland Government is proposing toprovide a $50 “electricity asset ownership dividend rebate” for each Queensland household. Thatcommitmentisrestrictedtohouseholdelectricitybillsandtothenexttwoyearsonly.

TheQueenslandgovernmenthascostedtheinitiativeat$100millionperannum.

Anassessmentoftheoverallimpactoftheinitiativeonthenetworks’averageprices(acrossallconsumers)identifiesthatitwouldresultinoverallaveragenetworkpricereductionofaround3%.

The Queensland Government has not outlined any specific policies that would drive the networks’ coststowardsefficientlevels.

Consequently,overall theQueenslandGovernment’spolicieswillpotentiallyreducethenetworks’averagepricesbyaround3%.

QueenslandLiberalNationalParty(LNP)Policies

Inrelationtoaddressingthenetworks’excessiveprofits,theLNPisproposingtowritedowntheQueenslandnetworks’regulatedassetbases(RABs).

On 3 April 2018, the LNP Leader (Deb Frecklington) endorsed the findings and recommendations of theGrattan Institute paper, which called for the Queensland government to write-down the Queenslandnetworks’regulatoryassetbases(RABs).61

TheGrattan InstitutepapercalculatedarangeofrequiredRABwrite-downsfortheQueenslandelectricitynetworksbasedonvariousassumptions.TheestimatedpricereductionsarebasedontheGrattanInstitute’scalculated RAB write-downs of $2.5bn (38%) for Powerlink Queensland, $3.9bn (33%) for Energex and$2.8bn(26.3%)forErgonEnergy.

Implementation of those write-downs would amount to a total reduction in the Queensland networks’chargesofaround19%.

Asoutlinedinchapter8ofthisreport,theGrattanInstituteadoptedhighlyconservativeassumptionsinitsassessment of the required RAB write-downs for the Queensland networks. Most other independentanalystshaveconcludedthattheQueenslandnetworks’RABsareovertwicetheefficientlevel.

However,itisimportanttoacknowledgethattheQueenslandLiberalNationalParty(LNP)proposaltowritedownthenetworks’RABsisthefirstsuchproposalfromadominantQueenslandpoliticalparty,reflectingalong overdue acknowledgement of the unsustainability of continuing to allow the Queensland networks’excessiveRABstodrivetheirexcessivepricesandprofits.

In relation todriving thenetworks’ costs towards efficient levels, the LNPhas proposed toput consumerrepresentativesonthenetworks’boardsandtotiethenetworkexecutives’bonusestopricedecreases.

Thereisaveryhighlikelihoodthatthoseinitiativeswouldbetokenisticandineffective.Tobeeffectivetheywouldneedtobeaccompaniedbymuchstrongergovernancearrangements that transformthecultureoftheorganisationsfromacultureofprofligacyandinefficiencytoacultureofefficiencyandcustomerfocus

61Downtothewire:AsustainableelectricitynetworkforAustralia,GrattanInstitute,March2018y

60

However,thisanalysishasassumedthattheLNP’sinitiativeswouldmakeasmallcontributiontofacilitatingthe required cultural transformations and has assumed that they would result in a 1% reduction in thenetworks’prices.

Overall,theLNP’spolicieswouldthereforepotentiallyreducethenetworks’pricesbyaround20%.

OneNationParty

The One Nation Party promised to reduce Queensland’s electricity prices by 20%, by ceasing dividendpaymentsfromtheQueenslandGovernmentownedenergycompanies.AlthoughtheOneNationPartydidnot outline the calculations and mechanisms for achieving the 20% price reduction, this analysis simplyacceptsthattheintentofOneNation’spolicyistoreducethenetworks’pricesby20%.


TheKatter’sAustralianPartyproposedtorevertthenetworks’pricingto“recoveryonly”,andtoabolishtheapplicationofthedepreciatedoptimisedreplacementcost(DORC)assetvaluationmethodology.

The Katter’s Australian Party did not define what it means by “recovery only” pricing. This analysis hasassumedthatitmeanstheremovalofprofitsfromthenetworks’charges.62

The Katter’s Australian Party also proposed to revert to Queensland Government controlled networkrevenueregulation.Ifimplementedeffectively,robustQueenslandGovernmentcontrollednetworkrevenueregulationwould deliver further substantial reductions by restricting the networks revenue allowances toefficientcostsonly.

Subject to clarification of the Katter’s Australian Party’s definition of “recovery only” pricing, it has beenassumed that their policies would potentially deliver the efficient prices outlined in Chapter 10 of thisreport–i.e.pricereductionsofupto60%.

QueenslandGreens

The Queensland Greens proposed to revert the networks back to non-profit public authorities, therebyremovingprofitsfromthenetworks’prices.

TheQueensland Greens also proposed to revert to Queensland Government controlled network revenueregulation.

Consequently,theQueenslandGreens’policieswouldalsopotentiallydelivertheefficientpricesoutlinedinchapter10ofthisreport–i.e.pricereductionsofupto60%.

ItisclearfromthevariouspoliciesproposedbyQueensland’spoliticalpartiesthatthereisabroadpoliticalawarenessthatbusinessasusualisunsustainable.


62AsoutlinedinSection10.1.1ofthisreport,adebtriskpremium(DRP)of1.25%hasbeenprovidedtoprovideanallowanceforthenetworks’specificnon-diversifiablefinancialrisks

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