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ATTACHMENT United Energy and Multinet Gas Submission to:

Review of Limited Merits Review Regime Issues and Questions for Stage Two

Overview

Effective independent merits review is essential for maintaining investor confidence and delivering the investment required to meet customers’ demand for reliable energy supplies.

We accept that there is scope to improve the operation of the current merits review regime. However, any changes to the current regime must be targeted and proportionate, having regard to the specific issues identified by the Panel. It is essential to minimise any inefficient use of resources, which are better directed to the AER.

A key finding in the Stage One report is that the Panel rejects de novo merits review. United Energy and Multinet Gas strongly agree with the Panel on this issue. De novo merits review requires stakeholders to ‘roll the dice’ on all aspects of the regulatory decision, including matters that are not being contested. It exposes investors to the uncertainties of a lottery and will be used infrequently, as evidenced by UK experience. Accountability and the quality of regulatory decisions will be adversely affected as investors avoid the de novo review process.

De novo merits review also has important resource implications. It requires the review body to attract and retain highly skilled resources. It will divert resources away from the AER at the very time that additional resources should be attracted to improve the AER’s primary decisions. The infrequent use of these resources by the appeal body would make the exercise particularly wasteful, and retaining the necessary skills within the appeal body will prove impossible.

For these reasons, we welcome the Panel’s view that de novo review merits review should be rejected. There are other important aspects of the Panel’s Stage One report that we also support. In particular:

• Accountability is an important feature of merits review, which has been enhanced by the current regime.

• Improved customer engagement is essential throughout the regulatory process, as well as the merits review process.

• There is already scope under the current merits review regime for the AER and the ACT to widen the issues beyond the grounds of appeal raised by the NSPs.

• We agree that the building block regime is not a formulaic process that involves simply adding the components together. However, in making ‘top down’ assessments of the overall budget to inform individual building block assessments, the regulator must exercise judgment in a reasoned way, supported by evidence or some legitimate ‘reference point’. It cannot be based on ‘gut feel’.

• We agree that blind adherence to a formula – such as CAPM – can lead to outcomes that are inconsistent with the objectives and principles set out in the Law.

While there are many areas where United Energy and Multinet Gas agree with the Panel’s findings, there are also some important differences of view:

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• We regard it as an overstatement for the Panel to suggest that the ACT’s decisions have not properly considered the NEO and NGO. It is apparent from the ACT’s decisions that the ACT is acutely aware of the objectives and principles in the Law.

• It would not be appropriate for the ACT to take a ‘top down’ assessment of revenue determinations in deciding whether an error should be corrected. This approach unavoidably leads to de novo review, with all its associated problems.

• The Panel overstates the linkages between elements in the building blocks. In addition, it is not appropriate to examine related issues until an error has been found in the decision.

In terms of the way forward, United Energy and Multinet Gas consider that:

• Merits reviews should continue under the ACT for the following reasons:

— External review is an essential feature of effective merits review, and the ACT is very well equipped to perform this task.

— Investors place a high value on a quasi-judicial, open review process where issues can be tested and argued in a transparent manner.

— An administrative review body would too closely replicate the AER’s processes, and may ultimately be regarded as duplicating regulatory functions.

• There should be a two-step process in any merits appeal, which requires:

— the identification of an error, and then

— the determination of any corrective action.

• In relation to determining any corrective action (the second step), the AER should present evidence to the ACT on:

— whether the ACT should consider any related issues

— whether the correction of the identified error will promote the NEO/NGO.

• Our recommended ‘second step’ in the appeal process will address the Panel’s efficiently because:

— The AER, as the expert regulator, is best placed to identify any related matters.

— The ACT should only examine related matters if it first determines that there has been an error. To consider related matters earlier in the process would be a wasteful use of resources and lead to unnecessary delays in appeal decisions.

• The ACT should not undertake its own independent assessment of whether the initial and/or amended decision meets the NEO/NGO. Such an approach inevitably leads to de novo merits review, which the Panel has rejected.

• We propose the establishment of a consumer advocate that can represent consumers in all price setting processes including merits reviews.

• The AER’s desire for greater unfettered discretion should itself encourage the Panel not to provide it. The case for greater discretion is not borne out by the ACT’s decisions to date, which have, in many cases identified the inappropriate exercise of discretion by the AER.

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1. Introduction

United Energy and Multinet Gas welcome the opportunity to lodge this submission on the Panel’s Discussion Paper on Stage Two of its review1. The Discussion Paper follows the Panel’s finalisation of its Stage One Report2, in which the Panel concluded that the merits review regime has not worked as intended. In Stage Two, the Panel is considering what, if any, changes it might be appropriate to make to the current regime.

Given the linkages between the Panel’s Stage One report and its Discussion Paper, it is appropriate for this submission to comment on both documents.

By way of background, it is worth reminding the Panel that United Energy and Multinet Gas are privatised Victorian electricity and gas distributors with considerable experience of regulation by Australian standards.

Both companies have been subject to incentive-based regulation since its inception in Australia. Since privatisation, the companies have been directly involved in 6 price control reviews, conducted by 3 different regulatory bodies, each subject to different legislative arrangements and appeal provisions. Regulatory stability and investor confidence – especially in the current financial climate – remain front-of-mind in responding to the Panel’s Discussion Paper.

Our discussions with the Panel have led us to think carefully about the Panel’s Stage One report. Our further thinking is reflected in this submission.

In summary, we agree with many aspects of the Panel’s Stage One report. In particular, the Stage One report provides a timely reminder for all stakeholders of the objectives of regulation, which are focused on promoting the long-term interests of customers. Furthermore, these objectives are only achievable if all stakeholders have confidence that the regulatory framework and its institutions are stable. The current examination of the merits review process must be seen through this lens.

Where differences remain between our position and those of the Panel in Stage One, these tend to be matters of emphasis or degree, rather than a more fundamental divergence of views. Importantly, however, these apparently minor differences of view in relation to Stage One have potentially material consequences for the direction of the Panel’s Stage Two work.

To explain our views fully, the remainder of this submission is structured as follows:

• Section 2 highlights the matters where United Energy and Multinet Gas substantially agree with the Panel.

• Section 3 discusses those aspects of the Stage One Report where United Energy and Multinet Gas take a different view from the Panel.

• Section 4 examines the way forward and responds to the questions raised in the Panel’s Discussion Paper.

1 Expert Panel, Review of the Limited Merits Review Regime, Discussion Paper, Issues and Questions for Stage Two, 23 July 2012.

2 Expert Panel, Review of the Limited Merits Review Regime, Stage One Report, 29 June 2012

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2. Support for the Panel’s Stage One findings

It is helpful at the outset to highlight those areas where United Energy and Multinet Gas agree with the Panel’s Stage One findings. In particular, we agree with the Panels’ findings that:

• Limited merits review delivers important benefits and must be retained. De novo merits review is not acceptable to investors and will involve an inefficient use of resources.

• The NSPs have not exploited the merits review process by ‘cherry-picking’. The NEL and NGL provisions should be amended to clarify the circumstances in which an appeal may be broadened to include other matters.

• Regulatory stability and better customer engagement are key elements that must feature in the new merits review arrangements.

• Regulation requires judgment and cannot be reduced to a formulaic approach.

• The merits review process should provide a greater focus on the promotion of the NEO, NGO and the Revenue and Pricing Principles.

2.1 Benefits of limited merits review and rejection of de novo regime

Merits review is, and should be, available to all stakeholders. This was clearly the intention of the MCE3. It must also be cost-effective and not lead to unnecessary delays in regulatory decisions4. It must have the confidence of all stakeholders5. On these matters, United Energy and Multinet Gas agree with the Panel’s observations.

The Panel is also correct to highlight the importance of merits review in providing ‘a second pair of eyes’6. Most importantly, however, United Energy and Multinet Gas support the Panel’s rejection of de novo merits review.

Some stakeholders suggest that de novo merits review is desirable because it will reduce the number of appeals. Indeed, de novo merits review provisions in the UK have been used very infrequently. The experience, however, illustrates that investors regard de novo merits review as a lottery. It requires the re-examination of the determination as a whole, even if the appeal relates to a specific, isolated error. United Energy and Multinet Gas regard the re-opening of an entire determination as a wasteful use of resources. It will either lead to unacceptable delays in regulatory decisions or, more likely, weaker accountability, worse regulatory decisions and heightened risk for investors.

The Panel should also be cognisant of the difficulty that the appeal body will face in attracting and retaining resources. As the process will be infrequently used (if at all) it will become increasing difficult for these resources to be retained. Investors will increasingly regard the appeal body as ‘the B team’, and as such, investors will not trust it to improve the AER’s initial decision. The Panel is therefore right to reject de novo merits review. As discussed

3 Ibid, page 43. 4 Ibid, page 63. 5 Ibid, page 17. 6 Ibid, page 66.

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later in this submission, the Panel’s recommendations for Stage Two must not inadvertently lead to the establishment of a de novo merits review regime.

United Energy and Multinet Gas concur with the Panel’s comments that the current regime has provided greater accountability7. It is good public policy to ensure that organisations are held accountable for their decisions. The discipline and transparency of limited merits review ensure that the AER’s decisions comply with the Rules. These important principles must be kept in mind in Stage Two of the Panel’s work.

At this point, it is helpful to remind the Panel that the Rules have been specifically designed to promote the NEO and NGO, and to provide ‘guided discretion’ to the AER. The Panel is aware that Rule changes are only accepted by the AEMC if they demonstrably promote the NEO and NGO. It is therefore reasonable to assume that compliance with the Rules will promote the NEO and NGO, and that non-compliance will not. We will return to this reasonable presumption later in the submission.

2.2 Cherry-picking and scope of appeals

We welcome the Panel’s comments that it is not accurate or helpful to ascribe the outcomes of appeals brought by the NSPs to ‘gaming’ behaviour by NSPs8. The Panel correctly explains that s71O(1) of the NEL and s258(1) of the NGL were enacted to give the AER power to introduce wider considerations in the event that it believed that the ACT was considering matters of appeal on too narrow a basis9. The Panel explains that if the AER has not raised related matters in appeal hearings, it is not reasonable to criticise the NSPs for this outcome10.

Justice Finkelstein also points to the ‘unstated assumptions’ that underpin the cherry-picking argument. Justice Finkelstein explains that the cherry picking argument “seems to be simply a matter of assertion” and he observes that11:

“No party raising this contention has put forward concrete examples of erroneous favourable treatment of regulated businesses.”

We also agree with Justice Finkelstein’s response to those submitters who have argued that the AER does not truly defend its position in appeal proceedings12:

“With respect to those who hold this view, an examination of the conduct of the AER in proceedings before the ACT will show the position to be quite the opposite.”

Justice Finkelstein’s comments should provide the Panel with assurance that the ACT has considered the full force of the AER’s case in each appeal. It is also reasonable to infer from Justice Finkelstein’s observations that the AER would be expected to make full use of its powers under the law.

This latter observation may initially appear to add to the Panel’s ‘puzzlement’ that the AER has not made use of s71O(1) of the NEL and s258(1) of the NGL. However, as explained

7 Ibid, page 61. 8 Ibid, page 57. 9 Ibid, page 58. 10 Ibid, page 59. 11 Justice Finkelstein’s submission, 12 June 2012, page 9. 12 Ibid, page 5.

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below, we think that there is a simple explanation for this apparent puzzle, which has been described by the Panel as follows13:

“A major question that has arisen in the context of evaluating the operation of the LMR to date is: why has the AER systematically declined to use its s71O(1) powers in electricity (s258(1) powers in gas), even in circumstances where it was manifestly the case that (a) the matters being appealed were economically related to other aspects of the AER’s determinations which were not being appealed, and (b) decisions on the contested matters could be expected to have very significant implications for the long term interests of consumers.”

As explained in further detail in Section 3 of this submission, we take a different view to the Panel on the extent to which elements of a determination are truly inter-connected. The Panel’s puzzle would be partly explained if the AER shared our view that the appeal points have been largely separable from other aspects of the AER’s determination.

A possible exception arises in relation to the gamma appeal, which is an important element in estimating the tax allowance. It is arguable that the gamma appeal could, in theory, have raised issues that were relevant to the cost of capital estimates. It would be reasonable to assume, however, that the AER considered this matter at the time of the appeal and came to the view that any consequential impact on the cost of capital flowing from a change in the value of gamma would be negligible or immaterial.

It is also worth noting that the Panel’s Stage One report does not appear to give much weight to the ability of other stakeholders to act as an intervener. This is another means by which an appeal may be broadened to include other issues.

In Victoria, the Minister for Energy and Resources acted as an intervener in the appeal brought by United Energy in relation to the AER’s electricity distribution determination14. The Minister raised two issues – the treatment of related party costs and depreciation. The Minister considered that the AER had erred in favour of the NSPs. While the Minister was unsuccessful in his intervention, the example illustrates that the NEL provisions have been used to expand the scope of an appeal. The Panel does not appear to have considered this example in its Stage One report.

In summary, we agree with the Panel that s71O(1) of the NEL and s258(1) of the NGL should be amended to clarify their intended operation. The ACT should also be able to identify related issues if it so chooses. However, the apparent “puzzle” that the Panel has identified may have a relatively simple explanation, as follows:

• The AER vigorously defends its position in appeal hearings and is therefore highly likely to make use of its powers under the law.

• The Panel overstates the extent to which appeal matters are inter-connected with other elements of the determination.

• The AER does not make compensating errors in its determinations. Consequently, the AER is unlikely to argue that it made an error in relation to the appeal matter, but also made a compensating error elsewhere that ought to be corrected.

13 Expert Panel, Review of the Limited Merits Review Regime, Stage One Report, 29 June 2012, page 59. 14 Application by United Energy Distribution Pty Limited [2012] ACompT 1 (6 January 2012)

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2.3 Regulatory stability and customer engagement

The Panel makes a number of observations regarding the importance of regulatory stability and its linkage to effective customer engagement. We agree with the Panel’s observations that regulatory certainty depends on customers’ trust in the regulatory framework and institutions:15

“In particular, the regulatory certainty associated with the institutions of independent regulation depends upon the legitimacy of the regime, reflected in the extent to which the consumers are willing to go along with arrangements that expose a matter of some interest to them (the cost and reliability of their energy supplies) to the outcomes of the deliberations of groups of non-elected ‘experts’. Closely associated with the notion of legitimacy, is the degree of trust that is enjoyed by those institutions.”

The Panel is also correct to highlight the key role that customers play in securing the certainty on which the regulatory system and investment in long-lived assets depends16:

“Legitimacy is, in turn, closely linked to regulatory certainty: without the confidence and trust of end consumers, a system of delegated, independent regulation is difficult to sustain in the longer term, and regulatory certainty will likely never effectively be established.”

In terms of legitimacy, it is important to remember that privatisation and independent regulation have delivered very significant benefits to Victorian customers. This conclusion has been demonstrated consistently by numerous benchmarking studies commissioned by regulated companies and regulators over an extended timeframe. However, we also recognise that customers are beginning to feel disenchanted with the regulatory process.

We agree with the Panel that there is a need to improve customer engagement throughout the regulatory process, not just the appeal process. We note the recent work by Professor Stephen Littlechild on customer engagement17. We agree with the Panel that incentives should be created to encourage better customer engagement, and possibly, these should be reflected in the merits review process. These developments need to be carefully considered, and we set out some initial thoughts on these matters in Section 4 of this submission.

We accept that the current merits review regime has not worked as intended because it has not been customer-friendly. The Panel is correct to focus on customer engagement as an important aspect of the new merits review arrangements. Our position is that better customer engagement is the most compelling reason for reform.

2.4 Regulation is not formulaic

On reflection, we agree with the Panel’s comment that ‘top down’ assessments are part of the regulatory decision-making process18:

“There is nothing in the rules that says that the AER cannot make assessments of the overall budget to inform individual building block assessments, whilst at the same time using individual building block assessments to inform the overall assessment.”

15 Expert Panel, Review of the Limited Merits Review Regime, Stage One Report, 29 June 2012, page 46 and 47.

16 Ibid, page 39. 17 Stephen Littlechild, "Regulation, customer protection and customer engagement," Cambridge Working

Papers in Economics 1142, Faculty of Economics, University of Cambridge, 2011. 18 Expert Panel, Review of the Limited Merits Review Regime, Stage One Report, 29 June 2012, page 46

and 47.

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An obvious example of this approach relates to operating expenditure, where the AER is able to apply benchmarks to assess the efficiency of the company’s forecasts. In our price reviews, we have frequently reminded the AER of our good benchmarking performance relative to our national and international peers. A similar ‘top down’ view can be applied in relation to our overall price and service levels.

However, it remains essential that regulatory judgments must be soundly based on evidence, not ‘gut feel’. If the AER is encouraged to aim for a particular price outcome and ‘back-solve’ for the building blocks it will lose the confidence of investors and other stakeholders.

In this regard, it is important for the Panel to have regard to the history of regulatory development in Australia. It differs markedly from the experience in the UK, where the Panel observes that regulators “made it up as we went along.”19 The success of a laissez-faire approach to regulation will be judged, not unreasonably, on its performance.

Specifically, in Australia the greater discretion afforded to the ACCC in the early years of regulation did not produce acceptable outcomes. Today’s Rules are, therefore, not an accident of history. The Rules reflect a conscious decision by policy makers to ensure that regulatory discretion is “guided”.

The Panel appears to assume that not following the Rules is acceptable providing that the NEO or NGL is satisfied.20 However, such an observation is inconsistent with a Rules-based approach to regulation. The Rules were drafted specifically to promote the NEO or NGL. In addition, Rule change proposals must demonstrate how the proposed change will promote the NEO or NGL. It is therefore contrary to the regulatory framework to suggest that the Rules should be ignored or put aside in some circumstances.

Although the Panel’s Stage One Report has not, in our view, given sufficient weight to the Australian context, the Panel is right to remind all stakeholders that the regulatory process requires judgement. Regulation cannot and should not be reduced to a spreadsheet. We strongly agree, for example, that the cost of capital assessments must be broader than a mechanical application of a theory. The blind application of the Capital Asset Pricing Model is capable of producing an outcome that is entirely inconsistent with the regulatory objectives set out in the Law. The AER is required by law to have regard to the NEO, NGL and the Revenue and Pricing Principles in undertaking its functions. We agree with the Panel on these points.

As noted already, regulatory judgments should be objective and reasoned – not based on ‘gut feel’. This places a natural limit on the extent to which ‘top down’ judgments can be brought to bear on regulatory determinations. Nevertheless, some broad judgments can be made. In previous regulatory submissions, United Energy and Multinet Gas have pointed to their superior price and service performance, compared to their peers in other States. We have sought to use this high-level comparative benchmarking to provide a top-down validation of the individual building block allowances we have proposed. To date, regulators have been unwilling to factor these matters into their decisions – preferring instead to adopt a bottom up approach. These matters relate, however, to questions of ‘regulatory best practice’, which are beyond the scope of the Panel’s review.

19 Ibid, page 27. 20 Ibid, page 42.

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2.5 Greater focus on the NEO, NGO the Revenue and Pricing Principles

We agree with the Panel that the merits review process should give greater emphasis to the overarching purpose of regulation as reflected in the NEO, NGO and the Revenue and Pricing Principles in the Law. The Panel makes the following concluding remarks21:

“In summary, the Panel is of the view that the NEO and NGO are given inadequate weight during the merits review process. Not only is consideration of the long term interests of consumers neglected, but the fact that it is neglected means that no credible account can be given as to precisely why, at this late stage of the regulatory process, it has been determined that consumers have been required to pay significantly larger amounts of money for their energy supply than the amounts determined by the expert regulatory body. The resulting lack of explanation is not conducive to establishing that ACT decisions have been preferable to those of the primary decision maker that they have displaced, or, more generally, to the development and maintenance of trust, legitimacy and regulatory certainty.”

While we agree with the thrust of the Panel’s comments, increasing the focus on achieving the NEO and NGO must not lead to de novo merits review. If the Panel’s Stage Two recommendations effectively led to the establishment of a de novo merits review regime, it would be a case of the cure being worse than the disease. Specifically, de novo merits review would not provide investor confidence nor improve regulatory decisions, for the reasons noted already.

We agree with the Panel that network companies, the AER and the ACT have not always articulated clearly why the ACT’s decisions are consistent with promoting customers’ long-term interests. This may have contributed to a view that the appeal process is not working appropriately or is unduly favouring the network companies. We agree with the Panel that it is important to address these shortcomings. Section 4 of this submission explains our suggested approach to remedy this issue.

3. Remaining differences of view on Stage One

Section 2 highlighted those aspects of the Panel’s Stage One report that United Energy and Multinet Gas support. The purpose of this section is to focus on those matters where we take a different view to that presented by the Panel. Importantly, while these differences are principally ones of emphasis or degree, they have potentially significant implications for Stage Two of the Panel’s work.

As explained in further detail below, the key areas where our views differ from those of the Panel are:

• The Panel overstates the extent to which the ACT may have failed to promote the NEO and NGO in its decisions.

• The Panel wrongly assumes that the ACT’s role should mirror that of the AER.

• The Panel overstates the extent to which elements of a determination are inter-connected.

21 Expert Panel, Review of the Limited Merits Review Regime, Stage One Report, 29 June 2012, page 54.

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3.1 Tribunal’s performance to date

The Panel describes the ACT’s decisions in the following terms22:

“Major transfers of resources have taken place in consequence of those decisions, without any substantive evaluation of whether those transfers were merited in terms of the NEO and NGO.”

We regard it as an overstatement for the Panel to suggest that the ACT’s decisions have not properly considered the NEO and NGO. It is apparent from the ACT’s decisions that the ACT is acutely aware of the objectives and principles in the law. In many decisions, the NEO and NGO are discussed at length. In addition, it is open to all parties to argue that a particular outcome will, or will not, promote the NEO, NGO or satisfy the Revenue and Pricing Principles.

We also regard the Panel’s language as unfortunate because ‘a transfer of resources’ implies that there is no basis or reason for the exchange. In fact, the ACT is only able to uphold an appeal if it can be demonstrated that the AER’s determination involves:

• a material error of fact;

• an incorrect exercise of discretion; or

• unreasonableness.

The burden of proof is therefore with the NSP to show that the AER has erred. It is a high hurdle that must be satisfied. In layman’s language, the AER is afforded the benefit of the doubt.

In a similar vein, we do not regard the financial impact of the ACT’s decisions – which has been significant - as evidence of either good or poor performance. Instead, the financial sums involved illustrate the importance of the ACT’s role and the dangers of dispensing with merits review.

In summary, we are concerned that the Panel’s Stage One report may give the false impression that the ACT has readily overturned the AER’s decisions without good cause. On the contrary, however, Justice Finkelstein’s submission is unequivocal in highlighting the repeated errors in the AER’s decisions and the importance of merits review in providing for correction23:

“What is evident is that there have been significant (and repeated) errors in the AER decisions. The fact that there are regular review applications is not, in itself a bad thing if the reviews consistently rectify errors. This is particularly so when, for the most part, the errors are not ones that could be rectified in judicial review proceedings.”

We recognise that the language of the Stage One report will not necessarily affect the Panel’s conclusions in Stage Two. However, it is important to remind the Panel that the existing merits review process is not tilted in favour of the NSPs and has not produced unjustifiable decisions. We regard the ACT’s deliberations – whilst often disagreeing with the position put by NSPs – as carefully reasoned and balanced.

22 Ibid, page 18. 23 Justice Finkelstein’s submission, 12 June 2012, page 8.

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3.2 Scope of the Tribunal’s task

It is important to recognise that the ACT’s role and expertise differs from that of the AER. In particular:

• The ACT does not undertake its own review of the issue and reach its own conclusions by exercising the same discretion afforded to the AER.

• Instead, the ACT’s role is limited to correcting unreasonable decisions or decisions that contain errors or an inappropriate exercise of discretion.

• The ACT cannot simply prefer a different decision to that of the AER.

Justice Finkelstein has made similar observations in his submission24:

“The role of the ACT is not, as some submissions suggest, simply to substitute its preferred decision when reasonable minds differ. The ACT can only interfere with a decision if error is shown or if the AER has acted unreasonably.”

“On a review the ACT will only reconsider the AER decision to the extent necessary to address the ground of review. It is not permissible for the ACT to reconsider the whole AER decision.”

We consider that the Panel overstates the extent to which the ACT could or should reconsider the AER’s overall determination. For example, the Panel argued that:

“The following section of the decision on the Application by United Energy Distribution Pty Limited [2012] ACompT 1 (6 January 2012) at 415 illustrates:

It might be thought that the AER included the APT bond estimate in order to derive a DRP that was lower than that derived solely from the FV curve and that its hybrid benchmark provided a better estimate of the DRP. However, the long-term interests of electricity consumers will not be served if, in the long run, DNSPs are not permitted to recover their efficient costs.

There is nothing to disagree with in the final sentence referring to the relationship between the long term interests of consumers and the ability of Distribution Network Service Providers (DNSPs) to recover efficient costs, and what the Panel is concerned about is simply the gap between the first and second sentences here. To answer the question of whether or not the outcome of the ACT decision is preferable to the AER’s determination, it is necessary to assess whether or not the revenues determined by the AER did or did not prevent United Energy from recovering efficient costs. The Panel has no view on the appropriate answer to this question; but does think that the appropriate question was not asked.”

In contrast to the Panel’s views, we consider that it is reasonable for the ACT to assume that correcting the DRP error would promote the National Electricity Objective. It is appropriate for the ACT to hear evidence on this question from the AER, as the expert industry regulator. Absent evidence to the contrary, it is appropriate to conclude that correcting an error is better than leaving it uncorrected.

To illustrate our point, let us consider the conditions that would be necessary in order for the ACT’s decision in relation to the DRP to be contrary to the NEO or NGO (i.e. for the Panel’s concerns to be justified). The following conditions would be required:

24 Ibid, pages 2 and 4.

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• The financial consequences of the error had already been compensated for in another aspect of the AER’s decision; and

• The compensating error was not raised by either the AER or other stakeholders; and

• There is no benefit in correcting the error for future regulatory decisions.

United Energy and Multinet Gas note that it would be highly speculative to suggest that a compensating error had been made elsewhere in the AER determination. As already noted by Justice Finkelstein in relation to the cherry-picking argument, no concrete examples of compensating errors have been identified to date.

United Energy and Multinet Gas disagree with the Panel’s view that the ACT should undertake exactly the same role as the AER. Such an approach implies that the ACT should re-examine the AER decision in its entirety and will be able to retain the necessary resources to do so effectively. We are concerned that the Panel’s approach will lead unavoidably and unintentionally to de novo merits review. For the reasons already provided, such an outcome is unworkable and would expose investors to unacceptable risks and uncertainty.

In relation to the DRP example, would it be reasonable for the ACT to revisit the entire AER decision because of a difference in view on the selection of the Bloomberg fair value curve for estimating debt costs? In our view, it would not be reasonable. The delays and risks involved with a de novo review would effectively deny investors the opportunity to correct an isolated error in the AER’s approach. In addition, the AER’s uncorrected error in estimating the DRP would continue to be applied in future regulatory decisions, further damaging incentives for efficient investment.

3.3 Extent to which issues are inter-connected

We consider that the Panel overstates the extent to which regulatory decisions are inter-connected. For example, the Panel sees a linkage between the WACC and expenditure allowances25:

“It is beyond the capacity of the Panel to say, in relation to the final determinations of the cost of capital, whether the eventual outcomes served to better promote the long-term interests of consumers than the AER’s original determinations. That is a matter that can only properly be assessed by a broad review of the determinations in their entirety, for example because operating expenditure (opex) and capital expenditure (capex) decisions themselves have implications for the cost of capital.”

We would be concerned if correcting the AER’s estimate of the WACC led to a reconsideration of the operating and capital expenditure allowances in its decision. While it is appropriate for the AER to make ‘top down’ judgments regarding overall costs and revenues, they should have some reasonable basis. It would damage investor confidence if correcting an error in relation to the WACC simply led the AER to ‘pull the expenditure lever’ in the opposite direction to arrive at the same overall revenue outcome.

By the same token, addressing an error in the estimated costs of complying with vegetation management regulations, for example, should not necessitate a re-opening of decisions in relation to the cost of capital. There is no connection between these matters.

On balance, we consider that the Panel has overstated the extent to which appeal issues are inter-linked to other aspects of a determination. We consider that it is appropriate for the

25 Expert Panel, Stage One Report, page 56.

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ACT to confine itself to the appeal points raised, including those raised by the AER or interveners. It would be very costly to re-open an entire AER determination because of errors in relation to a small number of specific matters.

The differences of view outlined above have implications for the Panel’s work for Stage Two of its review, which we turn to next.

4. Way forward – Ideas for Stage Two

Section 4.1 below provides an overview of our recommended approach for remedying the issues identified by the Panel. The remaining sections respond to the detailed issues raised by the Panel, adopting the Discussion Paper’s sub-headings and structure.

4.1 Overview of our proposal

United Energy and Multinet Gas support better customer engagement. Measures must be taken to ensure that customer representation is properly funded and involved constructively throughout the regulatory process.

United Energy and Multinet Gas also accept the Panel’s finding that the appeal body should only correct an error if it promotes the NEO/NGO. However, it is essential that seeking this outcome does not lead to de novo merits review.

In our view, a merits review should start from the reasonable presumption that the AER’s initial decision – with the possible exception of the matters claimed on appeal to be in error - complies with the NEO/NGO. In the absence of this presumption, the process employed by the review body to check whether the overall determination complies with the NEO/NGO would inevitably and inappropriately lead to de novo merits review.

With these considerations in mind, United Energy and Multinet Gas propose the following merits appeal arrangements:

• The ACT should be retained as the appeal body.

• There should be a two-step process in any merits appeal:

1. Identify if there is an error, and

2. Determine the necessary corrective action.

• In the second step the AER should be obliged to put to the ACT their assessment of:

- Any interrelated issues

- The implications for the NEO/NGO of any error correction.

We consider that our recommended appeal process is justified for the following reasons:

• Merits reviews should continue under the ACT because:

— External review is an essential feature of effective merits review, and the ACT is very well equipped to perform this task.

— Investors place a high value on a quasi-judicial, open review processes where issues can be tested and argued in a transparent manner.

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— An administrative review body would too closely replicate the AER’s processes, and may ultimately be regarded as duplicating regulatory functions.

• Our recommendations address the Panel’s concern that the current merits review regime has been too narrow and has not fully considered whether correcting an error will promote the NEO/NGO.

• The Panel’s concerns are addressed through the ‘second step’ in the appeal process. Our proposed design is efficient because:

— The AER, as the expert industry regulator, is best placed to identify any related matters.

— The ACT should only examine related matters if it first determines that there has been an error. To consider related matters earlier in the process would be a wasteful use of resources and lead to unnecessary delays in appeal decisions.

— The AER is also best placed to provide an assessment of the implications for the NEO/NGO of correcting, on appeal, any errors in the AER’s determination.

• The ACT should not undertake its own independent assessment of whether the initial and/or amended decision meets the NEO/NGO. Such an approach inevitably leads to de novo merits review, which the Panel has rejected.

• The ACT’s expertise is in reviewing and testing the AER’s analysis and reasoning. Our recommendation therefore recognises the ACT’s strengths in acting a review body.

• Our recommended approach is relatively low cost because it will deliver important improvements to the existing merits review arrangements without introducing institutional change or requiring substantially greater resources.

4.2 Scope of issues / questions that the review body can / must consider

The Panel explains its view that the review body should examine the decision as a whole, as follows26:

“The Panel’s provisional view is, as already stated, that where a review decision might have significant effects on consumer interests, it is a requirement that, save possibly where agreed otherwise by relevant parties (see further below on incentives to reach agreements), the review body should assess the regulatory decision as a whole, to test both the merits of the original decision and of any changes that the review body might be considering, where merits are assessed on the basis of the relevant statutory objectives (in the current context, the NEO and NGO).”

As explained in section 3, we consider that the assessment by the appeal body of the regulatory decision as a whole would lead to the establishment of de novo merits review. We agree with the Panel’s rejection of de novo merits review.

A merits review should start from the presumption that the AER’s initial decision – with the possible exception of the matters claimed on appeal to be in error - complies with the NEO/NGO. In the event of an appeal being brought:

26 Expert Panel, Discussion Paper, 23 July 2012, page 5.

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• The AER would be required to identify issues that are inter-related with the claimed errors in the determination, and to provide an assessment of the implications for the NEO/NGO of correcting those errors.

• The review body would then test the AER’s reasoning and analysis.

These arrangements would maintain the AER’s role as the expert industry regulator. The ACT’s role would be to review and test the AER’s analysis and reasoning in specific matters that are subject to appeal. Our proposed arrangements would deliver improvements to the existing merits review arrangements without introducing institutional change or requiring substantially greater resources. Moreover, the maintenance of a clear delineation of the roles of the regulator and the appeal body should foster the confidence of all stakeholders in the regulatory regime.

4.3 Substitution / Remittal / Recommendation

The Panel identifies three alternative actions for a review body if an appeal is upheld:

(1) the review body may have powers to substitute its own decision for that of the initial decision maker;

(2) the review body is required to remit the decision back to the primary decision maker for reconsideration; or

(3) the review body can issue a direction or, alternatively, a non-binding recommendation as to a possible remedy, after which the primary regulator makes the final decision.

The evidence from Justice Finkelstein is that the AER has made repeated errors. On this basis, rebalancing the existing arrangements towards remittal may prove counterproductive. We agree with the views expressed by Justice Finkelstein that there is no benefit in remitting the matter to the AER if the review body has sufficient information to correct the error.

We note that the ACT has remitted matters to the AER where further analysis is required. In our view, the existing arrangements have worked well in this respect.

It would be a major retrograde step if the Panel concluded that non-binding recommendations would provide an appropriate merits review outcome. There does not appear to be any rational basis to support this approach.

4.4 Resources of the review body

The Panel asks whether, given the nature and breadth of the issues that may be raised, the review body is sufficiently well resourced to be able to consider and assess each relevant issue in sufficient depth and with the required level of technical analysis.

If the Panel concluded that the review body should reconsider the AER’s entire determination, the resource implications would be very significant indeed. For the reasons set out in sections 2 and 3 of this submission, however, we strongly discourage the Panel from adopting this position. In our view, the resource requirements on all parties would be so significant that it would make merits review impractical.

In our view, the ACT has been able to address the substance of the appeal issues with the resources it has available to it. In the case of the gamma appeal, the ACT was able to draw on expert advice from a consulting firm, SFG. This approach appeared to work well, and we would support further use of consultants where the review body considered this to be appropriate.

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We are also conscious of the comments made by Justice Finkelstein that resource requirements could be reduced if more stringent guidelines applied regarding the length of submissions.

4.5 Time constraints

The Panel explains that under the current LMR arrangements, an applicant has 15 business days to bring an application for review and the ACT has a time limit, after granting leave, of three months (which may be extended), to determine the review. However, reviews have frequently lasted longer than the specific time periods set down in the legislation, and in some cases have lasted much longer.

We agree with the Panel that some relaxation of the time constraints may be sensible. However, it remains important that timeframes are kept manageably short. If decisions are delayed for significant periods, customer pricing can be affected, and on-going uncertainty for all parties would persist.

4.6 Location of review function

The Panel explains that in jurisdictions such as the UK, Germany and Ireland, review bodies are completely external to the original decision maker. In other jurisdictions, such as the US, reviews of decisions tend to take place within the same regulatory commission.

We strongly agree with the Panel that there are significant benefits of an external reviewer. We also consider that the quasi-judicial nature of the ACT is advantageous because it provides a different perspective in reviewing the decision, with a particular emphasis on transparency, impartiality and independence.

Having said that, we consider that more can be done prior to the Final Decision to alert the AER of stakeholder concerns regarding a possible appeal. By introducing a formal process that involved all stakeholders, a better understanding of the issues could be obtained by all parties and the number of appeals may thereby be reduced. The details of such an arrangement would need to be developed, but we consider that it would be likely to deliver benefits.

For the avoidance of doubt, however, we would not regard the development of an internal review process within the AER as replacing the ultimate sanction of an external review.

4.7 Nature and processes of the review body

The Panel is concerned that the current review resembles a judicial/legal process, rather than an administrative one. The judicial nature of the process is regarded as a barrier to the participation of consumer and user groups.

We accept the criticism that the current process is overly legalistic. However, the appropriate response is not to replace the ACT with an administrative body. The ACT is very experienced and the learning curve for a new organisation should not be under-estimated. The case for subjecting all stakeholders to the ensuing costs is difficult to make out.

It must also be noted that investors obtain significant comfort from a quasi-judicial process because it provides confidence that its decisions will be free from political interference. The benefit of merits review in promoting investor confidence should not be underestimated.

The identified barriers to customer participation can be readily addressed through appropriate funding, and by enhancing customer engagement throughout the regulatory process. Furthermore, it should be possible to reform the existing processes to lessen the

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burden on participants. Justice Finkelstein has pointed to some simple ways in which this could be achieved, such as greater reliance on written submissions.

4.8 The composition of the review panels

The Panel has raised questions regarding the composition of review panels. In particular, there is a question as to whether the number of review panel members who hear decisions should be drawn from a larger pool of qualified persons.

We do not have strong views on this issue. It is noted, however, that decisions should be consistent over time and that outcomes should not be dependent on the composition of the review panel. This observation points to the need for some continuity in the composition of the review panels.

4.9 Consumer / user engagement in the process

We agree with the Panel’s conclusion that more needs to be done to foster consumer engagement early in the regulatory process. As discussed in section 2 of this submission, we accept responsibility for customer groups being disenchanted with the existing regulatory process.

Conceptually, it is appropriate that those companies that engage better with their customers obtain some benefit in doing so. Such an outcome would mirror outcomes in a competitive market where companies that understand their customers are more likely to be successful. We are keen to embrace this concept by engaging with our customers much more effectively throughout the regulatory process.

In addition, it should be possible to take account of the level of customer engagement in the merits review process. The Panel is conscious of this possibility in commenting that27:

“What we have in mind is that a review body, in considering AER adjustments to a NSP’s initial proposals, might, when assessing relevant matters, be required to have regard to the extent to which the regulator on the one hand and the NSP on the other hand, have been pro-active in seeking out information about consumer or network user requirements and willingness to pay, and/or have been pro-active in introducing innovations that serve to promote the long term interests of consumers. Put another way, is it possible to replace a review process currently heavily based on competition among lawyers with one based more on competition in demonstrating service to the fundamental policy objectives themselves?”

We agree with the Panel’s sentiments. These are complex matters, but it is clear that much more can be done to give customers a stronger voice in the regulatory process. This enhanced engagement with customers should also reduce the incidence of reviews.

We are conscious that funding to enable effective consumer participation is a major issue for customer groups. These are matters on which the industry could take a lead in developing in light of the Panel’s recommendations.

4.10 Margins of regulatory discretion

The AER is seeking greater discretion both with the AEMC rule-making process, and the appeals process (illustrated, for example, by its proposed removal of one ground of review). We do not support this change. Moreover, we note that the genesis of the current architecture of the Rules and the merits review arrangements has been the desire of policy

27 Ibid, page 16.

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makers to establish a framework that provides the regulator with ‘guided discretion’. As noted earlier, the current framework reflects the unsatisfactory exercise of discretion by the ACCC in the early period of independent economic regulation of energy networks. We see no reason to move away from the existing level of discretion.

4.11 The incentives to reach agreement / settle

The Panel observes that its contemplated changes, including removing obstacles to a more holistic review of regulatory determinations and linking margins of discretion to demonstrable performance in consumer/customer engagement, should themselves increase incentives for negotiated settlements or agreements ahead of review.

We agree that better customer engagement should reduce the scope for appeals and increase the prospect of settlements. However, it must be emphasised that effective merits review should not expose the parties to excessive costs or delayed regulatory decisions. As explained in this submission, some aspects of the Panel’s views raise concerns in these areas.

It must also be emphasised that merits review is the only protection for investors against regulatory error. Therefore, while negotiated settlements may be the ultimate regulatory goal, the regulatory process must remain subject to merits review.