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New investment in the national energy market. Address to the 14th National Power and Gas Conference, Sydney, 18 August 2003



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NEW INVESTMENT IN THE NATIONAL ENERGY

MARKET

14th NATIONAL POWER AND GAS CONFERENCE

Monday 18 August 2003

ED WILLETT - COMMISSIONER

Introduction

Good morning.

Today I will examine the topic of new investment in the national energy market.

Understandably new investment has attracted considerable interest. Adequate

investment is a test of the success of Australia’s energy market reforms. Without

investment we will not be able to support the needs of industry and consumers.

New investment has been a focus of the COAG Energy market Review’s final Report

in December last year and then again recently with the release of NEMMCO’s 2003

Statement of Opportunities (the SOO) so it is not surprising this topic has again

attracted much attention.

The focus of my speech today is on the regulated electricity transmission networks

and the gas transmission pipelines as the Commission regulates these areas of the

energy market. It is in these areas that I as a Commissioner of the ACCC can make

the most difference.

Investment in these services is also particularly important to the operation of energy

markets. It is needed to cater for growth in energy demand and improved reliability.

It also plays a central role in the development of competitive energy markets. New

pipelines can create inter-basin competition, while electricity interconnection between

states promotes competition between generators in different states.

1

In carrying out its regulatory functions the Commission strives to achieve the right

investment outcomes by providing the appropriate incentives for investment while at

the same time protecting the interests of the users of the regulated business.

Competitive energy prices are part of the investment equation. There is little point in

promoting investment in transmission if we deter downstream investment in areas like

manufacturing.

In the absence of regulation high prices will affect business-input costs and the ability

of businesses to compete in Australia and overseas. Over time prices such prices will

also deter downstream investment. An obvious example is the impact of energy prices

on energy intensive manufacturing and resource processing sectors. For example in

the aluminium smelting and paper manufacturing industries energy costs are 20

percent of production costs, while energy costs in brick manufacturing and steel

production are 18 percent and 11 percent respectively of production costs.

In today’s speech I will be discussing the Commission’s approach to regulation, the

investment outcomes in electricity and gas transmission and options the Commission

is pursuing to further improve promote investment.

The Commission’s approach to regulation

The Commission carries out regulation of gas and electricity transmission assets under

the requirements set out by the respective Codes. To a large extent the Commission’s

approach to regulation is determined by the industry Codes but in a number of

important areas the Codes require the Commission to develop guiding principles such

as, under the Electricity Code, the Draft Regulatory Principles (DRP) and the

regulatory test

In this regard the Commissions approach to setting CPI-X caps for gas and electricity

is largely set out in its DRP document which uses a building block approach to

determine the CPI-X parameters. The aim is to provide service providers with the

incentives to operate more efficiently and undertake needed investment.

2

Building block approach

The building block approach has been widely adopted by Australian regulators as it

establishes an appropriate revenue requirement that fully compensates the regulated

businesses for the efficient costs of providing the regulated service. The building

block approach in determining the X parameter in the CPI-X caps uses forward

looking efficient costs (as actual costs may reflect past inefficiencies of the regulated

firms business) and a benchmark rate of return.

If the regulated firm is able to outperform its benchmark rate of return it can keep the

excess revenue and vice versa. This provides strong incentives for service providers

to cut costs and improve efficiency. Service standard benchmarks combine to protect

users from reductions in quality.

The regulatory framework also aims to provide an environment of certainty for

investors. Our revenue and price cap decisions accommodate new investment by

providing revenues to undertake proposed projects.

Investment outcomes

The best way to assess the effectiveness of the Commission’s approach to regulation

is to look at the evidence. What investment is being undertaken? Are these higher or

lower than in the past, are they adequate.

The available data for electricity transmission businesses (TNSPs) suggests that the

Commission’s approach to regulation has delivered sound investment performance in

that sector.

Electricity Transmission

In electricity the data shows unprecedented levels of transmission investment. Around

$3 billion in investment has been approved by the Commission over the five year

regulatory period. This will add 40 to 50 percent to the existing asset base.

This is the amount accommodated in ACCC decisions, but evidence suggests

outcomes will be higher. 3

Investment Outcomes in Electricity Transmission

TransGrid Powerlink SPI

Powernet ElectraNet TransEnd *

Asset base-RC (millions) $3,726 $3,300 $3,356

$1,585 $1,000

Asset base DORC (millions)

$1,935 $2,276 $1,835 $824 $604

Capex (millions) $881 $1,040 $379 ^ $358 $391

% Growth (RC) 24% 32% 11% 23% 39%

% Growth (DORC) 46% 46% 20% 43% 65%

* Denotes proposal

^ - Does not include augmentations

Source: ACCC decisions

Of the close to $3 billion accommodated by the Commission approximately three-quarters relates to new augmentations which must be assessed against the regulatory

test.1 When you compare these figures to the opening asset base the figures range from

an increase of 20 percent in Victoria to a proposed 65 percent in Tasmania. The

overall average is 44 percent2.

Constraints

Further we can see from figures provided in NEMMCO’s 2003 Statement of

Opportunities (SOO) that this increase in transmission investment in the NEM is

translating into an easing in constraint hours in the network. The bar graph labelled

‘Constraints” shows for 2001 and 2002 the inter3 and intra-regional constraints in the

NEM and the hours that constraints occur in particular regions.

1 The remaining quarter related to refurbishment and replacement capex

2 The comparison here is to the replacement cost of existing assets. For comparison purposes it does not depreciate the assets.

3 In relation to the inter-regional constraints, some of the interconnectors such as QNI, Directlink, and Murraylink and the SNOVIC 400 have come on board after 2000.

4

It is clear from the bar graph that constraints in the NEM may be generally decreasing

however there have been smaller increases registered on the NSW/Snowy/Victorian

interconnectors. This information is consistent with the evidence of solid investment

in electricity transmission in particular in Queensland and New South Wales. In other

words as transmission investment increases constraints in the NEM decrease.

5

Constraints

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2001

2002

Let us turn now to investment in gas transmission. The gas industry has claimed in

recent times that the gas regime is inhibiting new investment. The evidence does not

support this claim.

Gas transmission

In gas there has been substantial investment since the commencement of the reforms.

From 1990-91 to 1994-95 there was only $250 million invested in gas transmission

facilities. Since 1995-96 there has been over $3 billion invested, with another $7.7

billion proposed over the forthcoming decade.

In that time the transmission network has expanded from 12,069 km to 19,043 km.

6

Investment Outcomes in Gas Transmission

0

100 200

300

400 500

600 700

19 90-91 19

91-92 19 92

-9 3

19 93

-9 4

19 94

-9 5

19 95-96 19

96-97 19 97-

98

19 98

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20 01-02

Source: AGA, Gas Statistics Australia, various issues

The Commission recognises however that there are issues specific to Greenfields

investment versus existing pipeline infrastructure and the so called regulatory

truncation problem. Put simply the truncation problem arises where the upside on

risky investments is capped by the regulator, but companies are not protected from the

downside risks. Under certain circumstances the outcome may give negative expected

returns under regulation where the expected returns would be positive without

regulation.

Greenfields Gas Guideline

The Commission has put out a draft Greenfields guideline consistent with the gas

Code which addresses the issues that arise where there is risky new investment as

compared to situations where there is investment in long established public utility

facilities. The draft guideline directly addresses the regulatory truncation problem.

• It allows companies to retain any upside. Tariffs are set on an ex ante basis using

expected demand. If demand exceeds the projections the regulated companies

retain all of the additional revenues and profits.

7

• It eliminates some of the downside risks faced by the regulated companies.

Service providers can seek a review of the tariffs if demand outcomes are worse

than originally forecast. They can also capitalise losses in early years so that they

gain greater upside in later years when their market may have grown.

The evidence suggests that the current regulatory provisions and their application to

electricity and gas transmission businesses provide a solid base for future investment.

Furthermore as I mentioned earlier, regulated businesses can outperform the

Commission’s benchmark rate of return and retain the additional profits. New

investment expenditure be accommodated in Commission decisions if that investment

passes the regulatory test.

Getting the right balance

Although we are seeing strong investment outcomes in both the regulated electricity

transmission and gas transmission sectors the Commission needs to ensure that they

are the right investment outcomes. The Commission’s objective is to get the right

balance of incentives for investment and certainty for investors.

In order to ensure that the balance is right the Commission is reviewing a number of

issues covering its approach to regulation. As I mentioned earlier, the Commission’s

approach to regulation is determined by the gas and electricity Codes. But in a number

of important areas the Codes require the Commission to develop guiding principles.

Today I would like to touch on two areas where the Commission is further developing

its approach to regulation.

The first of these is the Commission’s review of its Draft Regulatory Principles for

electricity transmission. The second is the review of the Regulatory test.

Slide 9

Let me turn first to the review of the DRP. The focus of the Review will be on

improving incentives for investment and efficiency.

8

The review is occurring now as the Commission has had several years of experience

in regulating price and revenues for electricity transmission network service

providers.

The Review will cover all of the main issues in the current Draft Statement of

Principles for the Regulation of Transmission Revenues (Draft Regulatory Principle)

including valuation of the asset base.

Draft Regulatory Principles

As I have mentioned earlier in my speech to you today, in the regulated electricity and

gas transmission sectors we are seeing some solid investment performance. The

Commission needs to ensure that in its revenue cap determinations this solid

investment performance continues.

An important element of a TNSPs revenue cap outcome is the asset base of the TNSP.

Asset base

Since taking over the regulation of TNSPs from the jurisdictions the Commission has

completed the first round of revenue cap determinations. In accordance with the Code

for all first round revenue cap determinations the Commission adopted the state

regulators valuations of TNSP’s asset base value. While the Commission does not

have unlimited discretion in determining an asset valuation methodology, the Code

provides for the Commission for the second revenue reset to revalue the asset base.

The problem with revaluation is the level of uncertainty that the TNSP might be

subject to. Revaluation could potentially lead to significant variations in the value of

the asset base from one period to the next. That is a revaluation might result in a

windfall gain or downward loss for the TNSP.

The revaluation can subject the TNSP to an unpredictable revenue stream creating

uncertainty. The risk for the regulated firm is that it invests now, but has its

investment revalued downwards in future. It may never fully recover its costs. 9

The advantage in a revaluation of the asset base is that it would provide a useful

transitional tool from the change of regulatory regimes. The Commission has never

commissioned a full valuation of any of the TNSPs’ assets. If the Commission is not

confident that the jurisdictional asset values generate efficient returns it could revalue

at the initial reset to ensure that errors in the asset base are not perpetuated into the

future.

Should the Commission decide to revalue it would use the DORC methodology. The

Commission decided to adopt the DORC approach in regard to fixed assets to avoid

the problem of circularity that arises when trying to value a regulated asset on the

basis of associated regulated revenue.

The Commission’s preferred position would be to adopt the initial jurisdictional

valuation and add in new investment at cost. The attraction to this option is that a

lock-in of the jurisdictional asset base is unlikely to deter new investment. However,

the problem with a lock-in is that if there are existing errors in the jurisdictional asset

base these would be locked-in and carried forward into the future.

It is envisaged that the Commission’s Discussion Paper 2003 - Review of the Draft

Regulatory Principles will be released for public comment towards the end of this

month. The Commission will be inviting submissions on the issues raised and will be

holding workshops later on in the year or early next year.

The second review being undertaken by the Commission is its review of the

regulatory test.

Review of the Regulatory Test

The regulatory test is a new investment test applied by the TNSPs on capital

expenditure that augments the network. The test compares costs and benefits of

alternative feasible options to the new augmentation. The test then chooses the one

that maximises the net benefits.

10

Some obvious questions for the Commission’s review of the regulatory test is whether

the test should be retained and whether any changes need to be made to the test.

While the Commission strives to achieve the right investment outcomes for new

investment it also aims to protect the interests of the users of the regulated business.

Given that regulated businesses are natural monopolies and therefore do not have

competitors, users cannot make the decision to switch to an alternative provider.

Instead, potentially users are stuck with poor investment decisions through

unnecessarily high prices, poor service standards etc. Thus the regulatory test provides

a hurdle for inefficient investment and works to ensure that only efficient investment

is rolled into the asset base.

The attraction of the regulatory test is that it is a comprehensive test for new

investment that protects the interests of the user, and provides a critical level of

certainty for the TNSPs as once the new investment has passed the regulatory test it

will not be subject to optimisation.

On the whole the regulatory test has provided good solid outcomes in investment. The

test is well understood by the industry in general and there is a considerable amount of

built up experience and expertise in applying the test.

This does not answer the question on should there be any change to the test. In

particular there is the important question whether the test include competition

benefits. The debate is a straightforward one. Should the impact of increased

transmission capacity on competition between generators be taken into account? The

idea is there is limited competition between generators in some regions and that

increased transmission capacity can enhance competition from interstate generators to

those regions. The benefit from this is lower prices in the ‘competition poor’ region.

While the Commission is keeping an open mind on the matter there is unlikely to be a

radical change to the test as a radical new approach could put at risk the outcomes on

the investment front that we have seen to date. Further, assessing any likely increase

in generator competition resulting from transmission investment is extremely difficult.

Nonetheless, it would seem a strange outcome to ignore these important potential

benefits. 11

12

Conclusion

The issue of new investment has been increasingly topical since the COAG Energy

Market Review released its report at the end of last year and then more recently with

NEMMCO’s release of the 2003 SOO.

New investment is important to the efficient operation of the national energy market

in so far as transmission network services are critical to the development of a

competitive NEM and a competitive gas market with more pipelines providing greater

inter basin competition.

The evidence points to a solid investment performance in the regulated areas of

electricity and gas transmission. It is clear that the Commission’s approach to

regulation is achieving appropriate investment incentives and protecting the users of

the regulated businesses.

The Commission has endeavoured to enhance the results of this solid investment

outlook through continuing to improve on the incentives for efficient investment. This

is seen in its current reviews of the DRP and the Regulatory test.