53 December 2014 Assessing Proposals for Regulatory Write-downs Crawford* The regulatory asset base plays a central role in monopoly infrastructure regulation across Australia, and most developed economies. It represents unrecovered past capital investments made by the existing and past infrastructure owners. Provision of a rate of return on the value of these past investments usually represents the single largest component of access charges for many infrastructure services, under the commonly applied ‘building block’ approach to setting access prices. The regulatory asset base exists to recognise that networks are required to fund capital intensive physical assets that will supply both existing and future consumers over their service life. In the case of electricity networks, these physical asset lives typically span between 30 and 50 years. The mechanism of the regulatory asset base allows these costs to be borne through time by beneficiaries of the services enabled by the assets, avoiding current consumers subsidising future consumers, or an unfair deferral of current costs on to future consumers. Importantly, the regulatory base quite often also reflects large investments that have been made to meet regulatory obligations. As a common example, because electricity is deemed to be an essential service, most
jurisdictions place (and have for decades) an ‘obligation to connect’ on electricity distribution networks covering a broad range of customer types. This places the network in the position of being required to make customer-specific investments in connection (in addition to any required shared system augmentation to enable that connection) to discharge statutory obligations. Furthermore, many jurisdictions place statutory restrictions on how and from whom networks recover these and other capital investments. This means that network businesses are effectively barred from allocating the price or adjusting terms and conditions for access, taking into account the risk of future stranding. Rather, state and territory arrangements, combined with the existing regulatory rules framework (providing for returns over the life of the asset, irrespective of the risk of future stranding), effectively dictate how, when and from whom many electricity networks recover networks investments. The treatment of the regulatory asset base represents a critical part of the overall regulatory compact. This is because assets that form the regulatory base, unless they are protected by either credible or binding long-term regulatory rules or commitments from a regulatory body, are subject to the risk of regulatory ‘asset stranding’ or ‘regulatory taking’ (Greenwald 1984). The degree of this risk will affect the cost of financing the regulated firms new and existing investments, since the regulatory treatment of past capital investment is the best objective information available to investors on how
contract. No regulatory contract can ever be (efficiently) fully specified, and so, it might be argued, perhaps regulatory asset write-downs could be viewed as a clause of the regulatory contact that policy makers and regulators simply neglected to fill out. That is, that the regulatory bargain always has an implicit clause that ‘if things change, things may change’. In the case of long-lived capital intensive networks, however, this thesis faces a few problems. First, with the latest version National Electricity Rules stretching to 1469 pages, incompleteness is amongst the least of its vices. In fact, Rules around the updating and stability of the regulatory asset base are amongst the most specific and detailed, with specific nominated values arising from past decisions ‘locked in’ to a schedule of the Rules. Second, implementation of these Rules by regulators and the underlying regulatory bargain have also been publicly and transparently laid out in a series of regulatory decisions. A series of AER decisions have quite clearly set out its views on both how the risks of changing demand levels should be shared over future current regulatory periods. Therefore, Rawlsian puzzling about what regulatory bargain ‘might have been struck’ in the face of changing demands is not required. Indeed, as a construct applied to the actual circumstances applying to energy networks, such puzzling is highly artificial. Rather, the bargain is detailed, detailed indeed at what many would say was inordinate length. A problem is that even if the thought experiment is followed – it leads in different directions from write-downs. In cases where new sunk capital investments are entered into
in competitive markets in the face of uncertain demand conditions, the result is not pricing based on volumetric usage charges and low fixed charges. Rather, the revealed preference from users and providers is that ‘take or pay’ contracts predominate. These commonly underwrite significant gas pipeline infrastructure, for example. In the case of toll roads, for example, volume and demand risk are increasingly underwritten by taxpayers. Literature on Regulatory Stranding Due to the rarity of regulatory stranding actions, is a substantially smaller regulatory economic literature around the issue than perennial regulatory issues such as pricing or alternative approaches to access pricing. An exception to this is examination of the issue of regulatory stranding associated with the construction by US utilities of nuclear power stations in the wake of the Three Mile Island disaster. These events triggered a substantial regulatory review of approved and partially constructed power plants, raising the issue of the allocation of the risks and costs of changed regulatory policy. As Professor Ingo Vogelsang recently pointed out, a choice exists – compensation of the owners before the stranding event, or compensation afterwards (Vogelsang 2014). Delivery of that compensation prior to any stranding also involves choices. Some options include the deliberate allowance of an additional allowance in the regulatory cost of capital, or equivalent adjustments to cash-flows (in a sense an ‘insurance premium’). Regulators in energy and telecommunications have previously indicated that advancing depreciation could be one mechanism adopted,
could be expected to increase network charges. Networks rapidly substituting operating for capital expenditure would be likely to lead to a ‘price shock’ for consumers, because operating costs are recovered in full from current consumers within each regulatory period. By contrast, the costs of capital network investments are (typically) recovered over 30-40 years from both current and future consumers. This particular impact is additional to any of the network or final price outcomes estimates detailed in this analysis. It is difficult to quantify because the existence and scope of these substitution possibilities will only be known with any certainty by network owners, and will differ according to the characteristics of each electricity network. A further issue relevant to the implementation of any regulatory asset write-down is that it would clearly the issue of the economically appropriate level of the new asset base. That is, it cannot be presumed without evidence that a value lower than the existing level is unambiguously more efficient than an alternative value. In these circumstances, there would be potentially strong arguments to revisit the original asset valuation processes undertaken for the most part in the late 1990s, to establish a satisfactory basis for a view of whether they represented an economically efficient starting point for price and revenue setting purposes. There is certainly evidence to suggest that electricity distribution networks operate a significant range of assets that were not actually recognised in original asset valuation processes. There are credible economic efficiency arguments to recognise and incorporate open
service’, or ‘stranded’. Otherwise, a further discussion is needed to establish ‘how much’ of the asset is truly stranded, which is a not a simple exercise. Aside for a relatively limited set of clearly by-passed, or obsolete assets, these conditions may be genuinely hard to establish. A regulator’s hope of doing so is not assisted by the inevitable uncertainty and subjectivity that may attach to forecasting future demand and competitive conditions, technological developments, and potential alternative uses of assets. An example of challenges is the widely unforeseen use of the decades-old copper network to deliver very high-speed broadband through a combination of technological developments. Similarly, it is not obvious in respect of electricity networks that distributed energy developments, potential for electric vehicle developments, and increasing ‘two-way’ flow of energy and information mean that the electricity grid will not be more valuable, rather than less. A second claim is that regulatory asset write-downs are an important tool to ‘punish’ or ‘discipline’ excessive investment. This claim is typically predicated on an assessment that regulatory gaming may lead to the embedding within the regulatory asset base of excessive past investments. Both claims are complicated, typically, by the presence of past or existing obligations to invest. Where a regulated firm has invested to meet binding licence or minimum service obligations, on a basis, it is difficult to see ex post regulatory action as a particularly well-targeted regulatory tool enshrining sound future incentives. In the case of the electricity
regime, opportunities for ex post reviewing of capital expenditures, and in some limited circumstances, stranding of capital investments made during of the previous regulatory period that are in excess of original allowances, are already tools being trialled in upcoming decisions. Practical Alternatives – which is the better approach? If regulatory write-downs are not the answer, the question remains: how should network regulators and policy makers think about some of the drivers that lead to this issue being raised? Economically speaking, the logical question to ask is: if networks prices are established to be commercially constrained by competing technologies, should the community continue to expend significant resources applying costly pricing regulation in the first place? The real redundant asset, in the case where workable competitive forces are evident, would appear to be the original regulatory and institutional regime. It is unclear whether this is the circumstance the community now, but emerging competition and increasing pricing constraints seem to be, if anything, good reasons for evolution to a leaner and more flexible regulatory regime; rather than one that features scope for ad hoc confiscation. In particular, emergence of competition should direct attention to adaptable frameworks, and calibrated forms of price control to any residual areas of ‘bottleneck’ power. Also, the results of ENA’s quantitative analysis show the strong consumer benefit in capacity to efficiently finance long-lived capital investments. Focus must
South Australia Essential Services Commission of South Australia (ESCOSA) Economic Regulation of SA Water – Framework and Approach On 21 November 2014 the ESCOSA published the final framework and approach to regulating SA Water’s revenues and service standards for the four-year regulatory period commencing 1 July 2016. Tarcoola to Darwin Railway – Ten-Year Review On 19 November 2014 the ESCOSA released an Issues Paper to commence the review of the revenues received from the provision of access to the Tarcoola – Darwin Railway during the ten-year period ending 30 June 2013. Determination of the 2015-2016 Minimum Retailer Solar Feed-in Tariff – Submissions Received On 14 November 2014 the ESCOSA announced that it has received submissions on the Draft Determination of the 2015-2016 Minimum Retailer Solar Feed-in Tariff and will be making its Final Determination in December 2014. Tasmania Office of the Tasmanian Economic Regulator (OTTER) TasWater Proposed and Service Plan On 3 October 2014 TasWater provided copies of the required draft policies with respect to Service Extension and Expansion, Water Metering, Service Introduction Charges and Developer Charges. Victoria Essential Services Commission (ESC) Energy Retailers Compliance Report 2012-13 On 13 October 2014 the ESC issued its Energy Retailers Compliance Report for 2013-14. Review of Victorian Ports Regulation 2014 Final Report See on Interesting Decisions’. Western Australia Economic Regulation Authority (ERA) Rail WACC – Revised Draft Decision and Call for Comments On 28 November 2014 the ERA issued its Revised Draft Decision on the WACC and invited public comment. Wholesale Electricity Market Discussion Paper Released On 19 November 2014 the ERA announced that is seeking public comment from interested parties on any issues impacting the effectiveness of the Wholesale Electricity Market in meeting the Market Objectives. This is to assist it to prepare the 2014 report to the Minister for Energy. . Goldfields Gas Pipeline – Proposed Revised Access Arrangement On 3 November 2014 the ERA published an issues paper on the proposed revised access arrangement for the Goldfields Gas Pipeline (GGP). . Rail WACC Calculation 2014
its Review of Victorian Ports Regulation: Final Report in August 2014. The of the review was to make recommendations to the Minister for Finance who administers the Essential Services Commission Act 2001. The recommendations concern whether or not prescribed port services should be subject to price regulation and the form of that regulation. The review covers only those port services that are prescribed by the Port Management Act 1995. Further, the review was conducted in the context of the existing legislative, regulatory, and ownership arrangements, and does not consider potential changes in ownership arrangements regarding the Port of Melbourne. The assessment of market entailed analysis of the potential for competition in the provision of the prescribed services within defined markets for channel services, container and motor vehicle services. This analysis takes into account the following factors: The existence of barriers to entry: obstacles to new market entry by alternative providers and may include physical, economic or regulatory barriers. Competition between ports: the potential for rivalry between ports in providing port services, including whether there are any other services which could be used in place of the prescribed services by the Port of Melbourne Corporation. Countervailing market power: where a monopoly service provider’s customer(s) also hold some degree of market power, strengthening the customer’s bargaining position with the Port of Melbourne Corporation. This may occur if the customer is a large or the sole user of port facilities; or if the customer has the ability
and/or incentive to use alternative port services. The choice between and heavy-handed economic regulation needs to take into account whether Port of Melbourne Corporation has actually exercised its substantial market power. To this end, the ESC assessed the available evidence regarding movements in the prices, service quality and profitability of Port of Melbourne Corporation’s prescribed services to ascertain whether there has been any misuse of Port of Melbourne Corporation’s market power, in relation to the provision of prescribed services. The available evidence indicates that price movements have been in excess of Consumer Price Index growth but not substantially so, with the exception of the impact due to the introduction of the Port Licence Fee. Reported service-quality outcomes are observed either to have been stable or improved, and reported profitability does not appear to have been excessive. To assist further in determining the appropriate form of regulation to the ESC also assessed the existing regulatory framework based on the following assessment criteria: Transparency: is the objective and operation of the price-monitoring framework clear? Effectiveness: is the framework appropriately addressing the regulatory problem? Proportionality: are the elements of the framework proportional to the nature of the regulatory problem, including the obligations currently placed on the Port