Lawyers' picnic drives up the cost of electricity

Australian
29 June 2011, Page: 14

ELECTRICITY prices have been rising across the nation; dramatically in some states. With the introduction of a carbon tax there will be more pressure on prices.

In recent years, very little if any of the upward pressure on prices has come from the cost of the energy itself. Most of the pressure on prices has come from increasing network charges: distribution plus transmission. Various renewable schemes, such as the federal renewable energy target and various state solar schemes, have also been adding to costs and hence final electricity bills.

All this is relatively recent. Up until about five years ago, network cost increases had been relatively modest since the microeconomic reforms of the 1990s. Most of the pressure on electricity prices came from the underlying cost of the energy, not the cost of delivering (network charges) or supplying (retail margins) the energy to end customers.

Networks had been effectively regulated in some form for years; in the case of NSW, since the early 1990s. We are witnessing substantial increases in network charges. Andrew Reeves, chairman of the Australian Energy Regulator, has expressed frustration over his (in)ability to effectively regulate energy networks. The AER is foreshadowing a series of rule changes that could significantly change the way electricity networks are regulated.

Several commentators (Ross Garnaut, Rod Sims, Roman Domanski, Mark Duffy and myself) have expressed reservations about not just the regulatory model but the incentives that seem to be driving the network businesses. Businesses are being accused of gold-plating; the regulator is regularly losing appeals against arcane elements of the cost of capital a main driver of network costs. Many are now suggesting that the system is broken.

So what has changed? The basic model is essentially the same as was introduced by the Independent Pricing and Regulatory Tribunal and its predecessor the Government Pricing Tribunal of NSW in the early 1990s. But the way in which the regulator and some of the businesses now engage with the model is very different from the relatively simple model that worked for nearly 15 years.

The model of regulation that was introduced in NSW in 1992-93 was based on that developed in Britain, particularly its water regulator, Ofwat, a few years prior. A few key features underpinned its success. It was designed to be light handed (and light hearted); that is, data was kept to the minimum required to form a view about a business's efficient costs and prices.

It was explicitly based on sound commercial principles, rather than a complex legal framework. Indeed, lawyers were explicitly not a part of the IPART process for many years. In the original NSW model there was no provision for merit appeal; the decision of the regulator was final. The model was highly transparent, relatively simple and low cost, for businesses, customers and the regulator. Most important, the regulatory model was based on incentives.

The regulator formed a view about the efficient costs of the business operating costs; capital costs; depreciation; and financing costs (debt and equity) and provided incentives for the businesses to out perform the regulatory allowance during the period of price control.

The key to the incentive regulation model was that the businesses had an incentive to perform better than the regulator allowed, keeping some of those benefits for a period, with customers capturing a share of those benefits in the next regulatory period. A win-win scenario. And it worked as well for the NSW regulated utilities that were government owned as it did for privatised utilities.

At the risk of over simplification, what does the present (national) regulatory model look like today (and many of these observations apply equally to the British regulation)? It is still based on building blocks, but many of the other key features have changed substantially. Regulation today is far from light handed; the data requirements on the businesses and the burden on the regulator are very much greater, more detailed and much more intrusive than nearly 20 years ago.

The amount of material submitted as part of a regulatory submission is vast. The regulator is now attempting to second guess management in many areas of the business. Has it led to the regulator having a better understanding of the businesses and a better handle on efficient costs? I doubt it.

Lawyers have found another lucrative source of revenue in economic regulation in Australia. The regulator and the regulated now use lawyers extensively at all stages of the process. Appeals (on merit) against the regulator's determinations are standard and the regulator has lost some appeals before the Australian Competition Tribunal.

These appeals are increasingly about arcane elements of the cost of capital (the angels on pinheads of regulation) that are increasingly accounting for large increases in network charges. Regulation is now far from low cost; large regulatory budgets are standard for the businesses as well as for the regulator.

But, most important, the fundamental role of incentives appears to be missing from regulation today. The regulator doesn't appear to accept that a business will drive all of its costs, including efficient financing costs, so that customers can share in those benefits. And some of the businesses, notably the government owned businesses, are not demonstrating the same governance drivers that gives the regulator confidence that the incentive model will work.

For incentive regulation to work, the owners and management of the regulated network need to actively seek out every opportunity to drive efficiency in all the costs of the businesses. Whether all of the government owned businesses in NSW and Queensland (and Western Australia) have the same drivers that we saw in the 1990s and early 2000s is starting to be questioned.

And if governance is not transparently aligned to efficiency incentives, then the Australian regulatory model is very close to broken. How to fix it? That is the billion dollar question. Hopefully, policy makers at state and national levels of government will re engage with this critical area of micro economic reform. They need to; there is substantial economic welfare at stake.

Tom Puny was foundation executive chairman of the Independent Pricing and Regulatory Tribunal and its predecessor, the Government Pricing Tribunal of NSW, from 1992 to 2004. These views are his own.