In brief

Today the Australian Competition Tribunal (Tribunal) set aside the 2015 final decisions by the Australian Energy Regulator (AER) on the allowed revenues for the NSW electricity businesses (Ausgrid, Endeavour and Essential) (Networks NSW).

The final decisions released by the AER in April 2015 on Networks NSW’s distribution determinations for the 2014-19 regulatory control period significantly reduced the allowed annual revenues of the NSW electricity distribution businesses by 22-24% for each of the businesses.

Networks NSW was successful in establishing grounds of review in relation to the allowance for operating expenditure, return on debt, and gamma.

The Tribunal directed the AER to remake the constituent decisions on the operating expenditure, return on debt, and gamma, and to vary the AER’s final decision in such other respects as the AER considers appropriate in light of such variations.

Tribunal overturns AER revenue determination for Networks NSW businesses

Today the Australian Competition Tribunal (Tribunal) overturned the 2015 final decisions by the Australian Energy Regulator (AER) for the NSW allowed revenues for the electricity network businesses (Ausgrid, Endeavour and Essential) (Networks NSW) for the period 2014-2019 (Networks Case).

On 21 May 2015 Networks NSW had appealed the AER’s final decisions to the Tribunal under the National Electricity Law.1 The appeal followed the AER’s decision to cut the annual revenues for the 2014-19 regulatory control period by between 22% and 24% for each of the three businesses. The amount of revenue that was subject to the appeal was approximately $5.7 billion across the three businesses over the 2014-19 regulatory control period.

Networks NSW was successful in establishing grounds of review in relation to the allowance for operating expenditure, return on debt, and gamma.

Networks NSW did not make out grounds of review in relation to the efficiency benefits sharing scheme (EBSS) and return on equity.

Ausgrid did not establish grounds of review in relation to metering costs.

The Tribunal has set aside the AER’s final decisions, and remitted them back to the AER, subject to certain directions and guidance.

An appeal by Jemena under the National Gas Law in relation to the AER’s final determination of the allowed revenues for the NSW gas distribution business, heard contemporaneously with the Networks NSW appeal, was successful.

Implications of the decision for network businesses in Australia

The Networks NSW appeal is the first to the Tribunal by a network business since amendments to the National Electricity Law (Law) in 2013 and amendments to the National Electricity Rules (Rules) in 2012.

The amendments to the Law were made to introduce a two stage process for the Tribunal. Firstly the Tribunal must find error or unreasonableness and secondly the Tribunal must be satisfied that a decision, other than the decision made by the AER, is likely to be materially preferable having regard to the National Electricity Objective (NEO).The NEO is to promote efficient investment in, and efficient operation and use of, electricity services for the long term interests of consumers with respect to price, quality, safety, reliability and security of supply.

In passing the 2013 amendments to the law, the South Australian parliament Second Reading Speech for the 2013 amending legislation stated that amendments were required to:

“… ensure that the limited merits review only results in changes to decisions under review where the Australian Competition Tribunal concludes that there is a materially preferable decision in the long term interests of consumers…

The Australian Energy Regulator will also be required to give reasons in its decision as to the basis on which it is satisfied that the decision is the preferable reviewable regulatory decision.

This will provide a greater degree of transparency about the Australian Energy Regulator's decision-making process, with the Australian Energy Regulator's explanation also assisting the Australian Competition Tribunal and other parties if the decision is subject to review.”

In the Networks Case the Tribunal made the following observations in relation to the application of the new appeal regime:

  • It may be accepted [as contended by Networks NSW] that the proper application of the building block methodology in the Rules will promote the NEO.
  • However, another step is required. There may be other matters which the AER considered, and which may balance out any adverse consequences of such non-compliance. The amounts involved may not impair in a material way the NEO.2
  • The elements of the NEO are potentially in conflict. Where the line is to be drawn between price on the one hand, and quality service, reliability and security of supply on the other, is not an easy question.3
  • Networks NSW had established that in significant respects the AER formed its decision on foundations that are not properly established. The AER’s decisions have been reached on complex factual bases and/or exercise of discretions giving rise to very significant outcomes, which are not appropriate to support the ultimate decision of the AER.4

In relation to operating expenditure the Tribunal found that Networks NSW’s submission that the AER had used an experimental benchmarking model as the sole determinant of opex, contrary to sensible regulatory practice, including significant experience of modelling in other jurisdictions, was cogent.5

In relation to the allowance for debt the AER erred in adopting a “one size fits all” approach to the application of the Rule that the allowance for debt must be commensurate with the efficient costs of a “benchmark efficient entity with a similar degree of risk”.

In relation to the estimation of the value of gamma the Tribunal held that “it is how shareholders act in the marketplace, in relation to the utilisation of the franking credits available to them, which should inform the value of those imputation credits”.6

Opex allowances & flawed use of benchmarking by the AER

The Tribunal held that there were a number of respects in which Networks NSW established grounds for review of the AER’s allowance for opex. At a general level, this was because the AER placed too much weight on the outcome of a particular benchmarking model (EI model). The Tribunal had a series of concerns about the specification of inputs to the EI model, data imperfections, the AER’s treatment of vegetation management costs of Essential and Endeavour, and the AER’s treatment of labour costs of Networks NSW.7

The Tribunal found that the AER’s application of the EI model gave a “discordant weight” to one operating expenditure factor (the benchmark opex that would be incurred by an efficient distribution network service provider (DNSP)) as against the other operating expenditure factors.8

In relation to inadequacies in the EI model, the Tribunal found that:

  1. The data set of Australian DNSP costs used for the benchmarking exercise was immature and in many instances based on estimates rather than actual costs and consequently not fit for the purpose it was used for.
  2. The AER in its final decisions had acknowledged the issues with the data set by exogenously applying “operating environment factors” or “OEFs”. The Tribunal observed that the AER’s defence of its adjustments for “directionally ambiguous OEFs” is an acknowledgement by it of the immaturity of its data, which should have alerted it to the vagaries of relying on it to the extent it did.9
  3. In relation to the use of Australian, New Zealand and Canadian data in the EI Model the Tribunal found:
    1. The data used by EI was dictated by what was available, not what was likely to give the most reliable indicator of efficient costs.10
    2. There is “credence” to Networks NSW’s submission that it makes no sense to compare small New Zealand and Canadian DNSPs which may experience volatile changes, to large DNSPs in Australia which do not.11
    3. The “country dummy variables” used in the model to correct for systemic reporting differences were ineffective. The AER’s defence of EI’s use of country dummy variables glossed over the multitude of differences that no doubt exist between the poles, wires and transformers of the Australian DNSPs and those of their overseas counterparts – differences due to such matters as topography, climate and regulations. In fact, the EI model’s use of country dummy variables reveals a significant weakness in the model.12
  4. The Tribunal noted that the limited opportunity afforded to the DNSPs and other interested parties to comment on the AER’s application of a benchmarking methodology reliant on overseas data does not of itself give rise to a relevant ground of review “it tends to tell strongly against the acceptance of that methodology and the resulting estimates of the DNSP’s required opex that the AER derived from it”.13

In summary the Tribunal found that Networks NSW’s submission that the AER used an “experimental model as the sole determinant of opex, contrary to sensible regulatory practice, including significant experience of modelling in other jurisdictions” was “cogent”.14 There are lessons to be learnt from overseas regulators, particularly Ofgem.15 The Tribunal adopted the observation that the “AER placed undue faith in the ability of it, and its advisers, to develop a single benchmarking model that can capture very well relative inefficiency.”16

Networks NSW was also successful in its contention that the AER had been wrong to disregard the constraints imposed by EBAs on the ability of the businesses to adjust their costs.

The Tribunal observed that the policy of government is that, to the extent that the EBAs are an inefficient imposition on the DNSPs, nevertheless they are a cost to be borne by the consumers of electricity. “The AER may, of course, assess the extent of inefficiency reflected by the number of employees. It may review the terms upon which employees may be reduced under EBAs. It may consider the timing for the expiration of the EBAs….But, having regard to the regulatory prescriptions, the Tribunal does not accept that it may, by use of the EI model, simply select the measurement of efficiency which it did in this respect without regard to the obligations under EBAs as they presently exist.”17

The Tribunal noted that the AER’s approach to EBAs may have been on a firmer footing where there is hard information to support a finding that a DNSP’s labour practices are inefficient vis a vis its peers. But, having regard to the expert evidence, that is not the case here.18

Return on Equity – AER approach not erroneous

The Tribunal held that Networks NSW did not establish any grounds of review in relation to the AER’s decision on the return on equity.

The AER was required by rule 6.5.2(e) to have regard to “relevant estimation methods, financial models, market data and other evidence” in determining the allowed rate of return.

The Tribunal found that the words “relevant estimation methods, financial models, market data and other evidence” are broad and general. They do not suggest a prescriptive obligation to consider particular methods, models or data. Rather, it is left for the AER to decide what is relevant, and to give material such weight as the AER decides.

The Tribunal held that the AER’s approach of using the SL CAPM model as its foundation model does not reflect any misunderstanding of the Rules or any fundamental misapplication of them. The AER was well alive to the SL CAPM providing a starting point only. Further, the Tribunal found that while other material exposed the risk of bias in the SL CAPM where the entity concerned has an equity beta of less than 1, the AER was alert to that.19

It is possible to argue for an alternative model (including the Black CAPM) as the more suitable, but faced with a range of competing views, the Tribunal does not reach a firm view that a different model should have been chosen.20

Despite Networks NSW’s “forceful submissions”, the Tribunal was not satisfied that the AER’s estimate of an equity beta of 0.7 was understated. The Tribunal rejected the contention that the AER chose to ignore empirical material suggesting an equity beta outside its starting range.21

The Tribunal held that the AER’s estimation of the MRP was not erroneous. The AER selected an available starting point. It addressed the relevant material, and then applied its own experience to the qualitative findings to be made, and it sought to cross-check them with other sources of information.22

There is no single econometric modelling or other financial technique which can particularly and correctly provide a figure for the forward-looking estimate of MRP.23

Return on Debt – AER misdirected

The Tribunal determined that Networks NSW made out certain grounds of review in relation to the return on debt. The matter is remitted to the AER in accordance with the following direction:

“the AER is to make the constituent decision on a return on debt in relation to the introduction of the trailing average approach in accordance with these reasons for decision”

Rule 6.5.2(c) provides that the allowed Rate of Return Objective is that the rate of return for a DNSP is to be commensurate with the efficient financial costs of a “benchmark efficient entity with a similar degree of risk” as that which applies to the DNSP in respect of the provision of standard control services.

The AER decided that the benchmark efficient entity (BEE) is a pure play, regulated, energy network service provider, operating within Australia – one that was regulated under the Rules. As a consequence of this view, it approached its task on the basis that a BEE under the version of the Rules that applied in 2009 for the calculation of the cost of debt (the on-the-day approach) would hold a debt portfolio with staggered maturity dates and use swap transactions to hedge interest rate exposure for the duration of the regulatory control period. This led to a critical step that the AER took in transitioning to the trailing average approach, which was permitted as an alternative approach to determining the return on debt following the 2012 amendments to the Rules (the trailing average approach). The AER decided that a transitional method should be applied because immediate change to a trailing average approach would require the regulated BEE to unwind its hedging contracts, therefore it would allow for a gradual transition so that the BEE could adjust to changes.24

Networks NSW opposed the adoption of the transitional method including because its debt portfolio was already consistent with the trailing average approach.

The Tribunal held that the AER erred in its approach to the BEE:

  • First, the BEE referred to in the Rate of Return Objective is not a regulated entity. The BEE is likely to refer to the hypothetical efficient competitor in a competitive market for standard control services. Such a BEE is not a regulated competitor, because the regulation is imposed as a proxy for the hypothetical unregulated competitor. Otherwise, the starting point would be a regulated competitor in a hypothetically regulated market. That would not be consistent with the policy underlying the purpose of the Law.25
  • Secondly, the AER erred in adopting a “one size fits all” approach. The BEE must have a similar degree of risk to that of the relevant DNSP. The relevant DNSP is the DNSP that is being determined by the AER. Once it is accepted that different DNSPs have in fact different degrees of risk, and so may have different efficient financing cost structures, it leads to the conclusion that there will not be an identical BEE for all DNSPs.26

The Tribunal found the BEE “is likely to refer to the hypothetical efficient competitor in a competitive market for those services. Such a BEE is not a regulated competitor, because the regulation is imposed as a proxy for the hypothetical unregulated competitor”.27

Having determined that the AER erred in its approach to the definition of the BEE the Tribunal found that it misdirected itself in considering whether the transitional method was needed in moving from one methodology for determining the cost of debt in the 2009 AER revenue decisions to the 2015 decisions under the 2013 version of the Rules.

The Tribunal held that the compulsory consideration in rule 6.5.2(k)(4):

  • starts with the efficient financing costs of a BEE as described (i.e. not a regulated BEE);
  • in the case of a changed methodology to estimate the return on debt, determines whether the BEE would suffer any impacts as a result of the changed methodology; and
  • if so, have regard to those impacts in deciding on the transition process to the new methodology.28

While the PIAC’s contentions in respect of the return on debt did not need to be determined by the Tribunal, in commenting on its order to remit the matter, the Tribunal noted that the AER may make some adjustment to the return on debt if consumers may be paying a second time for the consequences of the spike in the cost of debt following the GFC.29

Gamma

The Tribunal determined that Networks NSW made out grounds of review in relation to “gamma”, which is an adjustment made to corporate tax allowance to account for the value of imputation credits. The matter is remitted to the AER in accordance with the following direction:30

“the AER is to make the constituent decision on estimated cost of corporate income tax (gamma) in accordance with these reasons for decision, including by reference to an estimated cost of corporate income tax based on a gamma of 0.25”.

The common approach of the parties was that gamma is to be calculated as the product of:

  • the distribution rate for imputation credits, and
  • the value of distributed imputation credits (also referred to as “theta”).31

The Tribunal noted that:

  • It is necessary to consider corporate income tax as part of the total revenue allowance for a network service provider so that the “cost” of taxation can be offset through its revenue allowance.
  • The calculation of gamma must be approached in this context. The proper concern is not the extent to which imputation credits can be translated to real money. The reduction in the cost of income tax represented by gamma reflects the personal taxation benefits gained by shareholders from holding equity in the network service provider and the value of those benefits as ascribed by shareholders. Consequently, it is necessary to consider both the eligibility of investors to redeem imputation credits (distribution) and the extent to which investors determine the worth (value) of imputation credits to them.32

Estimation of the distribution rate

The AER calculated the distribution rate based on data only for listed equity (0.8). This was a change from past practice, which used data for all equity (0.7).

The Tribunal did not consider there was sufficient explanation from the AER for introducing the alternative measure. The AER did not explain how the change would be consistent with the Law, or otherwise advance the NEO. The Tribunal was of the view that it is appropriate to follow past practice.33

Estimation of the value of credits (theta)

The Tribunal noted that market-value studies of imputation credits suggest that investors may not value cash dividends and eligibility to reduce their income tax liabilities, equally. Moreover, the AER’s reasoning ignored the fact that other parameters in the WACC calculations are market values that already incorporate the effects of the differences in investors’ tax positions and transaction costs. Consequently, there is no inconsistency between the use of market studies to estimate the value of imputation credits and the methods used to calculate other parameters of the costs of debt and equity from market data.34

The Tribunal held that it is how shareholders act in the marketplace, in relation to the utilisation of the franking credits available to them, which should inform the value of those imputation credits. The Tribunal therefore did not accept the AER’s approach that imputation credits are valued at their claimable amount or face value.35

In relation to the estimation of theta, the Tribunal held that:

  • consistent with its earlier decision in Energex (No.2), tax statistics can only provide an upper bound on the estimate of theta,36
  • the equity ownership approach overstates the redemption rate. Even on the AER’s own definition of theta, equity ownership rates are above the true maximum possible figure for theta, and are therefore useful only as a further check on other estimates,37
  • it follows that the assessment of theta must rely on market studies. Market studies are best placed to capture the considerations that investors make in determining the worth of imputation credits to them,38
  • by placing most reliance on the equity ownership approach, the AER adopted a conceptual approach to gamma that redefines it as the value of imputation credits that are available for redemption, which is contrary to the concept of gamma which underlies the Rules.39

The Tribunal did not accept the AER’s approach that imputation credits are valued at their face value: “The value is not what can be claimed or utilised, but what is claimed or utilised as demonstrated by the behaviour of the shareholder recipient of the imputation credits” and “of course, the valuation is, or may be, a complex exercise depending upon the inference to be drawn from a range of data sources”.40

Estimation of gamma

The Tribunal held that the AER’s decision on gamma was too high, given that the relevant upper bound for theta should be no more than the ATO statistical data (0.43).

The Tribunal provisionally considers that the best estimate of theta derived by the updated SFG Study is 0.35.41 However, the Tribunal noted that the SFG Study represents only one point of view. There are competing expert views.42 Given that there are finely balanced decisions to be made in this light, the Tribunal considered that it is likely to result in a materially preferable NEO decision if this issue is also remitted to the AER, requiring the AER to step back and make the overall assessment required.43