9
Jan
2014

The end of the gold-plated electricity network

by Tony Wood


Published by The Australian Financial Review, Thursday 9 January 2014

Between 2006 and 2013, the average Australian household power bill increased by more than 85 per cent: from $890 to $1660 a year, with network costs being the biggest contributor. Indeed, the businesses have been accused of “gold plating” their networks to get higher profits.

In December 2013, the Australian Energy Regulator (AER) announced new price-setting guidelines that should bring some much-needed relief from this pain. Small changes in a complex formula can deliver big savings to customers.

Electricity network costs account for about 50 per cent of retail prices. The network businesses are natural monopolies, so the laws of the market in which competition sets prices cannot apply. Instead, regulation is needed to ensure the businesses efficiently meet the long-term interests of consumers and to provide reasonable profits for the business owners.

In December 2012, a Grattan Institute report concluded that the businesses have been earning profits significantly higher than would be consistent with the relatively low business risks that they face.

Poor regulation has meant that the overall outcome has unduly disadvantaged consumers. The report recommended four changes that could deliver savings of about $2.2 billion a year. These were aligning rates of return with risks faced, addressing the poor performance of government-owned businesses, ensuring that reliability standards are no higher than needed, and avoiding over-investment in a period of falling demand.

Network businesses require large capital investment and the rate of return (RoR) on investment can make up about 50 per cent of the revenue collected. For each five-year regulatory period, the rate of return is set by the AER and combines a return on equity (RoE) for the shareholders and a return on debt to finance borrowings. Small changes in these returns can make big impacts.

The Grattan report estimated that better aligning returns with the business risks and actual cost of borrowings could deliver savings of about $400 million a year.

In December 2013, the AER released new rate of return guidelines. The overall RoR will be updated annually, with the expected RoE being set for the duration of the regulatory control period and the return on debt being updated annually. This is a major and positive step forward as it is far more aligned with the financing arrangements of the actual businesses.

EQUITY MARKET RISK PREMIUM

The expected RoE is made up of the risk-free rate and a premium for market risk. The first of these is relatively uncontentious and the AER is proposing to use the 10-year Commonwealth government bond rate. The second factor applies a specific risk adjustment, known as the equity beta, to the overall equity market risk premium. The AER’s choice of 6.5 per cent for the market risk premium is relatively high, given a range of expert advice. It has been justified as striking the best balance between under and over investment.

The equity beta measures the extent to which returns for specific businesses correlate with the overall share market, a value of 1.0, meaning perfect correlation. Most expert advice to the AER supports conceptual analysis that the low risks faced by regulated electricity network businesses lead to an equity beta that would be low and below 1.0. Since 2009, the AER has applied an equity beta of 0.8, even though it noted that empirical studies at the time supported a range of 0.41 to 0.68.

The mean annual returns on equity for these businesses have generally been above those of other listed companies, including energy companies that face significant market risks and would be expected to earn higher returns.

In its latest guideline, the AER concluded that a range of 0.4 to 0.7 would be appropriate, and chose 0.7 as its point estimate, that is, at the very top of the range. Submissions to the AER from the network industry argued this value would be so low as to prevent the companies from efficiently competing for capital.

Consumer groups argued for the selection of a point estimate around the mid-point of the range. The AER maintains that its estimate at the top end of the range is a reasonable balance of a number of theoretical and empirical analyses. Regulatory stability and investor confidence seems to have again trumped lower prices for customers. Analysis in the Grattan report estimated that a reduction from 0.8 to 0.7 could deliver savings to customers of about $240 million a year and would at least begin to restore the balance towards customers.

The Grattan analysis found that applying a 10-year moving average of the 10-year Bloomberg BBB fair value curve, rather than the current single-period estimate for the cost of debt, would have made annual savings to customers of about $170 million. The good news is, the AER proposes to use a similar approach.

The AER has been supported by federal and state ministers and the Australian Energy Market Commission in setting new guidelines, and they will be applied for the first time in 2014 as a new round of regulatory determinations begins.

Household and business customers deserve a better deal, and the real test will be whether the published guidelines are followed into actual decisions. The setting of regulated prices is always highly contended, and it will be important for the AER to resist any watering down of the guidelines in the negotiations they will have with the businesses. Even more important will be for governments to insist on delivered outcomes that align risk and reward for investors with affordability and reliability for customers.