The political reaction to yesterday’s Full Federal Court decision on network charges in NSW and ACT has again highlighted the importance of independent energy regulation, which is both free from error and free from political interference.

The Federal Court decision followed an unusual 15 month legal challenge by the Australian Energy Regulator (AER) to decisions of the independent expert Australian Competition Tribunal. Like the Tribunal, the Federal Court rejected key arguments put forward by the energy regulator. It confirmed the need for the AER to review its approach to key issues relating to operating expenditure and debt allowances.

These judgements do not require the regulator to approve more or less funding – but to make its decisions correctly.

The Federal Government’s response was to reject the message and to renew its calls for the messenger to be shot. In a strongly worded statement, Federal Energy Minister Josh Frydenberg called for COAG Energy Council to strip the independent appeal process administered by the Australian Competition Tribunal, Limited Merits Review.

The Minister argued that networks were ‘gaming the system’ despite comprehensive judgements of the independent expert Tribunal upheld by the Full Federal Court that AER decision making could be improved.

Infrastructure Partnerships Australia rejected the Federal Government’s logic that the availability of an appeals process was the problem:

“Today’s decision by the Federal Court to uphold the findings of the Australian Competition Tribunal shows precisely why the merits review is needed…. If regulatory errors are not corrected, the consumer will end up paying much more than they should or suffer poor reliability outcomes.” [i]

The Australian’s John Durie had a similar reaction:

“Federal Energy Minister Josh Frydenberg was wrong once again to play politics and in the process back the regulator’s push to ban limited merit reviews of its decision.

If anything, the full Federal Court, in backing the Australian Competition Tribunal’s decision, has underlined the reality that regulators make mistakes.”

Danny Price of Frontier Economics argued that the Federal Court decision “…demonstrated that the protections against regulatory error provided by the limited merits review regime are working as they ought to.”  He cited the Frontier publication Unappealing Prospects, which previously stated:

Some have suggested that the repeated success of the businesses is evidence that the appeal arrangements are stacked against the AER. Ill-informed media reports have presented the Tribunal’s decision as a disaster for consumers, as though the Tribunal had imposed calamitous price increases on customers… In fact, the Tribunal has overturned some large regulatory errors. 

The Interest of Consumers

It was inevitable that the media would report a Federal Court “win” for network businesses as a “loss” for customers.  In fact, the Competition Tribunal cannot legally make a decision to set aside an AER decision unless it would be materially preferable to achieve the long term interests of customers, as defined in the National Electricity Objective and National Gas Objective.

Energy networks initiated the appeals to ensure they could meet customer needs, to keep the lights on, energy reliable and to manage bushfire and other safety risks. The history of energy regulation is littered with evidence that political interference, artificially low prices and price freezes are a sugar hit that customers end up paying more for. The hidden costs of poor decisions emerge in poor service, reliability impacts and ‘catch up’ spending down the track.

Clearly, customers are critically concerned about bill increases. Everyone wants to ensure that customers pay no more than necessary for the service they value. The challenge is to balance short-term price reductions with service impacts and long-term bill outcomes. That judgement is appropriately subject to expert regulation, which is independently reviewable to avoid material errors. The Competition Tribunal decision, upheld by the Federal Court, was made because there was a serious prospect that the regulator’s decision had provided insufficient funding to meet the long-term interests of customers.

The businesses expect customers to avoid any price ‘spikes’ when the AER’s decisions are finalised and will be working with the AER under proposed rule changes that allow any adjustments to be phased in over 5 to 7 years.

The Federal Court Decision 

In early 2016, the AER appealed against a number of merits review decisions by the Australian Competition Tribunal on network charges for access to Ausgrid, Endeavour Energy, Essential Energy, ActewAGL and Jemena Gas Networks energy infrastructure.

The key issues in this review were:

• the role and use of benchmarking models in setting operating cost allowances – including the extent to which economic  benchmarking alone could inform future allowances;
• how to set an efficient estimate the cost of debt, and approaches to moving between different methods of regulatory cost of debt estimation following a change in the regulatory rules in 2012; and
• ways of reaching a robust forward estimate of the cost of corporate income tax that correctly accounts for the value of imputation credits (sometimes referred to as the ‘gamma’ parameter).

Yesterday’s Federal Court decision upheld the AER position on the cost of corporate income tax, but upheld the Australian Competition Tribunal’s original decision on network operating expenses and the cost of debt. The Federal Court ruling is a painstakingly detailed and thorough explanation of how the Tribunal came to form its original judgment. It documents explicitly the problems contained in the AER original decision on operating costs and cost of debt matters, and why the independent Competition Tribunal’s original views should be upheld. For instance:

“The AER had a number of options as to how it proceeded to make its estimate of forecast opex. The fact is that up until the present decision, the AER had adopted what its counsel described as the traditional form of benchmarking often described as a bottom-up or engineering approach (see the passage referred to below at [379]). That in whole or in part was an option as was a broader range of modelling or a combination of these methods.

“Instead, it used a model with recognised limitations as the sole basis or, at least even on the AER’s case, the primary basis for arriving at its estimate in circumstances where that was being done for the first time for an Australian regulatory decision. The Tribunal was entitled to conclude (as it did) that that was an incorrect exercise of discretion.”  [Page 97] [ii]

The original Tribunal decision provided useful guidance on how to improve regulatory decision making. While leaving the decisions to be remade by the AER, the Tribunal’s guidance:

• discouraged the regulator from solely relying on untested benchmarking methods in setting forward operating allowances; and
• suggested closer engagement with stakeholders to test approaches, ensure good quality data inputs, and resolve the role and use of international data in the regulators models.

The Tribunal forwarded issues to be resolved by the AER with respectful and constructive guidance. In a rare move, the AER challenged the Tribunal’s decision arguing that it was legally flawed.  Consequently, the decisions for NSW and ACT customers were delayed, along with the opportunity to positively address the issues identified by the Tribunal with all stakeholders.

What does this decision mean for Limited Merits Review ?

Like the COAG Energy Council, the AER and consumer groups, network businesses would rather see network regulation which is constructive and not characterised by multiple protracted and adversarial appeals.

The appeals by energy businesses or customer advocates in 2015 did not challenge the fact that Australia has a high quality, expert energy regulator in the AER.The oversight of the Competition Tribunal is part of the quality assurance framework which protects customers’ long-term interests, and which should be welcomed in best practice regulation. Such appeal mechanisms are common in the United Kingdom, Germany, the Netherlands and New Zealand.  Regulators routinely respond to the kind of constructive feedback provided in both the Tribunal and the Federal Court decisions, which confirmed substantial opportunities to improve information management,  benchmarking and other aspects of the regulatory decision making process.

Energy networks have proposed a set of practical detailed reforms to the existing limited merits review, to streamline appeals, lower costs and reduce the frequency of appeals. None of these, or any other proposed reforms, are able to fix the weaknesses of relying only on Judicial Review if limited merits review is removed. The legalistic judicial review process has high costs, barriers for consumer participation, and long delays compared to the less formal administrative review model possible under through the specialist Tribunal.

Front foot collaborative action will be required. Networks are committed to working with customers and the AER to build stronger regulatory process. Part of this should be a shared goal of working to ensure greater confidence in benchmarking approaches, following criticism of past approaches from both networks and customer groups.

There is an urgent need to refocus on opportunities to improve outcomes for customers. In the real world, energy markets are rapidly transforming outpacing debates about the regulatory framework, market design or energy market institutions and governance.

In this, the real world, network service providers must innovate, drive down costs to customers and maintain reliable, secure systems in a transforming energy market. Regulators have similar challenges to maintain confidence of customers and other stakeholders in high quality, accountable decision making that enables a secure, affordable and more sustainable energy future.