The important role of regulatory appeals

The Australian Competition Tribunal decisions last week provided important guidance and clarification on the operation of Australia’s system of energy network regulation.  In a series of ‘firsts’ the Tribunal decided appeals of the Australian Energy Regulator’s 2015 determinations on NSW and ACT electricity distribution networks and provided initial orders relating to an appeal based on the NSW gas distribution network determination.

The Tribunal decisions were the first to occur under limited merits review arrangements revised by the COAG Energy Council in 2013, the first to involve full participation by electricity consumer groups and stakeholder hearings, and the first review of decisions made under the new rules framework for rate of return estimation and benchmarking introduced in 2012.

The Tribunal made three types of ruling across the dozen or so individual areas raised by consumer groups and networks in the appeals. The Tribunal:

1) upheld the AER’s decisions in some areas – such as in the calculation of return on equity;

2) remitted decisions back to the AER to be reconsidered and remade – such as in the use of benchmarking to set operating expenditure and approaches to cost of debt allowances;

3) made no decision, usually where it was unnecessary to make a finding as it related to issues to be reconsidered as the AER sees fit in re-making the network determinations.

Some participants rushed to conclude these judgements are ‘bad news’ for consumers or to predict specific price impacts.  As the AER will remake key decisions, however, it is difficult to make definitive conclusions about overall final revenue or price impacts.

Under the new laws approved by Australian Governments, the Competition Tribunal is only able to set aside, vary or remit an AER decision where it is satisfied that to do so will result in a “materially preferable” outcome that better contributes to the long-term interests of consumers.

Operating allowances and benchmarking – taking care with new tools

The Tribunal asked the AER to remake its decision on operating cost allowances for NSW and ACT electricity distributors. It requested that it use:

• a broader range of modelling and benchmarking of Australian businesses; and
• a closer ‘bottom up’ assessment of the networks forecast operating costs.[1]

The key reason for this finding is an assessment by the Tribunal that the data and methodology applied by the AER in its new benchmarking modelling released in 2015 had significant limitations. These limitations meant that, in the Tribunal’s view, key modelling should have not been used as a key determining factor in future operating cost forecasts made by the regulator.[2] The Tribunal has noted that the timeframes of the regulatory process created difficulties for the AER in providing for appropriate stakeholder engagement on its approach.  It has pointed to the need for processes to ensure adequate opportunities for testing the benchmarking data underlying the modelling, and also providing time for the testing of networks own expert benchmarking reports.

Finally, the Tribunal noted evidence from both consumer groups and networks that the AER’s benchmarking approach departed, in material ways, from that used by overseas regulators such as the UK energy regulator, Ofgem, both in how it defined good performance, and in the way significant after-modelling adjustments were made.[3]

Estimating an efficient rate of return

The issue of the appropriate rate of return to apply to regulated assets was one of the most significant of the review. This followed from the development by the AER of its 2013 Rate of Return Guideline, and its decision to use a single asset pricing approach as a primary ‘foundation’ model for return on equity estimates. The Tribunal noted the competing views of experts, and did not overturn any element of the AER’s approach or return on equity estimates.[4]

The Competition Tribunal set aside key elements of the AER determination in relation to the transition to a different methodology for the cost of debt.  The final AER determinations had set out transition pathways to a new ‘trailing average’ cost of debt methodology introduced in changes to the National Electricity and Gas Rules in 2012. Without challenging the AER’s final decision on the level of the allowance, the Tribunal provided additional guidance for the AER to take into account on the type of “benchmark firm” the regulator should consider as it re-determines the cost of debt. Specifically, it questioned why, if a firm’s debt arrangements already reflect efficient debt management practices, a complicated transition should apply.[5]

Estimating corporate tax allowance – the need to rely on consistent empirical market evidence

A further area where the AER has been asked to remake its decision is the setting of the ‘corporate tax’ (or ‘gamma’) component of the overall regulatory revenue allowance that the regulator is required to estimate. A critical issue in estimating this is the value of imputation credits under Australia’s taxation system. In its decision, the Tribunal agreed that ‘market value’ studies should be given greater weight in estimating the value of imputation credits, as they represented – like other elements of the rate of return – the result of actual market transactions.

This essentially reaffirmed the outcomes of the original 2010 Competition Tribunal ruling.  As in that case, the Tribunal has found that AER determinations had reached their final tax allowance estimates by mixing two different types of statistical evidence – potential theoretical upper bounds of some of the relevant parameters, and actual market data on likely point values.[6]

The important role of merits review

These decisions highlight how important it is for the long-term interests of consumers that Australia’s major regulatory determinations are subject to merits review.  This review provides a critical, independent assurance that regulatory decisions, which affect millions of people and are a critical input to our economy, have been made appropriately with full account of the long-term interests of consumers.

The decisions under review, for example, affect around four million households and businesses using electricity and gas across New South Wales and the ACT and relate to allowed revenues of more than $16 billion over the next regulatory period. The critical price, reliability, and investment impacts of these decisions are part of the reason why the Productivity Commission, along with the recent COAG Energy Council governance review and the Australian Energy Market Commission have also supported the principle of access to merits-based review.

Merits review also plays a critical role in supporting and promoting high quality decision-making, based on sound evidence. Past AER/ACCC Commissioners have publicly spoken of the discipline which merits review avenues introduce into the analysis, and work of regulators flowing from recognition that regulatory findings must be evidence-based.[7]

The review process also provides guidance to all stakeholders on applying the regulatory framework – how the rules should be consistently and predictably applied in the long-term interests of consumers. These decisions will improve the clarity and certainty of future regulatory decision-making – however, it will take time for the AER to review decisions previously made.

This is no accident.  The reforms to the limited merits review regime made by COAG Energy Council in 2013 were intended to encourage a more frequent remittal of decisions which had been set aside to the AER, rather than them being remade by the Tribunal itself. This is exactly what has occurred in these cases, with the AER being requested to re-make decisions, taking into account a holistic view of the relevant issues and Tribunal findings.

The COAG Energy Council is due to commence a review of the limited merits review regime later this year.  While it will have a limited set of case studies to examine under the new regime, the recent Tribunal findings highlight the continuing need for a merits review framework that supports high quality regulation in the long-term interest of consumers.