New Customer Contributions for the Water Sector: Workshop 4 August 2004

Items for discussion  Purpose of workshop  Objectives for NCCs  Principles underpinning Commission’s approach to NCCs  Practical implications  Discussion  Next steps

Purpose of workshop  ESC to articulate its understanding of industry concerns with its proposed approach to NCCs articulate its understanding of industry concerns with its proposed approach to NCCs explain the rationale for its approach explain the rationale for its approach demonstrate its practical application demonstrate its practical application  Industry encouraged to respond

Objectives  To work with industry in implementing an approach to NCCs that is efficient, equitable and consistent with water businesses earning sustainable revenue streams  To ensure that the approach to NCCs is transparent and practicable

Commission’s approach to NCCs  Commission’s principles/guidance  Issues with the proposed approach: Efficiency Efficiency Equity Equity Viability Viability  Wider issues with the choice of NCC method  Transitional arrangements

Commission’s principles / guidance  Water plans include principles / methodology for calculating new customer contributions  Combination of prices and developer charges to provide an efficient signal at the time of development  Practical effect – sunk assets and (generally) shared assets excluded  Views sought on how to implement practicably

Commission’s principles / guidance  Current approach – most of the contributions reflects ‘sunk’ cost Change in approach would imply a reduction in new customer contributions Change in approach would imply a reduction in new customer contributions  Three main issues raised with the proposed approach: Efficiency Efficiency Equity Equity Viability / impact on ongoing prices Viability / impact on ongoing prices

Efficiency  WIRO encourages the use of prices as ‘signals’ to customers Need to ask how prices better can be used to change customer behaviour and improve efficiency Need to ask how prices better can be used to change customer behaviour and improve efficiency Separate question from cost recovery Separate question from cost recovery  Relevant objective – encourage customers to change behaviour in a way that reduces cost Encourage better use of existing infrastructure Encourage better use of existing infrastructure

Efficiency  Should ‘bridge the gap’ between incremental revenue and cost Making up for less than perfect prices Making up for less than perfect prices  Only forward-looking costs are ever relevant Only costs that can be reduced Only costs that can be reduced  Generally, should reflect locational assets: Cost of shared infrastructure should be signalled to all customers Cost of shared infrastructure should be signalled to all customers  Precise allocation of sunk costs not necessary for efficiency: Efficiency may permit a wide band Efficiency may permit a wide band

Equity  Different dimensions: Treatment of new customer vs existing customers – serving new customers should not cause prices to rise Treatment of new customer vs existing customers – serving new customers should not cause prices to rise Spreading of costs over time – need to charge for capacity when it is used Spreading of costs over time – need to charge for capacity when it is used Equal treatment of customers – new customers should be treated in like manner those who recently connected Equal treatment of customers – new customers should be treated in like manner those who recently connected  Questions raised: Are new customer contributions to the right tool? Are new customer contributions to the right tool? Are there other equity considerations? Are there other equity considerations?

Equity  Ongoing prices are an alternative tool: A higher price can be set for higher cost areas A higher price can be set for higher cost areas Depreciation can ensure equitable share over time Depreciation can ensure equitable share over time Transparent Transparent  Different perspectives on equity: Relative share of benefits from previous government policies Relative share of benefits from previous government policies Relative contribution to shared assets from new vs existing customers Relative contribution to shared assets from new vs existing customers Relative treatment of growth costs and renewals costs Relative treatment of growth costs and renewals costs  Can manage some equity issues through transitional arrangements

Viability / Impact of prices  Historical context – reliance on contributions inevitable  Cost-based regulation is a substantial change: New expenditure is ‘self-financing’ New expenditure is ‘self-financing’  Problem at the transition – a reduction in contributions has to affect: ‘Business value’; and/or ‘Business value’; and/or Prices Prices

Viability / Impact on prices  Process for setting RAVs – Minister to set, ESC to advise  Implications of a change to customer contributions: ‘Business value’ vs prices ‘Business value’ vs prices Timing of cash flow Timing of cash flow Financing requirements (debt), but future size of businessesFinancing requirements (debt), but future size of businesses Financial ratiosFinancial ratios  Undertaking analysis – will ensure the Minister is fully informed: Consultation proposed Consultation proposed  Potential for transitional arrangements

Other issues  New customer contributions are variable: Use for ‘shared assets’ introduces unnecessary risk Use for ‘shared assets’ introduces unnecessary risk  Tax effectiveness: Increased total cost to customers Increased total cost to customers  Regulatory perspective: relative robustness of the regulatory regime: Ongoing prices vs contributions Ongoing prices vs contributions  Consistency with other utility industries

Transitional arrangements  Foreshadowed by ESC – subject to there being a transition  Design needs to understand: Reason for the transition (eg equity vs viability) Reason for the transition (eg equity vs viability) Options for transitional arrangements available Options for transitional arrangements available Appropriate rate of change Appropriate rate of change

Practical examples  ESC approach: Each development assessed separately at time of proposal Each development assessed separately at time of proposal Assessment based on development as a whole Assessment based on development as a whole  Examples: Developer proposes a 4-stage new estate, each stage containing 250 lots Developer proposes a 4-stage new estate, each stage containing 250 lots Town is connected to sewerage scheme Town is connected to sewerage scheme

Practical examples (2)  New development example (1)  Parameters of assessment 30 year period 30 year period Discount rate equal to WACC Discount rate equal to WACC  Incremental cost (IC) of entire development $2 million of capital for supply mains $2 million of capital for supply mains Operating costs of $10/cust pa Operating costs of $10/cust pa Total IC for development = $2.2 million Total IC for development = $2.2 million  Incremental revenue (IR) of entire development Tariff revenue of $500/cust pa Tariff revenue of $500/cust pa Total IR for development = $7.0 million Total IR for development = $7.0 million  IR is greater than IC, therefore no contribution required

Practical examples (3)  New development example (2)  Parameters of assessment 30 year period 30 year period Discount rate equal to WACC Discount rate equal to WACC  Incremental cost (IC) of entire development $8 million of capital for supply mains (development long way from current network) $8 million of capital for supply mains (development long way from current network) Operating costs of $10/cust pa Operating costs of $10/cust pa Total IC for development = $8.2 million? Total IC for development = $8.2 million?  Incremental revenue (IR) of entire development Tariff revenue of $500/cust pa Tariff revenue of $500/cust pa Total IR for development = $7.0 million Total IR for development = $7.0 million  IC is greater than IR, therefore contribution of $1.2 million required?  Issues How to deal with ‘leapfrog’ development capital cost How to deal with ‘leapfrog’ development capital cost 3 options: 3 options: Treat mains as incremental – include all costTreat mains as incremental – include all cost Treat mains as pre-committed – exclude all costTreat mains as pre-committed – exclude all cost Treat project as bringing forward the mains – include financing costTreat project as bringing forward the mains – include financing cost

Practical examples (4)  Town connected to sewerage scheme  Parameters of assessment 30 year period 30 year period Discount rate equal to WACC Discount rate equal to WACC  Incremental cost (IC) of scheme $6 million of capital costs $6 million of capital costs Operating costs of $50/cust pa Operating costs of $50/cust pa Total IC for development = $6.7 million Total IC for development = $6.7 million  Revenue requirement Average revenue requirement per customer = $480pa Average revenue requirement per customer = $480pa  Business establish price to recover average revenue requirement – mixture of fixed and variable