Revised draft decision: Initial default price-quality paths for gas pipeline services Briefing for financial market analysts 24 October 2012

Overview Revised draft decision to set initial default price-quality paths 1.Proposed approach and context 2.The paths we have proposed for suppliers 3.Details on the approach we have used to set the paths 2

Proposed approach The proposed default price-quality paths apply to: – Three distribution businesses under price caps (GasNet, Powerco, and Vector) – Two transmission businesses under revenue caps (Maui Development and Vector) Paths apply for a regulatory period of 4 years, 3 months from 1 July 2013 to 30 Sept 2017 We expect to make a final decision by 28 February

Proposed approach Key features of the proposed default price-quality paths – Prices based on current and projected profitability using recently re- determined input methodologies (decisions NZCC27 and NZCC28) – Quality standards based on emergency response times – Overall reduction in prices/revenue for industry – Significant price reductions for Vector – Building blocks approach the same as that used for electricity distribution revised draft reset

Context for change in prices 5 Changes brought about by new Part 4 regime – New purpose statement to guide us in setting prices – Input methodologies define key “building blocks” – Price path set base on current and projected profitability Prior to Part 4 – Powerco and Vector distribution services (excluding network purchased from NGC) subject to Authorisation – Maui Development, Vector transmission services, Vector distribution services (excl. NGC) and GasNet not subject to the Authorisation

Context - Authorisation 6 Authorisation used a building block approach. Differences between then and now include: – WACC for Authorisation on average 10.45% compared to 7.53% now – Authorisation used tax payable (now using deferred tax approach for distribution, tax payable for transmission) – Authorisation prices included claw-back of 50% of previous over- recovery of revenues – The initial default price-quality paths use updated projections for opex, capex and revenue growth

Proposed adjustments 7 Forecast revenues minus forecast costs - 1 July 2013 to 30 September 2017 (if no reset)

Proposed adjustments 8 Adjustments for the first full pricing year of the regulatory period

Other features – clawback 9 We propose claw-back for GasNet – Claw-back applies for the over-recovery of revenues for the period 1 January 2008 to 30 September 2012 compared to CPI increases – Negates effect of delay to establishing the initial paths – GasNet is the only supplier to have over-recovered during this period Claw-back could still apply to other suppliers – Before making a final decision we will assess revenues from 1 October 2012 to date of determination Recovery of claw-back – Claw-back will occur across the regulatory period 1 July 2013 to 30 September 2017

No alternative rates of change proposed 10 We have not proposed any alternative rates of change at this point – Increases for Powerco and Maui Development are below the levels we have previously considered for price shocks to consumers – We do not have sufficient evidence to conclude that the proposed downward adjustment for GasNet and Vector will result in undue financial hardship If suppliers believe the proposed price adjustment will cause undue financial hardship, they should provide evidence in their submissions

Quality Standards 11 Quality Standards set for emergency response time – suppliers of gas pipeline services must take 180 minutes or less to respond to any emergency; and – gas distributors must take 60 minutes or less to respond to 80% of emergencies Our preferred option is to also establish quality standards based on reliability – we consider reliability as the most important measure of the level of service that suppliers should be providing to consumers – however, we currently have little data to establish robust reliability targets By contrast response times to emergencies targets can be set independently of historical time series data, and are based on industry knowledge

The approach to adjusting prices 12 Step Four Apply an alternative rate of change if necessary or desirable Step Three Determine starting prices for each supplier Step Two Set forecast revenues equal to forecast costs over the regulatory period Step One Forecast costs over the regulatory period Overview of our proposed approach

Building blocks allowable revenue 13 Derive present value of building blocks allowable revenue based on costs Main building block cost categories Return on capital (net of any revaluations of the Regulatory Asset Base) Return of capital (to allow recovery of depreciation) Operating expenditure (excluding pass through costs and recoverable costs) Tax costs

WACC 14 We have used a vanilla WACC of 7.53% (cost of capital determination for information disclosure decision NZCC20) We will estimate a WACC for our final decision by 1 Dec 2012 – risk-free rate and debt premium using data from the month of November 2012

How we forecast capex 15 Capex forecasts – We use suppliers’ own forecasts of network capex up to a 20% increase over historic levels – Forecast of non-network capex is based on each supplier’s historic expenditure – Change in input prices based on capital goods price index We propose to rely on each supplier’s capex forecast because suppliers are well placed to forecast required capex We limit suppliers’ forecast average expenditure to a 20% increase over average historic expenditure – relying on suppliers’ forecasts would create an incentive to bias their forecasts to increase their starting price – Customised price-quality path can address material increase in investment requirements

Reasons for limiting increases in capex 16 Customised price-quality paths can address material step changes in capex Maui Development and Vector forecasts included capex increases over 20%. The have the option to either: – apply for a customised price-quality path – undertake these projects within the DPP price cap – defer these projects Note that even if we used Vector’s capex projections, its price decrease would still be 23%

Projected growth in network capex 17

How we forecast opex 18 Opex forecasts (network and non-network) – Basis for projections is actual opex for 2010/11 – Considered impact of changes in network scale on opex – Partial productivity growth assumed to be zero – Change in input prices (using weighted average forecast of labour cost index and producer price index) Network Scale – For distribution elasticities for network length and customer numbers applied to historic trend (approximately 0.35 each – taken from Ofgem analysis ) – For transmission initial view number of customers and length not appropriate drivers of network scale, elasticity for energy throughput assumed to be zero due to information/data issues

Projected growth in opex Projected growth in operational expenditure from 2012 to 2017

Impact of opex and capex modelling – sensitivity analysis 20 Adjustments for the first full pricing year of the regulatory period impact of suppliers’ own forecast of opex and capex (all other inputs as per draft decision)

How we forecast constant price revenue for gas distributors 21 We forecast revenue from residential, commercial, and industrial users, broken down into the two types of billed quantity all three distributors use Forecasts of billed quantities of gas are based on the gas supply and demand scenarios study for the Gas Industry Company Limited Forecasts of the number of users billed for their connection are based on extrapolating each supplier’s historic trends

Constant price revenue (distribution) 22

Role of constant price revenue for gas transmission 23 We propose to put both gas transmission businesses under a revenue cap We do not require a forecast of constant price revenue for setting starting prices for gas transmission business However, we have developed forecasts for assessing compliance and to illustrate the size of starting price adjustments in percentage terms

How we derive smoothed price path 24 Calculate present value of building blocks allowable revenue from 1 July 2013 to 30 September 2017 (4 years 3 months) Derive a smoothed path taking account of forecast changes in – prices (CPI-X) where X = 0 – quantities (distribution only) derived from forecast of constant price revenue Compliance will be assessed on a pricing year basis – For all suppliers but Maui Development this results in a 15 month initial assessment period from 1 July 2013 to 30 September 2014 – For Maui Development 3 month assessment period at the end of the regulatory period (1 Jul 2017 to 30 September 2017)

Next steps 25 We will be holding a ‘Q&A’ of the model underpinning the draft decision in November MilestoneIndicative date Submissions on revised draft Initial default price- quality paths 7 December 2012 Cross-submissions on revised draft Initial default price-quality paths 21 December 2012 Final decision on Initial default price-quality paths28 February 2013

Questions? 26 For more information Please contact:Karen Murray Or visit: For information on: The revised draft decision The default price-quality path Or visit: electricity-and-gas-dpps/ For information on: The re-determined input methodologies