Review of the Initial Victorian Distribution Network Proposals for the Regulatory Period Orion Economic Services For The Consumer Action Law Centre February 2010

The Distributors Proposals Capital Expenditure: The Distributors are proposing a 58% increase in net capital expenditure (of customer Contributions) from the current regulatory period with the individual distributors proposing; CitiPower - 82% Jemena – 80% United Energy – 52% SP AusNet – 44% Powercor – 31% It is difficult to believe that such significant increases can be easily delivered when Australia’s projected growth rate and the mineral expansions in Western Australia which will attract the more mobile skilled workers that the distributors also require for work (e.g. plumbers and electricians).

Operational Costs Operational Expenditure: The Distributors are proposing a 35% increase in operational expenditure from the current regulatory period with the individual distributors proposing; CitiPower - 38% Jemena – 34% United Energy – 30% SP AusNet – 39% Powercor – 34% Given these forecasts it is important to look at the distributors ability to forecast accurately and to game the regulatory system. Distributors try to obtain higher than required operational benchmarks as it increases their revenue in the next regulatory period via the Efficiency Carryover Scheme.

Pricing Proposals The Distributors are proposing total price increases of; CitiPower – 42.1% Jemena – 57.6% United Energy – 32.6% SP AusNet – 68.2% Powercor – 42.3% As distributors prices are around 40% of the total bill the table below shows that the distribution change will increase by nearly 50% but the overall bill will increase by around 14% Curren t Bill New Bill%Change Generation $200 Transportation $100 Distribution $290$431Average 49% Retail $360 AIMRO $70 Total Bill $1,020$1,161 Bill increase =14% Table 1 – Impact on the Average Consumer of the Average Proposed Increase

Why Should We Consider Past Performance of the Distributors It is important to review the past regulatory decisions to determine if there are any lessons to be learnt for the present. It can help ask whether any distributor has: over – recovered revenue on a consistent basis so the AER can consider current submissions with some scepticism. over-spent capital and hence may need a higher amount in the next regulatory period. consistently under spent on operational expenditures which may indicate to the AER that such a distributor need to be more closely analysed to determine if it benchmarks are efficient and effective. reasonably accurately forecast all variables to indicate to the AER that such a distributor needs lower order of review by the AER.

Can Distributors Forecast Accurately Graph 1 - Victorian Distributors Revenue – Forecast vs. Actual

Can Distributors Forecast Accurately Graph 2 - Distributors Operational Expenditures – Forecast and Actua l Distributors are incentified to over forecast operational expenditure benchmarks as it makes it easier to be rewarded by the Efficiency Carryover mechanism which adds the additional revenue (in terms of Opex saved) in the next regulatory period.

Can Distributors Forecast Accurately Graph 3- Distributors Capital Expenditures – Forecast and Actual 2001=2007 Distributors are incentified to over forecast capital expenditure as the portion they don’t spend can be invested on money markets to earn additional revenue. However, as a counter to this incentive is the Service Standard Scheme where distributors can earn additional revenue by meeting service targets. Also the more capital distributors spend the higher the capital base and the higher the revenue in the following regulatory period (the gold plating incentive). The above table represents the fact that some distributors over spent and some under spent capex over the period

Can Distributors Forecast Accurately Graph 4 Customer Contributions – Forecast and Actual Distributors are incentified to under forecast customer contributions as for a given amount of capital if contributions are lower capital is higher and distributors can invest the spare capital on money markets and earn additional revenue. Given that such forecasts are strongly related to economic growth levels and that distributors all use a reputable macro-economic forecaster (NIER) it is surprising that they cannot forecast this area more accurately.

Extent of Over Forecasting of Operational Expenditure Table 2 – Extent of Over Forecasting of Operational Expenditures by Distributors DistributorOpex Over Forecasting $m % Over Forecast as a Percentage Compared to Actual Expenditure 2001 – % Over Forecast as a Percentage Compared to Actual Expenditure Jemena$ CitiPower$ Powercor$ SP AusNet$ United Energy$ This table shows that the distributors all spent operational costs below benchmarks which raises the question as to whether the cause is distributor efficiencies or the cheating on benchmarks or a mix of both. The data shows that CitiPower has under reported operational expenditures by over 100% over tow regulatory periods and their submission for the current review should be closely analysed by the AER

Extent of Over Forecasting on Capital Expenditure DistributorCapital Over Forecasting $m % Over Foresting Compared to Actuals Jemena$ CitiPower$ Powercor-$ SP AusNet-$ United Energy$ Table 3 – Extent of Over Forecasting of Capex Benchmarks by Distributors Note. No data in this table is available for the current regulatory period from the public data as United Energy failed to provide the necessary data to estimate the table for

Extent of Under Forecasting on Consumer Contributions DistributorUnder Forecasting $ m % Under Forecasting Compared to Actuals Jemena$ CitiPower$ Powercor $ SP AusNet$ United Energy$ Table 3 – Extent of Under Forecasting of Customer Contributions Note. No data in this table is available for the current regulatory period from the public data as CitiPower, Powercor and United Energy failed to provide the necessary data to estimate the table for

Extent of Over Forecasting of Revenue DistributorRevenue Over Recovery $m % Over Recovery Jemena$ CitiPower$ Powercor$ SP AusNet$ United Energy$ Table 4 – Extent of Over Recovery of Revenue by Distributors Note that the distributors to increase revenue over forecasts the most =Jemena and United Energy = also benefited the most from over forecasting capital expenditure and for under forecasting customer contributions Note. No data in this table is available for the current regulatory period from the public data as every distributor failed to provide the necessary data to estimate the table for

A New Methodology for Customer Contributions Distributor Average Capex divided by Customer Contributions to prices Forecast Average Capex divided by Customer Contributions for prices Extent of Under Forecasting Customer Contributions ($m) 2004 prices Recommendation Jemena CitiPower Powercor SP AusNet United Energy Table 5 – Capital Costs Divided by Customer Contributions and Recommendations Table 5 above looks at the ratio of actual capital expenditure to actual customer contributions for and for forecast customer contributions for In addition, it also estimates the extent of under forecasting for the period. It would be more appropriate to use the period for these latter estimates but the data was unavailable in most of the Distributors proposals. The AER would have the necessary data to undertake the preferred methodology. To estimate the new level for customer contributions we add the Average Capex divided by Customer Connections for 2001 to 2007 to the extent of under recovery over the same period. We note that this involves two different price sets but as this is not the preferred methodology the data is indicative only.

How Did the Distributors Perform over the Current Regulatory Period The graphs below show the Capital Costs benchmarks against actuals for the regulatory period for each of the distributors. No comparison is available for United Energy as they did not provide the data. Graph 34 – Jemena Capital Cost performance

How Did the Distributors Perform over the Current Regulatory Period Graph 6 – Powercor Capital Cost performance

How Did the Distributors Perform over the Current Regulatory Period Graph 38 – SP AusNet Capital Cost performance

How Did the Distributors Perform over the Current Regulatory Period Graph 5 – CitiPower Capital Cost performance The four graphs show that SP AusNet, Powercor and Jemena have all significantly exceeded current benchmarks and will possibly need more capital for the next regulatory period while CitiPower underspent in the first 2 years and then over spent during the last 3 years. No data was available for United Energy

How Did the Distributors Perform over the Current Regulatory Period Graph 4 Customer Contributions – Forecast and Actual

How Did the Distributors Perform over the Current Regulatory Period Graph 5 SP AusNet Customer Contributions – Forecast and Actual The two graphs on customer contributions clearly show that customer contributions were also poorly forecast over the current regulatory period

Lack of Adequate Data on Which to Analyse Distributors Proposal A critical part of the ability to effectively comment on the distributors ’ proposals is that a full set of data is provided in clearly marked tabular form for both the period and the all in consistent 2010 prices: Benchmark revenue and actual revenue for and forecasts for Benchmark net capital expenditure (excluding consumer contributions and disposals) and actuals and forecasts for Benchmark operational expenditure and actuals and forecasts for 2010—2015 Benchmark customer contributions and actuals and forecasts for Average Customer numbers for and forecasts for Electricity Consumption and forecasts for Asset Values and forecasts for

The Market Risk Premium The Market Risk Premium (MRP) is the difference between the market return on a portfolio and the risk-free rate derived from government bonds. The MRP is a forward looking variable and is therefore not easily measured and many assumptions must be made as to its calculation, such as that historical evidence is a good predictor of future value. The MRP can also vary substantially over time which makes the time period it is estimated over critical and that it is an up to date measure. A number of distributors have argued that the Global Financial Crisis (GFC) has resulted in: Material increases in the cost of capital across both debt and equity markets. General declines in the level of investor risk appetite. Reductions in liquidity and access to capital across virtually all markets; Change in market views on acceptable gearing levels In the proposed Statement of Regulatory Intent (11 December 2008) (SRI) the AER found that a MRP of 6.0 met the conditions of the National Electricity Law (NEL). However in light of the GFC the AER issued the final SRI on 1 May 2009 and increased the MRP to 6.5. However all distributors in their pricing proposals have proposed a MRP of 8.0 based on the work of Bishop and Officer.

The Market Risk Premium The most important interest rate that applies to international wholesale funds is the London Interbank Offered Rate (LIBOR) which is the rate at which banks offer to lend money to one another in wholesale money markets in London. It is also a standard financial index used in U.S capital markets. It is calculated each day by asking a panel of major banks what it would cost them to borrow funds for various periods of time and in various currencies, and then creating an average of the individual bank’s figures. It's an index that is used to set the cost of various variable-rate loans. Lenders use such an index, which varies, to adjust interest rates as economic conditions change. They then add a certain number of percentage points called a margin, which doesn't vary, to the index to establish the interest rate you must pay. When this index goes up, interest rates on any loans tied to it also go up. Although it is increasingly used for consumer loans, it has traditionally been a reference figure for corporate financial transactions. Interbank lending forms a critical part of modern financial markets. In normal times banks lend to each other in large volumes as a low cost for period ranging for one night to a few months. These interbank loans are the marginal source of funds for many banks, including Australian banks. Even for banks that are mostly funded by deposits, interbank loans may be a critical source of additional funds. Confidence in interbank loans is critical as shown in the Global Financial Crisis where some banks would not lend despite the rate of interest.

The LIBOR The Graph above shows the one year LIBOR interest rate from January 2000 to The graph shows that the recent peak as a result of the GFC for the LIBOR was in and that it has declined since that time to reach levels consistent with normal time in This suggests as debt and equity markets are closely connected that the MRP may have also declined to be more consistent with the AER ’ s proposed estimate of 6.0 for the MRP

The Market Risk Premium This Australia Reserve Bank Interest Series graph shows that the spreads between the Australian Government Bond (a risk free rate) and various corporate bonds of different risks have declined over recent time also suggesting that the MRP has declined. This graph can be viewed as the MRP for risky assets but usually a lower risk than the Market MRP which cover all assets in the economy weighted by their individual value.