Getting Ready! Potential issues for consumers Ergon Distribution Network Regulatory Proposal Bev Hughson, Consumer Challenge Panel (CCP) 2 September 2014 The data and charts in this presentation are based on the information provided by Ergon to the Australian Energy Regulator in its Economic Benchmarking Regulatory Information Notice (Consolidated), 30 April 2014, Public Version. The author cannot vouch for the accuracy of the information provided by Ergon in its Notice.

Agenda Some background – Ergon is special! – The regulatory dance Revenue trends Capital requirements – The RAB – Demand forecasts – Growth, Replacement & Reliability capex Operating costs (opex) Return on capital (WACC) Wrap up – some key questions to ask

A Regulatory Reset The things that matter The total revenue that the AER allows Ergon – This is today’s topic – We are looking at history – to help us assess future The way Ergon allocates this revenue in their prices – very important, but for another day The way prices change across the 5 years – The big jump (up usually, down if your lucky) – Or smooth across the years How Ergon engages with their customers in making these decisions

A warning: Ergon is a special case! Non-Ergon regions (Qld SE, NSW, Vic, SA) – Most customers don’t see a network price in their bill But the retail price will be influenced by the size & structure of the network tariff – For larger customers the network price is a ‘pass-through’ Ergon is different – Most customers have the same retail price as Energex What Ergon does is not of concern (except to Govt)? – However, larger customers (>100 MWh/year) do see Ergon’s network price And, they are not all happy! Tariff structures matter – Will the status quo change? – Importance of the very large high voltage (HV) customers

Ergon’s reliance on High Voltage Demand Consumers

The regulatory dance

We have a “propose-respond” regulatory model – Important because it defines the roles of the networks & the AER (and consumers – more on this later) – Step 1: Ergon “proposes” to the AER Revenue requirements, based on: Forecast capital and operating expenditure, return on assets, depreciation, tax costs, incentive payments, tariff strategy – Step 2: The AER responds (“Draft Determination) Yes, no, maybe yes if you fix up this and that – Step 3: Ergon amends their proposal – Step 4: The AER approves or rejects (“Final Determination”) – Step 5 (A): Ergon accepts, and publishes tariffs, or – Step 5(B): Ergon rejects and takes the issue to the Competition Tribunal Where do consumers fit in? Where is the most impact? – Talking to Ergon before the proposal? – Making submissions after the proposal? – Responding to the AER’s Draft Determination? – Other? Culture shock! Are all the players ready for a brave new world

Reading the Crystal Ball Things we need to do before we start: – Learn from history – Forecast energy use – Forecast customer numbers – Forecast average use/customer – Forecast technology change – Forecast government policies – Forecast input prices (labour/materials) – Forecast the weather… These forecasts will underpin revenue, tariffs, capex and opex – See later slides

What’s happening to Revenue?

Ergon’s revenue per customer accelerates – but not for all (truly strange!)

What determines the revenue allowance next reset? Capital costs – now over 70% of costs – Opening regulatory asset base (RAB) Plus capital investment (Capex) Plus inflation adjustment Minus depreciation – Closing RAB – Rate of Return on asset base Operating Costs (Opex) Tax allowance Incentive scheme payments (+/-)

How much capital & for what return Assess the regulatory asset base for each year – What is the capital expenditure (capex) each year? – Is it prudent and efficient? – Is it growth, replacement, or reliability capex? Growth: Forecasts of energy demand, peak demand & customers Replacement: Assess age & condition of network Reliability: Assess service performance (time off supply etc) What is the rate of return on asset base – Return on equity (shareholder) & – Return on debt What is the credit rating of the DNSP? What is the business risk profile? – Should government ownership make a difference?

Capex keeps driving the RAB

And per customer: Ergon’s RAB is bigger & growing faster

Growth capex: What’s happening to demand? Ergon is only network where there is no big decline in residential volumes?

What’s behind the demand trends? Decline in residential use from is only 7.3%. Energex is 15.6%

Growth Capex: Peak demand a bit of a question mark?

Growth & replacement capex How much more improvement required?

Getting younger by the year

Reliability Capex Are there still performance issues? Energex average SAIDI is less than 100 minutes

Do we see improvements in opex?

Ergon & Energex Opex & the FIT (and a corrigendum)

Rate of Return (WACC) -a new approach? Most networks seen very rapid price increases & currently very high profits – changes to Rules Cost of Debt (60% WACC): – AER new approach - move to 10 year average of 10-year tenor bonds over a ten year transition period – disputed – Credit rating (BBB+), and data sources - disputed Cost of Equity (40% WACC) – Cost of equity = [risk free rate + (MRP * beta)] - disputed – Risk free rate assessment (about 3.5% at this time) - disputed – Market Risk Premium (6.5%) - disputed – Equity beta (0.7) – disputed Imputation Credits (adjust the tax cost allowance) – disputed

Cost of Capital – going down… (cost of debt*0.6)+(cost of equity*0.4) cost of debt Approx 8.98% Cost of Debt? Ergon’s reported weighted average cost of debt (12/13) is 7.31% Input to Cost of Equity?

Cost of Equity Regulatory Benchmarks Source: AER Explanatory Statement RoR Guideline, Appendix C, p 32 NSW NSP’s proposing 10.1%; AER NSW Transitional Determination 8.9%

The bottom line & why you should care Forecast RAB & “Interest “rate figures are estimates – for illustration purposes only

Summary of Issues to Watch Are the forecasts reasonable? Is the capex prudent and efficient? Is the opex prudent and efficient? – 2012/13 will be the base year for next period Is the cost of capital reasonable given economic conditions? – Consistent with risk, and fair to consumers – Provide the right incentives for efficient investment Efficiency schemes (opex and capex)? – A problem unless AER sets tight allowances – Witness NSW distribution companies… Have consumers been adequately engaged in the decisions by the networks and the AER?