1. 1 Economic regulation of the Victorian water industry Essential Service Commission Workshop Approach to pricing Service standards & incentives Bulk water code Tuesday 20 April 2004

2. 2 Workshop Agenda  Workshop purpose  Approach to pricing10.00am – 12.00pm  Service standards 12.45pm – 2.45pm  Bulk water code3.00pm – 5.00pm  Next steps: Submissions due by 30 April 2004 Submissions due by 30 April 2004 ESC to release further guidance paper in May ESC to release further guidance paper in May

3. 3 Approach to pricing  Tariff structures  Approval of prices Price controls Price controls Pricing principles Pricing principles

4. 4 Tariff structures  Number of WIRO principles, prices should: Provide appropriate signals regarding costs of supply Provide appropriate signals regarding costs of supply Provide businesses with incentives to pursue efficiency improvements and promote sustainable use of water resources Provide businesses with incentives to pursue efficiency improvements and promote sustainable use of water resources Take into account the interests of customers, including low income and vulnerable customers Take into account the interests of customers, including low income and vulnerable customers

5. 5 Proposing tariff structures  Expect businesses to make the case for proposing alternative tariff structures or maintaining current structures  Number of issues businesses must consider Underlying costs Underlying costs Changes in customer behaviour Changes in customer behaviour Customer impact and implementation issues Customer impact and implementation issues

6. 6 Underlying cost justification  Businesses to demonstrate they have considered the underlying costs of particular tariff structures  Long run marginal cost provides effective signals to users and businesses provides effective signals to users and businesses businesses will need to make assumptions regarding demand, capacity and least cost least cost alternatives businesses will need to make assumptions regarding demand, capacity and least cost least cost alternatives no expectation that all businesses present estimates of LMRC no expectation that all businesses present estimates of LMRC The Commission expects that businesses will have regard for the factors affecting LRMC in justifying the underlying cost basis for alternative tariff structures

7. 7 Changes in customer behaviour  Businesses will need to consider the ability of proposed tariff structures to encourage customers to change their behaviour  In doing so businesses will need to consider demand elasticities  the responsiveness of demand to changes in price demand elasticities  the responsiveness of demand to changes in price understandability of tariff structures  complex tariff structures may not deliver the desired changes in customer behaviour understandability of tariff structures  complex tariff structures may not deliver the desired changes in customer behaviour

8. 8 Customer impacts and implementation issues  Businesses will need to consider: impacts on customers impacts on customers whether to introduce common tariffs of separate tariffs across towns or regions whether to introduce common tariffs of separate tariffs across towns or regions costs of implementing particular tariff structures costs of implementing particular tariff structures costs of educating customers costs of educating customers

9. 9 Approval of prices  Typically two approaches in approving prices  Approval of annual prices businesses propose prices and these are approved by the ESC businesses propose prices and these are approved by the ESC adopted in the case of generic services that are provided to the majority of customers or to specific customers on request adopted in the case of generic services that are provided to the majority of customers or to specific customers on request  Pricing principles prices determined by the businesses in accordance with ESC guidelines prices determined by the businesses in accordance with ESC guidelines adopted in case of customer specific services where pricing is determined on a case by case basis adopted in case of customer specific services where pricing is determined on a case by case basis

10. 10 Annual approval of prices  Options for approving prices annually tariff basket tariff basket revenue yield revenue yield individual price caps individual price caps revenue cap revenue cap combination combination  These options can be assessed against following criteria provides incentives to align price structures with underlying costs provides incentives to align price structures with underlying costs manages and allocates risks from demand uncertainty efficiently manages and allocates risks from demand uncertainty efficiently minimises complexity, cost and administrative intrusiveness minimises complexity, cost and administrative intrusiveness

11. 11 Preferred approach  Tariff basket and individual price caps best meet the requirements of the WIRO Encourage businesses to set prices in line with underlying costs Encourage businesses to set prices in line with underlying costs Provide greater certainty for customers Provide greater certainty for customers Administratively simple, easy to understand and provide flexibility for businesses Administratively simple, easy to understand and provide flexibility for businesses  For first period setting individual prices is preferable because: Need to ensure that businesses will implement their proposed tariff structures Need to ensure that businesses will implement their proposed tariff structures Short regulatory period (3 years) lessens advantage of using tariff basket Short regulatory period (3 years) lessens advantage of using tariff basket Tariff basket data is limited Tariff basket data is limited  In future tariff basket approach may be more appropriate especially when tariff structures are more stable and historical quantity data exists

12. 12 Dealing with unforeseen events  Price cap approach provides price path for given period based on service requirements, associated costs and levels of demand  Businesses expected to manage any differences between actual and forecast costs during the regulatory period  Number of approaches for dealing with unforeseen events reflect uncertainty within expenditure forecasts adjust prices within the regulatory period to reflect material changes in costs resulting from unforeseen events adjust prices at end of period to reflect significant cost increases or decreases resulting from unforeseen events

13. 13 Dealing with unforeseen events (cont)  Commission’s preference to adjust prices at the end of period  In response: several businesses agreed that uncertainty should not be included as an explicit cost item several businesses agreed that uncertainty should not be included as an explicit cost item several argued for adjusting prices at the end of the period several argued for adjusting prices at the end of the period a number also argued for a within period adjustment a number also argued for a within period adjustment  Commission remains of view that adjustment at end of period is appropriate especially given 3 year period  Adjustments limited to unforeseen changes in legislative obligations that have a material impact on expenditure Commission invites further comment on this approach, particularly to how ‘material’ should be defined

14. 14 Pricing principles  Best suited to services that are unique and separately negotiated, or only required by a small number or specific class of customers  Businesses required to demonstrate that prices are consistent with pricing principles reflect efficient costs are consistent with achieving sustainable environmental outcomes take into account customer impacts are transparent

15. 15 Trade waste  Pricing principles to apply where charges are negotiated and not included under price cap regime  Prices need to reflect costs of treating waste discharged by customer (ie load and volume)  Businesses expected to adopt approach in case of new contracts or where renegotiating existing contracts

16. 16 Recycled water  Combination of polluter pays, user-pays and beneficiary-pays pricing principles proposed: Costs of treating waste water to comply with discharge licences should be met on polluter pays basis Costs of treating waste water to comply with discharge licences should be met on polluter pays basis Additional costs of treating water to recycled standard should be met by beneficiary Additional costs of treating water to recycled standard should be met by beneficiary Prices should be based on assessment of demand and supply including what market will bear Prices should be based on assessment of demand and supply including what market will bear Any revenue shortfall associated with schemes to meet mandated targets recoverable from broader customer base Any revenue shortfall associated with schemes to meet mandated targets recoverable from broader customer base  Further guidance required?

17. 17 Developer charges  Up-front capital contributions provided by developers in addition to any contributed assets  Current (IPART) approach - ie developer charges reflect impact on existing assets plus future costs  ESC proposes incremental cost approach - impact in terms of direct (location-based) assets reflected in calculation of developer charges - impact in terms of augmentation of existing assets to be apportioned between existing customers and new development

18. 18 Calculating developer charges  NPV approach – ie PV(IC)-PV(IR)  Incremental cost generally based on the proportion of costs incurred for the benefit of the developer/customer  Incremental revenue based on projected tariffs/ demand for development  Basis for charge to be transparent  Have regard to development specific conservation measures Commission invites further comment on the merits of this approach

19. 19 Service Standards and Incentives  Commission’s general approach to standards and incentives  Service Standards  Performance Reporting  Guaranteed Service Levels  S Factor  Efficiency Carryover

20. 20 Commission’s general approach  Number of approaches for ensuring businesses met their service obligations Specifying obligations defined through regulatory instruments Specifying obligations defined through regulatory instruments Performance Reporting Performance Reporting Designing service incentives to reward (or penalise) performance that varies from predetermined benchmarks Designing service incentives to reward (or penalise) performance that varies from predetermined benchmarks Combination of these approaches Combination of these approaches  In assessing proposed prices, ESC needs to be satisfied that the Water Plans provide the business with incentives to pursue efficiency improvements to pursue efficiency improvements to promote the sustainable use of Victoria’s water resources to promote the sustainable use of Victoria’s water resources

21. 21 Establishing Service Standards  Clear specification of service an important reference point for assumptions regarding future expenditure  Service Standards to be established through a combination of regulatory codes and the water plan  Key issue is what core services should standards/targets be established for in the water plan Standards will also need to also address business specific issues Standards will also need to also address business specific issues Water Plans needs to incorporate standards set by other technical regulators Water Plans needs to incorporate standards set by other technical regulators  Commission proposes Standards/targets that are no worse on average than the service level currently provided (that is, the aggregate average service performance over the past 3 years) Standards/targets that are no worse on average than the service level currently provided (that is, the aggregate average service performance over the past 3 years) Water businesses consult with their customers on the issue of whether the proposed targets are appropriate Water businesses consult with their customers on the issue of whether the proposed targets are appropriate

22. 22 Core Service Standard - Urban Businesses Water Rate of unplanned water supply interruptions Rate of unplanned water supply interruptions Response times to attend unplanned water supply interruptions Response times to attend unplanned water supply interruptions Proportion of water supply interruptions restored within specified timeframes Proportion of water supply interruptions restored within specified timeframes Average customer minutes off water supply Average customer minutes off water supply Average frequency of water supply interruptions Average frequency of water supply interruptions Average duration of water supply interruptions Average duration of water supply interruptions Number of customers receiving a specified number of multiple water supply interruptions Number of customers receiving a specified number of multiple water supply interruptions Level of unaccounted for water Level of unaccounted for waterSewerage Rate of sewerage blockages Rate of sewerage blockages Response time to attend and remedy a sewer blockage Response time to attend and remedy a sewer blockage Customers receiving a specified number of multiple sewer blockages Customers receiving a specified number of multiple sewer blockages Customer service Rate of restrictions for non-payment of bills Rate of restrictions for non-payment of bills Rate of legal actions for non-payment of bills Rate of legal actions for non-payment of bills

23. 23 Core Service Standards - Melbourne Water Aggregated compliance with key aspects of Bulk Service Arrangements at interface points, such as water quality, flow rates and water pressure Aggregated compliance with key aspects of Bulk Service Arrangements at interface points, such as water quality, flow rates and water pressure Rate of unplanned water main breaks Rate of unplanned water main breaks Proportion of water supply interruptions restored within a specified time Proportion of water supply interruptions restored within a specified time Rate of sewer spills and overflows Rate of sewer spills and overflows Proportion of sewer spills restored within a specified time Proportion of sewer spills restored within a specified time Level of unaccounted for water Level of unaccounted for water Number of properties at risk of flooding from specified rainfall events Number of properties at risk of flooding from specified rainfall events

24. 24 Incentives  Economic regulators generally seek to ensure that regulated businesses have sufficient incentives to: achieve efficiencies in relation to minimise the actual cost of providing a particular level of service achieve efficiencies in relation to minimise the actual cost of providing a particular level of service deliver the desired level of service over the regulatory period, notwithstanding incentives to achieve efficiencies deliver the desired level of service over the regulatory period, notwithstanding incentives to achieve efficiencies  Incentive-based regulatory approaches are designed to address both price and service dimensions  Monitoring and information disclosure complements service standards Key incentive mechanism for the first regulatory period Key incentive mechanism for the first regulatory period Being addressed separately Being addressed separately

25. 25 Guaranteed Service Levels  Primary purpose of GSLs schemes is to provide incentives for businesses to improve key aspects of services rather than to provide compensation to customers  GSL involve making payments to customers who receive services that do not meet defined service levels  GSL have been Voluntarily adopted by a number of Victorian Water businesses Voluntarily adopted by a number of Victorian Water businesses Commonly used in other jurisdictions (eg, NSW, ACT, England, Wales) Commonly used in other jurisdictions (eg, NSW, ACT, England, Wales)  Comments on GSL in response to Consultation Paper 1, were mixed

26. 26 Preliminary view on GSLs  The Commission considers that GSLs are an effective incentive mechanism that has worked well in other sectors  Examples of potential GSLs, include customer who receive long or multiple unplanned water supply interruptions, sewage spills to property or multiple sewerage blockages  The metropolitan retailers are in a better position to implement GSLs in the first regulatory period Performance reporting and auditing Performance reporting and auditing Robust and reliable information systems Robust and reliable information systems  Regional businesses are encouraged to consider whether they put forward such a scheme as part of their proposed Water Plans  Ideally, GSLs should be consist across businesses

27. 27 Information to support GSLs  If a business proposes GSLs in its water plan. They will need to Define the nature of GSL service standards to apply Define the nature of GSL service standards to apply Identify the threshold at which payments are made. Generally threshold are set to address the more extreme incidence of poor service Identify the threshold at which payments are made. Generally threshold are set to address the more extreme incidence of poor service Identify the size of payments (typically $20 -$100) Identify the size of payments (typically $20 -$100) Identify the likely cost of the scheme Identify the likely cost of the scheme Forecast levels of actual payments based on historic performanceForecast levels of actual payments based on historic performance Implementation costs (such as IT upgrades)Implementation costs (such as IT upgrades) In other sectors the Commission has allowed these cost in businesses expenditure forecastsIn other sectors the Commission has allowed these cost in businesses expenditure forecasts

28. 28 Issues  Will GSLs provide incentives to water businesses to improve services?  If so, what aspects of service should GSLs cover?  If a water business proposes to include GSLs in its Water Plan what supporting information should be provided?

29. 29 Service factor  Allows prices to be adjusted annually to reflect actual performance against certain specified service standards or targets  Provides incentives to achieve, or exceed the service targets and standards established during a price determination and improve service performance where economically efficient  The Commission has adopted this approach in the electricity sector businesses may have prices increased or decreased each year to reflect performance against clearly defined average reliability targets businesses may have prices increased or decreased each year to reflect performance against clearly defined average reliability targets  In England and Wales, Ofwat has adopted approaches to reward and/or penalise water businesses for their performance against a package of service measures

30. 30 Preliminary view on S factor  Insufficient reliable data available on service performance for this first regulatory period to develop an adjustment mechanism that provides a clear incentive for businesses to develop an adjustment mechanism that provides a clear incentive for businesses without potentially exposing them to revenue uncertainty without potentially exposing them to revenue uncertainty  Further consideration will be given to this type of approach in the next regulatory period Establishment of performance reporting regime to further inform development Establishment of performance reporting regime to further inform development

31. 31 Efficiency carryover  CPI-X approach provides incentives to reduce expenditure  Efficiency carryover mechanism provides for same reward regardless of timing  ECO designed to meet principles: Objective, transparent, easy to administer Objective, transparent, easy to administer Focus on management gains Focus on management gains Minimal or no re-opening of forecasts Minimal or no re-opening of forecasts Equal incentives for opex and capex Equal incentives for opex and capex Gains should not be at the expense of service standards Gains should not be at the expense of service standards

32. 32 Example of carryover calculation

33. 33 Efficiency carryover (cont)  Commission’s preliminary views Some businesses supported financial incentives Some businesses supported financial incentives ESC considers a ECO mechanism would satisfy WIRO requirements ESC considers a ECO mechanism would satisfy WIRO requirements Proposal to adopt mechanism consistent with that applied in electricity and gas industries Proposal to adopt mechanism consistent with that applied in electricity and gas industries No practical implications until next regulatory period No practical implications until next regulatory period

34. 34 Bulk services code  Need for a Bulk Services Code  Wider considerations  Understanding the integrated framework for bulk services  Outcomes sought by Code/framework  Preliminary considerations for content of Code  Melb Water/ retailer presentations  Approach & timelines for developing Code for Melbourne Water bulk services

35. 35 Need for Bulk Services Code  Bilateral negotiations between monopolies  Significant consequences for end-use customers  General support from industry  Need to assess role and content in wider regulatory/governance (and policy) context Broad support for Bulk Services Code

36. 36 Wider considerations  Water Plan development process  Bulk entitlement conversion process  White Paper outcomes  Other regulatory/governance developments (eg specialist regulation, Statement of Obligations) Proceed with Bulk Services Code for services provided by Melbourne Water

37. 37 Water Plan -3-yr proposals -Service standards/ revenue requirements -Consultative process Bulk Services Code -Obligations -Scope for negotiation -Dispute resolution Bulk Supply Agreements -Detailed arrangements -Consistent with Code/WP -Enforcement/ monitoring Integrated Framework for Bulk Services

38. 38 Outcomes sought by Code/ framework  Clarity of roles & obligations (& risks)  Clear specification of service standards  Greater coordination of planning  Clear obligations and processes for dealing with change/ unforeseen events  Clear interface arrangements (eg billing, information exchange)  Dispute resolution

39. 39 Preliminary considerations for content of Code  Relevant legislation  Purpose of Code (end- customer interests)  Roles and responsibilities  Consultation (Water Plan and BSA)  Guidance for BSAs  Information provision and exchange  Directions for service standards  Directions for operating protocols (std and non- std events)  Risk management (least community cost and expenditure allocation)  Directions for performance incentives  Demand and supply management  Billing and meters  Dispute resolution

40. 40 Developing a Code  Working group process proposed  ESC cognisant of immediate pressures on businesses – ie Water Plan process  Finalise Code for Melbourne Water for 1 July 2005  Consider rural/regional position in light of White Paper