1. Productivity-based Regulation: The New Zealand Experience Presentation to 8 th ACCC Regulatory Conference 26 July 2007 Denis Lawrence

2. Background Many regulators acknowledge the desirability of moving to productivity index-based approaches to setting X and delinking the process from DBs’ own costs But most are concerned about inherent risks – Is the system sufficiently mature? Is there sufficient data? MCE Expert Panel recommended the AEMC review the rules to facilitate the use of productivity-based approaches What can we learn from the use of productivity-based approaches elsewhere? New Zealand is one of the few places to have implemented productivity-based regulation How was it implemented? How were the problems encountered overcome? How successful has it been?

3. Electricity reform in NZ Distributors and retailers corporatised in 1992 – variety of ownership structures, no explicit regulation Information Disclosure required from 1995 as first step in light handed regulation Separation of distribution and retail in 1999 Targeted control regime under Commerce Commission foreshadowed in 2001 and move to incentive regulation Thresholds seen as next logical step in evolution Progressive amalgamation of distributors – 29 in 2002, down from 60 in mid-1980s Important practical issue that Building Blocks Method not feasible for 29 ELBs in a small country so need to look at alternative of comparative benchmarking (regardless of whether it be a thresholds or a control regime) Pre-existing database allowed TFP approach

4. Rationale for productivity- based regulation Aim of mimicking competitive markets Productivity-based regulation by price caps (CPI-X) :  industry average price prevails;  not based on own costs;  response to efficiency and other changes gradual High power but also high risk (under or over earning) Innovation encouraged, less scope to ‘game’ system Delinks prices and own costs, low regulatory costs X  [  TFP   TFP E ] – [  W   W E ] –  M Index approach can be mechanistic when firms starting from similar points Rolling X factor particularly attractive When there is a wide spread of efficiency levels will need to include ‘stretch factors’ (+ve for laggards, possibly –ve for leaders) as well as industry average

5. Development of the scheme Need to allow for variety of starting points, particularly given no previous regulation and range of DB ownership As well as allowing for industry TFP growth, also need transitional factors in the X given different starting points X = B + C 1 + C 2 ‘B’ factor reflecting the overall or average productivity trend for DBs ‘C’ factors reflect different productivity and profitability starting points  3 C 1 factor groupings based on relative productivity performance  3 C 2 factor groupings based on relative profitability performance Price thresholds rather than explicit price caps but could be transferred to a control regime Based solely on results of quantitative study

6. Productivity measurement TFP is an index number measure which forms the ratio of all outputs to all inputs Relatively simple, robust and readily replicable technique It requires price and quantity data for all outputs and inputs Specification used includes 3 outputs: energy throughput, customer numbers and system capacity (based on line length, voltage and engineering characteristics) Outputs weighted by output cost shares from cost function 5 inputs: opex, O/H lines, U/G cables, transformers and other capital Use physical measures of capital input to better reflect depreciation characteristics of network assets

7. B factor X = [(TFP – TFP E ) – (W – W E )] TFP for distribution trend rate of increase 2.0% pa Economy TFP trend rate of increase 1.1% pa Conflicting information on relative input price movements so set this differential to zero Distribution B of 0.9% pa but round to 1% pa

8. Relative productivity: C 1 factor component Use 2 techniques: Multilateral Total Factor Productivity (MTFP)  allows analysis of productivity levels as well as growth rates  allows the B and C factors to be calculated in an integrated framework  density factors incorporated in output specification  divide sample into high, medium and low productivity level groups  average level of high productivity group around 15% above average of medium group which was around 15% above average of low group Econometric cost function  used to verify MTFP results and obtain output cost shares  obtain broadly similar results to MTFP

9. Relative productivity performance

10. Relative profitability: C 2 factor component Incorporate profitability differences between the businesses using residual rates of economic return Calculated consistently with TFP from same database but less detailed than WACC process Divide sample into high, medium and low profitability groups Average residual rate of return of high profitability group was 10.3%, of medium group was 7.3% and of low group was 3.4%

11. Deriving the X Factors X = B + C 1 + C 2 Divide distributors into groups of high, average and low productivity levels and profitability Productivity C 1 factor components of –1, 0 and 1 per cent Profitability C 2 factor components of 1, 0 and –1 per cent Leads to overall X factor groupings of –1, 0, 1 and 2 per cent C factors set conservatively given quality of the data and industry characteristics – consistent with a 10 year glide path Mixture of business types in each X factor group with urban high density, urban low density, rural high density and rural low density businesses appearing in each X applied to each DB’s actual starting price

12. Assessment Objective, highly transparent and replicable process with relatively low regulatory cost delivering real price reductions to consumers None of the vagaries of BBM (eg ‘in our professional opinion’) – less scope for gaming Building blocks reviews of two of the larger DBs indicated they were earning better returns than they would have under BBM A few businesses have breached because they think they have a strong case for additional funds for investment – it has not been a deterrent to investment 2009 reset will take lessons learnt into account – may be role for allowing for position in asset lifecycle if impending ‘wall of wire’ effect is thought to be significant in next regulatory period Information Disclosure Data is now more forward looking allowing scope for more account to be taken of forward looking information Ongoing role seen for productivity-based approach irrespective of outcome of thresholds review Importance of having a consistent database available