Incentive-based versus cost-of-service regulation

Recently the National Irrigators’ Council (NIC) released a report claiming that profits made by electricity networks are more than $2.6 billion higher than they should be.  The NIC engaged the Sapere Research Group to compare profit data recently released by the Australian Energy Regulator (AER), with the profit “allowed” under the AER’s Rate of Return guidelines[i].

Energy Networks Australia (ENA) responded that such claims are a misrepresentation, because when network businesses earn profits above the allowed return set by the AER, it reflects efficiencies made in their operations, not more money out of customer pockets.

The debate around the AER Rate of Return Guideline, and its recent draft determination[ii], seems to have left all parties aggrieved.  Under the National Electricity Objective (NEO) and National Gas Objectives (NGO), the AER process must deliver a decision that is in the long-term interest of customers. Given that the lower the allowed rate of return the less customers pay, this would seem to be served by setting the rate of return as low as possible as the NIC suggests.  However, networks are capital-intensive businesses and the long-term interest of customers is not served by setting an inadequate rate of return that does not allow a network service provider to fund the necessary expenditure to maintain and operate the network safely and securely. 

The fact of the matter is that the AER does not, and should not for reasons outlined below, regulate profits.  The AER regulates the allowed return and expenditures for networks for five year periods.  It does so using analytical tools, techniques and sources of evidence to arrive at an overall best estimate of each of the parameters of the rate of return.  And these are all tested by various panels and independent experts attached to the review process.  Nonetheless the AER is ultimately required to make its best estimate of the Weighted Average Cost of Capital (WACC) of a Benchmark Efficient Entity (BEE).  This is ultimately a matter of judgement – there is no determinative number.

What the NIC can see in the Sapere report, and is clearly concerned about, is simply the profits revealing of how close those allowed returns and expenditures were to the actual figures.  But this misses the critical point that the result will be reflected in future allowed earnings. The regulator uses the outcome to determine the resetting of the rate of return with profits returned to customers over the next five year period through the setting lower benchmarks – which means lower network prices in the long-term.

This is actually how incentive-based regulation is supposed to work. Due to all the information asymmetries, a regulator cannot possibly perfectly pre-determine an efficient firm’s revenue. Instead it sets a revenue for five years that represents its best estimate, and if the firm can truly operate with lower revenue it is encouraged to do so by retaining the resulting profit for those five years. But in doing so the firm reveals its efficient costs in a way the regulator could never do alone, and so the revenue can be corrected for the following five years. It is intending to incentivise the finding of efficiencies which are to the ultimate benefit of customers. Yes, it is possible to argue that the determination handed the distribution firm five-years of extra profits, but consider the alternative: Cost-of-Service regulation. In that model there is no incentive for the firm to ever find efficiencies as it gets to keep none of them.

The alternative of following the NIC/Sapere logic to its natural conclusion of advocating Cost-of-Service regulation, customers pay the initial higher rates forever. So customers pay more, but they are unlikely to realise that they are actually paying more.

Which brings us to the current rate of return guideline draft determination; because in practice, this is what the AER draft determination in its current form will do; reset revenue to better reflect efficient costs.  And according to the AER, if implemented, the current draft guideline could result in household customers’ bills decreasing by around $30 to $40 per year.  A modest decrease but one that reflects the efficiencies revealed, amongst other things, by the distributors profits’ at the end of the current regulatory period. 

[i] Regulated Australian Electricity Networks – Analysis of rate of return data, Australian Energy Regulator, October 2018  

[ii] Draft Rate of return guidelines, AER, July 2018, https://www.aer.gov.au/system/files/AER%20-%202018%20Rate%20of%20return%20guideline%20review%20-%20Draft%20guidelines-%2010%20July%202018.pdf