Capex Regulation in Australian NEM

1. Capex Regulation in Australian NEM NZ Commerce Commission workshop – March 2010

2. Australian NEM Regulatory framework • Main ex–ante capex allowance (one bucket) • with separate arrangement for contingent projects • Incentive based - keep (lose) return on, and of, capex below (above) main ex ante allowance during the regulatory period (RCP) • ACTUAL capex spent is “rolled into” Regulatory Asset Base (RAB) at end of regulatory period • Return on capital – determined from capex “as incurred” at the WACC rate • Return of capital – determined from capitalisations (via depreciation) based on agreed life by asset class

3. Objectives of Incentive Regulation • Incentives • Outperform pre-established benchmarks (eg. capex/opex) • Keep efficiencies for a certain number of years • To reveal ‘true costs’ over time • Desired Outcomes • Undertake necessary investment at efficient cost • Reasonable price outcomes • Maintain or improve service quality • Ongoing efficiency improvements • Inevitable information asymmetry between business and regulator • Incentives aim to keep business focussed on efficiency improvements.

4. Transmission Capex Framework • Ex-ante capex allowance (cap) • covers most/all expected investment • Due to main investment drivers (eg. demand) • $ included in cap up-front • No second chances • Forecasts are generally scenario based • No expectation for all projects to be “approved” before start of RCP • Contingent projects • uncertainty about timing and $ • rely on a pre-defined trigger to occur • $ not included in ex-ante cap up-front

5. How does the AER determine the cap? Structured process • Check governance frameworks • Overall and by project type – that capex policies and procedures facilitate efficient investment outcomes • Check all the inputs are robust and appropriate - probabilistic planning, demand forecasts and network planning criteria, replacement triggers, etc • Test application against an AER selected sample of projects from each area and $ range • there is a genuine forecast need for the project • the scope, timing and estimated costs are efficient • Regulatory Test assessment/business case for projects underway (approved) • Reasonable forecasts and estimates for projects further out (unapproved) • Check cost accumulation process including inputs • Incidence of expenditure, cost escalators, risk premiums, etc • Check the overall capex program is deliverable.

6. Practically – how does it work? • Business provides information for each step • 5 year regulatory period • balance between overhead of a revenue determination and forecast accuracy to set allowances • Powerlink’s next revenue period 1 July 2012 to 30 June 2017 • No expectation that all projects in Powerlink’s proposal are required to be approved • As incurred capex means forecast includes projects being completed 2019 or 2021 for easements • Not all are approved at time of revenue proposal • Determination made by AER – then “set and forget” until next time • Annual reporting by TNSP • No ex post prudency review at next determination

7. Types of projects • Project types are based on drivers for investment – not $ • Load driven – augmentations, connections, easements • Non load driven – replacements, security, EMS, etc • Support the business – IT, buildings, fleet, etc • Reason - Governance frameworks are based on drivers • Different levels of scrutiny based on $ - regulator and business • Augmentations must satisfy Regulatory Test and associated consultation process • Small investments >$5 million – lesser process • Large investments >$25 million • <$5 million – not applicable • Some assessments complete, some not, at time of Revenue Proposal • Substitution OK amongst all categories • Is actually expected under incentive arrangements • Re-prioritise other categories if something unforeseen occurs • Depending on circumstances – may be in next proposal

8. Ex ante capex cap – a genuine bucket • “Notwithstanding that specific capital projects have been proposed by Powerlink and a sample of these assessed by the AER, this decision does not require Powerlink to undertake or not undertake any particular investment. Under the ex ante framework, Powerlink has full operational discretion to allocate its expenditure allowances as it sees fit. It has an incentive to seek more efficient ways of delivering its services in order to maximise its profits while maintaining the service standards that have been set in the decision. These arrangements should provide benefits to users over the longer-term.” Powerlink Final Decision, June 2007, p5.

9. Contingent projects • Large >$10 million or 5% or 1st year MAR; AND • Uncertain – whether trigger will occur or cost. • Once trigger is activated • Application made to AER – capex, opex and revenue • Mini reset for contingent project • Adjusts MAR within period

10. Powerlink’s 11 Contingent Projects • Ex ante capex allowance included 478 projects

11. How did we get here? • In Qld, vertical separation occurred 1995 • Revenue regulation commenced then • First one year, then three years, now five years (or more) • NEM commenced 1998 • Powerlink regulated by ACCC since 2002, now AER • Draft Statement of Regulatory Principles (SRP) in 1999 • Capex framework – initially ex post with capex efficiencies • Now ex ante (without ex post) • Major review of SRP during 2004 – change to ex ante • “Chapter 6A” review – 2006 & 07 • Ex ante confirmed – without ex post • Arrangements are now in NER – effectively law