1. NSP Inputs for Use in Economic Benchmarking AER Economic Benchmarking Workshop #3 20 March 2013 Denis Lawrence and John Kain

2. www.economicinsights.com.au 2 Data requirements Require data on the price and quantity (and hence value) of all outputs and inputs and on the quantities of operating environment variables (noting that output prices may be shadow prices where the output is not explicitly charged for). This then allows any of the key economic benchmarking methods to be implemented. Given its tops-down nature, it is important to concentrate on a relatively small number of key outputs and inputs in economic benchmarking Desirable to have robust and consistent data Data backcasting may be possible and facilitate early use

3. www.economicinsights.com.au 3 Different types of inputs Non-durable versus durable inputs Opex (labour, materials and services) versus capital (lines, cables and transformers) Different treatment of these inputs required in economic benchmarking studies Obtaining price and quantity of non-durable inputs is relatively straightforward But obtaining accurate annual cost and quantity of capital inputs is more challenging Capital service flow is the quantity of capital inputs’ contribution to production each year Annual user cost is cost of using capital inputs each year

4. www.economicinsights.com.au 4 An asset’s capital service flow will depend on its physical depreciation profile If there is no physical depreciation over asset life then the profile is said to be ‘one hoss shay’ or ‘lightbulb’ type If there is more physical depreciation over time then profile could be of the geometric, straightline or hyperbolic type Distinction between physical depreciation profile and regulatory depreciation profile Capital service flow is unobservable so need proxy measures – usually assume it to be proportional to the capital stock Best aggregate capital service flow proxy will depend on physical depreciation profile of components, robustness of data used, whether aggregate profile mirrors components Capital input quantities

5. www.economicinsights.com.au 5 Annual user cost of capital consists of:  depreciation  plus opportunity cost  minus capital gains Equivalent building block concepts are return of capital (depreciation less inflation allowance) and the return on capital (opportunity cost) Building blocks also implicitly include concept of ex-ante financial capital maintenance based on RAB and WACC Preferable to have (approximate) consistency between the ways annual capital costs are calculated in building blocks and economic benchmarking Annual user cost of capital

6. www.economicinsights.com.au 6 Relevant capital input measures for economic benchmarking are capital service flow and annual user cost of capital Capex only measures additions to capital stock each year It is therefore not appropriate to use capex (nor ‘totex’) as an input in economic benchmarking studies Focus of economic benchmarking will be on the efficiency of operating and maintaining the network Therefore NSP inputs used for the construction of capital assets should be excluded to avoid double counting Some grey areas such as treatment of pole replacement Items excluded

7. www.economicinsights.com.au 7 1) input coverage is comprehensive and non–overlapping 2) measures of capital input quantities are to accurately reflect the quantity of annual capital service flow of assets employed by the NSP 3) capital user costs are to be based on the service provider’s regulatory asset base (RAB) and should approximate the sum of the return of and return on capital components used in building blocks, and 4) be consistent with the NEL and NER Input selection criteria

8. www.economicinsights.com.au 8 OPEX INPUTS

9. www.economicinsights.com.au 9 Opex coverage Are separate data on labour, materials and services available? Given extent of contracting out, generally use aggregate opex Diverse composition requires deflating opex by a price index to derive the quantity of opex inputs indirectly Sometimes need to remove accounting adjustments that do not reflect opex input usage that year Need uniform treatment of asset refurbishment and allocation of corporate overheads Need some consistent disaggregation of opex to allow consistency checking and to provide more information Do we need to allow for differing system structures and opex coverage across NSPs?

10. www.economicinsights.com.au 10 Opex price index Around 60% of opex is typically made up of labour costs Remainder covers operational, office and professional services and consumables NSP-specific price indexes generally not available Use ABS broad EGWW sectoral and economy-wide price indexes instead Ongoing debate over whether labour price index should be AWOTE or LPI Use combination of Producer price indexes for rest of opex – reclassification by the ABS often necessitates index splicing Do opex input price levels vary across NSPs? How representative are the high level price indexes of the price changes NSPs actually face?

11. www.economicinsights.com.au 11 Opex specification QuantityCostPrice Nominal opex / Weighted average price index Opex (adjusted to remove accounting items not reflecting input use that year) Weighted average of an ABS labour price index and several ABS producer price indexes Advantages - Uses readily available data - Unlikely to be any practical alternatives Disadvantages - Dependent on changes in ABS sectoral and economy-wide price indexes accurately reflecting changes in opex prices faced by all NSPs - Assumes all NSPs face the same levels of opex component prices - Assumes the same range of opex coverage and functions for all NSPs

12. www.economicinsights.com.au 12 CAPITAL INPUTS

13. www.economicinsights.com.au 13 Capital input quantities Capital service flow is not directly observable – have to use proxy measures instead No proxy measure will be perfect – all have pros and cons Best proxy measure will depend on:  Physical depreciation profile of constituent assets  Robustness of the data used to form the proxy – the more accurate the better and the fewer assumptions that have to be made, the better  Whether depreciation profile of the aggregate mirrors that of the components

14. www.economicinsights.com.au 14 Physical depreciation profiles Important to distinguish between physical and financial regulatory depreciation Asset physical ‘carrying capacities’ can have one of four different physical depreciation profiles:  one hoss shay (no reduction in carrying capacity throughout the asset’s life)  hyperbolic (small decline in early years, larger decline in later years of the asset’s life)  straight–line (ie equal absolute reduction each year of the asset’s life), or  geometric (equal percentage decline over lifetime, ie bigger absolute falls in early years and smaller absolute falls in later years)

15. www.economicinsights.com.au 15 NSP asset physical depreciation NSP assets subject to little physical deterioration over their lifetime provided they are properly maintained Failure rates may be higher towards the end of asset life leading to Weibull distribution of asset ages But service flow relatively constant over the asset’s life meaning one hoss shay depreciation is closest Can approximate service flow under one hoss shay by using physical measures (eg MVA-kms) or gross capital stock in constant prices Using constant price depreciated asset value proxies assumes depreciation profile other than one hoss shay If the decay of the asset over time is overestimated by the proxy then efficiency will also be overestimated

16. www.economicinsights.com.au 16 Data robustness Critical to have accurate input quantity measures Best to minimise reliance on indirect measures where quantities derived by deflating value by a price index Capital goods price indexes are particularly problematic EGWW sector prices may not be close to prices actually paid by NSPs Also small sample and lumpiness problems Starting asset value data may not be consistent and often adjusted – particularly a problem for long lived assets Asset value proxies assume constant asset lengths of life but regulatory depreciation rates have varied widely through time for some NSPs, across NSPs and sources Asset register data likely to be the most accurate data available

17. www.economicinsights.com.au 17 Asset aggregation US BEA advanced ‘portfolio effect’ example in support of its use of geometric depreciation and a constant price depreciated asset value for macro productivity data But the US BLS is the main US productivity agency and it has been at the forefront of using a ‘productive capital stock’ proxy based on the hyperbolic physical depreciation profile ABS and SNZ also use the BLS hyperbolic model which is closer to one hoss shay for structures Aggregation issues also not likely an issue for NSPs given more bunched nature of network roll-outs and few NSPs Include 4 asset categories: overhead lines, underground cables, transformers and other capital Use MVA-kms to aggregate up lines and aggregate up cables, KVA to aggregate up transformers

18. www.economicinsights.com.au 18 RAB depreciation as a proxy AER Issues Paper raised possibility of using real RAB depreciation as a proxy for service flow This has some similarities to a physical quantity based one hoss shay proxy But it would need to be converted to capital goods constant prices rather than the CPI constant prices used in RAB calculations It would have the same limitations as other indirect proxies, namely differences in the basis of initial valuations, differing assumed asset lives across NSPs, over time and across sources, and the need to rely on sectoral capital goods price indexes that may not well approximate the prices paid by NSPs

19. www.economicinsights.com.au 19 Conclusion on capital quantities While no capital service flow proxy will be perfect, the use of physical quantity based proxies appears best on a number of grounds:  They reflect the one hoss shay physical depreciation profile of individual NSP assets  Asset register data is likely to be the most accurate data available and will more accurately reflect actual asset lives  They are the available proxy that comes closest to approximating the hyperbolic profile used by leading statistical agencies for aggregate structures The constant price RAB depreciation proxy is likely to be the second best proxy – this option is subject to further investigation

20. www.economicinsights.com.au 20 Capital annual user costs Annual user cost can be measured either directly or indirectly Direct approach applies formula taking in depreciation rate, opportunity cost rate and rate of capital gains This produces an exogenous measure of the ex ante or shadow annual user cost Most exogenous formulas used to date differ from building block return of and return on capital calculations Indirect approach simply takes residual of revenue minus opex as the annual user cost It is an ex post measure of the annual user cost and will not be FCM-consistent except by chance The annual user cost used in economic benchmarking should be similar to the building blocks return of and return on capital components

21. www.economicinsights.com.au 21 Alternative capital specifications (1) QuantityAnnual user costPrice O/H MVA-kms U/G MVA-kms Transformers & other KVA Return of & on O/H capital Return of & on U/G capital Return of & on Trf & other capital O/H AUC/MVA-kms U/G AUC/MVA-kms Trf & other AUC/KVA Physical proxies Advantages - Reflects individual component carrying capacities - Uses the most robust data available and captures actual asset lives - Approximates productive capital stock used by leading statistical agencies for aggregate structures - Ensures consistency with building blocks calculations Disadvantages - Small amount of extra data required - May not fully reflect aggregate depreciation profile

22. www.economicinsights.com.au 22 Alternative capital specifications (2) QuantityAnnual user costPrice Nominal RAB depreciation/ABS CGPI Return of & on capitalAUC/Const price RAB depreciation RAB depreciation proxy Advantages - Potentially reflects individual component carrying capacities - Potentially approximates productive capital stock used by leading statistical agencies for aggregate structures - Uses existing regulatory data Disadvantages - Assumes consistency of treatment over time and across NSPs - May not capture actual asset lives - Dependent on accuracy and consistency of initial capital base values - Dependent on ABS CGPI accurately capturing prices paid by NSPs

23. www.economicinsights.com.au 23 Alternative capital specifications (3) QuantityAnnual user costPrice Nominal depreciated RAB/ABS CGPI Revenue minus opexAUC/Const price depreciated RAB Depreciated RAB proxy Advantages - Easy to implement - Uses existing regulatory data Disadvantages - Unlikely to reflect carrying capacities of assets - Dependent on accuracy and consistency of initial capital base values - Assumes consistency of RAB treatment over time and across NSPs - May not capture actual asset lives - Dependent on ABS CGPI accurately capturing prices paid by NSPs - Unlikely to be consistent with financial capital maintenance