Bruce Mountain Director Quo vadis CPI-X and independent regulation of electricity networks in Australia Economic Society of Australia “Policy in the Pub” 18 March 2015

Outline 2 RPI-X origins Potted history of CPI-X and “independent regulation” in application to Australian electricity networks Outcomes Reforms?

RPI-X origins in GB Fixed price, multi-year contracts common in commercial business and used in local authority contracting for electricity from private providers in the U.S. in early years until 1930s. In GB, Stephen Littlechild (then B’ham Univ. academic) invited in Oct 1982 to advise on discussion between Inter-departmental Working Group (Treasury, Industry, others) and Professor Alan Walters (Prime Minister’s economic advisor), on appropriate control of British Telecom’s profitability after privatisation. Littechild considered and rejected Maximum Rate of Return (from Working Group) and Output Related Profits Levy (from Walters) and suggested instead “Local Tariff Reduction” (aka RPI-X). RPI-X - adaption of “Buzby Bond” – a (pre-privatisation) proposed recapitalisation of BT in exchange for which BT’s prices would not increase faster than CPI - X. 3

A little more on RPI-X origins RPI-X developed for regulation of private monopoly Intended as approach “to hold the fort” until industry sufficiently competitive to do away with controls (as expected in telecoms). Institutional arrangements (regulator = non ministerial government department reporting to Parliament) to administrate RPI-X. Political independence of regulation sought by investors and consumers. RPI-X + independent regulator rolled out in telecoms then gas, electricity,water, rail (all privatised), post (only recently privatised). When devised, RPI-X not envisaged as “repeat game”. Key elements (RAB, WACC, treatment of tax not defined in the beginning – Michael Beesley suggested RAB should not be specified). Rationale for RPI-X became increasingly evident in practice: incentive to efficiency - investors rewarded for beating regulatory allowances, consumers share in efficiency gains when control subsequently re- established; rely on “revealed costs”; strong desire by regulator to avoid the illusion of the perfect mousetrap). This characterised its early application in GB. 4

And CPI-X in Australia … CPI-X + independent regulator model adopted at privatisation in Vic (1995) + SA (2000). CPI-X applied ipso facto to government distributors in NSW from 1999 after failure of Carr government’s privatisation attempt. Then applied in QLD and TAS. Although CPI-X + independent regulator developed in response to private ownership, idea that it could also work in application to government-owned monopolies largely unchallenged by economists. Some academic support for this – Newbery, Yarrow et al suggested competition more important than ownership (and by implication if the purpose of CPI-X is to replicate competitive market pressures then ownership of monopoly need not undermine effectiveness of CPI-X). Public choice theories of regulation (and consequential implications for relationship between regulation and ownership largely ignored in Australian economic debate). Corporate finance theories (risk - hence required return - defined by asset not source of its funding ) provided additional cover for idea that (government) ownership does not matter. 5

Questions about the application of CPI-X (and independent regulation) to government-owned networks have been (and remain) ignored 1.If WACC (allowed) much greater than WACC (actual) then higher profits achieved by expanding the RAB not spending less than regulatory allowance 2.For government networks, WACC (allowed) is much greater than WACC (actual) because governments collect profits + tax on profits and have access to low cost borrowing (when allowed return on borrowing much greater than actual cost of borrowing, evidence in QLD, TAS and NSW shows that Treasurers discount corporate finance theories that suggest actual cost of government borrowing is higher than it appears) 3.In designing a regulatory framework, a government has to balance (among many other things) the interests of customers and investors. A government that is also an investor, as the owner of a regulated company, and as the recipient of its tax revenues, has a financial interest in the profitability of that company. It will be more receptive to a regulatory framework that limits the extent of regulatory power and discretion and how this is exercised. When these issues raised with AEMC (and state governments that own networks) response has been that the treatment of government-owned distributors as if they were private is consistent with Competition Principles Agreement. It is not - CPA very specifically about government-owned businesses that compete, not about monopolies) 6

CPI - X and independent regulation of government-owned monopolies undoubtedly unsuccessful (in protecting consumers) 7

Econometric analysis confirms the explanatory power of ownership 8

And it shows up in revenues 9 Privately ownedGovernment owned Source: regulatory decisions

And profits far higher than regulatory assumptions 10 AusGrid Endeavour Essential And the picture is the same in Queensland ….

And consequently (deeply) unimpressive prices 11

Is ownership the issue ? 1.Clear disparity in government / private distributor performance suggests the problem is ownership. 2.But history of electricity prices in Australia suggests stable prices until “independent regulation” and CPI-X. If ownership is the problem, why do we only see it now? 3.International evidence (New Zealand, Canada, U.S. Germany, Norway, Denmark) suggests non investor-owned networks’ prices comparable to those of investor- owned peers (or at least if there is a gap it is not very large). Regulation and ownership must be considered together. Australian regulatory arrangements (for electricity) are unusual in comparison to those in other countries: –V. high level of codification; –Bifurcation of regulation between AEMC and AER; –Non-discrimination on the basis of ownership (typically in NZ, Canada, U.S Germany, “regulation” of non-investor owned networks achieved through ownership, not “independent regulator”); –Onus of proof placed on regulator, not regulated entity; –Australian government-owned distributors v. large: non investor-owned networks in other countries typically much smaller (local government or co-operatives). 12

And questions also to be asked about effectiveness of CPI-X regulation of privately owned networks 1.Actual return on equity has turned out much higher than regulatory allowances. 2.Tax allowance charged to consumers seems to be much higher than actual tax paid 3.Weighted average price cap resulted in much higher revenue than expected. 4.Demand forecasts have been problematic (although not as problematic as for government distributors) In new world of distributed generation (and possibly storage) do 5 year “contracts” make even less sense? 13

So, what to do about ownership, institutions and methods? 1.Privatisation (full, not partial) eliminates conflict of interest. And, history of successful regulation of private utilities in U.S., GB, Canada, NZ, Australia suggests consumers can be protected through regulation. More generally, have governments not got more worthwhile things to do than own utilities? 2.Where privatisation not politically feasible, reform regulation to recognise political economy of blame shifting through independent regulation. This means accountability for profits and prices should ultimately reside, transparently, with the owning government. Independent regulation of government-owned monopolies must be recognised as the oxymoron that it is. Still a key role for economic authorities in this– as specialist advisors to the owning government, or to determine control with relevant parameters (such as cost of equity and debt, asset valuation) transparently set by owner. 3.Need to fundamentally re-think CPI-X. It has strayed a long way from its origins and now seems to be no more than “rate-base” regulation but with particularly strong incentives for regulated entities to discover future wants and convince the regulator that they are needs (through 50,000 page proposals!). 14