1 ElectraNet SA Draft Regulatory Principles Workshop Asset Base ( Strengthening Incentives for Investment) 2 April 2004 Draft Regulatory Principles Workshop Asset Base ( Strengthening Incentives for Investment) 2 April 2004

2 Incentives for Investment Financial capital maintenance “…investors should have a reasonable expectation of recouping the costs involved in the prudent provision of assets. So long as this condition is met for outlays efficiently incurred, then investment will be appropriately encouraged” Henry Ergas, “Epic in Retrospect and Prospect”, June 2003

3 A Step in the Right Direction  The ACCC’s proposals on asset base and asset valuation are a good step towards achieving this objective  ElectraNet supports the ACCC’s preferred position to “lock in” the value of sunk assets and adopt an asset base roll forward methodology  BUT… only once a fair and reasonable asset valuation has been established

4 A Step in the Right Direction  A key benefit of the preferred approach is removal of the significant investment risk that prudent capital expenditure will not be recovered if it is excluded from future asset revaluation - i.e. removal of optimisation risk  Optimisation doesn’t really make sense…  difficult to administer – ACCC methodology still not specified  imposes risks for which TNSPs are not compensated  difficult for TNSPs to manage risk – limited value on influencing behaviour

5 A Step in the Right Direction  The ACCC has in recent revenue cap decisions recognised a key aspect of this risk arising from the use of the modern equivalent asset valuation (MEAV) methodology  legitimate refurbishment capex does not necessarily affect the cost of buying a modern equivalent asset  replacing the engine in a car may be necessary expenditure, but it does not change the cost of buying a new car  The ACCC’s short-term solution has been to quarantine refurbishment/ replacement capex from revaluation

6 A Step in the Right Direction  However, developing ODRC guidelines to address these and other issues for the longer-term would require a substantial investment of resources by the ACCC, TNSPs and other interested parties  Guidelines would need to address:  unit costs  brownfields or staged development factors  locality, terrain and environmental factors  level of asset recognition etc. etc. etc.

7 A Step in the Right Direction  Adopting a roll forward methodology would simplify and improve the efficiency of the regulatory regime by avoiding the subjectivity and cost of future revaluation exercises – “do it once and move on”  Approach is also consistent with:  Code objective of achieving reasonable certainty and consistency over time of regulatory outcomes  ACCC’s approach in gas  ACCC’s capex framework and other proposals for a more “light handed” approach to regulation

8 Drawing a “Line in the Sand”  The ACCC’s proposal to effectively “draw a line in the sand” on the valuation of sunk assets makes it essential to first ensure that a fair and reasonable asset valuation has been established  The valuations of TNSP fixed network assets have generally followed a consistent approach and methodology  BUT… there are some stand out anomalies – for ElectraNet the treatment of project financing costs and easements has varied widely from that adopted in other States

9 Comparison of Easement Values Source: ACCC revenue cap decisions Note: TransGrid value includes land

10 Easement Valuation “It is apparent then, that the easements for ElectraNet are grossly undervalued and that there is a strong case for this aspect of the ElectraNet SA asset base to be revalued” Sinclair Knight Merz, November 2003

11 Easement Valuation  Easements were not valued in ElectraNet’s initial asset base because… “asset valuations consistent with the approach set out in the [ACCC’s] Draft Statement of Regulatory Principles have not yet been undertaken” - Electricity Reform and Sale Unit, August 1999  The ACCC did not address this issue in setting ElectraNet’s initial revenue cap - however, it must be addressed before any “locking in” of ElectraNet’s asset value

12 Easement Valuation  The ACCC has indicated that it is likely to adopt a historical cost approach when valuing easements  In recent decisions, the ACCC has only recognised those costs for which a TNSP could produce receipts of actual costs incurred  However, the ACCC paper recognises that a benchmark approach would “…deliver values for TNSPs which lack historical records. This approach would also maintain consistency between the valuation methods used for TNSPs”

13 Easement Valuation  ElectraNet supports the proposed benchmark approach to easement valuation where reliable historical cost records are unavailable  The omission of easement value from ElectraNet’s asset base has been clearly identified, is discrete, and can be easily remedied without imposing the burden of a full asset revaluation

14 Project Financing Cost Comparison Source: ACCC revenue cap decisions IDC on fixed network assets

15 Project Financing Costs “In our view IDC is a valid project cost and should be included in the valuation of all assets in the ElectraNet asset base. In addition, the treatment of IDC in the ElectraNet asset base is inconsistent with the approach used for other TNSP valuations. It is material and it is considered that there are strong grounds for a revaluation of this aspect of the ElectraNet valuation” Sinclair Knight Merz, June 2002

16 Asset Valuation Guidelines  As for easements, the omission of IDC from ElectraNet’s asset base has been clearly identified, is discrete, and can be easily remedied without imposing the burden of a full asset revaluation  If a full revaluation were to be conducted then considerable effort would be required to first develop transmission asset valuation guidelines that fully recognise the costs incurred in developing the network  Current valuation tools fail to fully recognise significant prudent capital expenditure

17 Depreciation Adjustment  Consistent with the principle of financial capital maintenance, compensatory depreciation adjustments should only occur where a revaluation due to changes in replacement costs takes place  In other circumstances, such as correcting errors, a depreciation adjustment would be inappropriate because it would simply cancel the effect of the intended error correction

18 Asset Base Roll Forward  Adoption of the asset base roll forward approach is generally supported  BUT… “the devils in the detail” – the Regulatory Principles needs to clearly set out how the approach is to be implemented  ElectraNet believes that within the current capex framework the currently accepted methodology for rolling forward the asset base from one year to the next should be maintained

19 Asset Base Roll Forward  i.e. closing asset base in year t equals…  The opening asset base in year t  plus new investment rolled into the asset base at build cost (based on actual capitalisations during the year)  plus indexation of the asset base by actual CPI  less outturn straight-line depreciation  less asset disposals  The opening asset base in year t+1 equals the closing asset base in year t Note: More detailed implementation issues are not considered here

20 Asset Base Roll Forward  Benefit… consistent with treatment of the regulatory accounts  Does the ACCC agree that this is the currently accepted implementation? - understand that the ACCC may be considering other views  Either way it is important that the ACCC share its views and consult with stakeholders on this important issue  Suggest that this consultation include “worked examples” to clarify the roll forward methodology and settle any confusion – these should be included in the Regulatory Principles

21 Locking in?  What does this mean – how can we be sure that asset values will remain “locked in” and won’t be revisited in 5 years time by a new ACCC/ AER team?  How will “locking in” be achieved?  correct obvious anomalies first  is a Code change good enough?  Improved certainty of asset valuation vital to:  avoid cost “premium” for customers and TNSPs  allow regulatory regime to focus on getting incentives for future decisions right