23 December 2014
Practice Group(s):
Energy, Infrastructure
and Resources
Renewable Energy
Climate Change and
Sustainability
Australian National Electricity Rules Adopt a More
'Cost Reflective' Approach to Network Pricing
Australia Energy Alert
By Jenny Mee and Jemimah Roberts
The National Electricity Amendment (Distribution Network Pricing Arrangements)
Rule 2014 No. 9 (Rule Change) came into effect on 1 December 2014, amending the
Australian National Electricity Rules (NER) by introducing a more 'cost reflective'
model for network pricing. Under the new regime, distribution tariffs must comply with
several new pricing principles, with the objective that the network prices that a
Distribution Network Service Provider (DNSP) charges each consumer should reflect
its efficient costs of providing network services to that consumer.
Background
Under the previous regime, distribution pricing principles were intended to guide
DNSPs to set network prices that were efficient and met the regulated revenue
requirements of DNSPs.1 However, as noted by the Australian Energy Market
Commission (AEMC) in its Rule Determination, the principles failed to impose firm
obligations on DNSPs (for example, DNSPs were only required to 'take into account'
their long run marginal cost (LRMC) when developing their prices). The AEMC was of
the view that this lack of firm obligations had resulted in price structures that were
inconsistent with the policy intent behind the principles, and that there was a need to
impose clearer obligations on DNSPs to develop network prices that "are cost
reflective and provide efficient signals to each consumer, while transparently
addressing consumer impacts and jurisdictional pricing obligations".2
This Rule Change is part of a series of reforms to assist consumer participation in the
energy market.
Summary of Rule Change
Pricing Objective
The Rule Change introduces a new 'Network Pricing Objective'. Clause 6.18.5(a)
provides that:
"The network pricing objective is that the tariffs that a Distribution Network Service
Provider charges in respect of its provision of direct control services to a retail
customer should reflect the Distribution Network Service Provider's efficient costs of
providing those services to the retail customer."
The focus of this network pricing objective is cost reflectivity. In its Rule
Determination, the AEMC considered that more cost reflective network prices would
allow consumers to make more informed choices about when, where and how they
1
AEMC 2014, Distribution Network Pricing Arrangements, Rule Determination, 27 November 2014, Sydney (Rule
Determination), page 17.
2
Rule Determination, page 18.
Australian National Electricity Rules Adopt a More 'Cost Reflective'
Approach to Network Pricing
use electricity. For example, if consumers choose to use electricity in ways that
reduce network costs (such as by using less power at peak times when the network
usage is at its highest), they will be rewarded through lower electricity charges.
Under the new regime, network businesses must comply with the pricing principles
(discussed below) "in a manner that will contribute to the achievement of the network
pricing objective" (clause 6.18.5(d)).
Pricing Principles
Long Run Marginal Cost
Under the first of the new pricing principles, each network tariff must be based on the
LRMC of providing the service (replacing the previous obligation merely to 'take into
account' LRMC). LRMC is "the cost of an incremental change in demand for direct
control services provided by a Distribution Network Service Provider over a period of
time in which all factors of production required to provide those direct control services
can be varied" (see the new definition inserted in Chapter 10 of the NER).
Amended clause 6.18.5(f) of the NER provides that:
"Each tariff must be based on the long run marginal cost of providing the service to
which it relates to the retail customers assigned to that tariff…"
Although LRMC is now prescribed as a distribution pricing rule, network businesses
will have flexibility about how they measure LRMC. The method of calculating LRMC
and the manner in which that method is applied is determined having regard to:
1. the costs and benefits associated with calculating, implementing and applying
that method as proposed
2. additional costs likely to be associated with meeting demand at peak times
3. the location of retail customers and extent to which costs vary between
different locations in the distribution network.3
The AEMC considered that under this approach, consumers would be encouraged to
choose actions that will reduce future network costs (such as by reducing their peak
demand), as they will then be rewarded with lower network charges.
Total Efficient Cost Recovery
In its Rule Determination, the AEMC was of the view that limiting network pricing to
only recovering LRMC would not take into account significant costs incurred by
DNSPs in building and maintaining the existing network to meet existing demand,
and complying with reliability standards and other regulatory requirements.4 As such,
the second principle introduced by the Rule Change is a "total efficient cost recovery
principle" (clause 6.18.5(g)).
Under this principle, the revenue to be recovered from each network tariff must
reflect the network business' total efficient costs of providing services to the
consumers assigned to that tariff. The AEMC considered that in order to maximise
the benefits of providing efficient pricing signals to consumers under LRMC based
3
4
See clause 6.18.5(f)(1)-(3).
Rule Determination, page 21.
Australian National Electricity Rules Adopt a More 'Cost Reflective'
Approach to Network Pricing
network prices, DNSPs should recover the difference between LRMC based prices
and total efficient costs in a way that minimises distortions to consumers' usage
decisions. The pricing principle does this by requiring DNSPs to recover their
revenue in a way that minimises distortions to the price signals for efficient usage
that would be sent by LRMC based prices.5 Network businesses will be able to
determine the method they use to comply with this principle.
Consumer Impact Principle
Under the previous pricing principles there was no specific requirement for DNSPs to
have regard to the impact of network tariff changes on consumers. The Rule Change
amends this by introducing a broad consumer impact principle in clauses 6.18.5(h)
and (i).
In practice, this principle essentially falls into two parts:
 Firstly, DNSPs are required to consider the impact on consumers of changes in
network prices between regulatory years. The rationale is that consumers are
more likely to be able to respond to price signals if those signals are consistent
and apply for a reasonable period of time. Sudden price changes or significant
year-to-year price volatility will make it difficult for consumers to make informed
consumption decisions.
 Secondly, network prices must be reasonably capable of being understood by
consumers. The AEMC identified that consumers will not be able to respond to
price signals if they cannot relate price structures to their usage decisions.
There may be cases where the consumer impact principle and the new cost
reflectivity principles will produce outcomes that are inconsistent (for example, cost
reflective tariffs may involve significant price changes for some consumers, but
consideration of consumer impacts may justify gradually transitioning to those new
prices over time). In such situations, DNSPs may depart from cost reflective prices to
the minimum extent necessary to meet the consumer impact principle.
The AEMC was of the view that this principle would assist consumers to make
efficient long term consumption and investment decisions and help manage the
transition to cost reflective network prices.6
Comply with Any Applicable Jurisdictional Pricing Obligations
Under the previous principles, there was no direct conflict between the pricing
principles and jurisdictional pricing obligations, as DNSPs had a high level of
discretion in applying the pricing principles (for example, a DNSP was only required
to take into account LRMC, and have regard to transaction costs and customers'
ability to respond to price signals when determining network tariffs). By contrast, the
new requirement to set network prices on a cost reflective basis has the potential to
create a conflict with jurisdictional pricing obligations (for example, where those
obligations require prices to be set to achieve some other objective, or in a situation
where states have state-wide uniform pricing requirements).
5
6
Rule Determination, page 22.
Rule Determination, page 23.
Australian National Electricity Rules Adopt a More 'Cost Reflective'
Approach to Network Pricing
To address this, the Rule Change introduces a specific jurisdictional pricing
obligation principle that allows DNSPs to depart from the cost reflectivity principles to
the extent necessary to meet jurisdictional pricing obligations. If they do so, this must
be done transparently.
Network Pricing Process
The Rule Change also contains a new process and new timeframes for setting
network prices. More notable changes include the following:7
 Under the new regime the network pricing process is split into two stages:
o
The first stage will occur at the same time as the regulatory determination
process. DNSPs will be required to develop a Tariff Structure Statement (TSS)
to apply for the next regulatory control period that outlines the DNSPs' tariff
classes, tariff structures and approach to setting tariff levels in accordance
with the pricing principles. This will be accompanied by a schedule of
indicative price levels. Each TSS will be assessed for compliance with the
pricing principles by the Australian Energy Regulator (AER) in conjunction with
the relevant DNSP's regulatory proposal.
o
The second stage will occur on an annual basis. In this stage, DNSPs develop
and submit their annual pricing proposals to the AER. The annual pricing
proposals essentially apply pricing levels to the tariff structures outlined in the
already approved TSS. The AER's assessment of the DNSP's pricing proposal
will be a compliance check against the approved TSS and the control
mechanism as specified in the AER's regulatory determination.
 DNSPs will be required to describe how they have consulted with retailers and
consumers on the design of the network tariffs that they propose to implement
over the next regulatory control period. This consultation will occur prior to the
submission of the TSS to the AER.
 DNSPs will be able to amend their TSS during the regulatory control period, but
this will be limited to specific circumstances where a change to the TSS would
result in outcomes that better meet the pricing principles.
 The timeframe of the annual network pricing process will be moved forward to
facilitate notification of approved annual network prices at least six weeks before
they commence.
Impact
According to the AEMC, the changes will benefit all consumers in the longer term by
better catering to different patterns of consumption, and reducing the need for
spending on infrastructure due to lower peak demand. The AEMC chairman, John
Pierce, has estimated that under the changes, around 70-80% of consumers would
have lower network charges in the medium term.
However, critics have noted that certain types of consumers, particularly those with
solar PV rooftops, may be impacted heavily by the changes, as most of the solar
energy is generated at non-peak periods during the day, meaning they still rely on
7
See Rule Determination, pages 56-57.
Australian National Electricity Rules Adopt a More 'Cost Reflective'
Approach to Network Pricing
the network during peak times. Some concern has been expressed by critics
regarding the way in which solar PV may be treated in a similar manner to houses
with large air conditioning units, without taking into account the potential grid benefits
that rooftop solar households offer (such as shifting the peak and stabilising the grid).
These matters are the subject of ongoing industry debate.
Consumers and retailers are expected to have a greater role in the development of
new network prices through consultation with DNSPs in the price setting process.
Next Steps
Network businesses will shortly need to commence consulting with retailers and
consumers on the network prices that they propose to apply from 2017. Under the
Rule Change, DNSPs will need to submit their initial TSS to the AER by late 2015.
Authors:
Jenny Mee
jenny.mee@klgates.com
+61.2.9513.2555
Jemimah Roberts
jemimah.roberts@klgates.com
+61.2.9513.2406
Australian National Electricity Rules Adopt a More 'Cost Reflective'
Approach to Network Pricing
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