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Network Pricing, VoLL and
Interconnection in the NEM
Conference
30 September 1999
Interconnection issues
in the NEM
Allan Asher
Deputy Chairman
Australian Competition and Consumer
Commission
1.
Introduction
(Slide 2)
There is a current move in the NEM away from the traditional model of central
planning for networks towards market provision of network services. This raises
several issues, including whether networks should be regulated.
Today I want to raise these and other emerging interconnector issues that will
need to be debated in the industry, if an effective and efficient framework for the
operation of regulated and non-regulated interconnectors is to be developed. The
views I am expressing today do not in any way prejudge the outcome of the
market network service provider Code changes before the Commission for
authorisation and access code variation – I am merely setting out some of the
issues that the industry will need to consider in the coming months.
I will also give an outline of the major issues that are facing the Commission in
developing its regulatory principles for the regulation of transmission revenues,
since these principles also apply to regulated interconnectors.
2.
History of network planning and regulation
(Slide 3)
The Australian electricity supply industry has traditionally consisted of state based
vertically integrated public utilities with little interconnection between the
jurisdictions.
Another historical feature of the Australian electricity industry is that governments
have considered networks to be natural monopolies, which require regulation to
prevent the potential abuse of market power by network owners/ operators. This
has lead to the inclusion of interconnector assets into the relevant transmission
company’s regulatory asset base and therefore TUoS charges. There has also been
an emphasis on regulated network solutions, rather than non-regulated or market
network services.
In 1996, the Productivity Commission’s international benchmarking report argued
that an interconnected electricity grid, which improves opportunities for power
exchanges between the States, would allow electricity generators to make better
use of capital assets and thereby reduce excess capacity and improve productivity.
(Slide 4)
In the original authorisation of the National Electricity Code (December 1997), the
Commission stated that there are four main sources of economic benefit from an
interconnected wholesale electricity market. Firstly, interconnection will lead to
greater competition between suppliers. Secondly, it will lead to the development
of market based incentives, which will put pressure on electricity producers to
reduce costs and use their assets more efficiently. Thirdly, an interconnected
wholesale market will lead to the deferral of new generation plant investment
because of the potential to share reserve capacity. Lastly, it will lead to increased
flexibility and reduced costs as a result of better utilisation of the mix of
generating technologies.
3.
Future options for network planning and operation
These traditional views are now changing, raising questions about whether all
networks should be regulated. Some of the options that are emerging are the
establishment of market network service providers (also called entrepreneurial
interconnectors); and hybrid interconnectors, which comprise regulated and
non-regulated components.
3.1
Market Network Service Providers
(Slide 5)
NECA has submitted Code changes that allow for the operation of market network
service providers to the Commission for authorisation and for acceptance as a
variation to the NEM access code. NECA has also submitted an application for
interim authorisation on the basis that it would provide some protection for
imminent projects such as Directlink and Basslink that are in vital stages of their
auctioning and bidding processes respectively. The Commission is currently
assessing the application for interim authorisation of the market network service
provider Code changes and will make a decision in the next couple of weeks.
The Commission will conduct a full assessment of these Code changes over the
coming months and will consider whether it is necessary to impose any conditions
on the authorisation in its draft determination. The Commission is aiming to
release a draft determination on the market network service provider Code
changes and the network pricing Code changes in December. Parties will then
have the opportunity to provide further submissions and may request a
pre-decision conference before the final determination is released.
There are several new issues that have been raised by the introduction of market
network service providers (MNSPs) into the NEM. The major issues raised in
submissions to the Commission’s authorisation and access assessments were:

whether market network network services will deliver benefits to customers,
such as lower prices, or whether the benefits will all be captured by the
MNSP?

whether market network services will deliver an optimal level of
interconnector capacity?

whether system security obligations be placed on MNSPs?

to what extent should MNSPs be required to pay TUoS?
As part of NECA’s review into the integration of energy markets and network
services, NECA is examining the appropriateness of a nodal pricing regime. If the
market decides to move to either a full nodal pricing regime or even a modified
zonal model, with more zones than at present, then it will be important to consider
how well the entrepreneurial interconnector model fits with these options. One
particular issue to consider is how the ability for market network service providers
to control usage of their interconnector sits alongside a nodal pricing regime?
Some participants in the industry have argued that the provisions for
entrepreneurial interconnectors should be broadened to also apply to other
network elements. In considering this issue the industry needs to carefully
consider the implications of an entrepreneurial interconnector that has the ability
to withdraw capacity and is part of the meshed transmission network.
Another issue regarding MNSPs is the appropriate form of their access
undertakings. Given that MNSPs will not earn their revenue through TUoS
charges, they are exempt from complying with the network pricing provisions in
Chapter 6 of the Code. However, according to the Trade Practices Act an
acceptable access undertaking should include details of the terms and conditions
used to allocate the MNSP’s capacity. An undertaking should also outline the
MNSP’s approach for dealing with future access applications once the initial
capacity is fully allocated.
3.2
Hybrid Interconnectors
(Slide 6)
NECA is in the process of developing rules for the operation of hybrid
interconnectors, though these have not yet come before the Commission for
authorisation or variation of the access code. There are several circumstances in
which a hybrid interconnector could be envisaged; for example an entrepreneur
may wish to upgrade an existing regulated link. This situation occurred with the
interconnector between Scotland and the England and Wales pool. ScottishPower
built the original interconnector with a capacity of 850 MW. These assets and
associated costs were included in the price control determination for
ScottishPower’s transmission business because the interconnector was deemed to
have system security benefits for Scottish customers. The interconnector was
subsequently upgraded to a capacity of 2,200 MW, however this was funded by
contracts between ScottishPower and the users of the interconnector, rather than
recovered through TUOS charges.
One important issue that will need to be addressed when developing rules for the
operation of hybrid interconnectors is to ensure that there are adequate ringfencing
provisions in place to prevent cost shifting between the regulated and unregulated
components of the business. Some other issues that will need to be considered
are:

How would financial hedges be sold for hybrid interconnectors?

Should the hedges for the regulated and unregulated components of the
business be auctioned together?

Should any outages or constraints on interconnector capacity affect either the
regulated or the unregulated parts of the business, or should the impact be
pro-rated between the components? and

How should ancillary services be split between the regulated and unregulated
components?
All of these are important issues that the industry must resolve when establishing
rules for the operation of hybrid interconnectors.
4.
The test for regulated network augmentations
(Slide 7)
Chapter 5 of the Code establishes several avenues for planning and undertaking
interconnection, including regulated and unregulated options. Regulated assets
earn a regulated return in accordance with chapter 6 of the Code, while
unregulated assets earn a return through transactions in the market. Chapter 5
describes decision processes and criteria, under which interconnectors may
become part of a transmission NSP’s regulated asset base. In essence, an
augmentation may receive approval to enter the regulated asset base (before it is
built) if it passes a “Customer benefits test” administered by NEMMCO.
The rules governing interconnection came into the spotlight when NEMMCO
rejected the application for the proposed South Australia - New South Wales
interconnector to be a regulated interconnector. Indeed, NEMMCO found the
Customer benefits test to be highly volatile, which would make it difficult for any
proposed inter-regional augmentation to satisfy the criterion.
On the basis of these concerns, in late July NECA lodged an application for
authorisation of a number of Code changes. Included in this application, was the
proposal to replace the existing Customer benefits test with a regulatory test to be
defined by the Commission. Public comments to the Commission were supportive
of this proposal.
(Slide 8)
At the Commission meeting last week, the Commission made a draft
determination to accept the Code changes subject to two minor conditions. The
first condition is that there be changes to the language that requires the
Commission to promulgate the regulatory test and to assess asset values on a basis
consistent with that regulatory test. The purpose of this condition is to ensure that
the Commission’s obligations deriving from these Code changes are consistent
with the Commission’s broader regulatory obligations as contained in Chapter 6 of
the Code.
The second condition is that when using the regulatory test, a market network
services option should be included as one of the alternatives to the network
options under consideration. This would place the market network service option
on the same basis as that currently held by generation and demand side options.
A copy of the draft determination is available from the Commission’s web site. If
requested to do so by an interested party, the Commission will hold a pre-decision
conference in late October before releasing the final determination.
In addition to assessing the Code changes, the Commission has also developed a
draft of the regulatory test. This draft of the regulatory test builds on the earlier
report for the Commission by Ernst & Young and the subsequent staff paper that
was released in April.
Consistent with the earlier staff paper, the current draft of the regulatory test
proposes replacing the current Customer benefits test with a market benefits test.
This revised test is more consistent with the usual approach for assessing net
public benefits and includes those benefits and costs that accrue to both consumers
and producers of electricity. Moreover, by focusing on a least cost approach, the
test attempts to avoid the problems of including into the assessment of network
options any non-competitive price behaviour that may occur in the generation
sector. By requiring the use of commercial discount rates, the draft test attempts
to ensure that network options do not possess a competitive advantage over other
generation or demand side alternatives. Finally, the test also provides for the
inclusion of environmental costs or benefits as part of any assessment of a
network investment.
However, on the basis of the most recent submissions, the draft test includes a
number of changes from the earlier staff paper. First, the Commission has
expanded the provisions relating to environmental costs and benefits by requiring
the inclusion of any environmental taxes or subsidies into the analysis of new
network investments. Second, the Commission has attempted to clarify the extent
to which costs and benefits are included in the analysis. Finally, the Commission
has decided to set aside the earlier staff proposal to include a market failure
component to the test. Interested parties have indicated that this market failure
test could be easily gamed at the cost of an efficient outcome. Nevertheless, the
Commission has required that unregulated network options be considered as part
of the assessment of a regulated network investment.
The revised draft of the regulatory test is also available from the Commission’s
web site. Interested parties have a further opportunity to comment on the test,
prior to its promulgation once the Code changes have been finalised.
Several industry participants have indicated that the Commission should be the
body that applies the regulatory test rather than the IRPC, as proposed by NECA.
The Commission can see that there are some symmetries between this role and its
regulatory role of optimising transmission network assets as part of the revenue
determination process, however further thought will need to be given to this issue.
5.
Draft regulatory Principles
If interconnectors pass the regulatory test than they will be regulated on the same
basis as other elements of the regulated transmission networks. As such, the
principles developed by the Commission for the regulation of transmission
revenues will also apply to regulated interconnectors. In May this year, the
Commission released the Draft Principles for the Regulation of Transmission
Revenues (Draft Regulatory Principles) which establishes guidelines as to how the
Commission will regulate the industry. The Draft Regulatory Principles is
available from the Commission’s internet site.
The transmission regulation framework outlined in the Draft Regulatory Principles
is a building block approach based on forecasts of cost of service over the
regulatory period. The building block approach calculates the Aggregate Annual
Revenue Requirement as the sum of the return on capital, the return of capital, and
operating and maintenance expenditure.
While the assessment of operating and maintenance expenditures is relatively
straight forward, assessment of the other elements is not. Determining these
elements of the accrual building block raises significant issues with respect to
providing NSPs with a fair and reasonable return, while at the same time
promoting economic efficiency and an objective, transparent regulatory process.
It is therefore imperative that the regulator comes up with accurate revenue cap
decisions. The Commission implements the following procedures to ensure this is
the case. First, the Commission conducts a transparent and open process in the
determination of revenue caps for transmission NSPs. The Commission invites
stakeholders to put information forward to try to persuade the regulator and also
consults stakeholders to understand the implications of its regulatory decisions.
Second, the Commission attempts to gather the most accurate financial data it can
in determining regulatory parameters.
5.1
Determining a fair rate of return on the asset base
(Slide 9)
In determining a rate of return, the Code requires the Commission to consider the
weighted average cost of capital (WACC) for each transmission network. Given
the capital-intensive nature of electricity network businesses, the return on capital
component of the regulated revenue could account for 50 per cent or more of
annual aggregate revenue. As relatively small changes to the rate of return can
have a significant impact on the total revenue requirement and ultimately end user
prices, it is important that the regulator sets the rate of return at a level which
reflects a commercial return for the regulated businesses.
Setting a rate of return below the cost of funds in the market could make
continued investment in developing the network difficult or unattractive for the
owner. This would create pressure for the regulated business to reduce
maintenance and capital expenditure below optimum levels and undermine the
quality of service offered to users. Conversely, if the regulator set the rate of
return too high, the regulated businesses would earn a return in excess of their cost
of capital. This would distort price signals to consumers and investors, resulting
in a misallocation of resources and sub-optimal economic outcomes.
In the Draft Regulatory Principles, the Commission has adopted a nominal
post-tax WACC approach. In addition, the Commission will set the WACC on the
basis of financial market benchmarks, taking into account the level of commercial
risk involved in establishing the transmission infrastructure.
5.2
Return of capital
(Slide 10)
To encourage continued investment in natural monopoly industries, investors will
require an assurance that they will earn a reasonable (risk adjusted) return on their
investment capital, as well as the return of capital, provided the market continues
to value the services produced with that capital.
The building block approach for determining the annual aggregate revenue
requirement for TNSPs includes an allowance for depreciation. Such an
allowance recognises the need to recoup the outlay involved in the purchase of the
asset, over its useful life. Under the building block approach total revenue earned
from the regulated assets consists of the depreciation charge and the allowed
return on assets.
Traditional linear depreciation schedules, whether applied in a nominal or a real
framework, do not always provide a suitable revenue profile. The key problem
associated with the use of linear depreciation profiles is that there is typically a
jump in tariffs/revenues when a major asset reaches the end of its useful life and is
replaced by another.
The Commission therefore proposes a competitive depreciation profile in the Draft
Regulatory Principles. There are two aspects to the proposed depreciation profile:
the smoothing of revenue paths (via the competitive depreciation approach)
designed to avoid inter-generation pricing disparities; and adjustments to reflect
the impact of future potential stranding of identified assets (i.e. possible redundant
assets).
The approach links the long-term depreciation profile to a measure of the rate of
technological change. The revenue smoothing minimises inter-temporal price
distortions (inter-generation price shocks). It also minimises potential
geographical price distortions linked to the vintage of assets serving neighbouring
systems.
5.3
Benefit sharing
(Slide 11)
The Commission appreciates the form of regulation used and the incentives it
creates will have a major impact on market outcomes. The regulatory regime
adopted should ensure efficiency gains are passed on to final consumers, while
providing effective incentives to the service provider to maximise efficiency.
If regulation adjusts prices to simply allow the service provider to recover costs
and achieve a normal rate of return on investment, the service provider will have
little incentive to be efficient in the provision of such services; indeed there may
be an incentive to reduce efficiency.
The Commission believes with the ability to retain cost reductions as profits, the
service provider has a strong incentive to be more efficient in the provision of
network services. However, effective natural monopoly regulation involves not
only providing positive incentives for improved efficiency but also ensuring there
is sufficient disincentive to avoid inefficiency and the provision of poor quality
service. These incentives can be achieved by offering financial rewards for
improvements in long term cost efficiency above those determined by the
regulator, and penalising, through reduced profits or losses, failure to achieve
service standards and benchmark efficiency improvements.
5.4
Service standards
Under a CPI-X revenue cap regulatory approach, there is a risk a monopoly TNSP
may try to reduce costs and hence increase profits by reducing the quality of
services offered. Quality of service monitoring by a regulator, assisted by
penalties for non-performance, can ensure TNSPs maintain service quality. The
Commission believes under effective incentive based regulation, the TNSP will
have sufficient income to maintain the assets necessary to provide an explicit level
of service. There is also a need for some benchmark comparisons between
networks on service standards. These matters are discussed in the Draft
Regulatory Principles.
6.
Conclusion
In this presentation I have outlined the change that is taking place in the NEM
with the move away from centrally planned and provided networks, to various
options for the market provision of network services. There are several issues that
will need to be dealt with by the industry in order to make these regimes work
effectively. These issues must be addressed if the potential benefits of electricity
reform are to be fully realised and passed on to all customers.