Benchmarking and efficiency mechanisms

Stephen Clark - A/GM Connections & Development

Transend Networks

Challenges of regulation

“Network performance, especially by the transmission companies, is good. However, we consider that the Regulator’s concern to reduce costs to consumers should now be tempered by a greater emphasis on ensuring that electricity network owners have the financial resources necessary to secure a viable long-term electricity supply.”

House of Commons Trade and Industry Committee, March 2004, Resilience of the National Electricity Network,Third Report of Session 2003–04, Vol 1

Shared objectives

• Deliver the right services at the right price• Reward prudent investment – do not expose companies

to revaluation risk• Provide incentives to improve performance – in relation

to cost and service• Set “fair” allowances for opex and capex• Share efficiency gains “fairly” between shareholders and

customers

• Minimise cost of regulation

Holistic approach required

• Objectives unlikely to be met if:• Significant uncertainty regarding the regulator’s

approach or outcomes

• Weak incentive for better performance

• Opex and capex allowances are not set fairly

• Sharing of gains is not fair

• Processes are unworkable or impractical

• Regulation drives business decisions

Benchmarking & incentive mechanisms• Important aspects of regime

• Establish “fair” opex and capex allowance

• Establish “fair” sharing of cost efficiency and service performance gains

• But • Cannot be divorced from asset valuation and WACC

issues

• Danger if regulatory approach treats each “topic” as separate

Role of benchmarking….so far

• Simplistic benchmarking as part of the evidence for setting opex and capex allowances

• Opex benchmarking based on • ITOMS• Historic costs • Simple ratio analysis

• Partial recognition that capex is more difficult to benchmark, and incentive issues are more complex to resolve

Effective benchmarking

• To be effective, need set of peers• Distribution lends itself more easily to benchmarking• International models offer limited benchmarks for

Australian transmission

• ACCC Discussion Paper (page 61) cautions:"a substantial component of the differences in cost observations between firms are due to legitimate or ‘uncontrollable’ differences in factors which affect the level of costs incurred by the firms”

ACCC recognition

• ACCC identifies TNSP differences:• Nature, range, volume, quality of services

• Price of inputs

• Governmental regulations

• Number, density, load factor and size-distribution of customers [and generators]

• Environmental factors

• Age and quality of capital stock

Benchmarking non-peers

• Would require sophisticated analysis to normalise• Proper consideration of explanatory factors• Implies more intrusive regulation

=> Most effective Australian TNSP benchmark likely to be against own performance• same influences on efficient costs

(eg nature, range, volume, quality of service etc)

=> Well-designed incentive mechanisms: allow benchmarking against own performance over time

Incentive mechanisms…so far

• “Glide path” opex incentive mechanisms flagged in the DRP

• Limited application of capex efficiency to date (Powerlink)

• No clear system for application

• No distinction between cost and scope changes

• No clear models in recent revenue cap decisions

=> Companies cannot respond to incentives that only reveal themselves after the event

Incentive mechanisms… the future• Should be:

• Clearly explained at the outset

• Well designed, well understood, consistent over time

• able to recognise externally-imposed capex and opex cost-drivers

• Equitable - fair sharing of gains

• Unobtrusive/light-handed

ESC’s incentive mechanism

• Scheme appears to have good incentive properties provided cost allowances are set appropriately in the first place• Future opex allowances based on efficient costs being

“revealed”• Capex profiling important (this may introduce

distortions?)• Recognition of external unpredictable factors that may

affect cost performance

Note: Transend would not sign up to an ESC-type scheme based on its present revenue cap allowances

Suggested way forward

• Benchmarking - useful if organisation performance benchmarked against true peers

• In Australia, vastly different networks and operational environment=>most effective benchmarking for revenue-setting is

against organisation’s own performance

• Well-designed incentive mechanisms allow companies to benchmark against selves over time

• ESC and ESCOSA models - starting point for further analysis?

Principles for future incentive regulation• Scheme should be

• Well-designed, well-understood, consistent over time• Able to recognise externally imposed capex and opex

cost-drivers• Equitable - fair sharing of gains• Unobtrusive

• TNSP option to “sign up” to scheme• Where allowances are set properly and incentive

mechanisms well-designed - win/win situation for all:• a viable long-term electricity supply