Final Report
Gladstone Area Water Board: Investigation of Pricing Practices
September 2002
Queensland Competition Authority Table of Contents
TABLE OF CONTENTS
PAGE
1. EXECUTIVE SUMMARY 1
2. INTRODUCTION AND OBJECTIVES 8 2.1 The Direction 8 2.2 Monopoly Prices Oversight 9 2.3 Approach to Investigation 9 2.4 Structure of the Report 10 2.5 Limitations 10
3. GLADSTONE AREA WATER BOARD’S PRICING PRACTICES 11 3.1 Commercialisation 11 3.2 Description of the Business 11 3.3 GAWB’s Pricing Policy 12
4. DEMAND PROJECTIONS FOR GAWB 15 4.1 Introduction 15 4.2 History of Water Demand 15 4.3 Previous Estimates of Gladstone Water Demand 17 4.4 Stakeholder Comment 18 4.5 QCA Analysis 19
5. THE FRAMEWORK FOR MONOPOLY PRICES OVERSIGHT 23 5.1 Background 23 5.2 Efficient Pricing 24 5.3 Revenue Adequacy 27 5.4 Pricing Practices during Drought and other Force Majeure Events 28 5.5 Differential Pricing 32 5.6 Pricing for Seasonal Demand Variations 39
6. THE ASSET BASE 41 6.1 Introduction 41 6.2 Optimisation 44 6.3 Contributed Assets 56 6.4 Recreational Assets 59 6.5 Environmental Assets 60 6.6 Working Capital 61 6.7 Land and Easements 62 6.8 Relocated Assets 64
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7. RATE OF RETURN 67 7.1 Introduction 67 7.2 Issues in Determining the Rate of Return Framework 68 7.3 Issues in the Selection of a WACC Equation 69 7.4 Quantifying the Risk Free Rate 73 7.5 Quantifying the Market Risk Premiu m 77 7.6 Determining the Capital Structure 80 7.7 Determining the Cost of Debt 82 7.8 Determining Equity and Asset Betas 83 7.9 Determining the Dividend Imputation Rate 89 7.10 Determining the Tax Rate 91 7.11 Expected Inflation 92 7.12 Deriving the WACC 93
8. RETURN OF CAPITAL 95 8.1 Introduction 95 8.2 Theoretical Approaches to Asset Consumption 95 8.3 Periodic Depreciation Charges 95 8.4 Renewals Annuity 97 8.5 Approaches Adopted in other Jurisdictions 98 8.6 Stakeholder Comment 99 8.7 QCA Analysis 100
9. OPERATING EXPENDITURE 102 9.1 Introduction 102 9.2 Cost Allocation 102 9.3 Opex Efficiency 106 9.4 Other Costs 111
10. PUBLIC INTEREST AND PRICE MONITORING 113 10.1 Public Benefit 113 10.2 Monitoring of Prices 116 10.3 Recommendations for Price Monitoring 116
11. IMPLICATIONS OF THE RECOMMENDED PRICING PRACTICES 124 11.1 Aggregate Implications 124 11.2 Implications for Pricing Arrangements 128 11.3 Implications for GAWB’s Financial Viability 129
APPENDIX A: Estimating Long Run Marginal Cost APPENDIX B: Alternative Measures of WACC APPENDIX C: The Relationship between Equity, Debt and Asset Betas APPENDIX D: Gladstone Area Water Board – Water Distribution System and Existing Customers REFERENCES
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GLOSSARY
ACCC Australian Competition and Consumer Commission
ACTEW Australian Capital Territory Electricity and Water
AIC Average Incremental Cost
ARMCANZ Agricultural and Resource Management Council of Australia and New Zealand
ASX Australian Stock Exchange
Capex Capital Expenditure
CAPM Capital Asset Pricing Model
COAG Council of Australian Governments
CPI Consumer Price Index
CSO Community Service Obligation
DAC Depreciated Actual Cost
DEA Data Envelopment Analysis
DORC Depreciated Optimised Replacement Cost
EV Economic Value
FSL Full supply level
GAWB Gladstone Area Water Board
GOC Government Owned Corporation
GPOC Government Prices Oversight Commission (Tasmania)
GST Goods and Services Tax
HNFY Historic no failure yield
ICRC Independent Competition and Regulatory Commission (formerly IPARC)
IPA Integrated Planning Act
IPARC Independent Pricing and Regulatory Commission - ACT regulatory body
IPART Independent Pricing and Regulatory Tribunal - NSW regulatory body
IRR Internal Rate of Return
KPI Key performance indicator
iii Queensland Competition Authority Glossary
LRMC Long run marginal cost, or the cost of providing an additional unit when all production factors are variable
ML Megalitre
NPV Net Present Value
NRV Net Realisable Value
ODV Optimised Deprival Value
Ofwat Office of the Water Regulator - UK water industry regulatory body
OffGAR Office of Gas Regulation, Western Australia
Opex Operating expenditure
ORG Office of the Regulator General - Victoria’s regulatory body
OTTER Office of the Tasmanian Energy Regulator
QTC Queensland Treasury Corporation
SRMC Short run marginal cost, or the cost of increasing production by one unit when at least one factor of production is held fixed
TER Tax equivalents regime
TFP Total factor productivity
WACC Weighted Average Cost of Capital
WRP Water Resource Plan (previously known as WAMP or Water Allocation and Management Plan)
iv Queensland Competition Authority Chapter 1 - Executive Summary
1. EXECUTIVE SUMMARY
Introduction
The Premier and the Treasurer (the Ministers) declared the supply, distribution and treatment of bulk water by Gladstone Area Water Board (GAWB) to be government monopoly business activities and referred the pricing practices of GAWB in respect of these activities for investigation and monitoring by the Authority.
Approach to Investigation
To assess the pricing practices of GAWB, the Authority developed a pricing framework consistent with the objectives of monopoly prices oversight and assessed GAWB’s prices and pricing practices against that framework. In doing so, the Authority considered submissions from GAWB, its customers and other interested parties. The Authority also relied on data and analysis provided by independent consultants with specialist skills in various areas.
GAWB’s Pricing Practices
GAWB is a Water Authority, constituted under the Water Act 2000, which supplies water storage, delivery and treatment services to a small number of industrial and local government customers. The geographical context and system layout of GAWB’s operations are shown in Figure 1.1.
Following its restructuring as a commercialised water authority, GAWB established new, commercially focussed pricing practices which applied from 1 October 2000.
GAWB has applied its new pricing practices to some of its customers, including the Gladstone City and Calliope Shire Councils, and has applied interim arrangements to new customers, pending the outcome of the Authority’s investigation. However, many of GAWB’s larger customers are bound by long-term contractual arrangements and will not be affected by the new pricing practices until the expiry or renegotiation of the contracts.
Demand Projections for GAWB
An essential ingredient of the investigation into GAWB’s pricing practices was a comprehensive review of GAWB’s projected demand. The review took into account demand management options and alternate supply options.
The projected demand for treated and raw water is summarised in Table 1.1.
Table 1.1: Revised Preferred Planning Scenario (ML)
Type of Supply 2002-03 2003-04 2004-05 2005-06 2009-10 2014-15 2020-21
Raw water 42,276 44,529 49,306 52,162 58,534 62,853 62,736
Treated water 14,741 15,353 16,409 16,610 17,597 18,446 19,689
Total demand 57,017 59,882 65,715 68,772 76,131 81,299 82,425
The Framework for Monopoly Prices Oversight
The Authority recommends that, to ensure prices provide an appropriate signal for consumption and investment, prices should reflect the impact of current consumption on future augmentation needs and thus be based upon the long run marginal cost (LRMC) of supply. When considered in
1 Queensland Competition Authority Chapter 1 - Executive Summary
conjunction with the revenue adequacy requirements of GAWB, two-part tariffs will be required for the preferred planning scenario.
For the purposes of the investigation, the Authority adopted a 20-year planning perspective.
Differential Pricing The Authority found that GAWB’s infrastructure layout, with clearly defined activities and off- take points, meant that a segmented pricing structure was possible and its adoption is recommended for efficiency and equity reasons. Accordingly, the water supply system was disaggregated into nine raw water segments and four treated water segments. Spur-lines dedicated to individual customers were also identified for pricing purposes.
While there are significant differences in the cost of providing services to the two Council customers (Calliope Shire and Gladstone City), the Authority has accepted the Councils’ proposal for a single treated water price as a matter of equity. However, cost reflective prices are recommended for treated water supplies to industrial customers
Pricing for Excess Capacity GAWB operates in an environment that is characterised by uncertain demand and capital augmentations which are typically lumpy and indivisible. Depending on the rate of growth in demand, and the availability of augmentation options, augmentation may result in a significant level of excess capacity being present for a considerable period of time. For example, to meet expected growth in demand, GAWB has raised Awoonga Dam to increase its safe yield from 49,400ML to 87,900ML, resulting in excess capacity of about 35 to 40 per cent in the initial years.
GAWB has responsibility for the management of supply and is responsible for identifying appropriate options for capacity augmentation. Any augmentation should provide the least cost solution for meeting reasonably envisaged demand, and any resulting surplus capacity should be legitimately incorporated into the asset base. However, GAWB should carry the costs of any excess capacity installed over and above that necessary to provide the least cost option for meeting anticipated demand.
Pricing Between Existing and New Customers The Authority considers that there is an economic case for, and the public interest is better served by, charging similar prices to all users who place similar demands on the common infrastructure of the network system. Any differences between individuals’ prices should only reflect differences in their use of the monopoly infrastructure (dams, pipelines and treatment plants) and any commercial differences (eg. quantity demanded, long term vs short term contracts and the like).
Such an approach is consistent with the outcomes in competitive markets, the benchmark against which monopolists’ activities are assessed. Furthermore, the Authority considers that the community’s interests are best served by diverting water resources to their highest value use.
The application of differential pricing between existing and new customers is also potentially inconsistent with other matters which the Authority is required to consider such as regional development and equity.
Force Majeure and Drought In recent months, significant concerns have arisen as a result of emerging drought conditions. Consideration has therefore also been directed to the treatment of force majeure and drought management.
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GAWB’s existing customer contracts include force majeure provisions which excuse GAWB from lia bility. However, the provisions are not consistent and, in order to be able to appropriately manage any such events, a consistent definition of force majeure should be adopted in customer contracts. Different force majeure events may require different arrangements to be put in place according to the nature of the event. Prices will then need to reflect these arrangements and be reset by negotiation between GAWB and its customers. The Authority’s role should be limited to assessing pricing practices when force majeure events occur.
The risks associated with the current emerging drought were not incorporated in the Authority’s Draft Report. In managing its drought risk, GAWB relies on the specification of historic no failure yield, but has also adopted a precautionary Drought Management Plan.
The Authority considered that, in the particular circumstances of GAWB, the impact of drought should be included in the cash flow estimates rather than in WACC. However, the Authority also identified other drought management options available to GAWB, including introducing a volumetric charge in place of two-part tariffs, facilitating trading between customers, seeking alternative or remedial supply sources, negotiating different supply reliability products or applying a buffer to safe yield.
Should any remedial supply options involving impacts on revenue, capital expenditure and operating costs be undertaken in the near future, if they are agreed between GAWB and its customers then they would be accepted by the Authority. Were any such options to be unilaterally adopted by GAWB, this would need to be assessed to ascertain whether it represented an optimal response.
The Authority recommends that, in the light of the emerging drought situation, options including volumetric charging, trading of customers’ allocations, alternative sources of supply, different supply reliability products and a permanent safe yield buffer be reviewed in consultation with customers and the Authority, with results to be incorporated into pric es as appropriate.
The Asset Base
The Authority recommends assets be valued on the basis of their depreciated optimised replacement cost (DORC).
Optimisation of the asset base should adopt a ‘just-in-time’ approach to augmentation which allows for lead times of six to eight years for storage augmentation (allowing for construction and filling) and one to two years for distribution infrastructure.
On the basis of this framework, the Authority accepted that the current dam raising represents the preferred augmentation option for demand up until 2020-21, but that $2.4 million in construction costs that were incurred in preparation for the next raising should be excluded until warranted by demand.
The existing rock-wall construction was also considered appropriate as the alternative approaches were less suited to multiple staged developments. The staging of the dam’s construction was considered appropriate and, accordingly, staging costs were effectively incorporated by adding the optimised augmentation costs to the existing dam’s value.
The Authority’s ‘just-in-time’ approach for optimisation also resulted in changes to the timing and scale of pipeline and reservoir augmentations. The Authority also allowed for immediate upgrades in water treatment servic es to meet water quality requirements.
GAWB has benefited from various capital contributions by its customers, including capital contributions towards specific assets such as Awoonga Dam, funding of cash flow to cover
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operational deficits, security depos its for spur-lines and capital grants and subsidies from the State Government.
The Authority recommends that a contributed asset be accepted as a capital contribution where there is evidence that the contribution was made with the intent of obtaining future price benefits. It is also recommended that recognised contributed assets be included in the asset base for the purpose of determining prices, with rebates incorporated in the prices for relevant customers equivalent to the return on capital for the contributed assets.
After consideration of the factors identified above, the Authority arrived at a revised DORC for GAWB of $199.6 million in 2001-02. By comparison, GAWB’s asset valuation was $202.2 million in 2001-02.
Rate of Return
In determining an appropriate rate of return for GAWB, the Authority recommends the adoption of the widely accepted WACC/CAPM framework.
Based on its recommended approach, the Authority estimated a nominal post-tax WACC for GAWB of 8.72 per cent. This estimate was based on a risk free rate of 6.02 per cent based on the Commonwealth ten year bond, averaged over 20 days prior to 28 June 2002. This date was chosen to be consistent with other information inputs including demand projections. The Authority does not support GAWB’s approach of applying a premium to the risk free rate to approximate a 30-year bond rate.
Return of Capital
The Authority recommends straight line depreciation in preference to GAWB’s approach of using a financial annuity. It can be shown that, provided the starting periods are the same and the same asset life is used, there is no NPV difference between a financial annuity and straight line depreciation over the life of the asset, when both return of capital and return on capital are considered. There are, however, timing differences in the respective cash flows, with the straight line approach providing higher earlier cash flows, which the Authority considered appropriate given the uncertainties surrounding the demand estimates.
Operating Expenditure
On the basis of advice from the Authority’s consultant, the Authority identified an appropriate level of operating expenditure (opex) for GAWB, and developed an appropriate basis for allocating common costs including general administration costs.
The Authority found that approaches to the benchmarking of opex were inconclusive in identifying potential efficiency gains due to the lack of comparators and the lack of useable data. However, activity-based savings were identified in such areas as asset management, financial management, and operational management and maintenance scheduling.
The Authority recommends that ten per cent of general administration costs (billing, customer contract administration, customer enquiries, pricing) be allocated on a per customer basis. The remaining 90 per cent should be allocated according to the administrative effort involved in each segment (dam, raw water delivery and treated water delivery).
The Authority estimated efficient opex to be $6.4 million in 2001-02, inc luding $1.9 million in general administration costs and recommends that this be adopted for pricing purposes.
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Public Interest and Price Monitoring
The Authority considers that a further review of prices is necessary in the medium term as a result of the uncertainty in demand, the need to assess the appropriateness of the proposed pricing practices, the potential for identified alternative demand management and supply strategies, and the need to consider issues related to drought management. It is therefore recommended that the Authority review GAWB’s pricing structure by end December 2004, to apply from 1 July 2005. This corresponds with GAWB’s proposed timing for contract reviews.
It is also recommended that reviews within the regulatory period be triggered if changes in aggregate revenues as a result of demand variations or other exogenous events exceed fifteen per cent. The Authority’s monitoring role during the review period focuses on trigger events and pass-through of unforeseen costs, and is not envisaged to include oversight of individual commercial contracts between GAWB and its customers.
Implications of the Recommended Pricing Practices
Aggregate Revenue Projections The aggregate revenue requirement for GAWB based on the Authority’s recommended approach is shown in Table 1.2, with the aggregate revenue requirement estimated by GAWB based on their proposed pricing approach. In each instance, existing contracts continue unaffected.
Table 1.2: Summary of aggregate annual revenue projections for GAWB, Preferred Planning Scenario ($m)
Aggregate Revenue Projections ($m)
2001-02 2002-03 2003-04 2004-05 2009-10 2014-15 2020-21
GAWB Projected, based on 15.4 17.2 19.3 25.2 35.1 40.2 49.2 pre-October 2000 pricing practices.
GAWB Projected, based on 18.4 22.4 25.6 27.0 36.6 48.7 N/a post-October 2000 pricing practices.
Draft Report maximum 18.5 20.6 23.4 28.2 39.9 46.1 56.4 revenue requirement.1
Final Report maximum 20.5 22.4 24.7 29.2 41.0 51.5 62.3 revenue requirement1
Final Report projected 20.2 23.0 25.4 29.8 41.8 52.5 63.5 maximum revenue2
1. Based upon immediate application of the recommended pricing practices, regardless of current contractual arrangements. 2. Based on the continuation of existing contracts, with application of recommended pricing practices to all other existing and new customers.
The Authority’s final projected maximum revenue closely approximates GAWB’s post-October 2000 projections. The Authority’s revenue projections are generally higher after 2004-05 due to higher asset valuations in some years and the application of straight line depreciation rather than a financial annuity.
The aggregate revenue requirement consistent with the Authority’s recommendations, on a per megalitre basis, is $446 in 2001-02 for the preferred pla nning scenario. The lower and upper
5 Queensland Competition Authority Chapter 1 - Executive Summary
bound planning scenarios would require average revenues per megalitre of $455 and $466 respectively. The lower bound scenario results in a higher average price than the preferred planning scenario, as infrastructure requirements are not greatly different while the demand is lower.
Transition Paths In other regulatory decisions, the Authority has sought to transition from existing to new prices. In the case of GAWB, users have had substantial notice of likely price increases following GAWB’s commercialisation. In addition, GAWB’s current pricing is sub-commercial and its finances are being impacted by the effects of drought. At the same time, the Authority’s recommended pricing practices result in substantial increases for some users over and above those that users were advised of by GAWB post-commercialisation.
Accordingly, the Authority concluded that transitional arrangements should be put in place to allow customers to adjust from GAWB’s post-October 2000 pricing practices to the Authority’s recommended pricing practices. Transitional prices would apply from 2002-03 to 2004-05 inclusive for all existing customers moving to new prices during that time. These transitional prices do not have a material impact on GAWB’s financial viability.
Pricing Structure The Authority recommends that a two-part tariff be adopted, with a volumetric charge based on long run marginal cost (LRMC) and an access charge which is paid regardless of usage. For the preferred planning scenario, the Authority’s recommended revenue requirement for GAWB exceeds LRMC in all segments. Hence, if prices were based solely on LRMC, revenue would fall short of that required.
Due to the small number of identifiable customers with widely differing consumption, the Authority recommends that the access charge to recoup the revenue shortfall should not be set as a single flat charge. Rather, the Authority considers that the access charge should be based on anticipated demand. However, as the use of anticipated demand provides the potential for gaming, GAWB should periodically review the relationship between anticipated and actual demand for each customer, and re-adjust prices, probably with penalty, if anticipated demand is consistently underestimated.
The Authority recommends that prices established for each major user be maintained in real terms using the Consumer Price Index (CPI).
The Authority also recommends that within-period adjustments (both positive and negative) be considered for changes such as taxation, regulatory compliance requirements, water supply yield and hydrology and major relevant changes in government policy, subject to materiality.
Implications for GAWB’s Financial Viability Based on the pricing practices recommended by the Authority, GAWB will achieve a positive operating profit in 2004-05. However, operating profit remains very sensitive to demand. For example, a reduction (or non-realisation) in demand of around 5,000ML, or 7 per cent of total estimated demand in 2004-05, is sufficient to produce an operating loss. GAWB’s cash position reaches its lowest point at $12.5 million in 2002-03, and interest cover (operating profit before interest, depreciation and tax as a proportion of borrowings) reaches a low point of 1.6 in 2003- 04.
In the event of a demand reduction of 15 per cent, equivalent to the loss of a major customer such as CS Energy, interest cover falls to 1.2 in 2002-03. GAWB’s cash flow would become negative if annual revenue declined by more than 17.25 per cent over the 20-year period.
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Figure 1.1. here
7 Queensland Competition Authority Chapter 2 - Introduction and Objectives
2. INTRODUCTION AND OBJECTIVES
Summary
The Ministers have referred the pricing practices of the Gladstone Area Water Board (GAWB) for investigation by the Authority under the provisions of the Queensland Competitio n Authority Act 1997.
To assess the pricing practices of GAWB, the Authority has:
· developed a pricing framework consistent with the objectives of monopoly prices oversight;
· assessed GAWB’s prices and pricing practices against that framework ; and
· develo ped its proposals for monitoring pricing practices.
In preparing the Final Report, the Authority considered stakeholders’ submissions on a Draft Report released in November 2001.
2.1 The Direction
On 14 September 2000, the Premier and the Treasurer (the Ministers) issued the following declaration and referral notice under Sections 19, 23 and 24 of the Queensland Competition Authority Act 1997 (QCA Act).
As the Premier and Treasurer of Queensland, we hereby declare under Section 19 of the Queensland Competition Authority Act 1997 that the following government business activities undertaken by the Gladstone Area Water Board be declared to be government monopoly business activities:
(a) bulk water storage, including water storage for another person; (b) bulk water delivery services; (c) bulk water treatment services; and (d) supplying water to another person, other than supplying bottled or containerised water.
As the Premier and the Treasurer of Queensland, we hereby refer under Section 23 of the Queensland Competition Authority Act 1997 the declared government monopoly business activities to the Queensland Competition Authority for the following investigations:
(a) an initial investigation about the pricing practices relating to the declared activities; and (b) investigations for monitoring the pricing practices relating to declared activities.
Under Section 24 of the Queensland Competition Authority Act 1997 we direct the QCA in relation to this referral to:
(c) report the results of the initial investigation to the Ministers within three months of this notice; and (d) monitor prices included in contractual arrangements entered into during, and after, the period of the QCA initial investigation.
In directing the Authority to undertake the investigation, the Ministers also directed the Authority to consider the following matters when conducting the investigation:
· the weighted average cost of capital proposed by the Gladstone Area Water Board (GAWB);
8 Queensland Competition Authority Chapter 2 - Introduction and Objectives
· appropriate pricing for excess capacity and capacity augmentation; and
· identification and pricing of contributed assets.
2.2 Monopoly Prices Oversight
In undertaking pricing investigations, Section 26 of the QCA Act requires that the Authority must have regard to:
· the need for efficient resource allocation;
· the need to promote competition;
· the protection of consumers from abuses of monopoly power;
· the cost of providing the goods and services in an efficient way;
· the standard of the goods and services (including quality, reliability and safety); and
· the appropriate rate of return on government agency assets.
In addition, Section 26 also requires that the Authority take into account a range of other matters such as:
· the impact on the environment of prices charged;
· demand management;
· social welfare and equity implications;
· the promotion of investment and innovation by government agencies;
· ecologically sustainable development;
· workplace health and safety requirements; and
· economic and regional development.
2.3 Approach to Investigation
In accordance with the Ministers’ Direction, the Authority forwarded a progress report in December 2000, which identified and summarised the key issues relevant to the full investigation.
In this progress report, the Authority concluded that, in order for its obligations under Section 26 to be met, and for those matters identified by the Ministers to be addressed, the Authority would need to investigate all elements of the pricing framework. This included future demand projections, the appropriate asset base and rate of return on those assets, the treatment of contributed assets, the level of operating costs and the appropriate return of capital. The Authority has also undertaken a financial assessment of the impact of the recommended pricing practices on GAWB.
As part of the consultation process, the Authority prepared and released three Issues Papers:
· GAWB: Projected Demand for Water - 2000/01 to 2019/20, released in March 2001;
9 Queensland Competition Authority Chapter 2 - Introduction and Objectives
· GAWB: Framework for the Pricing of Monopoly Business Activities, released in April 2001; and
· GAWB: Elements of the Pricing Framework, released in April 2001.
In November 2001, the Authority released its Draft Report, Gladstone Area Water Board: Investigation of Pricing Practices. This report outlined draft recommendations on pricing practices.
In preparing the Final Report, the Authority has taken account of material provided by stakeholders in response to the Draft Report as well as further information and analysis generated by stakeholders’ responses.
In assessing the pricing practices of GAWB, the Authority has:
· assessed GAWB’s prices and pric ing practices against the recommended framework;
· where considered warranted, made recommendations about appropriate pricing practices relevant to GAWB; and
· developed its proposals for monitoring pric ing practices.
2.4 Structure of the Report
Each chapter of the Final Report provides an initial summary, a review of the issues, results of consultation and recommendations. Chapter 3 provides an overview of GAWB’s historical and current pricing practices. Chapter 4 reviews demand projections, while Chapter 5 identifies an appropriate pricing framework. The essential components are the asset base (Chapter 6), return on capital (Chapter 7), return of capital (Chapter 8) and operating expenditure (Chapter 9). Chapter 10 reviews public interest and price monitoring matters, and Chapter 11 concludes with an assessment of the revenue and financial implications of the recommended pricing practices.
2.5 Limitations
The Authority’s recommendations on GAWB’s pricing have the potential to identify information of a commercially sensitive nature for GAWB’s customers. For this reason, the Authority has not sought to report on the implications of the recommended pricing practices on the prices for individual customers of GAWB.
10 Queensland Competition Authority Chapter 3 - GAWB’s Pricing Practices
3. GLADSTONE AREA WATER BOARD’S PRICING PRACTICES
Summary
GAWB is responsible for the supply of both raw and treated water to industrial and local government consumers in the Gladstone region. GAWB’s pricing policy has evolved since its inception reflecting changes in funding requirements and government policy over that period. The new pricing practices reflect the COAG principles of full cost recovery and consumption- based pricing.
Many users are bound by contractual arrangements set under previous pricing policies. Within existing contracts between GAWB and its customers, there are variations in terms of contract length, pricing policy and various other conditions depending on when the contracts were established.
GAWB has implemented new pricing arrangements consistent with its new pricing policy for some of its customers, including the Gladstone City and Calliope Shire Councils, and has implemented interim arrangements for other new customers, pending the outcome of the Authority’s investigation.
3.1 Commercialisation
GAWB was reconstituted as a Water Authority1 under the Water Act 2000 on 1 October 2000. As a commercialised government owned entity, GAWB is required to adopt commercial pricing practices, consistent with the Council of Australian Governments (COAG) principles of full cost recovery and consumption-based pricing for bulk water suppliers. The COAG principles also require the implementation of two-part tariffs specifically for urban water services where cost effective.
3.2 Description of the Business
GAWB is responsible for the supply of both raw and treated water to industrial and local government consumers in the Gladstone region.
Pre-Augmentation
GAWB owns the Awoonga Dam located on the Boyne River to the south west of Gladstone. GAWB also operates a network of pipelines, pump stations, terminal reservoirs and treatment plants to supply water to customers.
As at October 2000, the dam consisted of a 45 metre high concrete faced rockfill wall and had a storage capacity of 283,000ML. At that time, the dam’s assessed ‘historical no failure’ annual yield (HNFY or safe yield) was 49,400ML.
Five major customers, CS Energy, Queensland Alumina Limited, Gladstone City Council, Calliope Shire Council and Gladstone Power Station accounted for almost 38,000ML of water, or 83 per cent of GAWB’s total water demand of 45,637ML in 2000-01.
1 Under the Water Act 2000, GAWB is defined as a category 1 water authority, a category which includes GAWB and the Mt Isa Water Board. Local governments fall into category 2. A water authority is a statutory body under the Financial Administration and Audit Act 1997 and Statutory Bodies Financial Arrangements Act 1982.
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Augmentation of Capacity
To meet expected growth in demand for water, GAWB augmented the capacity of the Awoonga Dam from a full supply level (FSL, set at the spillway level) of 30 metres to FSL 40 metres. The raising to FSL 40 metres has increased Awoonga Dam’s safe yield from 49,400ML to 87,900ML.
In addition, GAWB has completed major new works during the last two years, including refurbishment of the Awoonga pump station, sixteen kilometres of new pipeline between Awoonga Dam and Gladstone and a new 50ML reservoir at Toolooa.
Proposed new works include a new pipeline from Gladstone to Mt Miller and the northern industrial area. A further pipeline to the Aldoga industrial area is proposed in the longer term.
The augmentation of the dam to FSL 40 metres also required substantial outlays in relocating rail, road, electricity and telecommunications infrastructure.
Historic No Failure Yield
The HNFY s outlined above were estimated in 2000. As outlined in Chapter 5, the HNFY could be subject to revision as improved hydrological and climate information is evaluated.
3.3 GAWB’s Pricing Policy
GAWB’s pricing policy has evolved since its inception, reflecting changes in funding requirements and government policy over that period. There have been four pricing policy approaches adopted, with policy changes in 1980, 1991 and 2000. These are summarised in Table 3.1 and reviewed below.
Table 3.1: Summary of pricing policies – GAWB
Cost 1976-1980 1981-1990 1991-2000 From July 2000 element
Return on Actual interest costs Actual interest costs Actual interest costs Return on all capital capital recovered. recovered. recovered. employed.
Return of Redemption on actual Redemption on actual Redemption based on Financial annuity capital loans recovered. loans recovered. actual loans recovered. based on average Depreciation based on Financial annuity based asset lives in the key 20 year asset life. on an estimated asset segments. life (62 years).
Opex Included. Included. Included. Included.
1976 to 1980
In 1976, the Queensland Government approved a pricing policy which was essentially based on actual cost recovery principles designed to recover the full costs of GAWB’s operations and maintenance, and actual interest and redemption associated with the proposed capital works programme. This was reflected in a raw water price for industry of $100 per megalitre, to be indexed annually according to inflation, commencing in 1976/77.
For each major industrial customer, GAWB established a point of supply of water. The industrial customer was required to meet the full cost of connection from their plant to the nominated supply point by way of a repayable security deposit. The Board assumed ownership of these link pipelines, but recognised that the customers who paid a security deposit had a prior right to the
12 Queensland Competition Authority Chapter 3 - GAWB’s Pricing Practices
supply of water through the pipeline. Security deposits are being repaid to customers by means of rebates on annual charges.
To ensure that domestic consumers received the full benefit of government subsidy payments, the price of raw water for domestic consumers was set at 65 per cent of the industrial rate plus water treatment costs. While the operating cost for treated water was separately identified and allocated to treated water users, the interest and redemption cost for treated water assets was shared between all users, implying a potential cross-subsidy between raw and treated water users.
1980 to 1990
In the 1980s, the pricing policy was modified to explicitly include a return of capital, with asset lives depreciated over 20 years. New customers were required to contribute to any augmentations.
Existing customers remained with the prior charging arrangement of $100/ML indexed at CPI.
1991 to 2000
In 1991, the pricing policy was again refined for new customers. The key changes were that:
· a water asset replacement charge determined using a financial annuity based on an average 62 year asset life was substituted for the previous asset consumption charge based on five per cent of asset value; and
· a charge to fund the anticipated cost of known required system augmentations was included as a financial annuity.
2000 to Present
Since GAWB became a commercialised entity, it has sought to establish a new pricing framework which reflects COAG water pricing principles.
The key differences between the new pricing framework introduced in October 2000 and previous pricing practices which had applied to new customers since 1991 were as follows:
· the inclusion of a rate of return commensurate with market returns on capital applied to the reproduction cost of the dam and delivery infrastructure, replacement cost for plant and equipment and market values for land, buildings and improvements in place of the previously used actual interest and redemption costs; and
· the use of different average asset lives in different segments, rather than an overall average of 62 years, to determine a return of capital using a financial annuity.
Contractual Arrangements
GAWB has implemented pricing arrangements consistent with its new pricing policy for some of its customers, including the Gladstone City and Calliope Shire Councils, and has implemented interim arrangements for other new customers, pending the outcome of the Authority’s investigation. However, for a number of users, GAWB remains bound by contractual arrangements set under previous pricing polic ies. Table 3.2 provides a summary of the current status of GAWB’s contracts and the proportion of total demand affected.
13 Queensland Competition Authority Chapter 3 - GAWB’s Pricing Practices
Table 3.2: Summary of contractual status of GAWB’s customers, 2001-02
Customer Category % of Demand 2001-02
Customers holding original long term contracts 8
Customers on original contracts, but now subject to five-yearly reviews (in some cases 50 if no renewal agreed contract lapses, in others old prices remain)
Existing customers with no contract or annual contracts 25
New customers commencing usage in 2001-02 and seeking a contract 17
GAWB’s water supply agreements typically include provisions covering details of the volume supplied, the prevailing price, ‘deemed quantity’ and payment arrangements. Prices are usually based on a minimum ‘take-or-pay’ applying to a `deemed quantity’, typically 75 per cent of contracted supply. All existing contracts also provide for annual CPI escalation
For most customers on original contracts, the contractual arrangements are set for a given term and are then subject to five-yearly reviews. In most cases, changes to contractual arrangements require the agreement of both parties. Contracts also vary in terms of contract length, pricing policy and various other conditions depending on when the contracts were struck.
GAWB’s new contract pro forma includes schedules detailing the new pricing practices including the level of disaggregation between customer classes.
14 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
4. DEMAND PROJECTIONS FOR GAWB
Summary
The expected demand for water is a significant determinant of GAWB’s cost of providing water, and thus its price. A significant proportion of GAWB’s existing water supply is consumed by a small number of industrial customers.
In assessing projected water demand for GAWB, the Authority adopted an extensive evaluation and consultation process, the major steps involving:
· a review of GAWB’s demand projections with the release of a paper for consultation in March 2001 based on the Authority’s own analysis;
· the development of a preferred planning scenario based on an independent assessment prepared by SMEC Australia of submissions received and additional information on project timings and planning. This demand scenario incorporated the impacts of expected demand management strategies and the potential for alternative supplies;
· an assessment of comments provided by stakeholders in response to the demand projections outlined in the Draft Report; and
· a final review by SMEC Australia in response to comments received on the Draft Report and taking account of recent developments and data provided by GAWB, existing customers and prospective customers.
The Authority recommends that any demand scenario adopted for pricing purposes takes into account the impact of demand side management and alternate supply options and be developed in consultation with existing and prospective customers.
4.1 Introduction
The timing and location of major augmentations and asset upgrades is determined by the expected demand for water, and has implications for GAWB’s cost of providing water, and thus its price.
A significant proportion of GAWB’s existing water supply is consumed by a small number of industrial customers and most growth in demand is expected to come from a small number of new industrial customers.
4.2 History of Water Demand
Historic Demand
Since 1978, treated water has accounted for 31 per cent (on average) of total water demand and has grown by an average of 3.8 per cent per annum. While the trend for treated water demand is not consistently positive, year on year variations can be explained by seasonal influences and changing hydrology.
Raw water has accounted for the balance of demand and, since 1978, demand has grown by 6.7 per cent per annum.
The historic trends in the demand for water appear in Figure 4.1.
15 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
Figure 4.1: Actual Demand for Water 1978-79 to 2000-01
45,000 Total Demand
40,000 Raw Water Treated Water 35,000
30,000
25,000
20,000 Megalitres
15,000
10,000
5,000
0 1978/79 1980/81 1982/83 1984/85 1986/87 1988/89 1990/91 1992/93 1994/95 1996/97 1998/99 2000/01
Figure 4.2 charts GAWB’s actual water demand against the design capacity of its storage infrastructure. A key feature is that GAWB has carried an average of 11,500ML excess capacity, or 23 per cent of total capacity since 1978-79.
Figure 4.2: GAWB Actual Demand and Capacity 1978-79 to 2000-01
60,000 Design capacity
50,000 Actual demand
Excess capacity 40,000
30,000 Megalitres
20,000
10,000
0 1978/79 1980/81 1982/83 1984/85 1986/87 1988/89 1990/91 1992/93 1994/95 1996/97 1998/99 2000/01
Current Demand
In 2000-01, the total volume of water supplied by GAWB was approximately 45,600ML. This consisted of raw water used mainly for industry (71 per cent of total supply) and treated water used mainly for urban and commercial purposes (29 per cent of total supply). Table 4.1 refers.
16 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
Table 4.1: Water demand in 2000-01 (ML)
Market Sector Raw Water Treated Water Total
Industry 17,076 (53%) 1,516 (9%) 18,592 (41%)
Local Government 0 (0%) 10,464 (79%) 10,464 (23%)
Electricity 15,175 (47%) 1,406 (12%) 16,581 (36%)
Totals 32,251 71% 13,386 29% 45,637 100%
Source: Gladstone Area Water Board
4.3 Previous Estimates of Gladstone Water Demand
Projections by GAWB and QCA
The expectation of rapid growth in water consumption from new industry locating in the Gladstone region has been a consistent theme in GAWB’s planning. For instance, in 1990, water consumption was expected to grow to between 50,000ML and 80,000ML by 2000, primarily based on proposed consumption by the China Steel Corporation of Taiwan of 20,000ML per annum. However, the demand for raw water for industrial purposes has largely remained constant since 1991-92, despite general expectations of higher growth in demand.
Current expectations for future demand from the shale oil, ferro-chrome and alumina industries include projects which were first identified in the early 1990s.
GAWB considered a range of scenarios for planning purposes. These differed according to its expectations of projects proceeding. Based on its own assessment, GAWB proposed a ‘medium growth series’, outlined in Table 4.2, as the basis for price setting and planning after July 2000. GAWB’s projections were based on significant demand growth from the shale oil industry, the power generation industry and developments by industrial users such as Comalco and QAL.
In March 2001, the Authority released for public consultation an Issues Paper, Gladstone Area Water Board: Projected Demand for Water 2000/01 to 2019/20. The Authority’s projected demand was based upon discussions with major customers and relevant government agencies, including the Department of State Development, the Department of Local Government and Planning, the Department of Natural Resources and Mines and Queensland Treasury. The key differences compared with GAWB’s estimates related to the potential impact of a two-part tariff on Gladstone’s urban water demand and expectations regarding the timing of major industrial projects. The Authority’s March 2001 medium demand scenario is also shown in Table 4.2.
The Authority received a number of submissions on the demand study.
Draft Report
For the Draft Report, SMEC undertook further analysis using additional data from GAWB, water customers and other relevant stakeholders.
SMEC developed a risk profile for each project according to key criteria which included the development stage of the project, proximity to start-up, market conditions, alternative water sources and environmental issues.
SMEC’s risk analysis settled on three demand scenarios, upper bound, lower bound and most probable, each derived for a 20-year period.
17 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
The upper bound demand projection represented an ‘absolute’ upper limit to demand. The lower bound scenario illustrated GAWB’s infrastructure needs when growth in future demand was solely generated by existing and committed customers and included only projects with a high likelihood of proceeding. The upper and lower bound demand scenarios represented outlying possibilities with extreme risk profiles, and hence low probabilities.
SMEC’s most probable scenario included new demands for Comalco’s proposed alumina refinery, a ferro-chrome plant, a calcining plant and one aluminium smelter. Additional expansions and staged developments by existing customers were also recognised. However, some projects were not considered relevant to the current planning horizon after consideration of the timing of their start-up.
SMEC also reviewed the potential impact of alternative sources of water on the requirements envisaged for GAWB. These included use of wastewater, reduction in urban distribution system losses, trading of water entitlements and diversion of stormwater.
Demand management options identified by SMEC included removal or relaxing of disincentives for users to save water such as the take -or-pay contractual arrangements, adoption of water use efficiency technology, and support for public education on efficient use of water.
After consideration of the range of possible supply and demand management options, SMEC considered that significant reductions in projected water demand were feasible. Existin g industrial customers were considered able to reduce their demand by five per cent after 2010, while most new industrial customers connecting after 2008-09 were expected to achieve ten per cent reductions. The expected reductions for Calliope Shire Council and Gladstone City Council were ten per cent and fifteen per cent after 2009-10.
As a result, SMEC identified a preferred demand scenario considered most suitable for planning and pricing purposes based on most probable demand growth adjusted for demand management and alternate supply options (the ‘preferred planning scenario’). Table 4.2 refers.
Table 4.2: Summary of Draft Report demand scenarios (ML)
Scenario Date 2002-03 2003-04 2004-05 2009-10 2014-15 2020-21 Current
GAWB Medium Demand - Total July 2000 53,231 57,986 61,205 67,904 81,425 112,515
QCA Medium Demand - Total March 2001 52,916 55,438 56,135 65,180 79,698 110,838
SMEC Preferred Planning Scenario
Total treated water May 2001 14,697 16,749 16,271 18,085 17,601 19,024
Total raw water May 2001 42,321 44,043 54,115 62,987 63,768 65,297
Preferred Planning - Total May 2001 57,018 60,792 70,386 81,072 81,369 84,321
4.4 Stakeholder Comment
GAWB disagreed with the preferred planning scenario proposed in the Draft Report for the following reasons:
· demand behaviour of major industrial customers is unlikely to be altered due to the negligible impact demand management initiatives have on their total operating costs;
18 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
· based on Calliope Shire Council’s experience, the transition to a two-part tariff would have little impact on Gladstone City Council’s demand;
· trading of water entitlements is not a permitted activity as GAWB holds the full entitlement to the maximum dam height of 45m under the Water Resource Plan for the Boyne River; and
· there are no further wastewater reuse options once the Gladstone City Council’s scheme for supply to QAL is in place.
The following comments were received from other stakeholders:
· Callide Power Management and Comalco were concerned that if the preferred planning scenario were used with no change in the optimised asset value, the average cost of supply (and therefore recommended prices) would be increased;
· the Department of Natural Resources and Mines (DNR&M) sought clarification of the particular demand management strategies that GAWB’s customers might implement. DNR&M also suggested that some indication of support from the customers for the Authority’s assumptions would be desirable;
· QAL agreed with the adoption of the preferred planning scenario as it recognised incentives to use water resources more efficiently; and
· SEQWater considered that the basic demand model appeared robust, but that the ‘finessing’ of results (for the preferred planning scenario) reduced the credibility of the approach.
GAWB also identified changes in demand projections for new customers. These included changes to timing and volume of demand for the calcining and alumina projects, changes in the risk profile for some projects including the ferro-chrome project, and the inclusion of a new chemicals project. For some of these projects, demand for treated water has increased, changing the infrastructure requirements for treated water supply in the northern supply area.
4.5 QCA Analysis
The Authority engaged SMEC to reassess the demand projections for GAWB to address the issues raised by stakeholders. SMEC’s work focused on two key elements, namely a revision of customers’ water requirements and a reassessment of demand management impacts.
Review of Customers’ Water Requirements
SMEC’s revised demand projections are based on interviews with GAWB, the Councils, key industrial customers and the Gladstone Industry and Economic Development Board (GIEDB). Using the latest information, SMEC refined its risk analysis for allocating the proposed proje cts to low, medium and high risk categories. The key parameters used in this risk analysis included size of demand, status of project planning, proximity to start-up and specific sensitivities such as environmental issues and market uncertainty.
Relative to the preferred planning scenario used in the Draft Report, SMEC’s analysis identified increases in demand projections resulting from:
· the inclusion of a new customer taking 500ML of treated water and 360ML of raw water. Although this customer was previously not identified, the project has progressed quickly to pre-feasibility stage and is now regarded as having a low risk of not proceeding; and
19 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
· an increase in demand from a proposed aluminium forging plant of over 900ML per year, reflecting more current information as the project advances towards development.
Decreases in total demand were the result of:
· a reduction in demand from the proposed calcining facility; and
· the exclusion of some projects now considered at a high risk of not proceeding, for a total reduction of up to 4,800ML by 2020.
Comalco’s total demands were also revised, to allow for a delay of Stage 2 by five years. Other revisions were also introduced to reflect improved information on the proposed timing of Comalco’s staged developments. Net demand by electricity generators is also 4500ML higher through to 2004-05 and 1000ML higher from 2001-02.
SMEC’s revised assessment of customer demands takes into account information available as at 28 June 2002 on the progress of individual projects and represents the most recent and comprehensive assessment available to the Authority.
SMEC’s final forecasts do not provide for the effects of water trading or stormwater diversion, although such possibilities may exist in the future.
Demand Management and Alternative Supply Sources
The approach adopted in the Draft Report for applying demand management strategies to modify expected future demands attracted significant comment from GAWB and DNR&M. Their concerns related particularly to whether these demand reductions could realistically be achieved and whether they were supported by users. Their submissions were provided to SMEC for analysis.
In their survey of GAWB and customers, SMEC specifically sought comment on achievable demand reductions. SMEC’s findings were that:
· for many larger industries which have already achieved efficiency savings, future savings from expected advances in water use efficiency are already built into forward projections. This compares to the Draft Report’s savings of five per cent from 2011-12 for existing and new customers and ten percent from 2008-09 for new customers;
· efficiency gains of between five and fifteen per cent were identified by some existing smaller customers and deducted from their existing demand levels at nominated points in time;
· for the Calliope Shire Council, savings of three per cent in 2005-06 rising to eight per cent by 2019-20 are expected to be achieved through reductions in system losses and demand management strategies. This compares to the Draft Report’s savings of three per cent in 2009-10, six per cent in 2010-11 and ten per cent in 2011-12; and
· for the Gladstone City Council, savings of five per cent in 2005-06 rising to twelve per cent in 2019-20 are expected due to reductions in system losses and the introduction of a two- part tariff. In the Draft Report, the expected savings were four per cent in 2009-10, eight per cent in 2010-11, twelve per cent in 2011-12 and fifteen per cent in 2012-13.
The projected savings for the Calliope and the Gladstone City Councils were developed following consultation with both Councils. The Authority notes that, in response to GAWB’s comment, the savings that SMEC expects Gladstone City Council to achieve from two-part tariffs are modest
20 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
compared to the reductions that have been achieved by other Queensland councils through the adoption of well-structured two-part tariffs.
In relation to alternative sources of supply, SMEC concluded that there was limited spare capacity for effluent reuse once the planned QAL wastewater reuse project is in place. The demand projections already recognise these savings. Other options such as stormwater reuse, desalination or groundwater were either not viable or could not provide significant volumes.
Conclusions
The Authority has accepted SMEC’s revised preferred planning scenario.
Compared to the Draft Report:
· the revised preferred planning scenario shows generally lower demand throughout the period to 2020-21 (Figure 4.3 refers); and
· the effects of demand management are now ba sed on customers’ expectations.
Figure 4.3: Comparison of Preferred Planning Scenarios – Draft Report and Revised
90,000
85,000
80,000
75,000
70,000 Megalitres 65,000
60,000 Draft Report - Preferred Planning Scenario
Revised - Preferred Planning Scenario 55,000 Awoonga Dam safe yield
50,000
2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21
The implications of the changes in demand for capacity and operating cost, as raised by CPM and Comalco, are addressed in Chapter 6.
The implications of alternative demand scenarios are also assessed in the Authority’s sensitivity analysis using SMEC’s lower and upper bound demand scenarios (see Chapter 11). Figure 4.4 outlines the new preferred planning scenario together with the revised lower bound and upper bound demand scenarios.
21 Queensland Competition Authority Chapter 4 - Demand Projections for GAWB
Figure 4.4: Revised Demand Scenarios and Historic Demand
110,000 Upper Bound Scenario 100,000 Preferred Planning Scenario 90,000
80,000 Lower Bound Scenario
70,000
60,000
50,000 Megalitres 40,000
30,000
20,000
10,000
0 1978/79 1980/81 1982/83 1984/85 1986/87 1988/89 1990/91 1992/93 1994/95 1996/97 1998/99 2000/01 2002/03 2004/05 2006/07 2008/09 2010/11 2012/13 2014/15 2016/17 2018/19 2020/21
The revised preferred planning scenario is summarised in Table 4.3.
Table 4.3: Revised preferred planning scenario (ML)
Type of Supply 2002-03 2003-04 2004-05 2005-06 2009-10 2014-15 2020-21
Raw water 42,276 44,529 49,306 52,162 58,534 62,853 62,736
Treated water 14,741 15,353 16,409 16,610 17,597 18,446 19,689
Total demand 57,017 59,882 65,715 68,772 76,131 81,299 82,425
Recommendation:
That in setting prices, GAWB take into account relevant demand scenarios including demand side management and alternate supply options .
22 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
5. THE FRAMEWORK FOR MONOPOLY PRICES OVERSIGHT
Summary
As detailed in the Authority’s Statement of Regulatory Pricing Principles for the Water Sector, and consistent with the COAG strategic framework for water industry reform, the price of water should be cost reflective, forward looking, ensure revenue adequacy, promote sustainable investment, ensure regulatory efficiency, and take into account matters relevant to the public interest.
The Authority recommends that:
· GAWB’s prices should reflect the cost of augmentation and thus be based on the long run marginal cost. The recovery of revenues necessary to maintain the provision of services by GAWB must also be taken into account;
· in relation to force majeure impacts, the cost of insurance premiums should be included in the cash flow estimates, but the costs of uninsurable events cannot be incorporated with any degree of accuracy. These should be dealt with in GAWB’s customer contracts. GAWB should seek to achieve consistent treatment of force majeure in its customer contracts. The Authority’s role should be limited to assessing pricing practices when such events occur;
· in the particular circumstances of GAWB, the impacts of drought should be incorporated in the cash flow estimates. However, further consideration of alternate supply sources and system hydrology is desirable in the light of the current drought. The Authority recommends that GAWB, in consultation with its customers and the Authority, should review the drought management options available with the results to be incorporated into prices as appropriate ;
· prices should be differentiated between users according to their utilisation of the infrastructure network and reflect any infrastructure specific to those users. However, similar services provided by common infrastructure should be charged to all users on the same basis. The application of differential pricing between existing and new customers for common infrastructure is potentially inconsistent with public interest matters such as regional development and equity issues; and
· GAWB should be responsible for the costs of any excess capacity not considered optimal. However, with the current augmentation, the level of excess capacity was considered optimal by SMEC in the context of long term least cost supply to meet anticipated demand.
5.1 Background
General Rationale for Monopoly Prices Oversight
Monopoly or near-monopoly suppliers of water have the power to restrict services, increase prices, lower quantities of water available for sale or provide a lower standard of service or product quality, without the threat of competitive sanction.
For this reason the QCA Act 1997 has provision for regulatory oversight of monopoly service providers. The requirements of the Act were outlined in Chapter 2.
23 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
5.2 Efficient Pricing
General Principles
As detailed in the Authority’s Statement of Regulatory Pricing Principles for the Water Sector, and consistent with the COAG strategic framework for water industry reform, the price of water should:
· be cost reflective - that is, reflect the costs of providing the service and, where the demand for water exceeds its supply, incorporate a value for the resource;
· be forward looking - and represent the least cost which would be incurred in providing the requisite level of service over the relevant period;
· ensure revenue adequacy - the overall financial needs of the business must be addressed;
· promote sustainable investment - where the services are to be maintained into the future, the investor must be given the opportunity to enjoy an appropriate return on the current investment and be provided with the incentive to make necessary future investment;
· ensure regulatory efficiency - the pricing method which minimises regulatory intrusion and compliance costs relevant to a particular circumstance should be adopted; and
· take into account matters relevant to the public interest.
There are a number of alternative approaches to pricing, including average cost pricing and marginal cost pricing.
Average Cost Pricing
Average cost pricing is effective for ensuring revenue adequacy for the regulated business but, because the resulting prices are not based on the cost of the additional unit of consumption, does not generally promote efficient outcomes. Average cost pricing generally fails to signal the implications of continued growth in demand.
Marginal Cost Pricing
Two broad options exist for determining efficient prices - short run marginal cost and long run marginal cost.
Short run marginal cost (SRMC) is the change in total costs when an additional unit of output is produced, in a period in which at least one factor of production is fixed. Typically, capital costs are unable to be altered in the short run, and are considered fixed. Long run marginal cost (LRMC) is the change in total costs when an additional unit of output is produced, and where all inputs are adjusted optimally. LRMC therefore includes a component for the unit capital costs of expansion.
As capacity constraints are reached, SRMC will lead over time to sharp increases in prices, reflecting increased congestion costs (for example, capital costs for leakage repair, plant upgrades, purchase of water from external sources or additional operating costs) and any environmental costs. If new capacity is installed, prices based on SRMC would then decline, as congestion costs are relieved. SRMC pricing therefore results in prices fluctuating widely, producing a ‘saw-tooth’ pattern. The typically cyclical pattern in pricing is generally not acceptable administratively.
24 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
LRMC pricing incorporates a component to reflect future augmentation, and signals to buyers the future costs of their current consumption decisions. As an example, under LRMC pricing, a planned augmentation may be able to be deferred if consumers reduce their level of demand in the face of increasing costs (and thus prices). Prices are also typically smoother over time.
While SRMC can be estimated for any given year, LRMC requires estimates of capacity augmentation costs. LRMC reduces to the SRMC where no augmentation is considered necessary.
A concern with marginal cost pricing is that, where marginal costs are below average costs, prices based on marginal cost will not generate sufficient revenue to maintain the provision of services. Alternatively, where marginal costs are above average costs, prices will result in excess revenue being generated.
Decreasing Unit Costs Where the marginal costs of production decrease with output growth, the resulting revenue shortfall may be addressed by either:
· utilising a two-part tariff by incorporating a ‘fixed’ or ‘access’ charge in the tariff, or by applying a surcharge; or
· adopting price discrimination (eg Ramsey pricing or differential pricing) and charging more than the marginal cost of services to those customers who can afford it.
Ramsey pricing involves applying greater price mark-ups on marginal cost to those customers likely to respond least to higher prices. More responsive customers would receive lower prices. The use of Ramsey pricing requires knowledge of demand elasticities, and this may be difficult where demand is a derived demand, such as where water is used as an input to a production process. Ramsey pricing is not possible where trading can occur. Bonbright et al (1988) note that, ‘Ramsey pricing, because of its unsatisfactory formulation, remains for the present more of a theoretical curiosity than a workable regulatory rule’.
Increasing Unit Costs As indicated above, where the business exhibits increasing marginal costs, prices based on marginal costs may generate an excess of revenue above that required to maintain revenue adequacy for the entity. Such circumstances could occur in Gladstone, particularly under some upper bound demand scenarios, where relocation of some infrastructure such as transmission lines and railways will be required.
Marginal cost pricing is necessary to ensure allocative efficiency but there is no agreed prescription on how any excess revenues should be allocated. Options include: the payment of additional dividends to shareholders; the establishment of sinking funds to provide for future augmentation; or the provision of a rebate to users, in the same way that a surcharge or an access component would be applied when marginal cost is falling.
Estimating LRMC
A major drawback with using LRMC is the difficulty of estimation. Given that it is a forward looking measure, estimates are required of capital cost increments, timing, volume increases and changes in operating costs. The Authority is aware of two alternatives for measuring LRMC:
· the present worth of incremental costs as devised by Turvey (1976) and applied by Hanke (1981). Turvey’s method determines LRMC as the difference between the present worth of the next planned capital investment and the present worth of delaying that capital investment by one year. The result is then divided by the increment in capacity, to arrive at
25 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
a unit marginal capital cost. The difference in the marginal operating costs associated with the delay is also included; or
· average incremental costs (AIC). This approach essentially determines an average incremental cost over a designated planning horizon. It takes additional operating costs in each year (compared to present operating costs) plus capital expenditure and expresses the result in present value terms on a unit basis. It requires estimates of cash flows over a nominated planning horizon, which may incorporate future augmentations.
The AIC method is an average cost concept and requires accurate estimates of asset lives and cash flows to be effective.
The Turvey method is a more incremental approach and is therefore generally considered a more appropriate measure of LRMC.
Appendix A enlarges on the issues involved in estimating LRMC using the alternative approaches.
Other Jurisdictions
Ofwat (2001) has adopted LRMC pricing as a general principle for its 2001-02 tariff determinations for UK water companies. Ofwat viewed LRMC as a ‘central reference point for sound decision-making by both companies and the regulator’. LRMC was considered consistent with a long term least cost approach to balancing supply and demand, and with water companies’ duties to promote efficient water use. Ofwat was indifferent between the alternative methods for determining LRMC and has recommended to water companies that they may use either method for determining LRMC. However, unlike GAWB, most water companie s in the UK undertake incremental augmentation of their capacity.
Mann (1993), for the World Bank, also supports the use of LRMC pricing and suggests that the AIC and Turvey approaches are both compatible with economic efficiency.
Stakeholder Comment
Initial submissions on this issue indicated that:
· GAWB currently incorporates the cost of augmentation in its average price. GAWB submitted that demand in excess of the forecast revenue requirement be priced using LRMC to provide an appropriate signal about the cost of an additional unit of water. GAWB’s submission also suggested alternative approaches to the estimation of LRMC, including Average Incremental Costs and the Present Worth of Incremental System Costs (the Turvey method);
· SunWater preferred the SRMC pricing approach for service providers exposed to risks of open-ended supply commitments to major industrial customers. SunWater also argued that LRMC assumes an infinite opportunity to augment infrastructure and that the service provider will not encounter competition in providing additional capacity; and
· QAL noted that the overriding objective of price regulation is to ensure that prices charged by monopoly suppliers reflect, as closely as possible, the prices that would be charged for the same goods or services in a competitive market.
In response to the Draft Report, GAWB considered the two-part tariff approach based on the Hanke Turvey method for calculating LRMC to be overly complex and less transparent to customers. GAWB suggested that the approach was unlikely to provide any better pricing signals than the existing single price per megalitre with a 75 per cent take-or-pay arrangement.
26 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
SEQWater did not specifically comment on LRMC pricing, but considered that a single part volumetric tariff was more appropriate than a two-part tariff.
SunWater qualified its previous comments, advising that if a two-part tariff is adopted, the consumption component should reflect SRMC of supply, with the balance of costs, such as return on and of assets, included in the access charge.
QCA Analysis
Marginal cost pricing is considered to provide the correct economic signals for water use decisions and best reflect the outcomes of a competitive environment. The average cost approach is effective in ensuring sufficient revenue for the regulated business but may not promote efficient outcomes.
The Authority considers that, from an efficiency perspective, the LRMC pricing approach is most appropriate as it is signals the full economic cost of future consumption. When considered in conjunction with the revenue adequacy requirements of GAWB, it provides a basis for establishing an appropriate pricing structure.
LRMC based pricing is of particular relevance to GAWB as the augmentation options it confronts are typically large relative to the current capacity of the infrastructure and are therefore long term in nature. Furthermore, the major prospective users are long term industrial users typically seeking greater certainty of the pricing framework.
In relation to two-part tariffs, the Authority considers that it is important to send efficient pricing signals to end users.
Since it is based on the same or similar volume information used by GAWB for its current take- or-pay pricing arrangements, the two-part tariff comprising fixed and variable volume-based charges is not considered to be overly complex. The implications for administration and billing costs are negligible given the small number of customers and the arrangements already in place for take-or-pay charging. Two-part tariffs are now widely adopted by local governments and other water suppliers for end-user services of large customers.
The Authority continues to recommend that GAWB adopt two-part tariffs as they provide for volumetric pricing based on marginal costs while ensuring revenue adequacy through the access charge component. Such an approach is also flexible in that it provides relevant signals during periods of scarcity or surplus. However, alternative structures may be appropriate during drought, when LRMC would escalate and water conservation becomes the utmost objective. Drought issues are reviewed further below.
As to the method of calculating LRMC, the Authority considers that the Turvey method provides a more appropriate estimate of LRMC than the AIC method as it more closely reflects incremental costs.
Recommendation:
That, subject to the revenue adequacy requirements of GAWB, GAWB’s prices be based on the long run marginal costs of providing services, on the basis of the Turvey method.
5.3 Revenue Adequacy
If a service provider is to continue operations in the longer term, maintain existing capital and invest in new capital, the service provider needs to generate sufficient revenue to cover all operating costs, a return of capital, and a return on capital invested. Alternative approaches to determin ing this revenue are:
27 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
· the cash flow or Net Present Value (NPV) approach, where revenue is established which sets discounted cash flow estimates to zero using the required rate of return;
· the Internal Rate of Return (IRR) approach where revenue is set so as to generate the required rate of return on the basis of forecast cash flows; and
· the ‘building block’ approach, which allows the estimation of total revenue required, including a rate of return (WACC) on assets, return of capital (depreciation or renewals) and operating costs. The revenue requirement is determined by ‘building up’ the cost base and ensures revenue adequacy for the operator.
Stakeholder Comment
In initial submissions, all stakeholders supported the use of the building block approach to determine GAWB’s revenue requirement. CS Energy and Queensland Alumina Limited supported the building block approach on the basis that the Authority recognised previous capital contributions. No further submissions were received in response to the Authority’s Draft Report.
QCA Analysis
The Authority has adopted the ‘building block’ approach in its electricity and gas determinations but used the cash flow approach in its rail determination. Both the Independent Pricing and Regulatory Tribunal (IPART) (2000a) and the Independent Pricing and Regulatory Commission (IPARC) (1999) adopted the building block approach for determining revenues for NSW water authorities and Australian Capital Territory Electricity and Water (ACTEW) respectively.
While similar results will be generated by each of the approaches, the cash flow approach is simpler to apply over longer periods (particularly where construction occurs over a number of periods) and ensures that a ‘long term’ perspective, most relevant to water service providers, is maintained.
Recommendation:
That the cash flow method be used as the appropriate basis for ascertaining the revenues necessary to maintain the provision of services by GAWB.
5.4 Pricing Practices during Drought and other Force Majeure Events
Force majeure excuses parties from liability if some unforeseen event beyond their control prevents them from meeting their contractual obligations. Such events include war, riot or commotion, strike or lock-out, acts of God, fire, drought, flood, storm, tempest or washaway, and act or restraint of government.
The Draft Report did not contain any recommendations regarding pricing practices during drought or other force majeure events.
Stakeholder Comment
In responding to the Authority’s Draft Report, GAWB noted that, while its supply system provides a high reliability yield, this does not eliminate the need for precautionary supply restrictions during drought. GAWB is empowered by the Water Act 2000 to impose such restrictions.
GAWB’s submission suggested that the Authority’s pricing framework needs to ‘address impacts on revenue adequacy arising from drought and other events of force majeure’. GAWB suggested that these impacts were outside of the risk premium incorporated into the WACC. GAWB also
28 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
submitted that pricing practices should be established to allow GAWB to cover operating costs and interest on borrowings during force majeure and drought events.
CPM advised that, under the GAWB’s typical take-or-pay arrangements, the volumetric charge applies only to actual volumes received in the event that GAWB is unable to supply the specified take-or-pay volume. This may occur during drought or other force majeure events. CPM sought an assurance that the Authority’s recommended tariff would also be consistent with this principle, so that GAWB would bear the risk of force majeure events.
QCA Analysis
The Authority’s analysis focuses firstly on force majeure issues in the general sense and secondly on drought as the most pressing of GAWB’s force majeure risks.
Force Majeure Force majeure risks can be categorised into insurable and uninsurable risks. Currently GAWB insures most of its major assets (dam and reservoirs) against physical loss due to defined catastrophic events (including earthquake, storm, fire, flood, impacts by aircraft and road vehicles and acts of malicious persons). GAWB also has industrial special risks cover for physical loss or damage to ancillary equipment such as inlet/outlet works , pumps, treatment plants and buildings. The premiums for this coverage, and any associated administration costs, are already appropriately incorporated into cash flow estimates.
GAWB has chosen not to insure some assets, including all pipelines and some reservoirs. Additionally, GAWB has not taken up available insurance cover for consequential loss of income as a result of an insured property loss. Insurance is not available for loss of income or loss of customers’ income due to drought.
Where insurance is not available, the inclusion of the estimated costs of force majeure risks requires an estimate of the probabilities of such events and the direct cost impact. The Authority was unable to estimate such costs.
Furthermore, different force majeure events may require different arrangements to be put in place according to the nature of the event. Such arrangements, including supply options and pricing, need to be satisfactory to the service provider and the customer and will in most cases require commercial negotiation. On this basis, the Authority recommends that, when force majeure events occur, prices should be reset by renegotiation between GAWB and its customers.
The Authority could find no evidence that any Australian regulators have made determinations in relation to force majeure events for water supply. However, regulators have played a role in the potential impact of force majeure events on pricing in electricity and gas, for example:
· the ACCC indicated in its National Electricity Market Stage 1 – Commission Paper that ‘administered prices’ would apply if force majeure events were responsible for involuntary load shedding in Victoria;
· in August 1998, ACCC indicated that an “administered price cap” is to apply for force majeure events affecting gas supply in its determination for VENCorp; and
· in July 2000, the ORG reported on a claim for the application of force majeure for pricing by Gippsland Power Pty Ltd following the failure of a generator responsible for 50 per cent of the output from its Loy Yang B power station. ORG determined that the failure was not a force majeure event.
Notwithstanding the arrangements in some electricity and gas jurisdictions, as many responses to force majeure need to be determined between the service provider and customer, it is considered
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that the Authority’s role in force majeure should be limited to assessing pric ing practices when such events occur.
The force majeure provisions in GAWB’s existing customer contracts vary depending on when contracts were established. The Authority considers that GAWB should adopt, as much as possible, a consistent approach to the treatment of force majeure in its contracts.
On the basis of the available information, in relation to force majeure in general, the Authority considers that:
· the cost of insurance premiums for insurable force majeure events , and the administration and contract management costs associated with force majeure in general, should be incorporated into cash flow estimates;
· the potential cost of uninsurable force majeure events not be incorporated into cash flows given that the y cannot be estimated with any degree of accuracy or certainty. When such events occur, prices should be renegotiated;
· the Authority’s role in force majeure events should be limited to assessing pricing practices when such events occur; and
· GAWB should adopt a consistent treatment of force majeure in its customer contracts.
Drought
In their submission on the Draft Report, GAWB noted that the risk of drought was not incorporated into the Authority’s rate of return calculation. In the particular circumstances of GAWB, the Authority has concluded that the impact of drought should be reflected in the cash flow estimates rather than in the rate of return.
In managing its drought risk, GAWB:
· specifies HNFY so that water could have been continually supplied during all droughts that have occurred historically. Currently, the HNFY is based on the previous worst known drought from 1969-71. For the augmented dam, it is 87,900ML from a storage capacity of 777,000ML;
· adopts a precautionary Drought Management Plan (DMP). The DMP triggers supply restrictions at threshold levels, namely when two years’ supply (at current demand) remains, in order to extend supply to three years and cover another wet season; and
· includes clauses in customer contracts that excuse GAWB from liability during drought or other happenings beyond GAWB’s control.
A number of additional management options are available , in addition to the current proposal to introduce a DMP. These include:
· introducing a volumetric charge in place of the two-part tariff when the DMP is triggered. Such a charge could be set up to a level which balances demand and supply, but in any case, should ensure that GAWB as the service provider does not suffer a fall in revenue. To do otherwise would mean that GAWB would not achieve its WACC when it implements prudential drought management practices for its customers;
30 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
· facilitating trading of customers’ water allocations. Under this strategy, GAWB would allow market forces to determine the allocation of remaining supplies of water during drought. Trading may be triggered by the DMP, or may be available at all times;
· seeking alternative sources of supply. This option would involve additional capital expenditure and operating costs which may be ongoing;
· negotiating different supply reliability products, with reflective prices, to pre-define the priority of supply to different customers. It is likely, however, that GAWB’s customers would all require high reliability supplies; and
· applying a buffer to HNFY. This approach is similar to a capacity cushion and would increase capacity costs in cash flow estimates. A major issue would be the availability of appropriate hydrological information to determine a level of HNFY which would insure against the next worst drought.
Which approach should be applied is considered to be a commercial matter for negotiation between GAWB and its customers, as each is associated with a range of benefits and costs. The Authority’s concern is to ensure that GAWB receives a suitable return for the risk it assumes and that GAWB does not exercise its monopoly power.
The costs of the DMP were not reflected in the Draft Report’s cash flow estimates. Neither is it proposed to do so in the Final Report estimates, due to uncertainties relating to the current drought and potential responses. However, for comparative purposes, the Authority has estimated the impact of the application of the DMP, as a permanent premium to the price to cover the estimated loss of income over time, based on the probability of restrictions being triggered (less an adjustment for variable costs saved). This assessment:
· was based on an estimate of the probability of drought events over the last 110 years (to the end of 2001); and
· indicated that the resulting revenue loss would have been equivalent to 0.9 per cent, or $2/ML for water delivered at Awoonga Dam.
However, the Authority considers that prices should be adjusted to account for the impact of drought when the range of options for addressing drought management costs are agreed to by GAWB and its customers.
The Authority notes that there are two significant issues which may require a reassessment of prices to those that would currently be consistent with the recommended pricing practices, namely that:
· according to SMEC, the HNFY for Awoonga Dam is likely to require re-estimation when the current drought ends, as there is mounting evidence that it will eclipse the previous worst drought. SMEC also advised that there is evidence of climatic changes, in particular changes in relative air pressure between southern Australia and Antarctica, which have resulted in fewer tropical cyclones than expected. According to SMEC, rainfall over the last 25 summers has been on average 23 per cent below the 1891-1978 average for the Awoonga Dam catchment; and
· a remedial water supply may be necessary to obviate emerging storages and to meet customers’ needs for the current drought.
On its own, a reduced HNFY would increase the capacity cost by bringing forward the next planned augmentation. The Authority’s recommended pricing practices would accommodate this by reviewing the optimised asset base consistent with the revised HNFY. Any such analysis
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would need to take into account hydrological information available at that time and when decisions were originally made.
The effect of any remedial water supply initiatives on prices would depend on:
· how the capital cost is financed, for example, by customers, GAWB or the Government as shareholder; and
· whether the additional capacity is to be regarded as part of permanent capacity required to redress an expected reduction in the HNFY.
Where customers agree to contractually fund the remedial initiative either as an upfront contribution or through annual charges, the Authority would accept such an outcome.
Where funded by Government, recognition of additional costs in pricing would depend on the intent of the contribution.
If the initiative is funded by GAWB, without contractual agreement from customers, the Authority would need to review alternative strategies to ensure that the initiative represented an appropriate response. For example, where accepted as being necessary to redress an expected reduction in HNFY and this was consistent with customer requirements, it could be accepted as part of the asset base. Any such assessment would need to address the entire supply system as the system may need to be re-engineered to accommodate the initiative and this may in turn affect the allocation of costs to specific customers. Alternatively, the assessment may show that the augmented asset base is not optimal and should be adjusted.
The Authority recommends that:
· the impact of drought should be included in the cash flow estimates; and
· GAWB, in consultation with its customers and the Authority, review the drought management options available, with the results to be incorporated into prices as appropriate.
5.5 Differential Pricing
The Rationale
Identical prices (often referred to as ‘postage stamp’ prices) do not accurately reflect the cost of service provision nor provide incentives to either users or service providers to use resources and services in a cost-effective manner (unless LRMC pricing results in identical prices). At the same time, it is often not possible or cost-effective to achieve useful disaggregation.
Functional Categories and Geographic Differences
Key Issues The use of price differentials is particularly suited to GAWB as its water supply system has a number of clearly defined components and involves specific infrastructure to supply customers in defined geographic areas. The major geographic areas for the supply and distribution of water by GAWB (see map in Figure 1.1 and schematic in Appendix D) are:
· Awoonga Dam. Currently, this is GAWB’s only source of raw water. Water is supplied directly from the dam for transmission by SunWater to CS Energy and to Callide Power Management;
32 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
· Gladstone. This includes the distribution system from Awoonga Dam to the reservoirs at Gladstone. From this part of the system, raw water is distributed to the Gladstone Water Treatment Plant, QAL, Boyne Smelters and the Hansen Road pipeline for distribution to industrial customers to the north of Gladstone. Treated water is supplied from the Gladstone Water Treatment Plant to Gladstone City Council and Calliope Shire Council;
· Yarwun Industrial Estate and Fisherman’s Landing. From this part of the system, raw water is supplied to the Yarwun Water Treatment Plant, Ticor, Stuart Shale Oil, and to QCL and the Gladstone Port Authority at Fisherman’s Landing. It also supplies the pipeline to Mt Larcom; and
· Mt Larcom. This includes raw water supply to the QCL Mine and Mt Larcom township.
Water is provided to some groups in treated form and to others untreated, and the different costs associated with each are identifiable. It is also possible to attribute clearly and unambiguously certain infrastructure such as spur-lines to specific users.
In its Draft Report, the Authority recommended that a differentiated cost structure be adopted with prices based upon users’ share of common infrastructure together with costs related to any infrastructure specific to their own requirements. To estimate the relevant share of the common infrastructure the water supply system was disaggregated into eight raw water segments and one treated water segment.
Stakeholder Comment In initial submissions, GAWB and all customers support the adoption of differentiated prices. Comalco argued that, if differential pricing was used, the prices at each customer node should be based only on the asset base and operating costs relating to water delivery to that node.
Calliope Shire Council and Gladstone City Council submitted that GAWB and the two local governments have accepted that differentiation would make the cost of water to Calliope prohibitive. Calliope advised that ‘the decision to originally form the water board clearly shows that the provision of water supply to the region has no relationship to the location of local government boundaries’.
Calliope also argued that the supply of treated water to the local governments represented a guaranteed demand, resulting in a lower risk to GAWB, which should be reflected in lower prices to the local governments.
SunWater supported the approach of differential pricing within major service categories provided there were substantial differences in short run marginal costs. CPM, CS Energy and Brisbane Water supported price differentiation on the proviso that it reflected actual differences in GAWB’s cost of delivery.
In response to the Draft Report, Comalco submitted that the disaggregation of raw water delivery services beyond the four broad categories suggested by GAWB (Awoonga Dam raw water, Gladstone raw water, northern area raw water and treated water) would add to administration costs and price complexity. Comalco further added that the disaggregation of the raw water services was inconsistent with the ‘bundling’ together of all treated water services.
NRG Power Station (Gladstone) was concerned that the bundling together of all treated water services into one segment resulted in higher prices for industrial customers in the Gladstone area. It requested that this cross subsidy be removed by setting different prices for industrial customers supplied by the Gladstone City and Calliope Shire Councils. SEQWater supported combining the two councils as one group.
33 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
GAWB advised that changes in system segmentation are likely to occur as a result of reconfiguration of the Mt Mille r pipeline and the northern area raw and treated water services. In particular, GAWB suggested that a separate treated water sector may be identified for supplies from the Yarwun Treatment Plant to northern area treated water customers, including new customers at Aldoga and Mt Larcom.
QCA Analysis In response to Comalco’s concerns, the Authority considers that the establishment of prices for each user is more cost reflective and does not add to administrative costs or complexity, as GAWB already identifies costs on such a basis. It is therefore proposed to maintain the approach adopted in the Draft Report.
Regarding NRG’s submission, it is proposed that treated water supplies to the Councils be combined for pricing purposes on the basis of historical arrangements, but that separate cost reflective prices be set for GAWB’s industrial treated water customers.
The costs of future augmentation of supply to meet growth in demand, such as the proposed Stage II raising of Awoonga Dam or sourcing water from Baffle Creek, would result in a revised cost of total supply to be borne by all customers. Such augmentations, as well as those that may be specifically developed to provide a drought reserve, may have implications for the segmentation of the system and the allocation of costs between customers.
The Authority engaged SMEC to review the basis for segmenting costs related to the water supply system to allow effective cost allocation for users. On the basis of SMEC’s review, the system cost segments for raw water services are as follows:
· Awoonga Dam;
· Awoonga to Toolooa;
· Toolooa to Gladstone (Fitzsimmons St Reservoir);
· Gladstone (Fitzsimmons St to Gladstone Water Treatment Plant);
· Gladstone to Boat Creek Junction (Mt Miller pipeline);
· Gladstone to Yarwun (existing Hansen Road pipeline);
· Boat Creek Junction to Yarwun;
· Boat Creek Junction to Fishermans Landing; and
· Boat Creek Junction to Aldoga.
In addition, there are spur-lines to Boyne Smelters (from Toolooa), QAL (from Gladstone), QCL (from Yarwun) and Mt Larcom (from Yarwun).
Following GAWB’s advice that the northern area raw and treated water services were to be reconfigured, an additional segment has been identified for treated water supply from Yarwun to Aldoga and Mt Larcom, and is proposed to be incorporated. While the two Councils are combined for cost allocation purposes, separate cost segments are identified for industrial customers in the Gladstone and Calliope/Boyne Island areas.
The Authority has therefore adopted system cost segments for treated water as follows:
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· Gladstone City and Calliope Shire Councils;
· the northern industrial area and Mt Larcom, from Yarwun Water Treatment Plant;
· Gladstone area industrial customers, including NRG, QAL and Clinton Coal Loading; and
· Calliope and Boyne Island industrial customers, including Boyne Smelters.
Recommendation:
That differentiated prices be adopted, but that the proposal of Gladstone City Council and Calliope Shire Council to be treated as one entity be accepted. To this end, it is recommended that costs should be established for each of the identified segments of the network.
Differentiation between Existing and New Users and Pricing for Excess Capacity
Key Issues Water supply augmentation is typically lumpy and indivisible. Depending on the rate of growth in demand and the availability of augmentation options, augmentation may result in a significant level of excess capacity being present for a significant period of time.
GAWB, being a bulk water supplier primarily to large industrial customers, must manage potentially large demand increments. GAWB can respond to such demand growth in many ways. For example, it can expand capacity in anticipation of demand growth, adopt a just-in-time approach to capacity augmentation or adopt a lagged growth strategy with augmentation delayed until the costs of excess capacity are minimised.
GAWB has responded to Callide Power Management’s increase in demand and potential future demand by lifting the capacity of Awoonga Dam by about 80 per cent, resulting in excess capacity of about 35 to 40 per cent in the initial years.
Two issues require resolution:
· who should bear the costs of the augmentation - users of existing capacity (existing users), users of new capacity (new users), all users, the shareholders of GAWB or other sponsoring authorit ies (such as the Queensland Government which may wish reserve capacity to be held for development purposes); and
· how those costs should be allocated.
The Authority’s Draft Report discussed three main options for addressing capacity augmentation and excess capacity, namely:
· Option 1 - adopt an essentially SRMC pricing approach for existing users with new users meeting augmentation cost (LRMC). Existing users would be required to pay the new level of charges for any demand in excess of that currently contracted;
· Option 2 - apply LRMC pricing to all users with estimates of augmentation costs based on expected growth. If demand for a large customer does not eventuate, augmentation is delayed and LRMC falls. Rebates may be provided to customers if augmentation costs are not incurred, are delayed, or are revised downwards; and
35 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
· Option 3 - apply LRMC pricing to all users based on estimates of augmentation costs with a high probability of being utilised, that is for existing and committed users, plus an ongoing reserve.
Option 1 results in different prices for existing and new users and thus there is no early incentive for existing users to adjust consumption in response to changing aggregate demand. New capacity risk is allocated entirely to new customers and GAWB (which may be seen by some, in some circumstances, as being equitable).
With Option 2, the same price applies to all customers. Under this option, all users have the same incentive to adjust water consumption in response to changing aggregate demand. Because risks are allocated to users, it reduces incentives for GAWB to optimise excess capacity in the future and to actively seek new customers to take up any excess capacity. However, regulatory oversight should ensure that GAWB can only receive a return on optimised capital, thus encouraging more efficient capacity augmentations.
Under Option 3, prices for existing and new users would be the same and both groups would have an incentive to adjust water consumption. However, the approach may involve large price increases for all users when the next augmentation is considered necessary and it fails to signal the costs of augmentation consistently with anticipated growth in demand. It also places the responsibility for all excess capacity on GAWB, even if it is required for least cost supply reasons and therefore it would predispose GAWB to the adoption of short-term high cost capacity solutions.
Stakeholder Comment In initial submissions, most of GAWB’s customers supported some sharing of capacity costs among all users. GAWB further noted that:
‘in a competitive market, existing users are not necessarily afforded any price compensation where production costs increase as demand increases for a product or service. The increased costs may be related to such factors as the scarcity of the product/inputs or diminishing returns to scale. Regardless of the reason, all consumers would have to bear the increased production costs through higher prices.’
In relation to the distinction between existing and new users, CPM, a new customer for GAWB, submitted that:
‘it is aggregate consumption that drives the need for and timing of capacity upgrades. This suggests that all users are jointly responsible for any requirement to augment system capacity, and should therefore share jointly in any increased (or decreased) costs of supply that may result.’
GAWB also preferred that differential pricing did not apply between new and existing customers in respect of capacity augmentation because:
· on their estimates, the relative costs between existing infrastructure and new infrastructure were similar;
· each customer should be treated equally;
· administration for separate pricing would be complex and costly; and
· pricing structures would be less transparent.
Likewise, Brisbane Water was not in favour of differential pricing between existing and new customers, arguing that it enables existing users to position themselves unfairly against emerging
36 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
competitors. Differentiation between new and old customers would also be contrary to Brisbane Water’s use of postage stamp pricing.
Many existing customers have indicated that they should not be required to meet the additional costs of servicing new customers. For example, Calliope Shire Council argued that:
‘The whole purpose of the current raising of Awoonga Dam is to provide water for future industry. This raises the question of who should pay for the spare capacity held for future industry. It certainly should not be the current consumers who have already fully funded the existing facilities over the last 20 years. The State Government has purchased land at Aldoga to serve future industry. Similarly the GAWB will be providing excess capacity to serve future industry therefore the State Government and not the existing consumers should be the stakeholder in this project. Accordingly a strong case exists for differential pricing between current and future customers of GAWB .’
There was no support for meeting all of GAWB’s excess capacity costs. CPM submitted that ‘it was inconsistent with both sound commercial and regulatory practice that users be forced to bear the costs associated with over-investment in capacity ’.
Existing water users, such as CS Energy and QAL, advocated the exclusion of excess capacity from the asset base for pricing purposes. The principal reason provided was that an optimised asset value should be based on actual asset usage and should not include the cost of assets constructed ahead of use or for new customers expected to locate in Gladstone in the future.
GAWB considered excess capacity to be largely a function of meeting growth in existing demand and demand from new customers which requires there to be a reasonable level of excess capacity included in the optimised asset base. However, GAWB’s own price modelling excluded excess capacity in the (then proposed) Kirkwood Road pipeline.
Callide Power Management supported Option 3 for pricing excess capacity, particularly as the current augmentation of Awoonga Dam’s safe yield to 87,900ML in response to committed demand of 55,000ML would create a significant level of unnecessary excess capacity.
CS Energy suggested that GAWB carry the risks, and hence the costs, of excess capacity and that there be no cost pass-through to existing customers to make certain that GAWB’s management ensured due diligence in the running of the business. QAL expressed concern with the scale of GAWB’s augmentation of the Awoonga Dam and the associated capital costs on the basis that there is the potential that existing users will pay for the ‘blue sky’ expectations of GAWB.
QAL suggested that these issues can be mitigated through the adoption of an ‘adjustment mechanism that allows for re-calibrating prices where demand forecasts are plus or minus 10% on those originally forecast in the price determination process; and appropriate asset valuation methodology that allows for the exclusion of redundant, non-income producing regulatory assets.’
QAL suggested the approach provided in the National Third Party Access Code for Natural Gas Pipeline Systems (National Gas Code) for ‘redundant’, ‘speculative capital’ and ‘recoverable proportion’ investment in the capital base of a regulated entity. QAL argued that this approach represented an appropriate means for maintaining GAWB’s incentive to ‘stage’ the development of its water system while ensuring that existing customers pay prices reflective of actual use rather than prices that reflect poor or speculative investment decisions by GAWB.
The concept of a capacity cushion or contingency reserve has also been suggested by the Department of State Development, in the form of an ongoing 15,000ML reserve for GAWB, representing about 35 per cent of existing demand.
37 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
In response to the Draft Report, SEQWater supported the adopted approach. No further comment was received on these matters.
Other Jurisdictions In general, the issue of capacity augmentation costs and resultant excess capacity have not been considered as specific issues by other regulators.
IPART (1996) considered the issue of augmentation costs for electricity distributors and determined that any costs associated with excess capacity should be borne by the provider, unless costs are specific to an individual customer, are large in relation to the overall capital works programme of the supplier or the project can be shown to be persistently uneconomic.
The National Gas Code sets down specific mechanisms designed to balance the inherent risks associated with large stepped investment in infrastructure assets. Section 8.16 allows regulated entities to increase their capital base by the actual capital cost incurred from ‘new facilities investment’ provided:
(a) ‘that amount does not exceed the amount that would be invested by a prudent Service Provider acting efficiently, in accordance with accepted good industry practice, and to achieve the lowest sustainable cost of delivering Services; and
(b) one of the following conditions must be satisfied:
(i) the Anticipated Incremental Revenue generated by the New Facility exceeds the New Facilities Investment; or
(ii) the Service Provider and/or Users satisfy the Relevant Regulator that the New Facility has system-wide benefits that, in the Relevant Regulator’s opinion justify the approval of a higher Reference Tariff for all Users; or
(iii) the New Facility is necessary to maintain the safety, integrity or Contracted Capacity of Services.’
Where a service provider undertakes new facilities investment that does not meet the requirements of section 8.16, the Gas Code allows the service provider’s capital base to be increased by that proportion of the ‘new facilities investment’ which does satisfy section 8.16, defining the proportion as the ‘recoverable portion’. The remainder of the new facilities investment is allocated to a ‘speculative investment fund’ which is drawn down as the new facilities are used, satisfying section 8.16, and therefore added to the regulated entity’s asset base for pricing purposes.
QCA Analysis In establishing who should bear the costs of augmentation and any excess capacity, the Authority has taken into account the characteristics of the water industry generally, as well as the particular circumstances of GAWB.
Water is a resource with few, if any, substitutes and, in any particular region, few alternative economic sources of supply and the community’s interests are best served by directing resources to their most valued use. Its availability can also be limited by the infrastructure in place. All users, existing and prospective, are able to adjust their consumption to reflect the availability of water and related costs. For example, SMEC noted that the demand for industrial water in Sydney has almost halved since the introduction of cost reflective prices. The introduction of cost reflective prices for urban users is also generally associated with reductions in water consumption of 20 to 30 per cent. On the basis of the Authority’s analysis, the cost of augmentation of GAWB’s capacity, on a per megalitre basis , will rise over the longer term, if not under the current augmentation (see Chapter 6).
38 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
To ensure that water is allocated to its best use over the longer term, the cost of water should reflect the full value of the resources used in its delivery and any scarcity value that may accrue (including any environmental costs). To the extent that existing prices do not reflect the value of resources used, to apply differential prices between existing and new users may result in water being used in a less efficient manner.
Any differences between individuals’ prices should only refle ct differences in their use of the monopoly infrastructure (dams, pipelines and treatment plants) and any commercial differences (eg. quantity demanded, long term vs short term contracts and the like).
The Authority concluded that prices differentiated between existing and new users are potentially inconsistent with other matters which the Authority is required to consider under the QCA Act 1997. In particular, the application of differential pricing between existing and new users may have a detrimental impact on regional development to the extent that higher prices for new users would deter investments in the region in the future (when costs are expected to rise). Equity issues are also involved in charging different prices to different customers, or charging different prices to existing and new users, for the same product or service.
In any case, the Authority’s estimates indicate that, on average, prices for current users will be virtually unchanged from those that would have applied had the augmentation not proceeded.
Having regard to all of the above considerations, the Authority considers that existing and new users should pay the same price for common infrastructure services.
Current contractual arrangements are not affected by the Authority’s recommendations. However, when contractual arrangements expire, prevailing pric ing principles should be applied.
In relation to the question of who should carry the cost of excess capacity, it is considered that GAWB has responsibility for the management of supply and is responsible for identifying appropriate options for capacity augmentation. GAWB can also respond to demand in different ways - it can anticipate, meet or follow demand. If an augmentation does not provide the least cost solution to reasonably envisaged demand, it is considered that GAWB should carry the costs of any excess capacity installed over and above the assessed requirements. Conversely, GAWB should also enjoy any benefits on its ‘speculative investments’ should the relevant demand emerge. The value of such investments would then be incorporated in the asset base and incorporate a rate of return compounded from the time the investment was made.
However, as will be discussed in Chapter 6, the current augmentation represents the long run least cost of supply and the extent of excess capacity is therefore reasonable.
Recommendations:
That the costs of common infrastructure be allocated to all users provided they represent the least cost option to meet envisaged demand.
That GAWB should be responsible for the costs of any excess capacity not considered optimal.
5.6 Pricing for Seasonal Demand Variations
Where consumption is volatile, a water business may be justified in implementing peak and off- peak tariff structures (either on a daily or seasonal basis).
In off-peak periods, the system has excess capacity. Peak period demand typically accounts for installed capacity and drives decisions relating to further capacity augmentation. It is generally
39 Queensland Competition Authority Chapter 5 - The Framework for Monopoly Prices Oversight
contended that efficiency objectives would be met by charging all customers on the basis of SRMC in off-peak periods and LRMC in peak periods (Campbell, 1999).
The main issues in setting seasonally differentiated charges are determining the seasonal peak periods, establishing who the peak users are, and meeting the additional costs of administration and metering if required.
Stakeholder Comment
In initial submissions, CPM expected its demand to be relatively stable and observed that capacity augmentations are not driven by variable peak demand requirements. It noted: ‘This suggests limited efficiency gains (if any) to justify the considerable administrative investment necessary to support a peak/off-peak pricing framework’. CS Energy was more concerned with security of water supply and a predictable economic price over the long term than with the ‘complexities of peak and off peak pricing’.
No further submissions were received on these matters in response to the Draft Report.
QCA Analysis
Based on an examination of recent years’ actual consumption, demand by the major industrial customers is generally constant on a monthly basis from year to year. Any peak demands that do occur are not consistent across years. Although there are likely to be some seasonal variations in use, these are not substantial. Nor does urban demand exhibit significant seasonal variation. Further, augmentation of storage is not driven by peak demand pressures, but by new industrial developments.
The Authority is currently of the opinion that seasonal pricing or peak/off-peak pricing is unnecessary at this stage.
Recommendation:
That seasonal pricing and peak/off-peak pricing refinements are not currently justifiable.
40 Queensland Competition Authority Chapter 6 - The Asset Base
6. THE ASSET BASE
Summary
The Authority recommends that Depreciated Optimised Replacement Cost (DORC) should be used for establishing asset values as a basis for setting maximum prices for customers.
DORC ensures that over-capacity, over-engineered and over-designed assets are not included in the asset base and consequently are not paid for by customers. It allows for technological change as assets can be valued in a way that reflects current technology. Sub-optimal excess capacity and redundant assets are excluded from the asset base.
On the basis of SMEC’s advice that the current augmentation is optimal, the Authority accepted that the current dam raising represents the preferred augmentation option for demand at least until 2020-21.
The existing rock wall construction technology was also considered appropriate as the alternative structures are not suited to the geological characteristics of the site and are less suited to multiple staged developments. The staging of the dam’s construction was considered appropriate to ensure costs were minimised over the long term. Accordingly, staging costs were effectively incorporated by adding the optimised augmentation costs to the existing dam’s value.
The Authority’s ‘just-in-time’ approach for optimisation resulted in changes to the timing and scale of pipeline and reservoir augmentations initially envisaged by GAWB and allowed for immediate upgrades in water treatment services to meet water quality requirements.
Capital contributions by users and capital subsidies provided by the Queensland Government should be recognised where there is evidence that the contributio n was made with the intent of obtaining future price benefits - unless there is evidence that the contribution was a pre-payment for services, returned through explicit pricing arrangements or that it applies to assets that have since been consumed and replaced.
6.1 Introduction
In Chapter 5, the Authority recommended that the cash flow approach be used for the GAWB investigation. For this approach, it is necessary to determine opening asset values, closing asset values, and values for capital expenditure and asset disposals over the period of analysis.
Asset Valuation Approaches
There are a variety of asset valuation methods which are used, for different reasons and in differing circumstances, by both the private and public sectors. However, these methods can be characterised under two main approaches, namely, cost-based and value-based approaches.
Cost-based approaches relate the value of an asset to the cost of purchasing the asset or the service potential embodied in the asset, either at original cost or current replacement cost.
Cost-based approaches include:
· historical or actual cost, which uses the actual dollar cost of acquiring the asset, including the relevant financing cost during construction and installation, as the value of the asset;
· a variant of historical cost, inflation adjusted actual cost, which attempts to adjust the asset value for inflation. This can be done by revaluing assets according to some broad indicator of the price level such as the CPI;
41 Queensland Competition Authority Chapter 6 - The Asset Base
· reproduction cost, which is the cost required to reproduce the existing plant in substantially its present form using the production technology and specifications of the original asset. This approach is most relevant where the existing asset still represents significantly unchanged technology;
· the replacement cost of an asset, which is an estimate of the current cost of replacing the asset with one which can provide equivalent services and capacity to the asset being valued. It measures what it would cost today to provide an asset to deliver the same service potential, including any existing over-servicing or over-capacity; and
· optimised replacement cost, which is an estimate of the current cost of replacing the asset with one which can provide the required service potential in the most efficient way possible. Under this approach, asset values are adjusted if assets exhibit excess capacity, are over-engineered, are sub-optimally designed (having regard to technological advancements) or are poorly located.
In the cost-based approaches, depreciation is typically applied to reflect the service potential of the asset which has expired. In particular, depreciated actual cost (DAC) and depreciated optimised replacement cost (DORC) have been applied in regulatory decisions in Australia.
Value-based approaches determine the value of an asset by reference to its net cash-generating capacity. The value-based approaches include:
· Net Present Value (NPV), which values an asset as the present value of the predicted cash flows generated by the asset; and
· Net Realisable Value (NRV), or fair market value, which is the price that the asset would achieve in an open market. This reflects the value of an asset in its next best use.
In a regulatory context, value-based approaches are often affected by the problem of circularity as the asset value is determined by (regulated) prices and revenues which, in turn, are based on the asset value.
A hybrid approach, referred to as the optimised deprival value (ODV) method, values an asset as the loss that might be expected if the entity was deprived of the asset.
ODV is the lesser of the depreciated optimised replacement cost (DORC) and the Economic Value (EV) of an asset, where the latter is the maximum of the asset’s net present value (NPV) or net realisable value (NRV) (Figure 6.1).
Figure 6.1: Optimised deprival value
DORC
ODV Minimum of NPV
EV Maximum of
NRV
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If EV is less than DORC, then the asset would not be replaced and the loss would be equivalent to EV. On the other hand, if EV is greater than DORC, then the asset would be replaced and the loss would be equivalent to the cost of doing so, that is, DORC for an equivalent asset.
ODV has been endorsed by COAG as the preferred approach for valuing network assets for public reporting processes (performance monitoring) and by the Agricultural and Resource Management Council of Australia and New Zealand (ARMCANZ) as a basis for water pricing, unless specific circumstances justify another method.
Other Jurisdictions
There appears to be a general move by Australian regulators to adopt DORC as the preferred method for valuing utility assets. However, in recent water sector regulatory decisions, the ODV approach has been preferred. In determining maximum prices for medium term price paths for NSW water agencies, IPART (2000a) calculated EV as the net present value of existing cash flows projected into the future.
IPARC’s (1999) price determination arrived at a similar conclusion for ACTEW’s water and sewerage business, but applied DORC for the electricity assets.
A summary of recent regulatory approaches to asset valuation is provided in Table 6.1.
Table 6.1: Approaches to the valuation of water assets by other regulators
Regulator/Decision Approach Comment
IPART – Hunter Water, Sydney Water, ODV (Economic Asset values for first regulatory decision based on Gosford and Wyong Councils (2000a) value) NPV of cash flows.
IPARC (ACTEW) (1999) ODV Opening value based on DORC for electricity assets, economic value (NPV of cash flows) for water and sewerage assets.
GPOC (2001) DORC DORC for Hobart Water, methods used for other authorities based on independent valuations.
Ofwat (1999b) Modern Equivalent Method appears analogous to DORC. Replacement Cost
Stakeholder Comment
In initial submissions, all stakeholders, apart from Comalco, supported the Authority’s valuation of GAWB’s asset base using DORC. GAWB considered that the circularity problems of using EV could not be satisfactorily resolved, and that, where EV had been applied, the circumstances were different from those of GAWB.
Comalco preferred the use of EV but as a second option supported DORC as the upper limit for GAWB, on the proviso that DORC methodology be unrestrained and reflect a greenfields optimisation. To support its claim, Comalco engaged GH&D and Pricewate rhouseCoopers (PwC) to determine indicative estimates of EV and DORC for GAWB, the latter based on greenfields optimisation.
No further submissions on this matter were received in response to the Draft Report.
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QCA Analysis
The Authority considers that historic cost valuation methods can at times have advantages in terms of the availability of data as to the actual level of expenditure on assets. However, historic cost valuation approaches:
· do not have any relation to market values or replacement costs and therefore do not provide any relevant signals for future investment or consumption of services by users;
· may lead to price shocks when assets are replaced; and
· even when adjusted to reflect inflation, fail to capture the impacts of technological change or over-engineering.
Replacement (or reproduction) cost more closely approximates the actual cost of a new entrant in the market, thereby more closely replicating the outcomes that might be expected from a competitive market. The main disadvantage of this approach is that it measures what it would cost today to provide an asset to deliver the same service potential as the asset being valued, even though part of that service potential may not be needed.
ODV provides an appropriate method for the valuation of assets. However, because of the circularity problem outlined earlier, EV is generally not suitable for regulatory pricing purposes and this is the case with GAWB.
Accordingly, the Authority considers that DORC provides the most appropriate basis for valuing GAWB’s assets for pricing purposes. It provides a ‘ceiling’ to asset valuations above which GAWB would be considered to be receiving ‘monopoly’ returns (ie , returns above those sufficient to sustain investment and commercial operation).
While DORC involves more subjective judgement in determining the optimal network configuration and the degree of excess capacity deemed to be efficient, this can be addressed by ensuring appropriate technical expertise is applied in the process.
Recommendation:
That DORC be used as the basis for establishing initial asset values for GAWB.
6.2 Optimisation
The Basis for Optimisation
A key issue in establishing DORC is the basis for optimisation. Optimised values can range along a continuum depending on baseline assumptions. A pure ‘greenfields’ approach assumes that construction of assets occurs without the constraints imposed by existing other infrastructure or developments. A ‘brownfields’ approach accepts these constraints.
A practical brownfields approach is ‘incremental optimisation’ which is based on the premise that the existing assets would be replaced using fundamentally the same configuration as used presently. This approach identifies:
· redundant (or stranded) assets that may have been economically justif ied initially but have subsequently become uneconomic ;
· over-engineered or gold-plated assets that could be replaced with a lower-cost design without any impact on standard of service, safety, security and reliability; and
44 Queensland Competition Authority Chapter 6 - The Asset Base
· excess capacity.
Under incremental optimisation, costs associated with the staging of development are incorporated if such staging is considered optimal.
For its Draft Report, the Authority engaged SMEC to assess GAWB’s storage, distribution and treatment assets. SMEC indicated that, in general:
· development of storage and distribution infrastructure by GAWB in stages to meet demand growth over time represented the least cost means of service delivery; and
· once a particular approach to dam construction technology had been adopted, it was not possible to cost effectively alter the approach.
In addition, in respect to GAWB, SMEC noted that:
· the relatively recent nature of much of the infrastructure indicated that, in any case, the technology associated with its provision has not altered in any significant manner; and
· a ‘just-in-time’ approach, requiring all planning, approvals and design details to be completed and ready to proceed, is appropriate to manage GAWB’s lumpy supply and demand growth. This approach allowed for lead times of three to four years for storage augmentation (allowing for construction and time for filling, assuming that planning, investigation, environmental studies, design and approvals are completed in readiness) and one to two years for distribution infrastructure.
The Authority accepted SMEC’s assessment and requested SMEC to optimise GAWB’s asset base for each demand scenario on this basis.
Stakeholder Comment
In initial submissions, SunWater, QAL and CS Energy suggested a brownfields approach to optimisation, although there were differences in how brownfields would be defined. General indications were that the optimisation process should:
· remove obsolete assets;
· remove the value associated with gold plating of assets;
· provide allowance for technology changing asset values; and
· establish an asset value that reduces the risks of by-pass.
Comalco argued for a greenfields optimisation, and provided an estimated optimised value from GH&D and PricewaterhouseCoopers, which was based on a re-siting of the dam and use of updated technology. The resulting value for the augmented dam and distribution network was $95m ($140m less $45m of depreciation). Comalco also estimated an economic value of $65.9 million for the augmented dam, based on current profit levels and excluding treated water assets and working capital.
The method of asset valuation proposed by Comalco had a number of difficulties which were identified by SMEC:
· it excluded a contingency allowance for significant unknowns, such as material suitability, geo-technology, structural details, survey information and hydrology assumptions (which could raise costs by 25 to 40 per cent);
45 Queensland Competition Authority Chapter 6 - The Asset Base
· it excluded infrastructure relocation costs, land, construction financing costs and preliminary costs such as environmental impact assessments, and included low on-costs for investigations and management supervision;
· it was based on a greenfields approach incorporating a re-siting of the dam wall and use of roller compacted concrete technology with no staging of development, options that were unrealistic given the staged development of the dam over a number of years (see further discussion of this issue below); and
· the depreciated value assumed that the dam including the present augmentation was already 23 years old. This had the effect of reducing the current depreciated value of the assets.
Callide Power Management submitted that:
‘Optimisation is an integral aspect of DORC asset valuation… Optimisation would see the Board’s assets valued on the basis of what configuration would be built now to service existing and prospective future demand. It does not matter whether previous decisions were ‘appropriate’ given information available at the time, rather it seeks to value the assets that a hypothetical new entrant would construct to deliver the required service potential at lowest cost’.
CPM further added that competitive markets do not permit participants to recover from their customers the costs of poor investment decisions. CPM supported an approach for assessing alternative supply options for prospective/committed demand through temporary yield-increasing measures such as an inflatable barrier or reductions in annual supply reliability. Such options could have reduced GAWB’s exposure to interest and construction expenses.
In their responses to the Draft Report, CPM and Comalco were concerned that:
· optimisation should have considered the least cost way to service present and reasonably expected future demand, assuming a greenfields site and no other constraints; and
· reproduction cost, repeating the same design and construction as exists, is not optimisation. Consideration should be given to whether an alternative construction technology might have given a different valuation.
Comalco added that an optimisation approach which incorporates the additional costs of staging the storage development is ‘flawed and inconsistent with the desired competitive market benchmark’. Comalco noted that ‘competitive markets re-rate asset values to reflect that of the least cost new entrant, and effective regulation should seek to surrogate the same outcomes’.
Comalco’s submission further noted:
‘More importantly, the entire model of current cost (replacement cost) valuation is grounded in the concept of opportunity cost – what is the equivalent present value of resources committed to delivering the desired service. Opportunity cost is a symmetrical concept in that the opportunity cost of an asset today might be lower or higher than the actual cash outlay made when it was acquired. By putting a ‘floor’ under the asset valuation – the effect of requiring that the asset value cannot fall below the costs of staged construction – the QCA has denied this symmetrical relationship’.
In regard to future optimisation exercises, Comalco considered that the same principles should apply, that the assets should be fully revalued to reflect the least cost way of meeting present and future demand at the time. In this way, future valuations should not be simply based on adding required new assets to the existing asset base.
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QCA Analysis
In its Draft Report, the Authority indicated a preference for an approach to optimisation which reflected demand, technology and management practices current at the time of the review. In other words, an approach which resulted in an asset value which reflected the minimum costs consistent with expected demand.
The approach proposed by the Authority also allowed for the staging of infrastructure augmentation. CPM and Comalco considered that competitive market “rerate asset values to reflect that of the least cost new entrant” and that the least cost assets would be those consistent with meeting present and future demand at the time of the review.
The Authority notes, however, that the least cost asset base consistent with future demand will be that which minimises the present value of the costs involved and many involve staging of asset augmentations over the regulatory period. Furthermore, should the Authority not recognise past staging costs considered consistent with minimum cost of servic e provision, a service provider will, in effect, be penalised for adopting the least cost solution. To penalise such service providers will remove their incentive to undertake any augmentation. Such an approach does not introduce a ‘floor’ under the asset valuation as, if the staging approach adopted is not considered appropriate, or if the level of demand had been inaccurately estimated by the service provider, the appropriateness of the staging adopted would also be reassessed.
The Authority’s approach thus only provides an entity with a return on those assets consistent with the least cost of service provision consistent with present and future demand.
Recommendation:
That the incremental optimisation approach be retained as being more closely aligned with optimal capacity decisions over time, and that staging costs continue to be recognised.
Optimisation of Storage Assets
For the Authority’s Draft Report, SMEC reviewed the appropriate construction technology and the appropriate scale and location of storage infrastructure.
In regard to the construction technology, the existing dam is a concrete-faced rockfill structure, with rocks excavated on-site from the construction of the spillway. While this lowered the material costs, additional costs were incurred in the dumping of excess rock.
According to GAWB’s 1976-77 Annual Report, the rockfill construction was considered in lieu of the original massive buttress concrete design due to foundation problems encountered on the right abutment. The rockfill design also offered economies of construction with a dam height of FSL 30 being achievable for a moderate cost increase over the FSL 25 concrete dam proposal. The advantage of the rockfill structure is that it is more amenable to staged augmentations.
The alternative roller-compacted concrete technology required that the dam base structure be constructed with a view to the eventual scale of the fully augmented dam, necessitating substantial additional capital expenditure at an early stage. A roller-compacted structure was therefore less attractive where multiple staging may occur.
Accordingly, the Authority accepted that the current dam construction technology is appropriate for Awoonga Dam.
In regard to the scale and location of storage augmentation, SMEC examined alternative options for raising Awoonga Dam to FSL 33.5 (rubber dam on the spillway), 35, 38, 40, and 45, as well as other options such as Castle Hope Dam and Baffle Creek Dam. The rubber dam option was
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insufficient to meet the additional demand for Callide Power Management. For the FSL 35 option, planning for the next augmentation would be required almost immediately and with no better demand data being available.
SMEC indicated that any optimising to FSL 38 rather than FSL 40 was not appropriate under its ‘just-in-time’ methodology which takes the development timeframe, reasonable technical and economic considerations and the demand outlook into account. More specifically:
· a raising to FSL 38 was found to be cost inefficient on the basis that a further raising would be required in 2005-06 or 2006-07 under the preferred planning scenario, providing insufficient time for planning, approval and construction;
· raising the dam to FSL 40 rather than FSL 38 was cost effective as only an additional $6 million was required to increase safe yield from 76,900ML to 87,900ML. Both options require the relocation of inundated rail and road infrastructure; and
· raising the dam to FSL 40 would mean that a further raising would not be required for at least ten years, probably 20 years, which was considered to be an acceptable period given the lead times involved.
Based on available information, SMEC also identified the preferred augmentation options for meeting GAWB’s long term storage needs, and found that, on an annualised basis, marginal capacity costs can be expected to rise steeply beyond the current augmentation (Figure 6.2).
Figure 6.2: Marginal Costs of Water Supply Augmentations 2
New supply from Baffle Creek $800.00
$700.00
$600.00
Stage 2 augmentation $500.00
$400.00 Current augmentation
Existing Awoonga Dam $300.00
$200.00 1 20,000 40,000 50,001 70,000 88,100 98,100 113,800 123,800 Total supply capacity
SMEC confirmed that, on balance, the current storage augmentation was optimal in terms of timing (satisfying the ‘just-in-time’ criterion) and size, but some costs being incurred for later
2 The marginal capacity costs shown in Figure 6.2 are estimated per megalitre of capacity. As such, the costs shown are not indicative of prices recommended by the Authority, which are estimated on a per megalitre of demand basis.
48 Queensland Competition Authority Chapter 6 - The Asset Base
augmentations could be optimised out. SMEC determined that, for the FSL 40 option, an additional $10.6 million was being incurred by GAWB in preparation for the next augmentation presently envisaged to be FSL 45. This comprised $7 million in infrastructure relocation costs and $3.6 million in construction costs for 2.6 metres of embankment raising.
Other supply options, such as Castle Hope Dam and Baffle Creek Dam were not viable options for the present augmentation primarily for cost reasons. Compared to $2,750/ML for the current raising, Castle Hope had a cost of $4,564/ML while Baffle Creek had a cost of $6,372/ML. The SMEC analysis excluded the value of land at the Castle Hope dam site held by GAWB from the asset base as it was no longer required.
SMEC also reviewed the appropriate allowance over the projected levels of demand to meet unforeseen temporary new demands and variations in demand from existing customers (i.e. the capacity cushion). Options for determining the capacity cushion are to base it on industry norms for excess capacity, to determine a measure based on the requirements of existing and potential customers or to adopt a defined proportion of current usage. SMEC considered alternative criteria for determining allowable excess capacity:
· a fixed proportion of 20 per cent of usage for storage and ten per cent for treatment plants and distribution systems;
· a ten per cent over-allowance on predicted demands;
· a nominal buffer of 10,000ML; or
· expected growth plus allowance for one or two major new customers.
Under the preferred planning scenario in the Draft Report, a capacity cushion of between 6,500ML and 3,600ML from 2014 to 2020 was identified. While this capacity cushion fell short of the criteria listed above, it appeared reasonable in terms of SMEC’s ‘just-in-time’ framework under which augmentation would be deferred until a major customer materialises to justif y investment or projected aggregate demand becomes more certain.
This approach was also consistent with a view expressed by Ofwat (2001) which noted that a deferral of investment in excess capacity may be more valuable than the increase in risk of insufficient capacity for a short-lived period. Clearly, over the period, all planning and environmental approvals should be put in place to cater for any new commitment that may arise. In GAWB’s case, a premature Stage 2 augmentation to FSL 45 involving an additional 25,700ML of safe yield is at risk of being unutilised for a number of years.
In summary, the Authority’s Draft Report recommended that GAWB’s storage assets be optimised on the basis that:
· the current storage construction technology is considered appropriate;
· the current dam raising to FSL 40 is the most appropriate augmentation strategy, but that $10.6 million in asset relocation and construction costs that are being incurred in preparation for a raising to FSL 45, should be excluded;
· sufficie nt capacity cushion exists under the preferred planning scenario to defer the Stage 2 augmentation to beyond 2020-21; and
· the value of the land at Castle Hope be excluded from the asset base for pricing purposes.
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Stakeholder Comment
In response to the Draft Report’s asset valuations, GAWB disputed the exclusion of $3.6 million in embankment raising costs and $7 million in infrastructure relocation. GAWB submitted that the dam embankment should not have been optimised out of the asset base as it was not technically feasible to do so, and that the additional material cost was only $41,500. GAWB added that, if construction had to be re-mobilised at a later date to add the additional embankment height, the cost would be well in excess of the cost already incurred.
In relation to the road relocation costs, GAWB argued that the additional relocation costs were optimal on a present value basis. It advised that, because of alignment issues and necessary bridgework, the road relocation costs required for the next augmentation were no higher than the minimum cost option for the current augmentation. That is, the revised cost estimates for the alternative alignment options were virtually identical regardless of the choice of augmentation strategy.
DNR&M considered that the additional embankment height was potentially cost effective in forestalling a spillway upgrade that may be required in future by the Department in its role as the dam safety regulator.
DNR&M also expressed concern about timing dam raisings to ensure that sufficient time is allowed for filling. It suggested a ‘cautious approach’, arguing that ‘dam raisings should be commenced in sufficient time to allow for the additional yield required to be available even if well below average rainfall is experienced’.
GAWB also noted that it is subject to a commercial requirement to always have capacity to provide for regional growth and stable pricing, and it considered that, given the lead times required for infrastructure development, commitments to additional capacity are required well before demand impacts are felt.
CPM noted that the capex of the Awoonga Dam raising should be revised downwards to reflect cost savings achieved by the Awoonga Alliance.
SEQWater observed that storage construction costs tend to be lumpy and to involve substantial size economies up to a certain size. These construction cost variables often determine the optimal size of the dam rather than short or medium term demand.
QCA Analysis
The Authority engaged SMEC to respond to the issues raised in relation to the optimised valuation of Awoonga Dam. SMEC noted that the additional embankment height was valid in engineering terms as it provided advantages in terms of flood immunity and future construction efficiency. However, SMEC concluded that, based on the financial criteria, the embankment raising should have been delayed and excluded from the asset base if the next augmentation is required after 2014. There is also a risk in assuming that a further raising of Awoonga Dam is the most cost effective option for storage augmentation in the future as the safe yield for such an augmentation remains subject to revision.
SMEC also advised that GAWB’s estimate of $41,500 for the additional embankment cost overlooked the cost of extending the downstream face of the dam wall to support the embankment. Nevertheless, SMEC revised its estimate of the cost from $3.6 million to $2.4 million (July 2001 dollars), because of savings achieved in the actual cost of rockfill and the substitution of shotcrete for reinforced concrete on the upstream face during recent construction.
As no augmentation is currently foreseen as being necessary until after 2020, it is proposed that $2.4 million relating to the Awoonga Dam raising be excluded from the asset base.
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SMEC confirmed GAWB’s contention that the decision to relocate the road to the higher elevation and alignment to avoid a further relocation in future was the minimum cost option. It is therefore proposed to accept that the road relocation costs of $7 million not be excluded from the asset base.
Since the Draft Report, advice has also been received from SMEC in respect of:
· a significant reduction in the full capital cost of the raising by the Awoonga Alliance Development (down from $106 million to $97.2 million). This saving was in part due to contingencies for weather disruptions that were not encountered; and
· an additional $4.4 million in initial project development costs (for planning studies, environmental assessments and approvals, and preliminary design work) were omitted from the Draft Report estimate and should be included as part of capital costs.
A comparison of the estimates of asset values in the Draft Report and proposed revisions to asset valuations as at 1 July 2002 (in July 2001 dollars) for the Awoonga Dam raising, including land acquisition costs, is shown in Table 6.2.
Table 6.2: Summary of adjustments to Awoonga Dam raising asset valuations ($ million, July 2001) Draft Report Recommended Final Full cost of dam raising 106.0 97.2
Less optimised embankment -3.6 -2.4
Less optimised road relocation -7.0 0
Plus planning and design costs 0 +4.4
Total 95.4 99.2
In response to GAWB and DNR&M’s preference for a more cautious approach to the timing of future augmentations, the Authority engaged Cardno MBK to advise on lead times for dam developments, and sought further advice from SMEC on filling times. The conclusions drawn from this advice were that:
· for a greenfields dam development, a lead time of around seven years would be required to commissioning, including the completion of a Water Resource Plan (WRP), options and feasibility studies, impact studies, development and environmental approvals, design, construction and licensing. For a future Awoonga Dam raising, with planning and feasibility studies already in place, the process may be shortened to three to five years (Cardno MBK);
· filling time for the next raising is estimated within a range of one month to fourteen years, with a most likely estimate of 2.7 years (SMEC); and
· a total lead time of six to eight years would need to be allowed to ensure that the next raising of Awoonga Dam is completed and filled and to meet new demand.
To apply SMEC’s ‘just-in-time’ principle, GAWB would need to commence work on the next augmentation up to eight years before it is required. However, on current information, and based on the preferred planning scenario, the commissioning of the next augmentation is not required until some time after 2020-21. In addition, the capacity cushion under the revised preferred planning scenario establishes that an amount of 5,500ML is available until 2020-21, compared to 3,600ML in the Draft Report. A sufficient planning ‘window’ therefore exists before any further
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augmentation is necessary, on the basis of current estimates of demand and hydrological information. However, constant monitoring of demand is warranted.
Figure 6.3: Demand Growth and Storage Capacity Comparison
90,000
85,000
80,000
75,000
70,000
65,000
Megalitres 60,000
55,000
50,000 Projected Demand Safe Yield 45,000
40,000 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21 Year
In summary, the Authority recommends that the storage infrastructure asset base of GAWB be optimised on the basis that:
· the current location and storage construction technology is considered appropriate;
· the current dam raising to FSL 40 represents the least cost supply option with the exception that $2.4 million in construction costs that are being incurred in preparation for a raising to FSL 45, should be excluded from the asset base for pricing purposes; and
· sufficient capacity cushion exists under the revised preferred planning scenario to exclude the Stage 2 augmentation from current pricing considerations.
Raw Water Distribution Assets
The pipelines and associated facilities incorporated in the asset base for the Draft Report included the recent upgrade of pumps at Awoonga Pump Station and the duplication of the pipeline through to the Mt Miller off-take as these were considered optimal. The installation of a 50ML Toolooa Reservoir to enable more efficient pumping and gravity feeding into Gladstone and to provide for a future raw water main to Mt Miller to supply new industry in the Yarwun and Aldoga areas was also included. SMEC considered that capital costs of $23.1 million could have been deferred until 2002-03, and that $1.9 million in pipelines serving the Fishermans Landing area could have been delayed until 2004-05 if a ‘just-in-time’ approach were adopted. SMEC’s adjustments were incorporated into the optimised asset base for the Draft Report.
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However, for envisaged growth, SMEC also identified the need for further expansion of the network as follows:
· Awoonga to Toolooa: a third pump at Awoonga Pump Station and additional pipeline capacity downstream of Toolooa Reservoir was required in 2006-07 at a cost of $6 million. This pipeline would be further augmented in 2016 and the Toolooa Reservoir capacity increased in 2018;
· supply to northern industrial areas: the new Toolooa Reservoir provided the technically and economically most appropriate option for supplying future large industrial developments in the Aldoga and Yarwun areas. Delivery was best achieved by a new Mt Miller trunk main with pumps at the off-take from the main pipeline south of Gladstone to a new reservoir at Mt Miller. These works would be installed in 2001-02 at a cost of $19.7 million and duplicated in 2017-18 at a cost of $14.4 million; and
· supply to Aldoga: an additional pipeline was required from Mt Miller to new customers in the Aldoga area, in 2003-04 at a cost of $6.4 million.
Stakeholder Comment
In response to the Draft Report, GAWB advised that the alignment and timing of the Mt Miller pipeline is being changed following further analysis of changes in demands. The pipeline is now proposed to follow an alignment from Gladstone rather than from Toolooa to achieve savings in capital and operating costs. GAWB also advised that the installation of the pipeline would be deferred from 2002 to 2003.
Comalco considered that the optimised valuation of the Mt Miller pipeline should reflect the cost of whatever new works would be installed now to meet present and future forecast demand, in the hypothetical event that replacement was required.
QCA Analysis
SMEC was engaged to advise on the issues raised in submissions and to assess other impacts of changes in demand projections. SMEC concluded that, for the revised demand scenario:
· Awoonga to Toolooa: the third pump at Awoonga Pump Station could be further deferred to 2013-14 at a cost of $2.3 million This lower cost excludes the additional pipeline capacity downstream of Toolooa which is not required for the reconfigured Mt Miller pipeline;
· supply to northern industrial area: the realignment of the Mt Miller pipeline from Gladstone rather than Toolooa results in a reduction in length of some two kilometres. SMEC considered twelve alternative sizing/pumping options, and costed the preferred option at $14.96 million, compared to the $19.7 million estimate used in the Draft Report. A smaller diameter pipeline (900mm pipeline rather than GAWB’s 1130mm pipeline) is most cost effective, with installation deferred until 2003-04. The Mt Miller tank and booster pump is required in 2007-08 at a cost of $6.1 million. A further booster would be installed in 2013-14 at a cost of $0.3 million; and
· supply to Aldoga: the pipeline, boosters, pump and tank would be installed in 2003-04 at a revised cost of $7.62 million. This cost is higher than SMEC’s Draft Report estimate as the re-configured Aldoga pipeline requires an additional booster pump and reservoir.
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Recommendation:
That the scale and timing of raw water distribution augmentation as proposed in SMEC’s analysis be accepted for the purpose of establishing prices.
Treated Water Assets
For the Draft Report, SMEC found that the existing treated water system was either at or below optimum. In relation to water treatment services and treated water delivery, SMEC identified that both the Gladstone and Yarwun Water Treatment Plants required immediate upgrades to meet water quality requirements. The Gladstone Plant should be upgraded to comply with Environmental Protection Agency (EPA) requirements for chemicals and to run nearer capacity during periods of poor raw water quality, adding $1.4 million (2001 values) to the optimised asset base in 2001-02.
The Yarwun Water Treatment Plant required expenditure of $0.5 million in 2001-02 to improve treated water quality and $0.65 million in 2005-06 to increase capacity.
In addition, some of the low-lift rising mains out of Gladstone Water Treatment Plant required augmentation at a cost of $0.7 million in 2001-02. Further pump and pipeline upgrades were required over the 20-year timeframe under the preferred planning scenario, the most significant being a rising main upgrade to Boyne Island/Tannum Sands in 2016-17 at a cost of $4.2 million (2001 values). The main from Gladstone to Glen Eden required expansion in 2003-04 at a cost of $1.1 million.
Stakeholder Comment
Following the Draft Report, GAWB advised that treated water was required in the northern area (for LG Chemicals and potentially Astral Calcining) instead of raw water as initially advised for the Draft Report, and that this required changes to the treated water system. The changes include an upgrade of the Yarwun Water Treatment Plant and increased delivery capacity, with the conversion of the Mt Larcom pipeline from raw water to treated water.
QCA Analysis
The Authority engaged SMEC to re-assess capex for the treated water delivery system in the light of GAWB’s submission, and in response to changes in demand projections. In relation to treated water supply to the northern industrial area, SMEC recommended deferral of the Yarwun Water Treatment Plant to 2002-03 at a cost of $0.3 million (previously $0.5 million) and that pump capacity be brought forward to 2002-03 at a cost of $0.39 million (previously $0.65 million).
SMEC’s other major revisions to treated water distribution were as follows:
· deferral of the Gladstone Water Treatment Plan upgrade to 2002-03 at total cost of $1.5 million rather than $1.4 million;
· deferral of the $0.7 million duplication of the Gladstone low-lift raising main to 2002-03;
· the $4.2 million upgrade of the rising main to Boyne Island/Tannum Sands to be brought forward to 2007-08 because of excessive head in the existing main;
· inclusion of $2.85 million for duplication of the South Gladstone/Toolooa pipeline in 2002- 03 (previously $1.1 million in 2003-04); and
· exclusion of the Boyne Island reservoir duplication in 2013-14 at a cost of $0.8 million.
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While the total capex is virtually unchanged at $12.1 million compared to the $12.2 million in the Draft Report, there are significant changes in the timing of capex.
Recommendation:
That the revised optimal augmentation programme for treated water delivery determined by SMEC be accepted.
SMEC’s Revised DORC valuations
The revised future augmentations, when added to the existing asset base, produce the total asset values summarised in Table 6.3. Compared to the Draft Report, the significant changes are:
· total asset values are higher in 2001-02 due to additional capex for treatment plant upgrades at Gladstone and Yarwun required immediately;
· in 2002-03, the higher DORC for the Awoonga Dam raising is incorporated into opening values;
· in 2003-04, asset values are lower because the Mt Miller and Aldoga pipelines are deferred from 2003-04 opening values to 2004-05; and
· in 2009-10, the duplication of the Boyne Island treated water main is brought forward because of excessive pressure in the existing pipeline.
Table 6.3: Revised asset valuations - GAWB ($m, opening values) 1
2001-02 2002-03 2003-04 2004-051 2009-101 2014-15 2020-21
GAWB Valuations 202.2 208.3 327.2 337.7 376.2 473.9 523.3
SMEC Valuations Draft 191.3 194.2 329.7 360.1 390.1 412.4 473.5 Report
SMEC Valuations Final 199.6 201.8 308.6 360.1 394.1 423.8 457.9 Report
1. Note that the Draft Report values were inflated using an inflation rate of 2.5 per cent, while the Final Report estimates are inflated using a rate of 2.6 per cent.
In general, SMEC’s final estimates of asset values, on an asset by asset basis, are higher than GAWB’s, based on SMEC’s assessment of asset condition and current replacement cost. GAWB’s valuation was based on 1993 values indexed forward. Nevertheless, relative differences between GAWB’s and SMEC’s final valuations over the 20-year period vary:
· over 2001-02 and 2002-03, SMEC’s value is lower as a result of SMEC’s deferral of the Mt Miller pipeline;
· in 2003-04, SMEC’s value is lower due to deferral of the Aldoga pipeline, re-optimisation of the Toolooa to Gladstone pipeline, and reduced valuation of the Mt Miller pipeline;
· over 2004-05 to 2009-10, SMEC’s valuations are higher due to higher condition-based assessments and the bringing forward or addition of treated water distribution infrastructure to meet demand growth in the South Gladstone, Benaraby and Boyne Island areas; and
· over the period from 2014-15, SMEC’s valuations are lower due to the exclusion of the next storage augmentation proposed by GAWB.
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Implications of Service Standards and Other Costs
In assessing optimisation, care must be taken to ensure that required service quality and technical standards are defined. Standards such as water quality, probability of failure, risk levels, downtime and environmental requirements are effectively constraints on the optimisation exercise. Customers may be prepared to pay for higher asset levels where this would ensure that particular service standards were met.
The Department of Natural Resources acts as the industry regulator for GAWB and effectively manages many of these matters.
GAWB’s supply is based on a very high level of supply reliability reflecting the HNFY (87,900ML) of Awoonga Dam. This HNFY is estimated using a simulation model of daily inflows over 110 years of available data and reflects the supply required to survive the previous worst drought. Although it implies 100 per cent reliability, SMEC advises that the actual reliability is in the 95-99 per cent range as the HNFY remains subject to the risk of future droughts being more severe than previous worst droughts and to the unknown effects of climate change.
SMEC considered that, for GAWB, it may be possible to contemplate some lesser level of security than the high reliability currently targeted, in order to defer or downsize works. Some industries may prefer lesser security at a lower price, particularly if they can provide their own on-site reserve capacity or recycling. Both CPM and Comalco suggested that consideration should be given to whether the option of increasing annual yield by reducing supply reliability could defer augmentation.
The Authority, in reviewing GAWB’s pricing practices, is doing so in the context of monopoly prices oversight, and is establishing principles relevant to the establishment of maximum prices. Whether there should exist differentiation in the reliability of supply to different customers is considered to be a matter of commercial negotiation between GAWB and its customers.
6.3 Contributed Assets
The Ministers’ direction to the Authority specifically identified contributed assets as an issue to be addressed as part of the prices investigation.
Contributed assets are those assets that are funded or otherwise provided by a water user, or group of users, for their own benefit or for the collective benefit of water users associated with a particular supply system. Recognition of past capital contributions for pricing is proposed by users on the basis of equity, as contributors of assets should not be required to pay a price for water that includes a return on capital for assets that they have funded. Recognition is also justified by its proponents on the grounds of economic efficiency in that future investment could be discouraged if those water users who are required to make capital contributions do not receive a benefit proportionate to their contributions.
The general principle that ‘double -charging’ should be avoided is recognised in the National Electricity Code (NEC) and the National Gas Code. It is also reflected in the Local Government Guidelines for Full Cost Pricing in Queensland, which states that councils should not double - charge for the capital component of servicing new development areas.
Stakeholder Comment
In initial submissions to the Authority, GAWB agreed with the principle that it should not earn a commercial return on non-refundable funds contributed by customers when setting prices for those customers. However, GAWB argued that contributions should not be recognised where:
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· the customer has already received the benefits of the contribution through lower water prices;
· the capital contribution is subject to existing contractual arrangements between GAWB and the customer as they ‘should not form part of the QCA’s deliberations except in considering the total revenue as part of the Board’s overall commercial position’; and
· the capital contribution was made by the State Government or state authorities for ‘deficit funding’ purposes, with such contributions to be treated as equity.
The Calliope Shire Council and Gladstone City Council submitted that the capital subsidy made available to GAWB by the Department of Local Government should be used to limit the pricing impact on residential customers. The Calliope Shire Council argued that ‘the capital subsidy made available to GAWB by the Department of Local Government must be allocated directly against the cost of water to local government, as this is the direct purpose for which it is given’.
The most significant capital grants scheme is the Local Governing Bodies Capital Works Subsidy Scheme, which provides for grants of up to 40 per cent of the capital cost of eligible assets. Funding is also provided under schemes such as the Small Communities Assistance Program, which provides assistance for the development of new water supply and sewerage services or the upgrading / expansion of existing schemes.
Existing industrial water users, such as Callide Power Ma nagement, CS Energy and QAL, advocated that original capital contributions needed to be recognised by a lower water price. QAL supported the National Electricity Code and National Gas Code approach of excluding contributed assets from the asset base on the basis of fairness and equity. QAL also proposed that the regulator should make every attempt to quantify the value of contributed assets in the event that information is less than perfect. Submissions in relation to claims for contributed assets were made by CS Energy, Boyne Smelters Ltd and QAL.
In response to the Draft Report, GAWB disputed the recognition of contributed assets from a key customer and referred to existing binding contracts in this regard. GAWB also disputed the recognition of capital subsidies provided on behalf of local authorities on the grounds that the value of subsidies had been fully returned through past price concessions. However, no information was made available to substantiate this claim.
SEQWater’s submission supported the recognition of capital subsidies on the basis that the purpose of these subsidies was to benefit customers.
QCA Analysis
Recognition of prior capital contributions in the setting of prices should be determined on the particular circumstances surrounding the capital contribution, and particularly the expectations of the parties at the time the capital contributions were made.
Where a contribution is made towards an asset by a user and the contribution is made with the express intent of obtaining future price benefits (which will usually be reflected in a formal agreement between the contributor and the water service provider recognising these arrangements), there is a strong case for recognition of those capital contributions.
However, there are several other additional factors that need to be considered:
· whether there is any evidence that the contribution was viewed as a prepayment for future services;
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· whether past price reductions have compensated the contributor for that contribution (determined by whether any past price reductions have exceeded the return on capital); and
· whether the contributed asset has been consumed and replaced.
In some instances, formal agreements attesting to the quantum of the capital contribution, its nature, or its purpose, are not available or there may be a lack of clarity regarding those arrangements. In these circumstances, such matters may be discernible from:
· the nature of the pricing arrangements evident from other sources, such as stated pricing policies and/or tariff schedules;
· the management arrangements as they relate to responsibility for certain risks and costs;
· the financial accounts of the contributor which may indicate a right, claim or expectation of future benefits; or
· the existence of capital development or other such charges, details of which may indicate that they are of the nature of a capital contribution with certain price benefits.
GAWB has received various forms of funding contributions over the years. These include:
· capital contributions towards specific assets such as Awoonga Dam;
· funding of cash flow to cover operational deficits;
· security deposits for construction of spur-lines to supply individual customers; and
· capital grants and subsidies from the State Government.
Once contributed assets are recognised, an approach to their recognition in pricing is required. In general, the options are to:
· exclude the contributed asset from the asset base of the water entity for the purposes of calculating capital costs – this approach may be suitable if one user has contributed 100 per cent of the asset, and that user is the only beneficiary of the asset; or
· include contributed assets in the regulatory asset base, but adjust prices by a rebate (or surcharge) to the user(s) making the contribution. This rebate would be equal to the return on capital for the contributed asset.
The Authority recommends that capital contributions be accepted where there is evidence that the contribution was made with the intent of obtaining future price benefits - unless there is further evidence that the contribution was a pre-payment for services, has been returned to the contributor through explicit pricing arrangements or applies to assets that have since been consumed and replaced. The Authority observed that there was general agreement among stakeholders on these principles.
The Authority recommends that, if recognised, assets be included in the asset base for the purpose of determining the revenue requirement, with rebates incorporated in the prices for the relevant customers equivalent to the return on capital, and deducted from GAWB’s revenue requirement.
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Recommendations:
That capital contributions be recognised where there is evidence that the contribution was made with the intent of obtaining future price benefits - unless there is further evidence that the contribution was a pre-payment for services, was returned through explicit pricing arrangements or applies to assets that have since been consumed and replaced.
That contributed assets be included in the asset base for the purpose of determining the revenue requirement, with rebates incorporated in the prices for the relevant customers equal to the return on capital for the contributed assets, and deducted from GAWB’s revenue requirement.
6.4 Recreational Assets
For many water storages, there are significant assets associated with the delivery of other services such as recreational amenity requirements. Examples are picnic facilities, boat ramps, and public safety infrastructure. GAWB provides recreational facilities at Awoonga Dam, which attracted 150,000 visitors in 1999-2000.
In its Statement of Regulatory Pricing Principles, the Authority suggested that the preferred approach is for beneficiaries to meet the cost of recreational services where practical and cost- effective. This is consistent with the position of COAG and the Expert Group on Asset Valuation Methods and Cost Recovery Definitions for the Australian Water Industry.
However, in some instances, there are difficulties in applying ‘user-pays’ principles as transactions costs are typically high. For example, the costs of manning and collecting tolls may exceed revenues collected, while charges for facilities such as barbecues and boat-ramps may also be too costly. Other options include:
· costs being met by state governments as a CSO;
· costs being met by local governments; or
· costs being passed through to water users.
Where the recreational assets are limited to recreational purposes, there would not appear to be a case for their inclusion in the regulatory asset base. However, where such recreational assets provide a means for improved management practices, and where the standard of service is not excessive, there may be a case for their incorporation in the asset base for the pricing of monopoly business activities.
Stakeholder Comment
In initial submissions to the Authority, Calliope Shire Council considered that ‘a reasonable level of funding of recreational assets of the dam should be treated as GAWB’s contribution to the community as a good corporate citizen’. Callide Power Management responded otherwise, arguing ‘that these activities are more akin to community service obligations (CSOs), and specific funding should be provided by the State and/or local governments for their delivery’. CS Energy submitted that recreational facilities should be charged to the beneficiaries of such assets, notionally the residents of adjoining shires. It also disputed the suggestion that managed access provided benefits in terms of water quality and site management, arguing that there may be disadvantages in water quality from vandalism and pollution.
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QAL believed that recreational facilities should not be considered as part of the total cost of water infrastructure and that GAWB should not be able to earn a rate of return on investment and depreciation for these facilities.
Brisbane Water’s view was that facilities that maintained the previous amenity of the catchment and provided water quality benefits should be charged to users. Any additional amenity from the services should be charged to the beneficiaries or treated as a CSO.
GAWB considers that the maintenance of recreational facilities represents a ‘good corporate citizen’ approach to business, an approach that is ‘regularly adopted by major corporations, particularly in regional towns where the corporation is expected to maintain a high community profile and are expected to contribute to projects of benefit to the whole community.’ GAWB observes that it is accepted practice for dam operators that the net cost of these operations be passed through to consumers.
In response to the Draft Report, CS Energy re-iterated its view that the cost of recreational facilities should be charged to beneficiaries, or otherwise be regarded as a community service obligation. SEQWater supported the Draft Report’s inclusion of recreational assets in the asset base, citing benefits in community acceptance of large dams, control of public access and in managing site lands.
QCA Analysis
A significant proportion of the capital involved in the provision of recreational facilities would also be required for the provision of water catchment and site management services (for example, dam operations management, care-takers’ facilities, boat ramps and other facilities). On this basis, and given that the value of remaining facilities is a minor component of total capital, recreational and dam-site facilities were included in the asset base. Revenues from recreational facilities were also incorporated as a revenue item for GAWB.
The DORC of recreational facilities for the current dam is $2.7 million.
Recommendation:
That the DORC of the recreational facilities be included in the asset base.
6.5 Environmental Assets
Environmental assets operated by a water business may include such structures as fish ladders and monitoring equipment. These assets are required to address the externalities or resource management costs of operating water storages and managing catchment impacts.
Under the ARMCANZ water pricing guidelines, externa lities are costs that must be recovered by water businesses, and are approximated by the attributed resource management costs. Hence, assets relating to resource management or catchment impacts should legitimately be incorporated into the asset base for pricing purposes.
To some extent, GAWB has already addressed some of its externalities. It operates a fish hatchery to maintain fish populations and has successfully released barramundi and mullet fingerlings into Lake Awoonga and other waterways. The hatchery operates on an increasingly commercial basis through the sale of fingerlings.
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Stakeholder Comment
In initial submissions to the Authority, Callide Power Management and CS Energy accepted that externalities directly related to harvesting, storage and supply of water should be passed through to water users. However, CPM questioned whether the fish hatchery met these criteria and proposed that it should be excluded from the asset base. QAL submitted that environmental assets and operating costs represented an externality that should be passed through to water users.
GAWB argued that the net costs of the hatchery operations are part of its statutory obligations and should be passed through to customers. GAWB also advised that as the facility is operated jointly with the Gladstone Port Authority, only half of its value should appear in the asset valuation.
No further submissions on this matter were received in response to the Draft Report.
QCA Analysis
The Authority took the view that the fish hatchery would not have been required but for the demands of GAWB’s customers for water storage services. On the basis that the fish hatchery addresses the environmental impacts of storage activities, the Authority recommends that the fish hatchery assets be included in the asset base for GAWB. The DORC for the fish hatchery is $262,000.
Recommendation:
That the fish hatchery assets be included in the asset base for GAWB.
6.6 Working Capital
Working Capital represents the capital required to provide for timing differences between cash inflows (revenues) and cash outflows (expenses) over the short term operating cycle of the entity.
Working capital is typically measured as the excess of current assets over current liabilities.
Apart from the Authority, the only Australian regulators that have considered working capital in depth are the Office of the Regulator General (ORG) and IPART. ORG’s electricity determination (2000) reported that arguments for including a return on working capital pointed to a mismatch between the timing of revenues and costs over an operating cycle which left the entity with a shortfall in revenues. ORG undertook an analysis of this assuming a set of simplifying assumptions regarding the billing and receipt cycle and concluded that:
· if attention focussed only on the revenue required to meet operating expenditure, there was a shortfall in revenue to the electricity distributors;
· if all revenues and costs were considered, distributors were more likely to receive a revenue surplus relative to that required; and
· no working capital adjustment was necessary.
In contrast, IPART (1999e) considered that any business must maintain an investment in working capital to allow it to manage the lag between payments to suppliers and the receipts from customers. Similarly, many businesses also maintain an investment in inventory. IPART noted that to simply apply working capital as current assets less current liabilities would lead to a number of one-off distortions due to the effects of prepaid expenses and accruals. Instead IPART adopted a simplifying formula to identify the level of working capital which reflected the billing cycle for receipts and payments and allowed for inventories. This formula was based on the
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assumption that payments from customers were outstanding for 45 days from the day of service delivery and that suppliers were paid 30 days after service delivery.
The Authority’s determination for electricity distributors (2001) included the value of inventories and the difference between accounts receivable and payable in determining a value for working capital. However, the Authority also noted the potential for perverse incentives for efficient capital management which would require that the level of working capital be scrutinised ahead of the next review.
Stakeholder Comment
In initial submissions to the Authority, GAWB argued that the nature of its business, with a small number of large customers, meant that the requirement for working capital is more pronounced than it would be for a large number of small customers. GAWB concluded that it should be able to earn a commercial return on working capital as it would for any other assets. Brisbane Water observed that working capital should be included in the asset base, but only if the business can demonstrate best practice in the management of debtors, work in progress, and so on.
CS Energy and QAL preferred that GAWB not be allowed to earn a commercial return on working capital on the basis that to do so would send perverse incentives to GAWB to inappropriately manage short term funding requirements at the expense of customers.
No submissions were received on this matter in response to the Draft Report.
QCA Analysis
The Authority recommends that working capital should be determined on the basis of debtors (accounts receivable) less creditors (accounts payable), plus inventories, taken pre-augmentation and expressed on a megalitre basis. In the absence of any reliable data, the requirement post- augmentation is then determined by applying the per megalitre value to delivered quantities expected over the review period.
The Authority found that a five-year average of working capital over the years 1995-96 to 1999- 2000 inclusive was $15.50 per megalitre.
Recommendation:
That working capital be included in the total value of assets.
6.7 Land and Easements
A water business typically holds land for buildings, reservoirs and treatment plants, as well as the area submerged and adjacent to storages. Many water businesses also hold land for potential future dam sites. Easements are a right to construct and operate a pipeline and do not involve ownership of the land involved.
GAWB owns land associated with the Awoonga Dam, associated recreational areas, pump stations, treatment plants, reservoirs and the now abandoned Castle Hope Dam site. Pipelines are located along easements, acquired at the time of construction.
Land held for continued use and that would be replaced is typically valued at its opportunity cost, usually market price.
The appropriate method for the valuation of land and easements is currently the subject of much discussion Australia -wide. Options are to:
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· use historic cost. Depending on the date of purchase, this may be a meaningless figure. It relies on records being available, which may be difficult where assets are gifted or contributed to the operator;
· use historic cost indexed for inflation. This approach enables dollar values to be consistent with valuations for other assets and may better reflect the cost to the entity (and the outgoings on which the investment return is validly expected). Again, the approach relies on records being available; or
· use the market value of the land. Under certain circumstances, this may lead to price shocks. Further, the nature of land and easements is often such that realisation is not an option and, as such, a market value may not be appropriate.
The Australian Competition and Consumer Commission (ACCC) (2001) expressed a preference for an optimised deprival value approach for valuing easements, but concluded that, in balancing the need for an adequate return on investment and the need to avoid price shocks, indexed historic cost in valuing Sydney airport land and easements was appropriate.
IPART (1999d) argued that easements apply in perpetuity, are rarely replaced and that the use of replacement costs would result in price shocks. IPART concluded that actual cost should be used rather than replacement cost.
Stakeholder Comment
In initial submissions to the Authority, GAWB’s preference for land and easements was to include the assets in the regulatory asset base at market value to ensure a commercial return is earned, on the basis that land and easements are purchased as a function of GAWB’s planning requirements for future augmentation. A contrary treatment would discourage GAWB from undertaking appropriate planning. SunWater supported this approach and indicated that, in some cases, the cost of purchasing land and easements may be above market value.
Gladstone City Council considered that easements should be valued at zero. CS Energy was more concerned about the amount of land and easements attributed to them separately rather than the method for valuation. QAL considered that land should be valued on the same basis as other assets. It acknowledged the current contention relating to valuation of easements and suggested that the Authority look to the approaches adopted by other regulators.
In response to the Draft Report, QAL favoured using market value, arguing that valuation based on inflation-indexed historical cost does not reflect current opportunity cost or value in the next best use. Callide Power Management and Comalco also supported the market value approach, noting that land should not be treated differently to other assets. They further argued that historic cost has no relevance to current decisions, which should ‘properly account for future opportunity costs’.
However, SEQWater supported the indexed historic cost measure, noting its simplicity and objectivity.
QCA Analysis
Having regard to the current state of national debate on this issue, including the recent decision by the ACCC in the case of Sydney Airport, the Authority recommends that historic cost indexed for inflation be adopted for land and easements for GAWB.
The Authority was able to obtain historic valuations for GAWB’s total land and easement assets, excluding the Castle Hope Dam site land. When indexed to July 2001 dollar values, these totalled
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$15.4 million. However, as these historic costs could not be identified on a segment basis, they were apportioned to each segment on the basis of market values estimated by SMEC.
Recommendation:
That land and easements be included at historic value indexed for inflation.
6.8 Relocated Assets
GAWB’s proposed capacity augmentation includes capital costs for relocation of road, rail, telecommunications and electricity services. The initial Awoonga Dam raising to FSL 40 metres involved infrastructure relocation costs of $44.2 million (in the original total cost of $106 million).
The issues for the pricing investigation relate to the method of recognising infrastructure relocation costs and how these costs should be determined.
Stakeholder Comment
In initial submissions to the Authority, most of GAWB’s customers strongly believed that the full cost of relocation should not be included in determining prices. CPM and Calliope Shire Council considered that rail line relocation should be funded by the government. Comalco commented that
‘relocation costs should be capped at the cost of reinstating the asset to its current level of service. The value of the road to be recovered should be the depreciated replacement cost of the service potential of the existing road (ie unsealed, used road) and for the railway line should be economic value. This is arguably zero’.
Queensland Transport responded that the Gladstone-Monto rail corridor in question is sub-leased by Queensland Rail (QR) and contains an operational line subject to the Transport Services Contract (Rail Infrastructure). They further argued that GAWB has obligations to re-instate the rail assets sufficient to meet current contractual requirements. Queensland Rail submitted that if GAWB flooded QR’s assets, QR’s right to compensation would arise as a matter of law, and that QR has a continuing business in relation to the rail assets in question.
CS Energy considered that relocation costs associated with the current raising of Awoonga Dam should be carried by GAWB until new customers connected to pay for it, otherwise there is a perverse incentive for GAWB to pass on the costs of relocating assets to existing customers. Callide Power Management supported the capitalisation of relocation costs where relocations were:
· externally required of GAWB;
· directly and immediately associated with the current raising of the Awoonga Dam, ie not relocating assets associated with the next augmentation; and
· required under the ‘optimal’ storage level for the Awoonga Dam arising from the DORC process.
Gladstone City Council had difficulty accepting the approach that included the costs of relocating non-GAWB assets in the regulatory asset base and it considered the State Government requirement to replace the non-viable Monto railway line to be unfair. Calliope Shire Council submitted that the State Government should meet the costs of relocating assets.
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SunWater submitted that, in a commercial environment, a storage owner has little bargaining power in negotiating with land and asset owners and that this may result in the storage owner having to pay above what would otherwise be considered a reasonable cost. SunWater added that ‘to remove these relocated assets from the asset base would ignore the commercial reality that the storage owner faces and would also compromise GAWB’s ability to provide additional storage capacity’.
GAWB’s preference was to include the cost of relocating assets in the regulatory asset base on the basis that it represented an external requirement arising from the planned raising of Awoonga Dam and, as such, it was a part of the costs of construction.
In response to the Draft Report, Callide Power Management and Comalco re-iterated their view that the cost of relocating sub-economic assets should not be met by customers but by the ‘requiring agency’, that is, the government. Callide Power Management added this as a further qualification to the principles outlined in its initial submission. Both customers added that the Authority must have regard to the ‘need for efficient resource allocation’ and the ‘protection of consumers’ under Section 26 of the QCA Act, and that the inclusion of rail relocation costs conflicted with these objectives.
SEQWater submitted that the cost of rail line relocation is a valid cost of construction and should be included in the asset base for pricing purposes.
QCA Analysis
Where there is no market for an asset, but the owner has a genuine intention to continue using the asset, the appropriate measure of compensation for the resumption of the asset is the cost of reinstating or replacing the asset, taking into account its condition. Where a market does exist, market value is appropriate.
In the case of government to government transactions, policy considerations are likely to have a significant influence on the outcome of negotiations.
On one view, given that the assets are owned by third parties, that these parties are both government entities, and that the question of their economic value is a matter for those parties, the Authority does not have a discretion to establish a value other than the agreed cost of relocating the facilities.
However, under monopoly prices oversight, the Authority is required to investigate the pricing practices of an entity to determine whether they result from the application of market power following from the government monopoly status of the entity. Under this view, the Authority is required to assess outcomes to determine whether they could have been different if the entity operated in a commercial environment.
In the case of the road, it is recognised that the previous road has been replaced with a longer road, which has been sealed. The depreciation on an unsealed road would be low as its service potential is typically sustained through a maintenance programme. The cost of sealing the new road has been paid for by the Main Roads Department and any savings to maintenance costs appropriately benefit that Department. As a result, the Authority considers that GAWB has essentially only replaced the old road with a new road of similar service potential with the cost of the increased service potential being borne by the Main Roads Department.
In respect of the rail line, the situation is less clear. In the Draft Report, the Authority noted that it is likely that the replacement rail line will have a longer life than the rail line replaced, despite the low level of use of the existing rail line, and lower on-going maintenance costs. However, Queensland Transport has advised that existing rail and many timber sleepers were reused for the relocated line, and that it would not have a significantly longer life than the original line. They
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also supported the assessment in the Authority’s Draft Report that the carrying capacity of the rail line is not enhanced as part of its relocation.
Queensland Transport also advised that:
· to divert present rail freight (6237 tonnes in 1999-00) to the Gladstone – Monto road, a ‘base case’ upgrade of the road would be required at a cost of $85 million, not including maintenance costs;
· no additional users for the rail line have been identified, but reviews of the line’s potential are being conducted by prospective coal and ilmenite producers in the Monto region. Road transport is not viable for bulk coal transport; and
· GAWB is legally bound to meet the costs of relocating those parts of the rail line to be flooded.
In a community Discussion Paper prepared in October 2001, Queensland Transport suggested that a framework should be developed to evaluate the transport needs of communities affected by GAWB’s proposed next augmentation of Awoonga Dam. This augmentation would require the relocation of 27 kilo metres of track compared to the three kilometres being relocated for the current raising.
On balance, the Authority maintains its recommendation that the full relocation cost be incorporated into the asset base, on the basis that:
· the carrying capacity of the rail line has not been enhanced;
· the owner proposes to continue its on-going use and there is potential for significantly expanded use by mining industries;
· the necessary costs of road upgrades to meet immediate freight needs are significantly higher; and
· GAWB is legally bound to fund the cost of relocation.
However, the Authority notes that should the new line be capable of providing additional services to that of the old line, there would be a case for the new users to bear the inherent upgrade costs rather than GAWB’s customers. The Authority also notes that the relocation cost implications are likely to be more significant for GAWB’s next augmentation, and that these issues should be resolved on a timely basis as part of the planning process for the next augmentation.
Recommendation:
That the cost of assets necessarily relocated should be incorporated in the asset base at their cost of relocation.
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7. RATE OF RETURN
Summary
The Authority recommends that CAPM/WACC should be used in the determination of the appropriate rate of return for GAWB and, consistent with its other recent regulatory decisions, a post-tax nominal approach should be adopted.
The Authority recommends that a 20-day average of the ten year Commonwealth government bond rate is the appropriate measure of the risk free rate. As of 28 June 2002, this was 6.02 per cent.
Other underlying parameters are:
Market risk premium (%) 6.02
Capital structure – proportion of debt (%) 50 Cost of debt margin (%) 1.6
Cost of debt 7.62
Asset beta 0.45
Equity beta 0.63
Gamma 0.5
Tax rate (%) 30
Inflation rate (%) 2.6
On this basis, the Authority has based its revenue projection on a post-tax nominal WACC of 8.72 per cent, with a return on equity after tax of 9.82 per cent.
7.1 Introduction
Having determined the asset base, it is then necessary to determine the allowed rate of return on those assets.
The rate of return is a forward-looking concept based on estimated future returns and expected future risk. It represents the return expected by investors in capital markets for investments of a given level of risk. It should provide a stream of income from the investment of funds that would be sufficient to attract and retain that investment.
In competitive capital markets, the rate of return is determined by the forces of supply and demand for capital. However, for a regulated entity, this is not possible and the rate of return is established by the regulator. In such a case, the rate of return should be set at a level that is equal to the cost of attracting capital to fund a particular asset given its level of risk, that is, commensurate with what would be expected in a competitive market. If the allowed rate of return is too high, the prices charged to end consumers will be above the level that is truly reflective of costs. On the other hand, if the allowed rate of return is too low, investment by asset owners will be constrained and the quality of service offered to customers may decline.
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7.2 Issues in Determining the Rate of Return Framework
The rate of return for a group of assets used in a particular business activity can be derived by calculating the appropriate Weighted Average Cost of Capital (WACC). A firm’s WACC recognises that its capital is provided from two sources, namely lenders and equity investors (owners or shareholders). It is calculated by adding the cost of debt, weighted by the proportion of debt to total assets, to the cost of equity, weighted by the proportion of equity funds to total assets.
The Capital Asset Pricing Model (CAPM)
The cost of attracting and retaining equity funds is not directly observable and must be estimated using data from security markets. A number of alternative models have been developed to estimate the cost of equity funds, the most common of which is the Capital Asset Pricing Model (CAPM).
The central concept of CAPM is that of undiversifiable risk (known as beta (b)). Basically, the total risk of a business activity can be separated into two distinct classes of risk, being undiversifiable and diversifiable risk. Undiversifiable risk refers to the riskiness of an entity compared to the market as a whole. It is calculated by a linear regression based on historic data.
The remaining risk is known as diversifiable risk. This risk can be removed by holding the security as part of a well diversified portfolio of investments. CAPM assumes that investors will not be compensated for the risk they can cost-effectively avoid. That is, it assumes that investors will only be compensated through the rate of return for risk that cannot be avoided through diversification. This is not to say that diversifiable risk is irrelevant for valuation purposes, because the rate of return (based on undiversifia ble risk) is then applied to the organisation’s estimated cash flows. These estimated cash flows should reflect the diversifiable risks.
Accordingly, beta is a statistical assessment of the degree of undiversifiable risk associated with an asset or investment relative to the overall stock market. It assesses the systematic risk of the security, which is the risk that distinguishes it from the market as a whole. Since the beta of the market portfolio is one, all investments can be identified as being more or less risky than the market as a whole. For example, an enterprise with a beta of one has undiversifiable risk that is perfectly correlated with the expected return for the market as a whole. The further a beta departs from one, the more its returns are expected to vary from those of the market as a whole. A higher beta is considered more risky, and a lower beta less risky, than the market as a whole.
Beta is used as an input to CAPM. CAPM also requires estimates of the risk free rate and the expected return on the market as a whole. CAPM is expressed as:
R=R+-b éùRR ifiëûmf where :
Ri =the expected return on asset i
Rf =the risk free rate
Rm =the expected return on the market as a whole; and
cov,(RRim) bi ==2 systematic risk of asset i. s m Other Jurisdictions
Most regulatory decisions in Australia over recent years have employed a CAPM/WACC approach to determine the rate of return and the cost of equity.
68 Queensland Competition Authority Chapter 7 - Rate of Return
Stakeholder Comment
Initial submissions from all stakeholders supported the use of the CAPM/WACC approach. No further comment was received on this matter in response to the Draft Report.
QCA Analysis
The Authority is mindful of a preference amongst regulatory bodies in Australia for utilising CAPM to estimate a utility’s cost of equity, primarily because CAPM is considered more objective than alternative models, is conceptually simple in terms of defining and measuring the equity beta, and may be applied across all industries.
At the same time, the Authority notes that there are practical difficulties in implementing CAPM, especially in respect of publicly owned monopoly assets for which there are often no directly comparable entities listed on a stock exchange.
The Authority also notes that CAPM is a single period model, which assumes that all investors have a common time horizon of unspecified length. It therefore has difficulty capturing the multi-period nature of most investments. As a result, the application of CAPM involves a certain degree of imprecision. However, the Authority believes that CAPM remains the simplest and best understood approach to determining the cost of equity for regulatory purposes, and accordingly supports its use.
Recommendation:
That CAPM should be used in the determination of the appropriate rate of return for GAWB.
7.3 Issues in the Selection of a WACC Equation
WACC can be calculated on either a pre-tax or a post-tax basis and on either a nominal or a real basis. Alternative specifications are discussed in Appendix B. The appropriate WACC to use depends on what is included in the entity’s cash flow. For example, nominal cash flows should be discounted with nominal discount rates while post-tax cash flows should be discounted with post-tax discount rates. Each of the approaches should be equal in perpetuity but there can be significant differences when measured in discrete time.
The post-tax WACC for an entity (assuming that interest, taxation and the value of any imputation tax credits are included in the entity’s cash flow estimates), is as follows:
ED WACCRR=+ postta xequityVVdebt where
Requity = the return on equity (the cost of equity)
Rdebt = the return on debt (the cost of debt) V = the total market value of the firm E = the market value of the equity D = the market value of the debt
Alternatively, tax and dividend imputation can be included directly in the WACC rather than in cash flow estimates:
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1-T ( c ) ED WACC 11=re+-rTdc( ) (11--Tc ( g )) (E++D) (ED)
where:
Tc = corporate tax rate g = assumed level of the value of imputation credits.
As the formulas indicate, the major elements driving WACC are the determination of the cost of equity, the cost of debt, and the appropriate capital structure. The selection of an appropriate tax rate and the treatment of dividend imputation are also important, either through direct inclusion in the WACC formula or in the estimated cash flows.
Pre-tax or post-tax WACC
The formulation of WACC and the definit ion of the cash flows used to calculate the revenue requirement should be consistent. An entity’s cost of equity funds (as imputed using CAPM) is usually expressed on a post-tax (but before personal tax) basis.
The use of a pre-tax rate of return is advocated on the grounds that it avoids the need to explicitly estimate the tax obligations of the regulated business, and is therefore less intrusive, leaving the regulated entity to manage its own tax affairs. However, a tax calculation still needs to be undertaken to convert the post-tax rate of return indicated by CAPM benchmarks to the corresponding pre-tax rate required for the regulatory framework. Hence, as both approaches require tax liabilities to be properly assessed, there is little difference between a post-tax and pre- tax formulation of WACC on this aspect.
Arguments in favour of a post-tax WACC include:
· post-tax measures of return are more relevant to investors;
· corporate taxes are a cost to the company like any other cost;
· adopting a post-tax WACC requires cash flow modelling to explicitly address the cash flow implications of taxation liabilities and an organisation’s financial position. Accordingly, this approach is more transparent and rigorous; and
· there is difficulty in estimating a long term effective tax rate, as the tax system is not static.
Nominal or Real WACC
Nominal and real rates of return provide equivalent results provided consistency is maintained with inflation adjustments, depreciation allowances and debt. In other regulatory decisions, the Authority has adopted a nominal WACC. Arguments in favour of a nominal framework include:
· depreciation in a nominal framework is transparent and there is no potential for confusion over the extent of recovery. This is not the case for a real framework, as depreciation allowances include adjustments for inflation so that accumulated depreciation may exceed the actual cost of the asset unless depreciation amounts are deflated;
· similarly, interest expenses and other non-inflationary cash flows such as capped revenues or revenues from contracts containing no CPI adjustments require particular caution when converting from nominal to real. Errors in the conversion will result in discrepancies in the underlying cash flows;
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· tax and balance sheet items such as debt and equity are all expressed in nominal terms. Consequently, the stock of debt must be deflated if modelling is to be undertaken in real terms;
· a nominal WACC is directly comparable with other financial benchmarks such as the nominal rate of return of other investments; and
· the nominal approach is the preferred approach of academics and financial market participants.3
At the same time, the Authority notes that the use of a real WACC has sometimes been promoted on the basis that:
· there is no need to deflate the asset base, as is required in applying a nominal WACC;
· it simplifies the estimation of rebates for contributed assets (using a nominal approach, inflation gain on assets must be identified and separated); and
· it simplifies cash flow models, particularly when different rates of inflation may be defined for capital and opex costs.
Other Jurisdictions
The ACCC (1999a) notes:
‘Given there is little to choose between post-tax and pre-tax formulations, the issue is fundamentally how best to assess tax liabilities – short or long term. There are a number of flaws associated with the use of a long term pre-tax WACC including: · front end loaded investor returns (where actual tax payments tend to be concentrated towards the end of the life of the assets. This arises because tax depreciation provisions (especially in the presence of accelerated depreciation) historically have allowed capital expenditures to be written off faster than the economic rate of depreciation. As a result businesses obtain returns well in excess of those intended under the regulatory framework in the early years but these are offset by lower than commercial returns later on); · uncertainty over long term tax provisions; and · difficulties in estimating long term effective tax rates and applying them within a formula based approach.’
The ACCC (2000a) discussed a number of problems associated with converting a nominal post- tax WACC to a real pre-tax WACC, including:
· conversion formulae have been shown to be significantly in error in ensuring the correct return on equity, although this problem can be overcome by modelling the estimated cash flows and taxes over the life cycle of the asset portfolio; and
· the conversion process is unsuitable for assessing revenues over multiple perio ds where the business regime (principally taxes and inflation) is more likely to change, as it is extremely difficult to adjust the returns already allowed to take account of the new business regime, resulting in over- or under-recovery of costs.
The ACCC (2000a) noted that using a post-tax nominal framework avoids these problems as the return on equity and estimated taxes payable allowances are separated in the Annual Average
3 For example see Davis (2000).
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Revenue Requirement formula. The tax payable can therefore be adjusted from period to period. The ACCC cited support for such an approach from Professors Officer, Hathaway and Davis.
The ACCC also discussed a drawback of the post-tax nominal framework, namely that customers of a network at different points in time will pay different charges for the same set of assets as a result of the assets’ changing tax position rather than the underlying value of the service being provided. This is particularly the case where the firm takes advantage of tax concessions in the early years of the life of an asset, with tax liabilities increasing over time (the so-called S-bend debate). In effect, this approach passes on to users the tax benefit attached to the investment by the legislators. Moreover, where a firm has a portfolio of assets, this effect is somewhat muted. In addition, the forthcoming removal of accelerated depreciation will mean the S-bend phenomenon is progressively reduced.
Stakeholder Comment
In its initial submission, GAWB expressed a preference for a nominal pre-tax WACC, for the following reasons:
· ‘The business profile of GAWB is more aligned to that of its major industrial customers who are more likely to use a pre-tax approach in calculating their WACC;
· GAWB’s customer base consists of large industrial corporations who are looking for a stable price path. The ‘S-bend’ problem which will lead to pressure for prices to rise over time will expose GAWB and its customers to pricing risk; and,
· The change to the Commonwealth tax depreciation allowances will reduce the differentiation that exists between taxation paid in the earlier years and that paid in later years.’
SunWater supported the use of a pre-tax WACC on the basis that the post-tax WACC:
· may distort business decision-making by not rewarding active tax minimisation and pla nning as tax is simply passed through;
· may establish a regulated price which changes according to the tax position of the business;
· may increase regulatory risk whereby current prices may reflect no tax payable, while future prices may have to increase as tax becomes payable; and
· is more information intensive and intrusive.
QAL supported the use of a pre-tax real WACC framework using the statutory tax rate, as the post-tax WACC would weaken the positive incentives provided under incentive regulation and lead to higher prices. Callide Power Management and CS Energy did not have any firm views as to whether WACC should be before or after tax or in nominal or real terms. However, CPM saw merit in adopting an approach consistent with past QCA decisions and with those of other regulators to allow greater comparability.
In response to the Draft Report, SEQWater strongly supported the use of a pre-tax nominal rate rather than a post-tax nominal rate. SEQWater argued that pre-tax nominal rates are in general use in the commercial world and are consistent with financial reporting. However, the main concern was that after-tax cash flows would create a future ‘spike’ in the water price when tax depreciation deductions for dam structures cease (the S-bend effect described by GAWB in its initial submission). Because of accelerated depreciation on dams, these tax deductions would cease well before the end of the asset life, creating intergenerational pricing issues.
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QCA Analysis
The Authority accepts that the arguments for the use of a pre-tax real versus a post-tax nominal WACC are finely balanced at this point in time. However, the Authority supports the views of the ACCC and a range of independent experts (such as Professors Davis, Hathaway and Officer), which indic ate that there is a general trend toward the use of a post-tax nominal framework. For this reason all of its pricing decisions to date have been based on a post-tax nominal basis. The key advantage of the post-tax approach is that its transparency reduces the risk of incorrectly estimating tax liabilities.
With respect to the so-called S-bend effect, the Authority acknowledges the potential impact on prices caused by the difference between the timing of tax and accounting depreciation. However, the Authority considers that tax is simply one of the costs that must be met and should be incorporated in the estimated cash flows in the same manner as are other costs. Furthermore, the Authority notes that any impact will be substantially ameliorated by the Authority’s use of a 20- year cash flow model, reset every five years.
Recommendation:
That a post-tax nominal specification of WACC be used.
7.4 Quantifying the Risk Free Rate
As indicated by the formula in Section 7.2, the derivation of a return on equity under CAPM requires the estimation of a risk free rate. The risk free rate represents the rate of return on an asset with zero default risk.
There are two issues that need to be considered in the choice of an appropriate proxy for the risk free rate:
· the maturity period of bonds that should be used to identify the interest rate; and
· the method of measurement of the risk free rate (in particular, whether an ‘on the day’ rate should be applied or whether the rate should be averaged over some period of time).
Other Jurisdictions
Table 7.1 summarises the approaches adopted by different jurisdictions in determining the risk free rate.
Most regulators have elected to apply the ten year Commonwealth bond based on some form of averaging. IPART (2000a) has adopted a general approach of using the average of the nominal bond rate for the 20 business days prior to valuation date. The rationale of adopting the 20-day average is to minimise the effect of daily distortions while capturing the most recent information and expectations on inflation. This approach was also adopted by IPARC in its 1999 price direction for ACTEW’s electricity water and sewerage charges.
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Table 7.1: Risk free rates used in regulatory decisions
Entity/Author Industry Benchmark bond Estimation factor
ACCC (2000b) Gas transmission 10 year Commonwealth 40 day moving average
OffGAR (2000b) Gas transmission 10 year Commonwealth 20 day average
IPART (2000b) Gas distribution 10 year Commonwealth 20 day average
IPART (2000a) Water Supply 10 year Commonwealth 20 day average
IPARC (1999) Water and electricity 10 year Commonwealth 20 day average
GPOC (2001) Bulk water 10 year Commonwealth 45 day average
ACCC (2000a) Electricity transmission 10 year Commonwealth 40 day moving average
QCA (2001) Electricity distribution 10 year Commonwealth 20 day average
IPART (1999d) Electricity distribution 10 year Commonwealth 20 day average
ORG (2000) Electricity distribution 10 year inflation indexed 20 day average
OTTER (1999) Electricity distribution 10 year Commonwealth 12 month rolling average
Stakeholder Comment
In initial submissions to the Authority, GAWB preferred the use of the ten year Government bond rate, averaged over a period reflecting the level of volatility in the market at the time. In its own modelling, GAWB used an average over 20 trading days, but added a 0.5 premium to reflect the average difference in rates between a notional 30 year bond and the ten year bond. GAWB also argued that the Authority’s determination of the risk free rate should reflect that prevailing at the time that the decision was made to proceed with augmentation.
PricewaterhouseCoopers (PwC), for Comalco, supported the use of the ten year bond rate, but argued that the premium of 0.5 per cent was not justified. PwC suggested that recent regulatory decisions have not adopted such premiums, and that the 30 year bond market is not sufficiently liquid to give reliable indicators of such premiums.
CPM supported the ten year bond rate, and suggested that the addition of any premium to the bond rate is not advised as the difference between the ten year bond rate and longer term bonds is not stable. CPM favoured the ten year bond averaged over 20 days. CPM considered there was merit in adopting a method consistent with recent regulatory decisions to aid comparability. CS Energy accepted the ten year Commonwealth bond rate as being a reasonable measure of the risk free rate but suggested that a shorter bond rate may be more appropriate in times of volatility. CS Energy argued for an average over 40 days.
QAL also supported the ten year bond rate on the basis that it was not possible to match the maturity period of GAWB’s assets and liabilities, as it would require a risk free proxy instrument with maturity beyond 30 years. QAL considered that any difference between the term of the risk free rate and the life of the asset was not a major issue as long as consistency is observed between the definition of the risk free rate of return and the definition of the market risk premium. QAL’s preference for the appropriate risk free benchmark is the Commonwealth ten year capital indexed bond.
In response to the Draft Report, GAWB suggested that the risk free rate should be based on a security with a maturity closer to the life of the price review, rather than the life of the assets.
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QCA Analysis
Choice of Maturity In terms of the maturity period, the debate centres on whether the maturity of the risk free rate should be set equal to, or as close as possible to, the life of the entity, or to the regulatory review period. Officer (1981) states ‘the appropriate rate is that on a risk free security, eg. a government bond or note, of the same duration as the term of the investment’.
The ten year Commonwealth Government spot bond yield is a commonly used proxy for the risk free rate as it is a liquid instrument, provides the best reflection of the market risk free rate and can be identified using available market data.
The link between the longevity of the regulated assets and the planning/investment decision horizon of investors needs to be considered in determining the life of the risk free asset. As considered by the ORG (1998, p.14):
‘In other relevant jurisdictions, there is recognition that amortisation of relevant assets must be over their full economic life which implies that investors must have an expectation that they will be compensated for making long term investments before they commit to the investment. Therefore, even though regulators may review investment returns at regular intervals, it would be a mistake to believe investors’ planning horizons only extend to the next review. Models of expected returns and any regulation of those returns must reflect and take account of the investors’ planning horizons. The reapplication of the prevailing long term rate every five years is sufficient to achieve this, as the owners of the project make their investment decision based on the life of the project, using the appropriate discount rate determined with reference to the prevailing yield curve.’
The ORG also noted that some gas industry stakeholders had expressed concern that the use of short term rates to coincide with the regulatory period would cause companies to concentrate their re-funding around each price review determination. It was argued that the use of such a rate would also cause periodic spikes in corporate bond rates due to the concentration of refinancing around the time of each re-set of the regulatory WACC.
It is also important to ensure that there is consistency between the choice of the risk free rate and the assumed market risk premium. As noted by ORG (1998), given that the available risk premium is expressed relative to the ten year bond rate, this rate is preferred as there is no additional benefit for calculation of the equity rate of return in using the five year bond rate.
In this context, ORG argued that selection of the five year bond rate as the risk free rate would require the application of a market risk premium which measures the expected return on equities as a margin over the five year bond yields:
‘It has been suggested for example, that the choice of a shorter (or longer) rate will just lead to a higher (or lower) measured market risk premium, with no effect on the expected return for the well-diversified portfolio (and hence little effect on the required equity return). As the estimation of the market risk premium generally has used the current yield to maturity on Commonwealth Government securities of about ten years until maturity, this argument suggests that the risk-free rate should reflect a security of a similar term. ’
Davis (1999) suggests that, if the allowable WACC is to be revised periodically, then it is not necessary to use a long term rate for the risk free rate. Rather, Davis seeks to relate the prevailing interest rate to the length of the review period:
‘Given the anticipated life of the assets and the likely time pattern of the resulting cash flows, it would seem very difficult to sustain an argument for use of a risk-free rate greater than 10 years. Use of a shorter maturity rate would not be inappropriate – particularly if there were to be regular regulatory pricing reviews.’
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Other arguments used to support the use of a rate linked to the regulatory period include that:
· rarely does initial debt funding for capital investments extend beyond ten to fifteen years and, in any event, it is likely that interest swaps would be re-set on a five yearly basis. However, interest rate swaps are available for a range of maturities from one to ten years; and
· even where a long term cost of capital is appropriate to the valuation of long-lived assets, it does not follow that it is appropriate for pricing decisions in the short run when the asset values are adjusted annually for inflation (thus removing a need for an inflation risk premium) and the allowable cost of capital can be revised at each review (to adjust for long term changes in market perceptions).
However, as indicated earlier, adoption of a five year bond rate as a matter of principle would effectively require a counterbalancing adjustment to the market risk premium on the basis that it has traditionally been calculated against the ten year bond rate. Given the broad consistency of the margin between the five year and ten year bond rates over time, the most practical approach is to adopt the ten year bond rate and use the standard calculation of market risk premium. With respect to the issue of a premium to address the difference between the ten year bond rate and a 30 year bond rate, the Authority recommends that no adjustment should be made on the grounds that:
· the market is too thinly traded to return an appropriate measure of the premium; and
· consistent with the argument concerning the relationship between the risk free rate and the market risk premium, adoption of a 30 year rate would require a compensating adjustment to the calculated market risk premium, thereby substantively negating the impact of adopting a 30 year rate.
Method of Measurement In terms of the measurement of the risk free rate, it is possible to use either an ‘on the day’ rate or an average. The ‘on the day’ rate is considered to be the theoretically correct rate to use, as it reflects all available information, including any historical information about previous rates. However, this rate may be subject to short term volatility, for example, due to central bank intervention or trading activity. To overcome this problem, some form of averaging may be used. For example:
· a short term average of the ‘on the day’ rate could be applied if the rate suffers a perturbation on the day of the decision; or
· an average rate reflecting trading over (say) the past 20 to 40 trading days could be used. Short time frames for the calculation of averages are usually preferred on the grounds that they utilise the most recent (and therefore relevant) information.
The Queensland Treasury Corporation (QTC) (2001) has suggested that an ‘on-the-day’ rate was undesirable due to the risk of sampling from the market at an inappropriate time due to market interest rates being at the extreme of a cycle. A possible solution, according to QTC, is to use a rolling four to five year average interest rate.
The approach proposed by the QTC has not been adopted by any other regulator and it raises a number of substantial issues which need full consideration. Accordingly, the Authority recommends that the QTC approach be rejected on this occasion. At the same time, the matter should be given full consideration before the next regulatory review.
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On the issue of averaging versus an on the day rate, the Authority notes that other regulators considered the ‘on the day’ approach to have greater theoretical validity, but preferred an average on the grounds that it removes the potential for a short term fluctuation to influence the rate used.
The Authority’s analysis has shown that the use of moving average measures results in a lag following turning points in the spot market series which is further exacerbated the longer the moving average period.
At the same time, the Authority accepts that use of an ‘on the day’ interest rate could cause significant hedging difficulties and be likely to add to borrowing costs. In this regard, QTC argued that a short sampling period reduces the market window during which the service provider can implement interest rate hedging at reasonable cost. According to the QTC, averaging the risk free rate over a period of up to 40 days would reduce hedging costs significantly. The Authority is concerned that the choice of a risk free rate should not distort borrowing costs unnecessarily.
Accordingly, the Authority has concluded that, whilst an ‘on the day’ rate is theoretically correct for use in a CAPM model, using such a rate in practice may cause distortions to the total cost of borrowing. The Authority has therefore concluded that an averaging process should be used and has opted to average the selected interest rate over 20 trading days.
The Authority does not consider that it is appropriate, as GAWB proposed, for the risk free rate to be back-dated to that prevailing at the time that the decision to proceed with augmentation was made. The key reason for this is that a current measure of the risk free rate is consistent with the other information used by the Authority in assessing pricing practices, including demand forecasts, the optimised asset base and opex data. In addition, the Authority is aware that GAWB’s contract negotiations with new customers are subject to the outcome of the Authority’s recommended pricing practices, and that all stakeholders expect the Authority’s recommendations to be forward-looking.
For the purpose of determining WACC, the Authority recommends that a 20 trading day average of the ten year bond rate should be used, an approach consistent with the Authority’s recent regulatory decisions. To be consistent with other information inputs such as demand projections, the risk free rate was determined as at Friday 28 June 2002. For the 20 trading day period ending 28 June 2002, the Commonwealth government bond rate averaged 6.02 per cent.
Recommendation:
That a 20-day average of the ten year Commonwealth government bond rate is the appropriate measure of the risk free rate. For this recommendation, a risk free rate of 6.02 per cent has been used.
7.5 Quantifying the Market Risk Premium
The CAPM formula also requires the estimation of the market risk premium, measured as the difference between the expected return on equity investments as a whole and the risk free rate. The market risk premium represents the reward that investors require to accept the uncertain outcomes associated with equity investment, relative to the return provided by the risk free rate.
Other Jurisdictions
In recent regulatory decisions for electricity, gas and water throughout Australia, the market risk premium has been set at six per cent, with IPART preferring a range of five to six per cent. Ofwat’s final decisions for UK water suppliers used a range of three to four per cent.
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Stakeholder Comment
In initial submissions, GAWB’s WACC was based on a market risk premium of six per cent which was supported by QAL. QAL also referred to two recent research results on equity risk premiums: Professor Robert Officer found an equity risk premium of 7.1 per cent measured over the ten year government bond; and the Centre for Research in Finance found an equity risk premium of 6.2 per cent. PwC (for Comalco) preferred to adopt a range of between five and six per cent, arguing that recent evidence indicates that the premium has declined. Callide Power Management also suggested that the market risk premium should be in a range from five to six per cent, on the basis of recent decisions and commissioned research of other regulators.
CS Energy suggested that GAWB’s risk premium must be closer to five per cent considering GAWB’s ‘lower level of non-diversifiable risk’. Calliope Shire Council considered the rates proposed by GAWB, the Department of Natural Resources, and Queensland Treasury to be too high, arguing that the risk premium needs to be benchmarked against local industry and that achieved by the water supply industry generally, which was supported by Brisbane Water.
No submissions on this matter were received in response to the Draft Report.
QCA Analysis
The market risk premium is based on the difference between the return on the market as a whole and the risk free rate, both of which vary over time. As shown in Figure 7.1, equity market returns are significantly more volatile than debt market returns. Both the equity and debt markets are influenced by short term business cycles and the fact that measures of the risk premium are influenced by the measurement period.
Figure 7.1: Bond and equity returns: 1882 to 2000
80.00
60.00
40.00
20.00 Return (%)
0.00
-20.00
Bond Yields Equity Returns
-40.00 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 Year
CAPM requires that a forward-looking market risk premium be based on a time frame corresponding to the period of the analysis (that is, the life of the asset). However, in practice, this data does not exist. Alternative methods are suggested in the literature to estimate the market risk premium including surveys, consumption based modelling and the use of historical data.
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Most regulators have preferred the use of a market risk premium proxied from historical data. Officer (1985) measured the market risk premium as the difference between the arithmetic nominal return on shares and the average annual yield on long dated government securities.
Problems with the use of historical data to estimate the market risk premium include:
· the choice of proxies for the risk free rate and the return on the equity market. Typically , studies will use the All Ordinaries Accumulation index as their proxy for the equity market and the ten year Commonwealth bond rate as proxy for the risk free rate;
· structural breaks which may cause the average ex post returns for the market and the risk free rate to differ materially from the expectation period. A structural break occurs when time series data switches from one regime to another due to an exogenous shock. For example, the deregulation of Australian interest rates in 1979 or the floating of the Australian dollar in December 1983; and
· whether the averages should be arithmetic or geometric. Arithmetic means are consistent with the CAPM framework. However, the use of geometric means has been justified on the grounds that it takes into account continuous compounding. Geometric averages will be lower than arithmetic averages.
There is a view among academics, market participants and regulators that the market risk premium has fallen over recent years, and is currently below that implied by its historical measurement. The Authority calculated market risk premia for the period 1887 to 1998 using Officer’s method. Figure 7.2 shows a plot of the annual and the ten year moving average market risk premium. The ten year average equity risk premium is relatively stable over the past century. This has occurred despite increased volatility in the annual market risk premium series and the change from regulated to deregulated financial markets over the past 25 years.
Figure 7.2. Market risk premium: 1883 to 2000
60.00
50.00 Annual Equity Risk Premium Equity Risk Premium (10-year MA)
40.00
30.00
20.00
10.00
Equity - Bond (%) 0.00
-10.00
-20.00
-30.00
-40.00 1883 1886 1889 1892 1895 1898 1901 1904 1907 1910 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 Year
Prior to the introduction of dividend imputation in July 1987, equity returns observed in the stock market represented rates of return after all corporate taxes had been paid (but before shareholder taxes were paid) and therefore could be used in determining the post-tax cost of equity funds for
79 Queensland Competition Authority Chapter 7 - Rate of Return
an entity. IPART (1998b, p.16) suggested that, following the introduction of dividend imputation, the risk premium could have fallen to reflect the additional value of franking credits received on an investment.
The findings of Australian academic studies and regulatory decisions suggest that the market risk premium has ranged from six to eight per cent. There is also a general view that this historical range may be too high, though as yet the evidence is inconclusive. In correspondence with the Authority, Professor Officer indicated that he supports a range of five to seven per cent for the current market risk premium.
This change from earlier periods cannot be solely attributed to dividend imputation. This has also been a period of low interest rates, low inflation and stability in the Australian economy, combined with high levels of private share ownership, increased institutional ownership of shares arising from changes in superannuation, and reduced informatio n risks due to improved communication and technology.
Following consideration of submissions and recent regulatory trends, the Authority concluded that, notwithstanding recent observed volatility, the estimate of the market risk premium should be based on a long term view. Accordingly, the most appropriate estimate for the market risk premium is six per cent.
Recommendation:
That a market risk premium of six per cent be applied.
7.6 Determining the Capital Structure
Capital structure refers to the proportio n of debt in the total capital employed by a business. Capital structure affects the level of financial risk and return to equity holders. The higher the level of debt, the higher the equity beta will be and the higher the cost of equity. In general, there is potential for companies with predictable cash flow businesses, particularly in a regulated natural monopoly environment, to operate with higher gearing ratios than those with a mix of other business activities.
Other Jurisdictions
The level of gearin g assumed in other regulatory decisions is typically in the range of 50 to 60 per cent. IPART’s (2000a) review of NSW water businesses and ORG’s (2000) review of electricity distribution entities both used a debt to assets ratio of 60 per cent. IPARC (1999) used a range of 40 to 60 per cent in its price direction for ACTEW. In Tasmania, GPOC (2001) used a debt to assets ratio of 50 per cent. In all recent electricity and gas decisions, a gearing of 60 per cent has been adopted.
Ofwat in the United Kingdom has proposed a benchmark gearing (debt to debt plus equity) ratio of between 45 and 55 per cent for both regulated water and water and sewerage companies. This represents its view of a prudent and desirable capital structure for such companies. Where companies are outside this range, Ofwat imputes a shadow capital structure for the purposes of determining a regulated price.
Stakeholder Comment
In initial submissions, GAWB indicated that the capital structure should reflect an industry benchmark gearin g ratio, and that the low gearing levels of Australian water utilities were reflective of their government ownership. GAWB’s modelling adopted a range of projected debt levels, from 45 to 50 per cent, generally reflecting projected debt levels for the bus iness. GAWB observed that the average gearing of Australian water utilities was only 17.3 per cent, but this
80 Queensland Competition Authority Chapter 7 - Rate of Return
compared to 33.4 per cent for publicly listed water companies in the US and UK. Comalco considered that the 45 to 50 per cent range was consistent with current regulatory benchmarks for the water sector. Callide Power Management and CS Energy supported projected debt levels in the 45 to 50 per cent range, while QAL supported a debt to value ratio of 60 per cent. Brisbane Water recommended that the actual capital structure be used, provided it is within a reasonable bound.
In response to the Draft Report, QAL considered that an appropriate gearing for GAWB is at least 60 per cent debt to 40 per cent equity. QAL rejected the notion that the risks of managing excess capacity and meeting associated debt repayments constrain GAWB’s gearing to 50 per cent, noting that this assessment reflects a point in time when the augmentation is relatively new. QAL also considered that water businesses should be able to carry a higher level of gearing than electricity businesses due to their operational simplicity and limited product substitution.
QCA Analysis
The capital structure adopted for regulatory purposes may be that actually existing for the regulated entity, or some industry benchmark.
Adopting actual capital structures raises the question of how changes over time in the actual capital structure are to be incorporated into the WACC model, and at what point in time a capital structure is to be determined for input to the model.
Australian urban water utilities demonstrate generally low levels of gearing, as shown in Table 7.2 for selected entities. In contrast, the South East Queensland Water Corporation (formerly South East Queensland Water Board) has been established with a gearing of approximately 50 per cent as part of the corporatisation process, up from a gearing of around twelve per cent previously.
Table 7.2: Debt/equity ratios – Australian water businesses, 2000-01
Water Business Debt /(Debt + Equity)
Brisbane City Council 0.12
Gold Coast Water 0.12
ACTEW 0.841
Melbourne Water Corporation 0.26
Hunter Water Corporation 0.05
SA Water Corporation 0.21
Sydney Water Corporation 0.17
Source: Water Services Association of Australia (WSAA), 2001. 1. ACTEW’s level of debt includes borrowings to fund capital repatriation to the ACT Government.
The Authority notes that, while an industry average gearing for water service providers is less than 50 per cent, this is expected to rise with a greater emphasis on commercial practices. The Authority is of the view that, within a broad scope of commercial capital structures, the cost of capital is not highly sensitive to small changes in capital structure.
GAWB and its customers generally support a gearin g of 45 to 50 per cent. In response to QAL’s comments, the Authority considers that the lumpiness of water industry capex remains a major constraint on the capital structure. The industry is characterised by long periods of carrying
81 Queensland Competition Authority Chapter 7 - Rate of Return
excess capacity and only short periods of operational stability at full, or close to full, capacity. Primarily because of the resulting need for adequate coverage of debt payments associated with augmentation, the Authority recommends a benchmark level of gearing for GAWB of 50 per cent.
Recommendation:
That a gearing level of 50 per cent be adopted for GAWB.
7.7 Determining the Cost of Debt
The cost of debt is the return that an entity’s debt holders demand on new borrowings. It varies depending on the default risk of the borrower which, in turn, is affected by the gearing of the company (high gearing means a high level of debt relative to cash flows and consequently a higher risk of default), the short term volatility of cash flows and the long term security of revenue. A lender will charge a premium on loans corresponding to the degree of default risk associated with the loan.
The cost of debt may be determined either as a weighted average of the existing debt of the entity or the marginal rate at which a company can raise debt financing. The latter is usually expressed as a margin over the risk free rate.
Other Jurisdictions
The debt margins used by other regulators have ranged from 80 to 160 basis points. IPART (2000a) used a range of 80 to 100 basis points for its price direction for the Sydney, Hunter, Gosford and Wyong water suppliers. IPARC assumed a range of 100 to 120 basis points for ACTEW. GPOC (2001) used a debt margin of only 70 basis points for its bulk water prices draft report. The Authority (2001) adopted a margin of 165 basis points for its final determination for electricity distributors, consistent with a BBB+ debt rating.
Stakeholder Comment
In initial submissions to the Authority, GAWB supported the use of a margin over the risk free rate, as calculated by QTC to reflect GAWB’s notional BBB debt rating. This converted to 150 basis points above the risk free rate.
GAWB also suggested that the Authority should back-date the debt margin to reflect the prevailing interest rate market at the time that GAWB arranged its borrowings in July 2000.
PwC (for Comalco) used two options to determine a range for the cost of debt, firstly estimating a debt beta and using CAPM to determine the cost of debt, and secondly, applying an indicative margin over the Commonwealth bond rate. The resulting debt margin ranged from 50 to 150 basis points, with the mid-point of 100 basis points being selected.
Callide Power Management (CPM) was concerned that the desire for GAWB to maintain a BBB credit rating may lead to higher charges for water users, though with limited commercial justification. In their initial submissions, and again in their responses to the Draft Report, CPM supported a debt margin over the risk free rate of between 80 and 120 basis points, and QAL suggested a range of 80 to 100 basis points. CS Energy considered that the range should be 100 to 120 basis points. Comalco considered that the rationale for choosing a 180 basis point margin was not clear in the Draft Report and suggested an 80 to 120 point range.
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QCA Analysis
The use of the actual cost of debt (either an average of actual costs, or the marginal cost of debt) has the benefit of reflecting those costs currently faced by the entities concerned. However, such an approach has the potential to entrench higher debt costs and does not create incentives to seek the most efficient form of financing, as it accepts the prevailing rate of debt even if it is not the most cost effective available.
The use of a margin above the risk free rate may create the best incentives to ensure that debt costs are efficient. This view is consistent with the approach adopted by the ACCC, IPART and ORG.
The margin above the risk free rate should reflect the credit rating of the business. Credit ratings are normally performed in a two stage process. The first stage is qualitative and assesses the relative business risk profile of an organisation. The second stage is the quantitative assessment of the organisation’s financial risk profile as a consequence of the methods used to finance its activities and its capital structure. These assessments are used in combination to arrive at a credit rating.
The Authority’s own analysis suggests that, on the basis of the recommended debt to total capital ratio of 50 per cent, the effective credit rating would be in the range of A- to BBB. GAWB is required to maintain a minimum BBB credit rating, and ratings of A- to BBB are consistent with those of other Australian regulated utilities.
The spread between BBB-rated corporate bonds and Government bonds is known to increase with the maturity of the bonds. The current spread between BBB-rated corporate bonds of two to four years maturity and the yield on three year Government bonds is within the margins suggested by GAWB’s major customers, that is, 80 to 120 basis points. However, for internal consistency, the Authority has based its analysis on the spread between bonds of ten years maturity. For the Draft Report, this approach yielded a margin of 180 basis points.
The Authority contin ues to recommend the use of a BBB rating as an indicative target rating for GAWB as this is the rating which GAWB is required to maintain. Based on the differential between the risk free rate and BBB-rated debt with a ten year term as at 28 June 2002, a debt margin of 160 basis points is recommended.
Recommendation:
That a debt margin of 160 basis points above the risk free rate be used.
7.8 Determining Equity and Asset Betas
As noted previously, betas used in calculating WACCs should reflect the perceived undiversifiable risk involved in that business.
To assist in estimating betas (whether equity or asset) for GAWB, the following may be considered as reference points:
· comparable Australian companies listed on the Australian Stock Exchange (ASX), as well as listed companies that have a similar risk profile;
· overseas listed companies; and
· an analysis of the volatility of GAWB’s cash flows.
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WACC expresses the entity’s cost of capital as the weighted average of the required return on its equity and debt. Because of the equivalence between the assets of the entity and a portfolio of the entity’s equity and debt with respective market value weights of E for equity and D for ED+ ED+ debt, the return on assets can be expressed as follows:
æEDöæö Ra=+RRedç÷ç÷ èE++DøèøED
By substituting CAPM for each of the returns (Ra, Re and Rd) it is possible to express the above equation in terms of the relationship between the asset, debt and equity betas as follows:
æEDöæö ba=+bbedç÷ç÷ èD++EøèøDE where
ba is the asset beta
be is the equity beta
bd is the debt beta
An asset beta (ba) represents the risk arising from the sensitivity of the operating cash flows generated by the assets of an entity compared with the market in general (that is, the market risk associated with an entity’s assets). Asset betas vary with the volatility of free cash flows and are driven by sensitivity to the economy. They are not directly observable and therefore must be derived from equity betas.
The difference between an asset beta and an equity beta reflects the additional financ ial risk to a shareholder arising from the extent to which debt is used to finance the entity’s assets.
The debt beta (bd) reflects the financial risk borne by debtholders due to the entity’s use of debt financing. The CAPM can be used to identify the debt beta as follows:
éù Rdf=R+-bdëûRRmf Transformed : RR- b = df d éù ëûRRmf-
Appendix C discusses the equity, debt and asset betas in more detail and identifies issues in their calculation.
Other Jurisdictions
Table 7.3 outlines asset and equity betas used in recent regulatory decisions.
IPART’s (2000a) price determinations for the Hunter, Sydney, Wyong and Gosford water providers were based on asset betas over a range from 0.3 to 0.45. IPART’s method produced a range of real pre-tax WACCs from which a point estimate was selected. As a result, no point estimates for asset and equity betas were reported. IPART used a similar approach in its NSW electricity distribution determination (1999e), this time using an asset beta range of 0.35 to 0.5.
IPARC’s (1999) determination for ACTEW used asset betas ranging from 0.3 to 0.5, while GPOC, in its draft report for bulk water pricing, used an asset beta range of 0.3 to 0.55.
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Ofwat (1999b) quoted a range for equity betas of 0.7 to 0.8 for its water and sewerage charge determinations for UK water companies. Asset betas were not specifically identified.
Table 7.3: Asset and equity beta factors used in regulatory decisions
Entity/Author Industry Asset beta Equity beta
ACCC (2000b) Gas transmission 0.6 1.5
OffGAR (2000b) Gas transmission 0.65 1.33
IPART (2000b) Gas distribution 0.4-0.5 0.9-1.1
IPART (2000a) Water utilities 0.3-0.45 0.65-1.02
IPARC (1999) Water and electricity 0.3-0.5 0.74-0.79
GPOC (2001) Bulk water 0.3-0.55 0.495-0.958
OffGAR (2000a) Gas distribution 0.55 1.08
SAIPAR (2000) Gas distribution 0.45-0.6 0.94-1.06
ACCC (2000a) Electricity transmission 0.35-0.5 1.0 (range of 0.78-1.25) QCA (2001) Electricity distribution 0.45 0.71
QCA (2000b) Below-rail coal network 0.45 0.76
ORG (2000) Electricity distribution 0.5 0.95
Stakeholder Comment
In initial submissions to the Authority, QTC’s assessment of the equity beta for GAWB drew on information on observable equity betas from comparable companies (a sample of US and UK water companies), and an assessment of the riskiness of the water industry compared to other equity investments. In analysing the company data, QTC de-levered each company’s equity beta and then re-levered by the target capital structure of GAWB. This analysis provided an arithmetic average asset beta of 0.39 and a re-levered equity beta of 0.66.
QTC’s analysis of the riskiness of GAWB’s business concluded that, although the water industry is inherently less risky than other industries due to low technology risk, the absence of substitutes and the essential nature of water as a commodity, GAWB’s risk profile is different from other urban water utilities due to its high concentration of industrial customers. QTC observed that GAWB has an economic dependence on the profitability of two main industries (alumina processing and electricity generation) and, as a consequence, on the risk profile of these customers. Based on an analysis of proxy organisations for GAWB’s industrial customers, QTC considered that equity betas for these industries were greater than one.
QTC concluded that GAWB’s equity beta should be below that of its industrial customers but also at the high end of the range for water utilities, and selected an equity beta range of 0.7 to 0.8.
PwC’s analysis (for Comalco) also referred to observable equity betas from relevant overseas water companies, drawing on a sample from the US, UK, Germany and France. PwC estimated that the weighted average asset beta for these companies was in a range from 0.29 to 0.32, which with a target capital structure for GAWB of between 45 and 50 per cent debt to total assets, gave an equity beta of 0.45 to 0.55. PwC argued that the high concentration of major industrial
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customers would not increase GAWB’s market risk but would rather reduce it, because all major customers are financially sound, are dependent on water for their operations, have no alternate supplies and are supplied under long term take-or-pay arrangements.
CPM submitted that GAWB’s equity beta should be in the range of 0.45 to 0.55, reflecting an asset beta range of 0.29 to 0.32 and a zero debt beta. CPM also identified the QTC’s arithmetic average as an issue and pointed out that a weighted average would give an equity beta in the range 0.55 to 0.6. CPM suggested that an equity beta for GAWB of 0.45 to 0.55 was ‘consistent with expectations of the water industry as less risky than either rail or electricity distribution, for which QCA recently recommended asset (equity) betas of 0.45 (0.76) and 0.50 (0.8) respectively’.
CPM also took up the issue that GAWB’s risk profile reflected exposure to a small number of large customers. They noted that all customers are financially sound, are critically dependent on water, and hold long term contracts with take-or-pay conditions. The existence of long term contracts with financially sound customers should counteract any increase in the beta attributable to the small number of customers.
CS Energy echoed the latter comments and suggested that ‘the asset (equity) beta should be around 0.5’. QAL provided an extensive submission that was supportive of CPM’s comments, particularly GAWB’s risk profile as affected by the cyclical customers, degree of indebtedness and the relative levels of operating leverage. QAL suggested an equity beta in the range 0.42 to 0.75, arguing that GAWB has a lower risk profile than its ACT and NSW counterparts.
No specific comments on the equity and asset betas were received in response to the Draft Report. However, CPM and Comalco commented expansively on GAWB’s commercial risk profile. They considered that GAWB’s risk profile is below that of the urban water sector generally, and below that of the electricity and gas distribution utilities. Their arguments were that GAWB:
· is able to recover costs associated with capital surplus to present requirements, insulating it from any risk of asset stranding;
· has limited exposure to risks of future revenue fluctuations;
· is protected by long term supply agreements with financially stable industrial customers critically dependent on water; and
· is protected by significant take-or-pay obligations in contracts.
Comalco and CPM considered that GAWB’s revenue flows are more stable than urban water suppliers and expressed surprise that the Draft Report assessed GAWB as ‘being perhaps the most risk-exposed urban water business in mainland Australia’. Their submissions compared the Draft Report’s WACC for GAWB with other regulated entities around Australia. They found that, with measurement biases removed, GAWB’s WACC was higher than that used by IPART for the major urban water providers in NSW, higher than the WACC used by IPARC’s successor, the Independent Competition and Regulatory Commission (ICRC) for ACTEW, and higher than WACCs used for UK water businesses. Relative to other QCA determinations, Comalco and CPM noted that GAWB’s WACC was higher than electricity, but lower than rail and gas.
QCA Analysis
The calculation of WACC using CAPM to estimate the return on equity involves some degree of imprecision. To calculate an equity beta for GAWB requires:
· the selection of an appropriate asset beta based on an analysis of comparable asset betas;
· analysis of factors affecting the stability of its cash flows; and
86 Queensland Competition Authority Chapter 7 - Rate of Return
· the re-levering of a selected asset beta to account for the GAWB debt to equity ratio.
In most pricin g investigations of Australian utilities, the direct estimation of asset and equity betas is not possible as there is no direct market data available. No water utilities are listed on the Australian Stock Exchange.
After considering the theoretical and empirical issues discussed in Appendix C, the Authority estimated comparable companies’ equity, debt and asset betas using CAPM with an appropriate adjustment to raw equity betas for the tendency of the betas of many listed companies to move towards one over time (due to growth or diversification). The Authority adjusted betas in accordance with the approach applied by Bloomberg as follows:
Adjusted beta = 0.33 + raw beta * 0.67.
The procedure has a number of inconsistencies in its implementation which suggest that the use of adjusted equity betas is not without significant problems. These include:
· adjusted betas can potentially overstate (understate) the asset beta of low (high) raw equity beta firms (depending on whether the assumptions underlying the beta adjustment are justified in the particular case). For example, assume an entity has a raw equity beta of 0.39, debt to equity ratio of 0.50, debt beta of 0.12 and a corresponding asset beta of 0.30. The entity’s adjusted equity beta is equal to 0.59. This equity beta corresponds with an asset beta of 0.43. The adjustment for this relatively low equity beta firm is disproportionate when compared to a firm with an equity beta close to one;4
· the adjustment procedure does not consider the level of leverage in the firm – low leverage firms may substitute debt for equity over time thereby increasing the equity beta without increasing their business risk. For example, if the entity described above was 100 per cent equity financed, with a raw equity beta of 0.39, this would correspond to a raw asset beta of 0.39. However, using the beta adjustment would increase the equity beta to 0.59 which corresponds to an adjusted asset beta of 0.59; and
· the adjustment does not recognise that GAWB would be unlikely to increase its business risk over time, given its single purpose charter.
The difficulties outlined above merely serve to highlight that the calculation of WACC using CAPM to estimate the return on equity involves some degree of imprecision. At the same time, the Authority considers that, in applying CAPM in a regulatory setting, regard must be had to the risks of allowing too low a rate of return. Consequently, the Authority has considered adjusted (as well as raw) betas in the assessment of the rate of return for GAWB.
Asset betas derived for other utilities can provide some guidance for the Authority’s deliberations for GAWB. As shown in Table 7.4, asset betas were found to broadly range from 0.42 to 0.92 for electricity and gas utilities.
In deriving the asset beta for GAWB, the Authority has considered the views expressed by other Australian regulatory bodies (see Table 7.3) and by stakeholders. Based on this information, it has been concluded that asset betas for the water industry typically fall within a range from 0.3 to 0.45, with most falling around 0.3 to 0.4, although GPOC considers they may range up to 0.55 in Tasmania with smaller activities and less diversified customer bases.
4 For example, consider an entity with the higher raw equity beta at 1.05, debt to equity ratio at 0.40, debt beta of 0.06 and an asset beta of 0.77. This firm has an adjusted equity beta of 1.03 and a corresponding asset beta of 0.75.
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Table 7.4: Indicative asset betas
Asset beta range Industry (based on adjusted equity betas)
Electricity generation (listed companies) 0.66 – 0.925
Electricity and Gas distribution (listed companies) 0.42 – 0.476
It is generally accepted that the water industry has many characteristics that make it materially lower risk than other equity investments - including a non-cyclical business, little risk of insolvency and very limited competition (Ofwat 1998).
Factors which support an asset beta towards the lower bound of the range, include:
· urban customers currently comprise approximately 20 per cent of demand and, although it is predicted that demand management strategies will realise reductions in the order of ten per cent, any reduction in per capita consumption should be more than offset by population growth;
· historically, demand from existing large industrial users, which accounts for the remaining 80 per cent of demand, has been stable irrespective of the effects of economic cycles;
· revenue associated with existing large industrial users is insulated by long term take-or-pay contracts; and
· supply capacity is based on an historic no failure yield. The emerging drought risk, however, indicates that this is of less weight.
The main factor which supports a beta towards the upper bound of the range is uncertainty associated with future sales and thus future revenue stability. Firm commitments have been established for only 20 per cent of the 40,000 megalitre current capacity augmentation. A future tariff structure which potentially provides less stability in revenue than that achieved through GAWB’s current take-or-pay arrangements may also be a factor in choosing an asset beta in the upper range. The implications of the current drought and potential for GAWB’s historic no failure yield to be reviewed also suggest signific ant revenue uncertainty.
This uncertainty would tend to suggest that the upper bound of the range is more appropriate for GAWB. CPM and Comalco’s observations that the Authority’s estimated asset beta for GAWB puts it in a higher risk league than the ma jor NSW water supply businesses and ACTEW is consistent with the Authority’s view. By comparison with these water businesses, GAWB is smaller, less diversified and is exposed to a proportionately higher level of excess capacity and medium term demand risk. GAWB is therefore more exposed to non-diversifiable risks than other water businesses not so reliant on lumpy industrial demand uptake.
The Authority also investigated the potential for different asset betas to be applied to GAWB’s industrial and urban customers. However, existing industrial demand is in fact less volatile than existing urban demand, in all probability reflecting the essential nature of water to industrial customers. In addition, like future industrial demand, future urban demand is difficult to predict
5 The actual range for lis ted Australian electricity generators is 0.66 to 1.42. However, the asset beta of Pacific Energy Limited at 1.42 represented an extreme outlier and it was excluded. 6 The actual range for Australian gas distributors is 0.00 to 0.47. However, for Envestra (asset beta of 0.00) the equity beta was estimated using only 42 observations, and the company had a leverage ratio of 0.8013. This makes Envestra’s asset beta an outlier relative to other electricity and gas distributors which have a range of 0.1736 to 0.5302 and it was therefore excluded.
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as it is significantly dependent on the increased population associated with future industrial development. Accordingly, the Authority concluded that it was appropriate to apply a single asset beta to GAWB’s business. Furthermore, the probability of future industrial (and, by implication, urban) demand occurring has been taken into account in estimated cash flows via SMEC’s assessment of the likelihood of industrial projects proceeding. Therefore, there is no need to further ‘risk adjust’ GAWB’s beta to account for this uncertainty.
Recommendation:
That an asset beta for GAWB at 0.45 be used. With a 50/50 debt/equity capital structure and a debt beta of 0.27, the equity beta is equal to 0.63.
7.9 Determining the Dividend Imputation Rate
Under the dividend imputation tax system, Australian resident taxpayers who receive dividends from Australian resident companies can claim a credit for tax that has already been paid by those companies in respect of that dividend income. Ignoring the timing impacts, an Australian resident taxpayer can therefore be completely compensated for the incidence of company tax (but not personal tax).
It is possible to record the impact of dividend imputation either as an adjustment in the WACC calculation or as an adjustment to the cash flow estimates of the business.7 This adjustment factor is known as gamma.
Gamma is typically expressed as a number between zero and one. A gamma of 0.5 implies that $0.50 of each dollar of company tax paid will be redeemed as an imputation credit.
Estimation of gamma
The valuation of imputation credits is determined by the following three key events in the life of imputation credits, which are discussed below:
· creation;
· distribution; and
· redemption or utilisation.
The creation of imputation credits Franked dividends are those dividends paid out of profits on which Australian corporate tax has been levied and which therefore carry a credit for income tax paid by the company. The after tax return to an Australian resident taxpayer on a share with a franked dividend will be greater than the return on an equivalent share with a non-franked dividend.
Dividends are able to be franked if the entity’s income is earned in Australia and hence taxed at the corporate tax rate and if the income has been earned since the introduction of the imputation tax system on 1 July 1987. It should also be noted that both dividends and franking credits can be issued from retained earnings and not just from the current year’s free cash flows.
7 Recording the impact of dividend imputation in the cash flows helps to avoid any possibility of double counting of dividend imputation in both the cash flows and in the WACC.
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Distribution of imputation credits An entity’s dividend policy affects the value of imputation credits. The smaller the payout ratio , the less value imputation credits hold, as the time value of imputation credits diminishes if a company defers payment of fully franked dividends.
The introduction of dividend imputation in Australia has resulted in companies adopting generally higher payout ratios than during the pre-imputation period. Hathaway and Officer (1995) found that 80 per cent of company tax payments are distributed as imputation credits.
The New Tax System reverses some of the incentive for high dividend payout ratios that emerged from dividend imputation because it gives capital gains a favourable tax treatment.
Redemption or utilisation of imputation credits Each shareholder attaches a different value to imputation credits depending on their tax status. Investors who do not pay Australian income tax, such as governments and foreign companies, gain no value from imputation credits, whereas Australian resident taxpayers can gain a full 100 per cent benefit under the New Tax System.
Hathaway and Officer (1995) determined that 60 per cent of the distributed franking credits are redeemed by taxable investors. However, under the New Tax System, Australian residents who were previously only able to claim imputation credits to the extent of any tax liability are now entitled to a refund if their franking rebates exceed their tax payable. Subject to the other effects of the New Tax System, this of itself would tend to increase utilisation levels relative to historical benchmarks.
Other Jurisdictions
In most jurisdictions, a gamma of 50 per cent has been adopted for gas, electricity and water regulatory decisions. IPART has preferred to use a range, from 0.3 to 0.5, while IPARC (1999) used a range of 0.25 to 0.5. GPOC used a gamma of 0.5, as did the QCA’s recent regulatory decisions for electricity, gas and rail.
The ACCC (1999, 2000a) argued that there was no well-founded basis for discriminating in favour of one type of investor over another – such a process may distort pricing outcomes based on share ownership, and does not take into account other tax advantages or disadvantages that may be available to investors. As a result, the ACCC supported the use of an industry average gamma. This view is also supported by the Office of the Tasmanian Energy Regulator (OTTER) (1999) and IPART (1999d, 1999g).
Stakeholder Comment
In initial submissions to the Authority, GAWB submitted that, while the owner of GAWB is not able to use any franking credits, the principles to be adopted should mimic the outcomes of competition. The determination of GAWB’s WACC by the QTC was based on a gamma of 0.5, in line with current practice and reflecting what would occur if GAWB was not government owned.
This estimate of gamma was supported by Callide Power Management, CS Energy, and QAL. PwC assumed that, as the Government is the full shareholder, it receives the full benefit of dividend imputation and effectively receives 100 per cent of tax credits, while Brisbane Water considered that the value of imputation credits should be zero as the Government shareholder does not value imputation credits.
No further submissions were received on this issue in response to the Draft Report.
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QCA Analysis
In determining the appropriate value for imputation credits, the following factors were taken into consideration:
· the Authority has chosen to ignore the current government ownership of GAWB in reaching its conclusions;
· all of GAWB’s profits will be earned in Australia and hence are eligible to be franked; and
· the 80 per cent market average of fully franked dividends identified by Hathaway and Officer is the best available estimate, as is their estimate of the range of utilisation of imputation credits at 60 per cent.
On this basis, the level of gamma would be 0.5 (this reflects gamma calculated as the estimated distribution rate of 0.8 multiplied by the estimated utilisation rate of 0.6, equating to 0.48, or approximately 0.5).
While the changes to capital gains tax and the changes which allow the full flow through of imputation credits to resident taxpayers may have an impact on these levels, there is currently no indication of their likely impact. Further, the influences may be offsetting as the New Tax System may tend to reduce the level of dividend distribution, but may increase the utilisation rate.
As noted earlier, it is possible to record the impact of dividend imputation either as an adjustment in the WACC calculation or as an adjustment to the cash flow estimates of the business. The Authority’s view is that it is appropriate to address the impact of dividend imputation in the estimated cash flows as such an approach allows for more flexibility in modelling different scenarios and enhances transparency.
Recommendation:
That a gamma of 0.5 be used.
7.10 Determining the Tax Rate
The estimation of a post-tax nominal WACC requires the identification of the cost of tax either:
· as part of the WACC formula (as per WACC1, WACC2 and WACC4 discussed in Appendix B); or
· as part of the estimated cash flow (WACC3 in Appendix B is then applied).
In either case, it is necessary to determine the appropriate rate of tax to be applied.
In response to a recent report which reviewed the tax system, the Federal Government announced on 21 September 1999 that it would reduce the company tax rate from 36 per cent to 34 per cent for the 2000-01 income tax year and to 30 per cent thereafter. In addition, accelerated depreciation is to be abolished for tax purposes.
Other Jurisdictions
Tax rates in regulatory determinations in Australia have ranged from 30 per cent to 36 per cent largely reflecting the timing of decisions.
91 Queensland Competition Authority Chapter 7 - Rate of Return
Stakeholder Comment
In initial submissions, GAWB supported the statutory tax rate on the basis that it provides for stable prices and simplifies price calculations. GAWB adopted the 30 per cent tax rate applicable from 1 July 2001 in its cash flow model.
CS Energy suggested that, if GAWB has accumulated tax losses, the level of tax is of little consequence for the foreseeable future.
QAL suggested that, in adopting the pre-tax real WACC framework, the appropriate cost of tax should be determined by using the statutory rate of tax, the approach supported by Brisbane Water.
No further submissions were received on this matter in response to the Draft Report.
QCA Analysis
The Authority recommends incorporating taxation in the cash flow estimates as indicated in Section 7.9. The statutory tax rate will be applied wherever taxable income arises.
Recommendation:
That GAWB’s cost of tax should be included in the cash flow estimates using the statutory rate, currently 30 per cent.
7.11 Expected Inflation
In applying its preferred nominal post-tax approach, the Authority requires a projection for inflation over the regulated period. Four primary methods exist for the estimation of inflation:
· survey based methods where market participants are surveyed to assess their expectations of inflation;
· statistical methods using regression or time series models;
· models based on the Fisher Theory of Interest (1907), which suggests that there is a systematic relationship between nominal interest rates, real interest rates and the expected rate of inflation. Using this theory, the level of expected inflation is implied from the yields on nominal and Commonwealth Treasury capital indexed bonds; and
· the use of secondary sources including monetary and fiscal policy documents. For example, the Reserve Bank of Australia medium term inflation target is two to three per cent. Similarly, in forecasting future revenues, State and Commonwealth governments report anticipated CPI as part of their budgets.
Other Jurisdictions
The ACCC (2000a) stated that it is appropriate to derive the expected inflation parameter from the difference between Commonwealth 10-year bond rates and comparable indexed bond rates.
IPART has calculated inflation by reference to the difference between the ten year Commonwealth bond rate and the relevant indexed bond rate. GPOC (2001) also used this method.
92 Queensland Competition Authority Chapter 7 - Rate of Return
Stakeholder Comment
In initial submissions to the Authority, GAWB’s preference was to utilise the mid-point of the Reserve Bank of Australia’s two to three per cent inflation target.
QAL suggested that expected inflation can be estimated by utilising the expected inflation rate which may be determined through utilising the yields on the Commonwealth Treasury ten year nominal and capital indexed bonds and the Fisher equation. CS Energy suggested using statistical measures such as regression or time series models to predict inflation rates. Brisbane Water recommended that the CPI index be used.
No further submissions were received in response to the Draft Report.
QCA Analysis
The Authority’s preferred approach is to estimate inflation as the difference between the nominal bond rate and capital indexed bonds over the same period (that is, utilising the Fisher equation).
The benefit of such an approach is that it delivers a forward looking estimate of inflation rather than an historic measure. This method is also consistent with the approach adopted by other regulators. Being forward looking, it is more indicative of the underlying inflation rate exclusive of one-off impacts such as the introduction of the GST.
Consistent with the view that information should be as up to date as possible, the Authority has calculated an expected inflation rate based on the difference between the ten year bond rate and a similar maturity indexed bond rate, averaged over the 20 trading days to 28 June 2002. The implied infla tion rate is 2.6 per cent.
Recommendation:
That an inflation rate of 2.6 per cent be used.
7.12 Deriving the WACC
A summary of the parameters selected by the Authority as appropriate for GAWB is provided in Table 7.5. The nominal post-tax WACC for GAWB has been estimated to be 8.72 per cent. This compares to GAWB’s own nominal pre-tax WACC of 11 per cent, which equates to a nominal post-tax rate of 9.3 per cent, assuming a corporate tax rate of 30 per cent and a gamma of 0.5.
The post-tax nominal WACC of 8.72 per cent, adopted for GAWB provides a return on equity after tax of 9.82 per cent.
93 Queensland Competition Authority Chapter 7 - Rate of Return
Table 7.5: Summary of WACC parameters
Parameter QCA Recommendation
Risk free rate (%) 6.02
Market risk premium (%) 6.0
Capital structure – proportion of debt (%) 50 Cost of debt margin (%) 1.6
Cost of debt 7.62
Asset beta 0.45
Equity beta 0.63
Gamma 0.5
Tax rate (%) 30
Inflation rate (%) 2.6
Nominal post-tax WACC 8.72
.
94 Queensland Competition Authority Chapter 8 – Return of Capital
8. RETURN OF CAPITAL
Summary
The Authority recommends that straight line depreciation be adopted in preference to GAWB’s approach of using a financial annuity. It can be shown that, provided the starting periods are the same, and the same asset life is used, there is no NPV difference between a financial annuity or straight line depreciation over the life of the asset, when both return of capital and return on capital are considered. There are, however, timing differences in the respective cash flows, with the straight line approach providing higher earlier cash flows, which the Authority considered appropriate given the uncertainties surrounding the demand estimates.
The most appropriate approach, at least in respect of the dam wall, would have been to use a renewals annuity. However, GAWB does not have the necessary Total Asset Management Plan to provide the basis for such an approach.
8.1 Introduction
An asset consumption charge seeks to measure the decline in the service potential of an asset as a result of wear and tear, ageing or obsolescence. This charge is variously referred to as a depreciation charge, or the return of capital. It provides a measure of the service potential consumed, and should not be regarded as a method for funding asset replacement.
Depreciation is inextricably linked with asset valuation, the return on capital and treatment of maintenance expenditure. This is because:
· the asset base provides the starting value from which the asset is to be depreciated;
· the return on the entity’s asset base relates to that part of the value of the asset that has not already been returned to the owner through depreciation charges; and
· maintenance programmes can affect the rate at which the service potential of an asset declines.
For many water facilities, asset consumption and return on assets can represent up to 85 to 90 per cent of the total economic cost of providing water services, suggesting that derivation of estimates for these cost components is a critical pricing issue (Baxter 1999).
8.2 Theoretical Approaches to Asset Consumption
Methods of dealing with asset consumption include:
· a periodic depreciation charge can be allocated to assets. This periodic depreciation charge can be set using either accounting or economic depreciation methods; or
· a renewals annuity approach which assumes that, through regularly planned maintenance and renewals programmes, the system as a whole does not lose service potential and therefore does not need to be depreciated.
8.3 Periodic Depreciation Charges
Accounting Depreciation Approach
An accounting depreciation approach depreciates assets over the term of their useful lives. A number of central issues need to be addressed in determining accounting depreciation, including:
95 Queensland Competition Authority Chapter 8 – Return of Capital
· the opening and closing values of the asset;
· an assessment of the useful life of the asset, to determine the period of time over which the reduction in service potential for an asset should be charged; and
· the pattern or method of depreciation. Central to this choice is a consideration of the elements of consumption that drive changes or reductions in the service potential of assets. Different approaches may therefore be appropriate for different assets.
Where a smoothed pattern of the erosion of asset value over time is adopted, the best-known options are:
· straight line (or linear consumption) depreciation - this method provides for an equal amount of depreciation each year, found by dividing the difference between opening value and salvage value by the expected life of the asset. This is a simple approach that is well understood and widely accepted, and is suited to assets where the rate of consumption is stable from year to year;
· annuity based depreciation or constant efficiency – this method is most suited when assets maintain full productive capacity until they reach the end of their useful life, like a light bulb for instance; and
· accelerated depreciation – this method is most suited when productive capacity declines at a constant rate, for example, 25 per cent per year, like radioactive decay or a melting block of ice. Maintenance must grow at an increasing rate to sustain output. Accelerated depreciation, or the diminishing value method, results in higher depreciation early in the asset’s life. Under this method, a fixed percentage is written off each year, calculated on the declining balance at the beginning of each period.
Asset valuation patterns for an equivalent asset under each of these alternatives are illustrated in Figure 8.1.
Figure 8.1: Depreciation Schedules
120,000 Commencement of first regulatory period 100,000
80,000
60,000
40,000 Asset Value ($)
20,000
0 Time
Annuity Straight Line Accelerated
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It is clear that equivalent assets are valued more highly under the annuity depreciation approach compared to either the straight line depreciation or accelerated depreciation approaches.
The units of production method assigns a depreciation charge according to the asset’s use or productive output, typically on the basis of some measure of productivity or throughput. This approach is appropriate where water asset usage varies substantially from year to year. The main drawback is the difficulty of establishing an effective measure of capacity use that reflects the decline in the value of the asset.
For the water industry, cost based depreciation may result in a depreciation charge which exceeds the actual revenue requirement for the maintenance of the service potential of the asset, particularly because of the inability to accurately determine the lives of some water assets (for which the useful life may extend beyond 100 years). Under this approach, there is a tendency to under-estimate the useful lives of long-lived water supply assets such as dams and pipelines.
Economic Depreciation Approach
Economic depreciation measures the change in the economic value of the entity, measured as the difference between the value at the beginning of the period and at the end of the period. For regulated monopolies, this introduces a circularity problem as the ir economic value is dependent on the prices allowed by the regulator which are in turn dependent upon the level of depreciation allowed.
8.4 Renewals Annuity
Under the renewals annuity approach, the asset network is considered to be an integrated, renewable system to be maintained in perpetuity, rather than a collection of individual assets each with their own asset lives and maintenance requirements.
The renewals annuity approach is generally considered to be valid only for infrastructure assets satisfying the following characteristics:
· the asset system is renewable rather than replaceable. In other words, the components of the system will be replaced according to their own useful lives, but the operating capacity of the system as a whole will be maintained; and
· for the foreseeable future, demand is such as to warrant continual renewal of the asset system so that the assumption of an infinite asset life is warranted.
The essential input to a renewals annuity approach is an asset management plan. Taking account of the age, condition and service capacity of the system, a total maintenance plan is developed which identifies the most effective operating lives and times for replacement of all assets which together comprise the system or network. An expenditure programme , in some cases for a period as long as 35 years, is then developed to both replace component parts of the system when required and to carry out all other operations and maintenance.
Major expansions to the network, such as the addition of a new storage or transmission link, would form part of the capital expenditure. These would need to be dealt with separately, as would other ‘assets’ that do not comprise part of the overall network (such as office equipment, motor vehicles and other ancillary assets used by a water services business).
The potential advantages of the renewals annuity approach include:
· the existence of higher quality information about the total system or network that the overall plan provides;
97 Queensland Competition Authority Chapter 8 – Return of Capital
· the reduced requirement for determining the lives of long life assets (as compared to conventional depreciation approaches); and
· the smoothing out of lumpy annual operating and maintenance costs.
The renewals annuity approach is well suited to the water industry, which comprises network assets that are renewable rather than replaceable.
The major disadvantage of a renewals annuity relates to the difficulty of developing long term asset management plans, particularly plans encompassing realistic engineering and financial estimates. The approach is rendered more complex where expansion of the network is occurring, and where there is potential for asset components to become redundant in the future.
A renewals annuity approach also requires a decision on the time scale over which the renewals charge would be determined, and its frequency of adjustment. Where it has been applied in rural water businesses, the renewals annuity is typically determined over a rolling 30-year period, with yearly or five-yearly adjustments. However, if a significant peak or trough can be foreseen beyond the chosen time horizon, it is prudent to extend it to smooth the annuity charges. The choice of an earnings rate is also an issue, and the tax implications of these earnings may also need to be recognised in determining revenue requirements.
8.5 Approaches Adopted in other Jurisdictions
The potential for renewals annuities in the water industry has been recognised by ARMCANZ in its water pricing guidelines. These guidelines state that ‘an annuity approach should be used to determine the medium to long term cash requirements for asset replacement/refurbishment where it is desired that the service delivery capacity be maintained’. ARMCANZ further noted that in defining the minimum level of cost recovery for a water business to ensure viability, the return of capital should be a ‘provision for future asset refurbishment/replacement’, using the annuity approach. In defining the maximum level of cost recovery, to avoid monopoly rents, ARMCANZ considered a ‘provision for the cost of asset consumption’ appropriate.
As a consequence, renewals annuities have been widely adopted in the irrigation sector. Irrigation service providers such as Murray Irrigation Limited (NSW) and SunWater base their pricing policies on renewals annuit ies.
Variations on the renewals annuity approach have been adopted by a number of other jurisdictions, including Ofwat in the United Kingdom.8 Ofwat established an annual infrastructure renewals charge calculated as the average over several years of the forecast infrastructure renewals expenditure required to maintain the serviceability of the infrastructure network. The infrastructure renewals charge effectively takes the place of both depreciation and major maintenance expenditure. Differences between actual infrastructure renewals expenditure and the estimated infrastructure renewals charge are carried forward in the business’s balance sheet as an accrual or a pre-payment, with major differences redressed at price reviews.
In Queensland, amendments to the Local Government Act 1993 have been effected to allow local governments (when applying competitive neutrality reforms to a water business activity) to apply a renewals approach to asset consumption charges for pricing purposes. It is understood that a number of councils have adopted this method for their water and sewerage business activities.
The Government Prices Oversight Commission of Tasmania (GPOC) recommended in its 1998 investigation of bulk water services that authorities prepare information to allow return of capital to be based on a renewals annuity approach. In its 2001 investigation, GPOC noted that this task
8 To be more precise, Ofwat uses a form of renewals accounting, of which the annuity approach is a subset.
98 Queensland Competition Authority Chapter 8 – Return of Capital
had not been completed, and that the straight line depreciation method would therefore be adopted.
Recent regulatory decisions have been virtually unanimous in their choice of straight line depreciation for valuing return of capital (see Table 8.1). The only exception was IPART’s decision on bulk water prices for the Department of Land and Water Conservation (DLWC) which was based on a renewals annuity. This renewals annuity included major periodic maintenance and replacement expenditure expected over a rolling 30-year period.
Table 8.1: Summary of other regulators’ approaches to return of capital
Regulator Industry/Businesses Depreciation method
IPART (2000a) Hunter and Sydney Water Corporations, Gosford Straight Line and Wyong Councils.
IPART (2001b) Bulk water prices – Department of Land and Water Renewals Annuity Conservation
IPARC (1999) ACTEW (Electricity and Water) Straight Line
GPOC (2001) Bulk water pricing Straight Line
IPART (1999d) Electricity distributors Straight Line
ORG (1999) Electricity distributors Straight Line
QCA (2001) Electricity Distribution Straight Line
QCA (2000b) (Draft Below rail coal network Straight Line Determination)
Recent history suggests that renewals annuities have been adopted where there is a dominance of renewable long-life assets such as dams and earthen channels, as is the case for irrigation water suppliers.
8.6 Stakeholder Comment
In its initial submission, GAWB supported the financial annuity approach for estimating return of capital. The annuity was determined as the amount required to be set aside each year to fund the future inflated cost of asset replacement at the end of assets’ useful lives. The reserve was assumed to earn interest at a rate equivalent to the cost of debt, which was set at 7.7 per cent in nominal terms.
There was varied comment from other stakeholders in initial submissions:
· CS Energy noted that, since the Awoonga Dam is GAWB’s major asset, and has a life of over 150 years, annuity-based depreciation is the most appropriate;
· Brisbane Water commented that traditional accounting based depreciation methods are inappropriate, and supported the renewals annuity approach for determining asset consumption. Brisbane Water advised that this would require a Strategic Asset Management Plan over a period of at least 20 years, with external audit/review to ensure that ‘gold-plating’ of the renewals programme does not occur; and
99 Queensland Competition Authority Chapter 8 – Return of Capital
· QAL suggested the use of a straight line depreciation method based on an optimised deprival valuation of GAWB’s assets.
In response to the Draft Report, SEQWater supported straight line depreciation for estimating return of capital.
8.7 QCA Analysis
Depreciation is incorporated into the pricing framework by its inclusion in the revenue requirement for the entity. Most water industry decisions have proposed a straight line method for calculating depreciation, on the basis that, if a single approach is to be applied, straight line approach best reflects an average position of all types of assets.
However, no single depreciation profile is consistently the most appropriate for all asset classes. The applicable pattern depends upon the particular degenerative characteristics of each asset. Water supply and distribution assets fall broadly into two categories:
· assets that never need to be replaced (such as land and easements), or at least have a very long useful life and require very low maintenance, such as dams and reservoirs; and
· assets that need a relatively constant or increasing maintenance schedule as the life of the asset increases, such as some pipelines, pumps, valves etc.
Dams generally have very long lives requiring minor maintenance, and thus maintain much of their productive capacity. Such assets can be maintained indefinitely, providing an appropriate periodic maintenance and renewal programme is put in place, and the major threat is likely to be technical obsolescence rather than deterioration.
Other long-life assets such as pipelines may lose value more evenly over their useful lives, best fitting the straight line depreciation profile. Assets such as pumps and motors exhibit linear consumption or possibly geometric asset consumption patterns.
In principle, the Authority would prefer to apply a renewals annuity approach to long-lived infrastructure. However, as GAWB is yet to finalise an asset management plan, which is essential for the effective application of a renewals annuity, this is not possible.
GAWB’s approach of using a financial annuity does not overcome the problem of determining an appropriate asset life for long-lived assets. It can be shown that, provided the starting periods are the same, and the same asset life is used, there is no NPV difference between a financial annuity and straight line depreciation over the life of the asset, when both return of capital and return on capital are considered. It can also be shown that, if prices are smoothed over the full period, the same prices will be generated regardless of the depreciation approach chosen.
However, when lesser periods than the full asset life are used, there can be cash flow timing differences, with the annuity method biasing cash flows to later periods and reducing the revenue requirement in the earlier periods. This may be appropriate if it matched the likely consumption profile. However, GAWB has not proposed the annuity approach on this basis and a uniform consumption approach is more appropriate in the absence of such evidence. The Authority also notes that GAWB is undertaking a significant augmentation in advance of the demand necessary to ensure the viability of that augmentation. The adoption of straight line depreciation, which biases cash flow to earlier periods, will assist in ameliorating any potential for cash flow problems that may occur as a result.
Accordingly, the Authority recommends straight line depreciation for all assets over the asset lives recommended by SMEC, as summarised in Table 8.2.
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The Authority’s approach uses SMEC’s depreciated asset values as the starting values for DORC for each asset, with straight line depreciation applied over the remaining lives. In future reviews, regardless of the measure of asset consumption chosen, starting asset values should be consistent with the straight line method so that the potential for windfall gains or losses to GAWB is averted.
Table 8.2: Design lives for GAWB assets
Asset Type Design Life (Years)
Dam earthworks and spillways 150
Dam outlets 100
Bridges 100
Roads and pavements 30
Electrical/power 35
Switchboards 20
Flow meters 15
Pumps, electric motors, cranes and mechanical 25
Pipelines (asbestos cement, reinforced concrete, fibre resin cement) 50
Pipelines (ductile iron, mild steel, poly vinyl chloride) 70
Valves 30
Concrete reservoirs, buildings and other concrete structures 50
Steelwork 35
The Authority considers that the use of renewals annuities should be reviewed if and when GAWB develops an appropriate Asset Management Plan.
Recommendation:
That straight line depreciation be used for all GAWB’s assets.
101 Queensland Competition Authority Chapter 9 – Operating Expenditure
9. OPERATING EXPENDITURE
Summary
On the basis of advice from the Authority’s consultant, the Authority identified an appropriate level of operating expenditure for GAWB, both before and after the current augmentation, and developed an appropriate basis for allocating common costs including general administration costs.
Approximately ten per cent of general administration costs (billing, customer contract administration, customer enquiries, pricing) was allocated on a per customer basis. The remaining 90 per cent was allocated according to the administrative effort involved in each segment (dam, raw water delivery and treated water delivery).
The Authority found that approaches to the benchmarking of opex were inconclusive in identifying potential efficiency gains due to the lack of comparators and the lack of useable data. However, activity-based savings were identified in such areas as asset management, financial management, and operational management and maintenance scheduling.
The Authority estimated efficient opex to be $6.4 million in 2001-02, including $1.9 million in general administration costs and recommends that this be adopted for pricing purposes.
9.1 Introduction
In a water business, operating costs include electricity, chemicals, maintenance expenditure, employment expenses, administration, rent, insurance and other overheads.
The Authority has recommended that prices should be established for each user to promote appropriate signalling of the costs associated with use. Some costs, such as those related to the maintenance of spur-lines, are directly attributable to users. Under current arrangements, maintenance services for spur-lines are provided by the Gladstone and Calliope Councils under exclusive contracts and the costs incurred are billed directly to the users (as users have previously paid for these spur-lines).
GAWB operates the bulk storage and distribution system and incurs associated costs. In setting prices, GAWB has attributed certain costs to specific segments of the network and then apportioned them to users according to usage. All common operating costs, such as administration and recreational facilities, were allocated to users in proportion to each customer’s share of total water demand.
Significant issues in relation to opex include :
· the appropriate method for allocating segment and general administration costs to users; and
· the basis for determining efficient opex into the future.
In addition, certain cost elements such as environmental costs, the costs of operating recreational facilities, tax equivalents and competitive neutrality fees require consideration.
9.2 Cost Allocation
In general, the greater the degree to which costs can be related to the provision of services, the greater the cost reflectiveness of the pricing structure, and the more effective the pricing signals. To achieve this, costs should be directly allocated where a verifiable relationship is ascertainable between the expenditure and an individual product or service.
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Where such a direct relationship cannot be established, that is for general administration and other common costs, there are a number of approaches that may be applied:
· the fully distributed cost approach allocates common costs in proportion to the costs that can directly be attributed to a user/service or in proportion to the revenues generated;
· the demand measures approach allocates common costs to consumers considered most likely to be able to bear these costs, and least likely to by-pass the network. This approach is analogous to Ramsey pricing in that costs would be allocated to segments or customers exhibiting inelastic demand; and
· peak usage which allocates costs according to users’ share of peak demand.
Other Jurisdictions
The experience of other Australian water regulators provides very little guidance on the means by which operating costs should be addressed. The allocation of costs between nodes was not an issue for IPART’s (2000a) price determinations for Hunter Water, Sydney Water, Gosford City Council and Wyong Shire Council.
IPARC’s (1999) price direction for ACTEW does not provide any indication of how general administration and common costs were allocated between the electricity and water segments of the business. Likewise, IPART’s determination of bulk water prices for the Department of Land and Water Conservation’s irrigation business does not indicate how general administration costs were allocated between irrigation schemes.
The Queensland Water Reform Unit’s determination for SunWater (2000) allocated all administration costs, excluding human resource management costs, on the basis of each irrigation scheme’s operating and maintenance costs less 90 per cent of electricity costs. Most electricity costs were excluded on the grounds that they were determined externally , beyond SunWater’s control, and that there is considerable variation in the degree to which separate schemes rely on electricity. Human resource management costs were allocated by each scheme’s share of total employee numbers.
Stakeholder Comment
In their initial submissions, GAWB’s existing customers disagreed with GAWB’s method of allocating all general administration costs on the basis of water consumed:
· Callide Power Management argued that it was contributing to costs related to the management and administration of downstream distribution works and treatment plants;
· CS Energy requested an independent review of GAWB’s cost allocation on the basis that fixed costs associated with the dam should be minor in comparison to the rest of GAWB’s system; and
· QAL submitted that the cost allocation should be based on the demand measures approach. It suggested that residential or urban water users’ demand for water is more inelastic than water demand from other sectors and, as such, should be allocated a higher level of costs.
SunWater suggested an alternative approach to cost allocation on the basis that the operating costs associated with the dam are largely fixed and are driven by statutory compliance with dam safety and resource management requirements, such as the monitoring and reporting of water flows. As such, opex for the Awoonga Dam should be treated as fixed and allocated on the basis of water entitlements to each customer.
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SunWater raised a similar issue in relation to allocating operating and maintenance costs for GAWB’s distribution system, indicating that there are significant fixed costs for pipelines regardless of water throughput. SunWater proposed that the Authority allocate GAWB’s operating and maintenance costs for the distribution system as follows:
· fixed costs – allocated according to share of pipeline and pump capacity, or entitlement; and
· variable costs – allocated according to actual use.
No submissions were received on this matter in response to the proposed approach used in the Draft Report.
QCA Analysis
The Authority engaged SMEC Australia to identify an appropriate level of opex for GAWB, both before and after the current augmentation, to identify directly attributable costs and to allocate common costs including general administration costs.
SMEC’s assessment of GAWB’s future operating, maintenance and administrative costs was based on the following parameters:
· the operating, maintenance and administration costs derived from the 2000-01 financial year data (after adjusting for abnormal items) provided a cost base for existing service standards. Financial information from earlier years was not available;
· operating and maintenance costs for new works associated with future augmentation were determined by using a schedule of industry standard percentages applied to projected capital costs;
· future electricity costs were based on inflating current tariffs by modelling the daily average number of pumping hours using peak or off-peak tariffs;
· future chemical costs were based on current chemical costs per megalitre of water treated in each segment;
· SMEC’s analysis also added new operating and maintenance costs for future assets necessary to meet industry standards; and
· all future savings including one-off operating costs to improve operating and decision support systems were identified in the activity study (see next section).
SMEC also identified an appropriate basis for attributing certain costs to segments, and a means for allocating costs reflecting the broad principles of causality. SMEC found that:
· certain costs (referred to as direct costs) were directly attributable to segments of the network. These included operating, maintenance, chemicals and electricity costs. These were then allocated according to the users’ shares of the segments throughput;
· other cost items which could not be directly attributed to the raw water system and treated water system were allocated to each segment on the basis of the segment’s share of total direct costs and then to users according to their share of throughput; and
· general administration costs were distributed according to whether they related to management/administration effort or customer related activity.
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General administration costs represent about 30 per cent of total opex and are difficult to apportion. Based on SMEC’s analysis of GAWB’s general ledger entries and an examination of its operations, approximately ten per cent of general administration costs (billing, customer contract administration, customer enquiries and pricing) are customer based and have been allocated to customers.
The remaining 90 per cent was allocated according to administrative effort in each segment (dam, raw water delivery and treated water delivery). This relative administrative effort was approximated by the relative operating and maintenance costs per megalitre. This resulted in the following weights:
· 0.5 x ML delivered for supplies out of Awoonga Dam;
· 1.0 x ML delivered for supplies to raw water customers; and
· 2.0 x ML delivered for supplies to treated water customers.
These ratios conformed with SMEC’s industry experience.
The Authority considered that GAWB’s approach of allocating all costs to Awoonga Dam did not provide an adequate recognition of management effort for the different services. It resulted in the same general administration cost being allocated to each user on a megalitre basis regardless of location and service. The SMEC approach has a major advantage in that it provides recognition of the variation in management effort for different water products and services. The SMEC approach assigns progressively higher administration costs to storage activities, raw water delivery activities and treated water delivery activities broadly reflective of operating cost differentials.
The cost allocation procedure is also cumulative in nature. For example, general administration costs for treated water are effectively the sum of costs allocated to storage, distribution to treatment plants, and treatment, as all these activities are involved in providing treated water. The procedure results in general administrative overheads and other common costs of $10/ML at Awoonga Dam, $29/ML for raw water delivery and $71/ML for treated water delivery, which contrasts with GAWB’s uniform cost of $25/ML for all water delivered.
The Authority recommended that the SMEC approach should be used for allocating general administration costs for the current investigation on pricing practices. However, it also recommended that GAWB should undertake an activity analysis of general administration functions to enable identification of appropriate cost drivers for the allocation of general administration costs in future. The recommended cost allocation procedure is illustrated in Figure 9.1.
Figure 9.1: Recommended Cost Allocation Method for GAWB
Identification Allocation to Segments
Direct Costs Actual costs allocated to segments (operating, maintenance, and electricity)
Other Costs Allocated to segments by share of Direct Costs, and to (maintenance and staff costs) users by share of throughput
General Administration Costs 90 per cent allocated by administrative effort (with weightings of 0.5, 1 and 2 for storage activities, raw water delivery and treated water delivery respectively).
10 per cent allocated by customer.
105 Queensland Competition Authority Chapter 9 – Operating Expenditure
Recommendations:
That opex costs be allocated in accordance with the principles outlined in Figure 9.1.
That further analysis of general administration costs on an activity basis is warranted.
9.3 Opex Efficiency
In order to ensure that asset owners are not rewarded for any existing cost inefficiencies, it is important that only efficient costs are included in the determination of prices.
However, efficient costs are not necessarily easy to determine, particularly given the lack of comparability between monopolies and the lack of useable data.
At the same time, even if baseline costs are efficient, it is important to provide asset owners with an incentive to reduce these costs over time. Such incentives should apply to both capital and operating expenditures. However, optimum capital expenditure into the future is traditionally the subject of separate consideration as part of optimisation.
In respect of operating costs, the most common mechanism associated with incentive structures is CPI-X, where the CPI is a price escalation inflator and X is a pre-determined index reflecting the perceived capacity of the regulated business to realise cost savings, usually in operating expenditure. In applying the CPI-X adjustment mechanism, the main issues are the choice of cost index (escalation factor) and the measurement of the X factor.
Traditionally, Australian utility regulators have adopted the Consumer Pric e Index (CPI) as a basis for price/revenue cap escalation. In addition, it is widely used for general indexation of public and private sector contracts and charges, including those for GAWB’s customers.
The X factor may be determined by an assessment of overall efficiency not specifically linked to costs, or by cost-linked assessments. The unlinked approaches, or global efficiency measures, include total factor productivity (TFP) and data envelopment analysis (DEA). Limited sample size and wide variations in the nature of businesses mean that these general efficiency measures have not been widely adopted by Australian water industry regulators. A further issue is that the alternative approaches can yield widely varying results.
Cost-linked measures are usually expressed as unit costs, such as cost per property, cost per megalitre of water delivered or cost per kilometre of pipeline. These can then be compared either with those of other water businesses (benchmarking across the industry), with the previous performance of the organisation (benchmarking over time), or with the best performer in an industry. The UMS Group (1999) in its work for IPART identified potential weaknesses in the traditional benchmarking approach based on such partial measures:
· the cost vs service level trade-off. Cost may be reduced at the expense of service. Benchmarks need to include both;
· inconsistent data;
· weak peer groups. Comparisons need to be made with strongest competitors; and,
· structural and environmental differences. Because of structural differences, partial measures may not be comparable. In the water industry, differences may include weather, customer numbers and dispersion, size of the business etc.
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While IPART’s (2000) price paths for the four major NSW urban water service providers involved CPI price escalation, it incorporated efficiency savings into operating expenditure. These savings were identified from a benchmarking analysis using key performance indicators and varied between the service providers. IPARC’s (1999) price direction for ACTEW’s water business also used the CPI but provided for a real increase in costs to meet service quality improvements.
The approach used by Ofwat (1999) in determining water and sewerage charges for UK water companies was to review the actual cost structure of each company as the basis for determining current efficiency and areas where future efficiency gains could be achieved over the regulatory period.
This approach was similar to that adopted by the Authority for the Draft Report. The Authority requested SMEC to identify a means for estimating operating costs and associated efficiency gains that could be achieved by GAWB over the 20-year cash flow period, as a basis for estimating efficient costs.
SMEC benchmarked GAWB’s existing opex against a number of urban water authorities. In GAWB’s case, the most suitable comparators were other bulk water suppliers, namely, Melbourne Water, Hobart Water, South East Queensland Water Board, Sydney Catchment Authority, NQ Water, Caloundra-Maroochy Water Supply Board, Cradle Coast Water, Esk Water, Fish River Water Supply, Goldenfields County Council, Rous County Council and SunWater.
SMEC’s benchmarking study analysed GAWB across a range of productivity measures and, for benchmarking purposes, used the four key performance indicators identified in Table 9.1. In this table, lower ranking numbers signify better performance against comparators.
SMEC found that GAWB ranked better than many authorities when operating and maintenance costs were considered. However, on the basis of the limited available data, SMEC considered it inappropriate to recommend a general benchmark efficiency target for GAWB. As a substitute, SMEC undertook an activity review of GAWB and found that there were a number of key operational areas where GAWB could improve its efficiency and operational performance.
Table 9.1: SMEC benchmarking outcomes
Key Performance Indicator GAWB Result Average Result Rank1
Costs as a proportion of total asset value 2.42% 2.87% 3 (11)
Costs per ML delivered $131 $103 4 (12)
Costs per km of pipeline $38,867 $40,430 7 (10)
Treatment costs per ML of treated water delivered $90 $93 6 (10)
1. SMEC compared GAWB to twelve bulk water authorities. Some of the key performance indicators were not available for some of these water authorities. The rankings show GAWB’s performance, while the data in parentheses indicate the number of water authorities compared. A lower ranking indicates a better performance by GAWB relative to the other authorities.
SMEC found that GAWB could make significant savings in the area of asset management by directing maintenance more effectively, by fully integrating the asset and financial management systems and by improved recording and information systems as follows:
· a three per cent reduction in maintenance costs for four consecutive years, starting in 2001- 02, and annual savings of $100,000 per year after 2004-05 as a result of implementing an
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asset management plan. Planning provides for better recording, improved maintenance scheduling and more effective deployment of maintenance resources. The asset management plan required a capital outlay of $400,000;
· a ten per cent reduction in operating costs in 2003-04 and a further five per cent in 2008-09 achievable through the introduction of alarms and ‘call-out’ systems and greater use of automated technology; and
· a five per cent reduction in electricity in 2004-05 plus a further five per cent in 2009-10 arising from a greater ability to negotiate lower tariffs on the basis of increased throughput.
In addition, SMEC indicated that operating savings of five per cent were possible from 2003-04 and a further three per cent from 2008-09 from the use of automation and telemetry. These savings required a total capita l cost of $300,000 over three years from 2002-03. SMEC argued that GAWB’s larger scale of operations following augmentation justif ied this expenditure.
SMEC also suggested that additional costs would be incurred by GAWB in the following areas:
· customer service costs for working with industrial customers to identify options for managing supply risks and for delaying future works. These options could include, for example, customer provision of on-site storage to allow savings in electricity, maintenance and operation. Additional customer services would add $65,000 in 2001-02, and a further $65,000 in 2009-10 for the preferred planning scenario;
· costs for regulatory compliance of $65,000 from 2001-02; and
· $150,000 for a demand management programme in 2004-05 for the preferred planning scenario.
SMEC included these issues in its estimates of future opex to 2020-21, which the Authority then adopted in its financial modelling for the Draft Report.
Stakeholder Comment
In initial submissions, all stakeholders supported the concept that GAWB’s operating and maintenance costs should be efficient.
The preferred approach of industry stakeholders, including CS Energy and CPM, was an incentive-based approach building on costs of service. CPM commented that:
‘Clearly, the Board needs to be afforded the opportunity to recover the efficient and reasonable costs of providing bulk water services to its customers, yet should also confront sufficient incentives to encourage it to improve its performance over time’.
CPM supported the use of the CPI, citing that its advantages outweighed the disadvantages, and suggested that the X factor should be set to reflect GAWB’s ability to deliver real cost savings in total, not simply in terms of reductions in operating costs. CPM argued that X should account for the effects on the asset base of depreciation and the effects of demand increases. It also suggested that a balance be struck in providing incentives for GAWB to pursue cost savings while ensuring that customers benefit over time and commented that cost pass-through arrangements should be very limited in scope and defined ex ante. CS Energy also supported CPI-X and favoured GAWB being the beneficiary of any out-performance.
Brisbane Water suggested that direct comparisons of unit costs are usually inappropriate. GAWB’s prices were based on historical information relating to operating costs taking into
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account different circumstances. No attempts at benchmarking were made by GAWB on the basis that there were no appropriate comparators.
GAWB’s approach to recognition of efficiency gains was to index operating costs forward at 75 per cent of annual CPI, implying a real reduction in opex costs each year equivalent to 25 per cent of CPI (or an X factor of about 0.6). However, GAWB indicated that its previous estimates of opex may be too low in the light of emerging regulatory compliance matters.
In response to the Draft Report’s efficient cost estimates, the Department of Natural Resources and Mines sought further explanation of the assumptions underlying the cost savings identified by SMEC in the Draft Report. GAWB considered that the electricity savings were not appropriate, as competitive prices had been achieved following a tender process with the major retailers. The price was based on maximum off-peak use and recognised GAWB’s ability to avoid high spot prices for electricity from the pool.
GAWB further raised the issue of autonomy in cost management. It noted that the operations of the business were the responsibility of managers reporting to directors, and that there are checks and balances in the management system to ensure operational safety and cost efficiency. SEQWater similarly observed that the water supplier’s views on the appropriate level of operating expense need to be a vital consideration. SEQWater was concerned that expenses may be reduced excessively and that directors may be subject to personal liability if dam safety or water quality are compromised.
Following the Draft Report, QAL expressed its preference for an X factor to be applied to GAWB’s opex to provide an incentive for cost reductions. QAL believed that it was inconsistent for GAWB to be excluded from competitive tension created by CPI-X price increases.
QCA Analysis The Authority engaged SMEC to respond to the issues raised by GAWB and to revise the estimated opex costs to reflect the changes in demand projections.
The major changes recommended by SMEC were that:
· a saving in electricity costs of five per cent should be achievable in 2006-07 (previously 2004-05) and a further five per cent from 2015-16 (previously 2009-10). SMEC’s view was that these savings would reflect GAWB’s greater bargaining power in an increasingly competitive and interlinked national electricity industry. The revised timings of benefits reflect the timing of significant increases in water deliveries when GAWB could be in a position to negotiate more favourable rates; and
· the additional costs for the demand management programme should be reduced to $100,000 (previously $150,000) and commence from 2009-10 rather than 2004-05. The new estimate is based on only one customer support officer being required for these activities rather than two. SMEC considers that customers themselves will carry the initiative in promoting demand management, particularly as a result of the current drought, while the revised demand projections reduce the imperative for GAWB to consider such strategies until after 2010.
In relation to the issue of autonomy in cost management and the implications for service standards and safety, the Authority notes that the opex costs are derived from GAWB’s current costs, with additional costs identified for operating new infrastructure based on industry benchmarks. Aside from this, the suggested savings derive from technological advances and reforms in input markets that have driven cost efficiencies throughout the water sector.
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The changes in operating costs are summarised in Table 9.2. Compared to the Draft Report, the significant difference is that opex costs are significantly lower from 2002-03 to 2004-05. This is attributed to:
· lower water volumes delivered from Awoonga Dam to Gladstone under the revised demand scenario; and
· the deferral of opex for the Mt Miller and Aldoga pipelines, consistent with deferral of these assets in the asset base, while throughput volumes to customers in these areas are also lower.
SMEC’s general administration costs are lower in 2004-05 due to the deletion of $150,000 (2001 dollars) in demand management administration costs. From 2009-10, the estimated demand management costs are $50,000 lower than recommended for the Draft Report.
Table 9.2: Summary of projected opex costs, preferred planning scenario ($’000)1
Opex Cost Element 2001-02 2002-03 2003-04 2004-05 2009-10 2014-15 2020-21
Draft Report
Operations and Maintenance 4549 5296 5743 6177 8281 9787 11803
General Administration 1829 1875 1814 2025 2373 2685 3114
Total 6378 7171 7557 8202 10654 12472 14917
Final Report
Operations and Maintenance 4579 4849 5053 5294 7893 9441 11510
General Administration 1855 1904 1845 1893 2361 2685 3132
Total 6434 6753 6898 7187 10254 12126 14642
1. Note that the Draft Report values were inflated using an inflation rate of 2.5 per cent, while the Final Report estimates are inflated using a rate of 2.6 per cent.
The Authority recommends that the revised savings in opex costs identified by SMEC be included in the final cash flow analysis rather than via an explicit X factor. A similar approach was adopted by the Authority in its determination for electricity distributors.
In response to QAL’s submission, the Authority considers that the X factor approach is not appropriate for GAWB at this time. Rather, it is preferable to include estimated cost savings in the cash flows. In addition, GAWB’s opex cost base is relatively small and any further savings not identified by SMEC are likely to be insignificant in pricing terms.
Whether an improved means of ensuring efficiency gains can be established is recommended for consideration pr ior to the next review.
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Recommendation:
That potential efficiency gains be explicitly included in operating costs. That a further review of incentive mechanisms be undertaken as part of the next review of prices.
9.4 Other Costs
Externalities
Externalities such as environmental factors can also impact on operational costs.
Instances of specific charges being incorporated to meet environmental costs are rare but increasing. IPARC’s (1999) direction for ACTEW proposed a water abstraction charge initially of 10c/kL of water consumed to recover identified catchment management costs, identifiable environmental work and an estimate for the scarcity value of water. Most of the charge (7c/kL) is attributed to scarcity values. Many local governments apply green levies or the like, but these are not confined to water-related externalities.
Stakeholder Comment In initial submissions, Callide Power Management commented that pass-through of such costs should be limited to those areas where GAWB is responding to externally-imposed environmental and natural resource management requirements. QAL supported this approach, indicating that all external costs of providing a service should be included in the price of water. Brisbane Water suggested that the costs of externalities should be recorded and kept in a separate account and applied to recreational, community and environmental needs.
No further comment was provided on this matter in submissions on the Draft Report.
QCA Analysis In the case of GAWB, the costs of managing environmental and community impacts of water storage and supply activities are largely built into existing cost structures.
In Queensland, statutory Water Resource Plans (WRPs) (previously Water Allocation and Management Plans or WAMPs) provide a framework on a catchment basis for determining the total water resources, environmental flow requirements, other priority requirements and rules for further allocation and management of water (DNR 1997). The process combines hydrological, economic, social and environmental parameters to determine water allocations in a property rights framework. In essence, the WRP process provides for water allocation and usage constraints to minimise the potential for environmental externalities.
The Boyne River Water Mana gement Plan imposes costs on GAWB which are internalised through stream flow management requirements and constraints on total water allocations. These costs are then shared among all users as part of general administration costs.
A specific operational cost is incurred by GAWB in operating a fish hatchery in conjunction with the Gladstone Port Authority. The fish hatchery is designed to redress the impact on the Awoonga Dam fish populations as the dam does not incorporate a fish ladder. Accordingly, the Authority recommends the inclusion of the operating costs of the fish hatchery in opex. Fish hatchery revenues are also included in recognition of the hatchery’s wider commercial activities in the sale of fingerlings to outside purchasers.
Recommendation:
That fish hatchery operating costs be included in opex.
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Recreational Facilities
The operational costs for recreational facilities include operations and maintenance costs for picnic and boating facilities, roads, car-parks and buildings.
Stakeholder Comment In initial submissions, GAWB’s preference was to have all costs associated with recreational facilities, including return on capital of assets, passed on to existing water users. All existing water users considered that the costs associated with operating GAWB’s recreational facilities should not be passed on to water users in prices but should be borne by GAWB or by the local governments or by the State Government.
No further comment was received on opex costs for recreational facilities in response to the Draft Report.
QCA Analysis The Authority recommends that a reasonable level of recreational assets be included in the regulatory asset base for pricing purposes, on the basis that these costs are a necessary part of the operation of storages. Most of the opex costs relate to staffing costs, a significant portion of which would be incurred even in the absence of a recreational facility, in providing caretaking and site management services.
Recommendation:
That a reasonable level of the costs of providing recreational facilities should be recognised in opex.
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10. PUBLIC INTEREST AND PRICE MONITORING
Summary
In addition to considering the efficiency and revenue adequacy of GAWB’s proposed pricing practices, the Authority has taken into account a range of public interest matters in framing its recommendations.
With respect to price monitoring, the Authority recommends that GAWB’s pricing practices should be reviewed by the end of December 2004 because of:
· the uncertainty of demand;
· the need to assess the application of the recommended pricing principles;
· the need to assess the potential of alternative demand management and alternative supply strategies; and
· the need to consider pricing issues in connection to uninsurable force majeure events.
The Authority recommends that, between price reviews, the price cap established for each user should be adjusted by the CPI. In addition, the Authority recommends that material changes to the following costs should be passed through to customers:
· changes in taxation;
· changes in regulatory compliance requirements such as those related to health, water quality, dam safety, and environmental standards; and
· other major changes in government policy;
with any pass-through costs requiring formal approval by the Authority.
The Authority proposes not to actively monitor prices established in contracts between GAWB and its customers during the review period. It is proposed that any monitoring role be limited to within-period reviews consistent with the recommended trigger mechanism and assessment of any pass-through costs that may arise prior to the next review.
10.1 Public Benefit
Introduction
Under the QCA Act, the Authority is required to take into account a range of non-economic matters in framing its recommendations. These requirements are outlined in Chapter 2 and largely relate to resource allocation, equity, safety, environmental and regional development considerations.
In undertaking the investigation into the pricing practices of GAWB, the Authority was aware that:
· Gladstone is a region of particular economic and regional significance from both a state and a national perspective;
· to fulfil Gladstone’s potential, GAWB must deliver water to meet the requirements of local industry on a sustainable and least cost basis; and
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· at the same time, there are a wide range of related matters that are required to be considered to ensure that the public interest is advanced.
Against this background, the Authority has sought to identify those matters which will affect the nature of the pricing practices adopted by GAWB, including those matters which will ensure the lowest possible price for GAWB’s services while at the same time meeting other key objectives.
Efficient Resource Allocation, Competition, and Protection of Consumers
Effic ient resource allocation, competition and the protection of consumers have been explicitly taken into account in previous sections that established the Authority’s preference for a two-part pricing structure with the volumetric component based on LRMC. It was noted that such a price structure would provide effective signals to both GAWB and consumers for long term decision- making. For GAWB, it should provide the basis for long term capacity decisions. For consumers, it should provide a consistent and forward looking estimate of the costs associated with establishment in the Gladstone region. Furthermore, LRMC should provide an effective basis for the comparison of the cost of alternative sources of supply, should they exist, thus promoting competition in their development.
The general approach to pricing recommended by the Authority provides protection to consumers in that it reflects prices that would be expected to prevail in a competitive market.
Cost of Service, Standard of Service, Rate of Return on Assets, Effect of Inflation and the Environment
Pricing structures such as those based on LRMC reflect the future costs of the service to be provided. Considerations of revenue adequacy seek to ensure that the entity receives appropriate revenues to cover reasonable costs of service provision, including a rate of return on assets involved in the provision of services at the requisite standard. The Authority has further identified cost efficiencies in finance and asset management that require an initial capital investment in new technologies.
In its investigation, the Authority has proceeded on the basis that the current standard of service is suitable to the needs of GAWB’s customers. The Authority has received no submissions suggesting otherwise. However, it has included additional costs for customer service and liaison in view of GAWB’s increased regulatory responsibility under the Water Act 2000.
The effect of inflation is specifically factored into the Authority’s methodology for ensuring revenue adequacy.
The capital and operating cost implications of managing assets related to the maintenance of the environmental integrity of GAWB’s facilities have been explicitly incorporated in the Authority’s consideration in terms of both pricing and revenue adequacy.
Demand Management, Social and Equity Considerations, Social Impacts, Availability of Goods and Services
Demand management initiatives have not featured prominently as an explicit consideration by GAWB, although it does have an ongoing strategy for the investigation of technological innovations in demand management in cooperation with customers. However, the concept of demand management represents a significant strategy for the future management of capacity requirements. Indeed, the Authority’s preferred planning scenario is premised on the potential for demand management strategies to defer storage augmentations into the future. Demand management issues have been addressed in Chapter 4.
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No social or equity issues have been identified in the investigation or in submissions to the Authority except in relation to the pricing to be applied to Calliope Shire Council and Gladstone City Council, which has been addressed in this Report. The Authority is not aware of any community service obligations rele vant to its consideration.
As the Authority’s recommended approach is designed to ensure that GAWB achieves an appropriate rate of return, GAWB should be able to continue to provide its services on a sustainable basis.
Legislation Relating to Ecologically Sustainable Development, Occupational Health and Safety and Industrial Relations
Under the Water Resources Act 1989 and the Water Act 2000, the ‘use, flow and control’ of all water in Queensland is vested in the State. The State is empowered with the responsibility for determining how water is allowed to flow, or how it is to be extracted, stored, diverted or interfered with in any way. GAWB’s entitlement to utilise water resources is provided under its licensing conditions, primarily administered by the Department of Natural Resources and Mines.
Before a water entitlement can be granted, certain conditions must be met to ensure the ecological sustainability of the project including:
· a Water Resource Plan (WRP) that identifies both the flow regimes required to sustain agreed environmental values and a hydrological model on a catchment basis;
· a Resource Operations Plan that sets out infrastructure operation rules, water sharing rules, water transfer rules, environmental management rules, the operational responsibilities of the service provider; and
· completion of a satisfactory Environmental Impact Study for new augmentations.
As part of the approval process for the current, as well as any future augmentations, GAWB must comply with a number of issues under the Water Act 2000, including:
· infrastructure standards, such as continuity of service, pressure/flow conditions, and other service level objectives, will need to be reported in the form of a total management plan;
· customer service standards, including the type of water service, billing procedures and complaints procedures;
· dam safety standards, specifying dam operation and maintenance conditions, water release procedures and reporting and inspection requirements; and
· other requirements, such as flood mitigation operations and planning, provision of a firefighting water service and urban sewerage and water supply requirements.
The fact that GAWB has been provided with all the appropriate licences by the State provides prima facie evidence that it meets the relevant legislative requirements pertaining to environmental and safety matters and the Authority accepts that this is the case.
With the exception of the issues raised above relating to the management of water resources that impact on the availability of water, there is no known legislation, or government policies on these matters that is material to the Authority’s investigation of current pricing practices.
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Economic and Regional Development
As indicated earlier, Gladstone is a growing industrial base of national and state significance. Although there are supplies of water consistent with the requirements of existing and currently projected demand over the next 20 years, the availability of further significant sources of water is yet to be confirmed through the WRP process, and the cost of additional water can be expected to rise significantly in ensuing years.
Prices that reflect the lowest possible cost of service delivery should add to the competitiveness of the region’s industries. Prices that provide an early indication of the likely future costs associated with those resources will also assist existing and future industry to take these into account and ensure that the most appropriate water use technologies are put in place. For GAWB, such prices should ensure it is well positioned to ensure sustainable service provision until hydrological limitations, if any, become apparent.
The recommended pricing framework should promote the best use of the region’s resources. It is also noted that the proposal not to differentiate between the prices charged to existing and new users for similar services ensures that new projects do not solely assume responsibility for the funding of augmentations. Such an alternative approach would, over the longer term, result in higher prices being imposed on new projects and thus reduce the attractiveness of the Gladstone region to new investment.
Any Directions given by the Government to the Government Agency
The Authority is not aware of any directions by the Queensla nd Government to GAWB which would affect the Authority’s recommendations.
10.2 Monitoring of Prices
The Need for Price Monitoring
The Ministers’ Direction required the Authority to monitor prices included in contractual arrangements entered into during, and after, the period of the QCA’s initial investigation. The Direction also requires the Authority to undertake investigations for monitoring the pricing practices relating to the declared activities.
In some cases, the pricing practices recommended by the Authority are different to the current practices of GAWB. In addition, the Authority has recommended a range of additional measures which, if effectively put in place, should ensure that services are provided at least cost.
These factors, when combined with the uncertainties surrounding GAWB’s demand growth and the possible impact on the safe yield of the dam of revised hydrological and climatic data, suggest that a future review of prices will be necessary in the medium term, notwithstanding the Government’s Direction.
10.3 Recommendations for Price Monitoring
The issue of price monitoring raises a number of key questions, namely:
· when should the next review be undertaken?
· how should prices be set in the interim? and
· how should unforeseen changes in revenues and costs over the review period be managed?
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Review Period
Issues Issues which need to be addressed include:
· the length of time necessary for GAWB to implement the Authority’s recommendations, to develop its own perspectives as to their effectiveness and to identify any further changes that may be required;
· current uncertainties related to the prospects of key projects proceeding;
· the need for reasonable price certainty; and
· the need to minimise regulatory intervention.
In general, where regulators have sought to establish review periods, a time frame of between three to five years has been considered to provide appropriate incentives for efficiency improvements and for realisation of longer term objectives. Recent regulatory decisions in the water area have been within this range, with IPART’s (2000a) determination for water service providers applying for three years and IPARC’s direction for ACTEW covering five years. Stakeholder Comment In initial submissions, GAWB advised that its existing policy is for five-yearly reviews and that this policy is included in some water contracts. GAWB indicated that it preferred the initial review period follow ing the Authority’s recommendations to be three years, so that the review would closely coincide with GAWB’s next five-yearly review.
CPM considered it important that the Authority’s investigation provide a benchmark for negotiating supply agreements for a period far in excess of three years. CS Energy suggested that review periods were not relevant, due to the nature of long term agreements held by existing customers.
In response to the Draft Report, GAWB requested that the Authority address the methodology to be used for future price reviews in its Final Report. In particular, GAWB suggested that subsequent pr ice reviews should recognise that a price recommendation based on smoothed cash flow expectations over a 20 year period may result in a lower effective return on assets in the initial years and a higher return in later years. GAWB emphasised that future price reviews should recognise the basis of pricing determinations from previous periods so that the initial shortfall could be recovered in subsequent years to achieve the average rate of return over the long term.
CPM supported a 2004-05 price review by the Authority focusing on whether demand forecasts have proven correct.
QCA Analysis The Authority is of the view that, if GAWB’s pricing practices are to be reviewed, any review should correspond to the timing of contract reviews where practical. Accordingly, it is recommended that the Authority review GAWB’s pricing structure by the end of December 2004, to apply from 1 July 2005.
As a general principle, any future review should take into account the basis used for the current pricing recommendations, so that GAWB is able to achieve a commercial return on its assets over the life of its assets. Regulatory consistency in approach for subsequent reviews is a desirable objective. However, as regulatory principles and methods are still evolving, it is recommended that no specific constraints be placed on the basis for future investigations.
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A future review may also need to take into account pricing issues in connection to uninsurable force majeure events.
It is proposed that reviews within the regulatory period be triggered if demand changes have a significant impact on aggregate revenue or, more specifically, if revenues vary by more than fifteen per cent. These variations may be driven, for example, by revisions to the historic no failure yield of Awoonga Dam, which impact on the capacity costs and the timing of the next augmentation. A trigger level of fifteen per cent is consistent with that used in the Authority’s decision for the gas industry.
Recommendation:
That GAWB’s pricing practices should be reviewed by the end of December 2004. An earlier review would be triggered if revenues vary by more than fifteen per cent.
Revenue and Price Caps
Once the maximum revenue requirement for a monopoly business activity is established, the issue then arises as to whether this should be expressed in the form of a revenue cap or a price cap.
In essence, revenue caps provide the business with the flexibility to vary the level and structure of prices provided the revenue constraint is met. The additional flexibility available to the business under revenue caps may result in cross-subsidies between individual users, although revenue caps are often accompanied by approved pricing principles that attempt to eliminate such inappropriate pricing outcomes. There are three forms of revenue caps - fixed, average or variable.
A fixed revenue cap would allow a business to recover the maximum revenue requirement regardless of how much water is sold. As such, a fixed revenue cap may not provide any incentive to pursue new customers or to sell more water. Fixed revenue caps usually result in users bearing the financial risk associated with variations in demand projections.
Average revenue caps (or the ‘revenue yield approach’) are typically expressed on a per megalitre basis. There is no effective limit on total revenue as it varies with the volume of water sold. Average revenue caps usually result in the owner bearing the financial risk associated with variations in demand projections.
Variable revenue caps are a hybrid which usually combine a smaller fixed cap with variable components that reflect annual cost drivers. Variable caps require considerable information relating to customer numbers, rate and timing of uptake, augmentation costs and other supply and demand factors.
Price caps control the prices of specific categories of goods and services. Under price cap regulation, there is no effective limit on revenue as it depends on the volume of water sold. Depending on their degree of aggregation, price caps should limit the extent of inappropriate pricing outcomes. Price cap control usually results in the owner bearing the financial risk associated with variations in demand projections.
A key issue in deciding between revenue and price caps is the projected growth of GAWB’s business over the next ten years, as total water demand is projected to double. It is also significant that there is considerable uncertainty surrounding the demand forecasts.
Stakeholder Comment In initial submissions, GAWB’s customers generally favoured a price cap as they were concerned that a revenue cap approach would give GAWB the flexibility to raise prices for some customers in order to offset low returns from other customers locked into long term contracts. Callide Power Management commented that:
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‘A price cap approach if implemented properly, should prevent GAWB from unduly discriminating between consumers on grounds other than differences in the cost of supply. This approach also better allocates risks relating to the attraction of new customers (and retention of existing demand) in that, at least within the regulatory period, GAWB is provided with an incentive to grow the market and sell more water’.
CPM noted that there was a trend among regulators towards price caps or revenue yield mechanisms away from revenue caps. However, CS Energy was indifferent over the choice between revenue and price caps, subject to the treatment of contributed capital.
GAWB indicated a preference for an average revenue cap approach, as it would provide flexibility for pricing to recognise differences in contract terms. For example, a lower price may be negotiated for a long term contract with a high take-or-pay component than for a short term contract with a low take-or-pay component.
In response to the Draft Report, SEQWater supported the price cap approach.
QCA Analysis In addressing the issue of a price or revenue cap, the Authority needed to determine which approach most effectively provides the appropriate incentives for GAWB to ensure that the prices for its services reflect the least cost of service provision and that services are provided to those parties seeking them over the review period. The Authority also needed to determine which party is best able to handle the risk of variations in demand.
Two main options for achieving those objectives were identified. These were:
· setting a revenue cap and allowing GAWB to adjust the tariff structure within that revenue requirement; and
· setting the tariff structure and letting revenue be determined as a result of the ensuing demand.
In determining the appropriate approach, the Authority was guided by the following factors in rejecting the first option:
· a significant issue confronting GAWB is the uncertainty of demand and supply. In particular, while the demand of existing customers is relatively stable and in many cases GAWB is protected from undue fluctuations in revenue by long term contracts, the demands of prospective users are largely unknown; and
· existing users are in no position to manage the risks associated with the requirements of prospective users, or to assess supply options and manage associated risks. GAWB is in a better position than users to achieve these goals.
Not only is GAWB better placed to manage such risks, it should receive appropriate incentives and rewards to ensure that such risks are managed effectively. Price caps provide the necessary incentives to achieve this goal because:
· volume risk is left with that party most effectively able to manage that demand risk, as well as managing supply options; and
· they ensure that appropriate efficient price signals are given.
119 Queensland Competition Authority Chapter 10 - Public Interest and Price Monitoring
The major issues with a price cap in the envisaged circumstances are:
· how frequently the recommended two-part tariff should be recalculated. The clearest signals for appropriate decision-making, for both GAWB and users, would occur if the two-part tariff, in particular the volumetric component, was reset whenever changes in demand and supply were identified. However, it is unlikely that the projected demand/supply scenario will alter sufficiently in aggregate terms from year to year to warrant such adjustments. Reconsideration at each price review (usually at five-year intervals) should be sufficient to ensure appropriate incentives are achieved; and
· the revenue risks to GAWB could be significant if anticipated demand is not realised. However, this is not a risk which should be passed on to existing users should it eventuate.
It is therefore recommended that the two-part tariff structure established for the initia l year of the proposed regulatory period be maintained in real terms over the regulatory period, subject to the issues discussed in the following section.
Under such a proposal, GAWB would have an incentive to maximise sales in the early years but, in vie w of the potential cost and risks associated with further augmentation, would also have an incentive to explore strategies for demand management and alternative sources of supply. The possibility of further augmentation will, of course, need to be closely monitored.
Recommendation:
That a price cap approach be adopted, with a two-part tariff set for each user for the initial year of the proposed regulatory period.
Cost Escalation
Optimisation of the capital base and the incorporation of achievable efficiencies in operating expenditure provide the major bases for ensuring services are provided efficiently over the planning period. Combined with the application of price caps, the Authority considers that GAWB will have appropriate incentives to manage business risks into the future.
Nevertheless, there are several other matters that need to be taken into account:
· the effects of inflation; and
· the effects of unexpected and unforeseen variations in costs - for example, changes in regulatory compliance costs.
Other Jurisdictions Inflation IPART’s (2000) price paths for the four major NSW urban water service providers incorporated a CPI price escalation (as well as incorporating efficiency savings into operating expenditure as the Authority has recommended).
IPARC’s (1999) price direction for ACTEW’s water business also used the CPI but provided for a real increase in costs to meet service quality improvements. IPARC allowed a variation in water revenue per property based on the CPI plus four per cent per annum for the first two years and the CPI plus three per cent per annum for the remaining three years.
120 Queensland Competition Authority Chapter 10 - Public Interest and Price Monitoring
Unforeseen and Unexpected Changes in Costs When a monopoly service provider is confronted by unforeseen and unexpected changes in costs, the issue arises as to whether these should be passed onto customers or borne by the service provider. In general, this is determined by:
· whether the change in costs could have been anticipated and thus managed or avoided by the service provider; and
· whether the impact of the change in costs on either the service provider or the user is material.
For material and unavoidable changes in costs, regulatory mechanisms are generally put in place to assess whether the costs should be passed through to users or borne by the service provider.
Generally, Australian regulators have sought to identify certain costs as ‘potential’ pass-through imposts to price or tariff changes, but on the basis that the regulated business must apply to the regulator for approval. These costs have included changes in taxation, changes in the regulatory compliance requirements covering health, water quality, safety, environmental standards and other major changes in government policy.
However, cost pass-through events may have unintended and undesirable impacts on regulatory incentives. For example, if the regulatory regime permits one category of costs to be automatically passed through, there may be a bias towards that expenditure at the expense of a more efficient substitute. The pass-through process should, in general, only allow the efficient component of changes in costs, which could not be managed or avoided by the service provider, to be passed through.
Determining the materiality of a cost pass-through event may also prove difficult as regulators may not have sufficient information, or the information may be commercially sensitive in nature. Therefore, for an entity to gain approval for any cost pass-through event from a regulator, their case will have to be sufficiently detailed to prove the materiality of the claim.
Stakeholder Comment Inflation In initial submissions, Callide Power Management supported the use of the CPI, citing that its advantages outweighed the disadvantages.
GAWB’s own price modelling employed an adjustment to the annual CPI (75 per cent of annual CPI) as a means of recognising efficiency gains.
No submissions on this matter were received in response to the Draft Report.
Unforeseen and Unexpected Changes in Costs In initial submissions, GAWB suggested that all variable costs should be subject to the cost pass- through arrangement, while CS Energy and Gladstone City Council indicated that there should be no cost pass-through arrangements. Other water businesses, Brisbane Water and SunWater, indicated that the cost pass-through arrangement should recognise and allow increased operating and maintenance costs associated with uncontrollable or unforeseen costs, such as:
· those associated with the resource operating licence for the Awoonga Dam under the Water Act 2000;
· customer service standards;
· implementation and upkeep of strategic asset management plans; and
121 Queensland Competition Authority Chapter 10 - Public Interest and Price Monitoring
· natural disasters.
In response to the Draft Report, GAWB identified a number of additional exogenous cost impacts that it considered eligible for cost pass-through. These included:
· changes in law or pursuant to a law;
· changes in GAWB’s water allocation and its operating requirements; and
· changes in estimated yield resulting from reviews of river hydrology or climate change.
SEQWater agreed with the pass-through of exogenous costs.
QCA Analysis Inflation The CPI offers three major advantages, namely, it is widely available, timely and not subject to revision. The Authority therefore recommends the CPI. To its knowledge, there is not a reliable water industry index that could be used in place of the CPI to estimate increases in the cost of service provision.
Unforeseen and Unexpected Changes in Costs Within-period adjustments should only be made where major exogenous and unforeseen events (that is, events outside the control and influence of the regulated service provider) impact significantly, either up or down, upon the returns of the regulated business. Pass-through (both positive and negative) would be justified for:
· changes in taxation;
· changes in the regulatory compliance requirements - for example, those related to health, water quality, dam safety, and environmental standards;
· changes in law or pursuant to a law;
· changes in GAWB’s water allocation and its operating requirements;
· changes in estimated yield resulting from reviews of river hydrology or climate change; and
· other major changes in government policy.
It is noted that changes in water allocations and safe yields may have an impact on capacity costs by affecting the timing of future augmentations , and may be of sufficient magnitude to trigger a review of pricing recommendations (as outlined in Chapter 3).
It is recommended that any pass-through costs should be subject to an assessment of their materiality and approved by the Authority.
In summary, the Authority proposes not to actively monitor prices established in contractual arrangements between GAWB and its customers during the review period. Any monitoring role should be limited to within-period reviews consistent with the recommended trigger mechanism and assessment of any pass-through costs that may arise prior to the next review.
122 Queensland Competition Authority Chapter 10 - Public Interest and Price Monitoring
Recommendations:
· That price caps should be adjusted by the CPI each year between price reviews;
· That material variations in the following exogenous changes in costs may be passed through to the customer:
- changes in taxation;
- changes in the regulatory compliance requirements - for example, those related to health, water quality, dam safety, and environmental standards;
- changes in law or pursuant to a law;
- changes in GAWB’s water allocation and its operating requirements;
- changes in estimated yield resulting from reviews of river hydrology or climate change;
- other major changes in government policy;
with any pass-through costs requiring formal approval by the Authority; and
· That the Authority not actively monitor prices established in contractual arrangements between GAWB and its customers. Any monitoring role should be limited to within- period reviews consistent with the recommended trigger mechanism and assessment of pass-through costs .
123 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
11. IMPLICATIONS OF THE RECOMMENDED PRICING PRACTICES
Summary
Compared to GAWB’s post-October 2000 pricing practices, the Authority’s maximum revenue requirement is generally higher. This outcome largely occurs because of slightly higher asset valuations in some years, the use of straight line depreciation rather than a financial annuity and additional opex costs.
The Authority’s estimated maximum revenue requirement is also slightly higher than that estimated in the Draft Report, mainly due to lower demand projections and less infrastructure being optimised out of the asset base.
In other industries, the Authority has sought to transition from existing to new prices. Following the Draft Report, the Authority invited submissions on the appropriate basis and timing for transition to the recommended pricing practices. The Authority has concluded that, to allow customers to adjust to higher prices, changes should be phased over three years for existing customers who are not subject to long term contractual arrangements. New pricing practices should apply to any new customer of GAWB without any transition.
Based on the preferred planning demand scenario and recommended pricing practices, GAWB will achieve a positive operating profit by 2004-05.
11.1 Aggregate Implications
To maintain confidentiality, the Authority has only reported on the implications of its recommendations for pricing at an aggregate level.
Aggregate Revenue Projections
Table 11.1 provides a comparison of projected revenues based on:
· GAWB’s pre-October 2000 prices and pricing policies;
· GAWB’s post-October 2000 prices and pricing policies, assuming that existing contracts will continue until the next scheduled review;
· the Draft Report’s maximum revenue requirement, based upon immediate application of recommended pric ing practices, regardless of current contractual arrangements;
· the Final Report’s maximum revenue requirement, based upon immediate application of recommended pric ing practices, regardless of current contractual arrangements; and
· the Final Report’s projected revenue based on the continuation of existing contracts, with application of recommended pricing practices to all other existing and new customers.
The Authority’s revenue projection is generally higher than GAWB’s post-October 2000 projections, as a result of:
· higher asset valuations which were not entirely offset by the lower WACC rate used by the Authority in determining the return on capital;
· inclusion of the full value of the Mt Miller pipeline, on the basis that the excess capacity represents the least cost of supply option. By contrast, GAWB’s revenue projection was based on GAWB carrying the full cost of excess capacity in the Mt Miller pipeline;
124 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
· compared with the financial annuity method, the straight line depreciation approach provides a slightly higher return of capital during the during the early years of the asset life; and
· opex costs being higher than GAWB’s as a result of additional costs of regulatory compliance and water treatment costs associated with upgraded treatment facilities.
Table 11.1: Summary of aggregate annual revenue projections for GAWB, preferred planning scenario ($m)
Aggregate Revenue Projections ($m)
2001-02 2002-03 2003-04 2004-05 2009-10 2014-15 2020-21
GAWB Projected, based on 15.4 17.2 19.3 25.2 35.1 40.2 49.2 pre-October 2000 pricing practices.
GAWB Projected, based on 18.4 22.4 25.6 27.0 36.6 48.7 N/a post-October 2000 pricing practices.
Draft Report maximum 18.5 20.6 23.4 28.2 39.9 46.1 56.4 revenue requirement.1
Final Report maximum 20.5 22.4 24.7 29.2 41.0 51.5 62.3 revenue requirement1
Final Report projected 20.2 23.0 25.4 29.8 41.8 52.5 63.5 maximum revenue2
1. Based upon immediate application of the recommended pricing practices, regardless of current contractual arrangements. 2. Based on the continuation of existing contracts, with application of recommended pricing practices to all other existing and new customers.
The Authority’s Final Report maximum revenue requirement (in the absence of a transition path) is marginally higher than that estimated in the Draft Report. This reflects a slightly higher WACC (8.72 per cent rather than 8.6 per cent) and a slightly higher inflation rate (2.6 per cent rather than 2.5 per cent), but is mostly explained by the changes in demand projections and optimised asset value.
The application of commercial pricing principles by GAWB results in a substantial increase in overall revenue to GAWB. While existing contracts insulate some customers from the new pricing principles, there are substantial variations involved for some others.
Under the Authority’s preferred planning scenario, the average price consistent with the final maximum revenue requirement in 2001-02 is $446/ML (compared to $423/ML in the Draft Report). The lower and upper planning scenarios would require average prices of $455/ML ($445/ML) and $466/ML ($453/ML) respectively to provide GAWB with its maximum revenue requirement. In all cases, the revenue required is heavily influenced by the costs of optimal excess capacity that correspond to each demand scenario. For this reason, for example, the lower bound scenario results in a higher average price than the projected scenario, as infrastructure requirements are not greatly different, while demand is lower. In the absence of augmentation and any new customers, the price based on existing customers in 2000 would be $440/ML.
125 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
Transition Paths
In other industries, the Authority has sought to transition from old to new prices in order to mitigate the impact on existing users.
The Draft Report recommended that new pricing practices would apply to any new customer of GAWB without any transition. However, the Authority invited submissions from interested parties as to whether there should be any transition paths introduced between old and new prices, and, if so, over what time period should any transition path be applied.
The situation in GAWB is complicated by the fact that:
· for existing customers with contracts, prices will remain fixed until the next scheduled review under the contract, unless both parties agree to an earlier amendment; and
· for local government customers, substantial increases in prices have already been introduced from October 2000.
Stakeholder Comment In response to the Draft Report, NRG (Gladstone Power Station) supported a price transition path, suggesting that new prices should be phased in over a three year period commencing 1 July 2002. Annual increases of 25 per cent would apply each year until the new pricing practices were fully implemented from 1 July 2005.
NRG argued that it should receive a refund for any increase in water prices paid prior to the commencement of the transitional arrangement, as GAWB have already applied new pricing practices to NRG from 1 October 2001.
SEQWater also supported a transitional period, but only for long term existing customers, arguing that new customers should pay the full commercial water price. It argued that this differential treatment was justified because it recognised the contribution existing customers had made to GAWB’s establishment and ongoing financial viability.
Treasury supported a transition path if the Authority and stakeholders considered it necessary, subject to the proviso that it did not jeopardise GAWB’s commercial viability.
GAWB did not support a phasing in of price increases for existing customers, arguing that such customers have benefited from lower prices in the past. GAWB considered that in any case the proposed increases would not have a material impact upon the financial viability of industrial customers since water costs represent only a small fraction of their total operating costs.
GAWB also submitted that, where prices may decrease due to the recognition of contributed assets, the price change should be transitioned to ease the impact on GAWB’s financial viability, and should recognise that GAWB’s ‘liquidity is at its lowest point at present and the need to maintain a minimum interest cover’. However, since making this submission, GAWB has indicated that it does not support transitional pricing as a general principle for all circumstances.
QCA Analysis: The Authority has a predisposition towards transitional pricing as a mechanism for minimising the impact of unanticipated price changes on users. At the same time, the Authority must take account of the impact of transitional pricing on the viability of the service provider.
In the case of GAWB, users have had substantial notice of likely price increases following GAWB’s commercialisation. In addition, GAWB’s current pricing is sub-commercial and its finances are being impacted by the effects of drought.
126 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
At the same time, the Authority’s recommended pricing practices result in substantial increases for some users over and above those that users were advised of by GAWB post- commercialisation.
Accordingly, the Authority proposes that transitional arrangements should be put in place to allow customers to adjust from GAWB’s post-October 2000 pricing practices to the Authority’s recommended pricing practices. Transitiona l prices would apply from 2002-03 to 2004-05 inclusive for all existing customers moving to new prices during that time.
An analysis of the impacts on projected maximum revenues of transitional pricing over a three year period for those customers not subject to long term contracts as at 1 July 2001, indicated that the implications for GAWB’s viability were insignificant. Table 11.2 refers.
Table 11.2. Projected maximum revenues, with and without transitional pricing.
Revenue Projections ($m)
2001-02 2002-03 2003-04 2004-05 2005-06
Without transition 20.2 23.0 25.4 29.8 32.7
With transition 20.2 22.2 24.9 29.3 32.6
Based on the continuation of existing contracts, with application of recommended pricing practices to all other existing and new customers.
On the basis of its analysis , the Authority considers that recommended maximum prices should be transitioned from GAWB’s post-October pricing practices, over a three year period, for existing customers who are not subject to long term contractual limitations.
Recommendation:
That, for existing customers, prices should be transitioned over three years (2002-03 to 2004-05) from GAWB’s post-October 2000 prices to the recommended prices, subject to long term contractual limitations.
Segment Revenue Requirements
On a segment basis, the maximum revenue requirement per megalitre, assuming the Authority’s recommended pricing practices are applied to the preferred planning scenario regardless of contracts, ranged from 85 to 165 per cent of those applicable under GAWB’s post-October 2000 pricing practices.
The Authority’s estimated revenue requirements for each segment were lower than those proposed by GAWB for raw water delivery through to Gladstone. However, they were higher for delivery to other segments. This result follows from:
· the allocation of general administration costs according to management/administration effort across the entire network, rather than GAWB’s current method of allocating these costs according to users’ shares of water drawn from Awoonga Dam; and
· additional capital expenditure necessary to maintain the quality of treated water supply consistent with EPA requirements;
Delivery costs to Toolooa are lower than estimated by GAWB due to disaggregation of the Awoonga to Gladstone segment into two separate segments, namely, Awoonga to Toolooa and
127 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
Toolooa to Gladstone. For the Fishermans Landing and Aldoga segments, GAWB did not include capital and operating costs associated with unused capacity in the originally proposed Kirkwood Road pipeline, whereas the Authority considers that the excess capacity is reasonable in the context of the least cost expansion of the network.
11.2 Implications for Pricing Arrangements
Pricing Structure
The Authority recommends that a two-part tariff be adopted, with the volumetric charge based on LRMC as estimated using the Turvey method and an access charge that is paid regardless of usage. This compares with GAWB’s approach of a single tariff based on average costs, subject to a 75 per cent take -or-pay arrangement.
In Table 11.3, LRMC is shown as a percentage of the average annual maximum revenue requirement for 2001-02 for the key system segments (for each of the alternative demand scenarios).
Table 11.3: LRMC by system segments (2001-02 to 2020-21, % of maximum revenue requirements)
Segment Preferred Planning Low Demand High Demand (Committed Projects) (Maximum Growth) Awoonga Dam 16 15 84
Delivery to Toolooa 29 30 75
Delivery to Gladstone 27 34 135
Delivery to Fishermans 69 58 116 Landing
Delivery to Aldoga 62 89 106
Urban treated water delivery 73 75 93
Based upon immediate application of the recommended pricing practices, regardless of current contractual arrangements.
For the preferred planning scenario, the Authority found that the maximum revenue requirement for GAWB exceeds LRMC in all segments. Hence, if prices were solely based on LRMC, revenue would fall short of that required to sustain the operation and provide a return on the capital invested. However, the LRMC exceeds the average maximum revenue requirement per megalitre in most segments under the high demand scenario due to higher capacity costs associated with further augmentations.
The question then remains as to how to establish the access charge. Due to the small number of identifia ble customers of widely differing consumption, the Authority considers that the access charge to recoup the revenue shortfall could not be set as a single flat charge.
While a variety of alternatives are available, the Authority considers that, to ensure the shortfall is recognised on a consistent basis between customers, the access charge should be based on water entitlements. However, not all contracts have entitlements specified and, therefore, to ensure consistency between users, anticipated demand should be used.
128 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
Although anticipated demand is considered to be a stable basis for setting charges for existing customers, the potential exists for gaming behaviour by customers to achieve a lower overall charge. The Authority suggests that GAWB should periodically review the relationship between anticipated and actual demand for each customer, and re-adjust prices, probably with penalty, if anticipated demand is consistently underestimated.
The effectiveness of two-part tariffs in conveying the appropriate pricing signals can be demonstrated as follows:
· under the low demand and preferred planning scenarios, the tariff for the Awoonga Dam segment comprises a small volumetric charge and a large access (non-volumetric) charge. This charge structure encourages increased water usage at the present which (extracting from the current drought) is appropriate given that the scenario involves a significant volume of unused capacity being carried over the 20-year time frame. The volumetric charge would increase once the need for the next augmentation was identified (after 2020- 21); and
· by contrast, under the high demand scenario, the tariff comprises a large usage charge and a small access charge. Where the LRMC exceeds the maximum revenue requirement, the price structure becomes a single volumetric charge up to the maximum revenue requirement. This again is an appropriate signal, as this tariff encourages conservative usage strategies, which may help to defer the expected augmentation.
The Authority’s recommended two-part tariff incorporates an access charge determined with reference to each customer’s anticipated demand. An indicative comparison between fixed revenues generated by GAWB’s current take-or-pay arrangements and revenues from the Authority’s recommended access charge is provided in Table 11.4.
Table 11.4: Comparison of revenues from fixed charge components ($m)
Fixed Revenues From: 2001-02 2002-03 2003-04 2004-05 Authority’s two-part tariff 10.0 11.2 12.1 13.9
GAWB’s take-or-pay 15.5 17.0 18.6 21.5
Based upon immediate application of the recommended pricing practices, regardless of current contractual arrangements.
Table 11.4 indicates a lower level of fixed revenue generated by the recommended two-part tariff compared to GAWB’s take-or-pay arrangements. This indicates the extent to which the current take-or-pay structures diverge from efficient LRMC pricing practices. Although fixed revenues are significantly lower, there were no significant consequences for GAWB’s revenue stability given the stable annual demand by large industrial customers once established.
11.3 Implications for GAWB’s Financial Viability
In the Draft Report, the Authority provided an analysis of GAWB’s financial viability over the 20-year period of analysis, including revenue growth and interest cover.
Stakeholder Comment
In response to the Draft Report, GAWB suggested that more analysis be included in the Final Report of various financial viability measures, including interest cover. GAWB considered that a
129 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
more accurate measure of financial viability was earnings before interest, tax, depreciation and amortisation (EBITDA). GAWB expressed concern should this measure be found to fall below any accepted norms.
Treasury also requested that the Authority assess the impact on pr ices of the loss of a significant customer. It commented:
‘The concentration of demand among a small number of large customers reduces the capacity for GAWB to effectively manage the risk of demand changes. For example, if a single large project in the Gladstone area is cancelled, for reasons unrelated to GAWB but resulting in a significant drop in previously expected volume demand, restoring demand to profitable levels may prove very difficult.’
QCA Analysis
The Authority has assessed the financial viability of GAWB based on the projected maximum revenues with transitional pricing over the period from 2002-03 to 2004-05.
The analysis showed that a positive operating profit will be achieved in 2004-05 (Figure 11.1). However, operating profit remains very sensitive to demand actually occurring. For example, a reduction (or non-realisation) in demand of around 5,000ML, or 7 per cent of total estimated demand, in 2004-05 is sufficient to produce an operating loss.
Figure 11.1: GAWB’s Operating Profit and Cash Balance
$75,000,000
$65,000,000
$55,000,000
$45,000,000
$35,000,000
$25,000,000
$15,000,000
$5,000,000
-$5,000,000
Cash Balance Operating Profit
GAWB’s cash position reaches its lowest point at $12.5 million in 2002-03. Interest cover (operating profit before interest, depreciation and tax as a proportion of interest on borrowings) is at its lowest point of 1.6 times (based on recommended pricing practices) in 2003-04 and recovers to two times by 2004-05.
In general, under the recommended pricing practices, any reduction in revenue due to lower than projected demand and/or loss of a customer would be borne by GAWB and result in a lower operating profit. Conversely, additional revenue from growth in demand in excess of projections and/or new customers would accrue to GAWB with a corresponding increase in operating profit.
130 Queensland Competition Authority Chapter 11 - Implications of the Recommended Pricing Practices
The loss of a major customer would trigger a review of pricing recommendations if the resulting revenue impact exceeded fifteen per cent. The impact on GAWB’s viability of losing a major customer depends on the location of the customer and the timing of demand changes. For example, the loss of 10,000ML of raw water demand at Gladstone would reduce 2002-03 gross revenues by nineteen per cent while the loss of 10,000ML demand at Awoonga Dam would have a ten per cent impact.
The sensitivity of GAWB’s cash balance and operating profit to a 15 per cent lower demand each year is shown in Figure 11.2 (equivalent to the loss of a major customer such as CS Energy). Under such circumstances, interest cover, based on EBITDA, would fall to 1.2 in 2002-03. GAWB’s cash flow would become negative if annual revenue declined by more than 17.25 per cent over the 20-year period (equivalent to the loss of a customer such as QAL).
Figure 11.2. GAWB’s Operating Profit and Cash Balance – Sensitivity to 15 per cent Lower Demand
$70,000,000
$60,000,000
$50,000,000
$40,000,000
$30,000,000
$20,000,000
$10,000,000
$0
-$10,000,000 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21 Cash Balance - Projected Maximum Revenue Cash Balance - 15% Revenue Reduction Operating Profit - Projected Maximum Revenue Operating Profit - 15% Revenue Reduction
131 Queensland Competition Authority Appendix A – Estimating Long Run Marginal Cost
APPENDIX A: ESTIMATING LONG RUN MARGINAL COST
The estimation of LRMC involves the determination of values for two elements – the marginal capacity cost (MCC) and the marginal operating cost (MOC). The two widely accepted methods used for determining LRMC include the Present Worth of Incremental Costs or ‘perturbation’ method, developed by Turvey (1976) and the average incremental cost (AIC) method (Mann et al. 1980).
Present Worth of Incremental System Costs (the Turvey Method)
The Present Worth of Incremental Costs method was proposed by Turvey (1976) and applied by Hanke (1981). The ‘Turvey method’ is defined as the present worth of the increment in system costs resulting from a permanent increment in consumption at the beginning of year t, minus the present worth of the increment in system costs resulting from the same permanent increment in consumption starting in year t+1.
The central argument of the Turvey approach is that augmentations required to meet the preferred planning demand forecast are unavoidable, and that it is not the total costs of a system augmentation that require examination, but rather the consequences of a marginal change in the rate of demand growth. Turvey argues that the cost savings from deferral of augmentation are relevant to the marginal cost measure, not the cost saving from abandoning it entirely. Hence, the Turvey approach is related to an opportunity cost concept of delaying or bringing forward infrastructure augmentation.
Turvey (2001) further recommends that an appropriate measure of LRMC be obtained by taking an average of the impact on future costs when the preferred planning demand forecast is either deferred or brought forward by one year.
The Turvey method may be estimated by:
æ I I ö O - O + ç k - k ÷ ( t+ x t ) ç k-t k+1-t ÷ è (1+ i) (1+ i) ø PWISCt = Qt+1 -Qt
where: Ot = Operation and maintenance costs in year t Ik = Capacity investment in year k Qt = Water produced in year t i = Opportunity cost of capital
The Turvey method gives an estimate of LRMC that becomes larger as the augmentation becomes imminent.
Average Incremental Cost (AIC) Method
By contrast, the Average Incremental Cost (AIC) method bases LRMC on a measure of the incremental cost of a system augmentation.
A precise formula is provided by Mann et al (1980) and was also given by GAWB in a submission to the Authority:
132 Queensland Competition Authority Appendix A – Estimating Long Run Marginal Cost
T ü ì(Ot+x -Ot )+ It+x-1 åí x-1 ý x=1 î (1+ i) þ AICt = T ìQt+x -Qt ü å í x-1 ý x=1 î (1+i) þ
where: Ot = Operation and maintenance costs in year t It = Capacity investment in year t Qt = Water produced in year t i = Opportunity cost of capital T = Years for which expenditure and output are forecast
This formula provides an ‘annualised’ value for capital costs enabling consistency with annualised operating costs. It effectively generates an ‘average marginal’ capacity cost as part of the LRMC measure. Consistent with average cost pricing approaches, capex should be determined over the full life of the asset or, if determined over a shorter planning horizon, a residual value should be incorporated.
Analysis
The key criteria in choosing an approach for estimating LRMC for GAWB are:
· conceptual soundness;
· relevance in determining a basis for tariff design;
· consistency with the general principles adopted in determining the overall revenue requirement; and
· ease of determination from available information.
It can be argued that the Turvey method provides a theoretically purer determination of marginal cost as it reflects the cost impact of delaying or bringing forward expenditure on augmentation by one year. This most closely aligns with the smallest ‘averaging’ attainable when considering substantial lumpiness in capital expenditure.
The AIC method by definition provides an average cost per year and per megalitre of the expected capex. It essentially brings forward an average revenue requirement measure and adopts it as a proxy for marginal cost.
The Authority considers the Turvey method more appropriate for determining a measure of LRMC. However, it should be noted that, whichever method is adopted, it affects only the estimate of charges for services and not the overall revenue requirement for the service provider. The estimate of LRMC only applies to the volumetric charge.
Both methods can be readily determined, although the Turvey method is less demanding in terms of data requirements. The AIC method must be derived over the full asset life or, alternatively, a residual value established at the end of the planning horizon.
133 Queensland Competition Authority Appendix B – Alternative Measures of WACC
APPENDIX B: ALTERNATIVE MEASURES OF WACC
Classical tax system
As noted by Officer (1994), under a classical tax system, the appropriate definition of a company’s pre-tax weighted average cost of capital can be expressed as follows:
Cash Flow WACC
X0 r ED rr=+e od(1-TE) ( ++D) (ED) where
re is the return on equity
rd is the return on debt (the cost of debt) E is the market value of equity D is the market value of debt T is the corporate tax rate
The amount of tax collected from the company under a classical tax system by the government can be found as Xg = T(X0 – Xd). Hence,
X00=T( X-Xd) ++XXed which converts to:
X0 (1-=TX)1ed+-XT( )
The after-tax weighted average cost of capital under a classical tax system can be expressed as either:
Cash Flow WACC
X0(1-T) ED rc =r+-rT(1 ) 1 ed( E++D) (ED)
X--XXT c ED 00( dc) r=+rr 2 ed(E++D) (ED)
134 Queensland Competition Authority Appendix B – Alternative Measures of WACC
Dividend imputation system
Under the dividend imputation tax system, shareholders recover, via imputation tax credits, some proportion of the corporate taxes that have already been paid. This has two effects in relation to the calculation of WACC. First, it decreases the effective corporate tax rate and thereby increases the cash flows to shareholders. Second, the decrease in the effective tax rate will reduce the effective tax shield provided by debt relative to equity. Therefore, under dividend imputation, it is necessary to allow for increased cash flow to shareholders and the increased after-tax cost of debt.
In the presence of dividend imputation, the effective tax rate changes from Tc to Te = Tc(1-g) where:
· Tc is the statutory tax rate (equivalent to the classical tax rate); and
· g is the value of imputation credits, representing the proportion of tax collected from the company which gives rise to the tax credit associated with a franked dividend.
In the presence of dividend imputation, the appropriate definition of a company’s pre-tax weighted average cost of capital can be expressed as:
Cash Flow WACC
X0 re ED rrod=+ (11--Tc ( g )) (E++D) (ED)
Under dividend imputation, the effective level of company tax is defined as:
X=T( X-X) --gT( XX) g00dd =--T( XX0 d )(1g )
Hence:
X00=( X-Xd)Tc(1-++g ) XXed which converts to:
X0 (1--=Tc(1gg)) Xe+XTdc(11--( ))
135 Queensland Competition Authority Appendix B – Alternative Measures of WACC
In the presence of dividend imputation, the appropriate definition of a company’s post-tax weighted average cost of capital can be expressed as:
Cash Flow WACC
1-T XT1- ( c ) ED 0 ( c ) WACC 11=re+-rTdc( ) (11--Tc ( g )) (E++D) (ED)
XT11--g ED oc( ( )) WACC 2=re+--rTdc(11( g )) (E++D) ( ED)
ED X-( X--XT) (1 g ) WACC 3 =+rred 00dc (E++D) (ED)
ED XT(1-) +-gT( XX) WACC 41=re+-rTdc( ) 00ccd (E++D) (ED)
Under WACC 1, cash flows are presented as the standard after-tax cash flows under a classical system. The WACC must account for the imputation effects.
Under WACC 2, all operating income is taxed at the company tax rate, adjusted for imputation. The WACC must correct for the overstated tax shield.
Under WACC 3, the effective after-corporate-tax income attributable to equity and debt holders is fully and correctly recognised in the cash flows. All tax adjustments are kept out of the WACC and are recognised directly in the cash flows.
Under WACC 4, imputation is fully and correctly recognised as a modified cash flow but tax is overstated as the debt shield is ignored. The WACC must correct for the overstated tax effect.
136 Queensland Competition Authority Appendix C – The Relationship Between Equity, Debt and Asset Betas
APPENDIX C: THE RELATIONSHIP BETWEEN EQUITY, DEBT AND ASSET BETAS
WACC expresses the entity’s cost of capital as the weighted average of the required return on its equity and debt. Because of the equivalence between the assets of the entity to a portfolio of the entity’s equity and debt wit h respective weights of E for equity and D for debt, the ED+ ED+ return on assets can be expressed as follows:
æEDöæö Ra=+RRedç÷ç÷ èE++DøèøED
Substituting CAPM, expressed as Ri = Rf + ßi (Rm – Rf), for each of the returns (Ra, Re and Rd) gives:
æEDöæö Rf+ba(Rm-=Rf) (Rf+bbe(Rm-Rf))ç÷+(Rf+-d(RRmf))ç÷ èD++EøèøDE
which is equivalent to:
æEDöæö ba=+bbedç÷ç÷ èD++EøèøDE
where:
Ri is the expected return on asset i;
Ra is the return on assets;
Re is the return on equity;
Rd is the return on debt (the cost of debt);
Rf is the risk free rate;
Rm is the expected return on the market portfolio of risky assets;
ßi is the beta, or non-diversifiable risk, of asset i;
ßa is the asset beta;
ße is the equity beta; and
ßd is the debt beta.
An asset beta represents the risk arising from the sensitivity, or covariance, of the operating cash flows generated by the assets of an entity compared with the market in general. Asset betas are not directly observable and therefore must be derived from equity betas. The difference between an asset beta and an equity beta reflects the extent to which debt is used to finance the entity’s assets.
It is obvious from the above that the beta of an entity’s assets is equal to the betas of the entity’s equity and debt weighted by the respective weights for equity and debt. Whilst equity and debt
137 Queensland Competition Authority Appendix C – The Relationship Between Equity, Debt and Asset Betas
betas can be calculated via CAPM based methods, the asset beta can only be inferred via the above relationship.
Issues in the estimation of the equity beta
An entity’s equity beta (be) reflects both the market risk associated with its assets and the financial risk carried by shareholders due to the entity’s use of debt financing. CAPM assumes that a linear relationship exists between an entity’s gearing and the premium associated with that gearing. Two factors have been identified as key determinants of an entity’s equity beta:
· financial leverage – the ratio of debt to equity, where a higher level of debt implies a higher beta; and
· sensitivity to cash flows – relative to overall economic activity, where more cyclical cash flows are associated with higher betas.
Typically, equity betas are estimated using historical data through the application of the market model which is derived from CAPM (expanded as follows):
Rif=RRR++bbimif
Ri=RRf(1 -+bbi) im RR=+ab iiim where
abi is equal to Rfi(1- )
bi is the equity beta
The estimation of equity betas is not without controversy. There are numerous issues relevant to its estimation that the Authority considered, including the following:
· the choice of return measure – for example whether returns should be discrete or continuously compounded, whether raw or excess returns should be used and whether nominal or real returns should be used. Typically , the risk free rate and market risk premium are both expressed as discretely compounded returns;
· the choice of proxy for the market portfolio. By definition, the measurement of a beta is relative to a market risk premium, which in turn relates to a specific market. Accordingly, beta estimates for a company differ depending on which stock market index is used – systematic risk is largely country specific and meaningful beta estimates can only be derived using a national index from a company’s own country of operation. Therefore, caution is required in comparing betas of companies operating in similar industries but in different countries as betas reflect the risk of a company relative to the market in which it operates. Differences in market composition of national share markets do not facilitate direct comparison of betas. As outlined in Table C1, the Australian stock market has a greater component of resource stocks, which account for 16.5 per cent of total Australian market capitalisation. This suggests that the ASX may have a different risk profile compared with the US stock market (where resources stock account for 6.9 per cent of total US stock market capitalisation, and 7.4 per cent of total UK stock market capitalisation);
138 Queensland Competition Authority Appendix C – The Relationship Between Equity, Debt and Asset Betas
Table C1: Composition of market indices Index (as at 30 Nov 1998) Resource Sector Industrial Sector Market Capitalisation Australian All Ordinaries 16.5% 83.5% A$417.0 billion Accumulation Index US Standard & Poors 500 6.9% 93.1% US$10.6 trillion UK FTSE 100 7.4% 92.6% £1.04 trillion
· the sampling interval for the data and the length of the estimation period. Estimates using short interval data (measured at daily or weekly intervals) are systematically biased, such that highly traded securities are overstated whilst those of infrequently traded securities are understated. Alternatively, use of long intervals (measured quarterly or annually), lowers the number of data points used in the estimation process and diminishes the accuracy of beta measures. Empirical evidence discussed in Brailsford, Faff and Oliver (1997) shows that beta estimates using monthly data estimated over four to five year intervals provide the most reasonable trade-off between the number of observations and the stability of beta estimates; and
· beta is typically estimated using the market model, using an ordinary least squares approach. As with all econometric modelling applications, there are a number of assumptions which need to be satisfied in order to produce a robust estimate.
The Authority regards the stability of beta as an important issue in identifying the appropriate equity beta for utility businesses. Empirical evidence from Australian markets supports the mean reversion of beta. Raw beta values, derived from historical data, can be adjusted based on the assumption that beta factors change over time, especially in industries where there is considerable structural reform underway.9 The true beta has a tendency over time to move toward the market average of one and this adjustment may be represented as:
Adjusted (future) beta = Raw Beta * (0.67) + 0.33
This is the approach adopted by Bloomberg (2000), which appears to be generally accepted by practitioners.
The Authority is still reviewing the use of an adjustment factor for beta. However, for the purpose of this report, the Authority has applied the Bloomberg adjustment factor as follows when estimating betas:
Adjusted beta = 0.33 + 0.67bI
Issues in the estimation of debt betas
The debt beta (bd) reflects the financial risk borne by shareholders due to the entity’s use of debt financing. CAPM can be used to identify the debt beta.
9 International studies supporting the use of adjusted betas include Sharpe, Alexander and Bailey (1995) and Blume (1975).
139 Queensland Competition Authority Appendix C – The Relationship Between Equity, Debt and Asset Betas
éù Rdf=R+-b dëûRRmf
Transformed
(RRdf- ) b = d éù ëûRRmf-
where
R f = the risk free rate
R m = the expected return on the market portfolio of risky assets
R d = the expected return on debt
Cov( RRdm, ) b d == the debt beta VarR( m ) éù ëûR m - R f = the equity risk premium
The debt beta calculation is very sensitive to the size of the market risk premium. If the latter increases it will reduce the size of the debt beta.
Some regulators apply the CAPM based model with a 50 basis point adjustment to reflect the administrative costs of establishing and maintaining a debt financing facility. The resulting adjusted debt beta will be lower than the unadjusted debt beta. However, equity capital also incurs administrative and other costs and fees. To adjust the cost of only one form of capital (debt or equity) would distort the relative costs. Since there are administrative costs associated with both forms of capital, the Authority does not support an adjustment to the cost of debt or equity for fees which are operating expenses to the business.
Issues in the estimation of asset betas
CAPM assumes a linear relationship between the equity beta and the gearing of an entity. Hence, it is possible to calculate asset betas from equity betas. The asset beta refers to the beta applicable to the assets of an entity that has no debt. The gearing of the entity needs to be taken into account in estimating asset betas because default risk is incorporated in equity values and this needs to be removed to arrive at the entity’s risk profile independent of its financial structure. The adjustment of estimated equity betas to remove the financial risk associated with
a security, leaving the risk of the asset encapsulated in the asset beta (ba), is known as de- levering of the equity beta.
There are several approaches to de-levering and re-levering betas and there is no consensus as to which method is the most appropriate. The Authority identified the methods used extensively by academics and regulators to de-lever and re-lever equity betas, and broadly categorised them as follows:
· the standard or textbook approaches including both the Brealey Myers (1999) and Conine (1980) approaches;
· the Davis (1998) approach; and,
· the Appleyard & Strong (1998) / Monkhouse approach.
The Authority undertook an analysis of the alternative approaches and found that the resulting impact on WACC of using the alternative approaches was not significant. This view was also supported by the ORG (2000a) which noted:
140 Queensland Competition Authority Appendix C – The Relationship Between Equity, Debt and Asset Betas
‘‘The impact on the estimated after-tax WACC of using a different debt beta and levering approaches [is] not significant, however, provided that the same approach is used when deriving a proxy asset beta from the comparable entities, as is used when deriving a proxy asset beta back into an equity beta.’
Based on its analysis of the alternative approaches and consistent with its use of the post-tax nominal WACC, the Authority has used the Brealey/Myers approach in all de-levering/re- levering applications.
141 Queensland Competition Authority Appendix D
APPENDIX D: GLADSTONE AREA WATER BOARD – WATER DISTRIBUTION SYSTEM AND EXISTING CUSTOMERS
Awoonga Dam SunWater Pipeline CS Energy Callide Power Management
Awoonga Dam Pikes Crossing Benaraby Wurdong Heights
Boyne Smelters Boyne Island/Tannum Sands Calliope Township
Boyne Smelters Toolooa Reservoir
Gladstone Water Gladstone Treatment Plant Reservoirs
QAL Gladstone City Council (Note : NRG Power Station and Gladstone Port Authority are supplied by Gladstone City Council).
KEY:
Raw water supply and customers
Treated water supply and customers Yarwun Treatment Plant Pipelines
Proposed developments Mt Miller Reservoir
Boat Creek Reservoir Orica and Pump Station Australian Magnesium Aldoga – raw Comalco Orica Aldoga - treated Ticor Chemicals QCL Stuart Shale Oil Fishermans Landing: QCL Mt Larcom - raw
Mt Larcom - treated
142 Queensland Competition Authority References
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