Gladstone Area Water Board: Investigation of Pricing Practices

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 i Queensland Competition Authority Table of Contents 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 ii Queensland Competition Authority Glossary 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.

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