Expenditure review - Melbourne Water 2021 Price Submission Expenditure review - Melbourne Water 2021 Price Submission FINAL REPORT for the Essential Services Commission - Public 23 February 2021 1 Expenditure review - Melbourne Water 2021 Price Submission Commercial-in-confidence Contents Glossary ii Executive summary iii About this report iii Operating expenditure iii Capital expenditure v 1 Introduction 1 1.1 Background 1 1.2 Scope of review 1 1.3 Approach to review 1 1.4 Structure of this report 2 2 Summary of forecast expenditure 3 2.1 Key expenditure drivers 3 2.2 Operating expenditure 9 2.3 Capital expenditure 12 3 Operating expenditure assessment 15 3.1 Overview of approach 15 3.2 Historical controllable expenditure (2019-20) 17 3.3 Baseline growth-efficiency improvement rate 23 3.4 Forecast variations to baseline expenditure 27 3.5 Individual controllable expenditure items 41 3.6 Recommendations 55 4 Capital expenditure assessment 56 4.1 Overview of approach 56 4.2 Historical capex 57 4.3 Overall assessment of capital planning and asset management 62 4.4 Overall assessment of capital delivery 62 4.5 Overview of major programs / allocations 63 4.6 Major water projects 66 4.7 Major sewerage projects and programs 77 4.8 Major waterways and drainage projects 90 4.9 Recommendations 102 Appendix A – Demand forecast review 106 Key findings of the demand review 106 Population forecast comparison 107 Waterways and drainage 120 Sewage demand 125 Water demand 136 Limitation of our work 143 General use restriction 143 i Expenditure review - Melbourne Water 2021 Price Submission Commercial-in-confidence Glossary Acronym Full name AAD Average Annual Damages AEP Annual Exceedance Probability BOD Biological oxygen demand BNI Business Needs Identifier CAGR Compound annual growth rate Capex Capital expenditure EPA Environmental Protection Authority ESC Essential Services Commission ETP Eastern Treatment Plant FBC Functional Business Case HBT Health-based target MW Melbourne Water Opex Operating expenditure PREMO Performance, Risk, Engagement, Management and Outcomes PS16 Pricing Submission 2016 PS21 Pricing Submission 2021 RP4 Regulatory Period 4 RP5 Regulatory Period 5 SDR Standardised Death Rate TKN Total Kjeldahl nitrogen (TKN) TSS Total suspended solids WDCC Waterways and Drainage Customer Council WHO World Health Organisation WIRO Water Industry Regulatory Order WSCC Water and Sewerage Customer Council WTP Western Treatment Plant ii Expenditure review - Melbourne Water 2021 Price Submission Commercial-in-confidence Executive summary About this report The Essential Services Commission (ESC) is currently reviewing Melbourne Water’s (MW) proposed services and prices for the regulatory period 1 July 2021 to 30 June 2026. This period is referred to in this document as ‘the next regulatory period’ or the ‘fifth regulatory period’ (RP5). The ESC has engaged Deloitte Access Economic and Arup to review MW’s operating and capex forecasts and to provide advice on whether it is consistent with the requirements of the regulatory framework. In undertaking this review, our key responsibilities are to: • assess the appropriateness of the expenditure forecasts in relation to the key objectives of the review • provide advice to the ESC regarding the appropriateness of the forecasts, and • where our advice indicates that proposed expenditure is not appropriate, propose a revised expenditure level. Deloitte Access Economics and Arup have been asked to review the three major service areas provided by MW – bulk water, bulk sewerage and waterways and drainage. As part of our review, the ESC also requested that Deloitte Access Economics undertake a detailed review of the assumptions and methodology applied by MW in developing its growth forecasts for the three areas, and comment on the implications of any findings for the proposed expenditure. This analysis is provided in Appendix A. Operating expenditure The key features of MW’s operating expenditure (opex) forecast ($2020-21m) include: • baseline controllable opex in 2019-20 of $389.2m1 (before adjustments), which is lower than that forecast in the 2016 price submission ($400.7m) and the 2016 price determination ($394.2m) • a net growth-cost efficiency improvement rate of 0.05% per annum • $230.1m of forecast additional expenditure in total over RP5 above the baseline, primarily reflecting energy costs (which MW removed from its baseline) and new waterways and drainage projects supported by customer willingness to pay studies2 • a total cumulative controllable opex of $1,956.9m over RP5. Figure i shows MW’s total controllable opex from 2013-14 to 2025-26, comparing actual and forecast expenditure to the PS16 proposal and final determination. 1 Total baseline controllable opex is $1.93m higher than the figures presented in MW’s original price submission, this is due to revisions provided during the review process to reflect the final statutory accounts for 2019-20. Revisions to base year expenditure were removed from the baseline forecast as adjustments, therefore there is no change in proposed forecast expenditure. 2 Total adjustments are higher than proposed in MW’s price submission due to revised energy forecast provided by MW during the review process. During the review process, MW revised their energy forecast by $7.54 million. The new value of the total controllable opex with revisions for energy is $154.8 million. iii Expenditure review - Melbourne Water 2021 Price Submission Commercial-in-confidence Figure i: Historical and forecast total controllable opex ($2020-21m) 440 Regulatory Period 4 Regulatory Period 5 420 400 380 360 340 320 300 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 Actual PS21 Forecast PS16 Proposed Forecast PS16 Determination Source: Actual and forecast is based on MW 2021 Price Review Model – ESC Reviewed (provided 24 December 2020), 2016 proposed forecast is based on MW Price Review Template and 2016 Determination is based on the ESC’s Final – 2016 MW Price Review Template (provided 17 November 2020). Notes: 1. Base year (2019-20) actual expenditure is slightly higher than the original price submission due to revisions provided by MW during the review process. 2. Includes revised energy forecast provided by MW during the review process. We have recommended adjustments to forecast expenditure where we consider that insufficient information had been provided to support the proposed expenditure or where the expenditure was imprudent or inefficient. In total, we have recommended a reduction of $41.8m to MW’s RP5 forecast controllable opex, representing 2.1% of proposed controllable expenditure. The reasons for these recommendations are outlined in Chapter 3. Table i: MW forecast controllable opex and recommended adjustments ($2020-21m) Actual Forecast RP5 Opex item Base year 2021-22 2022-23 2023-24 2024-25 2025-26 Total 2019-20 Proposed 389.04 387.01 388.46 394.09 398.34 1956.95 controllable opex1 Recommended adjustments W&S base year -1.95 -1.95 -1.94 -1.94 -1.94 -1.94 -9.72 adjustment Waterways base year -0.48 -0.48 -0.48 -0.48 -0.48 -0.48 -2.39 adjustment Growth rate -0.52 -1.03 -1.54 -2.05 -2.56 -7.70 adjustment to baseline Waterways and drainage service -4.40 -4.40 -4.40 -4.40 -4.40 -22.00 increase Total recommended -2.43 -7.34 -7.85 -8.36 -8.87 -9.38 -41.81 adjustments Recommended 381.70 379.16 380.10 385.22 388.96 1915.14 controllable opex Source: Deloitte Access Economics Note: 1. Forecast proposed controllable opex includes a revised energy cost adjustment provided by MW during the review process. MW should clarify in its response to the ESC’s Draft Decision whether it intends to recover this higher amount. iv Expenditure review - Melbourne Water 2021 Price Submission Capital expenditure The key features of MW’s capital expenditure (capex) forecast include: • total capex forecast of $3,702.2m3 over RP5 • expenditure forecast to peak in 2022-23, particularly due to the proposed Western Treatment Plant (WTP) 55E ASP Upgrade and Hobsons Bay Main (HBM) Yarra Crossing Duplication projects which will reach peak construction in that year. • a 39% increase in capex compared to the previous regulatory period4 (2016-17 to 2021-22, ‘RP4’) capex (using actuals for 2015-16 to 2019-20 and forecasts for 2020-21). This is primarily driven by increases in: o ‘growth’ capex in response to strong population growth over the past five years o ‘renewals’ capex to keep current assets fit-for-purpose as they age and deal with the challenges presented by climate change. The key ‘renewals’ project is a large atypical sewer main renewal project (Hobsons Bay Main Yarra Crossing Duplication). o ‘improvement’ capex to deliver higher levels of service in response to customer willingness to pay analysis. • an additional desalination security payment capitalisation cost of $398.6m over RP5. Figure ii below presents forecast capex from 2021-22 to 2025-26, split by major drivers. Sewerage projects comprise the most significant proportion of spend for all years except 2025-26 in which Waterways and Drainage is the major capex driver. Figure ii: capex breakdown by major driver ($2020-21m) Source: Actual and forecast is based on MW 2021 Price Review Model – ESC Reviewed (provided 24 December 2020) *values for 2020-21 represent ‘pre- populated’ values using forecasts from the PS16 submission, MW forecast (at the time of the submission) capex of $663.0 (including desal security payment cost capitalisation) in 2020-21. The updated forecast (February 2021) for capex in 2020-21 is $670.2million (including desal security payment cost capitalisation). Overall, we recommend a 8% reduction ($296.8m) on total capex over RP5 compared to MW’s forecast. This reflects: • a $46.8 million reduction across the 15 major projects assessed in detail, which reflects a 4.4% reduction on MW’s 2021 price submission proposal for these projects • an overall reduction of an average $50m per annum across the broader capital program, resulting in a reduction of $250m over RP5.