Inquiry into the Efficiency of Synergy’s Costs and Electricity Tariffs Draft Report 4 April 2012 Important Notice This document has been compiled in good faith by the Economic Regulation Authority (Authority). The document contains information supplied to the Authority from third parties. The Authority makes no representation or warranty, express or implied, as to the accuracy, completeness, reasonableness or reliability of the information supplied by those third parties. This document is not a substitute for legal or technical advice. No person or organisation should act on the basis of any matter contained in this document without obtaining appropriate professional advice. 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Economic Regulation Authority Contents Executive Summary vii Introduction vii Background vii How are Efficient Cost Reflective Electricity Tariffs Calculated? viii Draft Findings ix Wholesale Electricity Cost xii Retail Operating Costs xiv Non-Controllable Costs xiv Retail Margin xv Cost Reflective Electricity Tariffs xvi Impact on Synergy and Government xvii Future Regulatory Arrangements xviii Invitation for Public Submissions xviii 1 Introduction 1 1.1 Terms of Reference 1 1.2 Background to the Inquiry 2 1.3 Review Process 3 1.4 How to Make a Submission 4 2 Inquiry Approach 5 2.1 Aim of the Inquiry 5 2.2 Current Process for Setting Tariffs 5 2.2.2 Economic Efficiency 6 2.2.3 Estimation of Synergy’s Efficient Costs 8 2.2.4 Allocating Costs to Customer Classes 10 2.2.5 Tariffs 11 2.2.6 Gap Analysis 11 3 Wholesale Electricity Costs 12 3.1 Background 12 3.2 Public Submissions 12 3.2.1 Wholesale Energy Procurement 12 3.2.2 Renewable Energy Certificates 13 3.2.3 Carbon Costs 14 3.3 Synergy’s Demand Forecasts 15 3.3.1 Synergy’s Approach to Demand Forecasting 15 3.3.2 Authority Assessment of Synergy’s Demand Forecasts 16 3.4 Purchase of Wholesale Electricity 18 3.4.1 Assessment of Synergy’s Contracts 19 3.4.2 Is Synergy Using its Existing Contracts Efficiently? 22 3.4.3 Consultant’s Approach to LRMC Estimation 24 3.4.4 Consultant’s Findings 24 3.4.5 Conclusion on procurement of wholesale electricity 25 3.4.6 Procurement of RECs 25 Inquiry into the Efficiency of Synergy’s Costs and Electricity Tariffs: Draft Report i Economic Regulation Authority 3.4.7 Costs of Carbon Pricing 28 3.5 Conclusion on Efficient Wholesale Electricity Purchasing Costs 29 3.6 Draft Recommendation 30 4 Retail Operating Costs 32 4.1 Background 32 4.2 Public Submissions 32 4.3 Service Standards 33 4.4 Synergy’s Estimates of its Retail Operating Costs 34 4.5 Synergy’s Capital Expenditure 35 4.6 Consultant Assessment 36 4.6.1 Consultant’s Approach 36 4.6.2 Consultant Findings 37 4.7 Authority Assessment 38 4.8 Draft Recommendation 40 5 Non-Controllable Costs 42 5.1 Network Charges 42 5.1.1 Background 42 5.1.2 Public Submissions 43 5.1.3 Authority Assessment 43 5.1.4 Draft Recommendation 45 5.2 Ancillary Services Costs 45 5.2.1 Authority Assessment 45 5.2.2 Draft Recommendation 46 5.3 Market Fees 46 5.3.1 Background 46 5.3.2 Synergy’s Market Fees 47 5.3.3 Authority Assessment 47 5.3.4 Draft Recommendation 48 6 Retail Margin 49 6.1 Background 49 6.2 Public Submissions 49 6.3 Benchmarking Approach 50 6.4 Bottom-Up Approach 51 6.4.1 Rate of return 52 6.4.2 Asset Valuation 53 6.4.3 Cost of Acquiring a Business 53 6.4.4 Cost of Acquiring and Retaining Customers (CARC) 54 6.5 Authority’s Assessment 56 7 Electricity Tariffs 58 7.1 Background 58 7.2 Cost Reflective Tariffs 58 7.2.1 Background 58 7.2.2 Allocation of Costs Across Customer Groups 59 7.2.3 Cost Reflective Tariffs 62 ii Inquiry into the Efficiency of Synergy’s Costs and Electricity Tariffs: Draft Report Economic Regulation Authority 7.3 Amalgamation of Tariffs 65 7.3.1 Background 65 7.3.2 Public Submissions 65 7.3.3 Authority Assessment 66 7.4 Draft Recommendation 67 8 Tariff Impacts 68 8.1 Public Submissions 68 8.2 Principles 68 8.3 Impacts on Customers 69 8.3.1 Residential Customers 70 8.4 Impacts on Synergy and Government 71 8.4.1 Background 71 8.4.2 Synergy’s Revenue Requirement 71 8.4.3 Impacts on Government 72 9 Regulation of Tariffs 75 9.1 Background 75 9.2 Removal of Regulated Tariffs for Contestable Customers 75 9.2.1 Background 75 9.2.2 Current Tariffs for Contestable customers 75 9.2.3 Public Submissions 76 9.2.4 Authority Assessment 79 9.3 Regulatory Arrangements 80 9.3.1 Public Submissions 80 9.3.2 Authority Assessment 81 Appendices 83 Appendix A. Terms of Reference 84 Appendix B. Background to the Electricity Sector in Western Australia 85 Appendix C. Synergy’s Current Tariffs 107 Appendix D. Synergy’s Demand Forecasts 111 Appendix E. Synergy’s Rate of Return 112 Appendix F. Synergy’s Concessions and Rebates 128 Appendix G. Glossary 129 Inquiry into the Efficiency of Synergy’s Costs and Electricity Tariffs: Draft Report iii Economic Regulation Authority List of Tables Table 1 Synergy's average efficient costs per cost component (c/kWh) xvi Table 2 Impact on Government ($m, nominal) xvii Table 3 Tariff Percentage Increases 2009/10 to 2014/15 2 Table 4 Synergy's Forecast Variations as Percentage of Total Electricity Volumes 2005/06 to 2010/11 17 Table 5 Authority's Estimates of Synergy's Wholesale Electricity Costs 2012/13 to 2015/16 23 Table 6 Adjusted LRMC Accounting for Additional Capacity Required by the IMO 2012/13 to 2015/16 25 Table 7 Synergy's Forecast LREC Expenses ($/LGC) 27 Table 8 Carbon Impact on LRMC of Utilising Gas-Fired Generation 2012/13 to 2015/16 28 Table 9 Carbon-Inclusive Efficient Wholesale Electricity Cost ($/MWh, nominal) 2012/13 to 2015/16 30 Table 10 Synergy's Actual and Forecast Operating Costs 2010/11 to 2015/16 34 Table 11 Synergy's Estimated Retail Costs for Contestable Customers in 2010/11 and 2012/13 35 Table 12 TEC Attributable to Synergy's Tariff Customers ($m, nominal) 2012/13 to 2015/16 44 Table 13 Synergy's Total Tariff Forecast Network Costs 2012/13 to 2015/16 44 Table 14 Actual and Forecast Ancillary Services Costs Paid by Synergy 2009/10 to 2015/16 45 Table 15 Actual and Forecast Market Fees Paid by Synergy 2009/10 to 2015/16 47 Table 16 Retail Margin Expressed as EBITDA per cent of Total Costs Adopted by Australian Regulators in the National Electricity Market 51 Table 17 Cost of Acquiring a Business, Total Asset Base ($) 2011/12 to 2015/16 53 Table 18 Estimated Regulatory Asset Base and Associated Retail Margin 2011/12 to 2015/16 53 Table 19 Regulatory Customer Acquisition and Retention Cost Estimates 54 Table 20 Estimated Value of Synergy's Regulated Asset Base (Tangible Asset Values, $m) 2012/13 to 2015/16 55 Table 21 Estimated Regulatory Asset Base and Associated Retail Margin ($) 2012/13 to 2015/16 56 Table 22 Cost Reflective Tariff Breakdown, Total Tariffs (c/kWh, nominal) TEC Excluded 2012/13 to 2015/16 59 Table 23 Synergy’s Capacity Allocation as Determined by the Authority for 2012/13 62 Table 24 Cost Reflective Tariffs, Individual Tariffs (c/kWh, nominal) TEC Exclusive 2012/13 to 2015/16 63 Table 25 Assumed Budgeted Tariffs versus Cost Reflective Tariffs (c/kWh) TEC Exclusive 2012/13 64 Table 26 Bill Impacts: Estimated Cost Reflective Bills, TEC Exclusive 2011/12 to 2015/16 70 Table 27 Synergy’s Efficient Revenue Requirement ($m, nominal) 2011/12 to 2015/16 71 Table 28 Synergy's Revenue Requirement Based on Actual Projected Costs ($, nominal) 2011/12 to 2015/16 72 Table 29 Differences Between Synergy's Efficient Revenue Requirement and Actual Revenue Requirement ($m, nominal) 2011/12 to 2015/16 72 Table 30 Synergy’s Estimated Glide Path CSO, Tax and Dividends ($m, nominal) 2012/13 to 2015/16 , Excluding TEC 73 iv Inquiry into the Efficiency of Synergy’s Costs and Electricity Tariffs: Draft Report Economic Regulation Authority Table 31 Additional CSO required to fund TEC ($m nominal) 2011/12 to 2016/17 73 Table 32 Impact on Government