IPART releases 2016 Draft Determination for Hunter Water

Notional revenue requirement and price structure

IPART’s draft decision is to allow a notional revenue requirement of $1.18B over four years, $25M (2.2%) higher than proposed by Hunter Water. The increase is mainly due to changes in the WACC parameters from the time of Hunter Water’s submission. IPART also revised their assumptions on Hunter Water’s asset lives, which increased the regulatory depreciation allowance.

IPART has proposed changes to prices to remove cross subsidies. The net effect of changes in the notional revenue requirement and the pricing structure is that most residential and small business customers will pay more in real terms while most large non-residential customers will pay less. Real price increases for a typical residential customer have been limited to 1% in 2016-17 and 2.9% for each year thereafter.

Expenditure allowances and efficiency targets

Operating costs: Hunter Water’s proposed operating expenditure was 1.5% lower than allowed in the previous determination as a result of lower input costs and efficiencies in operation. IPART’s draft decision is to reduce operating expenditure by a further 1.8% ($9.4M), to $525M over the regulatory period. Approximately 20% ($1.9M) of IPART’s reduction is due to an imposed continuing efficiency factor of 0.25% per year on controllable operating expenditure. This was considered to reflect what a frontier company competing in an open market would be implementing.

IPART has indicated it is working with regulated businesses and other regulators to expand the use of performance benchmarking in future price reviews.

Capital expenditure: The draft decision is for capital expenditure of $364.5M over the regulatory period, 6% lower than proposed by Hunter Water. Around 20% of the reduction was to take account of systematic over-estimation of project costs during the current regulatory period and 10% was due to efficiency savings. The remaining reductions were made to specific capital programs.

Rate of return

IPART’s set a real post-tax WACC of 4.8 per cent, consistent with the draft decision for Sydney Water. This represents the midpoint of the WACC calculated using current data (average of 40 days to 20 January 2016) and long term averages (10 year average). The WACC will be updated before the final decision to reflect the latest market data.

Pricing flexibility

IPART has proposed to allow Hunter Water and large non-residential customers to enter into unregulated pricing agreements for water supply and sewerage services. These agreements will only apply when both parties have agreed to opt-out of the prices set by IPART. A similar regime is proposed for Sydney Water.

While Hunter Water currently has differential water usage prices for around 20 of its major industrial and commercial customers located in specific zones, this decision will apply to a much larger number of customers (the threshold for eligibility is companies with annualised consumption greater than 7.3ML compared to 50ML under the current system).

Efficiency carryover mechanism

IPART’s draft decision includes an efficiency carryover mechanism (ECM) aimed at removing any incentive for Hunter Water to delay permanent operating cost savings. Permanent savings will be retained by Hunter Water for four years before they are passed on to customers, regardless of when the cost reductions are achieved in the regulatory period. The ECM regime is the same as that proposed by IPART for Sydney Water.

Demand volatility adjustment mechanism

IPART will consider, at the next determination, an adjustment to the revenue requirement and prices to address any under- or over-recovery of revenue due to material differences between the forecast and actual level of water sales.

In past determinations, IPART has specified a range of variation within which an adjustment would not be considered (previously set at +/- 10%). However, their draft decision is that they will consider whether and how best to make a revenue adjustment based on the circumstances at the time. This is consistent with IPART’s approach to the determination of Essential Energy’s water prices at Broken Hill and their draft decision for Sydney Water.

Commentary

The major changes to the regulatory framework for Hunter Water are a result of Sydney Water’s proposals for greater incentives and price flexibility. Hence our comments here are similar to those for the draft Sydney Water decision.

IPART proposes to have additional discretion about volume adjustments at the next price review. The risks to Hunter Water under these arrangements are asymmetric – a regulator is less likely to increase prices due to lower than forecast demand in the previous period, but is more likely to reduce prices if demand was higher. Irrespective of whether IPART has exercised its regulatory discretion responsibly in the past, the prospect of a retrospective application of discretion is problematic.

It is easy to be sceptical about new benchmarking initiatives. The National Water Commission’s national benchmarks for the water industry suffered from the usual problems of comparability of data sets as well as the businesses themselves. The narrow use of benchmarking by the AER to determine efficient expenditure – recently rejected by the Australian Competition Tribunal – also highlights the pitfalls on over-reliance on benchmarking to determine efficient costs.

Successful implementation of a broad-based benchmarking regime would require a long-term data set and significant and consistent cooperation across jurisdictions and businesses. If this could be done, benchmarking could be a useful tool for businesses and regulators as part of a broader analysis (e.g. including a ‘bottom up’ review) to assess the efficient costs and identify areas for potential improvement.

Next steps

Interested parties are invited to make further submissions and provide feedback by 18 April 2016, with IPART’s final determination to be released in mid-June 2016.