Productivity-based Regulation:The New Zealand Experience

Presentation to 8th ACCC Regulatory Conference

26 July 2007

Denis Lawrence

Background

Many regulators acknowledge the desirability of moving to productivity index-based approaches to setting X and delinking the process from DBs’ own costs

But most are concerned about inherent risks – Is the system sufficiently mature? Is there sufficient data?

MCE Expert Panel recommended the AEMC review the rules to facilitate the use of productivity-based approaches

What can we learn from the use of productivity-based approaches elsewhere?

New Zealand is one of the few places to have implemented productivity-based regulation

How was it implemented? How were the problems encountered overcome? How successful has it been?

Electricity reform in NZ

Distributors and retailers corporatised in 1992 – variety of ownership structures, no explicit regulation

Information Disclosure required from 1995 as first step in light handed regulation

Separation of distribution and retail in 1999 Targeted control regime under Commerce Commission

foreshadowed in 2001 and move to incentive regulation Thresholds seen as next logical step in evolution Progressive amalgamation of distributors – 29 in 2002, down

from 60 in mid-1980s Important practical issue that Building Blocks Method not

feasible for 29 ELBs in a small country so need to look at alternative of comparative benchmarking (regardless of whether it be a thresholds or a control regime)

Pre-existing database allowed TFP approach

Rationale for productivity-based regulation

Aim of mimicking competitive markets Productivity-based regulation by price caps (CPI-X) :

industry average price prevails; not based on own costs; response to efficiency and other changes gradual

High power but also high risk (under or over earning) Innovation encouraged, less scope to ‘game’ system Delinks prices and own costs, low regulatory costs X [TFP TFPE] – [W WE] – M Index approach can be mechanistic when firms starting

from similar points Rolling X factor particularly attractive When there is a wide spread of efficiency levels will need

to include ‘stretch factors’ (+ve for laggards, possibly –ve for leaders) as well as industry average

Development of the scheme

Need to allow for variety of starting points, particularly given no previous regulation and range of DB ownership

As well as allowing for industry TFP growth, also need transitional factors in the X given different starting points

X = B + C1 + C2

‘B’ factor reflecting the overall or average productivity trend for DBs

‘C’ factors reflect different productivity and profitability starting points

3 C1 factor groupings based on relative productivity performance

3 C2 factor groupings based on relative profitability performance Price thresholds rather than explicit price caps but could

be transferred to a control regime Based solely on results of quantitative study

Productivity measurement

TFP is an index number measure which forms the ratio of all outputs to all inputs

Relatively simple, robust and readily replicable technique It requires price and quantity data for all outputs and inputs Specification used includes 3 outputs: energy throughput,

customer numbers and system capacity (based on line length, voltage and engineering characteristics)

Outputs weighted by output cost shares from cost function 5 inputs: opex, O/H lines, U/G cables, transformers and other

capital Use physical measures of capital input to better reflect

depreciation characteristics of network assets

B factor

X = [(TFP – TFPE) – (W – WE)]

TFP for distribution trend rate of increase 2.0% pa

Economy TFP trend rate of increase 1.1% pa

Conflicting information on relative input price movements so set this differential to zero

Distribution B of 0.9% pa but round to 1% pa

Relative productivity: C1 factor component

Use 2 techniques:

Multilateral Total Factor Productivity (MTFP) allows analysis of productivity levels as well as growth rates allows the B and C factors to be calculated in an integrated

framework density factors incorporated in output specification divide sample into high, medium and low productivity level

groups average level of high productivity group around 15% above

average of medium group which was around 15% above average of low group

Econometric cost function used to verify MTFP results and obtain output cost shares obtain broadly similar results to MTFP

Relative productivity performance

Relative profitability: C2 factor component

Incorporate profitability differences between the businesses using residual rates of economic return

Calculated consistently with TFP from same database but less detailed than WACC process

Divide sample into high, medium and low profitability groups

Average residual rate of return of high profitability group was 10.3%, of medium group was 7.3% and of low group was 3.4%

Deriving the X Factors

X = B + C1 + C2

Divide distributors into groups of high, average and low productivity levels and profitability

Productivity C1 factor components of –1, 0 and 1 per cent

Profitability C2 factor components of 1, 0 and –1 per cent

Leads to overall X factor groupings of –1, 0, 1 and 2 per cent

C factors set conservatively given quality of the data and industry characteristics – consistent with a 10 year glide path

Mixture of business types in each X factor group with urban high density, urban low density, rural high density and rural low density businesses appearing in each

X applied to each DB’s actual starting price

Assessment

Objective, highly transparent and replicable process with relatively low regulatory cost delivering real price reductions to consumers

None of the vagaries of BBM (eg ‘in our professional opinion’) – less scope for gaming

Building blocks reviews of two of the larger DBs indicated they were earning better returns than they would have under BBM

A few businesses have breached because they think they have a strong case for additional funds for investment – it has not been a deterrent to investment

2009 reset will take lessons learnt into account – may be role for allowing for position in asset lifecycle if impending ‘wall of wire’ effect is thought to be significant in next regulatory period

Information Disclosure Data is now more forward looking allowing scope for more account to be taken of forward looking information

Ongoing role seen for productivity-based approach irrespective of outcome of thresholds review

Importance of having a consistent database available