regulator’s (aer’s) draft decision on essential’s tariff ... energy - revised... ·...

30 September 2016

Natalie Lindsay

Manager Network Regulation

Essential Energy

PO Box 5730

Port Macquarie NSW 2444

Dear Ms Lindsay

Expert review of Essential Energy’s proposed tariffs with the NER pricing

principles

Essential Energy (Essential) has prepared its response to the Australian Energy Regulator’s (AER’s) 2 August 2016 draft decision on Essential’s tariff structures statement (TSS).

Essential has asked Farrier Swier Consulting (FSC) to review the tariffs Essential is proposing in its revised proposal for compliance with the pricing principles in the National Electricity Rules, specifically, clauses 6.18.5(e) to (i).

This letter sets out:

The scope of our review

Our findings

Our expert qualifications and experience relevant to the task.

Yours sincerely

Robert McMillan

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Disclaimer

This report has been prepared by Farrier Swier Consulting Pty Ltd (FSC) for the sole use of the Essential Energy. This report is supplied in good faith and reflects the knowledge, expertise and experience of the consultants involved. The report and findings are subject to various assumptions and limitations referred to within the report, and supporting papers. Any reliance placed by a recipient of the report upon its calculations and projections is a matter for the recipient’s own commercial judgement. FSC accepts no responsibility whatsoever for any loss occasioned by any person acting or refraining from action as a result of reliance on the report.

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1. Review scope

We have reviewed Essential’s tariff changes—namely its new and structurally-amended tariffs—in its revised TSS for their compliance with the NER pricing principles, in accordance with review scope set out in Appendix A to this letter.

Essential’s revised TSS proposes seven key tariff changes relative to its original proposal

Since its initial proposal, Essential has:

Introduced five new tariffs:

1. BLNT3AL – LV Residential TOU_Interval meter – Default tariff (with opt out available) for all new residential customers with suitable metering

2. BLNT2AL – LV Business TOU_Interval meter – Default tariff (with opt out available) for all new small business customers with suitable metering

3. BLND1AR – Small Residential-Opt in Demand – Optional (opt in) for choice by residential customers with suitable metering

4. BLND1AB – Small Business-Opt in Demand – Optional (opt in) for choice by small business customers with suitable metering

5. BLNDTRS – Transitional Demand – Essential mandate assignment based on eligibility criteria.

Removed declining block structure from its residential and LV small business tariff and replaced with an anytime flat tariff structure.

These changes, and their implications for the compliance of its unchanged tariffs are considered in this compliance review.

What we reviewed

In completing our compliance assessment, we have considered:

Essential’s 27 Nov 2015 TSS submission

Essential’s modelling of the cost concepts prescribed in the pricing principles, namely: long run marginal cost, standalone and avoidable costs, residual costs and building block cost of supply (hereafter collectively referred to as ‘economic cost modelling’)

Essential’s proposed tariffs and tariff classes

The eligibility and assignment criteria for Essential’s proposed new tariffs

Essential’s customer engagement outcomes including:

– Essential’s summary of the outcomes of its customer engagement associated with its tariff changes as presented in its revised TSS and addendum

– IPSOS’s September 2016 report Essential Energy Correct Tariff Customer Consultation (the IPSOS Report)

Essential’s transition tariff customer impact modelling

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Samples of system and customer load profile data relevant to the new and amended tariffs

Essential’s current and draft customer brochures, which explain core components of Essential’s tariffs

The AER’s 2 August 2016 draft decision for Essential TSS

Selected AER draft and final decisions for other distribution network service providers’ (DNSPs) TSS submissions.

Where the AER’s 2 August 2016 draft decision deemed an element of Essential’s proposed TSS and tariffs as rule compliant, we have relied upon this and its associated basis of concluding that compliance when performing our assessment.

2. Our findings

We set out below our compliance assessment of Essential’s new and structurally-amended tariffs for each relevant pricing principle, including the basis upon which we reached this conclusion.

There are no inefficient cross subsidies

Table 1 – Standalone and avoidance cost – clause 6.18.5(e)

Pricing principle Review scope

Basis of FSC’s compliance assessment

Assessment

For each tariff class, the revenue expected to be recovered must lie on or between: 1. an upper bound representing the stand

alone cost of serving the retail customers who belong to that class; and

2. a lower bound representing the avoidable cost of not serving those retail customers.

Test for all proposed tariff classes

Review of Essential’s economic cost modelling

Compliant

We have reviewed Essential’s economic cost modelling for all proposed tariff classes, including the reasonableness of the assumptions and math associated with this. From this we are satisfied that:

No tariff classes are priced below the incremental costs that Essential would avoid if it did not service the customers on that tariff—avoidable cost, part 2 of the principle

No tariff classes are priced above the cost a customer would incur if they by-passed the network and built their own electricity delivery infrastructure—standalone costs, part 1 of the principle.

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Tariffs are based on Essential’s reasonable estimates of long-run marginal cost

Table 2 – Long-run marginal cost – clause 6.18.5(f)



Assessment

Each tariff must be based on the long run marginal cost of providing the service to which it relates to the retail customers assigned to that tariff with the method of calculating such cost and the manner in which that method is applied to be determined having regard to: 1. the costs and benefits associated with

calculating, implementing and applying that method as proposed;

2. the additional costs likely to be associated with meeting demand from retail customers that are assigned to that tariff at times of greatest utilisation of the relevant part of the distribution network; and

3. the location of retail customers that are assigned to that tariff and the extent to which costs vary between different locations in the distribution network.

Test for new tariffs

Essential’s economic cost modelling AER’s draft decision Load profile data

Compliant

Regarding part 1 of the principle, in its draft decision the AER stated that it was satisfied that, taken as a whole, Essential’s long-run marginal cost (LRMC) estimates and the average incremental cost method used to derive these as being compliant with this pricing principle.1

To assess parts 2 and 3 of the principle, we:

examined samples of system and customer cohort load profile data and the coincidence of peak usage for the tariff classes and customer cohorts on the new tariffs with the systems peaks that drive Essential’s incremental system investment costs

assessed sample feeder data across different geographies to understand the extent and materiality of any regional differences in peak load timings

investigated how Essential’s economic cost modelling identifies incremental growth-related costs and attributed these to the voltage levels and tariff classes applicable to these new tariffs for LRMC modelling, and for setting the cost reflective elements of these new tariffs.

We found the cost attribution for each tariff to be reasonable, having regard to their load profiles, and also that there was not a material geographic divergence in peaks that would presently warrant additional tariff complexity to add further price discrimination

1 AER, New South Wales —Tariff structure statement— Draft decision, 2 Aug 2016, pp. 85-86.

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by geographic area. In forming this view we also had regard to the robustness of the LRMC modelling based on the assumptions and methodologies used, recognising that there is an intent to improve this over time.

Tariffs recover allowed efficient costs and seek to minimise demand distortion

Table 3 – Recover efficient costs efficiently – clause 6.18.5(g)



Assessment

The revenue expected to be recovered from each tariff must: 1. reflect the Distribution Network Service

Provider's total efficient costs of serving the retail customers that are assigned to that tariff;

2. when summed with the revenue expected to be received from all other tariffs, permit the Distribution Network Service Provider to recover the expected revenue for the relevant services in accordance with the applicable distribution determination for the Distribution Network Service Provider; and

3. comply with sub-paragraphs (1) and (2) in a way that minimises distortions to the price signals for efficient usage that would result from tariffs that comply with the pricing principle set out in paragraph (f).

Test for new tariffs and amended declining block tariffs (DBT)

Economic cost modelling Essential’s proposed tariffs, and assignment and eligibility criteria

Compliant

Our review of Essential’s economic cost modelling and proposed tariffs, found that it employs a three-step process whereby:

1. The most cost reflective marginal charging parameters in each new tariff have been modelled based on an estimate of the LRMC for customers on that tariff—part 1 of the principle

2. Residual costs are allocated in greater portions to tariffs that have less efficient charging parameters, namely anytime usage and time of use usage tariffs, with allocations to demand tariffs minimised—part 3 of the principle

3. Finally, residual costs are allocated within any given tariff in greater portions to those charging parameters that have least impact on efficient pricing decisions in descending order of: standing charges, anytime usage charges, and time of use (TOU) usage charges—part 3 of the principle.

The residual costs are calculated as the difference between the revenues allowed building block under the AER revenue cap for that year and those revenues forecast to be recovered from the LRMC-determined charges. Thus, by design, Essential has ensured its tariff design complies with part 2 of the principle.

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We also had regard to Essential’s proposal to set the charges for the demand components of its new small residential opt-in demand tariff (BLND1AR) at below LRMC in order to engage customer take up of it. In doing so, Essential set the fixed and usage components of this tariff to ensure that the full efficient cost was recovered.

Essential’s new tariffs are mindful of customer impact

Table 4 – Reasonably reflect customers’ ability to respond to tariff change – clause 6.18.5(h)



Assessment

A Distribution Network Service Provider must consider the impact on retail customers of changes in tariffs from the previous regulatory year and may vary tariffs from those that comply with paragraphs (e) to (g) to the extent the Distribution Network Service Provider considers reasonably necessary having regard to: 1. the desirability for tariffs to comply with

the pricing principles referred to in paragraphs (f) and (g), albeit after a reasonable period of transition (which may extend over more than one regulatory control period);

2. the extent to which retail customers can choose the tariff to which they are assigned; and

3. the extent to which retail customers are able to mitigate the impact of changes in tariffs through their usage decisions.


Essential’s proposed tariffs, and assignment and eligibility criteria Transition tariff customer impact modelling Transition tariff customer engagement in the IPSOS Report

Compliant

The new residential and small business TOU tariffs—BLNT3AL – LV Residential TOU_Interval meter and BLNT2AL – LV Business TOU_Interval meter—will only apply to new customers who have suitable metering installed at their time of connection. This means these customers will not experience a bill-shock on the prior year—part 1 of the principle—because they were not customers in that prior year. Further these customers can opt out, should they choose to—part 2 of the principle.

The new opt in residential and small business demand tariffs—BLND1AR – Small Residential-Opt in Demand and BLND1AB – Small Business-Opt in Demand—will only apply where a customer elects to opt into the tariff, meaning:

it is preferable to move these tariffs immediately to cost reflective levels rather than transition them, while still providing incentive for customers to opt in – part 1 of the principle

customers that are unable to understand or mitigate bill impact on these cost reflective tariffs are empowered to opt out of them- parts 2 and 3 of the principle.

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The new transitional tariff—BLNDTRS – Transitional Demand—has been designed with the express intent of addressing the provisions of clause 6.18.5(h) parts 1, 2 and 3, specifically:

Being large customers >100Mwh who are currently incorrectly assigned to the least cost reflective tariffs—anytime usage—there is a pressing need to expedite their reassignment to more cost reflective tariffs.

However, these reassignments will not be voluntary or opt in.

Absent a targeted transition, some customers will face material bill shock and have expressed their concern about this in Essential’s customer engagement.

The behavioural response of some affected customers will take time—e.g. to adapt production methods to manage peak demand—and engagement results show that further education is needed to support this adjustment.

Essential’s transition length was supported by customers and is a key limb of its response to customers’ stated concerns, because it allows more time, in addition to the notification period, for Essential to focus on addressing the customer concerns and suggested response strategies set out respectively in sections 3 and 4 of the IPSOS report.

Essential’s new tariffs were accompanied by an information and engagement campaign, and complement the process of building customer understanding through opt in and out assignment provisions and tariff transition.

Table 5 – Tariffs can be sufficiently understood by affected customers – clause 6.18.5(i)



Assessment

The structure of each tariff must be reasonably capable of being understood by retail customers that are assigned to that tariff, having regard to: 1. the type and nature of those retail

customers; and 2. the information provided to, and the

consultation undertaken with, those retail customers.


Essential’s proposed tariffs, and assignment and eligibility criteria Customer engagement, brochures and Q&As, the IPSOS Report

Compliant

Essential has sought to inform customers about its new tariffs through various engagement channels and information materials. However, customer understanding and behavioural change necessarily takes time. Consistent with this pricing principle, Essential has therefore complemented its new cost-reflective tariff reforms with assignment arrangements and tariff transition that account for this.

The new residential and small business TOU tariffs—BLNT3AL – LV Residential TOU_Interval meter and BLNT2AL – LV Business TOU_Interval meter—will only apply to new customers who have suitable metering installed at their time of connection. This

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means these customers will, in appointing their new retailer to obtain connection, exercise choice in their retail offering. This is in addition to potentially exercising choice to opt out of this tariff should they find they do not sufficiently understand TOU pricing.

The new opt in residential and small business demand tariffs—BLND1AR – Small Residential-Opt in Demand and BLND1AB – Small Business-Opt in Demand—will necessarily be understood by customers, given they will have had to exercise their own discretion and/or been informed by advice from an agent or retailer, in order to be assigned to it.

Essential’s customer engagement and related information materials for large customers moving to the new transitional tariff—BLNDTRS – Transitional Demand—shows that Essential has tried to explain the tariff’s consequences to affected customers. The customer engagement feedback in the IPSOS report shows affected customers appreciate that it will impact them in potentially material ways, and these customers support having a notification period and transition period.

3. Our qualifications

The FSC team that completed this review comprised Robert McMillan and Eli Grace-Webb. Our relevant recent experience relevant to this review is set out below, and consultant profiles for Robert and Eli are provided in Appendix B.

Our team have advised regulators and businesses on network pricing rules, and network tariff design, consultation and compliance. We:

Developed Jemena Electricity Networks’ (JEN’s) TSS—the first one submitted to the AER under the new pricing rules and to propose cost reflective demand charges for all network customers—and led the customer engagement (2014 – 2015).

Provided expert input to the Australian Energy Markets Commission and Ministerial Energy Council on the NER chapter 6 network pricing rule design (2006 – 2008).

Led Jemena’s participation in the AEMC’s power of choice reviews that gave rise to the pricing principles and TSS rule change (2012 – 2014).

Implemented JEN’s transition of network connections regulation from the ESC’s guideline 14 to the NER chapter 5A (2015 – 2016).

Led the Victorian ESC’s application and modification of the Victorian network rules for its 2005-10 price review (2004 – 2005), and ran the annual tariff approval process in 2004, 2005 and 2006.

Advised Victorian networks on application of the NER network tariff regime in their 2010-15 price reviews (2010 – 2011).

Developed Jemena Gas Networks’ tariff strategy and tariff structures statement (TSS) and led the TSS customer engagement (2013).

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Appendix A - Scope of r eview

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Appendix B - Consultant profiles

Robert McMillan

Master of Regulatory Economics, Australian National University

Bachelor of Economics, Monash University

Certificate IV in government, Chisholm Institute

Diploma of Management, Australian Institute of Management

Member, Australian Institute of Company Directors

Overview

Skills: regulatory strategy, regulatory frameworks, regulatory support, project management, effective stakeholder engagement, energy policy, pricing network usage and connection services

Robert McMillan is an experienced economist and manager with expertise in regulatory policy and practice in the energy and water sectors. He has also advised clients in fiscal policy development, competition policy, tariff reform and market assessments.

Robert recently re-joined FSC after three and a half years as General Manager Regulation for Jemena. In this role he led Jemena’s regulatory team to manage the regulatory risks associated with Jemena’s $9 billion of electricity, gas and water network infrastructure. Robert was responsible for leading the protection and optimisation of Jemena’s regulated assets and their revenues, interacting with internal and external stakeholders to ensure Jemena meets its regulatory and statutory obligations and identifying future opportunities for Jemena’s asset portfolio.

Over the past 15 years Robert has applied his experience in regulatory strategy, market design and competition policy to advise governments, regulators, utilities and other corporations in Victoria, New South Wales, Western Australia, Queensland, South Australia, New Zealand, Singapore, China and the Philippines.

Robert has extensive experience in third party access regulation. He has project managed regulated access reviews and advised various clients on regulatory and tariff strategy. He brings considered commercial and policy understanding to access regulation and pricing. Robert has proven skill in managing multi-disciplinary teams to deliver regulatory submissions.

Previous roles include associate economist at FSC, senior consultant at NERA Economic Consulting and roles at the Victorian Essential Services Commission and Victorian Department of Treasury and Finance.

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Eli Grace-Webb

Bachelor of Laws, Bachelor of Commerce (Economics and Finance); Bachelor of Commerce with First Class Honours (Finance), Victoria University of Wellington; Chartered Financial Analyst

Skills: economic regulation, financial and economic analysis, corporate finance, regulatory reform, transaction advice, and financial modelling.

Eli Grace-Webb is an experienced economist who specialises in infrastructure. Qualified in law, economics and finance, Eli has diverse experience across electricity, water and gas networks, and other infrastructure, and primary sector industries in New Zealand, Australia, Vietnam and the Philippines.

Eli recently joined FSC. Previously Eli led the economic regulation function within Jemena, delivering critical leadership, management expertise and advice across Jemena on a variety of regulatory matters. Key projects include five yearly price reviews of Jemena’s gas and electricity distribution networks. He also led the Energy Networks Association (ENA) rate of return strategy working group and was a member of the regulatory affairs committee.

Prior to Jemena, Eli worked for EDF Energy in the UK, Castalia Strategic Advisors in NZ, and the NZ Institute for the Study of Competition and Regulation.

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