Application by ATCO Gas Australia Pty Ltd
[2016] ACompT 10
•13 July 2016
AUSTRALIAN COMPETITION TRIBUNAL
Application by ATCO Gas Australia Pty Ltd [2016] ACompT 10
Review from: Economic Regulation Authority File number: ACT 10 of 2015 Tribunal: MIDDLETON J (PRESIDENT)
PROFESSOR KT DAVIS (MEMBER)
MR R STEINWALL (MEMBER)Date of Determination: 13 July 2016 Catchwords: ENERGY AND RESOURCES – application under s 245 of the National Gas Law (NGL) for review of an access arrangement decision by the Economic Regulation Authority – national gas objective (NGO) – interrelationship of constituent components and preferable reviewable regulatory decision by the ERA under s 28(1)(b)(i) and (1)(b)(iii) – role of the Tribunal on review –limited discretion under r 40(2) of the NGR – topics for review – sustaining capital expenditure – depreciation – corporate support operating expenditure – reference tariff variation mechanism – return on equity – gamma – materially preferable NGO decision Legislation: Economic Regulation Authority (National Gas Access Funding) Regulations 2009 (WA)
Gas Standards Act 1972 (WA)
Gas Standards (Gas Supply and System Safety) Regulations 2000
National Gas (South Australia) Act 2008 (SA)
National Gas Access (WA) Act 2009 (WA)
National Gas Access (WA) (Local Provisions) Regulations 2009 (WA)
National Gas Amendment (Price and Revenue Regulation of Gas Services) Rules 2012
National Gas Rules
Statutes Amendment (National Electricity and Gas Laws – Limited Merits Review) Act 2013 (SA)
Cases cited: Application by ActewAGL Distribution [2010] ACompT 4
Application by ActewAGL Distribution [2015] ACompT 3
Application by APA GasNet Australia (Operations) Pty Limited (No 2) [2013] ACompT 8
Application by ATCO Gas Australia Pty Ltd [2015] ACompT 7
Application by ElectraNet Pty Limited (No 3) [2008] ACompT 3
Application by Envestra Ltd (No 2) [2012] ACompT 3
Application by WA Gas Networks (No 3) [2012] ACompT 12
Applications by Public Interest Advocacy Centre Ltd and Ausgrid [2016] A CompT 1
Applications by Public Interest Advocacy Centre Ltd, Ausgrid, Endeavour Energy and Essential Energy [2015] ACompT 2
Australian Competition and Consumer Commission v Australian Competition Tribunal (2006) 152 FCR 33
Dates of hearing: 15-18 February 2016; 26-27 April 2016 Registry: Western Australia Category: Catchwords Number of paragraphs: 693 Counsel for ATCO Gas Australia Pty Ltd: Mr P Gray QC with Mr D Farrands Solicitor for ATCO Gas Australia Pty Ltd: Johnson Winter & Slattery Counsel for the Economic Regulation Authority: Mr N O’Bryan SC with Mr E Heenan Solicitor for the Economic Regulation Authority: Holman Fenwick Willan IN THE AUSTRALIAN COMPETITION TRIBUNAL
ACT 10 of 2015 RE: APPLICATION UNDER SECTION 245 OF THE NATIONAL GAS LAW FOR A REVIEW OF A FULL ACCESS ARRANGEMENT DECISION MADE BY THE ECONOMIC REGULATION AUTHORITY IN RELATION TO ATCO GAS AUSTRALIA PTY LTD PURSUANT TO RULE 64 OF THE NATIONAL GAS RULES
BY: ATCO GAS AUSTRALIA PTY LTD (ABN 90 089 531 975)
Applicant
TRIBUNAL:
MIDDLETON J (PRESIDENT)
PROFESSOR KT DAVIS (MEMBER)
MR R STEINWALL (MEMBER)DATE OF DETERMINATION:
13 July 2016
THE TRIBUNAL DETERMINES THAT:
1.Pursuant to s 259(2)(c) of the National Gas Access (Western Australia) Law (‘NGL’), the Final Decision on Proposed Revisions to the Access Arrangement Decision for the Mid-West and South-West Gas Distribution System, including appendices published on 10 September 2015 (‘Amended Final Decision’), and the Economic Regulation Authority’s Revised Access Arrangement Decision for the Mid-West and South-West Gas Distribution System’, including appendices (‘Access Arrangement Decision’), are set aside and remitted to the Economic Regulation Authority (‘ERA’) to make the decisions again in accordance with the following directions:
(a)the ERA is to decide the constituent components of the Amended Final Decision and Access Arrangement Decision that involve the estimated cost of corporate income tax (gamma) by reference to a gamma of 0.25; and
(b)the ERA is to consider, and to the extent appropriate, to vary interrelated constituent components of the Amended Final Decision and Access Arrangement Decision, having regard to s 28(1)(b)(iii) of the NGL, where necessary in light of variations made to the Amended Final Decision and Access Arrangement Decision by reason of sub-para (a) above.
REASONS FOR DETERMINATION
THE TRIBUNAL:
INTRODUCTION
This is an application by ATCO Gas Australia Pty Ltd (‘ATCO’), pursuant to s 245 of the National Gas Access (Western Australia) Law (‘NGL’), for review of a full access arrangement decision made by the Economic Regulation Authority (Western Australia) (‘ERA’).
Section 7 of the National Gas Access (WA) Act 2009 (WA) (the ‘Act’) provides that the NGL, as set out in the Schedule to the National Gas (South Australia) Act 2008 (SA) and modified by Sch 1 to the Act, applies as a law of Western Australia. Section 26 of the NGL in turn, gives the National Gas Rules (‘NGR’) the force of law in Western Australia.
Background
ATCO owns approximately 14,400 km of natural gas distribution networks in Western Australia, servicing approximately 720,000 consumers in the Perth greater metropolitan area and regional centres including Geraldton, Bunbury and Kalgoorlie and an LPG network in Albany. ATCO’s application for review under s 245 of the NGL (‘Review Application’) relates to ATCO’s Mid-West and South-West Gas Distribution Systems network, which comprises approximately 13,700 km of pipeline delivering gas to approximately 700,000 customers in the Geraldton, Perth metropolitan, Bunbury, Capel and Busselton areas (‘ATCO gas distribution network’).
ATCO is a “service provider” within the meaning of s 8 of the NGL, in that it owns, controls or operates a scheme pipeline. The NGL defines a “scheme pipeline” to include a “covered pipeline”. The ATCO gas distribution network is a “covered pipeline” within the meaning of the NGL.
The “regulator” is defined in s 9 of the Act to mean the ERA “in relation to an ERA pipeline”. The ATCO gas distribution network is an ERA pipeline.
Section 27 of the NGL prescribes the functions and powers of the ERA. The ERA is responsible for the economic regulation of pipeline services provided by service providers, including ATCO, by means of or in connection with a scheme pipeline. In particular, under Pt 9 of the NGR, the ERA is responsible for determining the total revenue for ATCO for each regulatory year of an access arrangement period for the provision by ATCO of pipeline services through the ATCO gas distribution network.
Decision under review
On 17 March 2014, ATCO submitted for consideration by the ERA an access arrangement revision proposal for the access arrangement period AA4, being 1 July 2014 to 31 December 2019 (‘AA Revision Proposal’). On 14 October 2014, the ERA published a draft decision on ATCO’s AA Revision Proposal (‘Draft Decision’). The Draft Decision indicated that the ERA would publish its own revised access arrangement and access arrangement information.
The Draft Decision included a statement of reasons for the decision and set out 45 amendments to the proposed revised access arrangement that would be required before the ERA would be prepared to approve the AA Revision Proposal.
In response to the Draft Decision, ATCO submitted additions and amendments to its AA Revision Proposal and a revised access arrangement proposal on 27 November 2014 (‘Amended AA Revision Proposal’).
On 1 July 2015, the ERA published its access arrangement final decision entitled ‘Final Decision on Proposed Revisions to the Access Arrangement for the Mid-West and South-West Gas Distribution System’ (‘Final Decision’). In its Final Decision, the ERA refused to approve ATCO’s Amended AA Revision Proposal and indicated that it would publish its own revised access arrangement and access arrangement information.
Following, and in response to the ERA’s publication of its Final Decision, ATCO made further submissions and provided further information to the ERA.
On 10 September 2015, the ERA published:
(1)an amended Final Decision entitled ‘Final Decision on Proposed Revisions to the Access Arrangement Decision for the Mid-West and South-West Gas Distribution System’ (‘Amended Final Decision’), in which the ERA again refused to approve the Amended AA Revision Proposal submitted by ATCO; and
(2)a further decision entitled ‘Economic Regulation Authority’s Revised Access Arrangement Decision for the Mid-West and South-West Gas Distribution System’ for the ATCO distribution network (‘Access Arrangement Decision’), in which the ERA decided to approve the access arrangement drafted by the ERA (‘ERA Access Arrangement’).
The decision that is the subject of ATCO’s Review Application is the Access Arrangement Decision.
On 29 September 2015, the ERA published minor corrections to the ERA Access Arrangement.
Application for leave and review
On 1 October 2015, ATCO filed its application for leave to review and its Review Application, pursuant to s 245 of the NGL. In support of its Review Application, ATCO also filed the affidavit of Simon Harvey Byrne, sworn 1 October 2015 and the supplementary affidavit of Simon Harvey Byrne, sworn 5 November 2015.
On 1 December 2015, the Tribunal granted leave to ATCO to apply for a review of the Access Arrangement Decision made by the ERA, being satisfied of the relevant criteria in s 248 and s 249(2) of the NGL: Application by ATCO Gas Australia Pty Ltd [2015] ACompT 7.
ATCO applied for review in respect of the following grounds:
(1)Sustaining capital expenditure: the decision by the ERA, in assessing ATCO’s forecast conforming capital expenditure (‘capex’) for the current access arrangement period pursuant to r 79 of the NGR for use in the calculation of the projected capital base pursuant to r 78 of the NGR, not to allow the costs of three sustaining capex projects in forecast conforming capex;
(2)Depreciation: the decision by the ERA, in determining the depreciation schedule pursuant to r 89, to reject ATCO’s proposed depreciation schedule and underlying depreciation approach for the current and subsequent access arrangement periods, and instead to adopt an indexed straight line approach to depreciation of the capital base;
(3)Corporate support costs operating expenditure: the decision by the ERA, in assessing ATCO’s forecast operating expenditure (‘opex’) pursuant to r 91 of the NGR, not to allow any access arrangement preparation costs for 2015;
(4)Reference tariffs and the reference tariff variation mechanism: the decisions by the ERA:
(a)to use forecast (rather than actual) revenue of ATCO for July to December 2014 in the calculation of the reference tariffs for the remainder of the access arrangement period after 1 October 2015; and
(b)not to include in the access arrangement a cost pass through event pursuant to r 97 in relation to certain regulatory and licence fees;
(5)The allowed rate of return on equity: the decision by the ERA, in determining the rate of return pursuant to r 87 of the NGR, to:
(a)estimate the return on equity by use of a single model, the Sharpe-Lintner Capital Asset Pricing Model (‘S-L CAPM’); and
(b)adopt an estimate of equity beta of 0.7;
(6)The value of imputation credits: the decision by the ERA, in determining the estimated cost of corporate income tax pursuant to r 87A of the NGR, to adopt a value of imputation credits (theta) of 0.4.
The grounds will be considered below according to the order above.
Statutory Scheme for Review
Section 259(4a) of the NGL provides that, in a case where the decision under review is a “designated reviewable regulatory decision”, the Tribunal may only make a determination to vary the designated reviewable regulatory decision (under s 259(2)(b)), or to set aside the designated reviewable regulatory decision and remit the matter back to the ERA (under s 259(2)(c)), if:
(1)the Tribunal is satisfied that to do so will, or is likely to, result in a decision that is materially preferable to the designated reviewable regulatory decision in making a contribution to the achievement of the national gas objective set out in s 23 of the NGL (‘NGO’) (a ‘materially preferable designated NGO decision’); and
(2)in the case of a determination to vary the designated reviewable regulatory decision, the Tribunal is satisfied that to do so will not require the Tribunal to undertake an assessment of such complexity that the preferable course of action would be to set aside the decision and remit the matter to the ERA to make the decision again.
The Access Arrangement Decision that is the subject of this Review Application falls within the definition of “designated reviewable regulatory decision”.
In connection with the operation of s 259(4a), s 259(4b) of the NGL requires the Tribunal to:
(1)consider how the constituent components of the designated reviewable regulatory decision interrelate with each other and with the matters raised as a ground for review; and
(2)take into account the Revenue and Pricing Principles (‘RPP’) set out in s 24 of the NGL (in the same manner in which the ERA is to take into account the RPP under s 28 of the NGL);
(3)in assessing the extent of contribution to the achievement of the NGO, consider the designated reviewable regulatory decision as a whole; and
(4)not allow the following matters, in themselves, to determine the question about whether a materially preferable designated NGO decision exists:
(a)the establishment of a ground for review under s 246(1);
(b)the consequences for, or impacts on, the average annual regulated revenue of a covered pipeline service provider; or
(c)that the amount that is specified in or derived from the designated reviewable regulatory decision exceeds the amount specified in s 249(2).
It is important to note at the outset that the Tribunal may perform all the functions and exercise all the powers of the ERA under the NGL and the NGR for the purposes of making a determination: s 259(3) of the NGL. However, the Tribunal’s function is not to substitute a decision which the Tribunal may prefer to make on the material before the ERA, but to consider the review-related material in order to determine whether a reviewable error has been established: see Application by WA Gas Networks (No 3) [2012] ACompT 12 at [22]; Application by ActewAGL Distribution [2010] ACompT 4 at [28]; Application by ElectraNet Pty Limited (No 3) [2008] ACompT 3 (‘ElectraNet (No 3)’) at [64] and [69].
It follows that, if no reviewable error under s 246(1) of the NGL is made out, the Tribunal must affirm the decision under review: see ElectraNet (No 3) at [64].
The National Gas Objective and the Revenue and Pricing Principles
Section 28(1)(a) of the NGL requires the ERA to make the Access Arrangement Decision in a manner that will or is likely to contribute to the achievement of the NGO.
The NGO is defined in s 23 of the NGL, which provides:
The objective of this Law is to promote efficient investment in, and efficient operation and use of, natural gas services for the long term interests of consumers of natural gas with respect to price, quality, safety, reliability and security of supply of natural gas.
The NGO is the overarching objective for economic regulation under the NGL. It requires the regulator to seek – in its decisions – to achieve “efficient investment in, and efficient operation and use of, natural gas services for the long term interests of consumers”.
Additionally, when making those parts of the Access Arrangement Decision relating to a reference tariff, the ERA is required to take into account the RPP. The ERA is also permitted to take into account the RPP when performing or exercising any other “[ERA] economic regulatory function or power” if the ERA considers it appropriate to do so.
The RPP set out at s 24 of the NGL are as follows:
24 – Revenue and Pricing Principles
(1)The revenue and pricing principles are the principles set out in subsections (2) to (7).
(2)A service provider should be provided with a reasonable opportunity to recover at least the efficient costs the service provider incurs in—
(a) providing reference services; and
(b)complying with a regulatory obligation or requirement or making a regulatory payment.
(3)A service provider should be provided with effective incentives in order to promote economic efficiency with respect to reference services the service provider provides. The economic efficiency that should be promoted includes—
(a)efficient investment in, or in connection with, a pipeline with which the service provider provides reference services; and
(b) the efficient provision of pipeline services; and
(c) the efficient use of the pipeline.
(4)Regard should be had to the capital base with respect to a pipeline adopted—
(a) in any previous—
(i) full access arrangement decision; or
(ii)decision of a relevant Regulator under section 2 of the Gas Code;
(b) in the Rules.
(5)A reference tariff should allow for a return commensurate with the regulatory and commercial risks involved in providing the reference service to which that tariff relates.
(6)Regard should be had to the economic costs and risks of the potential for under and over investment by a service provider in a pipeline with which the service provider provides pipeline services.
(7)Regard should be had to the economic costs and risks of the potential for under and over utilisation of a pipeline with which a service provider provides pipeline services.
As a result of amendments made to the NGL following the enactment of the Statutes Amendment (National Electricity and Gas Laws – Limited Merits Review) Act 2013 (SA) (the ‘LMR Act’), the ERA is required by s 28(1)(b) of the NGL:
(1)to ensure that ATCO, users or prospective users of the pipeline services, and any user or consumer associations or interest groups that the ERA considers have an interest in the matter are informed of the material issues under consideration by the ERA and are given a reasonable opportunity to make submissions in respect of the decision before it is made;
(2)to specify:
(a)the manner in which the constituent components of the decision relate to each other; and
(b)the manner in which that interrelationship has been taken into account in the making of the decision;
(3)if there are two or more possible designated reviewable regulatory decisions that will or are likely to contribute to the achievement of the NGO:
(a)to make the decision that the ERA is satisfied will or is likely to contribute to the achievement of the NGO (the ‘preferable designated reviewable regulatory decision’); and
(b)to specify reasons as to the basis on which the ERA is satisfied that the decision is the preferable designated reviewable regulatory decision.
In Applications by Public Interest Advocacy Centre Ltd and Ausgrid [2016] ACompT 1 (‘PIAC and Ausgrid’), the Tribunal (differently constituted) recently made the following pertinent comments (at [77]) on the role of the NGO (and the National Electricity Objective, as relevant in that proceeding):
The ultimate objective reflected in the NEO and NGO is to direct the manner in which the national electricity market and the national natural gas market are regulated, that is, in the long term interests of consumers of electricity and natural gas respectively with respect to the matters specified. The provisions proceed on the legislative premise that their long term interests are served through the promotion of efficient investment in, and efficient operation and use of, electricity and natural gas services. This promotion is to be done “for” the long term interests of consumers. It does not involve a balance as between efficient investment, operation and use on the one hand and the long term interest of consumers on the other. Rather, the necessary legislative premise is that the long term interests of consumers will be served by regulation that advances economic efficiency.
Community Consultation
The LMR Act also introduced a new process in s 261(1)(b) of the NGL such that the Tribunal must, before making a determination that relates to a designated reviewable regulatory decision, take reasonable steps to consult, in such manner as the Tribunal thinks appropriate, with:
(1)users and prospective users of the pipeline services; and
(2)any user or consumer associations or user or consumer interest groups that the Tribunal considers have an interest in the determination, other than a user or consumer association or a user or consumer interest group that is a party to the review.
The consultation process is an additional procedural step which the Tribunal must take and, ideally, is to be accommodated within the target time prescribed by s 260 of the NGL.
The Tribunal notified the public of the consultation both via the Australian Competition Tribunal website and newspaper advertisement.
The consultation took place at the Federal Court of Australia in Perth on 2 December 2015.
To ensure a satisfactory process, the Tribunal issued a consultation agenda under which it provided for those who wished to speak to the Tribunal on that occasion either personally or on behalf of an organisation, to do so. In addition, opportunity was given to those who wished to make written submissions to submit them for consideration by the Tribunal following the consultation.
In this application, no member of the community sought to make any submissions to the Tribunal.
GROUNDS FOR REVIEW
Nature and scope of the grounds for review under s 246
Section 246(1) of the NGL provides that applications for merits review under s 245(1) may only be made on one or more of the following grounds:
(1)the original decision maker made an error of fact in the decision maker’s findings of facts, and that error of fact was material to the making of the decision (s 246(1)(a) of the NGL);
(2)the original decision maker made more than one error of fact in the decision maker’s findings of facts, and those errors of fact, in combination, were material to the making of the decision (s 246(1)(b) of the NGL);
(3)the exercise of the original decision maker’s discretion was incorrect, having regard to all the circumstances (s 246(1)(c) of the NGL); or
(4)the original decision maker’s decision was unreasonable, having regard to all the circumstances (s 246(1)(d) of the NGL).
Error of fact
In order to determine whether the ERA made an error of fact for the purposes of s 246(1)(a) and (b) of the NGL, the Tribunal must:
(1)ascertain the precise conclusion of fact made by the ERA;
(2)determine whether, within that conclusion, there is a finding of fact (or facts) that can properly be said to be erroneous (or erroneous in combination); and
(3)if the finding of fact (or combination of facts) was erroneous, determine whether the error was material to the making of the decision.
Incorrect exercise of discretion
A discretionary decision making process requires the decision maker to weigh up relevant considerations. Some of the circumstances in which an incorrect exercise of discretion will occur are set out in the following paragraphs.
A decision which is not determined by reference to the applicable criteria in the NGL or the NGR is likely to have involved an incorrect exercise of discretion. Similarly, an incorrect exercise of discretion may occur where the exercise of the discretion is:
(1)based upon a misconstruction or misapplication of relevant principles, methodologies or factors required to be considered by the NGL or NGR;
(2)affected by a failure to have regard to a mandatory relevant factor prescribed by the NGL or the NGR;
(3)affected by the regulator taking into account factors which are extraneous to those relevant under the NGL or NGR; or
(4)affected by a failure to take into account a relevant submission.
If the reasons for a decision contain a logical error or an unexplained discretionary choice made in reaching a conclusion, then the decision is likely to have involved an incorrect exercise of discretion (and is also likely to be unreasonable). If factual error is made out and the exercise of discretion is based upon it, the exercise of discretion is incorrect.
However, the ground for review is not available merely because the Tribunal would exercise the discretion in a different way. If the ERA has exercised its discretion correctly, in accordance with correct principles, and if the particular exercise of discretion was open to it within the framework of the NGL, then it is not for the Tribunal to substitute a decision which it might prefer on the material before the decision maker.
Unreasonableness
The ground for review in s 246(1)(d) of the NGL requires that the decision under review is itself unreasonable.
For the unreasonableness ground in s 246(1)(d) of the NGL to be established, it must involve logical error or irrationality in the decision, and the decision must not be justified by reference to its stated reasons. A decision will be unreasonable if there is an absence of reason to explain the discretionary choices made by the ERA in arriving at its conclusions.
It is not possible to give an exhaustive definition of what constitutes an unreasonable decision. However, at one end of the spectrum, an arbitrary or capricious decision will be unreasonable, but at the other end of the spectrum, it is not sufficient merely to reach a different view to the original decision maker.
A decision which is not determined by reference to the applicable criteria in the NGL or the NGR is likely to be unreasonable in all the circumstances. A failure to take into account a matter which is required to be considered, or consideration of a matter which is irrelevant, may also constitute unreasonableness.
The unreasonableness ground in s 246(1)(d) and the incorrect exercise of discretion ground in s 246(1)(c) overlap to a certain extent. For example, if the reasons for a decision contain logical error or an unexplained discretionary choice made in reaching a conclusion, then the decision is likely to be unreasonable.
Interaction between the grounds
Notwithstanding the discussion above, and as noted by the Tribunal in Application by ATCO Gas Australia Pty Ltd [2015] ACompT 7, the Tribunal accepts that:
(1)the line between the several available grounds for review is not necessarily always clear cut;
(2)there is no clear line between factual error, opinion, and discretionary judgment, as one may feed into the other;
(3)any such error or errors - if accepted by the Tribunal - may be a combination of error or errors of fact, wrongful exercise of discretion, and the outcome of an unreasonable decision.
See Application by ATCO Gas Australia Pty Ltd [2015] ACompT 7; Applications by Public Interest Advocacy Centre Ltd, Ausgrid, Endeavour Energy and Essential Energy [2015] ACompT 2; Application by ActewAGL Distribution [2015] ACompT 3.
In accordance with the legislative context, ATCO’s Review Application to the Tribunal is limited in that:
(1)ATCO must establish that the ERA made an error of one of the four kinds described in s 246(1)(a)-(d) of the NGL;
(2)where, as in the present application, the application relates to a “designated reviewable regulatory decision”, ATCO must identify how addressing any errors it establishes by varying or setting aside the decision would, or would be likely to, result in a materially preferable designated NGO decision;
(3)ATCO may not raise any “matter” (by way of evidence or submissions) that it did not raise and maintain in submissions to the ERA before the decision was made; and
(4)unless the Tribunal is satisfied that a ground of review has been made out, the Tribunal must not consider any material other than that specified in s 261(1) of the NGL, which material essentially comprises the material that was before the ERA and the parties’ submissions to the Tribunal.
Sustaining capital expenditure
Introduction
ATCO seeks a review of the ERA’s determination of ATCO’s forecast capex used to determine projected capital base over AA4.
Specifically, ATCO contended that the ERA was in error in not approving forecast sustaining capex relating to the following projects:
(1)a proposed spur line from the existing Dampier to Bunbury transmission pipeline offtake at the Muchea gate station to Two Rocks and areas south of Two Rocks including Yanchep and Alkimos (‘Two Rocks project’);
(2)a three stage project commencing with reinforcement from the Fairbridge gate station to Pinjarra, then two further stages extending a new spur line to Greenfields and Mandurah (‘Peel project’); and
(3)a number of smaller interdependency projects to improve reliability and security of supply at certain points in the network (‘Interdependency project’) as well as metallic mains replacement.
Legislative framework
Under r 76(a) and r 76(b) of the NGR, two of the building blocks in determining ATCO’s total revenue for each regulatory year of the access arrangement period are a return on, and depreciation of, the projected capital base for the year.
The projected capital base is determined by adding to the opening capital base, forecast conforming capex for the period (less forecast depreciation and assets to be disposed of during the period): r 78.
Under r 79(1), conforming capex is capex that meets the following criteria:
(1)the capex must be such as would be incurred by a prudent service provider acting efficiently, in accordance with accepted good industry practice, to achieve the lowest sustainable cost of providing services;
(2)the capex must be justifiable on a ground stated in r 79(2).
Capex is justifiable under r 79(2) if:
(a)the overall economic value of the expenditure is positive; or
(b)the present value of the expected incremental revenue to be generated as a result of the expenditure exceeds the present value of the capex; or
(c)the capex is necessary:
(i)to maintain and improve the safety of services; or
(ii)to maintain the integrity of services; or
(iii)to comply with a regulatory obligation or requirement; or
(iv)to maintain the service provider’s capacity to meet levels of demand for services existing at the time the capex is incurred (as distinct from projected demand that is dependent on an expansion of pipeline capacity); or
(d)the capex is an aggregate amount divisible into two parts, one referable to incremental services and the other referable to a purpose referred to in paragraph (c), and the former is justifiable under paragraph (b) and the latter under paragraph (c).
ATCO contended that the capex in question is justified under one or more of the heads of justification in r 79(2)(c)(i)-(iii), namely that it is necessary to:
(1)maintain and improve the safety of services: r 79(2)(c)(i); or
(2)maintain the integrity of services: r 79(2)(c)(ii); or
(3)comply with a regulatory obligation or requirement: r 79(2)(c)(iii).
Rule 74 addresses the basis on which a forecast (like forecast capex) is to be determined, and the information necessary to support it. Rule 74 provides:
(1)Information in the nature of a forecast or estimate must be supported by a statement of the basis of the forecast or estimate.
(2) A forecast or estimate:
(a)must be arrived at on a reasonable basis; and
(b)must represent the best forecast or estimate possible in the circumstances.
Rule 71 is also relevant to the ERA’s consideration of forecast capex, and provides:
(1)In determining whether capital or operating expenditure is efficient and complies with other criteria prescribed by these rules, the [ERA] may, without embarking on a detailed investigation, infer compliance from the operation of an incentive mechanism or on any other basis the [ERA] considers appropriate.
(2)The [ERA] must, however, consider, and give appropriate weight to, submissions and comments received when the question whether a relevant access arrangement proposal should be approved is submitted for public consultation.
The ERA’s discretion in approving conforming capex is limited: r 79(6). The consequence is that under r 40(2) of the NGR, the ERA may not withhold its approval to an element of an access arrangement proposal that is governed by the relevant provision if the ERA is satisfied that it:
(1)complies with applicable requirements of the NGL and the NGR; and
(2)is consistent with applicable criteria (if any) prescribed by the NGL and the NGR
This is in contrast to other provisions of the NGR where the ERA has no discretion or conversely full discretion: see r 40(1), r 40(3).
There may appear to be some tension between these provisions in the NGR, and s 28(1)(b)(iii) of the NGL. However, putting aside any issues of the status of the NGR (which whilst they have the force of law in Western Australia are not elevated to have the same effect as the NGL), s 28(1)(b)(iii) is to be applied in contemplation of the operation of the NGR. So, for instance, if a provision of the NGR has mandatory effect (see, eg r 50) then the ERA must decide according to that direction. It could not rely on s 28(1)(b)(iii) to ignore the operation of a mandatory provision of the NGR, on the basis that there was a preferable designated reviewable regulatory decision. It is only when the ERA, in correctly applying the NGR, comes to the conclusion that there are two or more possible designated reviewable regulatory decisions, that the ERA needs to consider whether there is such a “preferable” decision. If the ERA has a limited discretion under the NGR, it must proceed accordingly, and not at large.
Factual background
Australian and New Zealand standards and their application
One justification for ATCO’s sustaining capex is its need to comply with a number of Australian standards. ATCO and the ERA had very different interpretations of what those standards required and how they should be applied. As much of the claimed sustaining capex turns on these standards, it is necessary to consider them in some detail.
AS/NZS 4645.1:2008 Gas distribution networks Part 1: Network management (‘AS 4645’) applies to gas distribution networks. Appendix C of AS 4645 is headed “Qualitative risk assessment”. The opening paragraph of Appendix C headed “C1 General” provides:
This appendix provides guidance for qualitative risk assessment undertaken in accordance with AS/NZS 4360.
ATCO relied on the references to the expression “qualitative” in the heading to Appendix C and the above passage in support of its view that AS 4645 does not require (and relevantly did not require) a cost-benefit analysis. It consistently maintained that position.
The reference in Appendix C to “AS/NZS 4360” is a reference to the Australian and New Zealand risk management standard AS 4360 (‘AS 4360’). It is undisputed that AS 4360 was replaced by AS/NZS ISO 31000:2009 Risk Management – Principles and guidelines (‘AS 31000’) in November 2009. The preface to AS 31000 traces the development of the standard and the decision to move to an international standard on risk management.
The preface to AS 31000 also states that the process described for managing risk is identical to that in AS 4360. Much of AS 31000 is devoted to describing that process and what it requires. Some of the features of that process include:
·communication and consultation with external and internal stakeholders during all stages of the risk management process;
·the internal and external environment in which the organisation seeks to achieve its objectives is to be assessed;
·risk assessment is the overall process of risk identification, risk analysis and risk evaluation;
·risk treatment involves selecting one or more options for modifying risks, and implementing those options;
·there should be planned monitoring and review as part of the risk management process; and
·risk management activities should be traceable.
The risk analysis process under AS 31000 may be undertaken with varying degrees of detail, depending on the risk, the purpose of the analysis and the information, data and resources available. It is expressed that the analysis can be qualitative, semi-qualitative or quantitative, or a combination of these depending on the circumstances. Again, ATCO pointed to this passage in support of its view that a cost-benefit approach is not mandated.
The management process under AS 31000 also requires
[s]electing the most appropriate risk treatment option [which]involves balancing the costs and efforts of implementation against the benefits derived, with regard to legal, regulatory, and other requirements such as social responsibility and the protection of the natural environment.
The ERA relies on this passage (among others) in support of its view that a cost-benefit analysis is required.
AS 4360 and its replacement, AS 31000 are useful in setting the framework for the management of risks. However, those standards are necessarily general in nature as they are intended to apply to many industries, not just gas. For that reason, the parties acknowledged that AS 4645 is more relevant as it applies specifically to gas distribution networks, including the ATCO gas distribution network. Unsurprisingly, AS 4645 was the subject of much attention by the parties.
AS 4645 requires that all actions and activities not unduly expose personnel, the public or the environment to unacceptable risks. Measures to mitigate those risks are to be identified, reviewed and documented. The areas to be considered include:
·safety of the public (including consumers);
·safety of personnel working on the gas distribution network;
·integrity of the network;
·minimisation of environmental impacts; and
·protection of property.
AS 4645 requires that the risk assessment of threats be undertaken under AS 4360. AS 4645 further provides:
Appendix C provides the requirements for qualitative risk assessment and it provides a risk matrix that should be used in an AS/NZS 4360 qualitative risk assessment.
There are circumstances where risk estimation using qualitative methods is required to enable comparison of alternative mitigation measures as a basis for demonstration of ‘as low as reasonably practical’(‘ALARP’), and in some jurisdictions, to satisfy planning criteria.
Again, ATCO relied on the references to the expression ‘qualitative’ in support of its view that a qualitative approach, rather than a cost-benefit analysis is all that is required.
Appendix C of AS 4645 provides guidance for undertaking a qualitative risk assessment. That process first involves assessing the severity of the consequences of failure of each event. The consequences to be assessed include the potential for the following:
·Human injury or fatality
·Interruption to continuity of supply with economic impact
·Environmental damage
Other factors such as property damage and loss of reputation may also be considered.
A severity class is then assigned to each failure event based on the consequences at the location of the failure (‘consequence analysis’), using the class selected from the following Table C1:
A severity class is applied for each of the dimensions, people, supply and the environment, and a severity class assigned to each ranging from catastrophic to trivial (as seen across the top columns of Table C1) .
Second, a “frequency analysis” of each threat is to be assigned for each location where risk estimation is required. The frequency classes are those from the following Table C2:
The frequency classes range from “Frequent” (expected to occur once per year or more) to “Hypothetical” (theoretically possible but has never occurred on a similar gas distribution network).
Third, Table C3 below is then used to combine the results of the consequence analysis and frequency analysis to determine the risk rank:
For example, a severity class of “Catastrophic” with a frequency class of “Hypothetical” yields a risk ranking of “Intermediate” in Table C3.
Once the risk ranking is determined, action is to be taken to reduce the risk as set out in the following Table C4:
As can be seen from Table C4, any risk that is considered to be “Extreme” or “High” should be dealt with to reduce it to “Intermediate” or lower.
Continuing the example of a risk ranking of “Intermediate”, Table C4 specifies the actions required including repeating the evaluation process and where the risk is confirmed, modifying the threat, the frequency or the consequence to reduce the risk rank to “Low” or “Negligible”. Where the risk cannot be reduced to “Low” or “Negligible”, action is to be taken to:
·remove threats, reduce frequencies and/or reduce severity of consequences to the extent practicable; and
·demonstrate ALARP.
In relation to ALARP, AS 4645 provides:
A risk cannot be designated as ALARP until the following has been completed:
(a)Analysis of the means of further reducing the risk, including an analysis of various options.
(b) Review as to the reasons why these further means have not been adopted.
(c)Substantiation that the cost of further risk reduction measures is grossly disproportionate to the benefit gained from the reduced risk that would result.
Options that shall be considered include –
(i)relocation of the network components;
(ii)modification of the design of network components;
(iii)review of pressure levels;
(iv)modification or enhancement of specific operations or maintenance procedures;
(v)modification to gas distribution network marking; and
(vi)threat treatment for operating gas distribution networks shall consider interim control measures (e.g. reduction in operating pressure, access restrictions) to allow time for the implementation of permanent control measures (e.g. repair).
Again, ATCO maintains that ALARP can be demonstrated without a cost-benefit analysis.
The ATCO risk matrix
ATCO developed a risk management matrix in April 2014. The matrix adopts the factors specified in AS 4645, namely the impact on people, the environment and supply and the severity classes for each ranging from “Catastrophic” to “Trivial”. However, the matrix applied different definitions of “Consequence” (severity) from that specified in AS 4645 – presumably reflecting ATCO’s specific risk appetite, as identified in the following table:
ATCO also developed the following frequency table:
As can be seen, ATCO modified the descriptors for both consequence (severity) and frequency from that listed in AS 4645. A comparison of the specific changes ATCO made to the supply category of risk is set out in Table 37 below:
Similarly, a comparison of the specific changes ATCO made to the people category of risk is set out in Table 36 below:
It is worth noting some specific differences between ATCO’s approach and that specified in AS 4645, as they are the subject of dispute. Relevantly for “Supply”:
·ATCO’s matrix defines a “Catastrophic” event as one involving the interruption of supply affecting more than 25,000 customers. AS 4645 defines it as a “Long term interruption of supply”.
·ATCO’s matrix defines a “Major” supply event as one involving the interruption or restriction of supply affecting greater than 5000 customers. AS 4645 defines it as a “Prolonged interruption or long- term restriction of supply”.
Relevantly, for “People”:
·ATCO’s matrix defines a “Catastrophic” event as more than two fatalities. AS 4645 defines it as “Multiple fatalities result”.
·The ATCO matrix defines a “Major” event as “Up to 2 fatalities: Several people with life threatening or permanently disabling injuries”. AS 4645 defines it as “Few fatalities, or several people with life threatening injuries”.
ATCO’s Safety Case
The Gas Standards (Gas Supply and System Safety) Regulations 2000 (‘Regulations’) are made under the Gas Standards Act 1972 (WA).
Regulation 27 requires that a network operator submit a safety case to the Director of Energy Safety (‘Director’) for the distribution system of the network operator. A “network operator” is defined in reg 3 to mean an undertaker who operates a distribution system. It was undisputed that reg 27 applies to ATCO.
Regulation 3 defines a “safety case” as relevantly a document that sets out the safety management and technical practices and procedures to be followed by a network operator in the operation of a distribution system.
Regulation 27(2) requires that the safety case comply with a number of standards including:
·AS 4645;
·AS 2885.1 - 2007 (Pipelines - Gas and liquid petroleum Part 1: Design and construction); and
·AS 2885.3 - 2001 (Pipelines - Gas and liquid petroleum Part 3: Operation and maintenance).
Regulation 31(1) requires that the safety case be accompanied by a certificate signed by a nominated auditor certifying that the safety case complies with a number of matters:
31. Preliminary certification of safety case
(1)A safety case submitted under regulation 27 is to be accompanied by a certificate signed by the nominated auditor certifying that —
(a)the safety case complies with the requirements of this Division;
(b)the safety case is appropriate having regard to the size and complexity of the distribution system and the possible risks; and
(c)the safety case adequately identifies the measures necessary —
(i)to prevent hazardous events identified in the safety case from occurring; and
(ii)to protect consumers, the public, employees, plant, equipment and the environment, should such events occur;
(d)the safety case adequately identifies the training and equipment requirements necessary for personnel to be able to implement the various procedures set out in it; and
(e)the network operator has in place a plan (the “implementation plan”) for —
(i) implementing the measures referred to in paragraph (c); and
(ii) meeting the requirements referred to in paragraph (d)
Once submitted, the Director is required to assess the safety case: reg 32(1). The Director may approve the safety case for the purpose of certification under reg 33(1) or refuse approval and must notify the network operator: reg 32(2).
If a safety case is approved, reg 33(1) provides that a network operator may submit to the Director a certificate signed by the auditor certifying that the measures specified in reg 31(1)(c) have been implemented, and that the requirements in reg 31(1)(d) have been met. On receipt of that certificate the Director may accept the safety case or reject it: reg 34(1).
In 2011 ATCO, under previous ownership as WA Gas Networks Pty Ltd (‘WAGN’), submitted a safety case in relation to its gas distribution network to the Director under reg 27. In June 2011, EnergySafety approved the safety case for the purposes of certification.
In July 2011, WAGN submitted a revised and certified safety case, and acceptance of the safety case was notified by EnergySafety under reg 34(1).
The parties proceeded on the basis that the safety case as submitted by WAGN and accepted by EnergySafety (the ‘Safety Case’) now applied to ATCO. As indicated, the accepted Safety Case required ATCO to apply certain risk thresholds, and to then take prescribed actions based on those thresholds, under AS 4645 and AS 2885.
Regulation 37 requires that a “prescribed activity” comply with the accepted safety case:
37. Compliance with accepted safety case
If an accepted safety case has effect in relation to a distribution system, the network operator must ensure that a prescribed activity is carried out in such a way as to comply with—
(a) any practice or procedure set out in the accepted safety case; and
(b) any provision of a code, standard or specification compliance with which is required under the accepted safety case.
“Prescribed activity” is defined in reg 3 to mean
anything related to the conveyance, control, supply or use of gas done by, for, or with the authority of, the network operator in the course of the construction, maintenance, repair or operation of any part of a distribution system
Regulation 37(a) requires ATCO, in the course of operating its gas distribution network to comply with any “practice or procedure” set out in the Safety Case. ATCO said this clearly includes the procedure of assessing risks and then, to the extent that the Safety Case prescribes a practice or procedure that must be followed, dealing with them in accordance with the Safety Case – which must comply with AS 4645.
Regulation 37(b) requires compliance with any provision of a code, standard or specification. ATCO submitted that the reference to ‘standard’ includes for example AS 4645, compliance with which is required under the Safety Case.
Clause 1 of ATCO’s Safety Case indicates, as required by reg 31(1)(c) and (d), that it is intended to adequately identify:
·the measures necessary to “prevent hazardous events identified in the safety case from occurring”;
·the measures necessary “to protect consumers, the public, employees, plant, equipment and the environment, should such events occur”; and
·“the training and equipment requirements necessary for personnel to be able to implement the various procedures set out in it”.
The Safety Case is also expressed to comply with AS 4645 and where applicable, also with:
·AS 2885.1 - 2007 (Pipelines – Gas and liquid petroleum Part 1: Design and construction); and
·AS 2885.3 - 2001 (Pipelines – Gas and liquid petroleum Part 3: Operation and maintenance),
as required by reg 27(2).
The Safety Case also obliges ATCO to undertake a Formal Safety Assessment (‘FSA’) where aspects of the management of the network are not in accordance with the means of compliance identified in AS 4645 to ensure the risk measures implemented result in an acceptable level of risk.
ATCO says it implemented its Safety Case in January 2013.
The Two Rocks, Peel and Interdependency projects
On 17 March 2014, ATCO submitted its AA Revision Proposal. It proposed sustaining capex for the Two Rocks project, the Peel project and the Interdependency project (the ‘Projects’). As will be seen, ATCO claimed that the capex on these Projects is required to comply with the Regulations, the Safety Case and AS 4645. To understand this argument it is useful to describe these projects in more detail.
The Two Rocks project
In 2013, ATCO prepared a document titled ‘Spurline – Two Rocks (Growth and Maintenance Capex) in relation to the Two Rocks project’ (‘Two Rocks project report’).
The Two Rocks project report is a high level assessment proposing to secure supply to the North Metro HP network in the event that the pressure reduction station (‘PRS’) at various points is unavailable. The report draws on Western Australian Department of Planning Report Directions 2031 (‘Directions 2031’) identifying potential developments in the North West region over the next 20 years.
The Two Rocks project report presents three options. One of these is a ‘do nothing’ option.
Another option is the construction of a 36 km steel pipeline to Two Rocks and areas south of Two Rocks including Yanchep and Alkimos from the existing DBP Muchea off take, along existing roads and the installation of a PRS. This option was said to “ensure continuity of gas supply to existing customers and capacity to provide gas to an additional 111,000 customers from the proposed Greenfield developments in the northern part of North West region in (sic) next 20 years”.
A further option involves constructing a 44 km 300mm steel pipeline with two PRSs, from the existing DBP Muchea off take, along existing roads with a further 5 km 200mm steel reinforcement in the next access arrangement period (‘AA5’). Its aim is also to ensure continuity of gas supply to existing customers and capacity to provide gas to an additional 111,000 customers from the proposed Greenfield developments in the northern part of North West region. This option is shown in the following map:
As indicated, this option includes a subsequent reinforcement line to be constructed in AA5 (shown bounded within a circle in the top left of the map). The Two Rocks project report recommended this option.
In ATCO’s Amended AA Revision Proposal, these options were discussed in Appendix 8.2 which specifically addressed aspects of the Draft Decision, including as it related to the Projects. It noted the decision to proceed with the construction of the 44 km steel pipeline as described in the diagram above.
In the Amended AA Revision Proposal, ATCO indicated that the option was chosen to provide greater security of supply to current and future customers including to over 60,000 existing customers in the northern networks.
ATCO indicated that the construction of a new pipeline was required to reduce the supply risk, which it considered “High” to an acceptable level, by introducing a secondary supply of gas of sufficient capacity to an area that is currently vulnerable due to its reliance on a single supply.
In addition to the loss of supply to domestic customers, there are 635 small commercial customers and 29 large commercial customers it considered would be affected.
Broadly, therefore, the option was considered as a risk reduction measure against the possibility of a loss of supply. As discussed below, ATCO’s classification of that risk as “High” is disputed by the ERA.
The Peel project
In a similar way to the Two Rocks project, in 2013 ATCO prepared the ‘Project Feasibility Study: Peel Region Long Term Growth Strategy’ in relation to the Peel project (‘Peel project report’). It noted that the Peel region is expecting a significant growth in new residential and commercial developments including in Austin Lakes. The report discussed the options to connect the proposed developments in Austin Lakes as well as the future developments in the Peel region.
It identified that the Greenfields developments noted in Directions 2031 are predominantly along Pinjarra road. It noted that “[t]he route of the proposed pipeline along Pinjarra Rd has been strategically selected to accommodate the Greenfields developments.... This will allow the new developments to easily connect to the gas network without extensive mains extension”. The ERA pointed to this statement in support of its view that the Peel project was in reality a growth project and not one directed at addressing security of supply.
The Peel project report canvassed three options. The Amended AA Revision Proposal indicates that the Peel project was proposed to address the loss of supply risk in the Peel region. This includes the loss of supply to over 34,000 customers in the Mandurah gas network. It also stated that in addition to the loss of supply to domestic customers there are 437 small commercial customers and eight large commercial customers affected.
The Amended AA Revision Proposal suggested that what was ultimately proposed was a three-stage project. It indicates that the project was selected after consideration of risks to reliability and security of supply identified in the Mandurah area and was ultimately proposed by ATCO in combination with the reinforcement of the existing spur line from the Fairbridge gate station supplying Pinjarra, and an extension of the line from Pinjarra in a north-westerly direction through Greenfields to Mandurah, where it would connect with the Rockingham High Pressure line.
The first stage is 3.2 km of high pressure main commencing with reinforcement from the Fairbridge gate station (GS011) to Pinjarra. The two further stages of 7 km and 15.6 km extend a new spur line to Greenfields and Mandurah. The location of the Peel project is shown in the following map:
ATCO considered that the growing Pinjarra area could not be adequately served by its present supply as the supply to Mandurah is currently largely dependent on a single spur line, originating at the Mandurah gate station (GS025) travelling west along Redheads Road to a point north of Mandurah. ATCO considered that the reliability and security of supply to the areas south of this spur line, including the Greenfields area, require improvement.
Therefore, like the Two Rocks Project, the Amended AA Revision Proposal indicated that the Peel Project was designed to address the possibility of the loss of supply, including to over 34,000 customers in the Mandurah gas network. In addition to the loss of supply to domestic customers, ATCO said that there are 437 small commercial customers and eight large commercial customers affected. Like Two Rocks, ATCO identified the risk of loss of supply to the Mandurah network as “High”. As discussed below, ATCO’s classification of that risk as “High” is disputed by the ERA.
Interdependency projects
As part of its annual asset management plan review, ATCO identified five interdependency projects it considered were necessary to reduce “High” loss of supply risk due to their relative size and location within the network and options to isolate in the event of interruption to supply. In Appendix 8.2 of the Amended AA Revision Proposal, ATCO pointed to three options, one of which is a ‘do nothing’ option.
One option involves constructing pipelines and regulating facilities which will reinforce isolated networks which have the potential to lose supply to over 25,000 customers for a long term period.
Another option involves increasing operational maintenance and third party damage mitigation initiatives by increased maintenance frequency of assets and increased frequency of patrols for third party interference.
ATCO’s classification of that risk as “High” is again disputed by the ERA.
In summary therefore, across the three Projects, ATCO identified aspects of the network that gave rise to a risk of supply interruption, in the event of pipeline failure, to more than 25,000 customers. This resulted in a risk, the consequence of which was “Catastrophic” according to ATCO’s risk matrix. ATCO then characterized the “Catastrophic” risk case having a “Remote” frequency. Therefore, under AS 4645 and its Risk Matrix, a “Catastrophic” risk with a “Remote” consequence resulted in the identification of a “High” risk ranking, for each of the Projects.
Regulatory decision
ATCO’s AA Revision Proposal and Amended AA Revision Proposal
In March 2014, ATCO submitted its AA Revision Proposal to the ERA.
In relation to the Two Rocks project and the Peel project, the following appeared in the “Asset performance and safety” section of the AA Revision Proposal:
Security of supply – HP spur lines
New high pressure spur lines and pipelines are primarily demand-related capital expenditure. However, the forecast investment also provides security of supply to new and existing customers. Therefore, a proportion of the infrastructure costs are allocated to network sustaining capital forecasts. These spur lines are discussed in detail in section 8.5.2(b) below.
In the “Growth capital forecast” section of the AA Revision Proposal, ATCO sought to provide justification for network growth capex. Section 8.5.2(b) was entitled “Demand related capital”. The first two “key demand related projects” ATCO identified were the Two Rocks and the Peel projects. In relation to the Two Rocks project, ATCO said:
To ensure continuity of gas supply, ATCO Gas Australia will construct a 44 km steel pipeline...The proposal will also accommodate potential consumers from developments in the North West Metropolitan region, predicted by the WA Department of Planning to be a high growth area over the next 20 years.
…
The construction of this pipeline in conjunction with the interdependency project described above will provide security of gas supply to North Metropolitan high pressure networks in accordance with AS/NZS 4645. It will also reduce the risk of loss of supply to as low as reasonably practicable in accordance the Safety Case. This option will also accommodate greenfield developments in the North West region.
In relation to the Peel project, ATCO said:
The Peel Region is expecting significant growth in greenfield residential and commercial developments. This pipeline is essential to economically grow the gas network and has the capacity to supply gas to future domestic and commercial developments in the Peel region. Directions 2031 forecasts the Peel region will grow by an additional 10,750 residential dwellings and several industrial sites in West Pinjarra, Greenlands and Waroona.
ATCO’s justification for these projects in the AA Revision Proposal was therefore broadly consistent with the reasons presented in the Two Rocks project report and the Peel project report.
Appendix 8.2 of the Amended AA Revision Proposal provided the ERA with further information in relation to ATCO’s requirement for the Interdependency, Two Rocks and Peel projects:
The requirement for the Interdependency, Two Rocks and Peel projects are to reduce risk from High for a loss of supply incident on high pressure infrastructure affecting greater than 25,000 customers. Currently the areas covered by the proposed projects have single source critical high pressure feeds, where the construction of secondary high pressure feeds reduces the assessed risks to an acceptable level.
To not address the High loss of supply risks would result in a breach of AS4645, the Safety Case and likely action from EnergySafety.
Although the Projects were expressed as a measure designed to address security of supply, clearly growth impacts also informed the decision:
When assessing the merit of individual projects, AGA considers the specific immediate and short term asset needs. However, to ensure that future growth investment is undertaken as efficiently as possible considerations of future needs are also taken in to account. Where it is efficient to do so, AGA will look to achieve both security of supply and future growth objectives.
In designing Two Rocks and Peel spur line projects to meet security of supply requirements, AGA has considered growth factors in the area and where possible increased the scope of the security of supply projects to ensure future growth can be accommodated to avoid higher future costs of supporting future growth through an additional standalone project.
The ERA argued that these statements indicate that the Projects were in fact growth projects not security of supply projects. While ATCO did not deny that the Projects had a growth element, it proposed to deal with the dual nature of the costs attributable to them in the following way:
In the AAI, where a project achieved both security and future growth objectives, the costs were allocated to the sustaining and growth investment categories on the basis of an NPV assessment. AGA conducted an NPV assessment of the project costs and future load and allocated the total amount of the project that enabled a neutral NPV value to growth. AGA considered that this provided a higher threshold test when considering projects against NGR 79 (2). The balance of the forecast expenditure for these projects was included in the sustaining capital expenditure category to be assessed in accordance with NGR 79 (2) (c).
Although AGA considers that its approach to categorising expenditure on shared objective projects remains appropriate, the following sections provide the stand alone security project assessments.
These assessments demonstrate that the cost of undertaking discrete projects to achieve the security and growth objectives is greater than the projects costs proposed by AGA. An alternative method of allocation might include adopting the stand alone security project costs as the costs to be allocated to sustaining capital expenditure and only allocate the incremental cost of a joint project to the growth project. This increases the NPV for the costs to be allocated to growth investment.
ATCO provided a confidential table in which it provided a comparison of the project costs to be allocated between growth and sustaining capex based on ATCO’s method adopted in the AA Revision Proposal and the alternative method outlined above.
Experts’ reports
Prior to considering the ERA’s decision and ATCO’s responses, it is worth noting that the ERA relied heavily on its expert consultant, Energy Market Consulting Associates (‘EMCa’). Similarly, ATCO relied heavily on its expert Zincara Pty Ltd (‘Zincara’) in responding to the ERA and to EMCa. In many respects, the position of each party is intimately tied to the opinions and conclusions of their respective experts. For that reason it is necessary to consider each report in some detail later.
In June 2014, EMCa prepared a report for the ERA titled “ATCO Gas Australia Proposed Access Arrangement for the Mid-West and South-West Gas Distribution Systems: Review of Technical Aspects of the Proposed Access Arrangement” (‘EMCa report’). EMCa also prepared two separate addendums; the first in April 2015 (‘April addendum’) and the second in June 2015 (‘June addendum’), each at the request of the ERA and in response to submissions made by ATCO. The April addendum assessed the Amended AA Revision Proposal. It canvassed whether the information provided by ATCO or third parties engaged by ATCO, changed the conclusions reached in the EMCa report. For the most part, EMCa’s June addendum traversed matters and conclusions which are broadly similar to those reached in the EMCa report and the April addendum.
On 25 November 2014, Zincara prepared a report for ATCO titled “Review of ATCO Gas Australia Capital and Operating Expenditure” (‘Zincara report’).
A minor preliminary issue in relation to these expert reports concerns the qualifications (and by implication, the expertise) of the authors of the EMCa report and the Zincara report.
The EMCa report was prepared by a team comprising senior management with expertise in economics and engineering across both gas and electricity. The April addendum included an additional member of the EMCa team – an engineer and business manager with 31 years’ experience in strategic planning, maintenance, operation and expansion of gas distribution businesses.
The Zincara report was prepared by a director and an associate of Zincara. The director is an engineer with more than 35 years’ experience in the energy sector, specialising in, among other things, business planning, implementation of utilities reforms, establishing organizations for privatisation, operating and capital cost reviews. The associate is also an engineer with more than 28 years’ experience in the gas industry.
The principal difference in expertise is that the Zincara authors have engineering qualifications alone, while the EMCa authors have qualifications in both engineering and economics. On the basis of this, the ERA therefore invited the Tribunal to conclude that the qualifications of the EMCa team ‘trump’ that of Zincara.
The Tribunal has not taken up this invitation. Rather, it has considered each report based on the strength of the arguments and evidence presented in each and given them weight accordingly.
The ERA’s Draft Decision
The ERA published its Draft Decision on 14 October 2014.
The Draft Decision notes that the ERA retained EMCa to assess ATCO’s proposed capex, opex and governance processes. In relation to capex, the ERA (relying on advice from EMCa) assessed ATCO’s proposed capex forecast under the NGR, by applying a three-stage process:
·first, evaluate whether the expenditure is justifiable on the grounds set out in r 79(2) of the NGR;
·second, consider whether the expenditure satisfies the prudent service provider test set out in r 79(1)(a) of the NGR; and
·third, assess whether forecasts or estimates comply with r 74(2) of the NGR.
As will be seen, this process is the same as that applied by EMCa. Under this approach, the ERA first considered whether any of the proposed expenditure satisfied one of the heads of expenditure in r 79(2), before turning to consider the test in r 79(1)(a) and then r 74(2). That is, the ERA considered that the expenditure must satisfy all three of these processes before that expenditure would be permitted to be included in the building blocks - it was not sufficient if it satisfied r 79(2) but failed r 79(1)(a).
The ERA noted EMCa’s assessment that the Projects had not undergone a cost-benefit analysis and the risk thresholds for “Catastrophic” events applied by ATCO are lower than other gas distribution networks:
EMCa has assessed the Safety Case, FSAs and the risk thresholds that ATCO has adopted when applying the ALARP test to security of supply projects, and has the following concerns:
•ATCO has not conducted a cost benefit analysis.
•ATCO has adopted a risk threshold for catastrophic events that appears to be lower than the threshold employed by other gas distribution networks. EMCa considers that the risk threshold that ATCO has adopted of 25,000 customers for loss of supply to be catastrophic is not prescribed in AS/NZS4645 and AS2885, nor mandated by EnergySafety, and is low by industry standards.
In concluding that ATCO had adopted a risk threshold which was “Low” when compared with other gas distributors and not prescribed by AS 4645 or mandated by EnergySafety, EMCa (although not expressly stating) must have considered that the consequence should be lower than “Catastrophic”.
Relying on EMCa’s advice, the ERA was therefore not satisfied that the Projects were justified under the test in r 79(1)(a) or under any head under r 79(2):
Based on EMCa’s advice, the Authority is not satisfied that the security of supply related portion in asset performance and safety ($86.34 million) is consistent with good industry practice as required by rule 79(1)(a) of the NGR. Therefore, the Authority is not satisfied that the following projects are justified under any ground in rule 79(2) of the NGR:
-Two Rocks Spur line ($18.13 million);
-Peel Spur Line ($20.93 million); and
-interdependency projects ($47.29 million).
ATCO’s response to the Draft Decision
ATCO’s Amended AA Revision Proposal can broadly be summarised as follows:
·ATCO maintained that the portion of the capex proposed for the Two Rocks project and the Peel project that it attributed to growth was justified under r 79(2)(b).
·ATCO maintained that the portion of the expenditure proposed for the Two Rocks project and Peel project that it attributed to sustaining capex was justified under r 79(2)(c)(i), (ii), and (iii).
·ATCO reassessed the proposed Interdependency Projects and decided that six of them could be deferred, reducing the forecast capex from $47.3 million to $34 million, and maintained that the remaining four Interdependency Projects were justified under r 79(2)(c).
·ATCO provided the conclusions reached by Zincara in its report of 25 November 2014.
·ATCO provided confidential Appendix 8.1 which included e-mails from an officer of EnergySafety in November 2014.
·ATCO provided a confidential Appendix 8.2, setting out its detailed justification for the three Projects.
The ERA’s Final Decision and Amended Final decision
The ERA published its Final Decision on 30 June 2015 and Amended Final Decision on 10 September 2015.
In relation to sustaining capex, it is sufficient to refer to the Amended Final Decision as it embodies conclusions very similar to those reached in the Final Decision. Like the Draft Decision, the ERA relied heavily on EMCa in reaching its conclusions in the Amended Final Decision. Indeed, a great deal of the Amended Final Decision is devoted to referring to various aspects of the findings and conclusions reached by EMCa and EMCa’s criticisms of ATCO, Zincara and the approach taken by EnergySafety.
In relation to the Two Rocks project, the ERA agreed with EMCa’s risk ranking of “Intermediate” and the actions consequently required under AS 4645:
The Authority accepts EMCa’s conclusion that the risk ranking for the ‘Northern Networks’ is ‘intermediate’ and not ‘high’. The Authority shares EMCa’s view that for intermediate risks AS 4645 and the prudent service provider test in rule 79(1)(a) requires ATCO to diligently consider all options for reducing the risk ranking to Intermediate or lower, applying a cost-benefit analysis test to determine if an Intermediate ranking is ALARP.
As the Authority accepts EMCa’s recommendations that the risk ranking for the ‘Northern Networks’ and ‘Two Rocks’ is ‘intermediate’ and not ‘high’, the Authority considers that:
•the expenditure is not required for ATCO to comply with rule 79(2)(c)(iii) of the NGR; and
•the expenditure that ATCO has proposed to reduce its considered security of supply risk does not satisfy rule 79(2)(c)(i) of the NGR.
•
Similarly, the ERA agreed with EMCa’s risk ranking of “Intermediate” for the Peel project in almost identical terms to its conclusion on the Two Rocks project:
As the Authority accepts EMCa’s recommendations that the risk ranking for the ‘Peel Region’ is ‘intermediate’ and not ‘high’, the Authority considers that:
•the proposed expenditure is not required for ATCO to comply with rule 79(2)(c)(iii) of the NGR; and
•the expenditure that ATCO has proposed to reduce its considered security of supply risk does not satisfy rule 79(2)(c)(i) of the NGR.
The ERA reached a similar conclusion in relation to the Interdependency projects.
As the ERA concluded that the risk ranking for the Projects is “Intermediate”, it determined that ATCO should formally reassess its security of supply risk for each Project under the steps specified in Table C4 of AS 4645 for an “Intermediate” ranked risk. The ERA considered that ATCO should submit how it proposes to treat the “Intermediate” risk in the form of a cost pass through which, if accepted, would allow ATCO to commence recovery of these costs (through tariffs) during AA5.
The ERA therefore required that ATCO include a cost pass through mechanism in the following terms:
The Authority requires that ATCO include the following clause 3.1(e):
ATCO Gas Australia incurs Conforming Capital Expenditure or Conforming Operating Expenditure as a result of addressing an “Intermediate” security of supply risk following an assessment in accordance with the required steps prescribed in Table C4 of AS 4645 for an ‘intermediate’ ranked risk. This expenditure can only be passed through for the following areas of the network identified by ATCO in its Response to the Draft Decision: Northern Network, Peel, Hillary’s, Canning Vale, Fremantle and Lathlain.
A cost pass through mechanism in this form was included in the ERA Access Arrangement as amended at 29 September 2015. It appears in cl 2.1(e) of Appendix B. It is necessary to return to this cost pass through later in these reasons.
EMCa’s report on capital expenditure
Taken collectively, the EMCa report (with its addendums) is an extensive document. Although the Tribunal has read and considered the EMCa report (and its addendums), what follows are those matters that featured most prominently in the ERA’s Draft Decision and Amended Final Decision and on which the substance of the dispute and the parties submissions were based.
EMCa adopted a three-step approach in assessing ATCO’s capex and opex proposals. First, it considered whether the expenditure was justified on any of the grounds set out in r 79(2). Secondly, it considered whether the proposed expenditure on Projects, justified under r 79(2), satisfied the prudency test in r 79(1)(a). Finally, it considered whether the forecasts or estimates underlying those Projects that are justifiable under r 79(2) and satisfy the prudency service test, have been arrived at on a reasonable basis and represent the best forecast or estimate possible in the circumstances, as required by r 74(2). It will be noted that this is the approach which the ERA itself adopted, undoubtedly following the approach taken by EMCa.
EMCa reviewed the methods employed by ATCO to forecast its capex and opex. Although EMCa found that many aspects of ATCO’s approach to forecasting aligned with good industry practice, it considered that ATCO’s descriptions of its forecasting approaches for specific expenditure components were vague, listing a range of factors that have been “taken into account” but without defining how they were taken into account. EMCa also found significant subjectivity in the way the ATCO managers had made assumptions at detailed levels that then aggregate up to produce the proposed expenditure forecasts. Although not critical of the managers, EMCa considered that such an approach, when applied without strong top-down challenge, is likely to lead to overestimation.
EMCa also considered that ATCO had failed to provide sufficient evidence for its claims of poor or deteriorating performance of aspects of the network or the improvements in performance outcomes that could be expected from the proposed increases in expenditure. EMCa provided the following example:
ATCO was, for example, unable to identify any safety or non-supply incidents relating to “loss of pressure”, and the rate of leaks (as indicated by UAFG) has been declining steadily over the past five years, yet despite significantly increased proposed expenditure ATCO does not forecast it to decline further from its most recent level.
EMCa asserted that it sought ATCO’s business plans for the past four years on the basis that these might provide an insight into ATCO’s cost projections. EMCa said that they were not provided. ATCO only provided top–line capex and opex budgets that it advised were extracted from those plans. Those budgets figures are confidential. However, it is sufficient to note that ATCO’s capex budget figures for the AA4 are considerably higher than its 2012 and 2013 business plan forecasts for the same years, and are also higher than the capex and opex forecasts in its 2014 business plan. The ERA submitted that the disparity would make one wonder about the validity of the assessment that has been undertaken.
EMCa proceeded on the basis that ATCO’s Two Rocks project and Peel project contained both growth and sustaining capex elements, with the sustaining element sought to be justified under r 79(2)(c) and its Safety Case.
EMCa noted that most of ATCO’s increase in expenditure on sustaining capex was being driven by its application of the Safety Case and in particular the FSAs that it has conducted under the Safety Case and the risk threshold it applied to security of supply related projects when carrying out the FSAs. A greater concern for EMCa was ATCO’s failure to undertake a cost-benefit assessment when applying the ALARP test under the FSAs, which EMCa considered was required under AS 4645.
EMCa indicated than when conducting an FSA, AS 4645 and AS2885 require that, where risks are assessed and categorised as “Intermediate”, they must be considered further and only accepted if they satisfy the ALARP test. Importantly, EMCa considered that AS 4645 does not envisage risk mitigation at any cost. Rather, the ALARP test it says requires a cost-benefit analysis to be undertaken and measures implemented only if the costs are justified.
EMCa’s concern was that ATCO had “not provided any evidence (and confirmed in answer to questions during the on-site meetings) that it has conducted a cost-benefit assessment for any of the projects that have been identified as being required to reduce risks to ALARP as required by AS/NZS 4645 and AS2885”.
EMCa’s further concern related to the risk threshold applied by ATCO, which EMCa considered to be too low:
The second concern we have with ATCO’s approach is that the risk threshold it has adopted for catastrophic events appears to be lower than the threshold employed by other gas distribution networks, as highlighted in Table 18. This driving much higher levels of security of supply related expenditure than we would expect to observe, and which are much higher than this business has previously incurred.
As outlined by the Tribunal in PIAC and Ausgrid (at [640] – [648]), the 2012 Rule Amendments significantly altered the process for determining the return on capital. Previously r 87 of the NGR required the return on equity to be determined using “a well accepted financial model, such as the Capital Asset Pricing Model”. The subsequent, now, required approach is as set out above, and includes publication of rate of return guidelines
As previously noted, the ERA published rate of return guidelines on 16 December 2013, together with an explanatory statement document and appendices, one of which (Appendix 8) contained the ERA’s evaluation of models for the return on equity. This considered, inter alia, various forms of the CAPM and the FFM. The conclusion drawn by the ERA at that time regarding the FFM was that:
[o]verall, the Authority has significant concerns as to the robustness of the FFM model specification and its results, particularly as the model is not ‘based on a strong theoretical foundation’. The Authority’s view is that the model is not ‘fit for purpose’ or able to be ‘implemented in accordance with best practice’ at the current time. On this basis, the Authority considers that the model cannot be relied on to achieve the rate of return objective, and hence is not relevant at the current time.
The ERA’s conclusion was that:
The Authority has reviewed these asset pricing approaches in terms of their ability to contribute to the achievement of the allowed rate of return objective. The conclusion
from that assessment leads the Authority to consider that only the Sharpe Lintner CAPM model is relevant for informing the Authority’s estimation of the prevailing return on equity for the regulated firm, at the current time.However, the Authority proposes to give weight to relevant outputs from the DGM when estimating the market risk premium (MRP) for input to the Sharpe Lintner CAPM. In particular, estimates from the DGM will be used to inform the range of the MRP, which will be then used as input to the Sharpe Lintner CAPM.
Other models and approaches are considered to be not relevant within the Australian context at the current time, at least without some new developments in terms of the theoretical foundations or in the empirical evidence.
This explicitly excluded a role for the FFM at that time, but did not preclude a possible subsequent role if there were “some new developments in terms of the theoretical foundations or in the empirical evidence”.
Rather, the ERA outlined the following five step approach to be followed in estimating the return on equity:
In the light of the refined challenge by ATCO to the ERA decision, which focuses upon the decision to disregard estimates of the return on equity derived from the FFM, it is primarily the first step in that process, to identify relevant material and its role in the estimate, which is at issue.
Regulatory decision
The process of determination of the return on equity in the matter under appeal involved the following stages. First, ATCO provided its AA Revision Proposal in March 2014 in which it argued that adherence to the ERA’s guidelines would “not result in an estimate of a return on equity that achieves the ARORO or complies with the rules”. Among the reasons advanced was the primary reliance of the ERA on the S-L CAPM and exclusion of other relevant estimation methods and models. ATCO’s proposal thus was to propose that an equally weighted average of four methods of calculating the rate of return be used. These four methods were:
(1)the required return of the average firm;
(2)the S-L CAPM;
(3)the FFM;
(4)the dividend growth model (‘DGM’).
Based on expert advice from SFG, the rate of return on equity proposed by was 10.7% p.a.
In its Draft Decision, the ERA rejected the approach proposed by ATCO. It noted in its rate of return guidelines that “estimate materials” (estimation methods, financial models, market data, and other evidence) would need to pass an “adequacy threshold” to be considered relevant. It noted that some may perform better on some criterion, and that an “on balance” assessment of contribution to the ARORO and compliance with legislative requirements was required.
The ERA responded to ATCO’s criticism that by excluding consideration of other models, and in particular the FFM, it was not determining a return on equity consistent with the ARORO. The ERA rejected the arguments of ATCO and SFG, concluding that it “remains of the view that the FFM is not relevant information in the context of estimating the return on equity”. In coming to that view, the ERA:
(1)referred to its own empirical study of the FFM in Australia (incorporated at Appendix 4 of the Draft Decision) as confirming the inconsistency of results from previous applications of the FFM for Australia, with particular reference to the role played by portfolio formation methods in such empirical studies;
(2)reiterated its concern about absence of underlying theory for the FFM; and
(3)noted the recent development by Professors Fama and French of a five factor model.
Particularly relevant to the grounds of ATCO’s refined challenge, which relied heavily on the results provided by two studies by Brailsford, Gaunt and O’Brien (and updating by SFG), the ERA noted that its view on the lack of robustness of the FFM for Australia was not changed by the updated study of Brailsford, Gaunt and O’Brien.
In its Amended AA Revision Proposal, ATCO argued that ERA’s rejection of models other than the S-L CAPM is based on a number of errors. With reference to rejection of the FFM, ATCO noted the expert opinion from SFG that the errors are:
(1)to “reject the FFM on the basis of its empirical motivation” when FFM was developed for the purpose of improving on the very poor empirical performance of the CAPM; and
(2)giving weight to the ERA’s own study compared to “the published study of Brailsford, Gaunt and O’Brien, which concludes that the three factor model is found to be consistently superior to the CAPM in the Australian market”.
In its Amended AA Revision Proposal, ATCO argued that:
AGA has based its estimate from the FFM on the SFG 2014 study, which sets out the most recent estimates of beta and the size and book-to-market premiums using Australian and US-listed observations. As a result, AGA’s FFM estimate encompasses the most recent and relevant market information. In order to arrive at an estimate the FFM has been populated with the following parameters:
•Market beta of 0.77
•Ex-imputation MRP of 6.53%
•Risk premium in relation to the size factor of -0.19%
•Risk premium in relation to the book-to-market of 1.15%
•Risk free rate and required return on the market as specified in the SL CAPM model
Based on advice from SFG, ATCO argued that the return on equity should be calculated as a weighted average of four models: S-L CAPM (weight of 12.5%); Black CAPM (weight of 25%); FFM (weight of 37.5%); and DGM (25% weight), where these weights differ from those proposed in its AA Revision Proposal.
In the justification for the weights, SFG noted that
[o]f the 75% weight that is applied to asset-pricing-models, we apply half to the Fama-French model and half to the CAPM. That is the question of whether the value premium is a proxy for a risk factor or a statistical aberration is addressed by applying equal weight to each possibility.
This would appear to suggest that even ATCO recognised that some doubt exists over the appropriate interpretation of the empirical “facts” derived from the modelling exercises of researchers.
In its Final Decision and the Amended Final Decision – which involved no changes relevant to this topic – the ERA amended its approach to determining the return on equity in a manner which inter alia retained the S-L CAPM as the primary method for estimating the return on equity, but incorporated information based on the Black CAPM and the DGM.
In doing so, it maintained its prior position of allowing no role for the FFM. The ERA relied on the Australian Energy Market Commission (‘AEMC’) to explain that the 2012 Rule Amendments give the regulator greater discretion, that “[t]he objectives and factors show the regulator what it must bear in mind when it exercises that discretion”.
However, as the AEMC also said
the objective has primacy over other matters which the regulator is directed to consider.
These other matters include factors which the regulator is directed to consider….
The regulator must actively turn its mind to the factors listed, but it is up to the regulator to determine how the factors should influence its decision. It may, indeed, consider all of them and decide none should influence its decision.
In PIAC v Ausgrid (at [713]), the Tribunal affirmed the obligation on the regulator as
requiring it to give consideration to the range of sources of evidence and analysis to estimate the rate of return. It need not give particular weight to any one source of evidence, and indeed it might treat particular evidence as having title or no weight in the circumstances. It is for the AER to make that assessment.
Further, the Tribunal concluded that it “does not consider the AER, by selecting the S-L CAPM as its foundation model made an error of fact.”
The ERA went on to say that following ATCO’s Amended AA Revision Proposal including the proposed use of the FFM, the ERA “once again gives consideration to the ability of these models to deliver estimates that meet the requirements of the NGR, and the allowed rate of return objective, in what follows.” The ERA then devoted approximately 11 pages to an assessment of the FFM before concluding that:
the Authority is of the view that the Fama French three-factor model is neither relevant nor fit for the purpose of estimating a return on equity for a regulatory decision in Australia. As a result, the Authority remains of the view that the FFM should play no role in estimating a return on equity for ATCO. This decision is based on the following considerations:
•The Fama French three-factor model was not developed on a theoretical basis.
•New factors that are now included in the new Fama French five factor model raise questions about the validity of the FFM three factor model.
•The estimates from the Fama French three factor model vary significantly and produce mixed results.
•The Fama French three factor model is not used by economic regulators either in Australia or overseas to estimate the expected return on equity.
It is clear from the preceding, that the ERA did consider the potential role of the FFM in the determination of the return on equity, including making its own assessment of the strengths and weaknesses of the model, and of the resulting evidence from its application to Australian equity markets. The issue is then whether, in making that assessment, the ERA committed an error or errors of fact or was unreasonable in deciding to reject a role for the FFM.
Consideration
While ATCO listed a large number of failures by the ERA, they all stand or fall upon one specific question: was the available evidence such that incorporation of information from available FFM studies of the Australian equity market would have led the ERA to make a return on equity decision more consistent with the ARORO, and lead to a materially preferable designated NGO decision?
This ultimately involves comparison of the merits of alternative models generating different results, based on relevant criteria. However, while there are (or may be) cases where unanimity would exist about the superiority of one model over another, this, as reflected in the differing views of experts, is not such a case. Reasonable people could disagree based on different emphasis placed on different criteria as well as differences in assessment of how well different models met those criteria. This is particularly the case in the current circumstances where the objective of inquiry is estimation of the required rate of return demanded by equity investors in a company, at a particular point in time. That is, itself, directly unobservable, and must be inferred from other observable data using models incorporating allowance for risks (risk premiums), or other considerations, which are believed to influence the rate of return demanded by investors. Identifying what are relevant risks, and then reliably quantifying their effects are particular issues involved in this instance.
The FFM was developed as an empirical model prompted at least in part by observed anomalies inconsistent with the CAPM. In particular, it was observed that historical returns on equities (after allowing for the effect of the systematic risk factor implied by the CAPM) were related to size and to book-to-market value of companies. This prompted research as to whether these might reflect the effect of additional risk factors (rather than simply being characteristics of the company) contributing to required returns.
The FFM thus involved constructing variables which might represent such risk factors and assessing whether stock returns were reliably related (with differing sensitivities) to movements in these variables. The risk factors constructed in the FFM involved a relatively complicated process of constructing a number of portfolios each of which comprised stocks with particular size characteristics, and particular book-to-market value characteristics. For example, one portfolio might contain those stocks which were in both the top size decile and in the top decile by book-to-market value. At the other extreme would be a portfolio containing stocks in both the bottom deciles by size and book-to-market value.
The “risk factors” are proxied by the variation over time in the difference in returns between various portfolios. The HML (book-to-market) factor is the difference in returns between the portfolios including, respectively, the highest and lowest book-to-market value stocks. The SMB (size) factor is, similarly, the difference in returns between portfolios of smallest and largest stocks. There are potentially many ways of forming such portfolios (and in how their composition varies over time), and various ways of testing whether the resulting risk factors contribute reliably to explaining historical stock returns. By assuming that resulting historical relationships provide some guide to the future it is then inferred that the risk factors are also relevant for determining required returns (just as occurs in use of the CAPM). The contribution made to required returns reflects the estimated sensitivity of a stock’s return to the risk factor (its factor loading) multiplied by the risk premium associated with that risk factor.
The FFM has had a significant influence on the academic finance research agenda, leading to many studies applying similar methods to different markets as well as many attempts to find other risk factors. Academic research presented to the Tribunal indicates the “discovery” by various researchers of over three hundred such factors – although that research also raised questions about whether the processes involved in such discovery and statistical tests used as supporting evidence led to incorrect acceptance of many newly discovered risk factors.
While many of those subsequent studies build on the foundations of the FFM (by including the size and value factors), the FFM is not universally accepted as providing a “better” model for the explanation of equity returns for a range of reasons exemplified in the debate between the ERA and ATCO.
It is not the role of the Tribunal to assess the merits of the FFM versus the S-L CAPM, but rather to consider whether the ERA made errors in rejecting a role for the FFM, on incorrect reasons, or in misinterpreting, such reasons. It is those reasons to which the Tribunal now turns.
Theoretical Foundations
One plank in the ERA’s argument for disregarding the FFM is concern over its genesis as an empirical approach without prior theoretical foundation. As argued by ATCO (and SFG), the discovery of empirical irregularities prior to development of generally accepted theoretical explanations should not necessarily weaken confidence in a model. There have been subsequent attempts to provide a theoretical foundation for the FFM (including arguments that it is not inconsistent with some existing theories such as the Arbitrage Pricing Theory which admits of multiple risk factors but without identifying theoretically what they are). However, experts disagree on whether the research, to date, provides a clear theoretical foundation for the empirical findings.
The Tribunal is of the view that it was not an error, nor unreasonable, for the ERA to take into account, as one input into its decision, concerns over the theoretical foundations of the FFM in coming to its view to disregard the FFM in determining the ARORO. By itself, lack of a generally accepted theoretical explanation for a consistently demonstrated and agreed set of empirical “facts”, in the form of results of statistical analysis, would be unlikely to lead a reasonable person to disregard those facts in attempting to draw conclusions about their implications. In this case, the “facts” are the existence of a statistical relationship between the return on equity and some particular financial variables, variously constructed by researchers, and all purporting to represent the same concepts. However, where those empirical facts are not generally agreed, perhaps because different researchers have constructed empirical proxies differently for the same concept, concerns about lack of strong theoretical foundations could be expected to lead a reasonable person to place less, or no, weight on the model generating those “facts”. Thus whether the ERA’s decision in this regard was unreasonable, hinges on whether it erred in interpreting the robustness of the “facts” before it regarding outputs from the FFM. This is considered in later paragraphs.
New five factor model implications
The ERA made submissions referring to the development by Professors Fama and French of a new five factor model for equity returns. It was argued that their estimates of this model for the case of the USA had led to results which appeared to remove the role of the HML factor as a determinant of equity returns. Since there is no argument in this appeal to use the new five factor model in the determination of the ARORO, this reason has little relevance, other than its potential for causing the ERA or other parties to be sceptical of the three factor FFM to place reduced weight on the empirical facts emanating from it.
Mixed results
In the Amended Final Decision, the ERA argued that one reason for disregarding the FFM is that “the estimates …vary significantly and produce mixed results”. This general statement was made more specific:
•applications of the FFM in Australia fail to produce consistent outcomes;
…
•…studies in the Australian context do not consistently report this pricing – some studies price the size factor, while others price the value factor;
•different proxies are adopted…with the result that the estimates from the FFM vary significantly from study to study;
•…adopting different portfolio formation on the same dataset will provide difference outcomes, yet portfolio formation is a key characteristics of the FFM
In support of these contentions, the ERA provided at Table 73 the results of a number of prior studies (including two papers by Brailsford, Gaunt and O’Brien from 2012 which feature prominently in ATCO’s submission, namely: ‘The Investment of the value premium’ in the Pacific Basin Finance Journal (‘BGO PBFJ’), and ‘Size and book-to-market factors in Australia’ in the Australian Journal of Management (‘BGO AJM’)). The ERA also referred to its own FFM study, one conclusion drawn from which was that results were significantly dependent on the method of portfolio formation used. This was also the conclusion of the BGO PBFJ paper which stated that “different methods of portfolio formation lead to different conclusions.”
The ERA pointed to different results in a prior version of the BGO AJM paper from 2008 where a different portfolio formation process was used. The Tribunal recognises that the evolution of approaches and differences in results in succeeding versions of a research project’s output are an inherent feature of the research process, rather than indicating that the credibility of the most recent results is contaminated by differences with earlier results, as was suggested in the oral submission. However, the sensitivity of results to different approaches found in the two papers does reinforce the position of the ERA that results of applications of the FFM are dependent upon the approach used (in this, case for portfolio formation). In addition, in the absence of a single generally agreed “right” approach, there is therefore uncertainty about the superiority of one set of results over another.
ATCO argued that the ERA made an error (or errors) of fact in concluding that mixed results were a relevant factor for disregarding the FFM in determining the return on equity. Their argument was based on the existence of BGO PBFJ and BGO AJM, and the subsequent updating of those studies by SFG. The claim is that those studies (the latest available at the date of the ERA’s decision) adopt superior techniques and data to previous Australian studies (including that undertaken by the ERA itself), and should lead to acceptance of their results as providing confirming evidence of the relevance of the FFM to Australia, and providing reliable estimates of its quantitative significance. In particular, BGO AJM finds that the HML factor is priced and consistent with expectations, although the SMB factor results are not consistent with expectations. The ATCO proposal for an adjustment to the return on equity is based on results from SFG applying and updating BGO AJM (including the effects of both the HML and SMB factors).
There is little question that BGO AJM involves use of a more comprehensive database than prior Australian studies. It is also the case that the BGO studies carefully investigate the effects of some commonly used different methods of portfolio formation – and find (as does the ERA’s own study) that results are dependent upon the approach used. In BGO AJM they construct portfolios in a way which more closely resembles the FFM approach for the USA and which they state is “a more appropriate portfolio formation method” and find that the HML factor is priced, but the SMB factor is not. Specifically, the results involve a coefficient on the HML factor which is positive and statistically significant, but an insignificant negative coefficient on the SMB factor (which is of opposite sign to that expected).
The Tribunal accepts that there may be “more appropriate” ways to conduct empirical research which, in this case involves, inter alia, methods of portfolio formation. Whether there is a “most appropriate” way and whether the BGO approach is more appropriate than others simply because it resembles the Fama-French USA approach and generates some similar results are, at the current time, open questions. The issue thus becomes that of what weight a reasonable person would accord to the results of a range of studies and the implications of variations between them.
ATCO effectively argued that full weight should be given to BGO AJM (and SFG updates), and other FFM studies in Australia be given no weight. (In submissions, ATCO referred to the BGO studies as providing a “watershed” moment in the Australian search for reliable estimates of risk factors and their effects on the required return on equity). It thus argued that the claim that diverse results from a range of previous studies mean that the FFM is unstable and thus not relevant for determining the return on equity is invalid. The ERA alternatively argued that the diversity of results arising from different approaches means that no conclusive results can be drawn from existing Australian FFM studies regarding the required return on equity. The ERA argued:
The Authority disagrees with SFG’s view that a range of studies of variable quality produce a range of estimates and therefore should not be used as the basis for the outright rejection of the entire model and that a better approach is to consider the robustness and the reliability of the best available estimates of each model.
Furthermore, the ERA rejected BGO and the SFG updates as superior to other studies.
The Tribunal’s role is not to pass judgment on the superiority of one study over the others investigating the application of the FFM to Australian data. Its role is to assess whether the regulator made errors or was unreasonable in considering (or not considering) the available information available to it in forming a judgment about the merits of incorporating results from one, or some, or none of those studies into its determination of the return on equity.
The ERA decided that, contrary to the view of SFG (and some other experts), the range of diverse results from the range of available studies meant that no confidence could be placed on any of those results. In this, it was supported by the views of its own experts, McKenzie and Partington. Ultimately, the decision involves a subjective weighting of the facts available which, in this case, are varying statistical estimates of particular parameters from a range of studies. The claimed superiority (by ATCO) of BGO AJM (and the SFG updates) might lead one to accord greater weight to their estimates, relative to those of other studies.
Alternatively, one could be inclined to accord full weight to the results of the claimed superior study, and interpret that study’s method and results as demonstration of support for the model involved. This is a matter on which reasonable people could disagree, due to differences in caution, different prior beliefs, or subjective weightings of alternative types of evidence, without making demonstrable error. The Tribunal accepts that the ERA did carefully consider the merits of the FFM, including results from the latest available research, before rejecting the use of the FFM, and in doing so did not make errors of fact or act unreasonably.
No prior use by regulators
The ERA’s Amended Final Decision refers to no prior use of the FFM by regulators in Australia and overseas, as a further reason supporting its decision to disregard the FFM. This, it was argued by ATCO, involves circular reasoning, such that prior non-use justifies continued non-use, regardless of new evidence. That would be the case if decisions of other regulators to eschew the FFM were based on lack of investigation or evidence of merits of the FFM, and that the ERA acted similarly. It could then amount to an error of fact or unreasonable decision. However, an alternative explanation is that decisions by other regulators have been based on analysis of evidence and led them to a decision to reject use of the FFM, with those decisions not having been previously found to constitute errors in available appeal processes. This would then provide support, in the absence of new contradictory evidence, for adopting the same position – rather than simply revisiting arguments raised in such prior cases.
In this instance, new evidence has been advanced by ATCO. Thus, sole reliance on the rejection of the FFM in prior regulatory decisions as an explanation for the ERA’s decision would be unreasonable, or an error if that new evidence were persuasive. However, because the ERA has considered that new evidence and rejected it, it is not unreasonable to draw upon prior regulatory decisions in support of its view to reject the FFM in this case. Consequently, the Tribunal is of the view that the ERA did not make an error of fact or act unreasonably in relying on prior rejection of use of the FFM by other regulators as one factor in reaching its decision.
The Tribunal finds that the ERA did not make an error of fact or act unreasonably in rejecting use of the FFM in calculating the return on equity.
Gamma
The ERA considered the Tribunal’s reasons for decision in PIAC and Ausgrid.
The ERA accepted that it would undermine the effectiveness of the regulatory regime and would be against the public interest in consistency of decision-making for it to re-argue matters that have recently been considered and decided by the Tribunal in that matter, notwithstanding that aspects of the PIAC and Ausgrid decision relating to the value of imputation credits are currently the subject of an application for judicial review before the Federal Court.
For the purpose of this application, and applying the reasons of the Tribunal in PIAC and Ausgrid, the ERA accepted that:
(1)the ERA has made a reviewable error in its decision to apply a gamma of 0.4 in its rate of return determination in the Amended Final Decision; and
(2)the best estimate of gamma on the basis of the material before the ERA at the time of its Amended Final Decision was 0.25.
The Tribunal accepts, on the basis of the material before it, that a gamma value of 0.25 should be adopted and that the ERA erred in adopting the alternative figure of 0.4.
DISPOSITION
Sections 259(4a)-(4c) were inserted into the NGL with effect from March 2014. Section 259(4a) provides that, in a case where the decision under review is a designated reviewable regulatory decision, the Tribunal may only make a determination to vary the designated reviewable regulatory decision (under s 259(2)(b)) or to set aside the designated reviewable regulatory decision and remit the matter back to the ERA (under s 259(2)(c)) if:
(a)the Tribunal is satisfied that to do so will, or is likely to, result in a decision that is materially preferable to the designated reviewable regulatory decision in making a contribution to the achievement of the national gas objective set out in s 23 of the NGL (NGO) (a materially preferable designated NGO decision) (and if the Tribunal is not so satisfied the Tribunal must affirm the decision under s 259(2)(a)); and
(b)in the case of a determination to vary the designated reviewable regulatory decision, the Tribunal is satisfied that to do so will not require the Tribunal to undertake an assessment of such complexity that the preferable course of action would be to set aside the decision and remit the matter to the ERA to make the decision again.
In considering its role in the review process, the Tribunal in PIAC and Ausgrid (at [91] – [93]) made the following pertinent comments:
the correction of error or errors in a decision under review will not necessarily lead to a materially preferable decision. Whether there is a preferable decision to the decision made by the AER depends upon an assessment of the decision as a whole, and a comparison of that decision with a putative alternative decision; it does not depend simply on an assessment of errors in individual components of the decision under review. That reflects the Minister’s comments that the 2013 Legislative Amendments:
Require the [Tribunal] to undertake a holistic assessment of whether the setting aside or varying of the reviewable regulatory decision, or remission of the matter back to the original decision maker, will or is likely to deliver a materially preferable outcome in the long term interests of consumers.
See: South Australia, House of Assembly, Hansard, 26 September 2013 at 7173 (The Hon J R Rau).
The 2013 Legislative Amendments reflect a deliberate policy decision to change the NEL and NGL and, in particular, to change the scope of the Tribunal’s limited merits review function. They introduce a series of steps which require the Tribunal, even if it is satisfied of one or more grounds of review arising from one particular aspect of the AER’s decision, to consider whether and how the potential consequences of that ground being established may be reduced, counterbalanced or rendered immaterial following the processes mandated by ss 71P(2a), 71P(2b)(a) and 71P(2b)(c) of the NEL and ss 259(4a), 259(4b)(a) and 259(4b)(c) of the NGL.
…it is axiomatic in the principles of regulatory economics, that promoting allocative, productive and dynamic efficiency generally serves the long term interests of consumers. However, the 2013 Legislative Amendments contemplate that there can be more than one available decision that is economically efficient – and certainly more than one available decision that is roughly so, having regard to the unavoidable approximations involved.
The role of the AER and the Tribunal in giving effect to the NEO and NGO is to promote the “long term interests of consumers” with respect to the matters stipulated. This will always involve an attempt to promote efficient investment in, and operation and use of, services, but will also require taking into account other factors as appropriate.
As the Tribunal has not found there to be any error in the ERA’s decision, other than in relation to gamma, the question is as to the appropriate relief to provide. The Tribunal is of the view that the relevant decisions should be set aside and a new decision made so as to take into account the correct value of gamma, but this should be done by the ERA.
The Tribunal is satisfied that for it to do so would require the Tribunal to undertake an assessment of such complexity that it is not appropriate for it to undertake that task and it is preferable that the matter be remitted to the ERA.
The Tribunal is satisfied that in so acting in setting aside the relevant decisions of the ERA, and in remitting, will likely result in a decision that is materially preferable to the relevant decision set aside in making a contribution to the achievement of the NGO.
The Tribunal determines that:
(1)Pursuant to s 259(2)(c) of the National Gas Access (Western Australia) Law, the Amended Final Decision, including appendices, and the Access Arrangement Decision, including appendices, are set aside and remitted to the ERA to make the decisions again in accordance with the following directions:
(a)the ERA is to decide the constituent components of the Amended Final Decision and Access Arrangement Decision that involve the estimated cost of corporate income tax (gamma) by reference to a gamma of 0.25; and
(b)the ERA is to consider, and to the extent appropriate, to vary interrelated constituent components of the Amended Final Decision and Access Arrangement Decision, having regard to s 28(1)(b)(iii) of the NGL, where necessary in light of variations made to the Amended Final Decision and Access Arrangement Decision by reason of sub-para (a) above.
I certify that the preceding six hundred and ninety-three (693) numbered paragraphs are a true copy of the Reasons for Determination herein of the Honourable Justice Middleton, Professor K T Davis and Mr R Steinwall.
Associate:
Dated: 13 July 2016
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