Application by EnergyAustralia and Others

[2009] ACompT 8

AUSTRALIAN COMPETITION TRIBUNAL

Application by EnergyAustralia and Others [2009] ACompT 8

COMPETITION LAW – Review of decision of Australian Energy Regulator pursuant to National Electricity Law - merits review – judicial review – consideration of grounds of review - whether exercise of discretion was incorrect – whether decision was unreasonable – scope of separate ground of review of ‘unreasonableness’ – whether a decision under review is ‘unreasonable in all the circumstances’ – circumstances where the Tribunal may remit a matter for determination by the Regulator

EVIDENCE – Tribunal limited to information, documents, material and matters before the Regulator – extent to which the Tribunal may have regard to non ‘review related matter’ – matters to which the Tribunal may have regard

NATIONAL ELECTRICITY LAW – National electricity pricing and revenue regime – application for review of distribution and transmission determinations – distribution and transmission network service providers – assessment of appropriate regulatory control period – whether Regulator reasonably withheld agreement to proposed averaging period – whether decision was made by reference to national electricity objectives and pricing principles      

Gas Pipelines Access (South Australia) Act 1997 (SA)
National Electricity Law
National Electricity Rules

Application by East Australian Pipeline Ltd (2005) ATPR 42-047
Application by EnergyAustralia (2009) ACompT 7
Application by Epic Energy South Australia Pty Ltd (2003) ATPR 41-932
Australian Competition and Consumer Commission (ACCC) v Australian Competition Tribunal (2006) 152 FCR 33
East Australian Pipeline Pty Ltd v Australian Competition and Consumer Commission (2007) 233 CLR 229
Minister for Immigration and Ethnic Affairs v Wu Shan Liang (1996) 185 CLR 259

File No 2 of 2009

RE:APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO ENERGYAUSTRALIA PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES

BY:ENERGYAUSTRALIA

Applicant

AND:SOUTHERN SYDNEY REGIONAL ORGANISATION OF COUNCILS

Intervener

File No 3 of 2009

RE:APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO TRANSGRID PURSUANT TO CLAUSE 6A.13.1 OF CHAPTER 6A OF THE NATIONAL ELECTRICITY RULES

BY:TRANSGRID

Applicant

File No 4 of 2009

RE:APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO INTERGRAL ENERGY PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES

BY:INTERGRAL ENERGY

Applicant

File No 5 of 2009

RE:APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO TRANSEND PURSUANT TO CLAUSE 6A.13.1 OF CHAPTER 6A OF THE NATIONAL ELECTRICITY RULES

BY:TRANSEND

Applicant

AND:  NYRSTAR AUSTRALIA PTY LTD

Intervener

File No 6 of 2009

RE:APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION/TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO COUNTRY ENERGY PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES

BY:COUNTRY ENERGY

Applicant

JUSTICE MIDDLETON (DEPUTY PRESIDENT), MR R DAVEY AND MR R SHOGREN
12 NOVEMBER 2009
MELBOURNE (HEARD IN SYDNEY)

IN THE AUSTRALIAN COMPETITION TRIBUNAL

File No 2 of 2009

RE:	APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION/TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO ENERGYAUSTRALIA PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES
BY:	ENERGYAUSTRALIA
Applicant
AND	SOUTHERN SYDNEY REGIONAL ORGANISATION OF COUNCILS
Intervener
File No 3 of 2009

RE:	APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO TRANSGRID PURSUANT TO CLAUSE 6A.13.1 OF CHAPTER 6A OF THE NATIONAL ELECTRICITY RULES
BY:	TRANSGRID
Applicant
File No 4 of 2009

RE:	APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO INTERGRAL ENERGY PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES
BY:	INTERGRAL ENERGY
Applicant
File No 5 of 2009

RE:	APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO TRANSEND PURSUANT TO CLAUSE 6A.13.1 OF CHAPTER 6A OF THE NATIONAL ELECTRICITY RULES
BY:	TRANSEND
Applicant
AND	NYRSTAR AUSTRALIA PTY LTD
Intervener
File No 6 of 2009

RE:	APPLICATION UNDER SECTION 71B OF THE NATIONAL ELECTRICITY LAW FOR A REVIEW OF A DISTRIBUTION/TRANSMISSION DETERMINATION MADE BY THE AUSTRALIAN ENERGY REGULATOR IN RELATION TO COUNTRY ENERGY PURSUANT TO CLAUSE 6.11.1 OF APPENDIX 1 OF CHAPTER 11 OF THE NATIONAL ELECTRICITY RULES
BY:	COUNTRY ENERGY
Applicant

THE TRIBUNAL:	JUSTICE MIDDLETON (DEPUTY PRESIDENT), MR R DAVEY AND MR R SHOGREN
DATE:	12 NOVEMBER 2009
PLACE:	MELBOURNE (HEARD IN SYDNEY)

APPLICANTS AND APPLICATIONS........ ........ ........ ........ ........ ........ ........ ........ .....	[1]
GROUNDS OF REVIEW........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ....	[6]
MATTERS, DOCUMENTS, INFORMATION, OR MATERIAL BEFORE THE TRIBUNAL........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ..	[8]
THE REGULATORY FRAMEWORK........ ........ ........ ........ ........ ........ ........ ........ .....	[10]
DISTRIBUTION AND TRANSMISSION SERVICES........ ........ ........ ........ ........ ...	[15]
Building block determinations........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ..	[23]
Requirements relating to draft and final determinations........ ........ ........ ........ .......	[41]
The Regulatory Proposals........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .	[45]
TransGrid’s and Transend’s Revenue Proposals........ ........ ........ ........ ........ ........ ...	[51]
FUNCTION OF TRIBUNAL........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[56]
COST OF CAPITAL: WITHHOLDING AGREEMENT........ ........ ........ ........ ........	[68]
WHAT AVERAGING PERIOD SHOULD BE APPLIED?........ ........ ........ ........ ....	[104]
COST OF DEBT........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[114]
INFLATION FORECASTS........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .	[124]
ENERGYAUSTRALIA SPECIFIC MATTERS........ ........ ........ ........ ........ ........ ......	[126]
OPERATING EXPENSES........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ..	[126]
Step Changes........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[128]
Clauses 6.5.6........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[133]
The first Wilson Cook report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[136]
Proposed Step changes from Base Year........ ........ ........ ........ ........ ........ ........ ........ .	[140]
The AER’s draft decision on EA’s step changes........ ........ ........ ........ ........ ........ ...	[142]
EA’s response to the draft decision........ ........ ........ ........ ........ ........ ........ ........ ........ .	[143]
The PwC report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .......	[144]
The Concept Economics report........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[145]
The second NERA report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .......	[149]
The Huegin report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[157]
EnergyAustralia’s revised regulatory proposal........ ........ ........ ........ ........ ........ ......	[165]
The AER’s Final Decision on EA’s step changes........ ........ ........ ........ ........ ........ .	[166]
The second Wilson Cook report........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[169]
Wilson Cook’s response to the PwC report........ ........ ........ ........ ........ ........ ........ ....	[170]
Wilson Cook’s response to the Concept Economics report........ ........ ........ ........ ....	[171]
Wilson Cook’s response to the second NERA report........ ........ ........ ........ ........ .....	[172]
Wilson Cook’s response to the Huegin report........ ........ ........ ........ ........ ........ ........	[175]
The Tribunal’s consideration of EA’s step changes........ ........ ........ ........ ........ ......	[186]
The Tribunal’s conclusion on EA’s step changes........ ........ ........ ........ ........ ........ .	[199]
Maintenance Costs........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .....	[200]
EnergyAustralia’s June 2008 regulatory proposal........ ........ ........ ........ ........ ........	[202]
The first Wilson Cook report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[205]
The AER’s draft decision........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........	[211]
EnergyAustralia’s response to the draft decision........ ........ ........ ........ ........ ........ ...	[212]
The Sinclair Knight Merz report........ ........ ........ ........ ........ ........ ........ ........ ........ .....	[213]
The Huegin report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[220]
EnergyAustralia’s revised regulatory proposal........ ........ ........ ........ ........ ........ ......	[224]
The second Wilson Cook report........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[226]
Wilson Cook’s response to the SKM report........ ........ ........ ........ ........ ........ ........ ....	[229]
Wilson Cook’s response to the Huegin report........ ........ ........ ........ ........ ........ ........	[240]
Wilson Cook’s use of a mid-point........ ........ ........ ........ ........ ........ ........ ........ ........ ...	[245]
The Tribunal’s consideration of EA’s maintenance costs........ ........ ........ ........ .....	[246]
The Tribunal’s conclusion on EA’s maintenance costs........ ........ ........ ........ ........	[254]
PASS THROUGH........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .	[255]
PUBLIC LIGHTING........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ....	[262]
TRANSGRID SPECIFIC MATTER: DEFECT MAINTENANCE........ ........ ......	[263]
The meaning of ‘defect maintenance’........ ........ ........ ........ ........ ........ ........ ........ ......	[265]
The meaning of ‘new growth asset’........ ........ ........ ........ ........ ........ ........ ........ ........ ..	[266]
TransGrid’s May 2008 regulatory proposal........ ........ ........ ........ ........ ........ ........ ....	[267]
The first PB report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ....	[272]
TransGrid’s response to a draft of the first PB report........ ........ ........ ........ ........ ...	[274]
The AER’s October 2008 draft decision........ ........ ........ ........ ........ ........ ........ ........ ..	[278]
The SKM report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ .	[281]
TransGrid’s January 2009 revised regulatory proposal........ ........ ........ ........ ........	[283]
The second PB report........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........	[288]
The AER’s April 2009 Final Decision........ ........ ........ ........ ........ ........ ........ ........ ......	[293]
The Tribunal’s consideration of TransGrid’s defect maintenance........ ........ .......	[295]
The Tribunal’s conclusion on TransGrid’s defect maintenance costs........ ........ ...	[310]
GENERAL OBSERVATIONS........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ....	[311]
CONCLUSION........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ........ ......	[313]

REASONS FOR DETERMINATIONS

APPLICANTS AND APPLICATIONS

1. The applicants are as follows:

   (a)EnergyAustralia (‘EA’), the owner and operator of an electricity transmission and distribution network located in New South Wales;

   (b)TransGrid, the owner and operator of an electricity transmission network located primarily in New South Wales;

   (c)Integral Energy, the owner and operator of an electricity distribution network located in New South Wales;

   (d)Country Energy, the owner and operator of an electricity distribution network located primarily in New South Wales; and

   (e)Transend, the owner and operator of an electricity transmission network located in Tasmania,

   referred to collectively as ‘the Applicants’.

2. In addition, South Sydney Regional Organisation of Councils (‘SSROC’) was granted leave to intervene in the review in File 2 of 2009 in relation to EA’s application.  Nyrstar Australia Pty Ltd (ACN 124 535 468) (‘Nyrstar’) was granted leave to intervene in file 5 of 2009 in relation to Transend’s application.  Nyrstar relied upon written submissions, which have been considered by the Tribunal in the reaching of its conclusions.

3. The applications were heard by the Tribunal together.

4. On 19 June 2009, pursuant to s 71B(1) of the National Electricity Law (‘the NEL’) the Tribunal granted the Applicants leave to review final determinations of the Australian Energy Regulator (‘AER’) respectively entitled:

   (a)EA distribution determination 2009-10 to 2013-14 dated 28 April 2009, (‘EA Final Determination’).  The AER’s reasons for the EA Final Determination are set out in its Final Decision, New South Wales distribution determination 2009-10 to 2013-14 (‘Final Decision’) also dated 28 April 2009 and published on 30 April 2009;

   (b)TransGrid transmission determination 2009-10 to 2013-14 dated 28 April 2009 (‘TransGrid Final Determination’).  The AER’s reasons for the TransGrid Final Determination are set out in its Final Decision, TransGrid transmission determination 2009-10 to 2013-14 (‘TransGrid Final Decision’) dated 28 April 2009 and published on 30 April 2009;

   (c)Integral Energy distribution determination 2009-10 to 2013-14 dated 28 April 2009 (‘Integral Energy Final Determination’).  The AER’s reasons for the Integral Energy Final Determination are set out in the Final Decision;

   (d)Country Energy distribution determination 2009-10 to 2013-14 dated 28 April 2009 (‘Country Energy Final Determination’).  The AER’s reasons for the Country Energy Final Determination are set out in the Final Decision; and

   (e)Transend transmission determination 2009-10 to 2013-14 dated 28 April 2009 (‘Transend Final Determination’).  The AER’s reasons for the Final Determination are set out in its Final Decision, Transend transmission determination 2009-10 to 2013-14 (‘Transend Final Decision’) also dated 28 April 2009 and published on 30 April 2009;

   (referred to collectively as the ‘Final Determinations’).

5. On 21 August 2009, the Tribunal reserved its decisions in these matters and on 4 September 2009, pursuant to s 71Q of the NEL, the Tribunal extended the standard period for making its determinations until 27 November 2009.

   GROUNDS OF REVIEW

6. A review of the decision of the AER is conducted under Pt 6 Div 3A of the NEL.  The available grounds of review are specified in s 71C(1).  They are that the AER made an error or errors of fact in its findings of facts which error or errors, in itself or combination, were material to the making of the decision under review, or that the AER’s exercise of discretion was incorrect having regard to all the circumstances, or that its decision was unreasonable, having regard to all the circumstances.

7. Section 71C(2) of the NEL provides that it is for the Applicants to establish the ground of review which is pursued.

   MATTERS, DOCUMENTS, INFORMATION, OR MATERIAL BEFORE THE TRIBUNAL

8. Section 71R identifies the matters, documents, information or material the Tribunal may consider or have regard to in making its determination.  It is convenient to set it out in full.  It provides:

   (1)Subject to this section, the Tribunal, in reviewing a reviewable regulatory decision, must not consider any matter other than review related matter.

   (2)The Tribunal, in reviewing a reviewable regulatory decision, must have regard to any document –

   (a)prepared, and used, by the AER for the purpose of making the reviewable regulatory decision; and

   (b)that the AER has made publicly available.

   (3)In addition, if in a review, the Tribunal is of the view that a ground of review has been established, the Tribunal may allow new information or material to be submitted if the new information or material –

   (a)would assist it on any aspect of the determination to be made; and

   (b)was not unreasonably withheld from the AER when it was making the reviewable regulatory decision.

   (4)Subject to this Law, for the purpose of subsection (3)(b), information or material not provided to the AER following a request for that information or material by it under this Law or the Rules is to be taken to have been unreasonably withheld.

   (5)Subsection (4) does not limit what may constitute an unreasonable withholding of information or material.

   (6)In this section –

   review related matter means –

   (a)the application for review and submissions in support of the application; and

   (b)the reviewable regulatory decision and the written record of it and any written reasons for it; and

   (c)in the case of a reviewable regulatory decision that is a network revenue or pricing determination – any document, proposal or information required or allowed under the Rules to be submitted as part of the process for the making of the determination; and

   (d)any written submissions made to the AER before the reviewable regulatory decision was made; and

   (e)any reports and materials relied upon by the AER in making the reviewable regulatory decision; and

   (f)any draft of the reviewable regulatory decision; and

   (g)any submissions on the draft of the reviewable regulatory decision or the reviewable regulatory decision itself considered by the AER; and

   (h)the transcript (if any) of any hearing conducted by the AER for the purpose of making the reviewable regulatory decision.

1. The Tribunal was informed by the AER that all documents prepared, and used, by the AER for the purpose of making the Final Determinations, and that the AER had made publicly available, were before the Tribunal.  The Tribunal has had regard to such documentation. 

   THE REGULATORY FRAMEWORK

2. The NEL and the National Electricity Rules (‘the Rules’) provide the economic and legal framework for the regulation of the revenues of the Applicants operating in the national electricity market.

3. The NEL requires that in performing or exercising its economic regulatory functions or powers the AER must:

   ·do so in a manner that will, or is likely to, contribute to the achievement of the national electricity objective (s 16(1)); and

   ·take into account the revenue and pricing principles (s 16(2)).

4. The national electricity objective, found in s 7 of the NEL, is:

   ... to promote efficient investment in, and efficient operation and use of, electricity services for the long term interest of consumers of electricity with respect to:

   (a)      price, quality, safety, reliability and security of supply of electricity; and

   (b)      the reliability, safety and security of the national electricity system.

5. The revenue and pricing principles set out in s 7A of the NEL are:

   (2)A regulated network service provider should be provided with a reasonable opportunity to recover at least the efficient costs the operator incurs in –

   (a)       providing direct control network services; and

   (b)complying with a regulatory obligation or requirement or making a regulatory payment.

   (3)A regulated network service provider should be provided with effective incentives in order to promote economic efficiency with respect to direct control network services the operator provides.  The economic efficiency that should be promoted includes –

   (a)efficient investment in a distribution system or transmission system with which the operator provides direct control network services; and

   (b)the efficient provision of electricity network services; and

   (c)the efficient use of the distribution system or transmission system with which the operator provides direct control network services.

   (4)Regard should be had to the regulatory asset base with respect to a distribution system or transmission system adopted –

   (a)       in any previous –

   (i)as the case requires, distribution determination or transmission determination; or

   (ii)determination or decision under the National Electricity Code or jurisdictional electricity legislation regulating the revenue earned, or prices charged, by a person providing services by means of that distribution system or transmission system; or

   (b)       in the Rules.

   (5)A price or charge for the provision of a direct control network service should allow for a return commensurate with the regulatory and commercial risks involved in providing the direct control network service to which that price or charge relates.

   (6)Regard should be had to the economic costs and risks of the potential for under and over investment by a regulated network service provider in, as the case requires, a distribution system or transmission system with which a regulated network service provider provides direct control network services.

   (7)Regard should be had to the economic costs and risks of the potential for under and over utilisation of a distribution system or transmission system with which a regulated network service provider provides direct control network services.

6. The national electricity objective provides the overarching economic objective for regulation under the NEL: the promotion of efficient investment and efficient operation and use of, electricity services for the long term interests of consumers.  Consumers will benefit in the long run if resources are used efficiently, that is if resources are allocated to the delivery of goods and services in accordance with consumer preferences at least cost.  As reflected in the revenue and pricing principles, this in turn requires prices to reflect the long run cost of supply and to support efficient investment, providing investors with a return which covers the opportunity cost of capital required to deliver the services. 

   DISTRIBUTION AND TRANSMISSION SERVICES

7. It is necessary to say something about the economic regulation of distribution and transmission services and the process of making a determination by the AER.

8. Pursuant to cl 11.15.2 of the Rules, Ch 6 as it is set out in Appendix 1 to Ch 11 (‘the Transitional Rules’), applies to the Distribution Network Service Providers (DNSPs) EA, Country Energy and Integral Energy 

9. Clause 11.15.1 of the Rules provides that there is to be a regulatory control period of five years of the DNSPs commencing on 1 July 2009, which is referred to as the regulatory control period 2009 – 2014. 

10. Clause 6.2.4 of the Transitional Rules provides that the AER must make a distribution determination for each DNSP. A distribution determination is to impose controls over the prices of direct control services, the revenue to be derived from direct control services or both (cl 2.5.5(a) of the Transitional Rules).

11. The definitions in Ch 10 of the Rules provide that a direct control service is a service  that:

    (a)the Rules specify as a service the price for which, or the revenue to be earned from which, must be regulated under a distribution determination or transmission determination; or

    (b)if the Rules do not do so, the AER specifies, in a distribution determination or transmission determination, as a service the price for which, or the revenue to be earned from which, must be regulated under the distribution determination or transmission determination.

12. The Transitional Rules (cl 6.2.3A(b)) further divide direct control services into two subclasses: standard control services and alternative control services.  A standard control service is a direct control service that is subject to control mechanisms based on a DNSP’s total revenue requirement (Ch 10 of the Rules).  An alternative control service is a distribution service that is a direct control service but not a standard control service (Ch 10 of the Rules).

13. The control mechanisms for direct control services and alternative control services are set out in cl 6.2.5 of the Transitional Rules.  For standard control services the control mechanism must be of the prospective CPI minus X form, or some incentive-based variant of the prospective CPI minus X form, in accordance with Pt C of the Transitional Rules (which relates to building block determinations for standard control services) – Transitional Rules cl 6.2.6(a).  The control mechanism for alternative control services may (but need not) utilise elements of Pt C – Transitional Rules cl 6.2.6(c).

14. TransGrid and Transend, which are Transmission Network Service Providers (TNSPs), are also subject to a regulatory control period of 2009 – 2014 which is, for the purposes of this review, governed by Ch 6A of the Rules.  Clause 6A.2.1 of the Rules provides that the AER must make transmission determinations for TNSPs in accordance with Ch 6A in respect of prescribed transmission services and negotiated transmission services.

    Building block determinations

15. A building block determination is the component of a distribution or transmission determination.

16. The procedure for making a building block determination involves the submission of a building block proposal to the AER by each DNSP and TNSP.

17. A DNSP’s building block proposal is required to be prepared in accordance with the post-tax revenue model prepared and published by the AER and must comply with the requirements of, and must contain or be accompanied by the information required by, any relevant regulatory information instrument (cl 6.3.1(c)(1) and (2) and cl 6.4.1(a) of the Transitional Rules).  The contents of a DNSP’s post-tax revenue model must include, amongst other things, a method that the AER determines is likely to result in the best estimates of expected inflation (cl 6.4.2(b) of the Transitional Rules).  Like requirements which apply to a TNSP appear in Pt C of Ch 6 of the Rules.

18. The building blocks relevantly include:

    (a)       indexation of the regulatory asset base;
    (b)       a return on capital for that year;
    (c)       the depreciation for that year;
    (d)      the estimated cost of corporate income tax of the provider for that year; and
    (e)       the forecast operating expenditure for that year.
    (see cl 6.3.1(c)(1) and (2) and cl 6.4.1(a) of the Transitional Rules and cl 6A.5.3 of the Rules.)

19. The indexation of the regulatory asset base is calculated in accordance with cl 6.5.1 and Sch 6.2 of the Transitional Rules for a DNSP and cl 6A.6.1 and Sch 6A.2 of Ch 6A for a TNSP, which includes the rolling-forward of the regulatory asset base from one regulatory year in a regulatory control period to another regulatory year in a regulatory control period.

20. The return on capital is calculated in accordance with cl 6.5.2 of the Transitional Rules for a DNSP and cl 6A.6.2 of Ch 6A of the Rules for a TNSP.

21. The forecast operating expenditure for the year is the forecast operating expenditure as accepted or substituted by the AER in accordance with cl 6.5.6 of the Transitional Rules for a DNSP and cl 6A.6.5 of Ch 6A of the Rules for a TNSP.

22. The return on capital for each regulatory year is calculated by applying a rate of return for each DNSP and TNSP for that regulatory control period to the value of the regulatory asset base for the relevant distribution or transmission system as at the beginning of that regulatory year (cl 6.5.2(a) of the Transitional Rules and cl 6A.6.2(a) of the Rules, respectively).

23. The rate of return for a DNSP or TNSP for a regulatory control period is the cost of capital as measured by the return required by investors in a commercial enterprise with a similar nature and degree of non-diversifiable risk as that faced by the business of the provider and must be calculated as a nominal post-tax weighted average cost of capital (WACC) in accordance with the formula set out in cl 6.5.2(b) of the Transitional Rules and cl 6A.6.2(b) of the Rules.

24. Two important parameters in the WACC formula are the nominal risk free rate and the debt risk premium (DRP).

25. In respect of the nominal risk free rate, cl 6.5.2(c) of the Transitional Rules and cl 6A.6.2(c) of the Rules provides that the nominal risk free rate for a regulatory control period is the rate determined for that regulatory control period by the AER on a moving average basis from the annualised yield on Commonwealth Government bonds with a maturity of 10 years using:

    (a)       the indicative mid rates published by the Reserve Bank of Australia; and
    (b)       a period of time which is either:

    (i)a period (‘the agreed period’) proposed by the relevant DNSP, and agreed by the AER (such agreement not to be unreasonably withheld); or

    (ii)a period specified by the AER, and notified to the provider within a reasonable time period prior to the commencement of that period, if the period proposed by the provider is not agreed by the AER under (i),

    and for the purposes of (i);

    (iii)the start date and end date for the agreed period may be kept confidential, but only until the expiration of the agreed period; and

    (iv)the AER must notify the DNSP or TNSP whether or not it agrees with the proposed period within 30 business days of the submission of the building block proposal.

26. In respect of the DRP, cl 6.5.2(e) of the Transitional Rules and cl 6A.6.2(e) of the Rules provides that the DRP for a regulatory control period is the premium determined for that regulatory control period as the margin between the 10 year Commonwealth annualised bond rate and the observed annualised Australian benchmark corporate bond rate for corporate bonds which have a maturity of 10 years and a credit rating of BBB+ from Standard and Poors.

27. A building block proposal must include the total forecast operating expenditure for the relevant regulatory control period which the DNSP or TNSP  considers is required in order to achieve the operating expenditure objectives, which are:

    (a)meet or manage the expected demand for standard control services over that period;

    (b)comply with all applicable regulatory obligations or requirements associated with the provision of standard control services;

    (c)maintain the quality, reliability and security of supply of standard control services;

    (d)maintain the reliability, safety and security of the distribution system through the supply of standard control services

    (see cl 6.5.6(a) of the Transitional Rules and cl 6A.6.6(a) of the Rules).

28. The forecast of required operating expenditure of a DNSP or TNSP that is included in a building block proposal must:

    (a)comply with the requirements of any relevant regulatory information instrument;

    (b)be for expenditure that is properly allocated to standard control services in accordance with the principles and policies set out in the Cost Allocation Methodology for the DNSP or TNSP; and

    (c)include both:

    (i)the total of the forecast operating expenditure for the relevant regulatory control period; and

    (ii)the forecast of the operating expenditure for each regulatory year of the relevant regulatory control period.

    (see cl 6.5.7(a) of the Transitional Rules and cl 6A.6.6(b) of the Rules)

29. The AER is required to accept the forecast of required operating expenditure of a DNSP or a TNSP that is included in a building block proposal if the AER is satisfied that the total of the forecast operating expenditure for the regulatory control period reasonably reflects the operating expenditure criteria, which are:

    (a)the efficient costs of achieving the operating expenditure objectives;

    (b)the costs that a prudent operator in the circumstances of the relevant DNSP would require to achieve the operating expenditure objectives; and

    (c)a realistic expectation of the demand forecast and cost inputs required to achieve the operating expenditure objectives.

    (see cl 6.5.6(c) of the Transitional Rules and cl 6A.6.6(c) of the Rules)

30. A building block proposal must include the total forecast capital expenditure for the relevant regulatory control period which the DNSP or TNSP considers is required in order to achieve the capital expenditure objectives, which are:

    (a)meet or manage the expected demand for standard control services over that period;

    (b)comply with all applicable regulatory obligations or requirements associated with the provision of standard control services;

    (c)maintain the quality, reliability and security of supply of standard control services;

    (d)maintain the reliability, safety and security of the distribution system through the supply of standard control services.

    (see cl 6.5.7(a) of the Transitional Rules and cl 6A.6.7(a) of the Rules)

31. The forecast of required capital expenditure of a DNSP or a TNSP that is included in a building block proposal must:

    (a)comply with the requirements of any relevant regulatory information instrument; and

    (b)be for expenditure that is properly allocated to standard control services in accordance with the principles and policies set out in the Cost Allocation Method for the DNSP;

    (c)       include both:

    (i)the total of the forecast capital expenditure for the relevant regulatory control period; and

    (ii)the forecast of the capital expenditure for each regulatory year of the relevant regulatory control period; and

    (d)identify any forecast capital expenditure that is for an option that has satisfied the regulatory test.

    (see cl 6.5.7(b) of the Transitional Rules and cl 6A.6.7(b) of the Rules)

32. The AER is required to accept the forecast of required capital expenditure of a DNSP or TNSP that is included in a building block proposal if the AER is satisfied that the total of the forecast capital expenditure for the regulatory control period reasonably reflects the capital expenditure criteria, which are:

    (a)the efficient costs of achieving the capital expenditure objectives;

    (b)the costs that a prudent operator in the circumstances of the relevant DNSP would require to achieve the capital expenditure objectives; and

    (c)a realistic expectation of the demand forecast and cost inputs required to achieve the capital expenditure objectives.

    (see cl 6.5.7(c) of the Transitional Rules and cl 6A.6.7(c) of the Rules)

    Requirements relating to draft and final determinations

33. A distribution or transmission determination is predicated on a number of decisions by the AER which include:

    (a)a decision on the DNSP’s or TNSP’s current building block proposal in which the AER either approves or refuses to approve the annual revenue requirement for the provider, as set out in the building block proposal, for each regulatory year of the regulatory control period;

    (b)a decision in which the AER either:

    (i)accepts the total of the forecast capital expenditure for the regulatory control period that is included in the DNSP’s or TNSP’s proposal; or

    (ii)does not accept the total of the forecast capital expenditure for the regulatory control period that is included in the DNSP’s or TNSP’s proposal, in which case the AER must set out its reasons for that decision and an estimate of the total of the DNSP’s or TNSP’s required capital expenditure for the regulatory control period that the AER is satisfied reasonably reflects the capital expenditure criteria, taking into account the capital expenditure factors;

    (c)       a decision in which the AER either:

    (i)accepts the total of the forecast operating expenditure for the regulatory control period that is included in the current proposal; or

    (ii)does not accept the total of the forecast operating expenditure for the regulatory control period that is included in the proposal, in which case the AER must set out its reasons for that decision and an estimate of the total of the DNSP’s or TNSP’s required operating expenditure for the regulatory control period that the AER is satisfied reasonably reflects the operating expenditure criteria, taking into account the operating expenditure factors.

    (see cl 6.12.1(2), (3) and (4) of the Transitional Rules and cl 6A.14.1(1), (2) and (3) of the Rules)

    A distribution determination must also include:

    (a)a decision in relation to the rate of return;

    (b)a decision on the control mechanism for alternative control services; and

    (c)a decision on the additional pass through events that are to apply for the regulatory control period.

    (see cl 6.12.1(5), (12) and (14) of the Transitional Rules).

34. The reasons given by the AER for a draft distribution determination or a final distribution determination must set out the basis and rationale for the determination including:

    (a)details of the qualitative and quantitative methods applied in any calculations and formulae made or used by the AER;

    (b)the values adopted by the AER for each of the input variables in any calculations and formulae, including:

    (i)whether those values have been taken or derived from the provider’s current building block proposal; and

    (ii)if not, the rationale for the adoption of those values; and

    (c)details of any assumptions made by the AER in undertaking any material qualitative and quantitative analyses; and

    (d)reasons for the making of any decisions, the giving or withholding of any approvals, and the exercise of any discretions, for the purposes of the determination.

    (see cl 6.12.2 of the Transitional Rules and cl 6A.14.2 of the Rules)

35. The AER has limited discretion in making a distribution determination with respect to the total revenue requirement for a DNSP and its annual revenue requirement or with respect to a TNSP’s total revenue cap and maximum allowed revenue.  The AER is required to approve the total revenue requirement for a DNSP or TNSP for a regulatory control period, and the annual revenue requirement for each regulatory year of the regulatory control period, as set out in the provider’s current building block proposal, if the AER is satisfied that those amounts have been properly calculated using the post-tax revenue model on the basis of amounts calculated, determined or forecast in accordance with the requirements of Pt C of the Transitional Rules or Pt C of Ch 6A (cl 6.12.3(d) of the Transitional Rules and cl 6A.14.3(b) of the Rules).

1. The AER also has limited discretion in substituting an amount, value or methodology in respect of certain constituent decisions.  If the AER refuses to approve an amount, value or methodology referred to in cl 6.12.1 of the Transitional Rules or cl 6A.13.2 of the Rules, the substitute amount, value or methodology on which the determination is based must be:

   (a)determined on the basis of the current regulatory proposal; and

   (b)amended from that basis only to the extent necessary to enable it to be approved in accordance with the Rules.

   (see cl 6.12.3(f) of the Transitional Rules and cl 6A.13.2 of the Rules)

   The Regulatory Proposals

2. EA, Integral Energy and Country Energy were required to submit a regulatory proposal to the AER for distribution services provided by means of, or in connection with, its distribution system, on or before 2 June 2008.  Each submitted its regulatory proposal to the AER on 2 June 2008.

3. Relevantly, the regulatory proposal submitted was required to include, amongst other things:

   (a)for direct control services classified as standard control services – a building block proposal;

   (b)for direct control services classified as alternative control services:

   (i)the proposed control mechanism, a demonstration of the application of the proposed control mechanism, and the necessary supporting information; and

   (ii)in the case of a departure from the AER’s likely approach to the relevant control mechanisms for alternative control services a statement of the reasons justifying the departure.

4. The regulatory proposal was also required to comply with the requirements of and to contain or be accompanied by the information required by, any relevant regulatory information instrument.

5. The AER released its draft decision and determination on the DNSPs’ respective regulatory proposals in November 2008 and in March 2009 released a supplementary draft decision for alternative control (public lighting) services for the DNSPs.

6. In response to the draft determination, each DNSP was entitled to submit a revised regulatory proposal to the AER not more than 30 business days after the publication of the AER’s draft decision.  Each DNSP submitted a revised revenue proposal on 14 January 2009.

7. In submitting a revised revenue proposal, a DNSP may only make revisions so as to incorporate the substance of any changes required to address matters raised by the draft distribution determination or the AER’s reasons for it (cl 6.10.3(b) of the Transitional Rules). 

   TransGrid’s and Transend’s Revenue Proposals

8. Both TransGrid and Transend were required to submit a revenue proposal to the AER for their transmission services on or before 2 June 2008.  Transend submitted its revenue proposal to the AER on 30 May 2008 and TransGrid submitted its on 31 May 2008.

9. Relevantly, the revenue proposal submitted by each TNSP was required to include, amongst other things:

   (a)a forecast of the required capital expenditure that complies with the requirements of the Rules;

   (b)a forecast of the required operating expenditure that complies with the requirements of the Rules;

   (c)the estimated total revenue cap for each TNSP for the relevant regulatory control period and the maximum allowed revenue for each TNSP for each regulatory year of the regulatory control period using the post-tax revenue model together with details of all amounts, values and other inputs used by the TNSP for that purpose.

10. The AER released its draft decisions on the TNSP’s transmission determination in November 2008.

11. In response to the draft determination, the TNSPs were entitled to submit a revised revenue proposal to the AER not more than 30 business days after the publication of the AER’s draft decision.  Both TNSPs submitted their revised revenue proposals on 13 January 2009.

12. In submitting a revised revenue proposal, a TNSP may only make revisions so as to incorporate the substance of any changes required to address matters raised by the draft transmission determination or the AER’s reasons for it.

    FUNCTION OF TRIBUNAL

13. In view of the submissions made by the parties to the Tribunal, it is necessary to briefly make some observations on the function of the Tribunal.

14. The NEL limits to four the grounds upon which it is open to the Applicants to challenge before the Tribunal the Final Determinations.

15. Attention has been focussed on all grounds, but some comment needs to be made upon the grounds specified in s 71C(1)(c) and (d) – incorrect exercise of discretion and unreasonableness.

16. It is to be observed that the ‘unreasonable’ ground is a separate ground of review.  It is not, as in the Gas Pipelines Access (South Australia) Act 1997 (SA) (‘Gas Law’), related to the error of an incorrect exercise of discretion: see East Australian Pipeline Pty Ltd v Australian Competition and Consumer Commission (2007) 233 CLR 229, 250. The term ‘unreasonable’ does not just provide a basis for informing the presence of one or more of the established grounds which render a decision ‘incorrect’, in the sense of the incorrect exercise of discretion. It provides a separate and distinct ground of review.

17. The question arises then as to when it may be held that the decision under review is ‘unreasonable in all the circumstances’.  For instance, is it limited to so called Wednesbury unreasonableness?

18. On this question, the comments of the Full Court in Australian Competition and Consumer Commission (ACCC) v Australian Competition Tribunal (2006) 152 FCR 33 are relevant, accepting that for the purposes of the NEL (as distinct from the Gas Law), unreasonableness is a separate ground of review.

19. In ACCC v ACT 152 FCR 33, it was stated:

    176     The Tribunal has not been given a purely substitutive function in relation to the review of the ACCC’s discretion. That is to say, if the ACCC has exercised its discretion on correct principles and if the particular exercise of the discretion was open to it within the framework of the Code, the Tribunal is not empowered to set aside that decision simply because it thinks another decision would have been preferable. This is emphasised by the provision in s 39(2)(a)(ii) of the ground of review based on unreasonableness. The exercise of a discretion is not unreasonable simply because another decision-maker would have come to a different view. On the other hand unreasonableness in s 39(2)(a)(ii) is not limited to cases in which the exercise of the discretion was so unreasonable that no reasonable person could have so exercised it.

    177     In Application by Epic Energy the Tribunal (Cooper J presiding) said (at [30]):

    Section 39(2)(a)(ii) is concerned with the correctness or unreasonableness of an exercise of discretion having regard to the circumstances relevant to the proper exercise of that discretion. Those circumstances are ones which are demonstrable from the matters to which the Tribunal may refer under s 39(5). For the purposes of the subsection, error is made out if it is demonstrated that the exercise of the discretion was so unreasonable on the basis of the matters available to the decision maker that no reasonable decision maker could ever come to it: Associated Provincial Picture Houses Ltd v Wednesbury Corporation [1948] 1 KB 223 at 223–234. It also deals with the situation where the decision is so far outside the range of decisions open to a reasonable decision maker that it bespeaks of error even though the particular error cannot be identified: House v R (1936) 55 CLR 499 at 505. For the purposes of s 39(2)(a)(ii) of GPA Law, correctness and reasonableness are to be determined by reference to applicable criteria contained in the Code applied to the matters which were before the relevant Regulator before the decision under review was made.

    That passage does not limit the ground of unreasonableness to so called Wednesbury unreasonableness. It is compatible with the wider view of ‘unreasonableness’ which would pick up logical error or irrationality in the decision. The ACCC’s submission which would limit the unreasonableness ground to so called Wednesbury unreasonableness is not accepted.

    178     The concept of ‘unreasonableness’ imports want of reason. That is to say the particular discretion exercised by the ACCC is not justified by reference to its stated reasons. There may be an error in logic or some discontinuity or non sequitur in the reasoning. It may be that the decision has an element of arbitrariness about it because there is an absence of reason to explain the discretionary choices made by the ACCC in arriving at its conclusion.

20. The Tribunal considers it clear that the scope of the separate ground of review of ‘unreasonableness’ set out in the NEL goes somewhat beyond the so called Wednesbury unreasonableness ground.  To a certain extent, there is an overlap between the exercise of a discretion which is ‘incorrect’, and a decision which is unreasonable having regard to all the circumstances.  If the reasons for a decision contain an element arbitrariness, in the sense of an unexplained discretionary choice made in reaching a conclusion, then it may readily be concluded that the decision itself is unreasonable, and that the exercise of discretion miscarried or was in error.

21. If a decision is not determined by reference to the applicable criteria in the NEL and the Rules, then it will readily lead to a conclusion that the exercise of any discretion in reaching the decision was incorrect, and the decision was unreasonable in all the circumstances. 

22. In considering whether the Applicants have established any ground of review, s 71R limits the matters which the Tribunal may consider on its review to ‘review related matter’ as defined in s 71R(6).  It is only if a ground of review is made out that the Tribunal may allow new information or material to be submitted, and then only if it would assist on any aspect of the determination to be made and was not earlier unreasonably withheld from the AER: see s 71R(3).  Also, s 71O(2) prevents a party to a review, other than the AER, from raising any matter that was not raised in submissions to the AER before the reviewable regulatory decision was made.

23. Therefore, the Tribunal’s review is not at large, but is a review of the AER’s decision on the factual and legal grounds available, but only on the material provided to or before the AER.  Nevertheless, the Tribunal must consider the merits of whether the material provided to or before the AER leads to a finding or findings of material fact different from those made by the AER, or that it exercised its discretion incorrectly, or that its decision in all the circumstances was unreasonable. 

24. Once the Tribunal is satisfied that a ground of review is established, the Tribunal must consider the various options available under the NEL.  One option is to remit the matter to the AER.  The Tribunal has already indicated its approach to the appropriateness or otherwise of remitting the matter to the AER: see Application by EnergyAustralia (2009) ACompT 7 at [30-38].

    COST OF CAPITAL: WITHHOLDING AGREEMENT

25. The first principal issue for determination is whether the AER unreasonably withheld agreement to the original proposed averaging period within the meaning of cl 6.5.2c(2)(i) of Ch 11 of the Transitional Rules.  In addressing the Transitional Rules the Tribunal should also be taken to address the equivalent Rule.

26. A number of principles should be stated which assist in a determination of this issue:

    (a)an interpretation of the Transitional Rules that will best achieve the objective or purpose of the NEL is to be preferred to any other interpretation;

    (b)in determining the averaging period an exercise of discretion by the AER is involved, but such is limited by and subject to express prescriptions otherwise in the Transitional Rules;

    (c)the Applicants have the initial responsibility to propose the averaging period, which the AER is to consider, and then to determine whether there is a reasonable basis upon which the proposal should not be agreed to;

    (d)relevant considerations bearing on the decision to withhold agreement include:

    (i)whether the period proposed is likely to result in an unbiased risk free rate, given that the equity beta and market risk premium are deemed to be 1.0% and 6.0% respectively; and

    (ii)the achievement of the national electricity objective revenue and pricing principles;

    (e)the question of whether the decision of the AER withholding agreement was unreasonable can only be determined by reference to the circumstances under which the decision was made, taking into account the proposal, the information before the AER at the time of its decision, and the purpose, scope and provisions of the NEL and the Transitional Rules;

    (f)there is no legal or economic presumption in favour of any particular averaging period; in deciding whether or not to agree to the proposed period, the AER must consider the period proposed by the Applicants, and determine whether it should withhold agreement to that period based on the period proposed, the information before the AER at the time of its decision, and the purpose, scope and provisions of the NEL and Transitional Rules;

    (g)in considering its decision, the AER may take into account other averaging periods not proposed for the purpose of considering whether to withhold agreement to the proposed period.  However, if the averaging period proposed by the Applicants is otherwise appropriate, the AER cannot withhold consent only on the basis that there is another averaging period which it prefers over that proposed by the Applicants;

    (h)the reasons given by the AER at the time of its decision are to be examined to determine whether the AER has unreasonably withheld its agreement;

    (i)any reasons relied upon by the AER after its decision may also to be examined to determine whether the AER has unreasonably withheld its agreement;

    (j)the focus of the enquiry is upon the decision of the AER to withhold agreement to the proposed averaging period, not whether the proposed averaging period is itself reasonable although that consideration may impact upon an assessment of the decision of the AER to withhold agreement; and

    (k)if the Tribunal came to the view that the AER did unreasonably withhold its agreement, this could amount to either the exercise of the AER’s discretion as being incorrect in all the circumstances (see s 71C(1)(a)) or the AER’s decision being unreasonable in all the circumstances (see s 71C(1)(d)).

27. It is convenient to consider the AER’s response to EA’s original proposed averaging period.  On 8 July 2008, the AER purported to withhold agreement to EA’s original proposed averaging period, proposed a new averaging period for EA of 15 business days commencing on 2 March 2009 and ending on 20 March 2009 (the AER’s proposed averaging period), and invited EA to nominate an alternative averaging period between 1 February 2009 and 20 March 2009.  The critical reasons for which the AER withheld agreement were that:

    (a)the period was too early and thus too far removed from either the commencement of the five year regulatory period or the likely date of the AER’s final determination;

    (b)it was contrary to accepted regulatory practice to adopt a period so early;

    (c)the Capital Asset Pricing Model (‘CAPM’) theory, as interpreted by accepted experts, suggested that the risk-free rate should be calculated on or as close as possible to the day of final determination using the most up to date information; thereby giving an unbiased rate of return consistent with market conditions at the date of the final determination;

    (d)the purpose of an averaging period is to address possible daily volatility in financial markets but within the constraint that ideally one would be measuring the risk free rate at the date of the final determination; and

    (e)to the extent that EA required certainty for purposes of raising capital, it was enough to receive the ultimate regulatory determination.

28. For the purposes of this enquiry, the Tribunal takes the response of the AER dated 8 July 2008 to EA’s original proposed averaging period as representative of the response to the other Applicants.

29. Omitting formal parts, the AER’s response was as follows:

    I refer to EnergyAustralia’s confidential attachment 8.1 to its regulatory proposal dated 2 June 2008 which proposes the averaging period for the nominal risk free rate for the regulatory control period 2009-14.  EnergyAustralia proposed that the averaging period be the 15 business days starting on 2 June 2008.  This proposal was restated in a letter from Geoff Lillis to the AER dated 2 July 2008.

    Clause 6.5.2(c)(2)(iv) of the transitional chapter 6 in the National Electricity Rules (NER) requires the AER to notify a distribution network service provider (DNSP) whether or not it agrees with the proposed averaging period within 30 business days of the date of submission of its regulatory proposal.

    The AER does not agree with the averaging period proposed by EnergyAustralia as the starting date of EnergyAustralia’s proposed averaging period is almost 12 months prior to the commencement of the regulatory control period.  In this regard, the AER considers that the starting date of the proposed period is too far removed from the date by which the AER is likely to publish EnergyAustralia’s final determination, which is expected to be in April 2009, and the commencement of the 2009-14 regulatory control period.  The averaging period proposed by EnergyAustralia is contrary to accepted regulatory practice as reflected in previous AER and ACCC determinations; the ACCC’s Statement of Regulatory Principles and previous jurisdictional regulators’ determinations, all of which apply a nominal risk free rate averaging period considerably closer to the final determination date.

    The AER’s regulatory practice is supported by accepted expert views in economic and finance literature.  Capital Asset Pricing Model (CAPM) theory suggests that, ideally, the nominal risk free rate will be calculated on the day of the final determination.  The CAPM is an ex ante model and therefore the most up to date information should be used if available. 

    Further, applying an averaging period which is closely aligned to the date of the final determination provides an unbiased rate of return that is consistent with market conditions at the time of the final determination.  In this regard the AER notes EnergyAustralia’s concern about the need for certainty in order to manage its commercial risks and the CEG report which expresses the premise that ‘a particular business may wish for greater early certainty about its allowed rate of return’. 2   The AER does not agree that this premise goes to the issue of applying an averaging period, the purpose of which is to address the possible daily volatility in financial markets.  This is because the regulatory determination itself provides a DNSP with certainty in relation to the rate of return that will apply during the forthcoming regulatory control period.  Further, this information is provided to the DNSP prior to the commencement of the regulatory control period.  Accordingly, the AER does not consider that early certainty of EnergyAustralia’s allowed rate of return is necessary for EnergyAustralia to deliver on its proposed capital expenditure program for the upcoming regulatory control period.

    For the above reasons, the AER does not agree that EnergyAustralia’s proposed averaging period is appropriate.  Instead, the AER proposes a new averaging period for EnergyAustralia of 15 business days (the length of EnergyAustralia’s proposed averaging period has not changed) starting on 2 March 2009 and ending on 20 March 2009.  The AER accepts EnergyAustralia’s request that the averaging period be kept confidential.  It also intends to use the new averaging period to establish the commercial debt margin.  The AER’s proposed averaging period takes into account the time required for it to conduct financial modelling using the risk free rate, final determination drafting and the decision making process.

    If EnergyAustralia does not agree with the dates proposed by the AER, EnergyAustralia has until 14 August 2008 to write to the AER and nominate an alternative averaging period between 1 February 2009 and 20 March 2009.

    If you have any questions in relation to this matter please contact Scott Haig on [phone].

    See, e.g., Martin Lally, The cost of capital for regulated entities, report prepared for the Queensland Competition Authority, 26 February 2004, p.63; Martin Lally, Determining the risk free rate for regulated companies, report prepared for the ACCC, August 2002, p.14; Kevin Davis, Report on risk free interest rate and equity and debt beta determination in the WACC, report prepared for the ACCC, 28 August 2003, p.16.

    2 Competition Economists Group, Nominal Risk Free Rate, debt risk premium and debt and equity raising costs for EnergyAustralia, Attachment 8.2 of EnergyAustralia’s regulatory proposal, 2 June 2008.

1. The place to start in making any assessment of the AER’s decision is the Transitional Rules themselves and the NEL, under which the Transitional Rules were made.

2. The Transitional Rules provide the context for the proposing of an averaging period, but the proposal must be in accordance with the NEL, and more specifically with the national electricity objective and the revenue and pricing principles set out in s 7 and s 7A, respectively.

3. The principles in s 7A can be taken to be consistent with and to promote the objectives in s 7.  The principles are themselves stated normatively in the form of what is intended to be achieved.  They state that the price charged by a Network Service Provider (‘NSP’) for its service should allow a return commensurate with the regulatory and commercial risks involved in providing the service in the context that the NSP should be provided with a reasonable opportunity to recover at least the efficient costs it incurs and with effective incentives in order to promote economic efficiency with respect to the services it provides.  Economic efficiency includes efficient investment in the system with which it provides services, efficient provision of services, and efficient use of the system.

4. It is well accepted in the literature of regulatory economics and in regulatory practice that all these efficiency objectives are in principle met by setting prices for services that allow the recovery of efficient costs, including the cost of capital commensurate with the riskiness of the investment in the assets (infrastructure or ‘system’, as the term is used in the NEL) used to provide services.

5. It might be asked why the NEL principles require that the regulated NSP be provided with the opportunity to recover at least its efficient costs.  Why ‘at least’?  The issue of opportunity is critical to the answer.  The regulatory framework does not guarantee recovery of costs, efficient or otherwise.  Many events and circumstances, all characterised by various uncertainties, intervene between the ex ante regulatory setting of prices and the ex post assessment of whether costs were recovered.  But if, as it were, the dice are loaded against the NSP at the outset by the regulator not providing the opportunity for it to recover its efficient costs (eg, by making insufficient provision for its operating costs or its cost of capital), then the NSP will not have the incentives to achieve the efficiency objectives, the achievement of which is the purpose of the regulatory regime.

6. Thus, given that the regulatory setting of prices is determined prior to ascertaining the actual operating environment that will prevail during the regulatory control period, the regulatory framework may be said to err on the side of allowing at least the recovery of efficient costs.  This is in the context of no adjustment generally being made after the event for changed circumstances.

7. The Transitional Rules, consistently with these principles, set out procedures for determining efficient costs, including the cost of capital, ie, the return on capital.

8. It is important to note that under the Transitional Rules the cost of capital is not the actual cost to the NSP of raising finance (debt and equity).  The cost of capital is assessed by use of an economic theory, the CAPM, which in broad terms states that the cost of capital of a project is determined by the riskiness of the project relative to investment in the market as a whole, or equivalently, on average.  In fact, there are two levels of abstraction from the actual NSP in making the calculation.  The first is to measure the cost of capital ‘by the return required by investors in a commercial enterprise with a similar nature and degree of non-diversifiable risk as that faced by the distribution business of the provider’ (cl 6.5.2(b)).  The second is to use the weighted average cost of capital (WACC) formula derived from the CAPM to estimate that required rate of return.

9. This approach is not driven merely by a practical need to find a procedure that can generate an estimate of the firm's cost of capital, but is based on an important principle.  The principle being that the rate of return required by investors (and hence consistent with efficient investment) depends on the risk of the investment.  The principle is embodied in s 7A(5), as mentioned above.

10. The rate of return, or WACC, is applied to the value of the regulatory asset base of the NSP as at the beginning of a regulatory year to produce the return on capital (in dollar terms) for that regulatory year (cl 6.5.2(a)).  (The regulatory asset base is updated each year (cl 6.5.1(e)(2).)  Thus the WACC is applied in each of the five regulatory years within the regulatory control period.  It follows that the WACC to be applied each year should in principle be the rate of return required by investors at the beginning of that year.  This rate of return would naturally be expected to differ from year to year.

11. That is not, however, the scheme set out in cl 6.5.2.  Rather it provides for a single value of the WACC to be calculated and applied to each year's starting regulatory asset base.

12. The WACC formula has five inputs, viz. the equity beta, the market risk premium, the debt to equity ratio, the risk free rate, and the debt risk premium.  The first three of these are given deemed values in cl 6.5.2(b).  The choice of those values implies that the equity of NSPs is deemed to have the risk characteristics of the market as a whole.  The risk free rate is defined in cl 6.5.2(c) but is to be averaged over a period, as described above.  The purpose of averaging is to smooth day-to-day volatility that might make the choice of any particular day's rate in some way unrepresentative or inappropriate.  The debt risk premium is defined in cl 6.5.2(e) such that the cost of debt of NSPs is deemed to be the benchmark corporate bond rate for corporate bonds which have a maturity of 10 years and a credit rating of BBB+ from Standard and Poors.  Deciding this benchmark rate is a matter for determination by the AER.

13. On the face of it, this set of inputs and formula generates a rather strange rate of return estimate.  The risk free rate, whether agreed or specified, is, it seems to be agreed by all parties, that which prevails at some time (the averaging period) prior to the start of the regulatory control period; similarly with the benchmark corporate bond rate.  Those inputs might generate a rate of return value reasonably close to that actually required by investors at the start of the regulatory control period, and applied to the first year's starting regulatory base.  But with changes in market conditions over the regulatory control period, it is hard to see why the rate of return value would represent the return required by investors at, say, the start of the final year of the regulatory control period.

14. In the meantime, the risk free rate and corporate bond rates would almost certainly have varied from their initial values.  Consequently, there appears to be no virtue in setting those rates at values that prevailed close to the start of the regulatory control period, or to the publication of a final determination.

15. It may be accepted that, as the AER stated in its letter of 8 July 2008, its own regulatory practice and the practice of regulators more generally has been to apply a nominal risk free rate averaging period closer to the start of the regulatory control period.  This practice has been supported by economic experts.  The Tribunal observes, however, that this is not a universal practice.  In market conditions that are not wildly out of the norm, this may be expected to provide a figure that is fairly close to being an unbiased estimate of the risk free rate consistent with market conditions at the time of the final determination; and may consequently be expected to provide a reasonable estimate of the rate of return on capital that would be required by investors at the time of the final determination.

16. But as explained above, there is no proper basis for seeking such an estimate.  The views of economic experts appear to be based on a model where the regulatory control period is considered to be a single period (of five years), not five consecutive one-year periods.  In the scheme set out in the Transitional Rules, the nexus is broken between the period to which the rate of return applies and the period for which that rate of return is estimated.  Once that is realised, the basis for withholding agreement to an averaging period proposed by EA falls away.

17. It is useful to consider on what basis the AER might reasonably withhold agreement to an averaging period proposed by an NSP.  The only clear ground is that the period proposed would be likely to generate a rate of return that was inappropriate, ie, too high or too low having regard to the period in which it was to be applied.  No doubt that is the ground that the AER ultimately had in mind when it did withhold agreement.  Bolstered by regulatory practice and economic expert opinion, it considered that setting the risk free rate and hence the rate of return so far ahead of the period to which  it would apply was less likely to provide an appropriate return than was setting the rate of return at a period closer to when it would apply.

18. Putting to one side the Tribunal’s approach as set out above, the AER otherwise had no basis upon which to reject the averaging period proposed by the EA without further enquiry.  Rather than assume that the rate at a closer date would give a better estimate, the AER should have examined the evidence regarding expected future rates.  Such evidence of forward interest rates, ie, rates that will apply at some future time for a prospective period, is available from market data.  Comparisons could be made between rates expected to prevail during the averaging period proposed by the NSP and rates expected at later periods.  But it follows from the Tribunal's reasoning that it would be insufficient and inappropriate to only compare with rates expected to prevail close to the time of the final determination.

19. Given the uncertainties involved in forecasting future interest rates, withholding agreement to an NSP's proposed averaging period may be reasonable where market data indicated an expectation that rates would be considerably lower during the regulatory period than at the proposed period.

20. There is no suggestion that the AER made such an assessment prior to making its decision to withhold agreement to the proposed averaging periods.  However, in its Final Decision the AER did appeal to the fact that in June 2008 the yield curve for Commonwealth Government Securities (‘CGS’) was downward sloping.  This, the AER said, reflected prevailing market expectations that interest rates would be lower in the future.  Therefore, setting the risk free rate based on the proposed averaging periods (in June, July and August 2008) would lead to systematic ex ante overcompensation of firms relative to the efficient cost of capital.  This argument was repeated in the AER’s submissions to the Tribunal.

21. It may be noted that the NSPs’ regulatory proposals were made in May 2008, before the June yield curve came into existence.  However, nothing crucial has been said to hinge on whether a yield curve for June or (say) May is examined.  The AER was silent as to precisely what can be deduced from the downward-sloping yield curve beyond that it reflected market expectations of lower interest rates in the future.  Which interest rates?  How much lower?  When in the future?

22. The yield curve at a given time does indeed provide the basis for estimating market expectations about interest rates that will apply in future periods.  But it does not do so without further analysis.  By itself, it shows only what rates apply at the time the curve is calculated – June 2008 in this case – for securities with varying maturity.  Thus the downward sloping yield curve as at June 2008 showed that in June 2008 CGS maturing in two years’ time provided a lower yield than CGS maturing in one year’s time; a security maturing in three years’ time provided a still lower yield; and so on.  From examination of the chart in the Final Decision, it appears that yields were falling from just over 7 per cent for a security maturing in June 2009 to a little less than 6.6 per cent for a security maturing in June 2018.  That is not a large difference.

23. But the Rules prescribe that the risk free rate is a ten-year rate for CGS.  What the AER needed to do, and apparently did not do, was inquire as to what the yield curve implied about how the ten-year risk free rate would change in the future.

24. The method for doing so is well established.  Consider an investor who has $1 to invest and wants his capital returned in two years’ time (say).  He knows the interest rate at which he can invest for two years, and therefore what total return (capital and interest) he could receive in two year’s time.  He also knows the interest rate he could obtain now for investing the $1 for only one year.  If he invests now for only one year, what interest rate will need to be available to him in a year’s time so that he can then reinvest and achieve the same total return as he would if he invested for two years now?  This is the rate that is expected to prevail in the market in a year’s time.  For if that expected future rate were higher than needed for the investor to be indifferent between his two choices, he would do better by investing now for one year and then reinvesting.  Other investors would see things the same way, and the expected future interest rate would be driven down until it was such as to exactly equalise the expected returns.

25. By a generalisation of this logic, the so-called forward interest rates expected to apply at future dates can be calculated.  One consequence is that for the yield curve to slope downwards it is sufficient for the market to expect a fall in short-term interest rates.

26. Counsel for EA submitted calculations prepared by its expert, Dr Hird, of the ten-year CGS expected, as at June (and alternatively May) 2008, to apply on 25 February 2009.  The precise significance of this date will become clear later, but it is closer to the date of the Final Determinations than were the proposed averaging periods.  The Tribunal accepts that the methodology used is the well established one outlined above.  It notes that the methodology relies on assumptions beyond the factual information embedded in the yield curve.  Any methodology must.

27. Without accepting as facts the specific results of the calculations provided by counsel for EA, the Tribunal finds that the yield curve provided by the AER was not a sufficient basis to lead it to the conclusions stated above, viz. that using the proposed averaging periods would lead to systematic ex ante overcompensation of firms relative to their efficient cost of capital.

28. For these reasons, we consider that the AER’s decision, as expressed in its letter of 8 July 2008, to withhold agreement with the averaging periods proposed to it was unreasonable.  The AER’s submissions in support of its decision all fail because it did not have sufficient reason to believe that the proposed averaging periods were unlikely to produce an unbiased estimate of CGS rates in the regulatory control period, once it is properly understood how those rates are applied under the Transitional Rules.

29. In its written submission in reply, the AER resiled substantially from the position with respect to the yield curve that it had expressed in its Final Decision and its earlier submissions.  It stated that it pointed to the trend in the yield curve, not in defence of its decisions to withhold agreement to the proposed averaging periods, but as illustrating why, in April 2009, the AER discounted the certainty argument advanced by the NSPs for their choice of those periods.  In this context the Tribunal notes that, in reaching its decision, it has in any case placed no weight on the Applicants’ expressed desire for certainty regarding the WACC for the purpose of securing capital for its investment program.  An NSP is entitled to take whatever considerations it wishes into account in proposing an averaging period.  However, neither the NEL nor the Rules provide any basis for the regulator taking account of a desire for certainty of that kind.  As the AER correctly pointed out in its letter of 8 July 2008, the very process of determining an NSP's allowable revenue provides certainty with respect to the rate of return that will apply.  In any case, there is evidence that NSPs may or may not arrange the raising of finance to coincide with the averaging period, and that hedging arrangements are available to deal with risks associated with financing.

30. Moreover, the NEL and Rules seek to ensure that an NSP operates and invests efficiently in the manner of a firm in a competitive environment.  Such a firm would never have the luxury of knowing its revenues years in advance.

31. In light of the above, the Applicants have demonstrated that the AER exercised its discretion incorrectly, or its decision in this respect was unreasonable, for the purposes of establishing a ground of review under s 71C(1)(c) and (d).  The Tribunal is thus empowered to act under s 71P(2) of the NEL.

    WHAT AVERAGING PERIOD SHOULD BE APPLIED?

32. Having decided that the AER unreasonably withheld agreement with the averaging periods proposed by the Applicants in their original regulatory proposals, the Tribunal must decide what averaging period should apply. 

33. On the basis of the submissions put by the parties, three categories of possible averaging periods arise for consideration:

    •Those originally proposed by the Applicants, from which, the Tribunal has found, the AER unreasonably withheld agreement.  These periods differ from one NSP to another but all fall within the months of June, July and August 2008.

    •Those set out in the Applicants’ Revised Proposals, which again differ, but all fall within the period ending 5 September 2008.

    •The period specified by the AER:  2-20 February 2009.

34. The Applicants sought a decision by the Tribunal that adopted their revised proposed averaging periods or, as a second preference, their originally proposed averaging periods.

35. The Tribunal has already explained above that it sees no special virtue in an averaging period close to the date of the AER’s final decision (if indeed February be considered close to the end of April).  In addition, it accepts the Applicants’ submissions that by late April 2009 it was apparent that yields on CGS in February and March were at an unusually low level.  The only relevant facts agreed among the parties are that on 15 January 2009 the yield had fallen to 3.89 per cent, its lowest level in the 40 years since the Reserve Bank of Australia commenced publishing data in July 1969; and that, by comparison, between 1998 and mid 2008 the yield tended to range between 5 and 7 per cent and exceeded 6 per cent for most of the year immediately preceding the AER’s final decisions.  The average rate during the AER’s averaging periods was around 4.3 per cent. 

36. The Applicants submitted that these facts demonstrated that basing a risk free rate on the AER’s specified averaging periods would not achieve the objective of an unbiased rate of return consistent with market conditions at the date of the final decision.  They appealed to expert opinion that the market risk premium was far higher than its deemed value while the risk free rate was abnormally low, so that the return required by investors was much higher than the AER’s specified averaging period would generate. 

37. The AER argued that the decrease in official (ie, short term) interest rates – a policy response to the softening economic outlook – should not be ignored and that the AER could not assume that a low risk free rate was a short term phenomenon.  It considered that the February 2009 averaging periods did not represent an abnormal period in relation to the observed CGS yields.  The AER submitted that any argument that the actual market risk premium was out of kilter with the deemed value could not justify choosing an averaging period so as to consciously generate a higher risk free rate in compensation, nor would such a method of choice be permissible under the Rules.  However, this does not help the Tribunal in now deciding what averaging period to apply.

1. TransGrid seeks a review of the AER’s final decision to reduce its forecast opex by $13.5 million, a figure arrived at by reducing its forecast defect maintenance for new growth assets by $15 million and then allowing $1.5 million for non-recoverable and non-routine costs.

2. If found in favour of TransGrid, the first and foremost issue agitated by the parties under this heading (whether, in circumstances where the average age of TransGrid’s asset base will remain relatively stable over the next regulatory period (2009-2014), its acquisition of new growth assets skew TransGrid’s forecast opex for defect maintenance) is determinative of the question of error.  TransGrid submitted that other issues addressed by the parties (such as the extent of defects in new growth assets, the scope of warranty cover for them and the reasonableness of the AER’s decision based on advice from an expert which raised issues requiring further investigation) would not need to be decided.  While the Tribunal will need to return to that submission, the focus in the following paragraphs, which chronicle how the AER arrived at its decision, is on the first and foremost issue.

   The meaning of ‘defect maintenance’

3. TransGrid defines ‘routine maintenance’ as scheduled inspection and preventive maintenance, and ‘defect maintenance’ as maintenance addressing out-of-specification conditions that may affect the performance or reliability of the transmission network. This definition of defect maintenance captures all costs of a non-routine nature, some of which are required on a regular basis based upon condition analysis.

   The meaning of ‘new growth asset’

4. The term ‘new growth asset’ is short hand for an asset added to TransGrid’s system which results in the growth of the system, as distinct from an new asset that merely replaces an existing asset.  Expenditure on new assets in the next regulatory period is estimated to be approximately $2.5 billion, of which $1.58 billion will be for new growth assets and the balance on replacement assets.

   TransGrid’s May 2008 regulatory proposal

5. TransGrid’s opex model adopts 2006-2007 (adjusted for scope changes that will not be reflected in the forecast years) as the base year for forecasting its opex.  The key inputs to the model are:

   (a)routine maintenance forecasts; 

   (b)defect maintenance ratios; 

   (c)major operating projects forecasts; 

   (d)labour cost escalators; 

   (e)asset growth factors; 

   (f)economy of scale factors; and 

   (g)base year costs and adjustments.

6. TransGrid’s May 2008 regulatory proposal arrived at its opex forecasts by: 

   (a)building up from a ‘zero base’ a routine maintenance forecast for its existing asset base, thus allowing the forecasts to reflect cyclical requirements and to be adjusted for changes in scope when an asset is replaced with new equipment that requires less maintenance; and 

   (b)basing its defect maintenance forecast on an expected ratio of defect maintenance hours to routine maintenance hours as an average across all assets in particular asset classes. 

7. More particularly, the defect ratios are based on historic performance of asset types as appears from the following Table which appeared in the parties’ Agreed Statement of Facts:

Work stream	2005-05	2005-06	2006-07	Opex forecast
Lines	109%	72%	93%	95%
Substations	34%	114%	116%	115%
Communications	231%	232%	196%	200%
Secondary Systems	49%	28%	29%	30%
Land and Easements	732%	82%	48%	46%

Opex associated with new capex is calculated by multiplying the controllable opex associated with each category by the capex growth for each category (as a percentage) and an economy of scale factor (typically 95%).

1. The agreed Statement of Facts (omitting footnotes) states:

   Under TransGrid’s opex model an increase in the asset base increases the operating expenditures required to service the increased asset base.  An asset growth factor is therefore applied to the routine maintenance units for each maintenance category in each year.  The asset growth factor is the amount of capital expenditure on new growth divided by the existing asset base.  Therefore, if the asset base is $1 billion and there are new assets in the relevant year of $10 million, then the asset growth factor for that year will be 1%.

2. Applying its model, TransGrid’s May 2008 regulatory proposal forecast defect maintenance of $152 million ($2007-2008).  The AER’s draft decision noted that this represents an increase of approximately 28% compared to TransGrid’s defect maintenance expenditure in the current regulatory control period.

   The first PB report

3. To assist it in its consideration of TransGrid’s regulatory proposal, the AER sought expert advice from PB on, amongst other things, the appropriateness of the methodology used by TransGrid to forecast its opex. 

4. Observing that TransGrid’s opex model assumes that: 

   (a)the amount of additional operating expenditures is directly related to the increase in new assets under management; and 

   (b)the business is operating under a ‘business as usual’ scenario,

   the November 2008 PB report (the first PB report) contends that significantly larger forecast growth related capital works programs than those in place up until 2006-2007 will impact on the reasonableness of the opex forecasts the model produces.

   TransGrid’s response to a draft of the first PB report

5. Provided with an opportunity to comment on a draft of the first PB report, TransGrid’s September 2008 response commenced by explaining that: 

   (a)its model used defect ratios based on the historic performance of the asset base; 

   (b)the asset base consists of a range of old and new assets; and 

   (c)the defect ratio is based on this range in the age of the assets. 

6. Building on that explanation, TransGrid submitted that while it is likely that a proportion of new assets will require little in the way of defect maintenance, other new assets will require significant effort to address early life issues.  In addition, there will be an increasing number of assets moving from the random failure part of the ‘bathtub curve’ (illustrated below) into an area of increasing probability of failure, therefore increasing maintenance costs.

7. TransGrid’s response went on to submit that its ‘business as usual scenario’, which PB challenged, was supported by TransGrid’s modelling of the impact of the significant increase in new growth assets when included in a network of already aging assets.  This modelling found that the average system age, and the average age for most asset classes, remains reasonably stable through the next regulatory period.

8. TransGrid’s response also asserts that as the average age of the significant asset classes is not decreasing substantially over time, the average defect ratio for the range of assets will not change substantially.  It notes that: 

   (a)for a system such as its, with an average age in the centre of the ‘Random Failure Zone’ of the ‘bathtub’ curve, a significant shift in the average age is required to change the failure rate (defect cost); and

   (b)while a change in technology may result in changes to the defect ratio overall, expects this to be evolutionary rather than revolutionary and the opex effects will not result in a step change.

   The AER’s October 2008 draft decision

9. The AER’s October 2008 draft decision accepts that: 

   (a)the average age of most of TransGrid’s asset classes may not decline over time; and 

   (b)new assets may require some defect maintenance expenditure and notes that: 

   (c)it is condition rather than age that drives defect maintenance; and 

   (d)it did not consider the required defect maintenance expenditure to be significant.

10. Noting that TransGrid developed its defect ratios based on the historical performance of its assets, the draft decision observes that, as a result of a 200% increase in capex, TransGrid’s asset base will change considerably during the next regulatory period.

11. Agreeing with an adjustment proposed by PB and removing the defect maintenance costs for new growth assets, the AER draft decision states: 

    (a)this will result in the efficient costs that a prudent operator in the circumstances of TransGrid would require to achieve the opex objectives, as required by cl 6A.6.6(c) of the Rules; and 

    (b)TransGrid advised that the adjustment results in a reduction of $15 million ($2007-2008) to its forecast.

    The SKM report

12. To assist it in preparing its revised regulatory proposal, TransGrid requested SKM to provide an assessment of the first PB report, in particular, the asset growth escalation component of PB’s review.  After considering TransGrid’s opex model, its response to a draft of the first PB report and the report itself, the SKM report concludes that: 

    (a)TransGrid has been prudent and efficient in its modelling; and 

    (b)the adjustment to its opex forecast recommended by PB is not warranted. 

13. Based on pertinent detail in its report, SKM’s conclusion notes, amongst other things:

    TransGrid’s modelling is based on historic defect rates (which include defects on new asset) and the proposed capital investment programme does not materially alter the average age of any asset type.  Consequently, the defect rate across the network could be expected to remain at the same level as that experienced historically.

    TransGrid’s January 2009 revised regulatory proposal

14. TransGrid’s January 2009 revised regulatory proposal submits that there is no reasonable basis for the AER to reduce its forecast opex for defect maintenance of new growth assets because, amongst other things, its proposed acquisitions of new assets will not result in a significant change to the average age of its asset base and therefore defect rates will not be affected by the acquisitions. 

15. A graph provided in support of TransGrid’s submission shows that average age of TransGrid’s assets is reasonably stable over the next regulatory period.  This, the revised proposal says, leads to a conclusion that there would be no expectation that defect rates would be impacted by the acquisition of any new assets.

16. Challenging the AER’s assertion that new assets will not incur significant defect maintenance expenditure as un-supported by evidence, TransGrid’s revised regulatory proposal provides a graph of the ratio of defect v routine maintenance expenditure against the commissioning date of its assets.  This graph shows that defect costs for newer assets are significantly higher across all TransGrid’s asset categories.

17. Responding to the draft decision’s observation that the 200% increase in capex will change its asset base considerably, the revised regulatory proposal submits that: 

    (a)based on the evidence TransGrid has provided, the increase in new assets would be expected to lead to an increase in defect costs;  and

    (b)there is no basis for concluding that there should be no allowance for defect maintenance of these new assets.

18. TransGrid’s revised regulatory proposal on the defect maintenance issue concludes by: 

    (a)referencing and attaching a copy of the SKM report; and 

    (b)submitting that the evidence strongly supports its position that new assets will require an amount of defect maintenance at least equivalent to the requirement for mid-life assets and that it had included such an amount in its revised opex forecasts.

    The second PB report

19. To assist it in assessing the issues raised in TransGrid’s revised regulatory proposal, the AER again sought the assistance of PB.  PB provide a report (the second PB report) which generally confirms its earlier recommendation but does allow a moderate amount to compensate for: 

    (a)the non-routine but regular maintenance included in TransGrid’s definition of defect maintenance; and 

    (b)some costs associated with TransGrid organising and managing works under warranty. 

20. In the absence of specific data to support the magnitude of the amount, the second PB report recommends $300,000 per annum as a reasonable estimation of the amount that the AER should allow.

21. While the second PB report accepts at a macro level the conclusion in TransGrid’s revised regulatory proposal that defect rates would not be impacted by new assets, the report: 

    (a)notes, amongst other things, that over the period 2009 to 2012 the average age of the critical asset class of substations is reduced slightly; and 

    (b)states that it believes that the impact on specific asset classes is significant. 

22. In support of this statement, the second PB report refers to a graph of TransGrid’s average maintenance cost per switchbay over a two year period against various asset commissioning dates which, it says, shows that the average maintenance costs for newly commissioned switch-bays are lower than those for switch-bays commissioned during previous regulatory periods.

23. The second PB report concludes its review of TransGrid’s revised regulatory proposal by observing that as the TransGrid opex model uses system averages to forecast opex, it will tend to overstate the defect rectification expenditures required for newly commissioned assets.

    The AER’s April 2009 Final Decision

24. It is apparent from the AER’s Final Decision that the AER: 

    (a)reviewed TransGrid’s revised regulatory proposal, the SKM report and TransGrid’s answers to the AER’s questions along with the second PB report; and 

    (b)responded to each of TransGrid’s submissions as outlined above.

25. The foundation for the AER’s decision to reduce TransGrid’s forecast opex for new growth assets is a belief, based on PB’s advice, that the significant increase (200%) in TransGrid’s capex (in particular $1.58 billion for new growth assets), compared with TransGrid’s opex model’s base year, skews the model’s asset growth input and impacts on the reasonableness of the opex forecasts.  That is, based on PB’s view that TransGrid’s model assumes a ‘business as usual’ scenario, it is inappropriate to include new growth assets as an input to the model - this view being modified to allow the ‘reasonable and moderate’ amount of $300,000.

    The Tribunal’s consideration of TransGrid’s defect maintenance

26. It is common ground that: 

    (a)over the period 2005-2009, the average age of TransGrid’s assets was increasing – its capex program in this period was insufficient to maintain a constant system age; 

    (b)TransGrid has a growing and maturing asset base; 

    (c)during the next regulatory period, end of life issues will be more significant than has been the case in the past; 

    (d)the average system age and the average age for most asset classes will remain reasonably stable throughout the next regulatory control period; 

    (e)in the absence of a capex replacement program, the average age of the assets will progressively increase; and 

    (f)if there were no expenditure on new assets, over the next regulatory period an increasing percentage of assets would move from the random failure zone of the ‘bathtub curve’ into the wear out zone and average defect maintenance costs would be expected to rise. 

27. In reaching its decision, the AER focused on new growth assets and ignored what may occur to TransGrid’s system overall.  The new growth assets will merely slow the rate of the system overall, not render it younger than the base period used to calculate TransGrid’s defect ratios.  The AER’s approach that more new assets with lower defect rates will necessarily lead to lower defect rates in the next regulatory period ignores what is common ground, namely, that end of life issues will be more significant than has been the case in the past.

28. TransGrid’s defect rates are defect rates averaged across its system as a whole.  While in the next regulatory period there will be more new assets, because the system as a whole continues to age, there will also be more old assets.  Based on system age alone, the defect ratios in that period will be even higher than in the base year and TransGrid’s assumption of a constant defect ratio may be conservative.

29. As to the issue of what PB say is a key category of substations showing an age trend different from that contended by TransGrid, although the average age of substations may reduce a little in 2010, having regard to the base year, they do not really change much and after 2010 their age commences to increase again.  Thus, compared to the base year and the measurement period of 2005 through to 2007 for the defect ratios, no assumption favourable to the AER may be drawn from the substation average life. 

30. If TransGrid were replacing aging assets with new assets and adding new growth assets, looked at it statically the average age would reduce.  Average age should, however, be examined dynamically over the next regulatory period.  The end of the regulatory period (2014) is years on from the base period (2005).  While the addition of new growth assets may have a temporary impact in 2009/2010, the system will continues to age because the new assets will age. 

31. As described by counsel for TransGrid, PB’s view of ‘business as usual’ is ‘inapt’.  The base period was a period in which new assets were insufficient to replace ageing assets and was a period during which the system was ageing.  In the next regulatory control period, while there will be less of an ageing system, there will be a system that will age slightly overall.  This means that the average defect ratios, calculated over the base period, may be appropriately applied to the system overall for the next regulatory period.  The assumption made by PB and the AER in separating out new growth assets, that they would somehow reduce the average system wide rate of defects, is wrong.  Applying ordinary mathematical concepts, it is reasonable for TransGrid to apply an average defect ratio to the system that will emerge in the next regulatory period. 

32. The AER was wrong to: 

    (a)exclude defect maintenance in respect of new growth assets;

    (b)proceed on a basis that TransGrid would incur zero defect expenditure in respect of new growth assets; and 

    (c)assume that the existing pool of ageing assets, that is, assets other than the new growth assets, would have the same level of defects as in the base period. 

33. To put it another way, by disallowing the majority of defect maintenance opex for new growth assets, the AER assumed a constant set of defects for the remaining assets. 

34. In accepting PB’s advice that as TransGrid’s opex model uses system average ages to forecast opex, it tends to overstate the defect rectification expenditures required for new assets, the AER is saying it is wrong to apply an average rate of defects to new assets, because that overstates the defect level of new assets.  But that is not what TransGrid is doing.  TransGrid is not applying average defect rates to new assets.  TransGrid is applying average defect rates to the whole system and it therefore applies them to the old assets, (which have higher levels of defects), the mid-life assets, (which have medium levels of defects) and the new assets, (which have a level, albeit contested, of defects).  By removing one element to which the averaging is applied, the AER destroys the integrity of the averaging system as a whole.

35. If the impact of the new growth assets were to bring down TransGrid’s system age, the AER’s approach may be appropriate.  But that will not be the impact of the new growth assets. 

36. For the above reasons, TransGrid has established that either the AER exercised its discretion incorrectly, or its decision was unreasonable in all the circumstances.

37. As observed, TransGrid submitted that if the Tribunal were to reach a conclusion that the AER was in error on this first issue agitated by the parties, it need not decide the other issues addressed by the parties.  TransGrid did, however, also concede that whether new assets had higher or lower rates of defect maintenance costs than the average was a relevant issue, albeit far less important than system average age.

1. That is because, even if average system age stays constant, the question remains whether recently commissioned assets tend to have the same defect maintenance costs as those commissioned some years ago.

2. The AER argued before the Tribunal that if system average age remains constant, defect rates are likely to fall because newer technology will reduce defect ratios of assets commissioned in the 2009-14 regulatory period compared with defect ratios of new assets commissioned in previous regulatory periods. 

3. The AER did deal with this in its Final Decision.  However, based on PB’s reports, its concern remained that new growth assets have little or no defect maintenance costs – which, as explained above, is not the relevant consideration in excluding them from the averaging system.  Consequently, the AER was diverted into consideration of whether any, and if so what, costs are covered by warranty.  In dismissing TransGrid’s material suggesting the opposite of PB’s expectations, the AER accepted PB’s position that in the absence of further investigation (for which there was no time), it was not prepared to alter its view.  In short, whether defect maintenance costs for newly-commissioned assets are falling over time is unresolved.  The relevance of such a trend, if it exists, is its effect on overall average defect maintenance costs.  Over the relatively short span between the base period and the current regulatory period, the effect seems likely to be small.

   The Tribunal’s conclusion on TransGrid’s defect maintenance costs

4. In light of the above reasons, the Tribunal will set aside the AER’s decision in relation to reducing TransGrid’s forecast opex and remit the matter back to the AER to make the decision again.  Unless it has material to quantify any likely decrease in average defect maintenance costs due to growth assets, the AER should make the decision on the basis that TransGrid’s forecast opex is calculated using its opex model with asset growth factors.

   GENERAL OBSERVATIONS

5. In the course of submissions, a number of legal issues were raised that have not been necessary to consider in detail or to finally determine.

6. Nevertheless, as the Tribunal has had the benefit of extensive legal analysis upon some issues, it may be useful to state, in summary form, the Tribunal’s position:

   (a)As to the construction of cl 6.5.2(c)(2)(i) and (ii) of the Transitional Rules (and the equivalent Rules), the Tribunal considers that once a period has been agreed, there seems to be no mechanism by which that period of time can be altered. 

   Where a period is specified by the AER, then the AER could alter this decision and specify another period of time.

   However, in the case of a specified period, only if the NSP waives the requirement for notification within a reasonable time prior to the commencement of the period, can the specified period be a past period.  Otherwise, the period of time specified would need to be a future period of time.

   (b)The Tribunal, once an error is found to exist within the meaning of s 71C of the NEL, has the same powers of the AER.  In essence, the Tribunal could agree with the proposals of the Applicants (original or otherwise), once the specified period is set aside.  This is what the Tribunal has done in this review, agreeing to the revised proposals of the Applicants.  Alternatively, the Tribunal could specify a period of time, constrained in the same way as would be the AER. 

   In making its own decision, the Tribunal is bound to consider the submissions of the parties, and may (not must) allow new information or material to be submitted if the new information or material is of the type described in s 71R(3)(a) and (b). 

   (c)If an error is found to exist in a constituent decision of the AER, then it may be necessary to consider how it impacts upon the ‘reviewable regulatory decision’ (as defined in the NEL) to the extent that the constituent decision itself is not a reviewable regulatory decision.  Therefore, as an example, it is possible that an error of fact may be made in a constituent decision which is not material to the reviewable regulatory decision (as defined), or an error is made in a constituent decision which is unreasonable, but does not make the AER’s reviewable regulatory decision (as defined) itself unreasonable.  In the case of an incorrect exercise of the AER’s discretion, an error occurring in a constituent decision may or may not impact upon the reviewable regulatory decision.  If it does not impact upon the reviewable regulatory decision in such a situation, it may be that a ground of review is established, but the Tribunal in exercising its powers under s 71P(2) may still affirm the reviewable regulatory decision.

   (d)The grounds under s 71C do not directly embrace ‘procedural’ errors, such as failure to comply with s 16 of the NEL, any common law requirement of procedural fairness, or failure to consider submissions or give reasons as specifically required by the Rules.  Section 71C(1)(d) specifically focuses on the unreasonableness of the AER’s decision itself.  Section 71C(1)(c) focuses on the exercise of the AER’s discretion being ‘incorrect’.  Section 71C(1)(a) and (b) are directed to errors of fact in the findings of fact.  However, if for instance, the AER does not take into account a submission of a provider, then that may result in the exercise of the AER’s discretion being incorrect, as not taking a relevant matter for consideration, either the submission itself or a matter raised in the submission that was not taken into account by the AER.  Depending on the circumstances, a ground of review may be established (such as failing to take into account the submission), but the Tribunal may still affirm the AER’s decision (such as where the matter raised in the submission was independently and properly considered by the AER in any event). 

   (e)The Tribunal has not relied upon any contested non ‘review related matter’ (see s 71R(1) and (6)) in order to arrive at its determination in this case.  However, the Tribunal has considered the contested non ‘review related matter’ for the purposes of considering whether it would impact upon its determination.  Even if the non ‘review related matter’ was to be considered by the Tribunal for the purpose of its determination, the Tribunal is satisfied that none of the non ‘review related matter’ would impact upon its conclusions and determination. 

   Difficult questions may arise as to the scope of ‘review related matter’ where the AER specifically uses or refers to only part of a report or material in making a reviewable regulatory decision.  Does that mean that other parts of those reports or material not specifically used or referred to are ‘relied upon’ by the AER in making the ‘reviewable regulatory decision’ within the meaning of s 71R(6)(e)?

   No one answer can be given to this question.  If the reference made to part of a report or material is dependent, for instance, on another part, either to give meaning or explain the actual reference made by the AER, then presumably the AER has ‘relied upon’ the rest of the report or material to the extent necessary to giving meaning to or explain the actual reference made by the AER.

   However, this does not mean, that in an appropriate case, the Tribunal may not need to consider new evidence, if an issue arises as to the scope of the ‘review related matter’.  For instance, a factual issue may arise as to whether a report was relied upon by the AER in making the reviewable regulatory decision.  Section 71R(1) of the NEL would not prevent the Tribunal from performing its statutory function and employing its own general procedural powers to make a factual finding on this question to determine whether, in undertaking the actual review of the reviewable regulatory decision, the report was able to be considered by the Tribunal.

   (f)Looking at the purpose and scope of s 71O(2) and s 71R(1) and (6) of the NEL, the matters to which the Tribunal can have recourse include the subject matters raised, the issues raised and the materials relied upon in support of the position or proposal put forward by the Applicants’ to the AER prior to the final determinations, as being relevant to those determinations.  It is only if a matter, whether by way of argument or evidentiary material, cannot be identified as broadly arising out of a matter fairly raised before the determinations under review were made, that it will not be permitted to be raised in the review: see in Application by Epic Energy South Australia Pty Ltd (2003) ATPR 41-932 at [24] and also Application by East Australian Pipeline Ltd (2005) ATPR 42-047 at [9].

   (g)Many submissions were received upon the nature and characterisation of the correspondence between the Applicants and the AER on the proposed and revised averaging periods.  There was no doubt that agreement by the AER to the original proposed averaging period was withheld, and upon this basis the Tribunal has reached its conclusion.  The Tribunal does not need to consider the nature and characterisation of the correspondence, for having come to the conclusion that an error of review under s 71C has been made by the AER in its decision to withhold agreement to the original proposals, the Tribunal is empowered then to perform all the functions and exercise all the powers of the AER under the NEL or the Rules (s 71P(3)).  On any view, the Tribunal may now agree to one of the proposed averaging periods put forward by the Applicants.  As to which proposal, the Tribunal needs to evaluate the position as at the time of its determination based upon the review related matter, or any new information or material it allows to be submitted pursuant to s 71R(3).

   (h)For the purposes of this determination only, the Tribunal has proceeded on the basis that there is no material difference between any versions of the Transitional Rules or the Rules to the extent that any alterations have been made since any of the proposals of the Applicants were submitted to the AER.  This was the position accepted by the parties.

   (i)The Tribunal is mindful that in considering the reasons of the AER, it is important to recall that the reasons are there to inform and are not to be scrutinised in a over-zealous way seeking to discern error from the way in which the reasons are expressed: see eg Minister for Immigration and Ethnic Affairs v Wu Shan Liang (1996) 185 CLR 259, 272. It is all a matter of degree, as an obvious inadequacy of the reasons may amount in any given case to an error in the process of fact finding or the exercise of a discretion. The Tribunal refers to its comments in the Application by EnergyAustralia (2009) ACompT 7 at [16].

   CONCLUSION

7. The Tribunal directs that the parties confer and submit appropriate minutes of determination in accordance with these reasons. 

8. The Tribunal again takes this opportunity to express its gratitude to the legal representatives of the parties and those instructing them for their assistance to the Tribunal in this complex review. 

I certify that the preceding three hundred and fourteen (314) numbered paragraphs are a true copy of the Reason for Determination herein of the Honourable Justice Middleton (Deputy President), Mr R Davey and Mr R Shogren.

Associate:

Dated:       12 November 2009

Counsel for the Australian Energy Regulator:	Mr P Hanks QC with Mr P Gray, Mr P Wallis and Dr V Prisich
Solicitor for the Australian Energy Regulator:	Corrs Chambers Westgarth
Counsel for EnergyAustralia:	Mr JT Gleeson SC with Mr P Brereton SC
Solicitor for EnergyAustralia:	Gilberg + Tobin
Counsel for Southern Sydney Regional Organisation of Councils:	Mr FM Douglas QC with Mr WAD Edwards
Solicitor for Southern Sydney Regional Organisation of Councils:	HWL Ebsworth
Counsel for Transgrid:	Mr A Meagher SC with Mr C Moore
Solicitor for Transgrid:	Gilbert + Tobin
Counsel for Intergral Energy:	Mr R Dick SC
Solicitor for Intergral Energy:	Gilbert + Tobin
Counsel for Transend:	Mr A Payne SC with Mr JA Arnott
Solicitor for Transend:	Gilbert + Tobin Lawyers
Solicitor for Nyrstar Australia:	O’Donnell Salzano Lawyers
Counsel for Country Energy:	Mr JRJ Lockhart SC
Solicitor for Country Energy:	Gilbert + Tobin
Date of Hearing:	10, 11, 12, 13, 14, 17, 18, 19, 20, 21 August 2009
Date of Reasons for Determination:	12 November 2009