All Eyes on Electricity Regulators' Price Reset
Over the past two years, Victoria's privatised electricity businesses have been on a merry-go-round of analysis and lobbying. The focus has been on Victoria's Regulator-General, John Tamblyn. The major issue has been the 2001 price re-set for line charges, which comprise 30-50 per cent of the final cost of electricity.
In the Kennett Government's privatisation, the five electricity distribution businesses sold for $8.5 billion---twice the book value of the assets. Since the 1995 reforms which preceded privatisation, they have all achieved considerable productivity gains. The rural based Eastern Energy, for example, has made operating cost savings of 22 per cent. Even greater savings were made in the metropolitan based businesses, large parts of which were previously owned by municipal authorities which even made the SEC appear efficient. Thus, CitiPower has achieved operating cost savings of 38 per cent.
Most people consider electricity lines to be mainly (some say overwhelmingly) natural monopolies. Hence the need for a regulated price overseen by two key puppeteers:
* efficiency incentives: and the greater the profit left in the hands of the owners, the greater is their incentive to find more productivity improvements; and
* controls on price gouging: with governments determined to deliver lower prices to electricity customers.
One reality check on the 2001 price re-set will be subsequent share market or takeover activity. In the UK in 1995, failure to provide sufficient reductions saw rapid share price increases., forcing an embarrassing revisit of the decision. One problem with this reality check is asymmetry---although leaving more profits with the businesses than investors expected will boost share prices, the adverse productivity incentives from under-pricing will only become apparent over time.
This direct focus on profits was not what the Kennett Government originally had in mind in its electricity reform and subsequent privatisation. The requirement on the Regulator-General was to re-set electricity charges based on price not profit control. However the Regulator-General knows that the harshest and most politically powerful criticisms will be visited on him if he sets prices too high. As prospective profits are the best gauge of this, in a classic use of Orwellian New-speak, he has interpreted the 'explicit price capping' approach he is required to use, as offering him license to use a form of profit control.
Price re-sets in utility industries overseas have usually incorporated two key elements, an initial cut to account for productivity gains in the preceding period and an annual reduction (the X-factor) to account for forecast productivity increases. The Regulator-General has indicated that he prefers to use only the X factor so that the businesses get to keep efficiency savings longer and have a stronger incentive to find new cost savings. But he has also indicated that 'windfall' gains that are not due to the management skills of the businesses will be handed back in lower prices from the outset. And he wants to adopt a wide definition of these 'windfall' gains.
UK developments offer a guide---chilling for the electricity businesses---on the outcome for the Victorian re-set. There, the regulator eventually reduced line charges by about 25 per cent at the 1995 re-set and imposed an annual X-factor real price reduction of 3 per cent. In the re-set of December 1999, the UK regulator has reduced line charges by a further 23 per cent and maintained the 3 per cent annual price reduction.
This has already brought pressure on some business's share prices, including GPU, the owner of Victoria's gas and electricity transmission lines. The Wall Street reaction from the price reduction forced on GPU's UK subsidiary brought a change in the firm's strategy, including a proposed sell down of its Victorian holdings.
On first assuming office the Kennett Government raised then progressively lowered prices to end customers. It also required the new distribution businesses to reduce line charges of 1-1.92 per cent per annum. This was a form of X-factor impacting only on contestable customers. Non-contestable customers, those not free to choose their own electricity supplier, now comprise only households and the smallest businesses. The 2001 price re-set also coincides with freeing all customers' choice of supplier.
The scale of the X-factor and other price reductions so far required of the Victorian businesses would appear to be considerably less than those of the UK. Even though the UK businesses sold at a steep discount to their book value and those in Victoria fetched twice that value, the productivity improvements demanded of the businesses at the time of corporatisation now seem modest.
But this does not reduce the difficulty of setting prices to achieve a profit goal. Shortly before Christmas, the Regulator-General issued a report that tried to summarise and compare each of the five distributors' price proposals. However, the myriad different price and service bases defied the ability to standardise them.
This points to the need for a simpler method, perhaps one that draws upon the principles used over a century ago when natural monopoly utilities first emerged. The nineteenth century procedures put in place required a specific sharing of profits with customers, in the form of price reductions, for profits above a threshold. A modern variation of this may be to set prices based on an anticipated level of profits and require a share of profits above this to be handed back in the form of lower tariffs. The share could even be on a progressive rate scale.
In the next week or so the Regulator-General is to put out an Issues Paper on the distribution businesses' proposals. The sheer complexity of the price/quality mix in electricity and the likelihood of a substantial waste of resources in the analyses counsels in favour of greater simplicity. If a profit based approach to tariff setting is inevitable, it is best to make maximum use of an explicit profit sharing formula rather than persisting with the attempt to establish a synthetic profit forecast as a base for prices.