Capital drivers in the energy distribution sector

By Andrew Reeves. Australian Energy Regulator chairman (acting).

The Australian Energy Regulator (AER), which began operation in 2005, is an independent statutory authority and part of the Australian Competition and Consumer Commission (ACCC). It regulates electricity networks and gas pipelines in southern and eastern Australia (and gas pipelines in the Northern Territory), enforces energy market law and monitors wholesale energy markets. The AER will take on additional roles in retail energy markets under new legislation expected to be introduced in 2010. The AER also assists the ACCC on energy competition matters such as merger reviews and energy authorisations.

One of our key roles under the national energy framework is to approve the revenues and prices that electricity network businesses may earn from the services of transporting electricity to customers. We undertake a similar role for gas pipelines, but under a framework that derives prices for reference services. The AER has taken steps towards a more transparent and consistent approach to network regulation – although there are some obvious challenges in moving away from the mix of approaches applied by the states and territories under previous arrangements.

The AER determines revenues on the basis of projected efficient capital and operating expenditure needed to meet expected demand and licence conditions. We also assess an appropriate benchmark rate of return. While our role is to approve what is needed for efficient service delivery, network businesses have significant discretion as to how they spend their allowances in response to changing circumstances and priorities. There are also mechanisms to reward businesses for efficient investment and operating programs-balanced with incentives for reliable services.

The energy network sector currently faces a number of challenges that are driving higher levels of investment. The key drivers are:

• more rigorous licensing conditions for network security and reliability;

• load growth and rising peak demand;

• new connections; and

• the need to replace ageing assets.

Other drivers include challenges associated with climate change policies and the introduction of smart meters and grids.

While the energy frameworks establish a consistent approach to assessing capital requirements, the AER takes account of the differing circumstances faced by each network. For example, each network has unique issues relating to its age and technology, load characteristics, the costs of meeting the demand for new connections, and licensing and reliability requirements. The AER takes account of these differences to make determinations that reflect the needs of each network. Recent determinations have allowed for capital expenditure increases of up to 94 per cent in nominal terms, but have scaled back the proposals of some network businesses by substantial margins where increases have not been justified.

By way of illustration, it may be useful to consider some of the differences in the operating environments of the Victorian, South Australian and Queensland electricity distribution networks, on which the AER has made determinations this year, keeping in mind the Victorian decision is still in draft form. These are the first determinations for each network under the national regime, and contrasting outcomes in this transitional period in part reflect the mix of approaches applied under previous arrangements.

There are some similarities between the investment drivers for Queensland and South Australia. The Queensland networks have pressing capital requirements associated with population growth, new connections and industrial demand, as well as rising energy use per customer due to the increasing penetration of air conditioning. The networks have also been obliged to improve their performance in response to stricter reliability standards.

More than half of the expanded capital program for South Australia relates to load growth and rising peak demand. The network also needs to address reliability risks associated with ageing assets. Investment costs in both Queensland and South Australia have also been rising due to real increases in the cost of labour and materials.

The environment in Victoria is somewhat different. On the whole, the Victorian distributors operate mature and comparatively reliable networks. The AER considers that in a relatively stable operating environment, past expenditure provides a good starting point for assessing future needs. From this base, the recent AER draft determination took account of projected changes in expenditure related to rising demand, reliability requirements and increased costs – but did not accept the full extent of the proposed increases to meet these needs. It also allowed for prudent bushfire mitigation, but did not pre-empt any changes in regulatory requirements being considered by the Victorian Bushfires Royal Commission and the Victorian Government. In the event of new regulatory requirements, the AER will review whether any changes to network allowances are required.

The capital drivers for gas distribution networks are broadly similar to electricity distribution. The AER’s recent determination for the New South Wales networks approved higher capital expenditure to meet demand growth and maintain network capacity. The underlying investment drivers included rising connection numbers, the development of renewal and replacement infrastructure to maintain the capacity of ageing networks, and infrastructure to support changes in market operations.

Differing capital requirements between the networks are one of many factors that contribute to different price impacts on consumers. The retail impacts are obviously greater in those networks with substantial capital requirements. The price impact in Victoria was mitigated by the relatively stable operating environment, coupled with greater efficiencies in service performance and growth in electricity sales.

One factor that will increasingly emerge as an investment driver in all networks is government policy to mitigate climate change. With an expected influx of new low-carbon generation plant, the connection framework supporting remote generators – and the transmission network framework more generally – are being reviewed to ensure future network investment is efficient. The issues include how best to co-ordinate the connection of new remote generators, such as wind generators, to the networks. There are also challenges in finding innovative ways of responding to rising peak demand. When combined with appropriate tariff structures and communications technologies, smart meters are one way to reduce peak and overall demand by giving customers the information needed to manage their consumption more efficiently. The Council of Australian Governments has committed to a national rollout of smart meters where the benefits outweigh the costs. Victoria began a rollout of smart meters in 2009.

Smart grids take the concept of smart meters further towards direct control of load, the use of communications technology to rapidly detect and switch around faults to minimise supply disruptions and the integration of embedded generation to support the network. The Australian Government has committed $100 million for a trial of smart grid technologies. EnergyAustralia will develop Australia’s first commercial scale smart grid across five sites in New South Wales.

While smart grids will require investment, it does not automatically follow that this will be above existing levels. In many cases it may be about reallocating priorities. Ultimately we should see lower capital and operating spending due to better utilisation and operation of the networks.

With distribution charges accounting for around 40 per cent of retail energy costs, energy customers will expect rising expenditure allowances to be reflected in improved services – for example, through reliability outcomes, a better range of services, and in the longer term, more efficient networks with more competitive and differentiated pricing structures. The evidence shows that rising capital and operating expenditure over the past few years has enabled the networks to deliver reasonably stable reliability. The average duration of outages per customer in the National Electricity Market has been generally around 200-250 minutes per year, allowing for regional variations (see figure on opposite page). Consumers will expect these outcomes to be maintained or improved, especially in those networks where capital investment is driving higher prices.

In summary, a range of factors are driving higher levels of investment in Australia’s energy distribution networks. The relevance of each factor varies from network to network, depending on such issues as load profile, the stage of a network’s life cycle and the regulatory environment for licensing and reliability requirements. The AER takes full account of the relevant issues for each network when assessing efficient capital requirements.