Merit in COAG’s regime review

Ever laid awake at night wondering about Gamma and its relationship with Theta? If you have, you might be a mathematician, or linguist, or given you are reading this you just might be part of the energy industry insiders that lives the Limited Merits Review (LMR). The Council of Australian Governments (COAG) Energy Council has tasked its Standing Committee of Officials with examining the LMR regime.

Broadly speaking, the LMR provides a basis for the correction of material errors of fact, the incorrect exercise of discretion and (curiously) unreasonableness in the regulator’s decision making.  Unfortunately, because of the narrow nature of this basis, the LMR regime may not afford a proper opportunity for the overall balance of a regulatory determination to be considered.  The COAG Energy Council has raised its concerns that the LMR reviews are routine and that this does not complement the desired objective of the review process – namely, regulatory certainty and stability - nor the long term consumer interest. 

The opportunity for a regulated business to choose the issues it wishes to review has, in the view of governments and others, led to applications for a review of regulatory determination becoming the norm.  The COAG Energy Council is considering how to best reform the LMR through the introduction of a binding rate-of-return guideline, developed by the AER, covering the financial models, formulas, and market values to be applied by it in setting each network business’s revenue or pricing determination and with relevant elements of the regulator’s decision not subject to merits review. This would be binding on all parties in the determination process, such that regulated businesses must make proposals which give effect to it, and the AER is unable to act contrary to it in making determinations for each business.

This approach does raise the important question as to how much can be ‘locked in’. Broadening the scope of market values incorporated into a binding rate of return to other financial parameters, such as inflation, for example, may help minimise the tendency for either regulator or the regulated to seek ‘decisions’ that keep their options open.  This locking in could on the one hand represent a clear benefit.

However there are also risks.  Let’s consider the case of the inflation example. It is true that inflation has been able to be predicted relatively accurately using past and current values, and this historical performance has led some to believe that there would be benefit in using it to forecast actual expenses.  On the other hand it may become increasingly difficult to forecast inflation beyond 12 months in a world-wide economy that is subject to disruptions, for example, to available money supply.  This represents a clear risk.

Inflation aside, many of the existing Weighted Average Cost of Capital (WACC) parameters lend themselves to the establishment of methodologies and/or formulae that could be incorporated as rules into the rate of return rule.  Fixing a method or a formula may be the preferred approach.  This is because when you fix a number or a value (rather than a method) to the WACC parameters the risk may increase, especially given that the binding Rate of Return (ROR) could cover decisions over a five-year period, and be used for five-year decisions.  Could we be confident for instance that 10 years into the future any minor miscalculations in values in the WACC won’t translate to major increases or shortfalls in revenue?

As the COAG Energy Council has identified, reviews are costly, time consuming and unpredictable.  This may be true, but it doesn’t seem plausible that a binding rate of return rule could be so perfectly designed so as to provide no grounds for review.  As a matter of principle, and in order to ensure that appropriate checks and balances provide legitimacy and stability in regulation, we should maintain that revenue determinations must still ultimately be reviewable.  The binding rate of return rule could not be infallible.

Grounds for any in period review should be limited to the extraordinary.  The regulators will, and must be able to continue to, make binding decisions that are unpopular with some.  In standing up to powerful vested interests, some propose that the criteria for any within period review should be limited to extraordinary circumstances.  Extraordinary circumstances are clearly both unexpected and not in the course of ordinary operations.  Extraordinary circumstance should also require consideration as to whether the trigger is a suitably rare event.    

Even in a strengthened LMR framework, the reform program is still only partially effective where there is no effective consumer participation in the LMR. The COAG Energy Council isn’t convinced that there is effective consumer participation in any LMR and it appears they suspect that the costs, formal nature and the complexity of oral hearings discourages broader consumer participation in reviews.  In light of this, the COAG Energy Council wanted consideration given to moving away from oral hearings. 

The AEC’s view is that the key risk of not moving away from oral hearings is that consumer views will continue to go unrepresented.  The great majority of submissions come from either the regulated businesses or their investors.   Add in the legal counsel and other costs of oral hearings and the consumer participation rate would likely fall further.  The process changes are essential to simplifying participation. 

The threshold tests that apply to any review are also under consideration by the Project Team.  The COAG Energy Council has stated its preference for (and indeed its intent is for) a higher threshold to be met before any review.  To achieve this may require either or both of:

• Removing the ability to lump together small issues for their collective impact, making each individual issue meet the financial threshold for review; and
• Applying a materially preferable test with reference to the National Electricity Objective (NEO) or National Gas Objective (NGO) with the requirement to demonstrate that a materially preferable decision under the NEO or NGO exists.

This latter point would require more explicit demonstrations in any application for review that the overturning of the AER decision will lead to a materially preferable outcome under the NEO or NGO. 

The COAG Energy Council Project Team have also been tasked to recommend who should bear the costs of a review.  There is a number of ideas in the Project Teams papers including the regulated businesses financially support consumer and other groups (the AER and Minister included) in the LMR process.

Reforms that would require the regulated business party to a LMR bear the costs of each of the AER, consumer group and Ministerial participation in the review.  One fear is that this approach may provide perverse incentives to actually increase the number of reviews through a ‘no regrets’ approach to reviews. The AEC’s view is that the capability and capacity of consumer representation should be developed continuously within groups such as Energy Consumers Australia that would allow them to participate effectively in the AER’s consultation and any consequent LMR.  Funding for consumer groups through the current energy funding models is the preferred approach, with those consumer groups then determining what allocation of their funding is best applied to the LMR. 

Governments have deep enough pockets to look after their own costs, and the regulator needs to be resourced sufficiently to allow it to budget for appeals participation where necessary. Any regulator has to be able to stand behind the rigour and quality of its own decisions.  It is a reasonable fear that when a regulator does not bear the costs of bad decisions that the quality of those decisions may diminish.  The introduction of the rate of return guideline should help reduce the number of reviews, and so the level of costs required of all participants.

The issues are and will remain complex and we cannot predict all changes of circumstances that would affect a binding RoR determination over a long period.  The consequences of incorrect parameters can be large, and so the AEC supports maintaining a review process.  The LMR consultation is taking important steps to address the COAG Energy Councils concerns and to find ways for stakeholders (other than the regulator and the regulated) to provide a meaningful contribution to determinations.