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New Zealand's New Regulatory Regime: Incentive schemes for grid expansion [free access]

March 1, 2012

World over, electricity transmission infrastructure expansion and pricing practices are receiving increasing regulatory scrutiny. Traditional cost-based (or rate-of-return) regulation is giving way to incentive regulation as it is being increasingly realised that the traditional mechanisms may not be able to meet regulatory goals of maximising overall welfare. The transmission utilities or companies are being provided with incentives to lower costs, improve efficiency and share the benefits with the consumers. This is being done to ensure that necessary investments are made to maintain reliability of electricity supply and even more so now to secure adequate integration of mandated clean energy resources and smart technologies into the grid. Incentive schemes also provide regulatory certainty and help in mitigating financial risks for prospective investors.

 

New Zealand has also been gradually introducing a more defined incentive regulation in its electricity network industry. Transpower – the sole owner and operator of New Zealand’s electricity transmission grid – is now being regulated under the new individual price-quality path (IPP) method. The IPP method governs Transpower’s maximum revenues for each year for each regulatory period. This new form of regulation was announced in December 2010 and took effect from April 1, 2011.  The initial price-quality path is set for a four-year period (up to June 2015). The second price-quality path will be set for a five year period.

 

The new IPP regulation is not very different from the previous one (under the administrative settlement regime). While Transpower will remain subject to a cap on annual revenue, each annual revenue cap will be set at the start of each regulatory period. Thus the revenue cap is an ex-ante forecast of Transpower‘s revenue needs, for each year of the regulatory period, with which its pricing must comply. This ex-ante revenue cap is called the forecast maximum allowable revenue (MAR). At the end of each year, an MAR is calculated (as opposed to the forecast MAR). The purpose of this is to recalculate an MAR on an ex-post basis for the past year, and assess performance of that past year against actual expenditure, rather than forecast expenditure. A “wash-up” is undertaken each year, which is the difference between the MAR (not the forecast MAR) and actual revenue gathered. The end result of this wash-up is an economic gain or loss which is shared with the customers. The purpose of the wash-up process is to ensure that Transpower receives the correct return on its actual investment (rather than forecasts of investment), and to remove the forecasting risk relating to certain costs.

 

In order to set Transpower’s forecast MAR for each year of a given regulatory control period, the regulator Commerce Commission specifies the levels of operating expenditure and capital expenditure. Capital expenditure is categorised into two types: minor and major. Minor capital expenditure comprises replacement, refurbishment and enhancement projects, information systems and technology projects; and business support capital expenditure. Major capital expenditure comprises grid upgrade projects and is subject to individual approval. No provision is made to allow substitution between major capital expenditure projects. Major capital expenditure projects were reviewed by the former regulator, the Electricity Commission, prior to November 1, 2010. Requests for approval after that date are subject to review by the Commerce Commission.

 

Transpower will also be subject to quality standards, with targets, caps and collars being applied. An incentive mechanism will apply from 2015/16, which will place a portion of Transpower‘s revenues at risk.

 

As a part of the incentive regulation process, the regulator also finalised the input methodologies (defining the ground rules) in December 2010 to deal with issues relating to cost of capital; asset valuation (including depreciation and treatment of revaluations); cost allocation (between activities, businesses, consumer classes and geographic areas); treatment of taxation; pricing methodologies; and regulatory processes and rules.

 

A key input methodology that the Commerce Commission recently finalised (on January 31, 2012) deals with Transpower’s capital expenditure. The Commission is responsible for approving Transpower’s major grid upgrades. The capital expenditure input methodology includes:

 

 

Transpower plans to invest around NZD5 billion over the next decade in critical infrastructure upgrades, most of which are needed to accommodate the increasing share of renewable energy into the grid. The input methodologies are aimed to ensure that Transpower’s investment expenditure is subject to an appropriate level of scrutiny. They matter because they influence Transpower’s investment decisions and cost and consequently the prices paid by consumers. The underlying intention of the new regime is to deliver greater certainty so as to create more predictable regulatory outcomes and foster efficient investment and not to burden the consumers with excessive price hikes.

 

The above-mentioned steps more or less complete the strategy for setting in place a well-defined incentive-based regulatory framework for Transpower. One element in the regulatory framework is Transpower’s Information Disclosure rules, which will be released in the second half of 2012.

 

Thus with key initiatives in place, New Zealand is bringing in an open and certain regulatory regime for the benefit of both investors and customers. These steps will ensure a check on the monopoly transmission grid operator’s (Transpower’s) expenditure and share economic benefits of the electricity infrastructure expansion with the customers.

 

Table 1: Transpower’s yearly maximum allowable (MAR) revenue up to June 2015 (NZD million)

Regulatory year ending 30th June

2013

2014

2015

Forecast MAR

783.8

906.4

958.9

Pass-through costs

13.4

14.4

15.4

Recoverable costs

9.7

10.0

4.8

Forecast revenue

806.9

930.8

979.1

MAR: Maximum allowable revenue

Source: Transpower