Economic Regulation: Learnings from other sectors and application to water in NZ

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1 Economic Regulation: Learnings from other sectors and application to water in NZ Anton Murashev, May 2018

2 SUMMARY What is economic regulation? Economic regulation vs. other interventions Why governments choose economic regulation How does economic regulation work? Lessons from other sectors and jurisdictions The Big Questions to think about 2

3 What is economic regulation? One tool for Government to keep utility revenues in line with reasonable costs of providing the service Not tied to any particular ownership or governance structure and can aim to address a range of problems Problem 1. The utility is efficient, but keeps revenues well above reasonable costs (e.g. to extract monopoly profits) 2. The utility is efficient, but average tariffs are below actual costs (e.g. for political reasons) 3. The utility is inefficient, revenues are below actual costs, but above reasonable costs 4. Revenues are at reasonable cost, but some customers cannot afford service How economic regulation can help Limit revenues to no more than reasonable costs Provide a neutral, authoritative view on reasonable costs and revenues to support higher revenues; ensure long term financial sustainability of utility As above, and also support effective governance and incentive structures to promote efficiency Allow for cross-subsidies between customer categories to support policy objectives 3

4 Economic regulation vs. other interventions Government has several tools to achieve social, environmental, safety, and consumer protection objectives - Ownership Own the utility and tell it exactly what to do - Fiscal Incentives Give subsidies and tax incentives for specific desired outcomes (carrot) - Economic regulation Make and enforce laws and regulations through penalties, compulsion and incentives (stick & carrot) Economic regulation often overlaps with other forms of regulation 4

5 Why economic regulation? Prices/Revenues Some utilities, including water, are natural monopolies customers cannot choose between competing providers To make profits or cover inefficiencies, monopolies may: - charge prices well above cost - provide bad service Traditional regulation focuses on keeping prices/revenues down to: - stop utilities (especially privately-owned ones) from extracting excessive profits - put pressure on government-owned utilities to improve efficiency and reduce prices 5

6 Why economic regulation? Service levels Regulation also sets service levels to ensure customers receive the service they desire and are willing to pay for - Privately-owned utilities may try to reduce service levels to cut costs and increase profits - Government-owned utilities may charge low prices for poor service, even where customers are willing to pay more for better service - If service levels change, so too should costs and therefore revenues Charging below cost does not help consumers and can drive - poor service - asset deterioration - inability to invest to meet growing demand Economic regulation can result in much-needed service level improvements, funded by appropriate revenues 6

7 Service Standards How does economic regulation work? Building Blocks Existing Assets New Capital Expenditure + Regulated Asset Base x Reasonable Rate of Return (Cost of Capital) = Target Return on Assets + - Depreciation/ Capital Asset Maintenance + Maximum Allowed Revenue + Actual Operating and Maintenance Expenses Efficiency Adjustment and changes beyond utility s control Allowed Operating and Maintenance Expenses Pricing Methodology Customer Contract 7

8 Lessons from other sectors and jurisdictions In Electricity and Gas, excessive profits are usually the focus - NZ, AU, UK all have similar regimes focused on reducing prices - NZ eventually exempted consumer-owned electricity distributors from economic regulation, because they don t have a profit motive In Water, improving quality of service is often the focus - UK early stages: OFWAT used Q factor to allow extra revenues for capital costs of improving service to meet mandatory standards - Developing countries: Economic regulation often drives higher quality of and access to service, funded by tariff increases (Bogota, Colombia is on example of this) 8

9 Lessons from other sectors and jurisdictions Halfway houses don t work - NZ Electricity Lines Business Thresholds Regime tried to re-invent the regulatory wheel by regulating without regulating - In the end, it simply created confusion: the Part 4A thresholds regime is generally regarded as creating too much uncertainty for businesses and does not provide adequate incentives for investment in infrastructure - And was replaced with something more orthodox When private businesses are involved, the Opening Asset Base becomes a one-off battleground - Massive impact on establishing base price/revenue level - Contentious and subjective, no impact on future investment incentives, but huge value transfer between utilities and customers - Examples: Electricity Regulatory Regime, Gas and Airports inquiries 9

10 The Big Questions For Industry: Is economic regulation the right tool? If economic regulation were implemented - How would a regulator set required service levels? - How would a regulator calculate the Opening Asset Base? For Water Utilities: What is my estimate of my Opening Asset Base? Do I have an asset management and investment plan that tells a coherent story? (How will I meet the required service levels, and what will it cost?) How do my expenses compare to my peers and other benchmarks? Do my revenues reflect my building blocks costs (at least on a forwardlooking basis)? 10

11 Contact Us Anton Murashev Managing Director New Zealand & Pacific Castalia anton.murashev@castalia-advisors.com Paris 6, Rue Duret Paris France Sydney Young Street Sydney, NSW 2000 Australia Wellington Level 2, 88 The Terrace PO Box Wellington New Zealand Washington 1747 Pennsylvania Ave NW Suite 1200 Washington DC 20006, USA New York 200 Park Avenue Suite 1744 New York, NY 10166, USA Bogotá Carrera 7 No Torre 1, Oficina 1424 Bogotá Colombia