BEST PRACTICE REGULATION IN THE NSW URBAN WATER SECTOR

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1 BEST PRACTICE REGULATION IN THE NSW URBAN WATER SECTOR Phillip Dixon 1, Dr Kris Funston 1, Stephen Nelson 1 1. Sydney Water Corporation, Sydney, NSW ABSTRACT Recent, high-profile reports have highlighted the need for better economic regulation of the urban water sector in Australia 1. This paper sets out Sydney Water s current thinking on its proposals for improving economic regulation of the urban water sector. We will be submitting final proposals to the Independent Pricing and Regulatory Tribunal of New South Wales (IPART) in June However, we believe they could be applied across Australia. We look to enhance the existing framework through a suite of complementary incentives that promote greater cost efficiencies and better outcomes for customers. We suggest they be phased-in over the next two price periods ( and ). INTRODUCTION Economic regulation of monopoly utilities is wellestablished. Rate-of return regulation was dominant in the United States in the 20 th century. Work by Averch and Johnson (1962) spurred its gradual replacement by other forms of price control. In particular, work by Professor Stephen Littlechild and Professor Michael Beesley in the 1980s to develop price-cap regulation in the United Kingdom (UK) (Littlechild, 1983) led to the spread of this regulatory model around the world 2. Since then, economic regulation has continued to evolve 3. Further work by Laffont and Tirole (1993) on incentives in regulation was significant, and was recognised in 2014 with the award to Tirole of the Nobel Memorial Prize in Economic Sciences. Effective economic regulation relies on regulators achieving the right balance of controls and freedoms to incentivise monopoly firms to pursue the profit motive while protecting consumers from the worst excesses of monopoly behaviour. Economic regulation was always a means to an end (competitive markets), not the end itself. 1 Harper (2014), Frontier Economics (2014) 2 Mirrlees-Black (2014) outlines that more than 20 OECD countries adopt price cap regulation for at least one regulated industry. 3 See for example Ofgem (2010). A best practice regulatory economic framework should provide firms with incentives to pursue efficiencies (i.e. to do the right thing) allocative, productive, and dynamic efficiency. Incentives need to be targeted to ensure the regulated businesses seek to deliver outcomes that are desirable from the perspective of society. A strong, incentivebased regulatory system will align the regulated business financial outcomes with the benefits and costs it creates for customers. Regulators have recognised the benefits to customers from incentivising regulated firms 4, in terms of lower prices, greater efficiencies and better service levels. In other words, if firms have more control over decisions and the ability to use real time information, then they can choose how they deliver on outcomes and which projects they prioritise. It can also mean that firms are encouraged to innovate more than they otherwise would. This flexibility can lead to more cost effective solutions (and hence better outcomes to society) than if outputs were prescribed externally to the business. Strong incentives also allow the regulator to step back from detailed operational matters of the business, potentially reducing the overall burden of regulation, and avoiding the risk that information asymmetry leads regulators to take decisions about the business that are not in customers interests. For our analysis we have looked at how regulatory incentives have been developed for other water and energy service providers within Australia and in the UK. We examine their relevance to NSW urban water companies. We look more closely at incentives in the existing regulatory framework and the potential for improvements. We set out why we believe there are unexploited opportunities for delivering customer value. Our proposals seek to apply the tried and tested principles of economic utility regulation within the context of the NSW urban water sector. INCENTIVE-BASED REGULATION IN THE UK AND AUSTRALIA UK and Australian regulators have recognised the benefits of incentive-based regulation for utility 4 Ofwat (2009)

2 industries, adopting price-cap regulation in the 1980s and 1990s and evolving that in the 2000s and 2010s as the challenges they faced changed. Incentives (mainly financial) provided firms with means and opportunity to seek cost efficiencies, set cost-reflective prices, provide targeted services for customers and respond to changing supply conditions. The refinements made by the UK regulators for water (Ofwat) and energy (Ofgem) to the traditional price-cap building block model of regulation have strengthened incentives for firms to deliver better outcomes for society. As understanding of regulation grows (both its successes and its limitations), a more sophisticated application of incentives is possible and desirable. Similar enhancements have been or will be developed for the regulated gas and electricity sectors in Australia and New Zealand. These schemes have looked to establish the optimal mix of safeguards for customers by constraining the market power of monopoly suppliers and providing the regulated businesses with the necessary flexibility to promote outcomes in the long-term interests of customers. The key aspects of the regulatory model are summarised below. Cost efficiency incentives To the extent that costs are within a firm s control, incentives to improve efficiency motivate a business to deliver services desired by customers at the lowest sustainable cost. This in turn delivers lower average prices to customers. The principle is that by rewarding firms to seek further efficiencies, both firms and customers benefit in the long run. The early regulatory model encouraged firms to make efficiencies as soon as possible after the start of the regulatory cycle, because any benefits gained would be handed back to customers at the next regulatory review period. The sooner gains were made, the longer the firm could keep them. This approach also meant the firm was encouraged to reveal its actual costs (in order to gain the efficiency reward), thereby helping the regulator to overcome the problem of information asymmetry. This traditional approach meant the power of the incentive declined towards the end of the regulatory period. The outcome was sub-optimal behaviour, where firms might bring forward investment within the period, or even defer investment from the last year of the current period to the first year of the next one, so that benefits could be retained for longer. Regulators (in Australia and the UK) developed the Efficiency Benefits Sharing Scheme (EBSS) to correct this imbalance 5. The EBSS allows firms to retain gains for a defined period of time regardless of the year of the regulatory period in which the cost efficiency is achieved. By being able to carry over the efficiency benefit it means there is a continuous and equal incentive for cost efficiency in each year of the regulatory period. In this way, the basic principle is enhanced to the benefit of both the firm and its customers. Firms gain a greater share of the total efficiency savings; customers benefit because their share comes from greater overall level of savings. The outcome is highlighted in Figure 1, where the share of customer benefit is captured by the larger redshaded area. Figure 1. Effect of EBSS on benefits to customers and the regulated firm The EBSS can also be designed to assist in correcting the perverse inventive to choose capital expenditure (capex) over operating expenditure (opex), known as the capex bias. This problem occurs because capex earns a return (the WACC) while opex does not. Although opex is funded via prices in the year it is spent, and capex is funded over the long term (via depreciation), there is still a perceived problem 6. The corrollary to this is the use of cost pass-through mechanisms, where costs are not within a firm s control. Such mechanisms ensure that a regulated firm in not penalised where identified but unquanitifed costs occur during the regualtory period (i.e. after the regualtory determination has been made). This type of mechanism is not used to insure the firm against all unexpected costs, or as a substitute for good forecasts. Rather, there can be particular events that are potentially likely to happen within a control period, the costs of which need to be remunerated as they occur. Cost passthrough mechanisms ensure that customers only pay for legitimate costs when they occur. This type of mechanism has been used in the water sector in the UK for decades, While IPART currently has no general cost-passthrough provision, it uses such a scheme in allowing 5 Also known as the Efficiency Carry-Over Mechanism. 6 Ofwat considered this sufficiently serious to move to what is known as a TOTEX approach at the Price Review in See Ofwat (2011) and (2013) for details.

3 Sydney Water to pass through additional costs incurred when the Sydney Desalination Plant is turned on. Pricing flexibility within a price cap Water and energy firms in the UK and Australia are allowed the flexibility to set their own prices within the constraint of a price cap set by the regulator. A Weighted Average Price Cap (WAPC) approach means all tariffs within a basket of regulated services are set every year by the firm, with approval by the regulator, subject to a cap on the overall weighted average increase in charges. Prices for each service could be adjusted as long as the overall cap is met. Firms can apportion costs between services and set prices to reflect costs. Year-on-year, prices can be adjusted (rebalanced) so that efficiency and revenue are maximised. Price flexibility gives firms the encouragement and ability to ensure prices meet two key aims: (1) that prices reflect the costs of providing the service, and (2) that services can be targeted to particular customer groups to reflect their preferences ( adding value ). Crucially, firms have the scope to meet these aims during the regulatory period, as well as proposing reforms at the price review. A third benefit of price flexibility is that it allows firms to use prices to respond quickly to changing supply and demand conditions, if desirable. Using prices as a demand management tool has been widely used in energy, and to a lesser extent in water. During the Millenium drought, it would have been useful to have the scope to decide whether to use prices as an additional tool to moderate demand and signal the scarcity of water to customers. Service performance incentives Service performance incentives are used to motivate a business to invest in superior performance, as well as to act as a counterbalance to the incentive to minimise costs at the expense of service quality. Two forms of the mechanism used are (i) schemes that deliver rewards or penalties based on the extent certain aggregate performance targets are achieved; and (ii) penalty-only schemes focused on outcomes for the worst-served customers. This involves a financial reward for exceeding a socially-desirable standard of performance, and a penalty for under-performance. Service targets are chosen based on an assessment of customers priorities for service provision, and their willingness to pay for maintenance or improvement/reduction in services. Outcomes are measured in terms of quantitative and qualitative factors, using measurable performance metrics and customer surveys. Funding for the service improvement is agreed by the regulator based on willingness to pay surveys. Ofwat and Ofgem have both used service performance schemes to encourage firms to improve operational efficiency and, more recently, the customer experience. THE REGULATORY FRAMEWORK IN NSW The urban water market in NSW has been regulated by IPART since 1996, using the traditional building block model of regulation. Firms submit a business plan ( submission ) at the beginning of each Price Review. IPART uses these submissions as the basis for its price determination, where it set maximum prices for regulated water, wastewater and stormwater services. Price Review periods are usually four years. Sydney Water recognises IPART s recent willingness to enhance its regulatory framework. In particular, IPART has developed an innovative approach to estimating the Weighted Average Cost of Capital (WACC), which is a crucial element in regulatory price determinations. Further, IPART was the first regulator in Australia to establish a financeability test in price determinations for water utilities. These reviews 7 have increased transparency of the regulatory process and given more certainty for regulated businesses. Finally, IPART is the only regulator in Australia to have introduced an EBSS scheme for a water utility, having provided for an opex EBSS in the Sydney Desalination Plant s last price determination 8. However, the regulatory regime still has a strong focus on constraining suppliers as to how they serve and safeguard customers, rather than providing the flexibility to promote better long-term outcomes. For example, IPART has in the past prescribed both the structure and level of all regulated prices to residential and non-residential customers. Businesses have little scope to offer differentiated tariffs to customers or to adjust prices in real terms within the regulatory price period. Sydney Water encourages IPART to consider enhancing the current regulatory framework through the adoption of the mechanisms discussed in this paper. Doing so will support the regulated firm s efforts to drive cost efficiencies, incentivise them to strive for higher efficiencies beyond those that are (normally) identified as part of the process of determining the regulatory revenue allowance. The section below highlights those areas where we suggest the framework could most benefit from being strengthened. 7 See IPART (2013a, 2013b) 8 IPART (2011)

4 Weak cost incentives The current framework follows the simple approach to incentivising cost efficiencies inherent in the traditional building-block approach. This means there exists the problems of declining power of incentive within period, and the capex bias. We propose to IPART that it adopts an EBSS for both opex and capex, and that it also includes complementary cost pass-through mechanisms. Limited price flexibility IPART sets maximum charges for water, wastewater and stormwater drainage services to residential and non-residential customers. It does this at the start of every four-year review cycle, based on information submitted by the water utilities. Once the price period has begun, apart from the ability to pass through some limited costs identified prior to the determination, firms have little ability to adjust prices in real terms. This set and forget model means firms have little scope to respond to unanticipated events, customers changing preferences, or better knowledge of costs to serve within the regulatory period; or to use prices as a real-time demand management tool. Instead, there is a lag before any knowledge gained during the regulatory period can be applied to tariffs. This lag is inefficient and creates worse outcomes for customers. We propose to IPART that it adopts a WAPC approach to setting maximum price increases, with appropriate side constraints. Weak service performance measures Currently, water businesses are regulated via a range of conditions incorporated into their Operating Licence. These are based around infrastructure performance that looks to safeguard the interests of customers, the community and the environment. These conditions are set in terms of limits on poor performance (e.g. for Sydney Water it must have no more than 40,000 standard unplanned water interruptions of greater than 5 hours per year) rather than targets for incentivising better performance. For Sydney Water, where individual customers do suffer poor performance, there is a system of redress payments. However, this is a compensation scheme for customers, rather than an incentive scheme for encouraging service performance improvements. We propose to IPART that it consider adopting service performance targets. We do not propose a specific scheme at the moment. PROPOSALS FOR STRONGER INCENTIVES Key considerations when designing incentive schemes Within the current building-block model, the regulatory control period begins with the regulator approving a future stream of revenue based on its assessment of forecast expenditure over the regulatory control period and a return on and of capital expenditure. It is difficult for this regulatory determination to take into account new information that will be revealed through the duration of the regulatory control period. A strong and flexible incentive-based framework encourages regulated businesses to respond to changes in information in the most efficient way. As such, when faced with a financial incentive firms are encouraged to divert from approved plans where this maximises benefits for customers. Equally, firms are incentivised to seek information about customers preferences and values, and enhance their own understanding of their costs in order to price at the most efficient level. In a well-designed scheme the revenue outcomes for businesses and customers from incentives are largely delivered mechanically. That is, the rules for how a scheme will work are set out in advance and outcomes are automatically delivered to the business depending on its performance with respect to the incentive. The mechanical nature of incentives is necessary in order to provide confidence to businesses that, if and when they change behaviours, certain rewards or penalties will be delivered. The use of incentives can often lead to superior outcomes than might otherwise be the case. But this does not mean that they are always necessarily straightforward to implement. Before introducing incentives it is necessary to be aware of the challenges associated with implementation. Doing so can assist in limiting the prospect of unintended consequences arising, or examining alternatives to the financial schemes. In considering the scale and scope of the challenges it needs to be recognised that perfection is not a necessity. What is necessary is that outcomes are superior to those that would have occurred without the incentive. This may simply mean that the incentive, even in a simple state, nevertheless sufficiently motivates the business to undertake actions that are welfare-improving from the perspective of customers. Furthermore, it is prudent to consider the pace of introduction for proposed enhancements to the

5 incentive framework. It is wholly appropriate that such changes as we are likely to submit to IPART could be introduced on a trial or partial basis, then evolve over time. The Efficiency Benefits Sharing Scheme Cost efficiency is a central objective of economic regulation. Economic efficiency is promoted through the delivery of services at the lowest efficient cost, where those costs are within the firm s control. Given that cost efficiency has a direct impact on prices, customers are likely to place high importance on its achievement. The EBSS can acheive four objectives. To encourage firms to identify controllable costs and pursue efficiencies so that services are delivered at least sustainable cost. To lead the firm to make efficient trade-offs between capital and operating expenditure. For project specific expenditure, ensure that the most efficient project that meets the expected need is selected and is delivered at the most efficient time. To consider the trade-off between costs against consumer benefits when considering investments. The EBSS applied by the Australian Energy Regulation (AER) in the energy sector operates in the form of a rolling carry-over mechanism 9. Under this approach businesses retain the full efficiency gain that is earned for a set period of time. This is typically for the duration of a regulatory control period (e.g. at least 4 years in the case of the NSW urban water sector). If the holding period was less than this duration it would not be possible to deliver an equal incentive rate in each year. At the end of this holding period the benefit is then passed onto customers in full. Retaining the benefit of an efficiency saving for this period of time is the benefit that is provided to the business for making that saving. The fact that the business only retains benefits for a limited time means that they do not retain 100 per cent of the total efficiency gain created. Under the traditional form of the EBSS, the sharing ratio between the business and customers the power of the incentive is a function of the duration of the holding period and the discount rate. That is, the incentive rate is the net present value of a gain or loss in a particular year, relative to the value of that gain or loss in perpetuity. Therefore, a longer holding period will lead to a higher powered incentive and vice versa. For example, a four year holding period results approximately in a 25:75 sharing ratio in favour of customers, while a 10 year holding period would result in approximately a 50:50 sharing ratio. 9 See AER (2013) The broad design of the EBSS is summarised below, for opex and for capex. Opex EBSS For the opex EBSS it is assumed that the level of actual operating expenditure at the end of one regulatory period is used to set the starting point for the regulatory allowance for the next regulatory period. Adjustments are made only for new or ceased obligations, growth, productivity growth and real input price changes. This is referred to by the AER as the base, step and trend approach. Opex is incurred every year, whether it is salaries, maintenance, renewals or something else. Therefore, the principle of the opex EBSS is to incentivise the firm to continue to seek efficiencies in every year of the regulatory period. The way this is achieved is by rewarding (or penalising) the incremental change in efficiency between years (the carry-over ). It does not reward the total efficiency gain in any one year (i.e. not the difference between the regulatory allowance and the actual expenditure, except in the first year of the regulatory period). This is shown by the formulae: C t = E t E t-1 and E t = R t - A t where C t = allowed carry-over in year t E t = efficiency gain in year t R t = regulatory opex allowance A t = actual opex Gains are carried forward for the specified number of years and added to the revenue requirement in the next review period. A detailed example of the EBSS for opex is provided in Figure 1 of the Appendix. We propose that IPART introduces an opex EBSS in Cost pass-through The complementary aspect of the opex EBSS is for those costs which are not in the firm s control. In this instance, it is legitimate for customers to bear these costs if they occur. The mechanism to achieve this is a cost pass-through adjustment to the revenue allowed by the regulator. The regulator and the firm agree at the price determination the scope and scale of costs that might be incurred and what might trigger the activation of the mechanism. If the event transpires, then costs are automatically passed through to customers. In this way, customers bear the costs approved by the regulator, but only if they are incurred. They do not pay up front and take the risk that the costs do not materialise.

6 Capex EBSS Capex is different from opex, because it is not necessarily incurred in each year. There is no base, step and trend approach in a capex EBSS. Instead, actual capex from one regulatory period is added to the regulatory asset base and factored into prices for the next regulatory period. The new forecast of capital expenditure is independent of the level of expenditure in the previous period. For the capex EBSS, the efficiency gain (or reduction) in each year is defined as the annual financing cost associated with the difference between the actual capital expenditure in the year compared with the regulatory allowance. Gains are carried forward for a specified number of years and are added to the next period s revenue requirement. A detailed example of the EBSS is outlined in Figure 2 of the Appendix. We propose that IPART adopts a capex EBSS in Benefits and risks from EBSS As well as the general benefits that emerge from having a strong incentive regime, several other benefits for a regulated business exist (and its customers) from the implementation of an EBSS. It gives a stronger motivation to pursue efficiencies in the planning and delivery of capital and operational solutions. To the extent efficiencies are made in both choosing the right solution, and in delivering on it, this improves profitability, which delivers lower bills to customers through the normal regulatory process. Long-term benefits to customers are likely to increase through encouraging innovation in both the planning and delivery of investments. Research and development R&D becomes more worthwhile if a greater share of the benefits can be retained, with a consequent increase in the overall level of benefits available to be shared. It sharpens the firm s overall focus on planning and delivery of solutions. This leads to a greater awareness of risks, better risk management and benefits for customers through better outcomes at lower cost. The proposed introduction of stronger regulatory incentives also needs to consider the potential risks inherent in the transition to an EBSS. These risks are primarily in the design and implementation of such a scheme. It may incentivise corner-cutting in the shortterm at the expense of those plans and investments which generate a greater benefit over the life cycle but are only realised in the longer term. This can be mitigated by ensuring close attention is paid to identification of the correct targets and design of the correct incentives, and monitoring ongoing performance against those targets. Without adjustments to the power of the incentive, it may perpetuate the capex bias. The cost efficiency incentives may not be strong enough within a short regulatory cycle to affect behaviour. This is mitigated by making the reward / risk levels high enough, and by accepting that momentum takes time to build that is, improved performance is likely to manifest itself over more than one regulatory period. Weighted Average Price Cap (WAPC) The current model of the regulator setting maximum prices for individual tariffs for the entire regulatory period is unnecessarily sub-optimal. Its rigidity denies firms and the regulator the ability to respond quickly to changes in market conditions or the wider regulatory or policy environment. It gives firms only one chance in every regulatory cycle to propose different ways of charging for services. It provides no guarantees that those proposals will be adopted and hence creates uncertainty for the firm and its customers. Instead, we suggest that the approach to pricing for regulated services could be more efficient and effective. Setting maximum prices for each tariff for each year of the period by definition requires the setting of the annual rate of change of those tariffs. Therefore, it is possible to imagine an evolution to a framework where the regulator sets the maximum rate of change for a basket of tariffs but leaves the individual tariff-setting to the regulated firm. As long as the average increase in tariffs, suitably weighted, is within the agreed limit, the regulator can be assured that customers are protected. Additional constraints on the firm s price-setting behaviour can be implemented by the regulator, either through guidelines or adjustments to the price control formula. For example, the regulator may prefer to set an additional cap on the annual increase in a sub-set of regulated services, or constrain the differential between certain tariffs to within a specified limit. However, we also recognise that such an evolution is not without its challenges. In particular, both IPART and the regulated firms will need to familiarise themselves with the new approach to setting and approving tariffs on an annual basis. Equally, regulated firms will need to understand their customers preferences and their own cost base more closely before proposing targeted tariffs. We harbour no designs to radically alter our tariff structure; rather we want to put in place a flexible pricing framework that will help deliver better outcomes for customers over the long term.

7 Therefore, we propose that IPART adopts the WAPC framework in But we would commit to maintain annual changes in tariffs by an amount agreed by IPART for at least the first 2 years of the regulatory period. In this way, we could integrate the new WAPC approach into our business operations and carry out detailed work on our cost base and our customers values, to underpin any tariff proposals we might make in the future. This phased approach would also provide time for proper training and familiarisation with the new model and associated administrative processes. CONCLUSION Economic regulation of the urban water sector in Australia is not best practice. Established regulatory frameworks in other jurisdictions, notably in the water and energy sectors in the UK and in the Australian energy sector, demonstrate how regulation can deliver benefits to customers, to regulated firms and to the regulator. Sydney Water proposes that the current regulatory framework could be enhanced with the adoption of stronger regulatory incentives. Specifically, the adoption of an EBSS for opex and capex, a cost pass-through mechanism and a Weighted Average Price Cap approach to price setting could lead to lower costs, greater innovation, better allocation of costs and better services to customers. Our proposals for stronger incentives will help create a more robust regulatory framework, one which aligns the firm s interests with those of society. It helps create a long-lasting framework that encourages businesses to do the right thing, because the right thing for the firm is also the right thing for customers. We understand there are challenges associated with our proposals. We recognise that questions remain unanswered about the potential impacts on regulated firms and their customers. Sydney Water s proposals are evolutionary, not revolutionary. The incentives have been tried, tested and fine-tuned in other sectors in Australia and in the UK. There is much existing practice for regulators to draw on. But even when walking a well-trodden path, the walker needs to know they are going in the right direction, and that the path remains suitable for them. So we will work closely with IPART and other stakeholders in designing the schemes, providing evidence and support as necessary, and ensuring we make progress at the right pace. ACKNOWLEDGMENTS proposals for stronger regulatory incentives, in particular, the Competition and Regulation team at Sydney Water (Joel Aulbury, Amith Senanayake, Chwee Lim, Fiona Zhang). We also acknowledge Frontier Economics, Farrier Swier Consulting and Incenta Economic Consulting for their contribution to the development and refinement of our thinking on regulatory incentives. REFERENCES AER (2013) Better Regulation Efficiency Benefit Sharing Scheme for Electricity Network Service Providers, November Averch, H; Johnson, L.L (1962) Behavior of the Firm under Regulatory Constraint, American Economic Review, Vol. 52, Frontier Economics (2014) Improving economic regulation of urban water, A report prepared for WSAA, August Harper (2014) Australian Government Competition Policy Review Draft Report, September IPART (2011) Determination Prices for Sydney Desalination Plant, December IPART (2013a) Review of WACC methodology final report, December IPART (2013b) Final Decision Financeability tests in price regulation, December Laffont, J; Tirole, J (1993) A theory of incentives in procurement and regulation, MIT Press Littlechild, S (1983) Regulation of British Telecommunications Profitability, HMSO, London Mirrlees-Black, J (2014) Reflections on RPI-X Regulation in OECD Countries, CCRP Working Paper No.25 Ofgem (2010) RIIO: A New Way to Regulate Energy Networks, October Ofwat (November 2009) Future water and sewerage charges : Final determinations Ofwat (2011) Capex bias in the water and sewerage sectors in England and Wales substance, perception or myth? A discussion paper, May Ofwat (2013) Setting price controls for final methodology and expectations for companies business plans, July The authors would like to acknowledge the work of the many people who continue to develop our

8 APPENDIX Opex EBSS detailed example Incremental improvement Y2 underspend Y1 underspend 4-1 = 3 Incremental decline Y3 underspend Y2 underspend 1-4 = -3 Customers benefit from lower opex Regulatory Period Year Regulatory Allowance Actual Expenditure Under (over) spend Incremental improvement (decline) Carryover calculations Within period benefit (loss) EBSS carry-over Total benefit (loss) Figure 1: Four-year EBSS opex Revenue Allowance = 6 In this example, it is assumed that the regulator forecasts a $100 cost in year 1 of the initial regulatory period (Period 1), but the regulated business managed to reduce cost to $99. This implies a gain of $1. This gain is carried over for the next four years by virtue of the EBSS, and into the next regulatory period (Period 2). Without this scheme, the gain from efficiencies would cease at the end of Period 1. In year 2 a $95 cost is recorded against a $99 allowance. The red ovals show the incremental benefit of $3 carried over for the next four years and into Period 2. The 3 rd year records a negative increment ($1-$4 = -$3). The 3 rd year also becomes the base regulatory allowance for each year of Period 2. The total revenue added to the business building block revenues in Period 2 is $6. Capex EBSS detailed example Figure 2: Five-year EBSS capex In contrast to the opex example in Figure 1, the capex example here assumes a five-year, rather than fouryear, carry-over mechanism. In Figure 2, the regulated business underspends $10 in the first year. Based on a WACC of 7%, this provides a carry-over of $0.70. This is the savings to the business in its financing costs. The carry-over is highlighted by the red circles. In the remaining years of Period 1 the business spends more than the allowance in some years and less in others. The total revenue added to the business buidling block revenue in Period 2 is $1.12. In contrast to the opex scheme, the regulatory allowance for capex is reset in Period 2 based on actual forecast spend in that period. There is no revealed cost method, in recognition that capex is less predictable and subject to more significant variation than opex.