There have been a number of high profile electricity blackouts in August 2003 in the US and Canada (affecting 50 million customers) and the UK (affecting 250,000 customers in London). While the causes of the US and Canadian blackouts are currently being investigated, there is evidence to suggest that insufficient investment in the transmission network was a key driver of the outages – despite the cost of equity incentives provided by FERC to electricity transmission companies to join Regional Transmission Organisations. The state of under- investment can be seen in the following figures. Figure 23 shows the substantial differential between peak demand growth in the US and the quantum of new transmission:
Figure 23: Peak demand growth and new transmission investment 1990-2001 0 20 40 60 80 100 120 140 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year In de x o f T ra n s m ission M iles and A n n u al Load G ro w th, 1990 = 1 0 0
Total Annual Load Indexed, 1990 = 100
Miles of transmission lines >230kv Indexed, 1990=100
Figure 24 sets out the difference between construction expenditure and depreciation of investor owned electricity utilities in the US between 1980 and 2000
Figure 24: Capital expenditure and depreciation – investor owned utilities 1980-2000
Source: EPRI, Electricity Sector Framework for the Future, Volume 1, Achieving the 21st Century Transformation, August 2003, p17.
The need for investment (and greater co-operation) has been highlighted in many places. By NERC, for example:
Federal legislation is required to establish an independent, industry-led electric reliability organization to ensure the continued reliability of the interconnected, high-voltage transmission grid in North America. The existing scheme of voluntary compliance with NERC reliability rules is no longer adequate for today’s competitive electricity market. The grid is now being used in ways for which it was not designed, and there has been a quantum leap in the number and complexity of transactions. The users and operators of the transmission system, who used to cooperate voluntarily on reliability matters, are now competitors without the same incentives to cooperate with each other or to comply with voluntary reliability rules. As a result, there has been a marked increase in the number and seriousness of violations of these rules.
All of these changes are jeopardizing the very stability of the electric system upon which our economy and our society depends and there is little or no effective recourse today to correct such behaviour.105
And by informed commentators such as the Edison Electric Institute:
To maintain transmission capacity .. relative to summer peak demand would require utilities to construct 54,000 GW-miles… during this decade,… [at an estimated cost of] $56 billion… The deficit in past transmission investment poses large challenges to transmission planners. Not only must they plan for incremental needs, they must also plan to make up for transmission investments that did not occur during the 1990s.106
Some commentators have also noted the link between the lack of investment and uncertainty over returns. Frank Wolak, Chairman of the Market Monitoring Committee at the California Independent System Operator, notes:
the transmission network needed for a wholesale market should be much larger, The utilities said, ‘if we don’t know what kind of returns we’ll be getting or whether we get to keep our assets, then don’t build it.’ So leading up to restructuring, they didn’t build transmission.107
Two concurrent regulatory failures conspired to cause the hugely costly blackouts. First, local (state-based) regulators were reluctant to approve transmission investment because of a blind focus on short-term lower retail rates at almost all costs, difficulties in assessing the longer-term benefits of transmission and transmission pricing models that did not allocate
105 NERC, Legislative Action is Needed to Maintain Electric System Reliability, August 2003. 106 Eric Hirst and Brendan Kirby, Transmission Planning for a Restructuring US Electricity
Industry, Edison Electric Institute, June 2001.
107 N. Banerjee and D. Firestone, New Kind of Electricity Market Strains Old Wires Beyond Limit, New York Times, 24 August, 2003.
the costs of new transmission to the grid users that benefit from them.108 In addition, allowed
rates of returns were insufficient for investor-owned utilities to take on the enormous and costly regulatory imposts involved in developing new transmission.
FERC is currently seeking to reduce these problems by exerting jurisdiction over the transmission network, encouraging larger transmission operators to evolve that cross utility and state boundaries, and by giving rate increases to transmission owners that fall into line. But these are recent initiatives.
The most compelling lesson from the US is that the long-term costs of under-investment, whether caused by insufficient allowed return, other regulatory barriers to investment, or both, are likely to emerge slowly. However, when they do emerge they are likely to be very costly, and to take a long time to rectify.109
The recent blackout in a large proportion of London is likely to indicate that the sector has similar issues. The fact that these occurred in a network with a single transmission network suggests focus may shift to the regulated rates of return earned by the transmission owner, National Grid.
7.2.3 Railtrack
The Office of the Rail Regulator (ORR) decision on Railtrack provided Railtrack with one of the highest cost of capital allowances made by UK regulators (pre-tax real of 8% based on 50% gearing). However, this did not prevent, within the space of little more than two years, Railtrack from moving to administration and subsequently liquidation, as investors were not prepared to fund necessary investment during a period of significant rail crashes, attributed in part to ageing infrastructure. This experience is consistent with the suggestion that one of
108 For example, the costs of transmission fall upon the rate payers close to where transmission is built. As a result, regulators are reluctant to approve transmission investment in one area that benefits rate payers elsewhere.
109 The events suggest that the first manifestation of insufficient investment is that the risk of low probability catastrophic events increases.
the first implications of insufficient investment is that the risk of low probability catastrophic events increases.
As a result of these events, it appears likely that the regulator will have to provide National Rail – Railtrack’s successor – with higher capital charges on existing infrastructure. While National Rail is an exclusively debt financed company limited by guarantee, in its recent consultation paper ORR has flagged that the required cost of capital is likely to be in a similar range to that provided to Railtrack. However, the asset base to which this will apply is likely to rise because of one-off adjustments to the regulatory asset base for additional debt that the network business has accumulated over the three years since April 2001:
The value of Network Rail’s RAB will approximately double as a result of the principles set out by the Regulator at the last periodic review and in previous regulatory statements. In particular, the Regulator confirms in this document his intention to make a one-off addition to the RAB to reflect the additional debt that the network business has accumulated over the three years since April 2001 through its overspending.110
110 Office of the Rail Regulator, Interim Review of Track Access Charges: Third Consultation Paper, July 2003, p.4.
8 Conclusions
Our results show that WACC allowances in Australia are not generous in international terms, and certainly not excessively so. The results do not support the assertions of the ACCC that returns compare favourably with those in the UK and US, especially if these decisions are seen in relation to approaches to asset valuation and the overall level of uncertainty in the WACC in Australia and overseas.
Even if Australian rates were comparable with overseas rates, the evidence in some key sectors – namely in UK rail and water and the US electricity transmission sector – supports the view that comparability is not a sufficient condition for ensuring appropriate levels of investment. There is evidence that investment has not occurred in some sectors as required and that investors are seeking to shift away from a partial equity financed model. This evidence is indicative of inadequate rates of return.
If WACC allowances are provided to regulated businesses in Australia that are lower than a firm’s cost of capital, the impact will ultimately be borne by consumers through inadequate investment and lower service quality. While, in the short run, reductions in service quality may not be evident, because of obligations to supply for example, over time investors will be increasingly unwilling to finance otherwise efficient investments. The examples of the US blackouts and the performance of Railtrack in the UK suggest that the impact of under- investment will be seen in an increase in the risk of low probability catastrophic events, which are the most economically harmful form of service degradation in that they leave no opportunity for customers to adapt.
There is still significant uncertainty over the appropriate value of the WACC in Australia despite a large body of regulatory precedent. The appropriate bond maturity of the risk free rate is a key case in point – where the only other country with a similar level of uncertainty is New Zealand.111 An independent review of the WACC can assist in minimising uncertainty
for investors. Additionally, regulatory frameworks can provide greater certainty on the approach the regulator should adopt for the WACC as well as areas such as asset valuation
111 The New Zealand Commerce Commission has based its position on analysis by the same advisor as the ACCC.
that impact on investment. The ACCC recognises that the regulatory framework is not as well accepted in Australia as in the UK or the US. In its GasNet decision it noted:
However, the Commission is mindful that the regulatory regime in Australia is not as developed and accepted as in the UK and US.112
NECG believes the Commission has an opportunity within this current inquiry to put in place a framework for the cost of capital, which can act as a template for other access regimes. We look forward to corresponding further with the Commission on these matters.
112 ACCC, Final Decision, GasNet Australia access arrangement revisions for the Principal Transmission System, 13 November 2002.