Pipeline construction

Correct assessment method crucial

Well, pipeline pricing has been getting more attention than I expected when I started this series of articles. Unfortunately, a lot of detail is needed to properly explore these issues, but I’ll be as brief as I can.

Firstly, infrastructure owners and the regulator tend to disagree on capital recovery, asset valuations and their role in setting tariffs.

From a regulatory perspective, the amount of capital recovery (also called depreciation) that has occurred on a pipeline is a critical factor in determining asset value and tariffs. The more depreciation, the lower the asset value and tariff should be. Therefore, the correct assessment of that depreciation is crucial. The ACCC’s incorrect view on how much depreciation has occurred has major consequences for its view of the appropriateness of tariffs on unregulated pipelines.

Of course, unregulated pipelines have not historically paid much attention to the regulatory perspective. Asset values have been primarily based on a forward-looking assessment of future revenue (as they are in most markets). Tariffs are more focussed on being a fair price for the value delivered to customers than on an asset value.

This disconnect between the regulators’ perspective and the asset owners’ perspective is understandable: they have very different roles, priorities and world views. But, in an environment of intense scrutiny on energy prices, the difference in perspectives is of high consequence. Here’s one way that the difference of perspectives can lead, regardless of agreed facts, to very different assessments of depreciation.

The new information disclosure and arbitration regime, called Part 23 of the National Gas Rules, requires the publication of financial reporting of a host of pipeline information. This information is set out in the Financial Reporting Guidelines, published by the Australian Energy Regulator (which is separate to, but closely entwined with, the ACCC). The guidelines require pipelines to publish capex, opex, revenue and other data for every year a pipeline has been in operation. The guidelines also require that this information be used to determine an asset value using the ‘recovered capital methodology’ (RCM). It’s important to understand that the RCM is a model, it relies on factual and assumed inputs to reach its answer and it is not used in commercial practice.

One unique aspect of the RCM is that it insists all profit above a commercial rate of return be used to depreciate the asset value. This means assets that deliver above expected returns will reduce in asset value quickly. Obviously, this is not how markets assess asset value. Assets that deliver above expected returns increase in value.

A critical factor here is the commercial rate of return. Change your assumption about the commercial rate of return and you completely change the level of deprecation that occurs each year and thus the asset value delivered by the RCM. Guess who has different views on the appropriate commercial rate of return for a pipeline asset. Yes, the ACCC and pipeline operators.

This is really important. If the ACCC’s complaints about pipeline depreciation levels and asset valuations, and thus tariffs, under the RCM boil down to differences of opinion on the appropriate commercial rate of return and other assumptions, is there actually a real-world problem?

We’ve already seen that the ACCC has a differing view as to the levels of competition faced by pipelines and the amount of risk embodied in a pipeline investment. If the ACCC thinks there is little to no competition and little to no risk in a pipeline investment, then of course it would think there should be a low rate of return.

However, in heated political environment we find ourselves in, we should question the appropriateness of the ACCC judging, with a regulator’s perspective and the benefit of hindsight, investment decisions made in a competitive market for unregulated assets by companies that are expert in making these investments. The ACCC is likely to present its opinions about the RCM as an absolute truth and use them to demonstrate the presence of monopoly pricing.

This is simply not the case. We all know models can be useful tools to inform decisions. We all know models are wildly dependent on the assumptions that go into them.

Widespread application of a model like the RCM has the potential to impact on future investment decisions. No corporate board is going to be thrilled by the prospect of making a final investment decision based on internal rates of return if it can expect the regulator to review its decision a few years down the track and declare that the investment is delivering unreasonable results for customers.

The RCM also has consequences for efficiency and incentives. If an asset owner increases profit by reducing cost, under the RCM that leads to a lower asset value. This gives the asset owner no incentive to decrease costs. This is in direct contrast to the ‘incentive-based regulation’ that applies to regulated pipelines, whereby the regulator ensures asset owners are allowed to keep some, but not all, of the cost savings it makes through efficiency and productivity gains.

Even more bizarrely, if an asset owner makes a loss, under the RCM that leads to an increase in asset value. These two outcomes stand in complete contrast to real-world outcomes. In the real world, profitable assets have high value, not declining value. Unprofitable assets have low value, not increasing value.

The ACCC will be focussing on the pipeline industry’s performance under the new regime in its July Report of the ongoing Gas Inquiry. We will be focussed on what it has to say about actual market outcomes and I hope its summaries and statements do the same. This is what is important.

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