The interim Senate report into the performance and management of electricity network companies has rightly identified over-investment as a key reason for the increase in electricity prices.

But in choosing to focus on the most difficult and complicated area for regulators and governments to grapple with - what the efficient level of investment for these businesses is - the inquiry has struggled to come up with solutions.

One of the key recommendations is for yet another independent review to look at ways to exclude future imprudent capital expenditure and surplus network assets from a network service provider’s asset base. It also encourages state governments looking to privatise their networks to examine those networks to see if they are overvalued and to write them down if they are.

Good luck with that last recommendation.

Demands falls - yet prices go up

The proposal to look at ways to write down future imprudent assets is not a surprise. The risk in pushing a regulatory system too far is that it usually tends to get a political reaction. That is what is happening in the electricity sector.

Investment has grown well beyond what is required, especially in the government-owned companies in NSW and Queensland. Part of that may be due to older networks requiring upgrades and to the growth in peak demand from air conditioner use.

However, the inquiry found even after accounting for these factors there has been significant over-investment in these networks, leading to higher costs for consumers. This has occurred as electricity demand has fallen in recent years, due to a combination of the higher prices and the increased usage of solar panels. Neither the industry nor the market operator (AEMO) appear to have anticipated this.

What’s behind it?

A combination of the regulatory framework and government ownership has led to this over-investment. The evidence given to the inquiry shows that the problem is greater in NSW and Queensland. This is not news to regulators and analysts who have long recognised the problem.

Privatisation is part of the solution, but in itself that won’t be enough. Regulatory failings must also be addressed.

Proposals to retrospectively write down the assets are always extremely contentious. Such action gives rise to issues of sovereign risk which in the end results in higher cost for consumers. This is why when private investment is involved the rules need to be clear and give certainty to investors. If there is uncertainty this gets priced and consumers pay.

The question here is not due to uncertainty in the rules. There is no provision for stranding assets. The consumer bears the risk if the assets are no longer necessary or no longer fully necessary.

This is not consistent with what happens in a competitive market where the value of assets change constantly depending on the performance of the business. Policy makers have deliberately gone down the path of constraining regulator discretion and avoiding regulatory uncertainty. Changing the rules for existing investment would be problematic. That is why the inquiry’s recommendation focuses on future imprudent capital expenditure.

The risk-compensation equation

But if the companies don’t bear this risk, they should not be compensated as if they do. It’s on this side of the equation that the regulator can partly deal with the existing problem over time.

The recommendation to look at options to exclude imprudent capital expenditure from future capital programs, is back to the future. A higher threshold regulatory test for new transmission investment was applied by the past regulator, the Australian Competition Consumer Commission. This was effectively a cost benefit analysis.

The test was watered down by policy makers concerned that the regulatory system could chill investment - even though capital expenditure programs were growing strongly. In fairness, the test was extremely difficult to understand and to implement.

Currently the Australian Energy Regulator (AER) does have guidelines for assessing new investment, but clearly these are not considered adequate by the inquiry.

Regulators will always know less

While setting out many of the complexities and limitations of the current regulatory framework, the interim Senate report does not quite come to grips with the fundamental cause of the problem. Indeed a couple of its recommendations risk making the situation worse.

There is an asymmetry of information between the regulator and the regulated business which can never be resolved. In a regulatory system where the regulator is attempting to estimate the efficient cost, including capital costs, of the business he/she is always likely to be gamed.

The game becomes more complex as each responds to the other and more and more resources are thrown at the issues. It is not uncommon to hear the concern that the regulator needs more industry expertise and resources. Indeed the report makes just that recommendation. But that is not the solution. It is part of the problem.

This will simply throw good money after bad and risk even greater complexity. A potentially more productive approach is to take a more fundamental look at how we regulate.

What are the solutions?

We ask the regulator try to determine up front the appropriate level of investment, the appropriate level of operational expenses and the appropriate level of return on investment. It’s not surprising that we end up with the results that we have. The issue of gold plating of networks under “cost of service” regulation has been long recognised in the United States which has a much longer tradition of independent utility regulation than we have.

We should look to see whether there are better approaches in other jurisdictions. Rather than have the regulator do all the work up front we may be able to improve outcomes by giving network users greater prominence in the regulatory scheme.

This may involve consumer and business user groups but importantly also electricity retailers and generators. They too have an interest in keeping network costs as low as possible. Higher network costs and hence higher electricity prices are leading to lower quantities demanded and to off-the-grid generation.

Importantly these customers are much more likely to have the expertise to know whether an upgrade in the network or some other capital expenditure proposal is necessary or not.

The regulator needs to be there with the powers to arbitrate but not necessarily as the first port of call.

As is evident from the report, there are no simple solutions to the regulation of monopoly networks. We should, however, resist the urge to throw more resources and more rule changes at the current system. There are simpler, potentially more effective ways to tackle the problem.