Our analysis of network profitability data released by the Australian Energy Regulator (AER), for the Agricultural Industries Energy Taskforce, shows that electricity network profits and prices have been at least $2.1 billion higher than efficient cost – meaning electricity bills are perhaps five percent higher than they should be.

This outcome breaches the Rate of Return Objective in the Rules. It reflects the AER’s flawed method for setting regulated network profits or returns. It is based entirely on theory and does not refer to real world data on network profits.

These monopoly returns are in breach of the National Electricity Rules and possibly the Australian Consumer Law. They represent charges for services that are not actually supplied by the electricity networks, as a group.

Monopoly network returns mean that, averaged across the NEM, retail bills are around three (3) to five (5) per cent higher than they should be. The amounts vary depending on the network and retailer mark ups on network prices.

Despite these flaws, the method for regulating network returns is to be elevated to a binding instrument under proposed changes to the National Electricity Law. This also removes the Rate of Return Objective – the regulatory benchmark for assessing network returns. If this happens, excess returns may be locked in until at least 2023.

The COAG Energy Council should not make the binding instrument until the current method has been corrected to reflect the real world. The amendments should also require the AER to publish data on actual network returns that is comparable with its decisions on allowed returns.

In response to the release of our report by the National Irrigators’ Council, the Electricity Networks Association (ENA) has not disputed our estimate of excess (super-normal or economic) network profits.

The ENA claims that our analysis is misleading because, ‘…when network businesses earned profits above the allowed return…, it reflected efficiencies made in their operations, not more money out of customer pockets’. ‘In fact, under the incentive-based regulatory model, efficiency gains (reflected in higher than forecast profits) are returned to customers by way of reductions in prices.’

The ENA’s criticism completely misses the mark. Under our analysis, networks that outperform efficient benchmarks continue to earn economic profits while those under-performing would experience economic losses.

But under incentive regulation, and the Rate of Return Objective in the National Electricity Rules, the average network in the average year should not make unearned economic profits.

The ENA seems to be promoting a distorted version of incentive regulation: ‘if heads, networks win, if tails, consumers lose’.

Our estimate uses the AER’s own data. It simply converts percentages to dollar amounts using other public AER data regulated network asset values.

We find that sector wide actual network profits are at least 14.6 per cent higher than the allowed profits (excluding one out of the group of 18 networks) because the AER’s method over-estimates real financing costs.

An independent review of the AER’s method does not appear to test the method against real world outcomes. Its conclusions are therefore not evidence-based.

The AER’s Consumer Reference Group, consisting of a broad range of consumers, also considers that the AER’s method is error reinforcing rather than error correcting.

Because electricity networks are capital intensive, around half the network bill is the financing cost. Over-estimating financing costs results in excessive regulated prices and networks as a group receive unearned monopoly returns.

Monopoly network profits are reducing affordability. This is inefficient and unfair.

Many of the networks extracting monopoly profits are overseas owned. This means a loss to the Australian economy, not just a wealth transfer.

Table 1 below summarises the aggregated economic return relative to the allowed rate of return for the four year period to 2016/17.

Table 1: overview of economic profits for 2013/14 – 2016/17

Sector Allowed return Actual return Economic Profit Ratio Transmission $4,996 $5,565 $569 11.4% Distribution $16,424 $17,978 $1,554 9.5% Combined $21,420 $23,543 $2,123 9.9% ex Ausgrid $18,071 $20,709 $2,638 14.6%

The AER has yet to release data for 2017/18. This may reveal further substantial economic profits.

The ‘allowed return’ or ‘normal profit’ is as set by the AER. The economic profit is incremental returns above allowed returns, due to the over-estimation of financing costs by the flawed method for estimating financing costs.

Figure 1 below shows the same data but for each year of the four year period for the transmission and distribution components of the sector.

Allowed returns exceeded efficient returns over the four year period by more than $2.6 billion or 14.6 per cent above allowed returns of $18.1 billion, excluding Ausgrid. The losses mostly relate to just one network company, Ausgrid, which has the largest regulated asset base.

The AER has made or is making new decisions for Ausgrid, Endeavour, Essential and EvoEnergy, following successful network appeals, and returns for these networks will increase relative to the AER data.

The 14.6 per cent or $2.6 billion is a conservative estimate because the AER used higher RAB values for calculating the return on assets compared with the WACC. This reduces the differences between actual and efficient returns, and understates monopoly profits.

Table 2 below provides an indication of the error corrected allowed return (weighted average cost of capital – WACC) for each year, relative to the WACC estimated under the AER method. It highlights that the error has a structural bias or over-estimates the actual cost of capital.

Table 2: Allowed vs. evidence corrected WACC

2013-14 2014-15 2015-16 2016-17 Average Distribution Actual WACC 7.90% 6.95% 4.63% 4.60% 6.02% Economic Profit -0.58% 1.39% 1.22% 1.38% 0.85% Efficient WACC 8.48% 5.56% 3.42% 3.22% 5.17% Transmission Actual WACC 6.99% 5.25% 5.21% 5.19% 5.66% Economic Profit 0.51% 1.06% 0.69% 0.72% 0.75% Efficient WACC 6.48% 4.19% 4.52% 4.46% 4.91%

Figure 2 below shows the distribution of returns over the sample, based solely on analysis of the data published by the AER. This distribution shows the structural bias in network returns.

Figure 3 below shows an indicative error corrected WACC estimates for the same period and networks. This shows a distribution more indicative of normal profits, being centred around a zero value. Economic profits are offset by economic losses, and incentives are aligned with efficient costs. This is to illustrate outcomes in alignment with the Rate of Return Objective in the Rules.

Contrary to the assertion by the NEA, the indicative outcomes under Figure 3 retain performance incentives in the form of economic profits (on the right) or losses (on the left hand). This is not rate of return regulation.

To be absolutely clear, the indicative outcomes under Figure 3 retain performance incentives in the form of economic profits (on the right hand side) or losses (on the left hand side). It does not represent rate of return regulation. Industry-wide economic profits are not a feature of incentive regulation and are not consistent with the Rate of Return Objective in the Rules.

Under rate of return regulation, any variance from the allowed rate of return for a given period is corrected in the following pricing period. Under our analysis, the variances (positive or negative) are retained by the networks for the entire price control period of five years.

Simon Orme is Director of sapere research group limited www.srgexpert.com