Australian National Electricity Rules Adopt a More 'Cost Reflective' Approach to Network Pricing

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1 23 December 2014 Practice Group(s): Energy, Infrastructure and Resources Renewable Energy Climate Change and Sustainability Australian National Electricity Rules Adopt a More 'Cost Reflective' Australia Energy Alert By Jenny Mee and Jemimah Roberts The National Electricity Amendment (Distribution Network Pricing Arrangements) Rule 2014 No. 9 (Rule Change) came into effect on 1 December 2014, amending the Australian National Electricity Rules (NER) by introducing a more 'cost reflective' model for network pricing. Under the new regime, distribution tariffs must comply with several new pricing principles, with the objective that the network prices that a Distribution Network Service Provider (DNSP) charges each consumer should reflect its efficient costs of providing network services to that consumer. Background Under the previous regime, distribution pricing principles were intended to guide DNSPs to set network prices that were efficient and met the regulated revenue requirements of DNSPs. 1 However, as noted by the Australian Energy Market Commission (AEMC) in its Rule Determination, the principles failed to impose firm obligations on DNSPs (for example, DNSPs were only required to 'take into account' their long run marginal cost (LRMC) when developing their prices). The AEMC was of the view that this lack of firm obligations had resulted in price structures that were inconsistent with the policy intent behind the principles, and that there was a need to impose clearer obligations on DNSPs to develop network prices that "are cost reflective and provide efficient signals to each consumer, while transparently addressing consumer impacts and jurisdictional pricing obligations". 2 This Rule Change is part of a series of reforms to assist consumer participation in the energy market. Summary of Rule Change Pricing Objective The Rule Change introduces a new 'Network Pricing Objective'. Clause (a) provides that: "The network pricing objective is that the tariffs that a Distribution Network Service Provider charges in respect of its provision of direct control services to a retail customer should reflect the Distribution Network Service Provider's efficient costs of providing those services to the retail customer." The focus of this network pricing objective is cost reflectivity. In its Rule Determination, the AEMC considered that more cost reflective network prices would allow consumers to make more informed choices about when, where and how they 1 AEMC 2014, Distribution Network Pricing Arrangements, Rule Determination, 27 November 2014, Sydney (Rule Determination), page Rule Determination, page 18.

2 use electricity. For example, if consumers choose to use electricity in ways that reduce network costs (such as by using less power at peak times when the network usage is at its highest), they will be rewarded through lower electricity charges. Under the new regime, network businesses must comply with the pricing principles (discussed below) "in a manner that will contribute to the achievement of the network pricing objective" (clause (d)). Pricing Principles Long Run Marginal Cost Under the first of the new pricing principles, each network tariff must be based on the LRMC of providing the service (replacing the previous obligation merely to 'take into account' LRMC). LRMC is "the cost of an incremental change in demand for direct control services provided by a Distribution Network Service Provider over a period of time in which all factors of production required to provide those direct control services can be varied" (see the new definition inserted in Chapter 10 of the NER). Amended clause (f) of the NER provides that: "Each tariff must be based on the long run marginal cost of providing the service to which it relates to the retail customers assigned to that tariff " Although LRMC is now prescribed as a distribution pricing rule, network businesses will have flexibility about how they measure LRMC. The method of calculating LRMC and the manner in which that method is applied is determined having regard to: 1. the costs and benefits associated with calculating, implementing and applying that method as proposed 2. additional costs likely to be associated with meeting demand at peak times 3. the location of retail customers and extent to which costs vary between different locations in the distribution network. 3 The AEMC considered that under this approach, consumers would be encouraged to choose actions that will reduce future network costs (such as by reducing their peak demand), as they will then be rewarded with lower network charges. Total Efficient Cost Recovery In its Rule Determination, the AEMC was of the view that limiting network pricing to only recovering LRMC would not take into account significant costs incurred by DNSPs in building and maintaining the existing network to meet existing demand, and complying with reliability standards and other regulatory requirements. 4 As such, the second principle introduced by the Rule Change is a "total efficient cost recovery principle" (clause (g)). Under this principle, the revenue to be recovered from each network tariff must reflect the network business' total efficient costs of providing services to the consumers assigned to that tariff. The AEMC considered that in order to maximise the benefits of providing efficient pricing signals to consumers under LRMC based 3 See clause (f)(1)-(3). 4 Rule Determination, page 21.

3 network prices, DNSPs should recover the difference between LRMC based prices and total efficient costs in a way that minimises distortions to consumers' usage decisions. The pricing principle does this by requiring DNSPs to recover their revenue in a way that minimises distortions to the price signals for efficient usage that would be sent by LRMC based prices. 5 Network businesses will be able to determine the method they use to comply with this principle. Consumer Impact Principle Under the previous pricing principles there was no specific requirement for DNSPs to have regard to the impact of network tariff changes on consumers. The Rule Change amends this by introducing a broad consumer impact principle in clauses (h) and (i). In practice, this principle essentially falls into two parts: Firstly, DNSPs are required to consider the impact on consumers of changes in network prices between regulatory years. The rationale is that consumers are more likely to be able to respond to price signals if those signals are consistent and apply for a reasonable period of time. Sudden price changes or significant year-to-year price volatility will make it difficult for consumers to make informed consumption decisions. Secondly, network prices must be reasonably capable of being understood by consumers. The AEMC identified that consumers will not be able to respond to price signals if they cannot relate price structures to their usage decisions. There may be cases where the consumer impact principle and the new cost reflectivity principles will produce outcomes that are inconsistent (for example, cost reflective tariffs may involve significant price changes for some consumers, but consideration of consumer impacts may justify gradually transitioning to those new prices over time). In such situations, DNSPs may depart from cost reflective prices to the minimum extent necessary to meet the consumer impact principle. The AEMC was of the view that this principle would assist consumers to make efficient long term consumption and investment decisions and help manage the transition to cost reflective network prices. 6 Comply with Any Applicable Jurisdictional Pricing Obligations Under the previous principles, there was no direct conflict between the pricing principles and jurisdictional pricing obligations, as DNSPs had a high level of discretion in applying the pricing principles (for example, a DNSP was only required to take into account LRMC, and have regard to transaction costs and customers' ability to respond to price signals when determining network tariffs). By contrast, the new requirement to set network prices on a cost reflective basis has the potential to create a conflict with jurisdictional pricing obligations (for example, where those obligations require prices to be set to achieve some other objective, or in a situation where states have state-wide uniform pricing requirements). 5 Rule Determination, page Rule Determination, page 23.

4 To address this, the Rule Change introduces a specific jurisdictional pricing obligation principle that allows DNSPs to depart from the cost reflectivity principles to the extent necessary to meet jurisdictional pricing obligations. If they do so, this must be done transparently. Network Pricing Process The Rule Change also contains a new process and new timeframes for setting network prices. More notable changes include the following: 7 Under the new regime the network pricing process is split into two stages: o The first stage will occur at the same time as the regulatory determination process. DNSPs will be required to develop a Tariff Structure Statement (TSS) to apply for the next regulatory control period that outlines the DNSPs' tariff classes, tariff structures and approach to setting tariff levels in accordance with the pricing principles. This will be accompanied by a schedule of indicative price levels. Each TSS will be assessed for compliance with the pricing principles by the Australian Energy Regulator (AER) in conjunction with the relevant DNSP's regulatory proposal. o The second stage will occur on an annual basis. In this stage, DNSPs develop and submit their annual pricing proposals to the AER. The annual pricing proposals essentially apply pricing levels to the tariff structures outlined in the already approved TSS. The AER's assessment of the DNSP's pricing proposal will be a compliance check against the approved TSS and the control mechanism as specified in the AER's regulatory determination. DNSPs will be required to describe how they have consulted with retailers and consumers on the design of the network tariffs that they propose to implement over the next regulatory control period. This consultation will occur prior to the submission of the TSS to the AER. DNSPs will be able to amend their TSS during the regulatory control period, but this will be limited to specific circumstances where a change to the TSS would result in outcomes that better meet the pricing principles. The timeframe of the annual network pricing process will be moved forward to facilitate notification of approved annual network prices at least six weeks before they commence. Impact According to the AEMC, the changes will benefit all consumers in the longer term by better catering to different patterns of consumption, and reducing the need for spending on infrastructure due to lower peak demand. The AEMC chairman, John Pierce, has estimated that under the changes, around 70-80% of consumers would have lower network charges in the medium term. However, critics have noted that certain types of consumers, particularly those with solar PV rooftops, may be impacted heavily by the changes, as most of the solar energy is generated at non-peak periods during the day, meaning they still rely on 7 See Rule Determination, pages

5 the network during peak times. Some concern has been expressed by critics regarding the way in which solar PV may be treated in a similar manner to houses with large air conditioning units, without taking into account the potential grid benefits that rooftop solar households offer (such as shifting the peak and stabilising the grid). These matters are the subject of ongoing industry debate. Consumers and retailers are expected to have a greater role in the development of new network prices through consultation with DNSPs in the price setting process. Next Steps Network businesses will shortly need to commence consulting with retailers and consumers on the network prices that they propose to apply from Under the Rule Change, DNSPs will need to submit their initial TSS to the AER by late Authors: Jenny Mee jenny.mee@klgates.com Jemimah Roberts jemimah.roberts@klgates.com

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