Response to CER Consultation on Transmission Revenue for 2011 to 2015 (CER/10/102)

Response to CER Consultation on Transmission Revenue for 2011 to 2015 (CER/10/102) August 2010

... 3 E XECUTIVE SUMMARY... 3 INTRODUCTION... 7 A TSO RESOURCED TO MEET THE EVOLVING NEEDS OF INDUSTRY AND CONSUMERS... 9 A FINANCEABLE TSO IN A POSITION TO MAKE THE NECESSARY INVESTMENTS FOR THE FUTURE... 13 A TRANSMISSION SYSTEM BUILT TO REQUIREMENT: THE IMPORTANCE OF CLIENT ENGINEERING... 17 FACTUAL CORRECTIONS AND CHANGING CIRCUMSTANCES... 18 CONCLUSION... 20 APPENDIX 1: RESPONSE TO NETWORK CAPEX ANALYSIS APPENDIX 2: COMPLEXITY OF REAL TIME OPERATION APPENDIX 3: CLIENT ENGINEERING REQUIREMENTS APPENDIX 4: RETENTION OF SAVINGS APPENDIX 5: WACC SUMMARY APPENDIX 6: EIRGRID S WACC SUBMISSION OF 2 JUNE 2010 APPENDIX 7: EIRGRID S OPERATING COST BASE APPENDIX 8: WHY HICP IS INAPPOPRIATE APPENDIX 9: FACTUAL CORRECTIONS 2

EirGrid Response to CER Consultation on Transmission Revenue Executive Summary This submission responds to the Commission s consultation on the TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102). EirGrid welcomes the Commission s recognition that significant network capital expenditure is required in the period to support the facilitation of renewables. However, in a number of vital areas the transmission revenue proposed is not sufficient. Amendments to the draft determination are required to allow EirGrid to meet the needs of the electricity industry and consumers. There are also a number of factual errors in the calculations which we assume will be corrected. The factual errors will reduce EirGrid s allowed revenue by c. 18m over the five years, which is extremely significant for EirGrid s business. These points relate to the factual position consistent with the Commission s stated intent in the draft determination. The majority of this submission focuses on the key issues of debate, in particular: That the Commission s analysis has not taken into account the evidence that EirGrid s operating costs are appropriate and in line with market and the proposed allowance does not provide the necessary resources for EirGrid to meet industry requirements going forward; That the Commission s proposal may not support a financeable TSO business and has not fully taken account of EirGrid s specific circumstances; and That the Commission has not provided for the resources necessary for EirGrid to fulfil its Client Engineering function, which is essential such that EirGrid can be assured that the network is being built to requirement and is fit for purpose. We look forward to the opportunity to engage with the Commission on these issues. A sustainable operating cost base to meet industry requirements EirGrid has a crucial role to play in the next five years in terms of bringing forward the network development required to facilitate the Government s 40% renewable target and putting new processes and measures into place to ensure that the increased intermittent generation can be accommodated. It is important that EirGrid is in a sustainable position to respond to industry needs and proactively introduce improved measures. Since TSO vesting in July 2006, the scope of TSO activity has significantly increased and EirGrid has brought forward a number of efficiencies and process improvements which have delivered benefits to consumers. EirGrid is committed to continuing to create efficiencies and process improvements, and welcomes the ongoing application of incentives to its TSO business. EirGrid wishes to see an increase in the power and effect of incentives in areas which are highly valued by customers and in which the company is able to exert a 3

reasonable degree of influence 1. As per the process set out by the Commission, EirGrid will engage separately with the Commission on the specific incentives. The Commission is proposing a 5% 2 reduction in EirGrid s operating cost base. However, EirGrid has provided, as part of this process, numerous pieces of evidence that show that its labour cost base is appropriate. This includes an independent benchmarking exercise by Towers Watson which showed that EirGrid is in line with comparative markets in Ireland. In addition, and counter to trends in the wider economy, EirGrid has delivered a real reduction in unit costs over the PR2 period. Going forward, the Commission s proposes that EirGrid s operating cost base should trend with inflation. However, this proposal is overly coloured by the current economic environment. The ESRI has predicted that, having fallen in 2009-2011, salaries will increase by 2.4% - 3.2% 3 over the 2010-2015 period. In the event of economic recovery in the period, as predicted by the ESRI, EirGrid would not be in a position to recruit and retain the resources it requires, and therefore to meet the industry s and consumers needs out to 2015. EirGrid does appreciate that this is a particularly difficult time to determine how costs are likely to evolve in the coming years and there are divergent views between EirGrid and the Commission on this point. However, it is critical that EirGrid has an appropriate operating cost allowance over the five year period to effectively undertake its activities. EirGrid has therefore proposed a clause which will hedge both the consumer and EirGrid for the movement of labour costs versus HICP over the five year period. Turning to the proposed headcount, the SKM report recommends that the CER consider a request for additional control centre costs, including shift staff and associated IT systems when requirements become clearer. EirGrid welcomes the acknowledgement of the need for increased resources to manage the increasing complexity of real time operation as a result of the increase in intermittent, asynchronous generation and the commissioning of the East West Interconnector. A clause is proposed to provide for the associated costs when required. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 5% reduction in EirGrid s operating cost based in light of the evidence presented that EirGrid s operating costs are appropriate and in line with market. Recognising the increased operational complexity associated with the increased renewable generation and the East-West Interconnector, a clause to be included which states that: The Commission will provide the revenue associated with providing for an additional controller in the National Control Centre upon the Commissioning of the East-West Interconnector Recognising the current uncertainty in relation to forecasting cost movements, a clause to be inserted that protects both consumers and EirGrid if labour costs diverge from HICP: 1 Under the current industry structure, EirGrid s direct influence on network delivery is limited to specific Stage 1 activities. Upon EirGrid becoming Asset Owner, in addition to System Operator, the single accountability for endto-end delivery will provide the potential for greater incentivisation in relation to network delivery. 2 Due to the factual errors, the actual reduction applied by the Commission is 16%. As we assume these will be corrected, we focus here on the appropriateness of the proposed 5%. 3 Depending on the choice of scenario. 4

in the event labour costs, as measured by changes in average hourly wages, diverge from HICP to such an extent that a cumulative difference of greater than 2.5% emerges between them over the PR3 period, in either direction, the revenue allowance will be adjusted to take account of the revised labour costs in the economy and the revenue allowance for EirGrid indexed accordingly. Ensuring a Financeable TSO Business EirGrid is not a typical utility business. It is asset light, acts as a custodian of significant revenues for other parties, has a very thin operating margin, and has significant working capital requirements. These characteristics mean that EirGrid has little ability to absorb shocks and, in effect, the tests to ensure financeability are higher. However, it does not appear that the draft determination has taken EirGrid s specific characteristics into account. The Commission has proposed to claw-back 9.15m of historical savings made by EirGrid. The scale of the proposed claw-back is particularly significant in the context of EirGrid s business; it is in excess of the total proposed allowed return on the TSO RAB in PR3. It has implications for regulatory certainty and the continued applicability of the incentive based model, and with a potential impact on lenders perception of the risk in the regulatory model. EirGrid has recognised that if there are works specifically delayed due to exceptional circumstances, then associated savings could be considered to be outside of the scope of the ex ante incentive mechanism. EirGrid has returned 5.5m of non-network capex savings that fall into this category and do accept that there is some correlation between the nonnetwork capex not expended and IT operating costs, which SKM has estimated to be 3m. The Commission has also proposed a WACC of 5.00% for both EirGrid and ESB Networks which is below the cost of capital actually achievable in the market, and is more challenging for a company like EirGrid with small-company characteristics. EirGrid has provided significant evidence to show that the proposal does not align with market evidence and has not taken account of all relevant factors, such as Irish specific risks and EirGrid s smallcompany characteristics. EirGrid welcomes the fact that the Commission has recognised the need to amend the working capital arrangements. However, it is imperative that the working capital proposals outlined by EirGrid are implemented in full in order to appropriately remunerate its working capital requirements. In particular, the Commission should provide for the nominal cost of financing on the provision against external costs and a 0.5% margin on TUoS. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 9.15m clawback or, at the very minimum, the clawback to be reduced to the 3m of IT opex savings which EirGrid accepts were correlated to the non-network capex already returned. If any clawback is made, a clause to be inserted confirming that this is a once off provision associated with the exceptional uncertainty pertaining at the time of EirGrid establishment and does not represent a change to the underlying incentive regime pertaining. An amended WACC to take account of EirGrid s specific characteristics and the market evidence. Provision for the nominal cost of financing on the working capital provision against external costs. Otherwise no mechanism exists for the recovery of the time value of money as would exist in the case of a normal RAB. To do otherwise is anomalous. 5

Provision of a 0.5% margin on TUoS, rather than the 0.25% which was proposed, given the recognition that EirGrid s requirements exceed that sought and the degree to which the offsetting factors outlined by the Commission have been taken into account. Meeting our Statutory Requirements: The Importance of Client Engineering The role of the Client Engineer is essential under the current split responsibility model. It provides EirGrid with the assurances needed that the network is being built to requirement and is fit for purpose. The Commission s draft determination does not provide for any increase in Client Engineering resources, despite the significant increase in the level of network development to be undertaken. EirGrid already undertakes its Client Engineering function on an audit basis, focussing on key tasks and milestones in project delivery. This has been necessary in order to perform the function within the resources provided by the Commission for PR2. Going forward, EirGrid has proposed further efficiencies and economies of scale. EirGrid has submitted for 1 Client Engineer for every 17m of capital expenditure per annum in PR3; this compares to 1 Client Engineer per 11m of capex per annum in PR2. EirGrid rejects the Commission s claims that there is no value-add, and has advised the Commission of deficiencies identified in the past by the Client Engineer. These deficiencies would have had the potential to compromise safety and security of supply and to increase costs. AMENDMENT TO THE DRAFT DETERMINATION Provision of the revenue allowance for an additional 8 Client Engineers consistent with the proposed network development. To not provide this will detract further from EirGrid s ability to monitor work and identify shortcomings, and will impact on quality, security of supply, and increased costs in remedying defects at a later date. Factual corrections As previously highlighted to the Commission, there are a number of fundamental inaccuracies in the Commission s calculations. Taken together they will reduce EirGrid s allowed revenue by c. 18m over the five years. This is extremely significant relative to both EirGrid s underlying return and balance sheet. Similarly through the Commission s decisions made as part of this process, circumstances have changed since the making of our submission which will impact on our costs. Specifically, we have outlined an adjustment required due to the proposed non-alignment of the revenue and tariff years. AMENDMENT TO THE DRAFT DETERMINATION Factual corrections to be made in the final determination. Provision to be included for additional revenue of 150k per annum relating to the costs associated with the non-alignment of the revenue/ tariff/ accounting years. 6

Introduction This submission responds to the Commission s consultation on the TSO and TAO transmission revenue for 2011 to 2015 (CER/10/102). The submission comprises this core paper and a number of appendices and separate papers which support our position. EirGrid s TSO business is a high value-add service based business. We are committed to continuing to deliver value to the electricity industry and consumers. This will be vital in the next decade given the fundamental transformation of the Irish power system. The regulatory determination represents the only source of finance available to EirGrid. It must therefore provide the funding necessary for EirGrid to deliver the services that industry and consumers need. While EirGrid is a new business and therefore does not have a legacy of inefficiency, we remain committed to further efficiency improvements. We therefore brought forward cost reductions and efficiencies in both our operating costs and capital costs 4 in our submission of revenue requirements. EirGrid welcomes the ongoing application of incentives to its business. We have stated that we wish to see an increase in the power of incentives in areas highly valued by consumers and will be engaging separately with the Commission to this end. More generally the company welcomes the opportunity to be held to account for the ongoing delivery of quality transmission services, though this is only possible with a financeable balance sheet and sustainable operating cost base. Decisions made today will continue to have ramifications three, four and five years hence when economic circumstances will be significantly different. It is therefore important decisions are both appropriate today and flexible enough to be able to adapt to changing circumstances. One such change which we expect in the period is the transfer of the transmission assets to EirGrid in line with Government policy. EirGrid s submission has been made on the basis of the existing split responsibility industry structure. Therefore, the benefits which EirGrid expects to be able to deliver following asset transfer have not been factored in. Delivery today is the responsibility of two parties, neither of which has full control or accountability; this does not lend itself to well designed incentives. The single accountability, and end to end responsibility, which will result post asset transfer will at that time enable the Commission to put in place meaningful incentives for network build and will ensure consumers ultimately benefit. There are aspects of the Commission s draft determination we welcome: The Commission has concurred with EirGrid s own assessment that a significant increase in network development is required as part of the Grid25 Strategy and has proposed a flexible approach to the revenue allowance to cater for this 5. 4 An assumed 1% per annum productivity improvement in operating costs and a 10% reduction in Stage 1 costs; that element of the network capital spend currently within EirGrid s remit. 5 Appendix 1 further outlines EirGrid s considerations in respect of the network capex allowance and the approach taken by the Commission and SKM in deriving that allowance including our view that the Commission and SKM have placed something of an over-reliance on the use of Dynamic Line Rating and Special Protection Schemes. 7

The Commission has recognised the importance of financeability and its significance in the EirGrid context. While we do not believe it goes far enough we welcome the fact that the Commission has proposed to make some of the required amendments to remuneration of the pre-project Agreement assets and Working Capital. The Commission has proposed that pension deficits within both utilities will be dealt with, albeit outside of the PR3 process. This is very important to EirGrid as its deficit was almost entirely inherited from ESB upon vesting and therefore a matter over which it had, and has, limited control. We have already made a submission to the Commission and look forward to engagement with the Commission to address this important issue as soon as possible. However, in a number of instances, the Commission s proposals require further amendment to enable EirGrid to meet the needs of the electricity consumer and to fulfil its statutory functions. With the amendments we are proposing in the paper Ireland will have a Transmission System Operator business which: Is resourced to meet the changing and evolving needs of industry and consumers; Is financeable and in a position to make the necessary investments for the future; and Can ensure that the transmission system which is not only planned effectively but also built to requirement. The remainder of this paper outlines our concerns and proposals in these three key areas. We have also incorporated a section which details a number of factual errors. These errors reduce EirGrid s allowed revenue by c. 18m over the five years, which is extremely significant for EirGrid s business. We have also outlined the necessary amendments to correct these errors which we assume will be made in the Commission s final determination. 8

A TSO resourced to meet the evolving needs of industry and consumers To meet the Government s renewable targets and the needs of consumers and industry, it is vital that EirGrid has a sustainable ongoing revenue stream. This is extremely important as the extent of grid development ramps up, increased numbers of parties connect to the system, and as EirGrid looks to adapt to the challenges of meeting Ireland s renewable objectives. We are committed to the ongoing delivery of quality transmission services. However, in the absence of an adequate opex allowance EirGrid will need to make choices as to which services it can continue to provide over the 2011-15 period. The underlying opex allowance should be supported by well designed incentives which appropriately balance risk and reward. EirGrid is developing proposals for incentivisation in parallel with this response. Evidence Supporting EirGrid s Operating Cost Baseline The Commission is proposing an underlying baseline reduction of 5% to EirGrid s operating costs. While EirGrid is committed to keeping costs down and to contributing to national competitiveness, we do not believe that the Commission s proposal is justified. This is supported by the evidence. An independent benchmarking exercise undertaken by Towers Watson concluded that the remuneration arrangements within EirGrid are in line with the comparable labour markets in Ireland with EirGrid costs averaging 99% of market. Analysis undertaken on behalf of the Commission itself, commissioned from PWC in the context of the SEMO control, found EirGrid salary structures to be between 3% and 12.5% below the market median depending upon specific role. EirGrid has delivered a 1-1.5% real reduction in unit wages over the 2006-10 period despite a number of constraints inherited from ESB. This compares to an average real increase in average industrial wages of over 11% and in public sector wages of 8% over the same period. EirGrid has put in place a revised Grading and Remuneration System following its vesting from ESB. The revised arrangements are market and performance based with no automatic increments. In 2009 and 2010, EirGrid differentiated itself from other semi state companies by determining not to pay the payment due under the National Wage Agreement (NWA), recognising the economic circumstances prevailing. EirGrid has also already experienced a 4.5% fall in revenues in line with CPI. Meanwhile, average hourly wages across the economy continued to rise both in real and nominal terms according to recently published CSO data 6. The Commission s analysis has therefore not taken account of: The 4.5% reduction in revenues already experienced by EirGrid through the application of CPI indexation to the allowable revenues; 6 CSO, Statistical Release Earnings and Labour Costs Q4 2008 - Q4 2009 8 th July 2010 9

Statistical trends confirmed by the CSO; and The benchmarking evidence that EirGrid s baseline operating costs are appropriate and in line with market. The Commission should take into account the evidential basis outlined by EirGrid and reverse its proposed 5% reduction in operating costs. Appendix 7 provides further support for EirGrid s case in this regard. Adequate Resourcing for the Future EirGrid has outlined to the Commission and SKM the need for an additional controller in the NCC as a result of the increased complexity of managing greater levels of intermittent and asynchronous generation and the commissioning of the East West Interconnector. The SKM report recommends that the Commission consider a request for additional control centre costs including shift staff and associated IT systems when requirements become clearer. EirGrid welcomes this. The Commission should therefore include a specific clause within its final determination which provides for an additional controller in the National Control Centre concurrent with the commissioning of the East West Interconnector in 2012. Further detail and support for this is set out in Appendix 2. Trends Going Forward: Appropriate Indexation As part of its original submission at the end of 2009, EirGrid submitted a range of material outlining and substantiating how its operating costs are expected to move over 2011-2015. EirGrid s forecasts took account of, inter alia, CSO statistics for wage growth relative to CPI, EirGrid s particular demographics, and sectoral specific effects including the buoyancy of the energy sector internationally. EirGrid also factored in a 1% per annum efficiency improvement which it believes it can deliver. Taken together these factors implied that EirGrid s cost base will move by 1.7% relative to CPI. In contrast, the Commission s draft determination proposes that, having applied a 5% reduction to the baseline, operating costs should trend with inflation thereafter. The section above discusses why the 5% cut is neither appropriate nor evidential in its basis and should therefore be reversed. Looking forward, an overarching limitation of the Commission s analysis is that it is overly coloured by the economic environment pertaining in Ireland in 2009 and 2010, while the decisions made now will affect EirGrid s allowed revenue out to 2015. For example: The Commission employs the ESRI s Recovery Scenarios for Ireland report citing their forecast of a nominal decrease in wages of 6% over 2009-11. However, the Commission has chosen to omit the latter impact of this very same report including the ESRI s 10

predictions that wages will increase by between 2.4% per annum and 3.2% per annum over the 2011-15 period depending upon the choice of scenario 7. The Commission has ignored the fact that, while certain sectors of the economy have experienced significant contraction, the energy sector, which is largely international in nature, remains buoyant. This is something that has been acknowledged elsewhere by the Commission in the recently published consultation on the SEMO revenue 8. The Commission effectively applies a common approach to both EirGrid and ESB without regard to experience, qualifications, expertise and professional status, age or demographic profile. All of these factors mean EirGrid is in fact quite different from ESB in terms of its composition, make up and likely future cost profile. The Commission has not taken into account recent regulatory precedent which recognises operating costs in even efficient regulated businesses rise more rapidly than underlying price inflation (Ofgem: RPI+1.2%; ORR: RPI +0.75% and OPPA: RPI + 0.8%). The draft determination is therefore at variance both with domestic forecasters such as the ESRI and international regulatory practice. In addition, the Commission is seeking to change the underlying index from CPI to HICP. The change has been introduced at such a time as to effectively provide twice for the effect of the economic downturn with the worst of both indices cumulatively applied. Appendix 8 sets out EirGrid s views regarding the inappropriateness of HICP in this context. It is clear that there are diverging views regarding how operational costs will evolve over the 2011-15 period. EirGrid does recognise that these are difficult times in which to make such long range forecasts. However it is critical that EirGrid has an appropriate operating cost allowance over the five year period to effectively undertake its activities. To overcome this uncertainty EirGrid therefore proposes the following clause be included in the final determination. in the event labour costs, as measured by changes in average hourly wages, diverge from HICP to such an extent that a cumulative difference of greater than 2.5% emerges between them over the PR3 period, in either direction, the revenue allowance will be adjusted to take account of the revised labour costs in the economy and the revenue allowance for EirGrid indexed accordingly. The proposal focuses on labour costs as this is the main component of EirGrid s operational costs; EirGrid differs from ESB in this regard. It achieves two things: it protects EirGrid if economy-wide labour costs rise significantly above the HICP and will therefore allow EirGrid to continue to deliver the services which industry needs; however, if labour costs trend below HICP then the customers will see the benefit of this through lower allowed revenue for 7 The ESRI recently published a revised version of this report which is consistent with these figures, but suggested a greater likelihood that the outcome would be towards the lower end. 8 Page 25 of SEM/10/050 states The energy sector is certainly relatively buoyant, owing mainly to the sustainability agenda and, in the island of Ireland, the introduction of the SEM. 11

EirGrid. The clause hedges both the business and consumers from the consequences of having an inappropriate trend line for operational costs. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 5% reduction in EirGrid s operating cost based in light of the evidence presented that EirGrid s operating costs are appropriate and in line with market. Recognising the increased operational complexity associated with the increased renewable generation and the East-West Interconnector, a clause to be included which states that: The Commission will provide the revenue associated with providing for an additional controller in the National Control Centre upon the Commissioning of the East-West Interconnector Recognising the current uncertainty in relation to forecasting cost movements, a clause to be inserted that protects both consumers and EirGrid if labour costs diverge from HICP: in the event labour costs, as measured by changes in average hourly wages, diverge from HICP to such an extent that a cumulative difference of greater than 2.5% emerges between them over the PR3 period, in either direction, the revenue allowance will be adjusted to take account of the revised labour costs in the economy and the revenue allowance for EirGrid indexed accordingly. 12

A Financeable TSO in a position to make the necessary investments for the future Importance of financeability Financeability is an extremely important issue for EirGrid given its asset light structure, very thin operating margin and its custodianship of significant revenues for other parties. It therefore has significant working capital requirements. While it does not go far enough in its proposals, the Commission s draft determination does recognise the importance of financeability and EirGrid welcomes this. In particular, the Commission has provided both for remuneration of the Pre Project Agreement assets on an as-incurred basis and the application of a 0.25% TUoS margin. Significance in Scale of the Proposed Clawback The Commission has proposed a clawback of 9.15m of historical savings made by EirGrid in the PR2 period. To put the scale of this into context, it is in excess of the total proposed allowed return on the TSO RAB in PR3 and over twice the assumed equity return provided for in the PR3 period. EirGrid has concerns in relation to the implications of the proposed clawback for regulatory certainty and continued applicability of the incentive based model. If any clawback is made, the Commission should confirm that this is a once off provision associated with the exceptional uncertainty pertaining at the time of EirGrid establishment and does not represent a change to the underlying incentive regime pertaining 9. To fail to do so would result in the power of any future incentive being significantly diminished. More directly the decision has implications on EirGrid s ability to meet banking covenants entered into for the financing of EWIC and on the confidence of the banking sector in the robustness of the EirGrid financial model. EirGrid has recognised that if there are works specifically delayed due to exceptional circumstances, then associated savings could be considered to be outside of the scope of the ex ante incentive mechanism. EirGrid has returned 5.5m of non-network capex savings that fall into this category. We do further accept that there is some correlation between the non-network capex not expended and IT operating costs, which SKM has estimated to be 3m. Appendix 4 further outlines EirGrid s position in respect of the retention of savings made in 2006-10. Cost of Capital in an EirGrid Context The Commission has proposed a WACC of 5.00% be applied to both EirGrid and ESB Networks. The 5.00% proposed represents a low cost of capital for an asset owning business and below that achievable in the marketplace. The 5.00% is even more challenging for a company like EirGrid with its small company characteristics. The impact of these 9 The possibility of forecasts not aligning with outturns is a feature of ex ante based regulation, particularly where the forecast extends over a period of 5 years. Indeed, if the business had overspent due to forecasting error, then this would have been expected to be absorbed by the business consistent with preserving the incentive for the company to efficiently manage costs. This is the approach taken by the Commission in the case of the DSO. 13

characteristics on the cost of capital was recently recognised, and explicitly provided for, in the Competition Commission decision for Bristol Water. EirGrid questions the practicality and achievability of the components that derive the 5% WACC. It is clear from EirGrid s own recent market experience in acquiring funds for EWIC, that the Cost of Debt proposed is not achievable in the marketplace. This view is supported by evidence prepared by Deloitte 10. Furthermore, EirGrid points to clear evidence, supported by CEPA, highlighting the existence of a specific Irish Country Risk Premium which is not reflected in the Commission s proposal. The Commission has uplifted its assessment of the market cost of capital by 0.4% to take account of the asymmetric costs of setting the rate too low. This adjustment itself, however, has not considered the increased risks of the current volatile financial climate. The cost for the Irish government in raising finance has further risen even since the Commission has published its draft paper 11. The Commission should therefore further re-examine the cost of capital in light of the material provided and the continued uncertainty in the financial climate. A cost of capital in line with market evidence should be provided or, in the absence of this, the EirGrid specific characteristics outlined need to be recognised and provided for elsewhere. Appendices 5 and 6 include a set of accompanying papers which provides evidence substantiating our position in relation to the WACC. The Importance of Working Capital Systematic mismatches between revenues and receipts mean that EirGrid must manage a series of cashflow differentials. These give rise to working capital requirements. These differentials can be predominantly categorised in the following manner; Cost Variation, Income Variation and Timing Differentials. EirGrid proposed a number of provisions to remunerate the business for its working capital requirements. We welcome that the Commission has dealt with these provisions to some degree. However, it is imperative that the provisions are implemented in full. Specifically it is necessary that: The Commission provide for the nominal cost of financing on the working capital provision against external costs as it is ultimately the nominal cost of financing which is faced by the business; The Commission provides EirGrid with a 0.5% margin on TUoS rather than the 0.25% which has been proposed. In relation to the failure to provide for the nominal cost of financing the Commission has provided justification which confuses the indexation of costs on the one hand with the cost of the capital to finance potential mis-match in their incurrence and receipt on the other. The Commission suggests that because the external costs included in the TUoS tariff are 10 Refer Appendix 6, Part 3. This Appendix has been specifically excluded from the version for public release for reasons of commercial confidentiality. 11 See http://www.ntma.ie/publications/2010/auctions2010.pdf 14

indexed for inflation, applying the real WACC to the cost of financing potential forecast differences will compensate EirGrid for the effects of inflation. This is not the case. Therefore, EirGrid requires an inflation adjusted provision for working capital on the total amount. This simply brings this provision in line with all the other returns applied by the Commission across the control where a nominal WACC is effectively applied. In relation to the application of the TUoS margin, the draft determination acknowledges that the amount of working capital implied by the above.(i.e. the Commission s calculation of EirGrid s requirements).is an order of magnitude higher than the amount EirGrid is requesting. (CER/10/102 : page 131) The Commission then goes on to state that, as a result of offsetting factors, only 0.25% should be provided. However, it is precisely because EirGrid took these offsetting factors into account 12 that it was 0.5% which was sought rather than some higher number. EirGrid s explanation of how these offsetting factors have already been taken into account, is provided below: The timing of receipt and payment: where payments themselves did not give rise to any working capital mismatch (e.g. Ancillary Services) EirGrid did not include them in its specific examples provided to the Commission and referenced in the Commission s paper; The seasonal profile benefit of energy volumes: EirGrid specifically accounted for this in the examples provided to the Commission. This benefit is, however, now set to be reduced compared to EirGrid s forecasts as a result of the rebalancing decision; Early receipt of payment: negligible benefit at best; greater risk of late payment; Failure to factor in remuneration through Euribor: EirGrid did factor in the compensation received through the application of Euribor to the k factor. However, the impact of this is greatly overstated by the Commission as it applies solely in the case of inter year differentials and not in the case of intra year cash management which is the primary requirement in relation to the timing differentials which this provision is largely designed to deal with. The Commission recognises that EirGrid s requirements exceed that sought. SKM, the Commission s consultants, recommended 0.5% of a margin to be reasonable. We have demonstrated the degree to which the offsetting factors outlined by the Commission have in fact been taken into account. There is therefore no reason why the 0.5% margin sought by EirGrid should not be provided by the Commission. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 9.15m clawback or, at the very minimum, the clawback to be reduced to the 3m of IT opex savings which EirGrid accepts were correlated to the non-network capex already returned. 12 The benefits of which have since decreased due to the absence of seasonal benefit in tariff re-balancing. 15

If any clawback is made, a clause to be inserted confirming that this is a once off provision associated with the exceptional uncertainty pertaining at the time of EirGrid establishment and does not represent a change to the underlying incentive regime pertaining. An amended WACC to take account of EirGrid s specific characteristics and the market evidence. Provision for the nominal cost of financing on the working capital provision against external costs. Otherwise no mechanism exists for the recovery of the time value of money as would exist in the case of a normal RAB. To do otherwise is anomalous. Provision of a 0.5% margin on TUoS, rather than the 0.25% which was proposed, given the recognition that EirGrid s requirements exceed that sought and the degree to which the offsetting factors outlined by the Commission have been taken into account. 16

A Transmission System Built to Requirement: The Importance of Client Engineering The role of the Client Engineer is essential under the current split responsibility model. It provides EirGrid with the assurances needed that the network is being built to requirement and is fit for purpose. This is critical to enable EirGrid to operate and develop a safe and secure system. However, the Commission s draft determination does not provide for any increase in Client Engineering resources, despite the significant increase in the level of network development to be undertaken. This decision appears to be based on an assessment of the appropriateness of the role, rather than the efficiency with which EirGrid performs the role. The current revenue review is an inappropriate forum to provide judgement on the appropriateness of the industry model Response to the draft determination The Commission states that the CE role should be carried out on a generic and audit basis, Client Engineers should only be involved in critical stages of the work and there is no added value gained by site visits or witnessing commissioning. EirGrid already undertakes its Client Engineering function on an audit basis, focussing on key tasks and milestones in project delivery. This has been necessary in order to perform the function within the resources provided by the Commission for PR2. Going forward, EirGrid has proposed further efficiencies and economies of scale. EirGrid has submitted for 1 Client Engineer for every 17m of capital expenditure per annum in PR3 (less than 1% of the capital cost of the network build); this compares to 1 Client Engineer per 11m of capex per annum in PR2. EirGrid rejects the Commission s claims that there is no value-add and has advised the Commission of deficiencies identified by the Client Engineer. Appendix 3 further sets out EirGrid s role, specific examples of where the Client Engineering function has added value, and counters the arguments raised by the Commission and SKM. Summary The role and responsibilities of the Client Engineer are enshrined in the Commission regulated Infrastructure Agreement. Compliance with the Infrastructure Agreement is a requirement of EirGrid s TSO licence. A provision for an additional 8 FTEs is required consistent with the Commission s proposed network capex programme of 1.45bn. Without these resources comes the real potential and likelihood of increased costs and implications for both security of supply and health and safety. AMENDMENT TO THE DRAFT DETERMINATION Provision of the revenue allowance for an additional 8 Client Engineers consistent with the proposed network development. To not provide this will detract further from EirGrid s ability to monitor work and identify shortcomings, and will impact on quality, security of supply, and increased costs in remedying defects at a later date. 17

Factual Corrections and Changing Circumstances As previously highlighted to the Commission, there are a number of fundamental inaccuracies in the Commission s calculations. Taken together they will reduce EirGrid s allowed revenue by c. 18m over the five years. This is extremely significant relative to both EirGrid s underlying return and balance sheet. Similarly through the Commission s decisions made as part of this process, circumstances have changed since the making of our submission which will impact on our costs. Specifically, we have outlined an adjustment required due to the proposed non-alignment of the revenue and tariff years. Overview of errors The Commission recently provided spreadsheets detailing the calculation of the opex baseline and the revenue model. These have helped us to understand how the allowed revenue was derived. In particular, we have found that: 1. There were a number of anomalies and omissions in relation to the calculation of the 2009 baseline against which a 5% reduction has been applied. In effect this means that EirGrid s operating cost baseline has been reduced by c. 15% rather than the intended 5%. 2. There is a formulaic error in the spreadsheet in the derivation of Working Capital. This may be the result of a corrupt cell in the spreadsheet. 3. The RAB has not been calculated on a consistent basis with previous Commission determinations in relation to SEM readiness and Premises. EirGrid has outlined adjustments to the Opening Asset Value of the RAB and depreciation profile to fix this. Appendix 9 provides further detail of these errors and example workings to show how to correct them. Clearly these factual errors are extremely significant in scale and have a significant impact on the financeability and sustainability of EirGrid s business. These points relate to the factual position consistent with the Commission s stated intent in the draft determination, rather than issues of policy debate. Costs Associated with the Non-Alignment of Revenue Year The draft determination states that the Commission is not proposing to align the revenue tariff with the tariff year for PR3. In reaching this proposal, the Commission notes that: ESBN also maintained that the new arrangement would entail additional cost. The task of preparing regulatory accounts to a different reporting period than the statutory accounts would cause a significant additional administrative burden and cost, for instance two different closing periods and two different audits by external auditors. As the draft determination notes, EirGrid adjusted its accounting year to align with the tariff year on the basis of the Regulatory Authorities decision to also align the revenue year. EirGrid agrees with ESBN s comments that the arrangement would entail additional costs. Indeed, these additional costs are being faced by EirGrid at present. These costs were not 18

factored in EirGrid s revenue submission, as we assumed that the Commission would align the revenue year as previously stated. As this now does not appear to be the Commission s intention, we seek 150k per annum for costs relating to the non-alignment of the revenue/ tariff/ accounting years. AMENDMENT TO THE DRAFT DETERMINATION Factual corrections to be made in the final determination. Provision to be included for additional revenue of 150k per annum relating to the costs associated with the non-alignment of the revenue/ tariff/ accounting years. 19

Conclusion In this paper, we have set out the amendments necessary to enable EirGrid to meet the needs of the electricity industry and consumers and to fulfil its statutory obligations: 1. A TSO that is resourced to meet the changing and evolving needs of industry and consumers. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 5% reduction in EirGrid s operating cost based in light of the evidence presented that EirGrid s operating costs are appropriate and in line with market. Recognising the current uncertainty in relation to forecasting cost movements, a clause to be inserted that protects both consumers and EirGrid if labour costs diverge from HICP: in the event labour costs, as measured by changes in average hourly wages, diverge from HICP to such an extent that a cumulative difference of greater than 2.5% emerges between them over the PR3 period, in either direction, the revenue allowance will be adjusted to take account of the revised labour costs in the economy and the revenue allowance for EirGrid indexed accordingly. Recognising the increased operational complexity associated with the increased renewable generation and the East-West Interconnector, a clause to be included which states that: The Commission will provide the revenue associated with providing for an additional controller in the National Control Centre upon the Commissioning of the East-West Interconnector 2. A TSO that is financeable and in a position to make the necessary investments for the future. AMENDMENTS TO THE DRAFT DETERMINATION Removal of the 9.15m clawback or, at the very minimum, the clawback to be reduced to the 3m of IT opex savings which EirGrid accepts were correlated to the non-network capex already returned. If any clawback is made, a clause to be inserted confirming that this is a once off provision associated with the exceptional uncertainty pertaining at the time of EirGrid establishment and does not represent a change to the underlying incentive regime pertaining. An amended WACC to take account of EirGrid s unique characteristics and the market evidence. Provision for the nominal cost of financing on the working capital provision against external costs. Otherwise no mechanism exists for the recovery of the time value of money as would exist in the case of a normal RAB. To do otherwise is anomalous. Provision of a 0.5% margin on TUoS, rather than the 0.25% which was proposed, given the recognition that EirGrid s requirements exceed that sought and the degree to which the offsetting factors outlined by the Commission have been taken into account. 3. A TSO that can ensure that the transmission system is not only planned effectively but also built to requirement. 20

AMENDMENT TO THE DRAFT DETERMINATION Provision of the revenue allowance for an additional 8 Client Engineers consistent with the proposed network development. To not provide this will detract further from EirGrid s ability to monitor work and identify shortcomings, and will impact on quality, security of supply, and increased costs in remedying defects at a later date. EirGrid has also outlined a number of factual corrections to the Commission s draft, or where, through the Commission s decisions, circumstances have changed since the making of our submission. We assume these changes, which are not about issues of policy debate, will be addressed and amended in the Commission s final determination. AMENDMENTS TO THE DRAFT DETERMINATION Factual corrections to be made in the final determination. Provision to be included for additional revenue of 150k per annum relating to the costs associated with the non-alignment of the revenue/ tariff/ accounting years. 21