Branch Name Commerce Commission Wellington NEW ZEALAND 27 June 2011 ISBN:

Transcription

1 Draft decision Minor Capital Expenditure and Operating Expenditure Allowances, and Quality Standards to apply to Transpower for the Remainder Period of Regulatory Control Period 1

2 Branch Name Commerce Commission Wellington NEW ZEALAND 27 June 2011 ISBN:

3 Table of Contents EXECUTIVE SUMMARY 1 Purpose... 1 Summary of Decision... 1 Operating Expenditure... 1 Capital Expenditure... 3 Input Prices... 5 Foreign Exchange Forward Rates... 5 Quality Standards... 5 Next Steps... 7 CHAPTER 1: INTRODUCTION Purpose and Scope of this Paper Document Structure Background Regulatory Objectives Process and Timeframes Next Steps CHAPTER 2: SUMMARY OF TRANSPOWER'S PROPOSAL Chapter Introduction Summary of Adjustments to Expenditure A Prolonged Period of Under-Investment Operating Expenditure Minor Capital Expenditure Input Prices Foreign Exchange Forecast Risk Quality Performance Measures - Targets, Caps and Collars CHAPTER 3: COMMISSION'S EVALUATION APPROACH Introduction Operating Expenditure and Capital Expenditure Input Prices Foreign Exchange Forward Forecasts Quality CHAPTER 4: DRAFT DECISIONS AND REASONS Introduction Summary of Draft Decisions Business Improvement Initiatives Operating Expenditure Minor Capital Expenditure Input Prices Foreign Exchange Forecasts Conversion from as spent to as commissioned Quality Standards APPENDIX A: QUALITY STANDARDS APPENDIX B: INPUT PRICES B1 Overview B2 CPI as assumption for input price growth B3 Input price inflation greater than CPI B4 Transpower s proposal... 49

4 Purpose EXECUTIVE SUMMARY X1 X2 The purposes of this paper are to: a. set out the Commission's draft decisions on the operating expenditure and Minor capital expenditure allowances to be provided for Transpower for the Remainder Period of RCP1; b. set out the targets, caps and collars relating to the quality standards that will apply; and c. seek feedback from interested parties on the draft decisions within this paper, and the reasons supporting these draft decisions. Submissions are invited from all interested parties. Submissions should be received by the Commission no later than 5pm on Friday 22 July Cross-submissions are due by 5pm on Friday 5 August Summary of Decision X3 The Commission's draft decision is to provide an allowance for operating expenditure of $847.3 million and an allowance of $825.1 million for Minor capital expenditure for RCP1. These allowances are apportioned over each year of the Remainder Period, for the purposes of setting the forecast maximum allowable revenue (forecast MAR), as set out in Table X1 below. Table X1 Draft decision - Allowance for operating expenditure and Minor capital expenditure Approved expenditure Nominal 2012/ / /15 ($ million) Operating expenditure Minor capital expenditure (as commissioned) X4 One element of the regulatory framework is monitoring and assessing Transpower s performance against quality standards. The Commission's draft decision regarding quality is to set the targets, caps and collars at the same levels that applied during 2011/12 (Transition Year). In accordance with the individual price-quality determination, the amount of Transpower's revenue at risk/reward from quality performance is set to zero. Operating Expenditure X5 In reviewing Transpower s proposed level of operating expenditure, the Commission considered matters such as whether the processes Transpower has in place will ensure the forecasting and delivery of an efficient level of expenditure, Transpower's efficiency relative to comparable transmission service providers, the capacity of Commerce Commission Doc # _12 1

5 Transpower and its contractors to deliver against its proposal, and Transpower's assumptions regarding real price effects. In addition, the Commission reviewed a number of specific programmes of work and individual projects to test Transpower's processes and the application of those processes. X6 X7 X8 The Commission's draft decision is to accept Transpower s operating expenditure proposal. The Commission's key conclusions regarding operating expenditure are that: a. the overall level of expenditure proposed by Transpower includes an increased amount of expenditure on maintenance compared to that of previous years to address a backlog of work, as well as a number of one-off business improvement initiatives; b. Transpower s operating practices, in some instances, are not consistent with good international industry practice, which may result in some expenditure being less efficient that could otherwise be the case; c. it will take time for Transpower to transition from its current practices to good international industry practice, therefore efficiency savings will not be immediately available, and likely not until RCP2; and d. it would be counterproductive to provide an allowance for the Remainder Period that is less than Transpower's proposal because the overall level of expenditure proposed, including increased maintenance and improvement initiatives, given current circumstances, is not considered unreasonable. Transpower has acknowledged that it needs to make efficiency improvements and has identified and begun to implement a number of specific business improvement initiatives. Despite a number of inefficiencies being identified in this instance, the Commission does not consider it beneficial to make efficiency adjustments prior to those savings having been achieved. In order to move to a more efficient operational state, a large amount of investment is required. At the same time, an increased level of maintenance is required, over and above a business-as-usual amount due to historic under-expenditure. Reducing Transpower's operating expenditure during the Remainder Period would likely affect Transpower's ability to implement the process improvements identified in its proposal, at the same time as improving the current performance of the grid and focusing on business-as-usual issues. Transpower proposed its level of operating expenditure in 2010/11 prices. However, the operating expenditure allowance set by the Commission will be in nominal prices. A number of input price adjustments, such as CPI and other changes to input prices are, therefore, added to the expenditure in real terms to provide the final nominal operating expenditure allowance. This is shown in Table X2. Table X2 Draft Decision - operating expenditure Operating expenditure allowance 2012/ / / /11 prices Input prices Nominal X9 Figure X1 provides both historic and forecast expenditure in 2010/11 prices. Commerce Commission Doc # _12 2

6 Figure X Historical and forecast operating expenditure (2010/11 prices) Historical expenditure Transitionyear Remainderperiod $ Million / / / / / / /15 Grid Maintenance IST maintenance Investigations Ancillary services Departmental Insurance Metering and data Table X3 Draft decision - Input price allowance Input prices 2012/ / /15 Forecast CPI 2.40% 2.40% 2.30% Operating expenditure $14.7m $21.9m $29.2m Minor capital expenditure $15.2m $22.7m $30.2m Capital Expenditure X10 X11 In reviewing Transpower s proposed level of capital expenditure, the Commission considered the matters outlined in paragraph X5. The Commission's draft decision is to accept Transpower s Minor capital expenditure proposal. The Commission's key conclusions regarding the level of Minor capital expenditure that Transpower proposed, are that: a. various aspects of Transpower s approach to forecasting Minor capital expenditure do not reflect current international industry practice; b. based on a bottom up approach to forecasting expenditures, Transpower's proposal fails to provide sufficient justification for its proposed level of Minor capital expenditure; c. Transpower urgently needs to develop internal systems, such as: X12 i. an integrated asset management system that enables the organisation to make efficient whole of life asset management decisions; ii. one consistent source of asset information; and iii. a quantitative, risk-based asset management approach that requires risk to be assessed and traded off against costs. Transpower s current outdated practices raise concerns about the robustness of Transpower s forecasts. The Commission is concerned that the use of outdated Commerce Commission Doc # _12 3

7 practices may negatively impact on the effectiveness of the actual investment undertaken by Transpower, such as actual investment projects not targeting the right areas (i.e. as determined by a risk-based approach). Investments may, therefore, be suboptimal as they do not maximise the benefit delivered for a given level of expenditure. X13 X14 X15 X16 The Commission considers that determining an appropriate quantum and type of Minor capital expenditure is difficult without first defining clear targets and output objectives. Transpower has not developed long-term targets based on its view of the appropriate level of risk at a network level, nor targets for output-related measures such as the network performance and quality measures. The Commission considers that it is critical that Transpower makes significant improvements in its asset management capability during RCP1, in terms of both systems and implementation of a risk-based approach consistent with current international industry practice. For this reason, the Commission considers it also necessary that Transpower be required to report annual progress, including an estimate of the benefits delivered, against the business improvement initiatives outlined in its proposal. This includes, in particular, both the development of its asset management capabilities and the development of a new asset management information system. Transpower proposed its level of Minor capital expenditure in 2010/11 prices, and proposed a number of input price adjustments be applied. The Commission agrees with the overall approach, but has applied a number of different escalation adjustments to set the Minor capital expenditure allowance in nominal prices. The capital expenditure allowance, converted from real to nominal, is shown in Table X4. In addition to an escalation adjustment for input price changes, as shown in Table X4, an adjustment was required to convert expenditure which had been forecast on an expected spend basis to an expected commissioning profile (explained further in section 4.8). Table X4 Draft Decision Minor capital expenditure Capital expenditure allowance 2012/ / / /11 prices (as spent basis) Input prices Commissioning adjustment Nominal (as commissioned) X17 Figure X2 provides both historic and forecast expenditure in 2010/11 prices on an as spent basis. Commerce Commission Doc # _12 4

8 Figure X Historical and forecast Minor capital expenditure (2010/11 prices) Historical expenditure Transition year Remainder period $ Million / / / / / / /15 Replacement and refurbishment Enhancement and development Information system technology Business support Input Prices X18 X19 X20 The Commission s draft decision is to accept the CPI forecasts proposed by Transpower. The Commission has accepted the overall approach proposed by Transpower for deriving future changes to input prices. In this regard, the Commission has assumed a default position of CPI+0% for input price changes, and assessed Transpower's justification for increases in input costs in excess of CPI. The Commission has accepted some Transpower's assumptions (where input prices are forecast to be different to CPI), but it has not accepted all assumptions. Where the Commission has not agreed with Transpower, it has applied alternative inputs to generate the overall input price allowance. More detail regarding these changes is provided in section 4.6. The forecast CPI values adopted, as well as the overall allowances for changes in input prices have been set out in Table X3. Foreign Exchange Forward Rates X21 Transpower's proposal uses the forward exchange rate as a basis for calculating the Minor capital expenditure allowance. The Commission considers that its approach is appropriate. Accordingly, the Commission s draft decision is to accept the foreign exchange forward rates assumed by Transpower. The forward rates are provided in Table 2.8 on page 24. Quality Standards X22 The Commission considers that the quality targets, caps and collars that are to be set should ideally provide incentives for Transpower to ensure electricity services are provided at an appropriate level. Given the worsening trend in grid reliability Commerce Commission Doc # _12 5

9 performance, the Commission is of the view that the use of recent historical data alone will not establish targets that signal that a halt deteriorating performance is required. Furthermore, given that no revenue is at risk in RCP1, this limits the amount of immediate incentives to promote improvements in grid reliability performance. X23 X24 X25 X26 X27 Transpower has acknowledged in its proposal that quality performance needs to improve, 1 and that significant effort is required to lift its asset management practices and capability from a position of industry follower to industry leader. 2 For these reasons, and given its commitments to improving performance, Transpower submitted an amendment to its proposal suggesting that applying the Transition Year targets, caps and collars to the Remainder Period would be more appropriate than applying targets calculated using historical data. The Commission s draft decision is to accept Transpower s amended proposal, and to set targets, caps and collars for the Remainder Period at the same level set for the Transition Year. While this does not require improvements during RCP1, long-term targets will be required of Transpower when setting targets for RCP2. The Commission expects those targets will take account of Transpower s own objective to achieve significant improvements in performance. While revenue will not be subject to the incentive mechanism until RCP2, incentives still exist in RCP1. Incentives exist because if Transpower does not address reliability issues in RCP1, attaining targets in RCP2, when revenue is at risk, may be more difficult. In the meantime, maintaining current performance may be sufficiently challenging. In addition, the Commission will monitor and assess Transpower's performance. Transpower will be required to annually report its progress on both quality performance and in implementing its main business improvement initiatives. The targets for the quality measures are provided in Table X5 over page. Table X5 Draft decision - Quality targets Measure Target Cap Collar Weighting Loss of Supply Event Frequency > 0.05 system minutes Loss of Supply Event Frequency > 1 system minute % % HVAC circuit unavailability (unplanned) - % % Total impact of interruptions (in system minutes) % 1 2 Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.6. Ibid, p.102. Commerce Commission Doc # _12 6

10 Next Steps X28 X29 X30 The Commission welcomes submissions on its draft decisions and reasons. Submissions should be received by the Commission no later than 5pm on Friday 22 July Cross-submissions are due by 5pm on Friday 5 August Chapter 1 provides details on how to make a submission. The Commission intends to publish its final decisions and reasons on these matters in August. Allowances for operating expenditure and capital expenditure determined in this process will be used in the calculation of allowable revenues (forecast MAR) for Transpower for the Remainder Period. Once the forecast MAR for the Remainder Period has been determined, the Commission will give effect to this by making the consequential amendments to the Individual Price-Quality Path Determination in November Commerce Commission Doc # _12 7

11 CHAPTER 1: INTRODUCTION 1.1 Purpose and Scope of this Paper The purposes of this paper are to: a. set out the Commission's draft decisions on the operating expenditure and Minor capital expenditure allowances to be provided for Transpower for the Remainder Period (1 April 2012 to 31 March 2015) of regulatory control period 1 (RCP1); b. set out the targets, caps and collars relating to the quality standards that will apply; and c. seek feedback from interested parties on the draft decisions within this paper, and the reasons supporting these draft decisions In addition to its proposal, Transpower provided to the Commission supporting documents including policies and strategies, budgets, external reports, board reports and other publically and non-publically available documentation. To aid consultation, the Commission has placed a number of those supporting documents on the Commission's website ( 1.2 Document Structure The document is structured as follows: Chapter 1 provides background information such as regulatory context and framework, and details on how to provide submissions on this document; Chapter 2 provides a factual summary of Transpower's proposal, as well as historical data. Appendix A supplements the historical information provided in relation to the quality standards; Chapter 3 sets out the evaluation framework that the Commission used in reviewing and assessing Transpower's proposal. Chapter 4 sets out the Commission's draft decisions, and the reasons for those decisions. 1.3 Background Individual price-quality regulation applies to Transpower, under Part 4, 3 from 1 April Under this form of regulation, the regulatory periods must be between four and five years. The first regulatory period (RCP1) has been set at four years. Revenues for RCP1 are split into two separate determinations. The first revenue determination was made in December 2010 and specified the maximum allowable forecast revenue (forecast MAR) for the first of the four years (Transition Year). A second 3 4 All statutory references in this paper refer to the Commerce Act 1986, unless otherwise stated. Commerce Commission, Commerce Act (Transpower Individual Price-Quality Path) Determination 2010, 22 December 2010, p.3. Commerce Commission Doc # _12 8

12 determination which will set revenues to apply to the subsequent three years of the four year period (Remainder Period), will be made by 30 November This determination will incorporate the Commission s decisions in relation to operating expenditure, capital expenditure and quality standards Under individual price-quality regulation applying to Transpower, a bottom up framework, applying key building blocks, is used to calculate the forecast MAR which enables Transpower to achieve an appropriate return. Two of the key elements in this building block formula are the allowances for both operating expenditure and capital expenditure The Commission is also required to determine the quality targets for the period from 1 July 2012 to 30 June 2015 by 30 November In regard to capital expenditure, the December 2010 individual price-quality (Transpower) determination split capital expenditure into two categories: Major and Minor. The review of Transpower s capital expenditure submitted in its 14 February 2011 proposal includes only Minor capital expenditure. Major capital expenditure is reviewed separately under a different process For the Remainder Period, Minor capital expenditure 8 is: a. replacement and refurbishment capital (with no limit on the size of any project); b. IST capital expenditure (with no limit on the size of any project); c. enhancement projects or programmes where the value is less than $5.0 million; and d. Business Support capital expenditure (with no limit on the size of any project). Capital expenditure input methodology Running in parallel with the Commission's review of Transpower's operating expenditure and capital expenditure proposal is the development of a new input methodology to apply to the assessment and approval of all capital expenditure (both Major and Minor). The deadline for determining the new capital expenditure input methodology is 1 February For this reason, the new capital expenditure input methodology approach for reviewing and approving Minor capital expenditure cannot be applied in the review of Transpower's proposed expenditure in RCP1. However, it will apply to all Major capital expenditure proposed from the date of the capital expenditure and input methodology determination The reasons for separating the revenue determinations in RCP1 are set out in Commerce Commission, Individual Price-Quality Path (Transpower) Reasons Paper December 2010, 22 December 2010, pp 3-4. Commerce Commission, Commerce Act (Transpower Individual Price-Quality Path) Determination 2010, 22 December 2010, p.27. Ibid, Clause 4.2(2), p.15. Ibid, pp On 22 June 2011, the Commission received a three month extension from the Minister of Commerce to the 1 November 2010 deadline. The new deadline is 1 February Commerce Commission Doc # _12 9

13 Statutory framework The statutory framework that applies to Transpower is set out in detail in the Commission's individual price-quality (Transpower) reasons paper. 10 In summary, the regulation that applies, as a package, is intended to promote over the long-term, the overall objectives of the Act as set out in s 52A(1)(a)-(d). In particular, the individual price-quality path promotes the long-term benefit of consumers by providing: a. incentives to invest, by allowing Transpower to fully recover and earn an appropriate return on its investments, consistent with s 52A(1)(a), and by providing a penalty/reward framework around quality standards consistent with s 52A(1)(b); b. incentives for Transpower to become more efficient in its operating expenditure, as well as incentives to make efficiency improvements to outperform its targets for quality performance, and in the longer term, in its capital expenditures, consistent with s 52A(1)(b); c. requirements for Transpower to share efficiency gains with consumers, such as through the incremental rolling incentive scheme for operating expenditure, consistent with s 52A(1)(c); and d. limits on the economic gains that can be made by Transpower in any given regulatory period, consistent with s 52A(1)(d) While it is not always apparent in isolation how each individual component of the individual price-quality path gives effect to the central purpose, it should be noted that when combined, each component collectively contributes to a package that promotes the objectives of the Act. Each component has been designed in a manner that carefully balances the incentives provided, taking into account the package as a whole. When considered in combination with each other, and with other requirements such as the input methodology (IM) determinations and information disclosure regulation, it can be seen that the components that determine the individual price-quality path will provide strong incentives for Transpower to act in a manner consistent with the Part 4 Purpose The setting of allowances for operating expenditure and capital expenditure which will feed into the calculation of Transpower's revenues is only one of the many components that contribute to the package of incentives that promote the Part 4 Purpose. 1.4 Regulatory Objectives Regulatory objectives and the Part 4 Purpose are discussed in more detail in Chapter 1 of the Commission's Individual Price-Quality Path (Transpower) Reasons Paper December However, in brief, the Commission explains that the central purpose of Part 4 is to promote the long-term benefit of consumers in markets where there is little or no competition and little or no likelihood of a substantial increase in Commerce Commission, Individual Price-Quality Path (Transpower) Reasons Paper December 2010, 22 December 2010, p.5. Commerce Commission, Individual Price-Quality Path (Transpower) Reasons Paper December 2010, 22 December 2010, pp 5-6. Commerce Commission Doc # _12 10

14 competition. This central purpose is to be achieved by promoting outcomes consistent with outcomes produced in workably competitive markets such that the regulatory objectives set out in paragraphs (a) to (d) of s 52A(1) are achieved In approaching its review of Transpower's proposed level of operating expenditure and capital expenditure, and Transpower s proposed quality targets, the Commission has sought to promote outcomes consistent with those produced in workably competitive markets. In undertaking its review, the Commission has sought to ensure that appropriate tension exists to maintain the correct balance between operating expenditure and capital expenditure, that all expenditure is appropriate and targeted, that expenditure is efficient, and that expenditure produces outcomes that meets consumers needs The draft decisions set out in this Paper, together with all the other elements of individual price-quality regulation that comprise the regulatory package applying to Transpower, promote over the long-term the overall objectives of the Act as set out in s 52A(1)(a) to (d). 1.5 Process and Timeframes Process for making a submission Submissions are invited from all interested parties on the draft decisions set out in this paper. Submissions should be received by the Commission no later than 5pm on Friday 22 July The Commission is seeking submissions on any aspect of its draft decisions in relation to specifying the level of operating expenditure and capital expenditure to apply to Transpower for the Remainder Period. The Commission has not identified specific questions for submitters so that submitters do not feel constrained as to the matters they should discuss in their submissions Where parties disagree with the Commission's draft decisions, submissions should set out the reasons for disagreeing and the alternative approach submitters suggest. This will assist the Commission in weighing up the arguments for and against the various approaches. The Commission requests that parties put forward all arguments and supporting documentation in their submissions so that the Commission can fully consider all relevant matters before it makes its final decisions In order to meet the timeframes for setting Transpower's MAR, and to provide Transpower sufficient time to set prices, the Commission relies on submissions being provided by the due-date. The Commission will only allow extensions beyond the duedate if the submitter provides good reasons in writing. Unless an extension has been granted, the Commission may not be in a position to adequately consider submissions that are received after the due-date To foster an informed and transparent process the Commission intends to publish all submissions received on its website ( Accordingly, the Commission requests an electronic copy of each submission and requests that hard copies of submissions not be provided (unless an electronic copy is not possible). Submissions should be ed to regulation.branch@comcom.govt.nz by the due-date, Commerce Commission Doc # _12 11

15 with the subject heading '[Company Name] submission on Transpower Opex/Capex Draft Decision Paper.' Cross-submissions The Commission also invites cross-submissions on matters raised in submissions on this Paper. The purpose of these cross-submissions is to ensure that the Commission is aware of points of agreement or disagreement on matters raised by other submitters on the Commission's draft decisions prior to it making its final decisions. Crosssubmissions are due by 5pm on Friday 5 August Confidentiality The Commission discourages requests for non-disclosure of submissions, in whole or in part, as it is desirable to test all information in a fully public way. It is unlikely to agree to any requests that submissions in their entirety remain confidential. However, the Commission recognises there will be cases where interested parties making submissions may wish to provide confidential information to the Commission If it is necessary to include such material in a submission the information should be clearly marked and preferably included in an appendix to the submission. Interested parties should provide the Commission with both confidential and public versions of their submissions. The responsibility for ensuring that confidential information is not included in a public version rests entirely with the party making the submission Parties can also request that the Commission makes orders under s 100 of the Act in respect of information that should not be made public. Any request for a s 100 order must be made when the relevant information is supplied to the Commission and must identify the reasons why the relevant information should not be made public. The Commission will provide further information on s 100 orders if requested by parties, including the principles that are applied when considering requests for such orders. A key benefit of such orders is to enable confidential information to be shared with specified parties on a restricted basis for the purpose of making submissions. Any s 100 order will apply for a limited time only as specified in the order. Once an order expires, the Commission will follow its usual process in response to any request for information under the Official Information Act Next Steps Following consideration of all submissions and cross-submissions in relation to the draft decisions in this Paper, the Commission will publish its final decisions on its website. The approved levels for operating expenditure and capital expenditure will be included in the s 53ZD notice that the Commission issues to Transpower, for the purpose of setting the forecast MAR to apply to the Remainder Period Timeframes and steps are set out in detail in Table 1.1 over page. Commerce Commission Doc # _12 12

16 Table 1.1 Process and next steps Key Step Consultation on the level of operating expenditure and capital expenditure to apply to Transpower for the Remainder Period. Date June/July/August 2011 Submissions due. 22 July 2011 (4 weeks) Cross Submissions due. 5 August 2011 (2 weeks) Commission issues s 53ZD forecast MAR notice to Transpower. Early August 2011 Commission publishes final decision regarding operating expenditure and capital expenditure allowances. Late August 2011 Commission sets MAR to apply to Remainder Period. 30 November 2011 Commerce Commission Doc # _12 13

17 CHAPTER 2: SUMMARY OF TRANSPOWER'S PROPOSAL 2.1 Chapter Introduction This chapter provides a high level summary of Transpower's proposal and a comparison with its historical expenditure and the previous thresholds as set by the Commission A number of accounting adjustments have been made by the Commission to the historical expenditure and to ensure historical and forecast expenditures are presented on a like for like basis in constant 2010/11 prices. This is required because certain costs are treated differently under individual price-quality regulation than under the settlement agreement. These adjustments are provided below, followed by a summary of Transpower s proposal. 2.2 Summary of Adjustments to Expenditure In its proposal Transpower presents forecast expenditure on a real basis in 2010/11 dollars, but compares its forecasts with historical expenditure presented in nominal terms. For the purpose of its assessment, the Commission has adjusted historical expenditure to a real basis in 2010/11 dollars, so that historical expenditure is directly comparable to Transpower's forecast expenditure In addition, a number of accounting adjustments have been required to ensure expenditure proposed under individual price-quality path regulation is compared correctly with historical expenditure under the Administrative Settlement and the Transition Year of RCP1. IST operating leases, for example, under the individual price-quality path are included as operating expenditure, whereas under the settlement, these were classified as capital expenditure. 12 Likewise, Business Support costs are now included in the capital expenditure allowance, whereas previously, these were excluded from the capital expenditure threshold. The required adjustments, in nominal terms and on an 'as spent' basis (as opposed to an as commissioned basis), are shown in Table 2.1 and Table 2.2, and then converted to comparable real terms. 12 IST operating leases were included as operating expenditure under individual price-quality regulation to be consistent with the Commission's decision on intangible assets as set out in the Commerce Commission, Input Methodologies (Transpower) Reasons Paper, 22 December 2010, Chapter 4. Commerce Commission Doc # _12 14

18 Table 2.1 Adjustments to operating expenditure Operating expenditure Administrative Settlement Transition Year RCP1 Historical 2008/09 Historical 2009/10 Forecast 2010/11 Forecast 2011/12 Operating expenditure Less: pass through costs Less: Commerce Commission levies Less: HVDC instantaneous reserve availability charges Plus: provision for IST operating leases Plus: insurance payment multi-year operating expenditure Plus: provision of instantaneous reserve event changes Plus: Balancing adjustment to reconcile historical numbers Adjusted operating expenditure 2010/11 prices Table 2.2 Adjustments to Minor capital expenditure Capital expenditure Administrative Settlement Transition Year RCP1 Historical 2008/09 Historical 2009/10 Forecast 2010/11 Forecast 2011/12 Minor capital expenditure Plus: ex-post approval of expenditure to enter the RAB Less: IST operating lease payments Plus: business support Plus: minor fixed assets Plus: balancing adjustment to reconcile historical numbers Adjusted minor capital expenditure 2010/11 prices on a as spent basis A Prolonged Period of Under-Investment Throughout its proposal Transpower makes reference to an extended period of underinvestment in asset refurbishment and replacement. Transpower observes that it had incorrectly assumed that transmission assets would increasingly face bypass risk from Commerce Commission Doc # _12 15

19 distributed generation. 13 This resulted in a deliberate and relatively prolonged period of minimal investment in the transmission system Transpower has now revised its view on the role of distributed generation and the longterm requirements of the transmission grid noting that capacity will need to increase over time. 14 However, the prolonged period of underinvestment has now adversely affected the performance of the grid resulting in a highly loaded network with frequent capacity constraints Transpower's proposal argues that the implication of this is that a backlog of investment is required and that it is likely to take some time before network reliability returns to previous levels Transpower's argument regarding the state of the grid appears to be supported by the 2009 International Transmission Operations & Maintenance Study (ITOMS), 16 which compared performance of 27 participating companies, and provided benchmarking analysis of Transpower and other national transmission service providers. The ITOMS study shows that Transpower's performance in terms of costs are average when compared to other industry participants. The study also showed that Transpower's quality performance is well below average when compared to other industry participants. 17 In this regard, performance has deteriorated since The ITOMS 2009 study is discussed in greater detail in the section below. International Transmission Operations & Maintenance Study (ITOMS) The ITOMS 2009 study compares normalised cost of maintenance for selected asset classes, and normalised service level measured in terms of forced outage rates for these asset classes. Figure 2.1 shows the overall ITOMS 2009 results Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.2. Transpower, Transmission Tomorrow, p.15. Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.2. Ibid, p 26. Ibid, pp Commerce Commission Doc # _12 16

20 Figure 2.1 Overall 2009 ITOMS results Source: Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, page Figure 2.1 shows that Transpower's service level performance of substation equipment and forced and fault outage rates for various classes of equipment is well below the ITOMS average. In general, Transpower attributes its poor performance of substation equipment to: the age and condition of certain asset fleets. Underinvestment in power transformers is a notable example, where benchmarking shows that the average age of Transpower's fleet is around 8-10 years older than the ITOMS average, with Transpower having amongst the oldest power transformers, on average, in the study; weaknesses in manufacturers' design of certain equipment, particularly disconnectors, leading to high rates of forced and fault outage; the effects of the moist, maritime New Zealand climate. This has, for example, had a significant effect on outdoor SF 6 circuit breakers, in conjunction with unsatisfactory choice of materials by the supplier in the original manufacture; and human errors in the design, setting and maintenance of protection equipment ITOMS 2009 identifies scope for improvement in many areas. Transpower has recognised the causes of its poor performance and has committed to achieving sustained improvements through a broad range of initiatives. These are discussed below. 18 Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.26. Commerce Commission Doc # _12 17

21 Strategic vision and business improvement initiatives Transpower's proposal discusses, in detail, its strategic vision and business improvement initiatives. In summary, these initiatives include: safety initiatives - Transpower acknowledged that its safety performance record is below industry standard. Transpower has appointed a Safety and Health Manager to implement a major change programme across the business; enhancing the asset management system - Transpower is embarking on a fiveyear asset management programme to implement an enhanced asset management system; improved asset risk management - recent amendments to the Electricity Industry Act 2010 have introduced statutory requirements for Transpower to make improvements to its risk management systems. Transpower plans to achieve the required improvements through compliance with NZS7901:2008; integrated works planning improvements - Transpower is implementing an integrated works planning system which includes improvements in cost estimation, deliverability testing and efficiency tracking; 19 cost estimating systems improvement - Transpower has commenced a two year programme to identify and implement changes required to attain a more accurate, auditable, transparent and robust cost estimating system across all grid capital works; and goals and challenges - Transpower's primary focus over the past 12 months has been on improving its operational and safety performance, and planning and delivering the projects that will strengthen and secure the national transmission system Transpower expects that the impact of these initiatives on cost efficiencies and quality performance will be gradual, noting that many of these initiatives will take a number of years to implement. 2.4 Operating Expenditure Transpower's operating expenditure forecasts have been prepared using a bottom up approach, estimated on the basis of expected cost. Transpower argues that its forecast operating expenditure is the minimum required to address the extended period of underinvestment and the current poor performance of the transmission system Figure 2.2 shows Transpower's historic and forecast operating expenditure for the period 2008/09 to 2014/15 in real dollars (2010/11) Figure 2.2 shows that Transpower has forecast an increase of $28 million (or 11%) in operating expenditure between 2009/10 and 2010/11, and is forecasting a further increase of $19 million (or 7%) between 2011/12 and 2012/13. Transpower's forecast 19 More detailed information including the roadmap for further improvement, is provided in the supporting document, Transpower, Integrated Work Planning, February Commerce Commission Doc # _12 18

22 operating expenditure for the Remainder Period shows a step change in 2012/13, followed by a small decrease in 2013/14 and 2014/15. Figure 2.2 Historical and forecast operating expenditure (2010/11 prices) Historical expenditure Transitionyear Remainderperiod $ Million / / / / / / /15 Grid Maintenance IST maintenance Investigations Ancillary services Departmental Insurance Metering and data Table 2.3 provides a breakdown of the cost categories in Figure 2.2. Table 2.3 Operating expenditure cost categories Transpower s proposed Operating expenditure ( 2010/11 prices ) Historical operating expenditure Administrative settlement 2008/ / /11 Transition Year 2011/12 Forecast operating expenditure 2012/13 Remainder period 2013/ /15 Grid maintenance IST maintenance Investigations Ancillary services Departmental Insurance Metering and Data Total operating expenditure The three significant increases in Transpower's individual operating expenditure cost categories between 2011/12 and 2012/13 are: Grid maintenance has a forecast increase of $4.7 million (4%). The forecast takes into account the planned replacement of aging and poor performing assets, refurbishments, customer works, grid upgrades and work force competency Commerce Commission Doc # _12 19

23 improvement programme. This cost category remains flat for the last two years of the remainder period; IST maintenance has a forecast increase of $6.9 million (22%). Transpower attributes this increase to completing the build phase of Transpower's telecommunications and network programme. This cost category remains relatively static for the last two years of the remainder period, averaging an increase of $2 million (5%) over the two year period; and Insurance has a forecast increase of $5.3 million (53%). Transpower attributes this increase to global premium rates increases and the additional growth of transmission assets. This cost category remains relatively static for the last two years of the remainder period averaging an increase of $0.2 million (1%) over the two year period Transpower notes that its operating expenditure forecast does not contain contingencies over and above the expected costs. Transpower intends to meet unforeseen increases in operating expenditure by deferring or re-prioritising other work programmes Minor Capital Expenditure Categories of expenditure Throughout its proposal, Transpower presents its historical capital expenditure spend on an 'as commissioned' basis, and forecast capital expenditure on an 'as incurred' basis. Transpower's capital expenditure forecasts on an 'as commissioned' basis were separately provided in spreadsheets The Commission has presented Transpower's capital expenditure forecast on an 'as commissioned' basis to enable viewing of trends on a like for like, comparable basis. Figure 2.3 shows Transpower's historic and forecast Minor capital expenditure for the period 2008/09 to 2014/15 in real dollars (2010/11). 20 Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.3. Commerce Commission Doc # _12 20

24 Figure 2.3 Historical and forecast Minor capital expenditure (2010/11 prices) Historical expenditure Transition year Remainder period $ Million / / / / / / /15 Replacement and refurbishment Enhancement and development Information system technology Business support Table 2.4 provides a breakdown of the cost categories in Figure 2.3. Table 2.4 Minor capital expenditure on an as spent basis Transpower s proposed minor capital expenditure (2010/11 prices) Historical Minor capital expenditure Administrative settlement 2008/ / /11 Transition year 2011/12 Forecast Minor capital expenditure 2012/13 Remainder period 2013/ /15 Replacement and refurbishment Enhancement and development Information system technology Business support Total Minor capital expenditure Transpower attributes its 2011/12 and 2012/13 increase in capital expenditure largely to increases in grid replacement and refurbishment expenditure. Transpower claims that this is required to manage an ageing asset fleet and to help ensure poorly performing and/or high risk assets are replaced to avoid deterioration in quality performance Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.5. Commerce Commission Doc # _12 21

25 2.5.5 The IST expenditure forecasts provide for the enhancement or replacement of Transpower's systems. This includes renewal of the nationwide telecommunications network, the development of new asset management information system capabilities, and an upgrade to the SCADA system Forecast expenditure on business support increases to $11 million on average over RCP1, an increase of $9 million(79%) when compared to the average expenditure during the Administrative Settlement of $2 million. The largest increase is in 2014/15, when forecast expenditure increases to $22 million at the time the lease on Transpower House expires Transpower notes that the capital expenditure forecasts do not contain contingencies over and above the expected costs, and that it intends to meet unforeseen capital expenditure through substitution and re-prioritisation of expenditure within the overall expenditure allowances Input Prices Transpower s broad approach to forecasting its base operating expenditure and capital expenditure requirements involved: a. developing forecasts for base expenditure in 2010/11 constant prices; and b. inflating the constant price forecast to nominal prices using input price growth assumptions (to allow for expected input price growth over the period) Transpower uses forecast CPI as the default input price assumption. All other input price assumptions are calculated relative to forecast CPI The CPI assumptions used in the calculation of the input price allowance are those proposed by Transpower and are shown in Table 4.6. Table 2.5 CPI assumption Input Prices 2012/ / /15 CPI Assumption 2.40% 2.40% 2.30% Source: Transpower, Escalation - Operating and Capital Expenditure, Appendix A, Table 12: Average* of CPI Indices applied to both Operational and Capital Expenditure Escalations, page Table 2.6 and Table 2.7 set out the assumptions used by Transpower in calculating input prices for operating expenditure and Minor capital expenditure respectively, relative to Forecast CPI. 22 Transpower, Expenditure Forecasts and Quality Performance: 1 July 2012 to 30 June 2015, 14 February 2011, p.3. Commerce Commission Doc # _12 22

26 Table 2.6 Transpower's operating expenditure input price assumptions - relative to forecast CPI Expenditure Category (CPI + X%) Direct FTEs 3rd Party Consultants 3rd Party Contractors Non Labour/ materials Departmental 1% 1% 0% 0% IST operations 1% 0% 1% 0% Ancillary services 1% 0% 0% 0% Investigation 1% 1% 0% 0% Insurance 1% 0% 0% 0% Transmission lines 1% 0% 2% 2% AC stations 1% 0% 0% 2% Source: Transpower, Escalation - Operating and Capital Expenditure, Appendix A, A.1 Summary Opex Escalation Factors, page 11. Table 2.7 Transpower's Minor capital expenditure input price assumptions - relative to forecast CPI Expenditure Category (CPI + X%) 2012/ / /15 Copper 0.6% 0.6% 0.7% Aluminium 8.3% 8.3% 8.4% Steel Fabric 2.5% 2.5% 2.6% All Metals 3.8% 3.8% 3.9% Civils 1.0% 1.0% 1.0% Labour 0.0% 0.0% 0.0% Source: Transpower, Escalation - Operating and Capital Expenditure, Appendix A, Table 13: 4 year average of key metal forecast indices applied to Capital Expenditure Escalations form BIS Shrapnel, page Foreign Exchange Forecast Risk Transpower has estimated that approximately 16% of its total Minor capital expenditure will be denominated in foreign currencies For the purpose of its proposal, Transpower has proposed forward rates based on three year averages of the current forward rates for a number of foreign currencies. Transpower has also estimated its exposure to individual currencies based on a comparison of the forecast projects with the amount of expenditure to overseas suppliers in historical projects Table 2.8 and Table 2.9 below set out the forward rates and exposures assumed by Transpower in its proposal. Commerce Commission Doc # _12 23