PUBLIC SUBMISSION TO CHARGE RULES ISSUES PAPER FOR IRRIGATIONOPERATORS BY GOULBURN-MURRAY WATER ON 15 JULY 2008
INTRODUCTION
Goulburn-Murray Water (G-MW) is pleased to participate in the process for developing water charge rules for irrigation operators.
G-MW has unbundled its water entitlements into water shares, delivery shares and water use licences. Significant tariff reform has been an important and complementary component of water entitlement unbundling. G-MW is arguably one of the leading irrigation operators in relation to the development and implementation of delivery service access regimes.
G-MW welcomes further discussion with the ACCC in relation to the comments made in this submission or in relation to other matters that the ACCC may consider relevant to the development of water charge rules for irrigation operators.
COMMENTS ON SPECIFIC QUESTIONS IN THE ISSUES PAPER
Question 1 Are there any matters not mentioned above that are relevant in
establishing a methodology for determining prices consistent with the
objectives and principles of the Act?
G-MW comment
G-MW considers the proposed methodology suitable for determining prices consistent with the objectives and principles of the Act.
Question 2 Are there any issues the ACCC should be aware of in relation to servicestandards? Provide details including:
a) to what extent the proposed level of service is or should becommunicated to customers during the price-setting process
b) the role of customers when establishing service standards
c) the role of customers in determining the balance between thelevel of prices and the standard of service
d) the extent to which service standards are, or should be,reported publicly
e) the extent to which service standards form, or should form, partof a customer service contract
f) the types of service standards that currently exist.
G-MW comment
Goulburn-Murray Water develops prices and service standards in a consultative process involving customer-elected consultative committees. This process is overseen by the Essential Services Commission. Customers heavily influence the service standards that are established and thereby the balance between level of service and price. Service standards are reported publicly and form part of a customer service charter. Service standards include the level of service, availability and timeliness.
Question 3 Are there any issues the ACCC should be aware of in relation tolegislative and regulatory obligations? Provide details, including:
a) to what extent obligations are, or should be, clearly articulatedby regulators and government
b) the types of obligations placed on operators
c) how the obligations currently placed on operators are, or should be, funded
d) the extent to which obligations are applied consistently acrossthe basin?
G-MW comment
G-MW believes that obligations should be clearly articulated. G-MW’s functions and responsibility are described in the Water Act 1989 and its primary obligations in regard to discharging its functions are set out in the Statement of Obligations issued by the Minister. A copy is available upon request.
The funding of obligations placed on G-MW is generally by users. However, there are circumstances where other funding is provided or is appropriate in recognition that undertaking the obligation achieveswider public benefits or addresses legacies of previous government policies and therefore should not be funded solely by current users.
Question 4 In transitioning towards upper bound pricing:
a) What factors may influence the path or pace of transition? Howmight these factors be addressed?
b) Are there circumstances in which upper bound pricing cannotor should not be achieved?
G-MW comment
The factors which may influence the path or pace of transition include the base from which the transition starts, the quantum of increase required and the potential implications of upper bound pricing on future demand for the services. Transition plans that provide users with an adequate time to adjust are one mechanism that could be used.
If upper bound pricing would result in elimination of demand for the service then an alternative asset management and price path is indicated, possibly involving phasing out the service. In such circumstances upper bound pricing may not be appropriate. The Victorian Government has indicated in its White Paper Our Water Our Future that lower bound pricing is acceptable for existing rural water assets.
Question 5 To what extent are the two approaches applied consistent with theconditions listed above? Are there any issues that the ACCC should beaware of when considering the two approaches? Provide details, suchas:
a) the current approach, or what might be considered anappropriate approach, for determining forward-looking capitalexpenditure needs
b) whether forward-looking expenditure programs areindependently audited and, if so, at what frequency
c) what type of expenditure is suited to the renewals annuityapproach
d) the period over which the renewals annuity and regulatoryasset base expenditures are discounted and included in prices
e) how often the renewals annuity and associated bank surplusesor deficits are adjusted
f) what discount rate (or rate of return) is used under bothapproaches
g) what factors should be taken into account in determining thediscount rate
h) whether there are any inhibitors to using the weighted averagecost of capital as the discount rate and whether it is appropriateto use this approach
i) whether any operators recover a value of past investments infuture prices
G-MW comment
G-MW previously operated under the renewals annuity approach and now uses the regulatory asset base approach.Under the regulatory asset base approach, the only future capital expenditure that can be included in the calculation of prices is that which is forecast to be undertaken within the current 5 year regulatory period. The forecast expenditure is closely scrutinized by customer committees and independently audited by the Essential Services Commitment to ensure that it is prudent and efficient. There is a very high degree of probability that the expenditure will be undertaken and that it will be undertaken at the cost and at the time forecast.
Under the renewals annuity approach, forecasts of capital expenditure up to 100 years into the future (depending on the asset type) can be included. There is far less certainty about such forecasts than exists with the regulatory asset base approach. This would be especially the case if there is significant future structural adjustment in the irrigation sector. Even without structural adjustment, i.e. all assets are still required, the cost and timing of capital expenditure will not always be the same as predicted in annuity calculations used in developing prices, which has implications for the prices applied at a particular point in time.
G-MW adjusted the renewals annuity and renewals reserve on an annual basis. Prices were calculated using a rolling calculation process that sought to mimic the actual changes in the renewal reserve balances based on the expenditure forecasts for each of the future years which affected the annuity calculation. For example, to calculate a 30 year price path with a 50 year renewal annuity required an 80 year capital expenditure forecast.
Under the renewals annuity approach, which was used prior to price regulation by the Essential Services Commission, a real discount rate of 4% was used for the renewals annuity calculation. Under the regulatory asset base approach the Essential Services Commission determines the weighted average cost of capital to be used.
Under either the renewals or regulatory assets base approach, the value of past investments may form part of future prices. With the renewals annuity approach this occurs because in practice a mix of debt and equity is used to finance capital expenditure and because the regulatory asset base approach involves debt financing which can include the inclusion in the asset base of debts related to previous capital expenditure.
Question 6 Are there any issues that the ACCC should be aware of in relation toasset valuation? Provide details, such as:
a) how operators currently finance capital investments—whetherit is solely through the renewals annuity or through acombination of the annuity and separate contracts with certaincustomers (maintaining a separate asset base for pricingpurposes)
b) under the regulatory asset base approach how existing assetsshould be valued
c) in what circumstances might it be reasonable to revalue assetsunder the regulatory asset base approach?
d) Are there any characteristics of irrigation assets that lendthemselves to any particular asset valuation methodology?
G-MW comment
Capital expenditure related to renewal of assets is financed using the regulatory asset base approach. Creation of new assets is also financed in this way but can also be funded by grants, government equity contributions and customer contributions(either as up-front payments or by repayment of individual loans advanced by Goulburn-Murray Water). Only that component of the investment that is to be recovered from prices is included in the regulatory asset base.
Under the regulatory asset base approach existing assets should be valued at their depreciated value.
G-MW has not yet encountered any circumstances that would require asset revaluation under the regulatory asset base approach.
For accounting purposes G-MW believes the most appropriate valuation methodology is optimized depreciated replacement cost.
Question 7 Are there any issues that the ACCC should be aware of in relation totaxation? Provide details, including:
a) whether operators are subject to either the Federal Income Taxor National Tax Equivalent Regimes?
b) the implications for prices where varying tax obligations applyacross the Basin
c) the extent to which taxation liabilities are calculated in amanner similar to the table above and details of any differences
d) any relevant issues, rulings, or tax laws that may influence theestimation of taxable income for the purpose of constructing arevenue requirement for pricing
e) examples of where a significant, inexorable, real tax timingdisadvantage has been experienced from the receipt oftermination fees
G-MW comment
G-MW is subject to the National Tax Equivalents Regime.
G-MW is not aware of how taxation obligations impact other organizations.
For G-MW, any Government grants for capital purposes will be treated as an equity contribution direct to the balance sheet and not included as revenue for taxation purposes. Other treatments are similar to those outlined in the Issues Paper.
G-MW is still incurring large tax losses as tax depreciation is still calculated using accelerated depreciation rates, and therefore tax issues have not materialized yet. As the tax losses reverse in the future other tax treatments will gain importance.
Termination fee receipts to date have been immaterial. However the taxation implications will need to be modelled and they will need to incorporate a tax impact or there will be real revenue leakage.
Question 8 To what extent do operators prepare, or should operators prepare, plansand undertake consultation processes for future capital and operatingexpenditure requirements? Where possible, provide details, includingdetails of:
a) the consultation process undertaken by operators whendeveloping capital and operating plans, and the role ofcustomers in this process
b) independent review of asset management plans and operatingand capital plans, and to what extent these reviews ensure thatprices are based on prudent and efficient expenditure
c) how often independent reviews are undertaken
d) the role, if any, of independent consultants in the preparation ofplans
e) to what extent the results of independent reviews are, or shouldbe, made public and reflected in prices
f) programs currently in place, or that should be in place, toimprove productivity and efficiency over time.
G-MW comment
Goulburn-Murray Water develops capital and operating expenditure plans in consultation with customer-elected consultative committees. Following the Victorian Government’s White Paper Our Water Our Future, Goulburn-Murray Water is placing an increasing emphasis on developing these plans within a 30 year strategic service and asset management plans. This has involved the creation of reference groups comprising customer and stakeholder representatives who participate in the development of proposals for reconfiguration of the delivery system.Goulburn-Murray Water has used independent consultants to assist its in-house expertise in the development of the strategic asset and service management plans.
Goulburn-Murray Water’s expenditure proposals are reviewed and audited by the Essential Services Commission to ensure they are prudent, efficient and incorporate the outcomes of customer and stakeholder consultation. The outcome of the reviews is made public and reflected in prices. The timing of reviews is determined by the Essential Services Commission.Goulburn-Murray Water set targets for productivity improvement, communicates them with customers, and develops budgets, expenditure forecasts and prices assuming that the productivity targets will be achieved. This is an important element of G-MW’s continuous improvement process.
Question 9: What principles and approaches are most appropriate when allocatingfixed or common costs of irrigation delivery services (i.e. those coststhat do not vary with the volume of water supplied)? Provide details,including:
a) to what extent embedded cross-subsidies or community serviceobligations (CSOs) currently exist within irrigation networks;in what circumstances and to what extent such cross-subsidiesor CSOs should be maintained in perpetuity; and whatprocesses are, or could be, used to reduce or eliminate crosssubsidiesand CSOs
b) to what extent current charges do, and whether they should,reflect a uniform or postage stamp pricing policy
c) to what extent current charges do, and whether they should,reflect the costs of providing services to different segments ofthe market.
G-MW comment
G-MW believes there are few, if any, instances of CSOs in relation to its delivery services. Instances where this could arise might be the requirement to retain delivery infrastructure to deliver water for environmental watering purposes when the infrastructure would not otherwise be needed.
Prior to G-MW’s creation, postage stamp pricing was in place and prices were subsidized from consolidated revenue. As part of its formation and the transition to user –pays G-MW,in consultation with customers,adopted zonal pricing. The delivery system has been disaggregated into a number of zones based on the major nodes of the delivery system. As well as reflecting the physical delivery system, these nodes are geographically separate and align well with community identity and generally encompass a relatively similar agricultural industry mix with a common service level requirement. Within each of these zones, uniform prices apply.
Changing existing pricing aggregations is difficult. As well as determining whether the existing pricing arrangements are efficient there are also issues of equity, history and administrative feasibility to be dealt with. Landowners have bought and invested in properties based on current pricing approaches whereby all customers in a particular location have paid uniform delivery prices. Changes to pricing policies will have impacts on property values and wealth distribution between landowners and may undermine community harmony. These impacts need to be weighed against the possible efficiency gains that may be realized. With network services there is potentially a range of prices that can be efficient and community consultation and support is an important input to decision making about the extent of price differentiation.
G-MW does not believe that prices should be based on who is the end-user of the service or for the purpose for which water is delivered. Rather, price differentiation should reflect different levels of service and different levels of cost.
Question 10 To what extent and in what circumstances should the setting of fixed andvolumetric charges be allowed to deviate from the underlying (fixed andvariable) cost structure of the operator?
G-MW comment
G-MW seeks to align costs and revenues. Currently, its variable fees for delivery services are set somewhat higher than variable costs. This has resulted in significant operating losses in recent low delivery years.The imbalance between fixed revenue and fixed costs can be explained because G-MW is still in a state of transition from the tariff and price mix that existed for most of the last century, whereby:approximately 30% of revenue was variable; variable revenue was relatively stable due to high water availability; and, there was a stronger perceived need for overt price signals to minimise unnecessary water use.
Since then drought, the maturing of the water market and the introduction of carryover into the entitlement framework has changed the context within which prices are formed. Opportunity cost (rather than G-MW prices) is emerging as the primary determinant of customer behaviour in relation to water use.
Question 11 To what extent is pricing used as a cash management tool or insurancefund for irrigators? Are operators best placed to provide this service?What are the practical implications for the trade of water under such apricing arrangement?
G-MW comment
G-MW does provide some cash flow management to customers due to variable charges being higher than variable costs, though this a consequence of the current price mix rather than a deliberate policy.In response to customer concerns regarding the payment of fixed charges for infrastructure in years of low water availability, G-MW has examined ways in which it might provide risk management services to customers.While irrigation operators could provide risk management services, G-MW believes that others, such as banks and insurance companies, are better placed to assess customer business viability and help customers understand and manage these types of risks.
If prices are biased towards variable fees as a cash management tool or insurance service then any delivery shortfall relative to the delivery volumes used in pricing calculations will result in revenue shortfalls – these delivery shortfalls could be partly due to trade of water allocation or entitlement. These revenue shortfalls will need to be made up through price increases in future years. G-MW’s experience is that most customers express a high priority for relatively stable, predictable future price paths. This is more difficult to achieve with a bias to higher variable fees. Also with a bias to higher variable fees, the overall revenue requirement is likely to be higher due to increased financing costs associated with revenue shortfalls. Again, most customers would prefer that overall prices were lower and that individual customers, rather than the irrigation operator, were responsible for managing farm cash flow.