Frontier Economics was an independent advisor to AustralianSuper, for Brookfield and EIG's Origin Energy takeover scheme. Our role was to review the assumptions used in the Independent Expert’s Report (IER) in Origin’s Scheme Booklet.

Using robust economic analysis and long-standing expertise in the energy sector, our advisors, engaged by AustralianSuper - a long-term shareholder in Origin - found that the assumptions used in the IER to derive a business valuation are unrealistically low.

We refer all enquires in regards to this takeover bid, and our economic advice on this matter, to AustralianSuper.

A copy of the full media release from AustralianSuper can be downloaded below.

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Frontier Economics' Tim McNamara, Mike Woolston and Dinesh Kumareswaran were commissioned by the Water Services Association of Australia (WSAA) to produce the report Understanding Efficiency to explain in "plain English" the concepts of economic efficiency and how they apply to the water sector. The report also illustrates what efficiency looks like under different scenarios using examples from the water sector and detailed case studies. Below is the Executive Summary of the report.

About this report

The aim of this report is to explain in ‘plain English’ the concepts of efficiency and how these are utilised within businesses, by economic regulators and others to assess service and expenditure proposals in pricing submissions and business cases.

Efficiency in the urban water sector

It is important for businesses to be able to understand and demonstrate efficiency, not just to get approval of pricing submissions from regulators – but also to demonstrate they are providing value for money to customers, owners, and other stakeholders.

Common or dictionary definitions of ‘efficiency’ tend to focus on the relationship between inputs and outputs of producing a good or service, but this narrow interpretation may lead to misconceptions. Minimising costs may not necessarily be consistent with providing customers’ desired service levels, maintenance and investment in asset capability and supply resilience, or delivering broader outcomes which are desired by customers or society.

Rather, economic efficiency can be seen as synonymous with value for money - providing the services customers want at the lowest long-term cost. The regulatory frameworks applied by most economic regulators do provide for broader ’value for money’ outcomes in assessing efficiency.

Some common misconceptions about efficiency

There are a number of common misconceptions about demonstrating efficiency in the urban water sector. These related misconceptions include:

1. Efficiency means prices need to be flat or declining
2. Efficiency is about cutting costs to the minimum
3. Efficiency is incurring lowest possible costs over the upcoming determination period
4. Efficiency means providing services at the lowest possible standards consistent with regulatory and other obligations
5. Efficiency is about deferring new investment as long as possible and running assets to fail
6. Efficiency means minimising costs even if this leads to higher risks
7. Efficiency means neutralising the impact of other drivers of expenditure (e.g. growth) so prices remain constant overall without having to disaggregate the drivers
8. Efficiency means demonstrating on a once-off basis that a business is efficient relative to the industry standard.

A common thread underlying these misconceptions is that ‘efficiency’ is synonymous with cost minimisation. Not only is cost minimisation in itself not an appropriate objective - but it is not an appropriate interpretation of what it means to be ‘efficient’.

Minimising costs may not necessarily be consistent with:

• providing services at the level customers want
• maintaining and investing in asset capability and supply resilience
• delivering broader outcomes which are desired by customers or society.

How is efficiency measured and demonstrated?

While how best to demonstrate efficiency may depend on the audience, fundamentally it is about demonstrating that a proposal is in the long-term interests of customers.

The overarching approach of economic regulators in determining efficient levels of expenditure for regulated urban water businesses, which they then allow to be recovered in regulated prices, typically involves:

• Establishing the services to be provided to meet regulatory and other obligations and customers' preferences
• Establishing the minimum expenditure needed to efficiently deliver these services
• Setting prices which are forecast to enable the business to recover the total expenditure which the regulator has deemed to be 'prudent and efficient'.

Typically regulators adopt a ‘prudency and efficiency test’ to provide assurance that the businesses are (1) doing the right things; and (2) doing those things as efficiently as possible.

Regulators typically assess the prudency and efficiency of operating and capital expenditure individually, as well as the trade-off between these two types of expenditures:

• While both detailed ‘bottom up’ assessments of various operating expenditure items and broader ‘top down’ approaches which focus on broad categories of expenditure have been applied by regulators, the latter (particularly the base-step-trend approach) is becoming increasingly widespread.
• Approaches to assessing the efficiency of capital expenditure typically examine the business' capital governance frameworks, policies and procedures, and review a sample of the business's proposed capital expenditure projects. This generally requires reference to an identified need or cost driver, evidence that the business has considered alternate solutions including non-network solutions, and that the cost of the defined scope and standard of works is consistent with conditions prevailing in the relevant markets.

What lessons does recent regulatory experience provide?

We examined a number of recent regulatory reviews and decisions by state economic regulators. This provided a number of key insights and lessons that can be drawn upon for future periods.

• The Base Step Trend methodology is being adopted by a number of water regulators
• Capital projects exposed to uncertainty have the potential to be deferred to future periods
• Willingness to pay studies are helpful but should not be used in isolation to justify expenditure
• Consultation and analysis is required to demonstrate the prudency of projects
• The introduction of new services needs to predominately benefit customers
• Capital expenditure proposals should be supported by robust business cases
• Regulators often require alternative options to providing the service to be considered.

Guidance for demonstrating efficiency 

We have identified some overarching guiding principles that should be adopted to demonstrate the efficiency of expenditure proposals regardless of the context in which efficiency is being measured or demonstrated: 

• Adopt a business case (or cost-benefit analysis) approach to all expenditure proposals 
• Focus on the long-term interests of customers, considering factors including operating and capital expenditure trade-offs and the impact on service standards over time and supported by Net Present Value NPV (analysis)  
• Consider both prudency and efficiency of expenditure, including how cost proposals incorporate efficiency targets and continuing efficiencies (as would occur in a competitive market)
• Explain trends in operating and capital expenditure and key drivers of these trends  
• Develop a narrative that explains the link between expenditure and outcomes for customers 
• Conduct analysis that is proportionate to the size and impact of the potential expenditure. 

However, there is no single methodology or technique that is appropriate to use in all circumstances to measure and demonstrate efficiency. The appropriate approach may vary depending on factors such as the nature of the: 

• expenditure (i.e. operating vs capital expenditure or large ‘step’ in operating expenditure) 
• activity (discretionary vs non-discretionary expenditure). 

Table 1. Approach to demonstrating efficiency - a guide

Step	Type of expenditure	Evidence/  data required	Techniques	Example
Outline why the spending is in the long-term interest of customers	All	Link spending to specific outcomes for customers in terms of services and prices over the long term  Clear ‘golden thread’ narrative	Investment Logic Mapping	See section 4.2 and 5.5
Prudency: Link spending to non-discretionary obligation	Non-discretionary  opex & capex	Identify key drivers including relevant legislative or regulatory obligations	Understanding of non-discretionary service (and related) outcomes, including their timing	Central Coast Council (section 3.3.3)
Prudency: Demonstrate that customers want the proposed service/level or outcome	Discretionary opex & capex	Customer feedback	Surveys, customer forums	Case study 2
Prudency: Demonstrate that customers are willing to pay for this service	Discretionary opex & capex	WTP studies	Choice modelling	Case study 2
Analyse a range of options to produce the desired outcome	All	List of alternative options including capital vs recurrent solutions – ideally in business case	Cost-benefit analysis	Case study 3
Identify a preferred option	All	Business case or similar	Cost-benefit analysis (benefit -cost ratio, NPV etc)	Case study 3
Undertake sensitivity analysis to demonstrate the preferred option is robust	Capex/major opex step change	Business case or similar (preferred option is superior under a range of assumptions/scenarios)	Sensitivity analysis  Real options analysis  Scenario analysis	Case study 3, Sydney Water resilience expenditure (section 3.6.3)
Ensure/demonstrate the preferred option/proposed services will be delivered at the lowest cost	Opex	Historical expenditure   Productivity growth (continuing efficiency) forecasts  Market-tested estimates	Base-step-trend  Benchmarking	Case study 1
Ensure/demonstrate the preferred option/proposed services will be delivered at the lowest cost	Capex  Step jump in opex	Robust procurement process (e.g. market-testing or similar)  Detailed approach to managing delivery of project and associated risks  Proposed expenditure is within long-term context & strategy  Consideration of scope for application of continuing efficiency factor	Business case methodology	Powercor ICT investment (section 3.4.3)
Benefits realisation (ex pt)	All	Ex post assessment of benefits and costs	Post project review	See section 2.2

 

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Frontier Economics' Stephen Gray was commissioned by Vector to assess whether the draft Input Methodology decision by the New Zealand Commerce Commission will help or hinder the investment that’s needed to decarbonise the economy. The New Zealand Commerce Commission is currently developing a final decision over the key regulatory principles that bind the way electricity networks in Aotearoa New Zealand can operate and invest for the next seven years, and possibly longer (the Input Methodologies, or IMs).

In this video below, Stephen shares his view on how the IMs could support the network investments needed to deliver New Zealand’s energy transition to net zero by 2050.

Electrification is at the core of New Zealand’s decarbonisation strategy, and this will require extensive investment in transmission and distribution networks over a short period of time. Indeed, it will be impossible for New Zealand to meet its decarbonisation commitments without this extensive network investment.

Moreover, there is widespread agreement that investment in electricity networks today will secure long-term benefits for consumers. So it is important that New Zealand’s regulatory framework helps to facilitate the network investment that is required.  However, there is a real risk that the current regulatory framework will, in fact, hinder major network investment projects.

The key problem is that the regulatory cash flows tend to be back-ended, creating a risk that the cash flows in the early years of a project’s life are not sufficient to support the credit rating and gearing that the regulator has assumed. Where this happens, a project is not commercially viable and does not proceed. And, of course, no consumers receive any benefit from a project that does not proceed.

Our analysis found the draft Input Methodologies do not contain the sort of ‘financeability’ test that regulators in other markets employ. Nor do they provide potential investors with certainty about how a financeability issue would be addressed if it was identified.

A process to ensure that the regulatory cash flows are sufficient to support the credit rating and gearing that the regulator has assumed would remove a regulatory roadblock to the efficient investment that’s needed to meet the task of decarbonisation.

Extra for experts – a solution

A workable solution could be for the Input Methodologies to accelerate the allowed cash flows in a Net Present Value-neutral manner, as Stephen explains in this short video. The draft Input Methodologies decision canvassed several options to make this happen, of which the most promising was removing indexation of the Regulated Asset Base.

 

 

This excerpt was originally published in Vector's stakeholder newsletter. 

Frontier Economics' recently advised a number of clients in relation to the Queensland Competition Authority's review of its approach to climate change related expenditure. Below are some highlights and commentary on our advice included in the final position paper.

The Queensland Competition Authority (QCA) has released its final position paper for the Climate Change Expenditure Review 2023, referencing our independent advice to Dalrymple Bay Infrastructure (DBI) and Aurizon Network.

The QCA initiated this review to:  

• ensure its framework for assessing the prudency and efficiency of climate change related expenditure is fit-for-purpose and capable of incentivising timely investment when such expenditure would promote the long-term interests of consumers; and 

• provide greater clarity and certainty to stakeholders—including consumers and regulated businesses—on how the QCA intends to assess future proposals related to climate adaptation and mitigation expenditure. 

Economic regulators need to perform a difficult balancing act when assessing expenditure proposals related to managing climate change risks. The impact of climate change on regulated infrastructure (and, therefore, on users of that infrastructure) is fraught with uncertainty.  

• If regulators set a low threshold for the prudency of climate change related expenditure, then consumers may pay more than the efficient amount required to manage climate change risks effectively.  

• Conversely, if regulators are too conservative in their assessment of climate change related expenditure, that may imperil the reliability and safety of the infrastructure used to deliver regulated services. This, in turn, may expose consumers to significant economic losses.   

Uncertainty over whether regulators will approve climate change related expenditure—or over whether recovery of such expenditure would be disallowed once it has been incurred—may deter regulated businesses from making prudent and efficient investments to improve the resilience of their networks.  

Clear guidance about how proposals for climate change related expenditure will be assessed by regulators can help reduce this uncertainty and encourage prudent and efficient investments that may otherwise be foregone. 

For this reason, other economic regulators, should conduct their own reviews and publish formal guidelines on how they intend to assess regulatory proposals for climate change related expenditure. The QCA’s guidelines are not specific to any particular industry or jurisdiction, so would be a relevant starting point for other regulators and regulated businesses beyond Queensland. 

Managing climate uncertainty to invest prudently and efficiently in resilience

Of the many issues covered by the QCA’s review, our advice focussed on the development of a framework to assess the prudency and efficiency of climate change adaptation expenditure.  

Below are some highlights: 

We advised Aurizon Network that:  

“In assessing prudent and efficient ex ante resilience expenditure the QCA should encourage regulated entities to pragmatically incorporate the uncertainty inherent in climate change related risks into their proposals for adaptation expenditure.” 

 In our report to DBI, we added:  

“Climate-resilience should be a necessary condition to project prudency and efficiency. Investing in infrastructure that is vulnerable, by design, to an accepted range of climate-related risks is likely to be lower cost in the short term but higher cost in total over the life of the asset.” 

We discussed the development of an upfront expenditure framework that could facilitate investment under uncertainty, providing advantages to both regulated infrastructure providers and their customers. That is, a framework which: 

• is ex-ante in nature; 
• relies on the justification for the proposed expenditure; 
• includes in its ex-post review mechanisms a consideration of uncertainties related to climate-related risk; and
• is proactive in managing long-term demand uncertainty.  

We considered that these elements together would promote regulatory certainty and facilitate investment in prudent and efficient levels of infrastructure resilience.  

The Coal Effect – funding and financing approaches to address residual stranding risk

Fossil fuel exposed firms are exposed to transition risk, or risks arising from the process of adjusting towards a lower-carbon economy. This can impact forecasted demand, the value of assets and liabilities, and thereby the risk profile and viability of the regulated business. 

A key driver of transition risk for coal exposed companies is policy change. Net zero targets, can reduce domestic demand for coal. However, targets vary in status, development and expected achievement date. This uncertainty, in combination with uncertainty around technological development and carbon abatement costs, makes future demand for coal similarly unclear. 

We identified a scenario where Aurizon Network may support more adaptation expenditure to increase the resilience of the network (with the expenditure to go into the regulatory asset base). However, future customers may be unwilling or unable to continue to pay for past adaptation expenditure. These factors create asset stranding risk, which may disincentivise a regulated business from investing in network resilience today, even if the investments are supported by current customers. 

We then considered options the QCA might adopt to address asset stranding risk. We discussed the merits of addressing an increased stranding risk associated with climate change via an uplift to the allowed rate of return (i.e., the ‘fair bet’ approach) that would be just sufficient to compensate investors for the increase in stranding risk.  

Also considered was the use of accelerated depreciation, which has been used by regulators in Western Australia (ERAWA) and New Zealand (the Commerce Commission) to address the stranding risks faced by gas pipelines following the adoption of emissions targets that have shortened the expected economic life of those regulated assets. 

In our advice, we recommended that the QCA should confirm clearly that:  

• its regulatory framework will continue to provide regulated businesses with a realistic opportunity to recover past prudent and efficient expenditure over the long term;  
• regulatory allowances will be set such that climate change related expenditure that is deemed to be prudent and efficient, based on information available at the time, may be recovered over the expected economic life of the assets; and  
• the expected economic life of the assets should be reassessed periodically as new information becomes available. 

Overall, we identified the benefits in the QCA providing clear upfront guidance on the types of information and evidence it would require from regulated businesses, to demonstrate asset stranding risks and management responses.  

This could include the QCA needing to take into consideration a larger range of plausible future scenarios, rather than focusing on just the expected future profile of demand at a given point in time, reflecting the long-term uncertainty faced by the coal industry. 

Frontier Economics Pty Ltd is a member of the Frontier Economics network, and is headquartered in Australia with a subsidiary company, Frontier Economics Pte Ltd in Singapore. Our fellow network member, Frontier Economics Ltd, is headquartered in the United Kingdom. The companies are independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Pty Ltd.

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