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.
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