Capital punishment

One of the key reforms arising from the Finkel review was the introduction of the integrated system plan (ISP). By mapping out some plausible scenarios for changes in electricity use and the generation mix over the next few decades, the market operator (AEMO) was able to identify a business case for several large scale transmission upgrades. These are a mix of strengthening the connections between different states and new or bigger lines into areas with good renewables potential.

One by one, these projects have been going through a more detailed scoping process and progressively signed off on by the regulator (AER). This consists of two stages: the regulatory investment test (RIT-T) to confirm that the project is expected to deliver net benefits and the contingent project application, which entails a much more detailed costing and results in permission to recover the costs of the project from electricity customers. This is a lengthy process but one that has been speeded up by recent reforms.

Despite rhetoric from AEMO to the effect that if a project makes it into their ISP then it is a fait accompli and the local transmission provider should just go ahead and build it, this sign-off process by the AER is an important check in the process. After all, unlike generation where the asset owner is taking the risk that it doesn’t deliver the benefits (i.e. wholesale market revenue) they’re expecting, in transmission the customer carries all the risks. It’s no surprise then, that numerous customer groups have expressed concern at the growing bill for this new transmission.

On the flip side the fact that it is a safe investment for the transmission provider, should mean that once approved it just gets built and can be financed at a low cost. Unfortunately, even that premise is under threat.

NSW is essentially the centre of the NEM. It’s the biggest region, with current interconnection to both Victoria and Queensland (the next two biggest region) and soon to South Australia, too. So it’s unsurprising that the biggest chunk of transmission investment is in NSW and thus is being built by the local provider, Transgrid. In fact, including its business-as-usual capex (which runs at around $200m-$400m annually), Transgrid expects to spend over $13bn in capital expenditure in the ten years to 2029. This is more than double its current regulatory asset base. Looked at another way, it is around $3,500 per electricity customer in NSW. This will hit bills over 40 years or more. After allowing for the fact that large customers will pay more, a typically household may see their share rising to around $70/year by 2030. So, while it’s less than the proverbial “cup of coffee per week” it’s a noticeable step up.

For Transgrid, though, tripling their asset base requires a lot of finance. In a rule change proposal lodged with the AEMC, they are arguing that the current rules around cost recovery don’t work for this scale of investment. The regulatory framework is set up to provide networks with a real rate of return and to compensate them for inflation by increasing their asset base by CPI. This effectively defers their recovery of the inflation component of their total return. This has been a standard approach for over a decade and broadly accepted by the networks. Transgrid argues they cannot afford to defer the inflation component of their return as they will either have to borrow more and lose their investment grade credit rating (which would push their interest costs up above the benchmark assumed by the AER) or their owners will have to inject more equity that they will not be able to get a cash return on for many years. So Transgrid want a derogation from the rules so that they can receive a nominal return on the capital investment they make into their ISP projects. They also want to be able to start earning a return once they have spent the capex rather than when the project is complete. This is because their large interconnector projects will take four years or more from start to finish.

AEMC have yet to consider this rule change, but Transgrid are pushing them to do so urgently and to run an expedited rule change process, which will give other stakeholders less time to consider the issues and comment. The rationale is that Transgrid wants to get on with the project but by inference won’t do so until this issue is resolved. This is not the first time Transgrid have implied that they will down tools if they don’t get their way. The NSW government has had to pay for early works on some of the ISP projects in order to keep them on track because Transgrid would not spend the money until the AER had approved the full expenditure.

Transgrid are also using their supersize capital programme to lobby the AER for reconsideration of the Capital Expenditure Sharing Scheme that incentivises networks to keep the costs of their capital works as low as possible, and to justify changes in the way the AER treats inflation.

So if the way networks are funded isn’t suitable for transmission businesses with several ISP projects, what’s the answer? Turns out the ALP think they have it. Their “Rewiring the Nation” policy is scant in detail but apparently entails creating a new agency (just what the energy sector needs…), the  Rewiring of the Nation Corporation that will work with AEMO and networks and provide low cost public funds for ISP projects. The kicker is that it would also require networks to use local labour and local materials. As the networks’ lobby group points out, this is no recipe for delivering cost-effective transmission. Since they are large physical assets that are built on site, overseas kit and workers are only going to be used where they are better value than the local alternative. For specialist kit there may be one or no local supplier, and it would dampen competition among suppliers, leading to even higher costs. While in principle public finance costs could offset this, there would need to be a fundamental change in the rules for this saving to flow through to consumers.

As it is, the costs of the major ISP projects are blowing out. Project EnergyConnect, which will link South Australia with NSW has gone from a $1.53bn project when approved by the AER last year to a $2.4bn project (conveniently, the benefits have also increased so the project still stacks up…). Most of the cost inflation has come on the NSW side, which will be built by…Transgrid.

Policymakers are in a bind. They want these projects to get built on time, but not at any cost. A major reworking of the approval process and risk allocation would take years to implement. But it may be worth starting now so any reforms can apply to the projects scheduled for later in the decade. If transmission companies like Transgrid can’t work within the existing rules, then maybe we need to see if other parties are willing to try rather than bend over backwards to maintain the incumbents’ stranglehold on these projects.

Disclosure: the author is a member of the AER’s Consumer Reference Group, which advises the AER on the inflation and rate of return reviews. Any views expressed above are the author’s own and do not represent the CRG.