The Essential Services Commission (ESC) released a Position Paper that proposes a new model for regulating prices of water services in Victoria.
The proposal represents a quantum change in the way water businesses are currently regulated in Australia. It has been borne out of a recognised need for a simpler regulatory process and stronger incentives for water businesses to deliver efficient outcomes that are valued by customers.
A central pillar of the model is a requirement for businesses to engage with their customers, to better understand customer concerns, preferences and priorities and to demonstrably take them into account. Service levels, outcomes and ultimately prices are therefore to be informed directly by the things that matter to customers, as opposed to performance measures set by engineers, accountants and regulators.
The model has also been designed to give water businesses greater autonomy in setting their own course to achieve financial and reputational objectives – together with greater accountability for the outcomes they deliver.
The model draws on elements of approaches being used in the UK for regulating energy networks and water companies, which have been found to motivate businesses to prepare high quality price submissions and deliver better price outcomes for customers.
Key features of the model
The model has several key features that are crafted to work together to achieve the ESC’s stated objectives of customer focus, business autonomy, meaningful performance outcomes and regulatory simplicity. The design features are as follows:
Financial and reputational rewards for high-quality price submissions: Businesses that are assessed to have an “ambitious” submission (in terms of giving customers value for money for the services they want and in the quality of the documentation submitted to the ESC) will be rewarded with a higher allowable rate of return (as opposed to the current regulatory approach in which a standard cost of equity is applied across all businesses). Four types of pricing submission are defined, based on level of ambition: basic, standard, ambitious, and leading.
It is proposed that the allowable cost of equity for a ‘leading’ submission will be around 1.2% above that of a ‘basic’ price submission (assessed in conventional regulatory terms). The allowable cost of equity for a ‘basic’ submission will be below conventional regulatory benchmarks.
An assessment framework for rating the quality of submissions: Five criteria form the basis of the assessment framework, referred to as “PREMO”. PREMO is an acronym for the parameters of an assessment; an ambitious submission is one that rates highly against each of the five criteria, that is:
Performance measures for outcomes have been specified and adhered to
Risks to operations have been adequately managed and allocated appropriately
Engagement with customers has been adequately demonstrated and shown to have informed the business strategy and service levels
Management is effective, demonstrated through expenditure and demand forecasts that are well supported by data, based on sound methodology and aligned with outcomes to be delivered
Outcomes are defined that represent an improvement in service standards.
Self assessment: Each water business, in consultation with its customers, will determine the level of ambition to be adopted in its price submission. Businesses will be required to self-assess their level of ambition (and corresponding cost of equity) against the PREMO assessment criteria. Financial disincentives apply for businesses that overstate their level of ambition (an “incentive matrix” has been formulated, which assigns businesses a cost of equity that is lower than what it would have received had it accurately assessed its rating). This is effectively a penalty for businesses that seek to game the framework by claiming a level of ambition that they know to be untrue. Not only do they run the risk of their submission being downgraded, they also forego a potentially higher rate of return that could have been attained had the business honestly assessed its submission. There is a ‘red zone’ for very poorly developed submissions for which the consequences are unspecified at this time.
Provision made for within-period adjustments to cost of equity: The framework allows the cost of equity established at the start of a pricing period to be adjusted depending on how well a business performs against the outcome commitments in its price submission (however the ESC indicates that in-period adjustments should be the exception rather than the rule).
Fast tracking: High quality submissions will be fast tracked through the assessment process to an early draft and final decision, potentially saving businesses costs and time – thus representing an added incentive to prepare a high quality submission.
Implications for Victorian water businesses
The ESC is proposing to introduce the new model for the 2018 price review. Water businesses will need to prepare a price submission in September 2017. While the new pricing approach retains many of the elements of the current model (notably the retention of the building blocks methodology), there will be a substantial learning phase over which businesses will need to understand the new assessment criteria and how to prepare their pricing submission to meet the requirements of the new model. The ESC has undertaken to provide more guidance over the coming months and this guidance will be crucial to water businesses successfully navigating the new environment.
The PREMO criteria focus on matters that are within a business’s control but each business will need to consider how the criteria apply to their own business, where they likely rate along the “ambition” scale, what would be involved in lifting performance to the next level, and whether the incentives proposed by the ESC are sufficient to warrant the cost of attaining the uplift.
For some businesses, the new model will require a significant change in the way businesses engage with their customers. The model emphasises the need to make engagement the first step in developing a price submission, not a last step. This will challenge existing norms and require a deliberate cultural change within some organisations. There is a significant and deliberate attempt to shift away from formalised customer panels and representatives to place the focus on the business engaging with its customers – a development we applaud.
The shift to an outcomes-based framework for measuring and reporting outcomes may also prove challenging for some. The aim will be to develop measures that give an overall view on business performance (i.e. how well it is meeting its strategy) as opposed to granular, engineering-based measures.
The ESC’s PREMO framework is the most significant regulatory development since the reforms to energy markets and regulation with the creation of the AEMC. It has several laudable attributes that will reduce businesses’ incentives to game the process and will focus their attention on customers and outcomes. These initiatives will substantially enhance the accountability of businesses and boards in the regulatory process. It is the first time a regulator has offered regulated businesses a genuine opportunity to outperform its peers, another welcome innovation.
We congratulate ESC for its leadership in developing the model.
 The cost of equity benchmark for the 2013 price review was 4.5%, which coincides with the level proposed for a standard price submission.