The AER’s Draft Ring-fencing Guideline – is the balance right?

Submissions on the Draft Guideline are due by 28 September 2016. The AER is required to develop a national ring-fencing guideline by 1 December 2016.

Key features of Draft Guideline

The key elements of the Draft Guideline are as follows:

1. A DNSP is prevented from providing non-network services other than through a related body corporate if it incurs costs in providing these services above a $500,000 annual threshold.
2. Explicit obligations have been included to address discrimination, with the Draft Guideline stating a DNSP must:
   • Deal with its related bodies corporate on an arm’s length basis in good faith.
   • Deal with competitors of its related body corporate(s) on substantially the same terms and conditions as those for its related entity.
   • Avoid providing information that the DNSP has obtained through its dealings with a competitor of its related body corporate that may advantage the latter.
   • Avoid advertising or promoting the services of its related body corporate.
   • Have independent and separate branding for its distribution services and non-distribution services.
3. There is a general requirement for a DNSP to have functional separation between the provision of its network and non-network services i.e. physical separation and no staff sharing subject to some exceptions. For example, the staff sharing restriction does not apply to senior executives of both a DNSP and a related body corporate, in instances where a staff member is not involved in the provision of ‘energy-related’ services or staff not directly involved in the provision of direct control services (e.g. payroll, HR). Energy related services are undefined.
4. There is the potential for a DNSP to apply for a waiver of the obligations for functional separation (physical separation and staff sharing) in relation to a specific service it provides; these are the only obligations in the Draft Guideline potentially subject to a waiver.
5. Each DNSP will be required to report annually on its compliance against each obligation, any compliance breaches and remedies for each of its ring-fenced services.
6. Beyond the commencement date, a transitional period of up to one year will be provided for a DNSP to comply with the obligation for legal separation and six months to comply with its obligation to functionally separate.
7. All existing ring fencing waivers will be reviewed by the AER prior to the draft guideline coming into effect, via a separate consultative process.

Synergies’ preliminary views

There is an unavoidable tension between allowing DNSPs to exploit economies in entering non-network markets and protecting the competitive integrity of these emerging markets. Synergies maintains that this tension is best resolved, at least initially, by applying a necessity principle – regulators should not go further than necessary to protecting market integrity. In establishing a strict set of requirements on DNSPs’ future participation in newly contestable energy services markets, the Draft Guidelines go further than necessary (despite its more nuanced position on functional separation), and in so doing, risks imposing additional costs on businesses and in turn their customers both directly and indirectly.

The very broad non-discrimination provisions in the Draft Guideline in combination with the $500,000 cost threshold for functional separation effectively precludes DNSPs realising economies of scope when participating in newly contestable markets if unable to satisfy the limited waiver provisions. This will preclude customers benefitting from the efficiencies secured by vertically integrated US utilities that is, from the sharing of knowledge and resources at different levels of the electricity supply chain. Moreover, significant inefficiencies and compliance related costs could be imposed on customers of regional networks.

An example of the indirect costs can be seen in the restriction on branding. The AER is justifiably concerned by DNSPs leveraging monopoly power. However, in an informationally abundant world, a strong brand in a regulated sector will come from identifying and exceeding customer expectations. The AER’s prohibition will unintentionally reduce DNSPs incentives to invest in their brand through better serving their customers.

Overall, it appears the Draft Guideline intends to preserve the prevailing strict structural separation of generation, network and retail sectors of the Australian electricity supply chain, notwithstanding major market-driven changes that are challenging the underlying policy rationale for this separation. They could have better balanced scope for the realisation of network-related economies of scope while protecting the integrity of newly contestable markets – getting the balance right is crucial to the long term benefit of consumers.