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PEG concerns with WP gas benchmarking: allowed cost instead of actual data; “comparing oranges to tangerines”

Posted by gasweek on 26 September, 2007

The Essential Services Commission (ESC) was undertaking a gas access arrangement review (GAAR) for the three gas distribution businesses (GDBs) serving Victoria (Multinet, SPAusnet, and Envestra), noted PEG partner Larry Kaufmann’s response to Worley Parsons Benchmarking Analysis, Victoria (July 2007).

Revenue requirements: “A central part of the new GAAR is determining revenue requirements over the term of the upcoming arrangement. An important component of each company’s revenue requirements is its forecast of operating expenditures (opex). Worley Parsons (WP) has written a report for the three GDBs entitled ‘Review of Gas Access Arrangement for Victoria-Benchmarking Final Report’. Although most of the benchmarking metrics that WP examines focus on opex, some also reflect capital cost measures. This WP report is therefore potentially relevant for assessing all of the GDBs’ projected costs for the next GAA.

Two main concerns: “PEG has two main concerns with the WP benchmarking report. First, the opex data used in the analysis generally relies on operating costs that were allowed by regulators in other access arrangements rather than the operating expenses that companies actually incurred. Using allowed cost rather than actual cost data is very problematic in benchmarking studies. Fundamentally, benchmarking is designed to obtain an inference on the efficiency of the management of an enterprise. Such an inference can only be obtained by examining metrics that reflect the impact of management decisions. This will not be possible using data on the costs that are allowed by regulators, because these metrics depend directly on decisions that are made by regulators. Only data that reflect the actual operations, and hence management decisions, of the companies themselves will necessarily reflect the managerial efficiency of those companies.

Real issue: “This issue is material, because there is an expected bias associated with the use of allowed rather than actual cost data. It is typical for utilities’ actual operating costs during the term of a CPI-X plan to be less than what was allowed in the determination. Indeed, there is a strong presumption that companies’ cost performance will be below the cost ‘benchmarks’ embodied in a CPI-X determination. Australia’s incentive regulation frameworks are designed to encourage ongoing efficiencies in utility operations. If regulation is operating as intended, companies will be outperforming their cost benchmarks and their actual costs will be below allowed costs.

Biased data: “This implied that the opex data used in WP’s analysis are likely to be biased in the GDBs’ favor. If actual cost data were available for other Australian GDBs and used for the analysis, the costs for these companies would likely be lower than their allowed costs. Although the amount of this bias is not known, more accurate data would be expected to reduce costs for the comparator distributors while not affecting the GDBs’ own reported costs (i.e. the company’s actual costs).

Like-with-like: “In light of these points, comparing the actual costs of one enterprise with the allowed costs of another is an example of not comparing like with like. This process is more akin to comparing, say, oranges to tangerines than the more common analogy of comparing apples to oranges. There are some obvious similarities between oranges and tangerines, but tangerines can be expected to be smaller on average. If a tangerine is compared to a group of oranges, it would be a mistake to infer that the difference in size was due to the relative inefficiency of the tangerine grower.

Likely mistakes: “However, a mistake of this nature is likely when actual utility costs are compared to allowed costs. PEG would have similar concerns even if WP compared the operating expenses that were allowed for the GDBs with the allowed opex of other GDBs. Fundamentally, such a benchmarking analysis would be comparing regulatory rather than utility management decisions. Such an analysis has little or no bearing on how efficiently utilities manage their operations after the regulatory determinations have been made,” Kaufmann added.

Reference: Larry Kaufmann, PhD, Partner, Response to Worley Parsons Benchmarking Analysis, Victoria, July 2007.

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