Commission releases issues paper on asset recalibration

COMMERCE COMMISSION

Issues Arising from Comprehensive Audits

3 December 2001

RECALIBRATION OF ASSET VALUES OF LARGE ELECTRICITY LINE OWNERS BY COMPREHENSIVE AUDIT

TABLE OF CONTENTS

1. PURPOSE OF THE PAPER *2

2. THE Recalibration Process *2

3. Discussion oF Issues *3

3.1 Content of Valuation Reports *3

3.2 Assets Included in the Valuation *4

3.3 Accuracy of the Asset Register *5

3.4 Transformer Life Extensions *7

3.5 Fully Depreciated Assets *7

3.6 Optimisation *7

3.7 Underground Circuits *9

3.8 Profit Maximising Line Tariff *9

3.9 Segmentation for Application of the EV Test

*10

PURPOSE OF THE PAPER

Part 4A of the Commerce Act 1986 requires the Commerce Commission to undertake a comprehensive audit of the valuations of the line business system fixed assets of large electricity line owners. Every large line owner must, by 31 March 2002, publicly disclose a valuation report that has been approved by the Commission.

This paper on "Issues Arising from Comprehensive Audits" (Issues Paper) has been prepared to provide information to large electricity line owners about the issues that may impact on whether valuation reports will be approved. The Issues Paper identifies some of the more significant non-compliances found during the audits that have been carried out to date, and which may result in valuation reports not being approved. It should be noted this Issues Paper pre-dates the audit of Transpower. It is also important to note that additional issues may arise in other audits that are yet to be completed.

This Issues Paper is in response to submissions received by the Commission that there is too little time in the project plan between the date on which the Commission will advise lines businesses of whether or not their valuation reports are approved (31 January 2002), and the date by which valuation reports requiring revision must be re-submitted to the Commission (28 February 2002). The early advice of these issues will allow lines businesses to have more notice of issues likely to impact on whether or not their individual valuation reports will be approved and to consider any potential changes to reports now.

The Commission does not expect large electricity lines owners to respond to comments contained within this Issues Paper, but to take them into account in finalising any revised valuation reports, which are required to be provided to the Commission in February 2002.

The Commission has now undertaken audits of over half of the asset valuation reports of large electricity line owners. The Commission acknowledges the cooperation provided by the staff of the lines businesses to the personnel undertaking the audits. In particular it notes that the coordinators assigned to liaise with the audit teams have, without exception, been particularly helpful.

The Recalibration Process

The process for undertaking the asset recalibrations is set

out in the Asset Recalibration Document issued by the Commerce Commission on 28 September 2001.

This process requires the Commission, after receiving a valuation report, to undertake a comprehensive audit of each large electricity line owner's system fixed asset values. It is expected that the Commission will notify each line owner (except Transpower) by 31 January 2002 whether or not its valuation report has been approved.

If a valuation report is not approved, the Commission will give reasons why the report was not approved. Specifically, the Commission will not approve a valuation report if:

• the points in this Issues Paper are not adequately addressed; or
• the disclosure requirements set out in Clauses 6-8 of the Preface of the ODV Handbook are not met; or
• the valuation contained in the report is derived by methods that do not comply with the requirements of the ODV Handbook and the non-compliance is considered to be material. As a general rule, the Commission considers an identified value variance of more than 3% of the valuation to be material.

The Commission will also provide comments on the parts of a valuation report that need further consideration, additional work or alteration in order to assist line owners comply with the Commission's requirements.

Large electricity line owners (except for Transpower) whose valuation reports are not approved will be required to submit revised valuation reports no later than 20 February 2002 for further consideration.

The Act requires the Commission to revise a valuation report if the line owner does not resubmit a valuation report that meets the Commission's requirement by the specified date. Should this prove necessary the Commission will seek submissions from the line owner on the matter and take these submissions into account before finalising its revisions.

Discussion of Issues

3.1 Content of Valuation Reports

Under the Electricity (Information Disclosure) Regulations 1999 (the regulations), it is the responsibility of each large electricity lines owner to make a valuation report available to the general public for inspection. Sections 6 to 8 of the preface of the ODV Handbook set out the minimum information that must be included in the valuation report.

The valuation reports reviewed to date are generally an improvement on the valuation reports submitted to the Ministry of Economic Development under previous editions of the ODV Handbook. However, some reports did not include all the detail required by the 4^th edition of the ODV Handbook. In particular, reports must include:

• a full breakdown of assets by category as required by Section 6(a) of the Preface of the ODV Handbook. The asset base is required to be broken down by asset type, with each asset type to be further broken down by category. Each asset category must have a specific replacement cost and asset life. The quantity of individual assets in each category must also be specified. The breakdown in Table B.1 of the ODV Handbook is to be taken as a guide to the level of detail required.
• a description of the methodology used by the valuer in undertaking the network optimisation as required by Section 7(a) of the Preface of the ODV Handbook. This description must consider separately each test described in Appendix C of the ODV Handbook and comment on whether or not optimisation is considered necessary as a consequence of each test.
• the existing load and the forecast load at the end of the relevant planning period for each point of connection, each zone substation and each individual high voltage distribution feeder as required by Section 7(b) of the Preface of the ODV Handbook.
• details of the quality of supply criteria used as the basis for optimisation as required by Section 7(c) of the Preface of the ODV Handbook. These quality of supply criteria must be consistent with the current asset management plan required to be disclosed under the regulations.
• a full explanation of the reason for not optimising any part of the network where the quality of supply is greater then the disclosed optimisation criteria, including relevant details of any specific customer non-standard contract as required by Section 7(d) of the Preface of the ODV Handbook.
• a description of the methodology used by the valuer in undertaking the economic valuation, including details of the maximum sustainable tariff, as required by Sections 8(a) and (c) of the Preface of the ODV Handbook.

3.2 Assets Included in the Valuation

The valuation is to cover only system fixed assets. Such assets are defined in the regulations as:

All fixed assets of a line owner that are used or intended to be used for the conveyance or supply of electricity; but does not include:

1. Stores and spares over and above any levels prescribed in the [current] ODV Handbook; or
2. Works that are under construction.

Further clauses in the ODV Handbook provide guidance on the assets to be included in the valuation. In particular:

3.10 Assets such as Head Office buildings, office furniture and equipment, motor vehicles, tools, plant and machinery, works under construction, consumers' meters and consumer based load control relays, and non network land and spares should not be included in the asset register of system fixed assets that is used as a basis for preparing the ODV valuation of system fixed assets.

3.51 Network equipment spares may be included in the ODV as long as the spares are the same as the assets installed in the network. Further, the quantity of spares to be valued in the ODV must not exceed a reasonable quantity required to meet the ELB's disclosed quality of supply criteria.

3.54 Stranded assets that are not required as network equipment spares shall be assigned zero value for the purposes of ODV. It is permissible to assign the NRV of such stranded assets to the "other businesses" owned by the ELB.

The definition of system fixed assets and the above clauses from the ODV Handbook provide guidance in determining whether a particular asset should be included in the asset base for valuation purposes. The Commission will apply the following principles:

• the assets included in the valuation must be fixed and used (or intended to be used) for the conveyance or supply of electricity; and
• the lines owner may own, and earn a return on, other assets that are not included in the register of lines business fixed assets. Such assets are assigned to "other businesses" operated by the lines owner.

Consistent with these principles the Commission considers that:

• Streetlights, and poles or standards used exclusively for the support of streetlights shall not be included in the ODV asset base. Streetlight requirements are determined by the relevant territorial local authority or by Transit New Zealand and streetlights are generally owned by these organisations. Where streetlights are owned by the lines business the Commission expects the return on these assets to be derived from the authority concerned rather than shared across all customers on the network.
• Portable generators used to provide supply during power outages shall not be included in the ODV asset base. These are not fixed assets as defined by the regulations. The Commission recognises that use of a portable generator may be an innovative and cost effective way of meeting the business's quality of supply criteria. However, conceptually, portable generators are no different from vehicles, tools and other assets used to operate and maintain the network. Where a generator is owned by the network owner, it should be assigned to "other businesses" and funded by an operating charge against the lines business. This is consistent with the contestable nature of the provision of such a standby supply, since such a generator could conceivably be owned by a party other than the line owner.
• The valuations of customer service connections must not include high or low voltage service mains on a customer's property. This is consistent with the definition of "point of supply" in section 2 of the Electricity Act 1992. Customer service connections do not include service mains on consumers' property and should be valued only in accordance with the standard values provided in Table B1 of the ODV Handbook.

The audits have identified situations where the ownership of a network fixed asset is in dispute between neighbouring large electricity line owners and the asset has been included in the ODV of both businesses. This is clearly inappropriate. However it is not the role of the Commission to resolve such matters, which are best left to the individual parties concerned. Therefore, where such a situation arises, the Commission will not permit the asset to be included in the asset base of either lines

business, unless it is advised by all affected parties that the

ownership dispute has been resolved.

3.3 Accuracy of the Asset Register

The audits have identified a wide variation in the quality of the asset records held by different businesses. In particular, it is noted that, where GIS systems have recently been installed, the process of populating the GIS database, has had a significant impact on the reported asset valuation.

The Commission will only approve an asset valuation if it is satisfied that identified inaccuracies in the asset register will not have a material impact on the reported asset valuation.

In particular, the Commission is concerned to ensure that the depreciated replacement cost of the asset base is not inflated by

means such as:

• the use of excessive replacement costs for assets not included in Table B.1 of the ODV Handbook (non-standard replacement costs); or
• the use of non-standard replacements costs for items covered in Table B.1 of the ODV Handbook (e.g. trenching); or
• the inappropriate use of multipliers (e.g. unjustified use of the multipliers at the high end of the range indicated in the ODV Handbook, and also multiplying the "multipliers" to compound the effect on the replacement cost rather than applying each "multiplier" to the standard replacement cost and adding the incremental amount);
• asset life extensions except strictly in accordance with those permitted by the ODV Handbook; or
• inappropriate assumptions of asset age where records of asset age are not available.

In determining whether or not to approve a valuation, the Commission will examine the reliability of the process by which the asset register was assembled and the quality of the evidence available to support any assumptions made. This examination may include consideration of:

• the process used to assemble the asset register and, where applicable, the quality of the asset records on which the register is based;
• the methodology used to assemble the asset register where a business does not have detailed records. Where assumptions have been made as part of the process, the Commission will consider the extent to which the validity of such assumptions has been tested in the field;
• the extent to which sample checks on the asset register have been carried out;
• the method used and assumptions made to assign asset ages where records of the age of specific assets are not available;
• the evidence used to support life extensions and the use of multipliers where these are claimed in accordance with the provisions of the ODV Handbook. For the Commission to approve such adjustments, including the determination of the exact multiplier used within a range permitted by the Handbook, the assumptions must be supported by evidence such as written maintenance records, engineering reports or geotechnical maps. Where such evidence cannot be produced, the adjustments will not be allowed; and
• the methodology used to determine the replacement costs assigned to assets not included in Table B.1 of the ODV Handbook.

3.4 Transformer Life Extensions

Clause B.37 of the ODV Handbook makes a distinction between refurbishment and maintenance. This clause points out that a refurbishment is intended to materially extend an asset's service life beyond its standard total life. Clause B.38 permits a valuer to assign a new remaining life to a refurbished asset, provided the new remaining life is not greater that the maximum total life given in Table B.1, without the application of multipliers or further life extensions.

Clause B.43 of the Handbook deals with the possible life extension of distribution transformers. It notes that the core and winding of distribution transformers can normally be expected to have a longer total life than transformer tanks. It therefore allows valuers to extend the life of distribution transformers to 55 years provided that general maintenance, including tank replacement is expensed and not capitalised.

The Commission will allow businesses to take advantage of Clause B.27 for major refurbishments of zone substation transformers. The refurbishment must be specifically designed to extend the life of the transformer and would normally involve detanking the core to inspect the winding and retighten clamps etc. Importantly, the cost of the refurbishment must be capitalised rather than expensed.

In order to take advantage of the life extension of distribution transformers under Clause B.43, the Commission requires the business to have a proactive transformer maintenance programme in place. This would involve a programme of regularly inspecting all distribution transformers and a policy of proactively removing transformers from service when inspections reveal oil leaks or excessive tank corrosion. Life extensions will not be allowed by a lines business where a distribution transformer maintenance policy is reactive, i.e. distributions transformers are only replaced where there is an overload or transformer failure.

Clause B.37 must not be applied to the maintenance of distribution transformers.

3.5 Fully Depreciated Assets

Clause 3.27 of the ODV Handbook indicates that fully depreciated assets should normally be valued at zero since the net realisable value of system fixed assets, once the cost of disposal is netted off, is low and can be set aside as not of material value. The Commission will not approve any alternative approach unless it can be satisfied it is reasonable to do so.

3.6 Optimisation

The quality of supply criteria used as a basis for optimisation must be consistent with the standards normally applied by the business and must not be developed specifically for the purposes of valuing the network. The Commission will expect the quality of supply criteria included in the valuation report to be consistent with the criteria set out in the asset management plan and built into recent capital investment projects.

Further, the load forecast used for determining the allowed capacity of the various parts of the network would normally be consistent with the rate of growth experienced in recent years, unless justification is provided for an alternative approach.

A difficulty arises where the system fixed assets of a lines business owner are comprised of two or more networks of different designs reflecting different original design philosophies. This situation commonly arises where two or more lines owners' businesses have merged.

The ODV methodology requires the network configuration to be optimised to provide the existing or required level of service (whichever is lesser) as if the network had been constructed in a greenfields situation. In recognition of the fact that electricity networks evolve and are not designed from first principles, and also of the difficulties inherent in developing an optimal greenfields design, the ODV Handbook allows a more pragmatic approach to optimisation. Clause 3.33 provides constraints that may be assumed, based on the existing network design, and Appendix C specifies a series of tests that must be applied to derive the optimised network. The presumption is that if all required tests are applied in accordance with the ODV Handbook requirements, the resulting network will be considered optimal for the purposes of the ODV valuation.

Where common quality of supply criteria apply, a line owner would use a common design approach when replacing existing networks with an optimal network in a deprival situation, irrespective of any differences in design philosophy used for each part of the existing network. Hence, all other things being equal, the ORC per ICP across all parts of the optimised network will be of a similar magnitude.

Where this is not the case, the Commission will examine the optimisation processes determine the reason for the differences in value, as measured by ORC per ICP. If the ORC of the higher value network can be reduced by application of the required optimisation tests, the Commission will require the excess value to be optimised out.

For example, the network in one urban area has link boxes installed to allow the interconnection of low voltage circuits supplied by adjacent distribution substations. A second network owned by the same lines business and supplying another urban area does not have such link boxes. Common quality of supply applies to both networks and the lines business no longer installs link boxes on new reticulation. In this case, the value of the link boxes is material and the Commission will require them to be optimised out.

3.7 Underground Circuits

Appendix C of the ODV Handbook requires underground circuits to be optimised to equivalent overhead construction unless there is specific evidence that the local authority would not in normal circumstances grant consent for overhead reticulation. Such evidence would, for example, be a district plan requirement. The Commission will require a lines business to produce adequate documentary evidence in all cases where underground circuits are not optimised to overhead.

3.8 Profit Maximising Line Tariff

Section 8 of the Preface of the ODV Handbook requires details of the profit maximising line tariff to be included in the valuation report. These details must include a derivation of the profit maximising line tariff used in the application of the economic valuation test.

Clause 3.75 defines the network maximum unitised line charge, as set by an alternative source of energy (generally diesel generation), to be the full unitised cost of the alternative less the unit energy charge when using the network. Clause 3.76 gives a maximum value of profit maximising line tariff, which is defined as excluding energy costs but including transmission costs.

It should be noted that the values given in Clause 3.76 are maximum values rather than required values. In particular, the maximum value of the profit maximising line tariff given in Clause 3.76(a) includes Transpower's transmission costs allocated to consumers' electricity accounts. As the transmission component of revenue is not retained by large lines businesses, it must be deducted from the profit maximising tariff chosen to calculate the economic value of a segment.

While the ODV Handbook does not specify how the profit maximising line tariff is to be calculated, the value used must be supported by analysis such as:

• determination of the unitised cost of the alternative. The costs included in this analysis would normally be interest, depreciation, maintenance and operating costs, including fuel;
• determination of the unit electrical energy charge that currently applies (excluding network costs) subtracted from the unitised cost of the alternative. This is the network maximum unitised line charge; and
• determination of the applicable transmission charge. The unitised transmission charge that currently applies should be deducted from the network maximum unitised line charge, as this is a pass through. In determining the applicable transmission charge a reasonable allowance should be made for distribution system losses.

3.9 Segmentation for Application of the EV Test

Some lines business owners have confined their segmentation of the network for EV testing to the feeder level. Where a feeder is found to be economic (its EV is greater than its ODRC) no further analysis of that feeder is undertaken. This approach is not in accordance with the requirements of the ODV Handbook.

Section 3.70 of the ODV Handbook provides specific criteria for identifying segments where the EV of a segment must be calculated as follows:

• the EV of a feeder must be calculated if there is an average of 3 ICPs or less per km and an average of less than 20 kVA installed capacity of ICP over the length of the feeder, including the spurs;
• if this analysis gives the EV of the total feeder as less than the ODRC, the whole feeder, including spurs, should be valued at its EV. In these circumstances the spurs off that feeder do not have to be evaluated separately;
• it follows that spurs need only be separately evaluated where they form part of a feeder that, overall, has found to be economic. In such circumstances, Section 3.70 states that the EV of a spur must be calculated if there is an average of 3 ICPs or less per km and an average of less than 20 kVA installed capacity of ICP over the length of the feeder, including any branch spurs.

The Commission considers the wording of this clause is clear in that there is an unambiguous requirement to apply an EV test to spurs off feeders, even if the feeders themselves have been shown to be economic. Indeed the only circumstance where it should be necessary to apply an EV test to an individual spur is when that spur is fed from an economic feeder.

Lines businesses must apply the EV test to spurs connected to economic feeders in accordance with the requirements of the ODV Handbook.