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• 2. Avoidable Cost Allocation

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• 2.1 Avoidable Cost Allocation Methodology
• 2.1.1 Proposed Requirements
• 2.1.2 Rationale for Proposal
• 2.1.3 Additional Comments
• 2.2 Allocation of Boundary Items under the Avoidable Cost Allocation Methodology
• 2.2.1 Proposed Requirements
• 2.2.2 Rationale for Proposal

2.1 Avoidable Cost Allocation Methodology

14. The Gas (Information Disclosure) Regulations 1997 require pipeline owners to disclose separate financial statements for their wholesale (in the case of NGC), transmission, distribution and retailing activities (Regulations 6 and 7). The Regulations do not specify the cost allocation methodology to be used, but pipeline owners are required to disclose the allocation methodology that they used (Regulation 21).

2.1.1 Proposed Requirements

15. The Ministry proposes to replace Regulation 21 with a requirement that pipeline owners use a mandatory avoidable cost allocation methodology (ACAM), and fully comply with generally accepted accounting practice (GAAP). The ACAM would define the (natural monopoly) pipeline business as the "stand-alone" business, excluding expenses, revenues, assets and liabilities ("items") that would be avoided by pipeline owners if they did not operate their "Other" business (gas wholesaling, gas retailing and any other activities). The components of the items that would be avoided would be allocated to the Other business. More details about ACAM are provided in Annex 1.

16. Under the proposed ACAM, pipeline owners would be required to disclose "stand-alone" financial statements for their:

• distribution business, if they provide gas distribution services;
• transmission business, if they provide gas transmission services; and
• combined distribution plus transmission business¹, if they provide both gas distribution and transmission services.

17. Financial statements would no longer be required to be disclosed for (contestable) gas wholesaling and retailing activities.

18. The Ministry also proposes that pipeline owners would be required to disclose the details of how they applied ACAM, including:

• any models used;
• all significant assumptions and estimates underlying the calculations; and
• the nature of, reasons for and financial impact of any changes in the application of ACAM.

2.1.2 Rationale for Proposal

19. The Ministry is proposing a mandatory ACAM for the following reasons.

20. First and foremost, the ACAM is an economically robust methodology for identifying monopoly profits earned by natural monopolies and for allocating costs in a way that does not effectively cross-subsidises contestable activities.

21. Secondly, a mandatory ACAM is necessary to avoid arbitrary and/or inconsistent allocations between the business activities. The use of different allocators (which may satisfy "fair and reasonable" tests) could result in markedly different financial statements. This is supported by experience in the gas, electricity and telecommunications industries, where reliance on non-mandatory allocation rules has not provided comparable information amongst the companies or over time. It follows that the current non-mandatory rules allow companies to allocate inappropriate costs to artificially suppress their line business profitability (to hide monopoly profits) and reduce the costs included in their contestable activities (to hide subsidies).

2.1.3 Additional Comments

22. The discussion paper entitled Proposals for Amending the Gas (Information Disclosure) Regulations 1997 stated (section 4.4) that the Ministry was intending to integrate the ACAM in the Electricity (Information Disclosure) Regulations 1999 and the proposed ACAM for gas. The Ministry does not intend to pursue this proposal at this stage. The Ministry may review the proposal at a later date.

2.2 Allocation of Boundary Items under the Avoidable Cost Allocation Methodology

23. This section identifies how "boundary items" should be treated under the proposed ACAM methodology. Boundary items are defined as items (expenses, revenue, assets and liabilities) where it may be open to interpretation which business (or businesses) they should be allocated to. Specifically, the section:

1. identifies the items that fall within the boundary of gas distribution/transmission and "other" activities, and of gas distribution and gas transmission; and
2. proposes which business(es) these items should be allocated to.

24. Summary information on the proposals and their rationales are provided below. Full details are provided in Annex 2.

2.2.1 Proposed Requirements

25. The Ministry proposes the following allocations of boundary items between the Pipeline business (transmission and/or distribution) and the Other business:

• Gas Measurement Systems - filters, regulators and over pressure protection allocated to the Pipeline business; and meters² to the Other business.
• Isolation valves - allocate to the Pipeline business.
• SCADA - allocate to the Pipeline business.
• Gas meter test facility and testing - allocate to the Other business.
• Meter reading and provision of meter reading (or processed energy) information - allocate to the Other business. Where the line business requires metering information (eg for its own variable charges and/or asset management purposes) a transfer payment for metering services would be appropriate (the proposed list of items in Annex 3 provides for this transfer).
• Contracting activities (eg pipeline construction) - allocate to the Other business, with transfer payments from the Pipeline business to the Other business for provision of contracting services.
• Unaccounted-for gas - Allocate to the Other business for distribution, allocate to the Pipeline business for transmission (with a transfer payment for purchase of gas where appropriate - see the proposed list of items in Annex 3).
• Transmission system receipt point and custody point of transfer - Allocate the assets from the custody point of transfer at receipt points to the custody point of transfer at delivery points to the Pipeline business. Except for meters which should be allocated to the Other business, with provision for transfer payments from the Pipeline business to the Other business for metering information.
• Network growth (marketing) incentives - Allocate to Pipeline business, with provision for transfer payments from the Pipeline business to the Other business for internal payments. These transfer payments would have to be disclosed in the Pipeline business's financial statements (see Annex 3).
• Allocation & reconciliation services - Allocation and reconciliation expenses should be allocated to the Other business. Allocation and reconciliation charges should be unbundled from line charges and allocated to the Other business.
• Research and development expenses - Allocate to the Other business.
• Capital works under construction - If works under construction are a Pipeline business asset, allocate to Pipeline business. Otherwise allocate to the Other business.
• Intangible assets other than goodwill - Allocate to the Other business.
• Billing system (also used as connection and consumption databases) - This asset and the associated costs are common to (or shared by) each of the businesses. The asset and costs should be split between the Pipeline business and the Other business using ACAM principles (see Annex 1).
• Mergers and acquisitions expenses - Treat as a common cost and allocate between the Pipeline and Other businesses using ACAM Principle II (see Annex 1).
• Take-over defense expenses - Treat as a common cost and allocate between the Pipeline and Other businesses using ACAM Principle II (see Annex 1).
• Investments, losses/gains on sale of investments and returns (dividends/interest) on investments - Treat short-term investments as a common cost, and allocate between Pipeline and Other businesses using ACAM principles. Allocate long-term investments to the Other business.

26. The Ministry proposes the following allocations of boundary items between the gas distribution and gas transmission business (to apply to pipeline businesses, where they contain both gas distribution and gas transmission):

• Gate stations - Allocate to transmission.
• Pressure reduction from Transmission to Distribution - Allocate to transmission.
• Load/flow control at gate stations - Allocate to transmission.
• Cathodic protection - Directly allocable to transmission and distribution.

2.2.2 Rationale for Proposal

27. The allocation of boundary items between the Pipeline and Other businesses was based on the following criteria:

1. The allocation should be consistent with ACAM.
2. Where more than one option is consistent with this criterion, the allocation should minimise compliance costs.

28. The proposed allocation of boundary items between distribution and transmission takes into account all extant definitions of the two functions in legislation and standards.

¹This is consistent with "option 2" in section 4.3 of the October 1999 discussion paper.

²Meters that are within the network - that is meters other than the customer based (GMS) meters and meters that are part of the transmission system receipt point - should be allocated to the Pipeline business.