13. Pipeline owners are required to disclose separate financial statements for 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).

4.1.1 Proposed Requirements

14. The Ministry proposes to replace Regulation 21 with a requirement that pipeline owners use a mandatory avoidable cost allocation methodology (ACAM). 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 the pipeline owners if they did not operate their "incremental" businesses (gas wholesaling, gas retailing and other activities).¹ The components of the items that would be avoided would be allocated to the contestable businesses. More details about ACAM are provided in Annex 1.

15. The Ministry proposes that pipeline owners would be required to disclose the full 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.

16. Pipeline owners would also be required to retain all data, including calculation models and associated documentation, for at least seven years.

4.1.2 Rationale for Proposal

17. First and foremost, the ACAM is the only (economically robust) methodology that meets the conditions necessary to identify monopoly profits and cross-subsidies. The conditions for identifying monopoly profits and cross-subsidies are as follows:

R[GPB] > SAC[GPB]; and
If the revenue (R) of the gas pipeline business (GPB) is more than its stand-alone cost (SAC) (including the cost of capital) then the gas pipeline business is earning monopoly profits.
R[CGB] < IC[CGB].
If the revenue obtained from the contestable gas business (CGB) is less than the incremental cost (IC) of those businesses then the contestable business is being operated at a loss.
If both conditions (i) and (ii) are met then the gas pipeline business's monopoly profits are being used to subsidise the contestable gas business.

18. A mandatory ACAM is also necessary to avoid arbitrary allocations between business activities. The use of different allocators (which might satisfy "fair and reasonable" tests) could result in markedly different financial statements.² This is supported by experience in the gas, electricity and telecommunications industries, suggesting that reliance on non-mandatory allocation rules does not provide comparable information amongst companies or over time. It follows that the current Regulations allow companies to allocate inappropriate costs to artificially suppress their pipeline business profitability (to hide monopoly profits) and the costs included in their contestable activities (to hide subsidies).

4.2 Treatment of Contestable Activities

4.2.1 Proposed Requirements

19. The Ministry is considering removing the requirement for pipeline owners to disclose (contestable) gas wholesaling and retailing financial statements. The Ministry welcomes comments on this proposal.

4.2.2 Rationale for Proposal

20. The Ministry is considering this proposal for the following reasons.

The primary focus of the Regulations is on natural monopoly activities, with the expectation that, over time, competition should discipline gas wholesaling and retailing activities.
The proposal would reduce compliance costs.

21. The Ministry recognises that the proposal would make it more difficult to identify cross-subsidies to gas wholesaling and retailing activities. However, cross-subsidies have their source in monopoly profits from pipelines. Disclosure of pipeline profits would be retained.

4.3 Treatment of Gas Distribution and Transmission

22. Under the proposed ACAM, pipeline owners would be required to treat their (natural monopoly) pipeline business as the stand-alone business. Both gas distribution and gas transmission are "pipeline businesses".

23. The Natural Gas Corporation (NGC) provides both gas transmission and distribution services. This raises the question of which business NGC should treat as the stand-alone business; transmission, distribution or both?

4.3.1 Proposed Requirements

24. The Ministry is considering two options within ACAM to deal with gas transmission and distribution.

Option One is to remove the distinction between distribution and transmission in the financial separation rules.

All pipeline owners would then be required to disclose stand-alone gas pipeline business financial statements (SAC[GPB]).

NGC would only disclose stand-alone financial statements for the combined distribution + transmission (pipeline) business (SAC[GDB + GTB] = SAC[GPB]).

Option Two is to require pipeline owners to disclose:

stand-alone financial statements for gas distribution (SAC[GDB]), if they provide gas distribution services; and
stand-alone financial statements for gas transmission (SAC[GTB]), if they provide gas transmission services; and
stand-alone financial statements for combined gas transmission + distribution (SAC[GDB + GTB]) (as in option 1), if they provide both distribution and transmission services.

Exemption - If the common costs and assets accounted for less than 5% of the pipeline owner's pipeline business costs and assets, the pipeline owner would not be required to disclose the combined set of financial statements. (Explanatory note: If this threshold was satisfied the maximum possible level of the monopoly profits understatement through "double counting" of common costs would be too small to worry about.)

25. The Ministry welcomes comments on these two options.

4.3.2 Rationale for Proposal

26. In order to identify whether pipeline owners are using their natural monopoly activities to earn monopoly profits, the following conditions need to be assessed:

R[GDB] > SAC[GDB]; and
If revenue exceeds the stand-alone cost (including the cost of capital) of the distribution business, a pipeline owner is earning monopoly profits from its distribution business.
R[GTB] > SAC[GTB]; and
If revenue exceeds the stand-alone cost (including the cost of capital) of the transmission business, a pipeline owner is earning monopoly profits from its transmission business.
R[GDB] + R[GTB] > SAC[GDB + GTB].
Condition (iii) will identify whether pipeline owners (that provide BOTH distribution and transmission services) are using their combined gas transmission and distribution networks to earn monopoly profits. A pipeline owner may not be meeting conditions (i) and (ii) individually, but may nevertheless be earning monopoly profits because it is recovering common costs (CC) from both its gas transmission and distribution networks.³ Common costs would be duplicated in the SAC[GTB] and SAC[GDB] financial statements, where there are economies of scope between the businesses. Common assets have the same effect as they mean that the cost of capital from those assets could be recovered twice (under (i) and (ii)).

27. The arguments for each of the two options described in section 4.3.1 above are:

Arguments for Option One:

Option One would identify monopoly profits in the pipeline business activities as a whole, however this would leave open the possibility that undisclosed monopoly profits could be taken in one of transmission or distribution.
Both transmission and distribution services are natural monopolies (with the same associated regulatory concerns), so why distinguish between them?
Option One would have lower compliance costs than Option Two.

Arguments for Option Two:

Option Two would identify all sources of monopoly rents ((i), (ii) and (iii)), regardless of whether they were from distribution, transmission or a combination of the two.
Financial separation of distribution and transmission would assist identification of whether the charges for each of these services are reasonable.
Financial separation of transmission and distribution would enable better comparability of NGC's distribution activities with other distributors.

28. A key judgment in comparing the options is how significant the common costs and assets are in practice. The larger they are the stronger the argument for Option Two.

4.4 Treatment of Multi-Industry Companies

4.4.1 Proposed Requirements

29. The Ministry is considering integrating the ACAM in the Electricity (Information Disclosure) Regulations 1999, with the proposed ACAM for gas (see sections 4.1 to 4.3 above). The integration would have the following consequences for electricity line owners and gas pipeline owners:

Electricity line owners would be subject to the current requirements in the Electricity Information Disclosure Handbook 1999. They would disclose stand-alone electricity line business (SAC[ELB]) financial statements;
Gas pipeline owners would be subject to the proposed requirements in sections 4.1 to 4.3. They would disclose SAC[GPB] financial statements; and
In addition, multi-industry network owners that undertake both gas pipeline and electricity line business activities would be required to disclose combined (stand-alone) gas + electricity network financial statements (SAC[ELB + GPB]).
Exemption - If the common costs and assets accounted for less than 5% of the pipeline owner's combined gas and electricity line business costs and assets the pipeline owner would not be required to disclose the combined set of financial statements. Explanatory note: If this threshold was satisfied the maximum level of the monopoly profits understatement through "double counting" of common costs would be too small to worry about.

4.4.2 Rationale for Proposal

30. There is a trend, both in New Zealand and internationally, for owners of networks such as gas pipelines to be also involved in other network industries. This gives rise to regulatory concerns about monopoly activities, so the Regulations need to be robust enough to deal with such situations.

31. The issues that arise in the case of multi-industry companies are similar to those for pipeline owners providing both gas distribution and transmission services (refer to section 4.3). In order to identify whether pipeline owners are using their natural monopoly (electricity and gas) business activities to earn monopoly profits, the following conditions need to be assessed:

R[GPB] > SAC[GPB]; and
R[ELB] > SAC[ELB]; and
R[GPB] + R[ELB] > SAC[GPB + ELB].
(Refer to analogous discussion in paragraph 26.)

32. In essence, the concern is that pipeline owners disclosing stand-alone gas pipeline business and stand-alone electricity line business separately, under the gas and electricity disclosure regulations respectively, may not appear to be earning monopoly profits, but that costs common to both the gas and electricity networks are included in both sets of statements. Imposition of the additional requirement to disclose SAC[GPB + ELB] would address this.

4.5 Proposals for Amending Transfer Payment Disclosure Requirements

33. Regulation 22 requires disclosure of prices, terms and conditions for transfers of goods and/or services between businesses in prescribed business relationships with each other.

4.5.1 Proposed Requirements

34. The Ministry proposes to redraft Regulation 22 to require separate disclosure of transfers amongst each of the businesses , in order to be consistent with GAAP - in particular, SSAP 22 "Related party disclosure". The revised Regulation would require disclosure of the following information relating to revenue and expenditure transactions, including capital expenditure, between related parties:

The identity of each entity and the nature of the relationship between the entities involved in the transactions;
A detailed description of the good or service provided;
A detailed description of the good or service received;
The unit price, quantity, and recorded revenue and expenditure amounts;
The period during which the good or service was supplied;
The total outstanding balances arising from all related party transactions for each entity together with an indication of the terms of settlement for these balances;
Total debts arising from related party transactions that each entity has written off or forgiven during the financial year; and
If transactions take place at nil or nominal value, a brief description of the transactions and details of any nominal value.

35. Transfer payment disclosure would be likely to cover such transactions as payments from retail to distribution for access to pipelines, and payments by distribution to "other" for asset maintenance and construction.⁴ Note that these transactions may be notional rather than actual because the businesses are only required to be separated in a financial sense, and not in a corporate or ownership sense.

4.5.2 Rationale for Proposal

36. Where pipeline owners transfer goods and services amongst their businesses, they have scope for pricing these at inappropriate levels in order to suppress the apparent profitability of the natural monopoly services and/or subsidise their contestable activities. Disclosure of transactions between related parties would identify whether pipeline owners are setting these payments inappropriately. Experience in the electricity and gas industries suggests that without clear specification of the details of transactions between related parties, disclosures tend to be inadequate for assessing the appropriateness of transactions between related parties.

4.6 Items to Be Individually Disclosed in Pipeline Owners' Financial Statements

4.6.1 Proposed Requirements

37. Pipeline owners would be required to specifically identify the following items in their financial statements:

all material transactions between related parties (refer to section 4.5 above);
a range of nominated significant items (to be developed);
those items which form the basis of the financial performance measures; and
all items that are of such a size, nature or incidence that their disclosure is necessary for understanding of the business.

38. This list is not exclusive and would not preclude the disclosure of other individual items, particularly if required under GAAP.

4.6.2 Rationale for Proposal

39. A requirement to disclose certain information in the financial statements would facilitate analysis of the appropriateness of pipeline owners' allocations amongst their different businesses and reconstruction of the financial performance measures (if disclosed allocations are deemed inappropriate).

4.7 Consistency of the Financial Statements with GAAP

4.7.1 Proposed Requirements

40. The Ministry proposes that the financial statements, required to be prepared under the financial separation rules, be required to fully comply with generally accepted accounting practice ("GAAP").⁵ Under this proposal:

The application of ACAM would define the entity for disclosure reporting.
The auditor reports that accompany the statements and the performance measures would be extended to describe:

The work done by the auditor;
A description of the responsibilities of the directors;
A description of the responsibilities of the auditor;
The scope and limitations of the work performed by the auditor;
The existence of any relationship (other than that of auditor) which the auditor has with, or any interests which the auditor has in, the gas company;
Whether the auditor has obtained all required information and explanations;
Whether, in the auditor's opinion, proper accounting records appear to have been kept by the gas company; and
Whether, in the auditor's opinion, the financial statements comply with generally accepted accounting practice, give a true and fair view and comply with the Regulations.

Harmonisation with GAAP would be enhanced in areas covered by both GAAP and the Regulations (eg in respect of terminology such as "financial report", "statement of financial performance", "statement of financial position", and definitions such as "depreciation" and "subsidiary").
The present requirement that financial statements include only the statement of financial performance and statement of financial position (including notes), and a statement of accounting policies, would be extended so that cash flow statements and statements of movements in equity would need to be disclosed. The Ministry understands that the additional compliance costs will be minimal.

4.7.2 Rationale for Proposal

41. Section 55(1)(b) of the Gas Act 1992 specifies that financial statements should be GAAP compliant. Furthermore, GAAP is the authoritative set of rules for accounting purposes in New Zealand and it is sensible to base the regulatory accounts on this firm foundation.

4.8 Requirement for Common March Financial Year for Disclosures

4.8.1 Proposed Requirements

42. The Ministry proposes to change the definition of "financial year" so that all pipeline owners' disclosures relate to a common financial year, ending 31 March. The proposal would take effect from the 2000/2001 financial year (i.e. year ending 31 March 2001). Pipeline owners switching from a June or September year would be required to disclose 1999/2000 information on a June or September year basis, then disclose information for a full 12 months to 31 March 2001 (not 6 or 9 months).

4.8.2 Rationale for Proposal

43. The Regulations require pipeline owners to make many of their disclosures in relation to their financial year. Other disclosures are required within a certain period of the beginning or end of their financial year. "Financial year" is defined on the basis of the disclosing pipeline owner's balance date. This is in contrast to the Electricity (Information Disclosure) Regulations 1999, which impose a common March year on line business disclosures.

44. Of the four pipeline owners that make substantive financial disclosures, two have March balance dates (Orion, Powerco) and two have June balance dates (NGC, Wanganui Gas). The mixture of balance dates complicates comparisons of performance.

45. The Ministry considers a move to a common reporting year would complement the proposed introduction of ACAM and a mandatory ODV (see section 5 below), making inter-company comparison easier, more accurate and more timely. The ownership links between electricity and gas network owners Orion and Powerco make March the best option, since electricity line owners are required to disclose to a March balance date.

1 The "incremental cost" of a service is the cost incurred in supplying that service, excluding all costs that would be incurred if that service were not supplied. The "stand-alone cost" of a service is the cost that would be incurred if that were the sole service provided.

2 Baumol, Koehn and Willig "How Arbitrary is Arbitrary? - or, Toward the Deserved Demise of Full Cost Allocation", Public Utilities Fortnightly, September 1987, demonstrated that using a "fully distributed" (fully allocated) cost methodology can result in arbitrary and meaningless information. Using a railroad example, they show how the financial statements and profitability measures for the railroad's activities could vary markedly by using different allocators (all of which are consistent with the fully distributed cost methodology) and concepts such as "fair and reasonable".

3 Note that SAC[GDB+GTB] = SAC[GDB] + SAC[GTB] - CC.

4 Note that while transfers may occur between "other" and the gas businesses, financial statements for "other" will not be required to be disclosed.

5 Financial performance measures will not be required to comply with GAAP.

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Printed: 26/11/2009