Greg Houston

Director, NERA

20 February 2008

The Role of Merit Reviews under Part 4 and 4A of the Commerce Act

Presentation to ISCR Workshop

Mark Berry

Barrister

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Key Topics

1. What is a Merits Review?

2. The Australian Experience in Energy Regulation

3. The New Zealand Proposal

4. A Better Approach?

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Forms of Review

Appeals

Merits review

Judicial review

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Appeals

Standard rights of appeal exist under the Commerce Act 1986 for all matters other than regulatory decisions

Commerce Commission decisions remain in force pending the hearing of an appeal

Appeals are by way of rehearing:

– material and evidence before the Commission; and

– discretion to admit new evidence and to rehear evidence

The Court determines if the decision is right or wrong having regard to the totality of findings of fact and law

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Merits Review

Can carry a range of meanings

Can be akin to standard appeals (eg, Administrative Review Council formulation)

But powers can be subject to legislative restriction on matters such as:

– standing

– decisions that are reviewable

– grounds for review

– reviewable evidence

– potential relief

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Merits Review

The more limited the merits review process becomes, the more it can begin to resemble a judicial review

De novo appeal

Judicial

review

Merits review restricted on the basis of …..

parties with standing

reviewable decisions

grounds for review

reviewable evidence

potential relief

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Judicial Review

Standard grounds cover:

A. Wednesbury ‘unreasonableness’ which can be explained in two senses:

1. Overlapping heads of discretionary error such as:

a. Bad faith

b. Having regard to irrelevant considerations

c. Failing to have regard to relevant considerations

d. A clear misunderstanding of the facts

e. The lack of proper appreciation of the law

2. “Something so absurd that no sensible person could ever dream that it lay within the powers of the authority”

B. Natural justice, such as:

1. Failure to consult

2. Bias / predetermination

The grounds for judicial review are not static (A v Chief Executive for the Department of Labour, 2005)

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Judicial Review Formulations

Sec 39(2) Gas Pipelines Access (SA) Act:

“that the exercise of the relevant Regulator’s discretion was incorrect or was unreasonable having regard to all the circumstances”

NZ Proposal

c) “The exercise of the original decision maker’s discretion was incorrect, having regard to all the circumstances.

d) The original decision maker’s discretion was unreasonable, having regard to all the circumstances”

Observations from the Moomba to Sydney gas pipeline decisions

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For Improves accountability for the

regulator and improves regulatory decisions

Allows for correction of errors of fact and judgement

Improves business confidence in the regulatory regime

Against Increased costs

Ties the regulator up in the court system

Results in delays and uncertainty

Judicial review provides sufficient discipline

We return to these arguments when we examine the ‘New Zealand proposal’ in more detail…

Arguments For & Against Merits Review

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The Australian Experience

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Electricity

TransmissionACCC

DistributionState-based

regulators

No merits review of network pricing decisions

De novo hearing at Electricity Tribunal for some decisions

Limited merits review in Victoria & South Australia

No merits review in New South Wales & Queensland

Gas

TransmissionACCC

DistributionState-based

regulators

Limited merits review by the Competition Tribunal

Limited merits review by state-based appeal bodies

Each under Gas Pipelines Access Law (GPAL)

Very disparate!

But this is changing…

Recent Approach to Review

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Trend: Increasing Harmonization

Rule MakerAEMC

Empowered under the National Electricity Law & National Gas Law to make ‘Rules’ that regulate the Electricity and Gas Markets

Rules currently/will contain (among other things) rules in relation to the economic regulation of transmission and distribution services

Separation is a key feature

Limited Merits Review Competition Tribunal

Review available for (among other things):

– AER pricing and revenue determinations for transmission and distribution in electricity; and

– AER decisions to draft and approve gas access arrangements

Grounds for review based largely on Gas Pipelines Access Law

RegulatorAER

Exercises the economic regulatory function and monitors/enforces compliance with the Rules

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What Are ‘Rules’?

The Australian equivalent of ‘input methodologies’ - some are very prescriptive and others are more process orientated

Rule 6A.6.2 sets out how the annual return on capital must be calculated by electricity transmission businesses – it spans 5-pages and sets out:

– the WACC formula;

– the nominal risk free rate (based on a 10-year Government bond rate);

– the equity beta (deemed to be 1.0);

– the market risk premium (deemed to be 6.0%) and the debt risk premium (based on corporate bond rate for bonds with a BBB+ credit rating); and

– that the AER must review the parameters every 5 years

In contrast, Rule 6A.6.6 sets out the requirements for operating expenditure forecasts and includes mainly high-level efficiency objectives and process requirements

Rules are not merits reviewable in Australia - they are a legislative function

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Form of Merits Review

What decisions are subject to merits review?

– AER gas/electricity network pricing decisions;

– Ministerial decisions in relation to ‘coverage’ of gas pipelines;

– decisions by the AEMC on the form of regulation to apply in gas; and

– various decisions by the AER on ‘ring-fencing’ guidelines

For the Competition Tribunal to hear an appeal there must be:

– a serious issue to be heard;

– the amount at stake must exceed the lesser of $5m or 2% of the annual regulated revenue of the service provider

Some decisions stand in the interim (eg, network pricing decisions) and others do not (eg, Ministerial ‘coverage’ decisions)

Interveners (including the regulator) can raise additional points of review

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Grounds for Review

Consistent across the National Electricity Law and the proposed National Gas Law, based on the existing gas legislation (GPAL):

– the decision-maker made an error of fact in its finding of facts, and that error of fact was material to the making of the decision;

– the decision-maker made more than one error of fact in its finding of facts, and that those errors of fact, in combination, were material to the making of the decision;

– the exercise of the decision-maker’s discretion was incorrect, having regard to all the circumstances; and

– the decision-maker’s decision was unreasonable, having regard to all the circumstances

Choices between input methodologies are not findings of fact (ACCC v Australian Competition Tribunal [2006] FCAFC 83 (2 June 2006))

These are the grounds that are proposed in New Zealand, but with one critical difference…

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Summary

Until recently there was a disparate approach to merits review between electricity and gas and between distribution and transmission

There has been an increasingly harmonized approach in recent years – although this is not as complete as it could be

The Competition Tribunal is a more experienced body than some of the previous, state-based appeal bodies

An important difference to NZ is the separation in Australia of the ‘rule making’ body and the economic regulator that applies those rules

Few significant decisions to date under the new regime and no appeals

Given that the new legislation is based on the old gas law, seminal gas decisions will remain important, eg, Moomba-Sydney Pipeline case

As we shall see, there are potential problems in seeking to adopt this approach in New Zealand

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The New Zealand Proposal

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Final Decisions vs Input Methodologies

Currently merits review is unavailable under the regulatory provisions of the Commerce Act:

– this is difficult to justify given that appeal provisions exist for merger and restrictive trade practices provisions;

– the MED/cabinet papers seem to appreciate this;

– the vast majority of submissions to the MED supported some form of merits review

The Cabinet Paper distinguishes between:

– the final decisions made by the Commerce Commission; and

– the input methodologies that underpin those decisions

Judicial review only

Limited merits review

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Why Review Input Methodologies?

Rationale is to settle important matters ‘up front’ and improve certainty

– similar reasoning to the separation in Australia of the ‘rule making’ process to the ‘rule application’ process; but

– a critical distinction is that the Commission fulfils both functions

The intention is for the Commission to develop input methodologies over the next three years on (among other things):

– the cost of capital;

– valuation of assets (including depreciation);

– allocation of common costs;

– treatment of taxation; and

– pricing principles

Decisions can be appealed to the High Court within 20-days of their release, which may consider the appeal with up to 2 lay members

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Harmonization with Australia?

The grounds for merits review are based on the Australian legislation:

1. the Commission made an error of fact in its findings, and that error of fact was material to the making of the decision;

2. the Commission made one or more error of fact in its finding of facts, and those errors of fact, in combination, were material to the making of the decisions;

3. the exercise of the Commission’s discretion was incorrect, having regard to all the circumstances; and

4. the Commission’s decision was unreasonable, having regard to all of the circumstances

Criteria 3 and 4 are very similar to existing grounds for judicial review

Criteria 1 and 2 relate to errors of facts

But do input methodologies contain facts?

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Some May

Input methodologies may have parameters in them that could be considered ‘facts’, for example Rule 6A.6.2 of the National Electricity Rules:

– The return on capital must be calculated as a nominal post-tax weighted average cost of capital (WACC) in accordance with the following formula:

Where:

the nominal risk free rate is based on a 10-year Government bond rate;

the equity beta is deemed to be 1.0;

the market risk premium is deemed to be 6.0%

the debt risk premium is based on corporate bond rate for bonds with a BBB+ credit rating); and

D/V is deemed to be 0.6

V

DDRFPr

V

EMRPrWACC fef )()(

Potential ‘facts’

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Many Will Not

It is conceivable that an input methodology for the ‘cost of capital’ might contain no facts

Consider Clause 8.30 of the former Gas Code:

‘The rate of return used in determining a reference tariff should provide a return which is commensurate with prevailing conditions in the market for funds and the risk involved in delivering the reference service’

If the input methodology in question contains no facts criteria 1 and 2 become redundant:

– many of the input methodologies likely will not contain facts – they will be largely process orientated; and

– for others that could contain ‘facts’ (such as WACC) the degree of prescription is critical

Who determines the level of prescription?

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Level of Prescription Critical

In Australia, input methodologies are set by the AEMC and enforced by the AER, with decisions of the AER subject to merits review

However, the Commission will make and apply input methodologies - this creates an agency problem that does not exist in Australia:

– if the Commission wants to avoid the prospect of merits review, it will ensure its methodologies are devoid of ‘facts’; and

– doing so would also preserve for itself the maximum discretion when making ‘final decisions’, which are subject only to judicial review

The Cabinet Paper makes it clear that the Commission has complete discretion

Many methodologies cannot contain facts

Commission determineslevel of prescription for those that could

+

Will the proposed approach differ materially to pure judicial review?

Plus 3-years of uncertainty while the Commission develops methodologies

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Should Methodologies be Reviewed?

Setting aside the problems outlined is it a good idea to review input methodologies?

Review decisions about input methodologies are not suited for judicial decision-making:

– judges are used to interpreting and applying the law to particular factual situations; and

– without a factual context a judge would struggle to review, say, a set of pricing principles – even with lay member assistance

The Ministry of Justice highlighted these points in its advice to Ministers (although it supported independent review)

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Summary

There are dangers in trying to apply aspects of the Australian merits review framework to input methodologies:

– many methodologies cannot contain ‘facts’ that can be reviewed;

– the Commission has complete discretion over the level of prescription of methodologies, unlike in Australia; and

– review decisions about input methodologies are not suited for judicial decision-making in any event

The result is that it is not obvious that the outcome will be different to presently, with parties having to rely on judicial review

The proposal also involves 3-years of uncertainty while the methodologies are developed (an unduly pessimistic timeframe?)

The proposed changes risk not achieving their objective of improving accountability and certainty

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A Better Approach?

The case for de novo review can be established in terms of the Legislation Advisory Committee guidelines:

– the matters at stake involve important rights and interests;

– why afford lesser rights to regulated utilities than those that exist under other Parts of the Act?; and

– countervailing factors do not outweigh the above considerations:

costs are unlikely to be disproportionate to the matter at stake;

subject matter very significant;

delay not a significant factor - decisions can stand pending review;

while the Commission does has expertise, appellate avenues do exist for the assessment of errors in the regulatory context; and

principle of finality no reason to deny utilities standard appeal rights

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Preferred Form of Merits Review

The Commission should develop non-binding input methodology guidelines

Merits review would be of final decisions on customised proposals by the High Court assisted by lay members:

– where questions of fact are involved, the evidence before the Commission will be brought before the Court; and

– Court would have discretionary power to rehear the whole or any part of the evidence or to receive further evidence

Rights to review would encompass all aspects of the Commission’s decisions, including underpinning input methodologies

Decisions of the Commission should stand pending merits review

Commission would be required to update its input methodologies in accordance with any Court decision for next regulatory period

Court decisions would not affect businesses that did not seek merits review

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Business accepts Commission’s response

Business seeks merits review by way of rehearing in High

Court within 20 business days

How it Fits Together…

Transition from existing regime to new regime

Industry-wide price path & input methodologies set by

Commission within 12-months of amending legislation

Price & quality thresholds maintained in the interim

Regulatory processes improved / clarified

Amending legislation / timeframes for implementation

Enforceable form of regulation set for 5-year regulatory

period

Business does not submit alternative proposal

Business submits alternative proposal within 60-days

Commission must respond within 90-days

Industry-wide price path reset by Commission – initially applies to all businesses

Interested parties may provide submissions within 30-days

Commission must make final decision within 30-days

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Key Messages

The proposal to make input methodologies merits reviewable risk not achieving the objective of improving accountability and certainty:

– review of input methodologies is impracticable; and

– the ultimate result may be no different to presently with firms having to resort to judicial review

A preferable approach would be to allow for a de novo review in the High Court with assistance from lay members, consistent with:

– this is consistent with the Legislation Advisory Committee guidelines; and

– standard appeal rights that apply to other matters of Commission adjudication under the Act

Contact Us

© Copyright 2008NERA Australia Pty Ltd

All rights reserved.

Greg Houston

DirectorNERA Australia+61 2 8864 6501greg.houston@nera.com

Mark Berry

BarristerBarristers.Comm+64 4 914 1050m.berry@barristerscomm.com