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					National Energy Customer Framework - Second Exposure Draft

Supplementary Submission - Credit Support



Further comments to Retail Policy Working Group

Introduction

On 4 March 2010, the Retail Policy Working Group (RPWG) held a credit support forum with the
Energy Network Association (ENA) and distribution network service providers. At the forum the
RPWG presented the policy underpinnings of the (proposed) credit support regime in the NECF and
provided a more detailed explanation the technical aspects. ENA presented the RPWG with the key
matters of concern.

The presentation was made by Mr Jeff Balchin, PWC, (formerly at Allen Consulting Group (ACG).
ACG had advised the Essential Services Commission on the review of credit support arrangements in
2006. The proposed arrangements in NECF2 are based on the Victorian approach

This supplementary submission raises a number of concerns as a consequence of matters raised at
the forum. In light of these concerns ENA has sought to provide possible alternative approaches to
several aspects of the credit support regime.

Background - The Victorian model

As a way of background to the issues in this submission, we have summarised the key points from the
presentation given by Jeff Balchin (PWC) on the Victorian credit support arrangements. The
presentation clarified the policy rationale of the Victorian approach and that the three key features of
the Victorian model were:

    1. Breaking the link between the risk of retailer default and the risk borne by distributors by
        permitting a pass through for the cost of unpaid distribution charges. That is, if a material
        default risk exists that it was inappropriate for distributors to bear the costs of unpaid network
        charges;
    2. Customers would bear the risk of retailer default. Customers benefit from the enhanced
        competition therefore it is appropriate for them to bear the cost. A key issue is determining
        what is the maximum default risk that customers are prepared to bear noting the potential
        trade-off between the credit hurdle for entry and competition. The maximum default risk is
        the “maximum credit allowance”.
    3. Calculate credit support so that all retailers impose the same expected cost of default
        which depends on the probability of default and the size of the exposure. The approach was
        described as having a number of desirable economic features namely:
       - Taking account of the size of the retailer as well as its probability of default;
       - Is competitively neutral between retailers
       - Provides desirable incentives for retailers to diversify across distributors and retailers to
           improve credit worthiness as they get larger.

PWC stated that the Victorian scheme was designed deliberately to lower the barriers to entry and
growth of small retailers.

The Victorian approach and the proposal in the NECF have been based on the UK approach. We
have examined the approach in the UK to provide insight into the issues that were considered by the

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UK regulator. The Victorian model appears to have adopted the UK’s credit allowance approach but
not remedies for non-compliance by retailers

MCE policy intention

ENA wishes to express appreciation for the opportunity to discuss policy and technical matters with
the RPWG and its consultants at the targeted forum on the credit support. It is a complex issue that
has important consequences for distributors, retailers and customers.

An important outcome from the forum was clarification that the policy underpinning the regime is to
deliberately lower the barriers to entry and growth of small retailers into the retail market by reducing
the costs of credit support to small retailers. The policy intent of the credit support scheme was for
customers to bear the risk of retailer default. The reason for this is that customers, rather than
distributors, are to bear the cost of a defaulting retailer because they are the beneficiaries of retail
competition.

We note that the policy intention for customers to bear the risk of defaulting retailers was not
articulated by the MCE in the Explanatory Material. If indeed this is the policy intention of the MCE,
then it would be preferable for this intention to be made clear to the industry, the AER and customers.
The clear articulation of the policy intention will obviate regulatory uncertainty for distributors and the
AER. In particular, this policy has important implications with regards to the RoLR cost pass through
provisions that have been proposed into the NECF.

Discussion by participants at the forum disclosed major concerns with the proposed regime. The
regime is dependant upon the distributors firstly being assured of recovery of unpaid distribution
charges should the retailer default and secondly credit support being provided when requested -
neither of which is delivered by the regime. In particular:

        There are no provisions in the NECF that effectively compel retailers to comply with
         distributors’ request for credit support. This is a significant credit risk for customers.
        The cost pass through provisions, as currently drafted do not provide an effective mechanism
         for the recovery of costs associated with retailer default.
        Unless credit support is provided upfront, it may be problematic obtaining it at a time when a
         retailer is failing to pay its network charges to a distributor as it may be an indicator of a
         retailer’s deteriorating solvency. This affects the ability to stem the default risk faced by
         customers.

In this supplementary submission we have attempted to find ways to address these concerns. The key
issues are:
      ensuring retailer compliance to credit support requirements;
      Ensuring the credit support methodology adequately addresses the risk of retailer default; and
      Proposed amendments to the cost pass through provisions.

These approaches are set out below.

Retailer compliance to reduce risks to customers

The forum clarified that the policy intention (in Victoria at least) was to decouple the credit hurdle faced
by retailers by allowing distributors to pass through the costs of retailer default to customers.1 From

1
 This policy intention is referred to in Allen Consulting Report, Review of Retailer DUoS Credit Support Arrangements,
Report to Essential Services Commission, January 2006, page iv,
“In its Electricity Distribution Price Review 2006-10 Final Decision, the Commission expressed some concerns about the
credit risk hurdle currently in place. The Commission decided to separate the credit-hurdle that is imposed on electricity
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our understanding there was a deliberate intention to lower the costs and barriers to entry for small
retailers. It will be important to ensure that the credit support regime provides an appropriate balance
between the willingness of customers to pay for the default of retailers and the benefit of entry and
expansion of small retailers into the market. We query the extent to which this risk has been made
known to customers.

In light of this policy intention we contend that it will be important to provide incentives for retailers to
meet their financial obligations so as to limit the extent of the default risk faced by customers. These
incentives will need to be reinforced with enforcement measures that are effective.

We are disappointed that the NECF package did not address the issues raised on enforcement
requirements by ENA in the first submission. However, given that the intention is for customers to bear
the default risk there is perhaps an even greater imperative for the MCE to reconsider comments
previously made by ENA on this matter. To further support this position, we refer the MCE to the
arrangements in the UK upon which the proposed NECF and the Victorian approach have been
based.

The arrangements in the UK set out stringent remedies for default by retailers. If a retailer (or relevant
party) presents aggregate value at risk in excess of 100 per cent of the sum of its unsecured credit
limit and the agreed value of any security posted, they should on the following business day be given
notice requiring the provision of additional security in any of the acceptable forms. Such additional
security shall be provided within two business days following the date of the notice.

Where a counterparty does not comply with a distributor’s request to provide, or increase the level of,
security, and is therefore in default, the following should apply:2

           Number of days         Action suggested
           after default
           Day 0                  Due date
           Day +1                 Interest and administration fee trigger
           Day +1                 Distributor to issue a formal notice of default as to statement of position and how default is
                                  to be remedied
           Day +3                 Formal retailer response is required
           Day +5                 Ability to suspend registrations of (inward) transfers (emphasis added)

We note that the ACG report to the Essential Service Commission did present the UK approach for
remedies for retailer default.3

Ofgem’s guidelines state that in all instances interest and administration fees should be charged, in
line with the above timetable. The distributors should use all means generally available to them at law
to enforce their rights and remedies in order to mitigate losses arising from retailer default.

ENA strongly supports the remedy outlined by Ofgem, as set out in the above table, as this would
enable the distributor to object to new customer transfers to the defaulting retailer. This type of
remedy is consistent with suggestions put forward by ENA in its previous submissions to the MCE in
the NECF.

To reiterate:4

retailers from the credit risk that is borne by the distributors by introducing the ability for distributors to potentially pass
through to customers the net financial consequences associated with a retailer default. (page iv)
2
  Refer to Office of the Gas and Electricity Markets Authority (Ofgem), Best practice guidelines for gas and electricity
network operator credit cover, Conclusions document, February 2005, 58/05. page 44. We have replaced the UK terms for
“Network operator” and “supplier” with Australian terms “distributor” and “retailer”.
3
  The Allen Consulting Group, Review of Retailer DUoS Credit Support Arrangements, Report to Essential Services
Commission, January 2006, pages 19-20.
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           Distributors should also be entitled to object to further transfers of connection points to the
           Retailer (for electricity, in the MSATS system) where the retailer has failed to provide credit
           support or pay distribution charges in breach of the Retail Support Rules. This will prevent
           defaulting retailers from increasing their level of indebtedness and credit risk to distributors
           and (ultimately) to end use customers.

ENA’s submissions to the MCE on NECF1 and NECF2 discussed the necessity for the Retail Support
Rules to contain obligations for a retailer to pay network charges and to provide credit support in order
to stem the significant risk of financial risk. Without effective enforcement remedies, retailers can stop
paying network charges and refrain from providing credit support, yet remain registered for their
existing connection points and can continue to register more connection points with AEMO. Therefore,
electricity distributors are effectively obliged to continue providing retailers with services for their
connection points, without being able to terminate their services or take any other steps to limit their
exposure, while the size of their credit exposure is growing.

Now that we understand that the intention is for this financial risk to be transferred to customers we
would argue that the need for enforcement remedies is now relevant to protect the financial interests
of customers. We consider that an effective enforcement regime is an integral plank in the credit
support regime. We refer the MCE to the comments made by ENA on the other types of enforcement
provisions.

Recovery of costs

A key plank of the policy intention of the credit support regime is for customers to bear the cost of
retailer default as it is customers who are the beneficiaries of retail competition. The delivery of this
policy intention requires an appropriate mechanism for distributors to pass through the costs related to
a retailer default onto customers.

The cost of a retailer default placed other administrative costs on distributors such as making
applications to the AER for the recovery of costs and unrecovered debt, the AER’s assessment of the
applications, distributors IT costs for making adjustments to invoices to recoup the costs. These costs
are not insignificant. It will be important that provisions for the recovery of these costs are robust.

The NECF2 package contains an amendment to Chapter 10 of the Rules to include a RoLR Event as
a pass through event for a distribution determination.

In response to this ENA submitted that:5

      -    A distributor should be entitled to full cost pass through of all unrecoverable network charges
           accrued by defaulting retailers, because a distributor is required under the regulatory
           framework to continue accruing unpaid network charges with no control over the level of this
           and no allowance having been made for it in its distribution determination.

      -    This should be the case regardless of whether or not a RoLR Event is ultimately triggered for a
           defaulting retailer. This is because a financially failing retailer which fails to pay network
           charges does not necessarily always become the subject of a RoLR Event. The failing retailer
           may (for example) sell all its customers and energy trading book before going out of business
           with unpaid debts, with the result that no RoLR Event is never triggered.



4
    ENA, Submission in response to the second draft of the NECF, 26 February 2010, page 46.
5
    ENA, Submission in response to the second draft of the NECF, 26 February 2010, page 47.
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Further ENA suggested that to achieve the above that the following changes should be made to the
Retail Support Rules for electricity:6

-     The definition of RoLR event should be expanded to include "the writing off of unrecovered retailer
      network charges in accordance with applicable accounting standards".
-     A provision should be included that makes it clear that the AER must allow a pass through of all
      proven unrecovered retailer network charges which have been written off under applicable
      accounting standards, with no materiality threshold to be applied.


We have given further consideration to the appropriateness of using cost pass through provisions for
the pass through of costs related to the retailer default. Under clause 6.6.1(a) of the National
Electricity Rules, if a positive change event occurs, a distributor may seek the approval of the AER to
pass through to distribution network users a positive pass through event. Under Chapter 10 of the
National Electricity Rules, a positive change event is defined as a pass through event that materially
increases the costs of providing direct control services.

The cost pass through provisions were not designed to deal with costs related to the default of a
retailer. Especially, not in the case where prudent credit management has been eschewed/relaxed in
favour of a credit allowance regime designed to encourage small retailers into the retail market. The
current cost pass through provisions under Chapter 6 have been designed to apply to costs which
could reasonably be expected to have been forecast and included in operational or capital expenditure
forecasts at the time of the distribution determination but were not due to unforeseen circumstances,
usually outside the control of the distributor. Unpaid network charges and other costs incurred due to
defaulting retailers are not directly related to the cost of providing network service and therefore are
generally not regarded as costs which could reasonably have been included in expenditure forecasts.
In this case:

      -   It is not appropriate for a “materiality” threshold to apply to a distributor for a retailer default
          given that distributors would not be able to obtain credit support for the full amount of the
          outstanding debt.
      -   The definition of a positive change event refers to a pass through event that materially
          increases the costs of providing direct control services. We question how unpaid or
          unrecoverable network charges and the costs associated with retailer default meets the
          requirement of increasing the cost of providing direct control services. The AER has recently
          raised this issue in the context of its submission to the AEMC on a proposed rule change
          submitted by ETSA with respect to the recovery of feed in tariffs. We refer the working group
          to the Rule Change: “Payment under Feed-in Schemes and Climate Change Funds” and
          submissions made with respect to that proposed rule change.
      -   A distributor is required to submit an application within 90 days of an event occurring. The
          losses of a distributor due to a retailer defaulting on its financial obligations (for instance, in the
          case of insolvency) may take many more months to resolve.
      -   Proposed clause 6.6.1(l) seeks to limit the amount that may be recovered through the pass
          through application by excluding any amount “recovered or recoverable from a retailer or a
          guarantor of a retailer under Part 1, Division 3 of Chapter 6B”. The meaning of this exclusion
          is at best unclear and at worst negates the right of a distributor to recover unpaid network
          charges as it assumes that amounts are in some way recoverable under Chapter 6B. Chapter
          6B does not provide for the recovery of any amounts, but if it is intended to exclude amounts
          which have been properly billed to retailers then it will negate the right of distributors to recover
          under the pass through provisions. We request that the intent and effect of this provision be
          reviewed and clarified.


6
    ENA, Submission in response to the second draft of the NECF, 26 February 2010, Page 48.
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Consistent with the ENA’s submission, we consider that a new provision is required in the Rules that
applies specifically in the case of a default by a retailer – either under a RoLR event or any other
event. This should provide for the AER to assess and approve the recovery through network pricing of
unpaid network charges which are not recoverable by the distributor. The criteria for the recovery of
costs should be that the distributor has taken reasonable measures to comply with the credit support
arrangements. In relation to unpaid network charges, as stated above; there should be a right to pass
through unpaid network charges which have been written off in accordance with accepted accounting
practices. We also note that any changes to Chapter 6 to provide for the recovery of unpaid network
charges and other costs should also be included in the Transitional Rules which apply to NSW
Distributors for the duration of the current NSW Determinations ie until 30 June 2014.


Preferred approach

ENA’s preferred approach is for credit support to be provided upfront rather than the proposed “credit
allowance” approach. An upfront approach to credit support (that is an unconditional bank guarantee
from a major Australian Bank) will provide an incentive for retailers to pay their network bills on time
and ensure that the distributor provides coverage of outstanding debt in the event that a retailer fails
and a RoLR event occurs. The upfront credit support approach can be improved by strengthening the
enforcement provisions and tightening the cost recovery arrangements. This will ensure that
distributors will have ability to mitigate credit risk and recover costs of defaulting retailers.

If the upfront credit support approach is not adopted by the MCE, then there needs to be
improvements to the credit allowance proposal to:
     reduce the default risk faced by customers by introducing more effective enforcement
       provisions; and
     reduce financial risks faced by distributors by improving the cost pass through provisions.

How is credit support calculated?
  - Credit support for a retailer without a credit rating is based on a distributor’s reasonable
      estimate of distribution network charges. The calculation would be based on the charges likely
      to be incurred by a retailer during the period of 90 days following the request by the distributor
      for credit support.

   -   Credit support for a retailer with a credit rating is based on a distributor’s reasonable estimate
       of distribution network charges. The calculation would be based on the charges likely to be
       incurred by a retailer during the period of 90 days following the request by the distributor for
       credit support adjusted by the “retailer credit allowance percentage”.

                   Standard & Poor’s or   Moody’s credit rating    Retailer's Credit Allowance
                    Fitch credit rating                                  Percentage (%)
                        AAA to A-              Aaa to A3                       100
                      BBB+ to BBB-            Baa1 to Baa3           Between 0 and 100 (as
                                                                  determined by the distributor)
                      BB+ and below          Ba1 and below                       0

We note that the proposed rules do not state what occurs if a retailer does not provide the distributor
with a credit rating within a reasonable period of being requested to do so. This should be addressed
by providing that if a credit rating is not provided by a retailer within a reasonable period (which should
not be more that 15 business days), then the retailer should be treated as not having a credit rating in
the manner currently provided for in proposed clause 6B.6.3(c).

Remedies for non-compliance

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   -   When a retailer breaches the payment requirements as set out in clause 6B.6.5 of the draft
       Rules their credit allowance percentage falls to zero.
   -   If after five days of non-compliance for requests for credit support or payment of credit support,
       the distributor can request suspension of registrations of (inward) transfers.

Recovery of unpaid network charges
   - Consistent with the ENA’s submission, we consider that a new provision is required in the
     Rules that apply specifically in the case of a default by a retailer – either under a RoLR event
     or any other event.




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