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Proposed Reforms to the Capex Approval Process for

Electric Cooperatives

Consultation Paper

Energy Regulatory Commission

December 2015

Table of Contents

1 Introduction and Summary 1

1.1 Issues with Capex Approvals 1

1.2 The Proposed Approach 1

1.3 Consultation Process 2

2 Capex Approval Approach 3

2.1 Stage 1 – Assessment of the overall proposal 3

2.1.1 Primary Criteria—Consistency with an approved EICPM 4

2.1.2 Primary Criteria—Capex Spend Benchmark 5

2.1.3 Secondary Criteria for the Backlog 6

2.1.4 Stage One Assessment Process 6

2.1.5 Approval for Future Low Risk Applications 7

2.2 Stage 2 – Assessment of projects in Medium Risk Proposals 8

2.2.1 Project Assessment Components 8

2.2.2 Stage Two Assessment Process—Medium Risk Proposals 8

2.3 Stage 2 – Assessment of projects in High Risk Proposals 9

2.3.1 Assessment of options 9

2.3.2 Assessment of demand projections 10

2.3.3 Assessment of supporting technical analysis 10

2.3.4 Assessment of economic evaluations 10

2.3.5 Stage Two Assessment Process—High Risk Proposals 10

Appendices

Appendix A Capex benchmark model ........................................................................12

Tables

Table A.1: Comparison of Benchmark Capex Model to Actual Capex Approvals 12

Table A.2: Proposed Capex Model Regression Analysis—based on approved Capex Proposal 13

Figures

Figure 2.1: NEA Harmonisation—Option One 4

Figure 2.2: NEA Harmonisation—Option Two 5

Figure 2.3: Future Applications—Stage One Assessment 7

Figure 2.4: Future Applications—Stage Two Assessment—Medium Risk 9

Figure 2.5: Future Applications—Stage Two Assessment—High Risk 11

1

1 Introduction and Summary 1

We have been engaged by the Energy Regulatory Commission (ERC) to address the 2 process for the approval of the capital expenditure plans of the Electricity Cooperatives 3 (ECs), proposing measures for a more streamlined and efficient process for future 4 approvals. 5

1.1 Issues with Capex Approvals 6

There have been long delays in the approval of Capex plans and there is currently a large 7 backlog. 8

The reasons for these delays are many and include variable quality of submissions from 9 the ECs and the long public consultation and legal approval processes. However, the key 10 problem is that all proposals, regardless of risk are reviewed in the same complex and 11 detailed process. 12

The proposed changes to the processing of Capex plans will make the process more 13 efficient and streamlined as the level of review will be tailored to the level of risk. The 14 level of risk will be assessed as being both the probability that expenditure in the Capex 15 plan is unreasonable and/or the potential impact of such unreasonable expenditure being 16 passed on to consumers. 17

1.2 The Proposed Approach 18

The risk based approach has two stages: 19

Stage One is a proposal level evaluation that categorises proposals as low, medium or 20 high risk according to three objective criteria: 21

Primary Criteria—Consistency with an approved EICPM; 22

Primary Criteria—Capex Benchmark; and 23

Secondary Criteria—KPI and Compliance Benchmarks. 24

Those applications categorised as low risk will be approved at the proposal level. 25

Stage One is detailed in Section 2.1. 26

Stage Two takes those categorised as medium or high risk and subjects them to a 27 more detailed assessment at the project level using the following components: 28

options considered; 29

demand forecasts; 30

technical analysis; and 31

economic evaluation. 32

Stage Two for medium risk plans is detailed in Section 2.2 and for high risk plans in 33 Section 2.3. 34

The calculation of the RFSC Charge is linked to the ERC approval of an ECs Capex 35 plans. A separate consultation paper will be issued on the proposed changes to setting 36 the RFSC charge. 37

38

2

1.3 Consultation Process 1

The aim of this consultation is to get feedback on our proposed changes to the Capex 2 approval process. 3

All interested parties are invited to submit their comments on this consultation paper on 4 or before 12th February, 2016. Electronic copies may be sent to tariffs.erc.gov.ph. This 5 consultation paper may be downloaded at the ERC website www.erc.gov.ph or may be 6 photocopied at cost at the ERC Main Office at the Docket Section, 18th Floor, Pacific 7 Center Building, San Miguel Avenue, Pasig City. 8

9

10

3

2 Capex Approval Approach 1

For Capex approvals the proposal is for a risk based approach, categorising applications 2 as low, medium or high risk based on objective criteria. The criteria will include both 3 primary criteria and secondary criteria. 4

Those applications categorised as low risk will be approved at the proposal level. 5

Those categorised as medium or high risk will be subject to a more detailed assessment at 6 the project level. 7

This process applies to the review and approval of scheduled multi-year Capex proposals 8 for ECs. It assumes that ECs submit multi-year capex proposals in groups, with each 9 group to submit in separate years. 10

The suggested approach has two stages: 11

Stage 1 – Risk assessment and approval for low risk proposals 12

Stage 2 – Project assessment for medium and high risk proposals 13

Stage 1 assesses whether there is a high risk that the Capex proposals exceed the 14 reasonable needs of the EC. Proposals that are assessed to be low risk are approved at 15 this stage. Other proposals are classified as either medium or high risk and subject to a 16 more detailed second stage analysis. 17

Stage 1 places considerable reliance on the consistency with the program of works in an 18 EICPM approved by NEA. This will require greater coordination between NEA and 19 ERC. Stage 2 assesses the individual projects within the overall proposal in terms of the 20 option analysis, demand forecasts, technical analysis, and economic analysis. While the 21 structure of the process is the same for medium and high risk projects, the extent of 22 scrutiny is greater for high risk projects. The scrutiny of projects in high risk proposals 23 assesses the details of the supporting analysis and is similar to the current level of analysis 24 of Capex proposals. 25

The primary objective of a review is to reduce the risk of overspending. Furthermore, the 26 review process may delay projects and increase the risk of underspending. Hence, the 27 reviews should be focussed on higher risk proposals. The consequences of over-spending 28 and under-spending on Capex are the same across the high, medium and low risk 29 projects but the likelihoods are different. In the absence of a review the likelihood of 30 overspending is greatest for the high risk proposals and lowest for the low risk projects. 31 Hence, substantially greater scrutiny is applied to high risk proposals. 32

The assessment criteria fit closely with the requirements of the Planning Manual. Hence 33 adoption of this approach would not weaken the ERCs commitment to the proper 34 implementation of the planning manual, but it would make the testing of its application 35 through the Capex approval process more streamlined. Some modification of the ERC’s 36 existing rule on the review of Capex programs would be required but this would not be 37 substantial. 38

2.1 Stage 1 – Assessment of the overall proposal 39

The Stage 1 assessment has three elements: 40

Primary Criteria—Consistency with an approved EICPM; 41

Primary Criteria—Capex Benchmark; and 42

Secondary Criteria—KPI and Compliance Benchmarks. 43

4

2.1.1 Primary Criteria—Consistency with an approved EICPM 1

The first criteria for assessing Capex proposals is whether they are consistent with the 2 latest approved EICPM. This requires that each of the projects submitted in the 3 proposed capex plan is part of the program of works in the EICPM so that ERC can 4 place greater reliance on the approval processes of NEA. 5

To be effective this requires the coordination of the submission of Capex proposals to 6 NEA and ERC. 7

Capex proposals that meet this criteria will be assessed as low risk if they meet all the 8 other criteria. Those proposals that do not meet this criteria will be assessed as high risk. 9 Given the proposed coordination of the submission of Capex proposals it is expected 10 that most ECs will meet this criteria if their Capex planning process is well managed and 11 they meet the procedural requirements. 12

Currently ECs submit Capex proposals to NEA as part of the EICPM every second year 13 in January and these are approved by the end of March. ERC does not have the 14 resources to process applications from half the ECs concurrently. Hence, it is proposed 15 that NEA and ERC harmonise the applications to a three year cycle. 16

The two options for synchronisation are shown in Figure 2.1 and Figure 2.2: 17

Figure 2.1: NEA Harmonisation—Option One 18

19

20

5

Figure 2.2: NEA Harmonisation—Option Two 1

2

3 On balance Option 1 is considered likely to be more feasible and a better compromise 4 between the needs of NEA and ERC. 5

2.1.2 Primary Criteria—Capex Spend Benchmark 6

The proposed Capex benchmark—the primary criteria—is an Asset Based Capex Model. 7

The benchmark cost model is tailored to the specific cost drivers of each EC. In 8 principle a cost function will: 9

Retain the benefit of low cost and low effort regulation; 10

Set a benchmark that is tailored to each EC; and 11

Reflect the specific characteristics of the ECs in evaluating Capex proposals. 12

We have tested a number of different cost models using known drivers of network 13 capital costs. All cost models were tested against recently approved Capex plans to assess 14 the predicative power of different models, the significance of cost drivers and to ensure 15 each coefficient has the correct sign. 16

An initial model to estimate reasonable capex needs has been developed and shows that 17 physical measures of the core network assets (network length and substation capacity) are 18 the best predictors of Capex needs. 19

A non-linear model is preferred to a linear model, given that network costs are non-linear 20 and because a log-log model is the best fit to the diminishing returns from economies of 21 scale. The proposed Capex Model will use two core network attributes to calculate a 22 benchmark for each EC: 23

24

6

Total network circuit length in km, and 1

Substation capacity in MVA. 2

Based on regression analysis, the benchmark Capex spend will be calculated as follows: 3

4

[ ( ) ( ]

5

Growth and asset age measures were not statistically significant in our initial analysis but 6 may be included in the future to improve the overall performance of the model. The 7 Capex model will be continually developed and refined over time in a transparent process 8 so that ECs understand how it is used in the risk categorisation of proposals. A detailed 9 review of the Capex benchmark model is provided in Appendix A. 10

The aim of the model is to provide a guide to the typical level of Capex that would be 11 reasonable. Inevitably there will be cycles in Capex so that exceeding the benchmark does 12 not mean that the program is necessarily too high. But it will provide an indicator of 13 where further analysis (Stage Two) is warranted. 14

If the Capex proposals are higher than the benchmark they will be assessed as medium 15 risk as long as they meet both secondary criteria. Otherwise they will be assessed as high 16 risk. We expect that typically half or more of the proposals would be below the 17 benchmark. 18

19

2.1.3 Secondary Criteria for the Backlog 20

We suggest that the simple and objective secondary criteria, for future applications be: 21

Are KPIs met? (e.g. submission of data and compliance returns); and 22

Quality of justifications (i.e. assessed to be better than average). 23

Assessment of quality of justifications 24

Inevitably this will be some degree of subjectivity and the challenge will be to ensure that 25 the assessment is undertaken against clear criteria and is consistent. The key point is that 26 this is a relative assessment—in principle half of the proposals will be assessed as having 27 better supporting material than average and half having poorer supporting material. 28 There are two key steps to facilitate this: 29

Establishment of criteria and standards—this can draw upon the 30 development of criteria and standards for the assessment of the supporting 31 analysis for existing applications; and 32

Participation in NEA regional workshops with ECs—as part of the 33 NEA’s review process, NEA staff hold regional workshops where they test 34 the underlying analysis for the ECs proposals. ERC staff would participate in 35 these meetings as observers. This will be efficient means of assessing the 36 comparative quality of the underlying analysis. 37

2.1.4 Stage One Assessment Process 38

The recommended Stage One assessment process flowchart for future applications is 39 shown in Figure 2.3. 40

7

Figure 2.3: Future Applications—Stage One Assessment 1

2

3 2.1.5 Approval for Future Low Risk Applications 4

If they meet the primary and secondary criteria, future applications would fall under the 5 low risk category, thus they will be approved at the proposal level with no further 6 scrutiny. 7

This is because they have been assessed as being consistent with an approved EICPM, 8 below the Capex benchmark for a reasonable level of expenditure and have been judged 9 to have above average quality of justification and analysis. 10

A compliance check with the EICPM is an important measure for reducing ERC’s 11 current burden and to accelerate the approval process. This is because, it incentives the 12 EC’s to submit fully compliant Capex proposal submissions, and avoids unnecessary 13 interactions in gathering missing information. EC’s that do not conform to the EICPM, 14 would face a more rigorous review of their Capex submission and delays in receiving 15 ERC approval. 16

17

8

2.2 Stage 2 – Assessment of projects in Medium Risk Proposals 1

For those Capex plans that are categorised as medium risk, each of the components of 2 the underlying analysis is tested against objective, transparent criteria—through a series 3 of ‘Yes’ or ‘No’ questions. This means that the extent of judgement required is 4 minimised and detailed analysis of the supporting material is not required. This will 5 facilitate prompt review and decision-making and standardised decision documents. The 6 questions focus on the key requirements of the EC Distribution Utility Planning Manual 7 (ECDUPM). ECs whose Capex programs comply with the requirements of the 8 ECDUPM should be able to readily demonstrate compliance with the assessment criteria 9 for medium risk proposals. 10

The key difference from the Stage 1 assessment is that the Stage 2 assessment happens at 11 the project level. 12

2.2.1 Project Assessment Components 13

The components to be assessed are: 14

options considered; 15

demand forecasts; 16

technical analysis; and 17

economic evaluation. 18

A key part of the assessment will be the reliance on NEA’s assessment of the demand 19 forecasts. This will be made possible by coordinating the submission of Capex proposals 20 with the EICPM as discussed in Section 2.1.1. NEA places considerable emphasis on the 21 assessment of the demand forecasts and ensuring the forecasts are consistent with the 22 requirements of the planning manual. Hence, it is proposed to draw upon this rather 23 than duplicating the effort of NEA. 24

2.2.2 Stage Two Assessment Process—Medium Risk Proposals 25

The recommended Stage Two project by project assessment for future applications that 26 are deemed as medium risk is shown in Figure 2.4. 27

9

Figure 2.4: Future Applications—Stage Two Assessment—Medium Risk 1

2

3

2.3 Stage 2 – Assessment of projects in High Risk Proposals 4

This process has the same structure as the assessment of projects in medium risk 5 proposals but requires a more detailed qualitative assessment of the components, other 6 than the demand forecast component. The level of analysis may also vary according to 7 the size of the project. That is, the larger or more unusual projects should be subject to 8 closer scrutiny than smaller or routine projects. 9

2.3.1 Assessment of options 10

Unlike the medium risk assessment, the ERC will consider not just whether options are 11 considered but whether the options are appropriate. That is, do the options cover a 12 set of alternatives that are likely to meet the identified needs and include the best 13 available options? This does not require the reviewing engineer to undertake the option 14 analysis but if it is determined that the options are deficient it will be necessary to show 15

Individual

Projects

Future Standard Applications – Medium Risk

Are options

evaluated?

Is demand

forecast

reasonable?

Approve Reject

Yes

No

No

No

No

Yes

No

No

Is technical

analysis

adequate?

Yes

Are economic

evaluations

provided?

Yes

Test: the proposal includes an evaluation of options

Test: Are the forecasts consistent with latest forecasts accepted by NEA (as part of the eICPM).

Test: Is the analysis consistent with demand forecasts and standards?

Test: Is an economic evaluation provided?

No

No

10

in what way they are and identify or excluded options that could have been considered. 1 In practice this is likely to be the most critical part of the evaluation of the projects. 2

2.3.2 Assessment of demand projections 3

Reliance is placed on the NEA’s analysis of the demand projections. Further analysis will 4 only be required if the demand projections are not consistent with the approved EICPM. 5 This is unlikely, given the proposed coordination with the EICPM. 6

2.3.3 Assessment of supporting technical analysis 7

The focus of the assessment of the technical analysis remains on its consistency with the 8 demand forecasts and network planning standards. In addition, the engineer should test 9 whether the analysis clearly supports the proposed option over the alternatives. If 10 inconsistencies are identified that raise questions about the underlying models used these 11 should be investigated but these models would not normally be reviewed in detail. 12

2.3.4 Assessment of economic evaluations 13

For projects in high risk proposals the reviewing engineer is required to assess whether 14 the economic evaluation is adequate. The key questions in assessing this will be: 15

Whether the methodology used is consistent with the requirements of the 16 planning manual; 17

Whether the analysis is consistent with the demand forecasts, quality of 18 service, and network planning standards; 19

Whether the assumed costs of the proposal and options considered are 20 reasonable; 21

Whether the other assumptions that may be used (e.g. discount rate, project 22 life, and value of lost load) are reasonable; and 23

Whether the analysis supports the proposal over the alternative options. 24

This focuses the assessment on the methodology and assumptions. The reviewing 25 engineer would not normally undertake a detailed review of the underlying models unless 26 the results raise significant questions about the modelling. 27

2.3.5 Stage Two Assessment Process—High Risk Proposals 28

The recommended Stage Two project by project assessment flowchart for future 29 applications assessed as high risk is shown in Figure 2.5. 30

11

Figure 2.5: Future Applications—Stage Two Assessment—High Risk 1

2

3 4

5

Individual

Projects

Future Standard Applications – High Risk

Are options

evaluated?

Are the

forecasting

models valid?

Approve Reject

Yes

No

No

No

No

Yes

No

No

Is technical

analysis

adequate?

Yes

Are economic

evaluations

valid?

Yes

Test: Are appropriate alternatives specified and evaluated?

Test: Are the forecasts consistent with latest forecasts accepted by NEA (as part of the eICPM). If not, why? Are the models valid?

Test: Is the analysis consistent with demand forecasts and standards? Does it support the selected option?

Test: Review the adequacy of the evaluation. Are the methodology and assumptions valid? Do the results show the selected option is the best?

No

No

12

Appendix A: Capex Benchmark Model 1

Table A.1: Comparison of Benchmark Capex Model to Actual Capex Approvals 2

# EC Acronym Regulatory

Period

Total Annual Capex

Approved

Annual Benchmark

Capex Variance

1 AKELCO 2011-2014 41,698,425 63,210,063 51.6%

2 ASELCO 2011-2013 20,067,089 53,758,919 167.9%

3 BOHECO II 2011-2014 45,179,360 41,247,827 -8.7%

4 CANORECO 2010-2014 31,281,111 41,125,910 31.5%

5 CEBECO I 2014-2018 52,697,961 60,777,917 15.3%

6 CELCO 2011-2015 3,516,308 2,472,516 -29.7%

7 CENPELCO 2011-2014 139,503,425 84,564,144 -39.4%

8 COTELCO 2012-2015 104,213,816 91,358,854 -12.3%

9 DIELCO 2012-2016 1,871,743 4,716,841 152.0%

10 FICELCO 2011-2015 12,011,318 13,048,544 8.6%

11 FLECO 2011-2014 52,867,089 13,067,593 -75.3%

12 GUIMELCO 2011-2015 16,874,809 9,627,116 -42.9%

13 ILECO II 2012-2013 59,421,046 40,551,718 -31.8%

14 ISELCO II 2011-2015 67,846,860 34,044,893 -49.8%

15 MORESCO I 2011-2014 209,093,055 73,427,510 -64.9%

16 ORMECO 2012-2016 73,230,715 87,372,300 19.3%

17 PRESCO 2010-2013 4,151,599 5,029,895 21.2%

18 PROSIELCO 2011-2015 4,281,836 4,898,268 14.4%

19 SORECO II 2011-2011 6,669,964 20,200,562 202.9%

20 ZAMCELCO 2009-2013 19,111,457 61,102,471 219.7%

21 ZAMSURECO II 2011-2014 62,695,734 39,879,596 -36.4%

3 4

5

6

7

8

9

10

11

12

13

13

1

Table A.2: Proposed Capex Model Regression Analysis—based on approved 2 Capex Proposal 3

4

5 6

7

8 9 10

Model 8—Coefficiencts match and all variabale are significant

Regression Statistics

R 0.8535

R Square 0.72846

Adjusted R Square 0.69829

Standard Error 0.31309

Total Number Of Cases 21

ANOVA

d.f. SS MS F p-level

Regression 2. 4.73361 2.3668 24.14411 0.00001

Residual 18. 1.76451 0.09803

Total 20. 6.49811

Coefficients Standard Error LCL UCL t Stat p-level H0 (10%) rejected?

Intercept 4.017 0.8915 2.47109 5.56291 4.5059 0.00027 Yes

Log(Ckt length) 0.78844 0.3468 0.18706 1.38982 2.27343 0.03548 Yes

Log(SS) 0.50061 0.25437 0.05951 0.94171 1.96802 0.06467 Yes

LOG (ANNUAL TOTAL ) = 4.0170 + 0.7884 * Log(Ckt length) + 0.5006 * Log(SS)

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