INTOSAI Working Group on the Audit of Privatisation

PAPERS FOR THE SEVENTH MEETING
BUENOS AIRES, 18 and 19 SEPTEMBER 2000

• Guidelines referring to economic regulators 
• Issues related to the audit of the newly established economic regulator (on the example of the audit of the Energy Regulatory Authority)

Guidelines referring to economic regulators

Paper by the Supreme Chamber of Control, Poland (the NIK)

Section 1:

In the NIK, audits are divided according to their subject and performed by relevant departments, whose employees have the relevant technical knowledge and experience. For example the area of telecommunication is audited by the Transport, Maritime Economy and Communication Department, the banking and insurance sector – by the Finance and Banking Department, while the power engineering industry – by the Economy Department.

The first regulator not being a unit of a ministry was established in 1997. It was the Energy Regulatory Authority supposed to regulate the activities of enterprises dealing with electric power engineering, thermal power engineering and gas fuels. Auditors of the Economy Department had also previously performed audits of energetic enterprises and of the Economy Ministry that used to supervise and quasi-regulate those enterprises. As soon as the restructuring and privatisation of the enterprises had been started and the Energy Regulatory Authority had been established, two of the auditors participated in seminars dealing with the market of electric power, the heat market, and the electric power exchange. One of the auditors post-graduated from power auditing.

The NIK performed 3 audits of the budget execution (financial audit) in the Energy Regulatory Authority, and in 1999 it performed an audit of the Authority’s statutory tasks’ (stated in the Power Law) performance (performance audit).

Section 2

The audit mentioned above focused on the performance of statutory tasks (arising from the Law that established the regulator and stated the tasks in the field of the evaluation of companies’ costs and calculating the prices of power media) by the government and local government administrations and by power companies.

Therefore the Energy Regulatory Authority was audited as well as the Economy Ministry (supervising the national power system) and the network companies (natural monopolists). It let us understand the conditions of the Energy Regulatory Authority’s functioning and the limitations of the correct regulation process.

The President of the Energy Regulatory Authority is assisted by the Advisory Council that is supposed to represent the interests of both power consumers and producers. The NIK found that there were no representatives of the local government in the Council. Apart from that, out of the seven members of the Council four of them were related to the transmitting company (a monopolist). The NIK found that the Council’s composition is not representative and that its opinions may be not objective.

The NIK positively evaluated the recruitment of the Energy Regulatory Authority’s employees as well as numerous trainings (including ones taking place abroad) attended by its employees and their participation in conferences and seminars, which contributed to their knowledge’s updating and expanding.

Section 3

The NIK found that the regulator consciously licensed a company that was in a poor financial condition. It was caused by relying the decision on the positive opinion of the relevant voivod instead on the company’s financial documents. The regulator did not take into account the fact that the opinion-giver might be not fully objective as he was interested in the continuing company’s activity on his area (supply of heat, jobs). Despite the fact that the company could be expected not to continue its activity it was licensed. Six months later it went bankrupt. The NIK found that the regulator did not follow the relevant decision-making procedures and that it did not evaluate the circumstances correctly. (G7)

The audit by the NIK revealed that the regulator checks the quality parameters of the power supplied only when being submitted complaints of customers. The NIK recommended checking the quality parameters of the electric power at their own initiative and not just after having received a complaint, as well as including the checks in the Authority’s plans. (G10)

In the course of works on the amendments to the Power Law the NIK, that was asked to present its opinion, recommended introducing the provision that would enable the regulator to control the prices of the power companies. (G10)

The NIK analysed how the companies met the licensing condition obligating distributing companies to keep up or to guarantee a possibility to receive financial resources enabling to satisfy third parties’ claims (the claims might be caused by the incorrect way of performing the licensed activities) and to reconstruct the produce capacity of the machines lost in the result of incorrect activities, disaster or damage. It was found that the power companies deciding on their own how to meet that condition concluded insurance agreements. As the scope of the insurance was different the NIK recommended the regulator comparing the insurance scope and the costs borne by power companies as far as meeting of the conditions imposed was concerned. (G12)

The NIK took note of the fact that the power suppliers did not adjust the agreements with customers to the provisions of the law. Among other things the information on the consumer’s rights (incl. the right to complain) was missing. It was recommended to adjust the agreements as soon as possible. (G13)

Section 4

The power companies’ prices for the connections differed as much as over ten times from each other. The differences in the prices were not justified by the differences in the costs that were presented but by the fact that different kinds of costs were considered to be a part of the connection’s cost. The regulator after having approved of the prices took themselves note of unequal treatment of customers, and the NIK, after the audit, recommended analysing thoroughly the price proposals and comparing them before approving them. (G18)

Issues related to the audit of the newly established economic regulator (on the example of the audit of the Energy Regulatory Authority)

Paper by the Supreme Chamber of Control, Poland

1. Introduction

The results of the INTOSAI questionnaire distributed between SAIs show that there are more and more economic regulators being established. It is related to the privatisation of economic sectors, especially where there are operators on the market that have the qualities of natural monopolists. For example operators owning telecommunication, electric power, gas and other networks. At the same time SAIs face the necessity of auditing regulators already at the stage when they are being established and start to operate. It is important that the relevant institutions (government, parliament) could, within their competencies, take up the actions towards the regulators, that could prevent the effects of their irregular activity from occurring and getting consolidated.

In this text the most significant irregularities found in the course of the audit performed in 1999 by the Supreme Chamber of Control are presented, as well as the issues related to the evaluation of the activity of the President of the Energy Regulatory Authority.

2. The regulator

In June 1997 the Energy Law was passed that entered into force in December 1997. The law established the regulator – the President of the Energy Regulatory Authority, subordinate directly to the President of the Council of Ministers. The President of the Energy Regulatory Authority regulates the activity of power companies, operating on the markets of electric power, heat and liquid and gas fuels. On the basis of the law mentioned all operators, irrespective of the form of ownership, that have the relevant licence issued by the President of the Energy Regulatory Authority, may produce, transmit, distribute and trade electric power. The prices of electric power as well as fees related to the supply of electric power are fixed by power companies and approved of by the President of the Energy Regulatory Authority. Previously the Minister of Finance officially fixed the prices of electric power.

3. Irregularities disclosed and problems related to their evaluation

1. Problems of the evaluation of the regulator related to the lack of secondary legislation or its delayed issue.

The audit of the regulator disclosed that a number of its actions, although legal, changed the conditions of companies’ functioning. It changed the provisions of the licence, it did not provide companies with full information on the documents necessary for the prices of power to get approved of. Also it changed the prices and fees after they had been approved of.

For example:

• The regulator included in the licences the requirement that distributing companies should draw up the quality norms of the electric power supplied. A few months later when some of the companies have drawn up the norms the regulator gave up enforcing that provision and started the administrative procedure aiming at cancelling it. It might have seemed to be an action not thought over by the regulator. However, later on it turned out to be intentional and it originated from the regulator’s care for the customers. It was the Minister of Economy who did not execute his duty and did not issue the relevant regulation in time. As soon as the regulation on the quality of power was issued the provision in the licence became aimless and had to be cancelled.
• Several times the companies corrected and completed their applications for the prices to be approved of. One of the reasons was that the regulator changed their requirements on the scope of financial data of the companies, the way they should be presented and the details of the prices’ fixing. But also in this case the reason of such action by the regulator was a delayed issue of the regulation supposed to define the way of the charges’ fixing. The regulator was given only 2-3 weeks for drawing up the forms on which the companies were to present (in a uniform way) the data necessary for the prices to be verified and approved of. The mistakes found in the hastily drawn up forms made it necessary to introduce some changes and amendments. Despite all the inconvenience arising from this for the companies submitting their price applications, also in this case the Supreme Chamber of Control considered the regulator’s activity to be proper.
• Power companies should fix the prices on the basis of the justified costs, recorded separately for every kind of licensed activity and, apart from that, separately for every kind of the price. (eg. for individuals, for industry). The legislator obliged therefore the power companies to introduce the plan of accounts that would make the relevant record of costs possible. Already at the time of issuing the licence (1 year after the law entered into force) the regulator realised that the companies did not run such a record and the requirement to introduce the right plan of accounts became one of the conditions of the licence. When applying for the prices to be fixed most of the companies had already been running the relevant record. The calculations of the prices were based on the costs of the period, when the record of costs was not adjusted to the law yet. The prices calculated were not therefore based on the costs of the particular kind of activity and as such could not be approved of by the regulator. However, the regulator approved of the prices, which was considered by the Supreme Chamber of Control to be illegal. On the second hand, however, the Supreme Chamber of Control considered such an activity to be purposeful. Had not the new prices been approved of, the prices of the previous period, much lower, would have been applied. This would bring about the companies’ losses and could put their further activity at risk.

In all the cases mentioned the Supreme Chamber of Control’s first intention was to evaluate negatively the regulator’s activity. The regulator was considered to have introduced unstable conditions of the functioning of economic operators, and the Authority itself was considered not to be prepared to perform the function of a regulator. The deeper analysis of the irregularities showed, however, that their main cause was the Minister of Economy’s reluctance with respect to the issuing of the secondary legislation. Another cause was that the power companies were not prepared to face the requirements stated in the law. All in all, the Authority’s activity towards the situation on the electric power market was positively evaluated.

• The regulator did not draw up the specimen report of the licensed activity to be submitted by the companies and it did not check how the licence’s provisions were observed. The quality parameters were checked only after a complaint had been submitted. The Supreme Chamber of Control considered the Authority’s preparation to check how the licence’s provisions were observed and to control the quality of the electric power supplied to be insufficient. It recommended ad hoc audits to be performed as far as this issue was concerned.
2. Influence of the agreements concluded previously and of the previous way of regulation on the current evaluation of the regulator’s activity

The prices at which the distributing companies purchased the power from the operator of the transmitting system were not based on the costs of produce and transmitting. In the course of the in-depth analysis of the prices it was found that the regulator approved of the prices which were the mean prices of the power purchased from different producers plus the transmitting costs. Had an even deeper analysis not been made, the Supreme Chamber of Control would have considered the regulator’s activity to be illegal as the prices were not based directly on the costs borne and as the result they did not promote the development of competition.

However, before making such an evaluation the Supreme Chamber of Control analysed the mechanism of fixing the prices in the previous period. It appeared that the operator of the transmitting system had earlier concluded agreements with producers on the purchase of the significant part of the power. The prices of power fixed in these agreements were higher that other producers’ prices. The prices of power fixed previously by the Minister of Finance were the mean prices of power from different producers.

Applying the mechanism stated in the law, i.e. fixing the sales price on the basis of the real prices of producers, would bring about great unjustified differences of prices for the final purchasers. The distributing companies buying the more expensive power would have had to raise the sales prices for the final purchasers who, for the time being, do not have a possibility to select the supplier. The regulator’s approval of such an activity was correct as its mission is not only to promote competition but also to protect individuals from unjustified prices’ rises.

In such a situation the Supreme Chamber of Control negatively evaluated the lack of initiative on the part of the government, especially the Minister of Economy, who did not introduce the mechanisms that would neutralise the effects of the agreements concluded previously and the previous way of regulation.

3. Costs justified to be the basis of fixing prices

The Supreme Chamber of Control taking up the first audit of the regulator intended to evaluate whether the Energy Regulatory Authority had drawn up the criteria of approving the costs borne by the companies as justified. However, as the examples mentioned below show, the circumstances arising from the earlier time and the administrative limitations (imposed by the Minister of Economy) influenced the fact that the Authority approved of the power prices. That is why the Supreme Chamber of Control only in very few cases objected to the regulator’s considering some costs borne by companies to be justified. It referred only to the costs borne as the result of the companies’ uneconomical activity. The Supreme Chamber of Control decided to make the general evaluation of the regulator’s integrity as far as approving the costs as justified is concerned only during the next audit.

4. Remarks – dilemmas related to the evaluation of the regulator’s activity

Despite the fact that the audit’s objective was only to evaluate the regulator’s activity, it was necessary to perform audits also in other institutions, whose activity and decisions influenced the regulator’s activity. As it might be seen from the above examples the Supreme Chamber of Control did their best to evaluate the regulator in a moderate way. Even in those cases when the regulator’s activity was illegal the Supreme Chamber of Control would consider whether this activity was purposeful or not. We would also consider whether any other activity on the part of the regulator was possible if the market balance and the protection of individual purchasers were desired. As the Supreme Chamber of Control did not find a simple solutions that could have been applied by the Authority in the cases mentioned, the general evaluation of the regulator was positive. It was the Minister of Economy’s reluctance or lack of activity that were criticised.

In the conclusion it must be said that the legality and performance audit of the newly established regulator must meet the following criteria:

• it cannot be limited to performing an audit of that regulator only;
• it must cover also other institutions whose activity might determine the decisions made by the regulator;
• auditors must have the in-depth knowledge of the current issues of the area being regulated and the way of regulation before the regulator was established;
• auditors must understand the circumstances and reasons of the regulator’s decisions so that the audit is not just a legality audit of the regulator’s activity;
• the audit’s timing is crucial: it seems that auditing the regulator at an early stage of its activity should be limited to auditing just its organisation while the issues that influence its activity may not be found yet. However auditing the regulator for the first time too late might bring about the consolidation of irregularities and their effects.

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