Brian Fallow: Just set the rules so our lights stay on

A fortnight ago, the lights went out at my place.

It was a localised power cut - the other end of the street was fine - and it lasted only a couple of hours.

But I confess to thinking uncharitable thoughts, as I fumbled around for some candles, about the 30 per cent or so of my power bill that goes to the lines company, Vector.

Since then, we have seen the Government on Monday last week issue a formal policy statement emphasising the importance of investment and security of supply and de-emphasising short-term costs.

The next day, Finance Minister Michael Cullen told Auckland business leaders there was a concern the Commerce Commission's views on rates of return might be chilling investment.

That was despite a Cabinet paper from Energy Minister David Parker which said officials had said they knew of no instances where lines companies had decided not to make needed investments, and that the number of power cuts appeared to be reducing, not increasing.

But, said Parker, "it is crucial that incentives to invest in new infrastructure are maintained and I see no disadvantage in restating the point".

Two days after the Government policy statement to that effect, in a display of independence reminiscent of Ron Mark's gesture, the commission lowered the boom on Vector, announcing its intention to declare control of the company.

Vector responded by declaring an investment strike.

I don't know about the other 600,000 people who rely on Vector's networks, but none of that leaves me feeling particularly well-served by the Government, the regulator or the lines company, or any more confident that the lights will stay on.

The commission says Vector is overcharging many of its customers - especially industrial and commercial customers - and undercharging others.

Those benefiting the most, it says, are residential customers in parts of Auckland - the parts which elect the members of Vector's main shareholder, the Auckland Energy Consumer Trust.

It says Vector does this by unreasonably exercising the market power of a monopoly.

And it says Vector stands to earn excessive profits.

Responding to these accusation in a briefing to analysts and journalists on Monday, Vector accused the commission of not just moving the goal posts but moving the game to another playing field.

It said the regulations governing lines companies limited the rate at which they could increase their prices, in Vector's case to the rate of CPI inflation.

The rules did not limit a company's rate of return, nor did they require a company to rebalance its charges among regions or classes of customer. Vector said that was something it was doing anyway, without any guidance from the commission.

It was doing it over four years, to avoid "bill shock", and Auckland residential customers had already had increases in their line charges.

The company also says that it is all well and good to talk about efficient, cost-reflective pricing, but an element of averaging, cross subsidy if you like, is inevitable.

The company suspects it is being singled out for special and harsh treatment because of its size.

And it says this is unjust when its breach of the threshold that triggers regulatory scrutiny was so minor.

In the year to March 2004, it exceeded its allowed average price increase by $76,000. That is in the context of revenue of $477 million.

To avoid it happening again, it now aims to be 25 basis points below the projected CPI increase and, as a result, has taken $8 million less from its customers over the past two years than it is allowed under the commission's rules.

So what is the commission's problem?

It is its belief that the company is making excessive profits.

It is too simple for the company to assert we have price path regulations, not rate of return regulations.

The commission says the price pathway thresholds are "merely a screening device to identify those businesses that may require further investigation".

It says the goal is to ensure that lines businesses are limited in their ability to earn profits exceeding their weighted average cost of capital (WACC).

It is as if the commission is saying: We pulled them over because of a faulty tail light, but we found their boot full of what look like stolen laptops, so we have taken them into custody. What do you expect? We are cops.

But are they stolen goods, that is, what is an appropriate WACC for a company such as Vector?

The commission's report takes as given its view that a fair and efficient rate of return on the regulated value of the company's assets is 7.35 per cent.

But that figure is not holy writ. It is arrived at after feeding into a complex formula the results of a whole bunch of judgments.

Among them:

* What to take as the risk-free rate of return. If Government stock, of what maturity?

* What gearing ratio to take.

* What market risk premium.

* What is the company's asset beta, based on which comparators?

It is an arcane matter, and the 130-page report by Martin Lally on which the commission's view is based has been the subject of a critique by other well-credentialled academics.

The point is that what is the right yardstick to measure the company's returns is not a matter of established fact but of disputed opinion.

The company has told the commission it expects a return of 9.1 per cent in 2008/09, or 9.6 per cent depending on how you treat tax.

It says this reflects more users on its networks as economic activity and population expand in its areas.

But the commission doesn't buy the argument that the gap between such returns and its view of an appropriate WACC is justified by efficiency gains.

There are some who believe that Vector had this coming.

They say it paid too much for United Networks and NGC, whose American and Australian owners respectively could see a more assertive regulatory environment coming and were happy to bail out.

Vector says it has identified under-investment by the previous owners of United Networks which poses security of supply and safety risks.

But presumably that under-investment occurred in the good old days of light-handed regulation.

Now investment is frozen because of the threat of heavy-handed regulation.

It seems we can't win.