Brian Gaynor: Power shock for NZX

The NZX received another huge blow this week when the Commerce Commission threatened to take control of Vector because of overcharging. The regulator believes that Vector has a post-tax return of 9.6 per cent compared with a reasonable rate of 7.35 per cent (Vector is targeting 8.4 per cent).

Vector is the third widely held stock to hit the wall in the past few months.

Monday, May 1, now seems like a long, long time ago as the share price of Telecom, which has 52,000 shareholders, closed at $5.75. On the same day Feltex, which has 10,000 shareholders, finished at 35c and Vector, with 48,000 shareholders, ended at $2.76.

The troubles at Telecom and Feltex have been well documented and blame has been apportioned. Vector's problems are more complex and we need to look at the energy sector's regulatory regime to determine what went wrong.

Vector is divided into four main operations: electricity lines, gas transmission, gas wholesaling (production and processing) and technology (electricity and gas metering).

The electricity lines business is by far the most important, representing 64 per cent of group revenue and 75 per cent of operating earnings in the June 2005 year.

Electricity lines are extremely profitable with an ebitda (earnings before interest, tax, depreciation and amortisation) margin of 62.8 per cent compared with 72.1 per cent for gas transmission, 27.5 per cent for gas wholesaling and 65.4 per cent for technology.

Regulation of electricity lines is appropriate and acceptable because it is a monopoly or near monopoly business. Vector has a monopoly in Auckland City, Manukau City, parts of Papakura district, north and west Auckland and greater Wellington.

The Commerce Commission administers regulation of the country's 28 electricity lines companies and Transpower under Part 4A of the Commerce Act. The companies have price and quality thresholds with price thresholds linked to the consumer price index rate of inflation.

On April 1, 2004, all 28 electricity lines businesses began a new five-year regime with annual price increases set against the CPI. Vector was given a threshold of CPI-0 per cent, which meant that it could raise prices by the rate of inflation each year.

This regulatory regime appeared to be straightforward and there was no indication of any problems in the company's 2005 IPO prospectus or June 2005 year annual report.

Vector had minor breaches of the price threshold in 2004 and of the quality requirements in 2004 and 2006, with the latter two attributed to bad weather. These breaches gave the commission the opportunity to investigate Vector's line business.

The first sign of problems appeared in a Vector press release dated January 26 announcing an average line charge increase of 2.85 per cent for the year beginning April 1, 2006 (the inflation rate for the March 2006 year, announced later, was 3.3 per cent). The release noted: "This [price increase] will differ by network region as Vector continues to move towards a single and consistent price structure."

On July 19, the commission said it was discussing an administrative settlement with Vector over breaches of price thresholds. Commission chairwoman Paula Rebstock said: "The key issue here is the imbalance in Vector's charges to different consumer types."

The commission's statement was released by Vector without comment.

Investors took a positive view of Vector on Monday after the Government announced plans to encourage infrastructure investment by ensuring that these projects obtained a realistic rate of return.

Not surprisingly, analysts were euphoric as it signalled a more benign regulatory regime. Vector's share price leaped from $2.41 to $2.65.

But the euphoria was short-lived as the next day the commission announced its intention to declare control of Vector. It gave two main reasons for this:

* The company was undercharging some customers, mainly Auckland residential customers, and substantially overcharging others, especially commercial entities north of the harbour bridge.

* Based on Vector's pricing structure, it would be overcharging all customers between $13 million and $75 million in each of the next two years.

The announcement was a huge shock because neither the commission nor Vector had revealed the seriousness of the dispute.

The commission argues that Vector is overcharging a large number of customers by receiving excess returns on its investment. The table below shows that Vector expected to receive after-tax returns of more than 20 per cent from a number of customer groups in Wellington and on the North Shore in the March 2007 year.

The company claims that these are legacy issues following the acquisition of UnitedNetworks, which had a different pricing structure.

The commission released another table showing Vector would have to reduce prices by more than 20 per cent for a number of customer groups for each of the next two years to meet its rebalancing requirements. It contained no details of price increases.

For the past two years, the commission has been trying to get Vector to remove the imbalances but, according to Rebstock, "[Vector] has had ample opportunities to improve the situation. Instead, during the time that Vector has been aware of the imbalances, the situation has deteriorated further for many groups of customers."

The commission's chairwoman accused Vector of "abusing its monopoly power".

The next day, the company responded with a statement headed "Vector sets the record straight".

Vector argues that it was given until March 2009 to complete the rebalancing and the exercise would be completed by that date. It noted: "Rebalancing is not a feature of the commission's own threshold regime. There has been no guidance or methodology by the commission or legislative requirement on how this should be achieved."

A number of points can be made about this debacle:

* The commission's decision is not inconsistent with the Government's policy announcement on Monday. The dispute with Vector is essentially about historical issues, far less about future rates of return.

* The commission and Vector have been negligent at keeping investors fully informed on the issue.

* The commission's over-zealous regulation has dealt a huge blow to investor confidence. This will have an impact on the amount of funds available for infrastructure.

* This situation would not have occurred if Vector hadn't breached thresholds in 2004 and 2006.

* Vector's rebuttal was weak because it didn't contain any analysis of the commission's figures nor offer any figures of its own in response.

* Unfortunately, the regulator nearly always wins. The commission has been in dispute with Hastings-based Unison Networks for several years over threshold breaches. Unison claims the commission's consultation process for setting the thresholds was flawed and the threshold decisions were unreasonable. The High Court and Court of Appeal have rejected Unison's claims.

Vector started with a hiss and a roar after issuing shares at $2.38 and listing on the NZX on August 15, 2005. The stock hit a high of $3.37 on August 24 but since then it has gone mostly downhill through a combination of poor segmented reporting (which has been corrected), an inability to articulate a clear vision and regulatory concerns.

The company will release its June 2006 year results on Monday morning. Hopefully, it will take this opportunity to give a more analytical rebuttal of the commission's claims and articulate a clear strategy for the future.

Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management and a Vector shareholder.