Turbulence in revenue stream

By BRIAN FALLOW

In Wellington they call it competition policy. To the companies concerned it is regulatory risk - the risk that revenue streams and asset values of natural monopolies will be cut by regulators changing the rules of the game.

The decision of UnitedNetworks' American shareholders to quit New Zealand, thereby putting extensive electricity and gas networks assets in play, came at an awkward time when the regulatory environment was in the throes of being overhauled.

As Energy Minister Pete Hodgson explained it to the commerce select committee on Thursday: "The Commerce Commission has been given the task of setting thresholds and laying the groundwork for a targeted regulation approach, by which we mean if a lines company is silly enough to pop its head above the parapet it will get a CPI-X type measure biffed at it."

CPI-X is one form of price control, which ensures declining real prices over time.

The gas industry, too, could not be left unmolested any longer, Hodgson said. A long-running review of the gas industry by the Ministry of Economic Development is understood to be due for release within weeks.

The commission's work on what thresholds will trigger control of an electricity line company is supposed to be released next month, though many expect that deadline to be missed.

Under the deal announced last week, Auckland's lines company Vector will spend $1.5 billion in a full takeover of UnitedNetworks.

It will then on-sell two-thirds of the assets, retaining the Auckland electricity, gas and telecommunications networks and the Wellington electricity and telecommunications networks.

New Plymouth-based Powerco will acquire UnitedNetworks' non-Auckland gas network for $220 million.

Together with an unlisted lines company, Hawkes Bay Network, Powerco will buy the electricity networks in southern and eastern Waikato, the Thames Valley and Coromandel, Tauranga and Hawkes Bay for $785 million.

The final cost to Powerco will be $810 million, of which only $150 million is new equity, while $650 million is debt.

Vector, owned by the Auckland Energy Consumer Trust, is being coy about any eventual equity component to the funding of its acquisition, reflecting local political sensitivities. But it is understood that the interest rate on capital bonds being offered to the market will go up if there is no float.

With a high degree of leverage a regulatory change which nibbled at revenue could take great big bites out of the bottom line.

So how material is the regulatory risk to Powerco and Vector? Both companies insist they have no worries on this score.

It is expected the commission will opt for a system where no single measure - comparative prices, service quality, costs or return on investment - would trigger control, but rather a combination of some or all of those.

It is also expected that they will prefer to look at rolling average measures over three or five years, rather than one year.

And that the approach will be to ping the outliers, rather than set thresholds which would require regulating most or all of the 29 lines companies, which would be an administrative nightmare and inconsistent with Hodgson's preference for "targeted" regulation.

In principle it is easier for dense urban networks such as Vector's to keep their heads safely below the parapet.

Powerco chief executive Steven Boulton says that Vector has 3.5 times as many customers for every kilometre of lines than Powerco does. Also Aucklanders on average consume 30 per cent more than Powerco's residential customers do.

That is not something a lines company can do much about but it can make crude comparisons of line charges in terms of cents per kilowatt hour unfair.

Powerco's New Plymouth residential consumers s pay 22 per cent above the mean for city networks, Vector's Auckland customers 18 per cent below.

"But if our charges were too high our ROI [return on investment] would have to be high. It's not," Boulton says.

In the year to March 2002, Powerco's ROI was 9.5 per cent.

For comparative purposes the monopoly components of lines companies' businesses are valued on an optimised deprival value basis.

A broker's report on the transaction by First New Zealand Securities estimates that Vector's price for UnitedNetworks is 2x ODV.

Powerco is buying the gas network for about 2x ODV but it and Hawkes Bay are buying the eastern region electricity assets for 1.8x ODV, implying that Vector is acquiring the remaining assets for a generous 2.1x ODV.

It is sometimes argued that ODV is the "regulated value" of a network and that any premium paid above that either reflects the expectation that operating costs can be stripped out, or the expectation that excess profits can be earned with impunity.

However, Craig Rice and Lynn Taylor of PricewaterhouseCoopers said ODV was never intended to form the basis of pricing but only to provide a common basis for comparison of performance across different lines businesses.

In the end it is all well and good for chief executives, directors and trustees to be sanguine about the regulatory risk they are taking on. If they are wrong it is owners who will carry the can. That's the power consumers of Auckland, in Vector's case, and the shareholders of Powerco (chiefly New Plymouth ratepayers).