Brian Fallow: Decision will have impact on consumers

Transpower is facing a spike in capital expenditure because of prolonged under-investment in the past. Photo / Amos Chapple

The Commerce Commission has a big call to make by the end of the year.

It has to decide on a formula for determining regulated industries' weighted average cost of capital (WACC).

Why should we care?

Well, if it errs in one direction we will all pay more than we need to, year after year, to a bunch of monopolists.

If it errs in the other direction the risk is under-investment in vital infrastructure. The lights could go out, the airports could become a nightmare of congestion and so on.

Whatever result the commission comes up with will prevail for up to seven years, the Major Electricity Users Group's (MEUG) executive director Ralph Matthes points out.

And applied to an asset base of about $16 billion across the electricity, gas and airport sectors, a difference of 1 percentage point in the WACC, grossed up for tax, represents more than $200 million a year out of consumers' pockets.

The issue of an appropriate WACC is arcane and complex. Entire academic careers are devoted to it.

A draft determination setting out the commission's preliminary view back in June devotes five pages just to spelling out the formula it proposes to use, and defining the terms involved.

The commission has been inundated with submissions from the monopolists arguing the value of this or that variable should be higher.

But this is not a science. There is no correct number determined by the laws of physics or anything like that.

The most such an exercise can establish is a range of plausible or defensible values for WACC.

Within that range the commission has to make a judgment call. It has to decide how much weight to give to the two risks - excess profits on the one hand and under-investment on the other.

Transpower argues that the risks are asymmetric. The costs of consumers paying too much are relatively small compared with the potential losses from a failure of vital infrastructure like the grid because of under-investment arising from an allowed rate of return set lower than its actual cost of capital, it says.

It reckons the commission's draft formula would give it a rate of return of 7.3 per cent.

But if the Australian regulator's rules applied it would be 8.1 per cent and Transpower argues that it faces a greater risk of stranded assets than its Australian peers do.

Expert opinions it has commissioned come up with numbers in the 8.2 to 9.3 per cent range.

However, the argument about the risks of under-investment lose much of their force, at least in Transpower's case and for the time being, when you consider that the major projects to bring the grid up to scratch are already under way.

Chief executive Patrick Strange was asked, at Transpower's annual meeting last Friday, if failing to get at least the 7.7 per cent return assumed in its statement of corporate intent would affect physical investment.

"No. It's all committed," he said.

This reflects the peculiar governance arrangements of a state-owned enterprise. Its board and management are required to run Transpower as if it were an investor-owned company, but its actual owners are the Government and people of New Zealand.

And everybody involved understands their attitude to risk is different from an ordinary investor's. Much more weight has to be given to the economic, and therefore political, risks around security of supply, compared to financial risks that affect the bottom line and dividends (which are suspended right now in any case).

Transpower is in the midst of spending $3.8 billion on the national grid, a spike in capital expenditure necessitated by a prolonged period of under-investment in the past.

Strange said that over the next couple of years there would be double-digit increases in Transpower's charges, which make up about 8 per cent of a consumer's power bill. Even so, over the next decade Transpower charges are forecast to remain below 10 per cent of the bill, he said.

But the lines companies, like Vector and Powerco, which connect electricity users to national grid and whose rates of return are also overseen by the commission, take a much bigger bite out of our power bills.

Their national body, the Electricity Networks Association (ENA), says they expect to invest more than $7.5 billion over the next 10 years.

"The Commerce Commission has proposed a level of return that would be materially lower than offered to comparable Australian businesses, which would make it very difficult to attract capital," ENA chairman Richard Krogh said.

MEUG makes the point that you can only incentivise future behaviour but as it stands a WACC-based return will apply to firms' existing assets as well. It creates the risk of hefty windfall profits.

That result can be avoided if any deliberate bias in favour of ensuring investors have an incentive to proceed with new investment is confined to new capital, it says.

"The windfall has costs. It represents spending and investing power taken away from business and residential customers."

But MEUG's biggest concern about the commission's proposal is with the mathematical model for calculating WACC itself.

A modified version of the Capital Asset Pricing Model, it has the peculiar consequence that the cost of capital rises, and materially, as a firm's gearing increases.

Normally debt is considered a cheaper form of capital than equity so this result is, as the commission acknowledges, "counter-intuitive". That is officialese for "daft".

Faced with this, one might think, rather fundamental flaw the commission has chosen not to revisit the model itself but to pick one point on the rising line it gives, and assume that a regulated monopoly has 40 per cent leverage.

This is, of course, arbitrary and ad hoc. It cries out for merit review by the courts. But as the law stands the courts can only consider evidence that was laid before the commission and the consumer side of the argument is at a big disadvantage in resources.