WACC "out of whack with reality"
25 September 2003
WACC "out of whack with reality"
The nation’s second biggest electricity network company, Powerco, today raised concerns that the Commerce Commission’s indicative range for the Weighted Average Cost of Capital (WACC) is “out of whack with business reality”.
WACC is currently at the centre of a dispute between the Commission and Telecom in calculating the cost of the Kiwi Share service obligation. WACC estimates the cost of capital used to produce a product in any given industry. Overseas regulators then use the WACC to assess what are fair and allowable prices to charge for the product. This approach has been one of the heavy-handed responses to sector regulation in telecoms, electricity, gas and water in the overseas regimes.
WACC is also likely to be used by the Commerce Commission under Part4A of the Commerce Act to apply some form of price control to lines companies that have breached allowable price and profit thresholds.
Powerco Chief Executive, Steven Boulton, who has just returned from a capital-raising round in the United States, said the Commission’s WACC estimate was heavily at odds with Powerco’s experience of the real world.
“Our cold hard experience of business is that the cost of borrowing funds for capital investment and expenditure in our industry is substantially more than the Commission’s figure – presumably set by some external advisor.
“It is a classic case of academic theory not matching the realities of business practice.
“This is a particularly important issue for New Zealand’s economy as regulation itself compounds the risks in the sector from the view of investors, which in turn increases the cost of capital which is then followed by increasing costs to the consumers. This has become a downward spiral from which the overseas regimes are still trying desperately to recover.
“An inappropriate WACC means that firms cannot make a proper business case for new investment.
“They would not be allowed to earn enough revenue on the capital invested to make it worth their while. That’s bad for the industry, and bad for consumers who are demanding improved and more reliable services from the lines sector, particularly given moves to the digital economy,” Mr Boulton said.
Powerco asked Glen Boyle, Finance Professor at Otago University, to examine the appropriateness of WACC and the Commission’s indicative guide for the lines sector at 6-8% [Lally, Aug 2003].
Boyle reported that the figure was “unlikely to offer investors with rational profit motives sufficient incentive to make any significant investments in electricity lines”.
He said CAPM-based WACC estimates were subject to error and “should be treated with considerable caution” because they were “likely to be biased downwards”.
So Boyle says it would not be unreasonable for the Commission to adopt a margin over WACC, to allow for the inherent miscalculations and bias of the methodology. He notes other academics have suggested a margin of at least three percentage points.
If such a margin were to be added to WACC, then the cost of capital estimates implied by the Commission’s consultant range from 8.8% up to 11%. If a margin were applied to WACC figures deduced by other economists, the correct WACC range is from 10.09% to 12.19%.
“It is ironic that at a time when the nation needs more capital investment in our key infrastructure we are fiddling around with academic and economic theory on issues such as WACC,” Mr Boulton said.
“Thousands of pages of academic argument have already been produced on this topic in the overseas regimes – we seem to be following our international peers into a costly and resource intensive debate to find answers that cannot be found.
“Continued costly regulation in areas like WACC is not a panacea, it is a Pandora’s box. Our overseas trading partners have found just that. New Zealand cannot afford to make the same costly mistakes with our isolated island status and small population.”
Mr Boulton said the future was becoming clear.
“We can have continued forms of regulatory creep and cost impost, or we can have an innovative market to encourage investment in our key infrastructure. But we cannot have both,” he said.
Powerco is a publicly listed company, listing on the NZSE in December 2000 and on the NZSE40 index on December 2, 2002. Powerco is New Zealand’s second largest electricity lines company and largest gas pipelines company, with around 400,000 consumer connections in the North Island.