Draft decision on WACC for gas and electricity services

Commission releases draft decision on the WACC used for regulation of electricity lines and gas pipeline services

The Commerce Commission has released and is now seeking submissions on its draft decision on the weighted average cost of capital (WACC). The WACC is used in the price-quality path and information disclosure regimes that apply to businesses regulated under Part 4 of the Commerce Act 1986.

The draft decision proposes reducing the WACC used to determine price-quality paths for electricity lines and gas pipeline services. The WACC used will be the estimate at the 67th percentile of the WACC range rather than the current 75th.

The proposal is now open to submissions, with the Commission’s final decision due in October. The final decision will affect the prices electricity lines businesses can charge from April next year, and from 2017 for gas pipeline businesses.

“The proposed change in the WACC percentile would reduce consumer bills by about $33m per year across both electricity lines and gas pipeline services, without compromising efficient investment or service quality,” said Commerce Commission Deputy Chair Sue Begg.

“At the same time, regulated businesses subject to price-quality paths would see their rate of return reduce by about 24 – 28 basis points per annum. The decision aims to strike the right balance to ensure on-going investment while constraining excessive profits.”

The Commission’s work on WACC was in response to the High Court judgment last year which questioned the WACC estimate. The Court considered that the use of the 75th percentile was insufficiently supported by evidence, and might be at odds with the Part 4 objective to limit the ability of regulated suppliers to earn excessive profits.

“Our draft decision today takes account of evidence not available at the time the WACC input methodology was originally set, back in December 2010,” said Ms Begg. “The decision also builds on additional expert views that were commissioned to help inform our decision. These reports are all available on our website, and the public can express their views on these as part of their submissions.”

The Commission’s draft decision also proposes that, under information disclosure regulation, the 33rd to 67thpercentile WACC range is used to assess the profitability of electricity lines and gas pipeline businesses.

Submitters will be able to provide their views on the draft decision by 29 August 2014. Cross submissions will be accepted up to 12 September 2014.

The Commission intends to have the final decision released in time to be incorporated into its final decisions on price-quality paths for electricity lines businesses in late November.

You can find the draft decision on the Commission’s website, as well as copies of the expert reports on theFurther work on WACC page.

Submissions should be emailed to regulation.branch@comcom.govt.nz

Background

Part 4
Part 4 of the Commerce Act 1986 regulates a number of markets where competition is limited, including electricity lines services, gas pipeline services and specified airport services. The intention of Part 4 is to ensure that suppliers have incentives to innovate, invest, improve efficiency and produce quality services for consumers, while also limiting their ability to extract excessive profits.

Some of the services regulated under Part 4 are subject to price-quality paths (electricity lines services and gas pipeline services). This means the Commission restricts the revenue a regulated business can earn or sets the maximum average prices it can charge, as well as setting service quality standards that must be met. Other regulated services (Wellington, Auckland and Christchurch airports) are only subject to information disclosure which means they must publish certain information about their performance.

Part 4 also requires input methodologies to be set to promote certainty for regulated businesses and other interested parties. More information on input methodologies is provided below.

Input methodologies
Input methodologies are a range of upfront regulatory rules, processes and requirements covering matters such as the valuation of assets, the treatment of taxation, the allocation of costs, and the cost of capital. Part 4 of the Commerce Act requires the Commission to set input methodologies for specified airport services, electricity distribution and transmission, and gas pipelines. The Commission must review each input methodology no later than seven years after its date of publication and, after that, at intervals of no more than seven years.

WACC percentile estimate
The cost of capital is the financial return that investors require from an investment given its risk. Investors have choices, and will not invest in an asset unless the expected return on that asset is at least as good as that they would expect to get from a different investment of similar risk. The WACC reflects the cost of debt and the cost of equity, and the respective portion of each that is used to fund investments in the assets used to supply regulated services.

The WACC cannot be observed; it must be estimated, so there is a risk that the estimate is higher or lower than the true (but unobservable) WACC. To mitigate this risk the Commission calculates a distribution around the mid-point WACC estimate based on the standard errors of some of the key parameters. This defines a WACC range. A percentile in this WACC range distribution is then chosen, based on what best meets the purpose of Part 4. It is a change to this percentile that the Commission is currently proposing.

As it stands, the current cost of capital input methodologies require that the Commission apply the 75th percentile estimate of the WACC range (‘75th percentile’) when setting default or customised price-quality paths applying to electricity distribution businesses and gas pipeline businesses, or the individual price-quality path applying to Transpower. Electricity price-quality paths (excluding Orion) must be reset by the end of November this year.

The cost of capital input methodologies also require the Commission to publish 75th percentile WACC estimates, mid-point WACC estimates and 25th percentile WACC estimates for all suppliers that are subject to information disclosure regulation. ‘Consumer-owned’ electricity distribution businesses and the three main international airports are subject to information disclosure regulation only. In the Commission’s recent reports on how effectively information disclosure regulation is promoting the Part 4 purpose in respect of specified airport services, the Commission assessed airport profitability against a WACC range from the mid-point to the 75th percentile.

Reviewing the WACC estimate: steps in the process so far

In its December 2013 judgment on the Commission’s input methodologies, the High Court suggested that using the 75th percentile estimate of the WACC may be at odds with the Part 4 objective to limit the ability of regulated suppliers to earn excessive profits.

Following consultation with stakeholders about the implications of the judgment, on 31 March this year the Commission issued a notice of intention to do further work on the input methodologies relating to the percentile estimate of the WACC. The Commission considered this work to be necessary to address the uncertainty for investors that will exist until the question of the appropriate percentile is resolved.

On 23 June the Commission released a further process update paper, and a number of expert reports written for the Commission on the choice of the WACC percentile. The reports were prepared by a number of expert advisers and firms engaged by the Commission: Professor Ingo Vogelsang of Boston University, Professor Julian Franks of the London Business School, Associate Professor Martin Lally of Victoria University of Wellington, European economic consulting firm Oxera, and the Australian consultancy Economic Insights.

On 11 July the Commission released a peer review by Professor Vogelsang of Oxera’s analysis on the WACC percentile.

The consultation material to date on the WACC percentile, including the notice of intention and the expert reports, can be viewed on the Further work on WACC page.

Airports regulation is not covered by this draft decision

As notified in the process update paper on 23 June, the draft decision does not cover the WACC percentile for information disclosure regulation of airports. The Commission considers that given the combination of its different industry characteristics and its regulatory regime the airports decision should be considered in its own right at a later date.

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