Margin that it applies to regulated cost of capital reduced

Commerce Commission reduces the margin that it applies to regulated businesses’ cost of capital

The Commerce Commission has released its final decision on the weighted average cost of capital (WACC) used for regulated businesses. The WACC uplift (or margin) for price-quality regulation has been set at the 67thpercentile, down from the 75th percentile. This confirms the Commission’s draft decision.

The WACC is used in the price-quality path and information disclosure regimes that apply to electricity lines and gas pipeline businesses regulated under Part 4 of the Commerce Act 1986. The new WACC will take effect in the price-quality paths for electricity lines businesses from April next year, and from 2017 for gas pipeline businesses.

“By reducing the margin we allow regulated businesses to earn on their cost of capital, we expect consumers to save about $45 million per year across both electricity lines and gas pipeline services,” said Commerce Commission Deputy Chair Sue Begg. “And this reduction in the WACC margin should mean regulated businesses subject to price-quality paths will see their rate of return reduce by about 24–28 basis points per annum.”

The Commission’s work on WACC was in response to the High Court judgment last year which questioned the WACC uplift. The Court considered that the use of the 75th percentile was not supported by sufficient evidence, and might be at odds with the Part 4 objective to limit the ability of regulated suppliers to earn excessive profits.

“We have responded to the High Court’s judgment. We have consulted extensively, and been able to consider a wide range of evidence and expert opinions,” said Ms Begg.

“The evidence received following our draft decision reinforced our view that the 67th percentile WACC should provide appropriate incentives for regulated businesses to invest in and maintain their networks,” said Ms Begg. “A WACC margin at this reduced level more appropriately promotes the long-term benefits for consumers, both residential and business.”

“The conclusion of this review is another important step in bedding down the Part 4 regime. It ties up the most significant remaining loose end following three years of appeals. Our decision builds on substantial new evidence, not available during the initial input methodology development, putting the WACC percentile on the same footing as other input methodologies,” said Ms Begg.

The Commission has also released a revised draft decision which proposes that, under information disclosure regulation, the profitability of electricity lines and gas pipeline businesses is assessed against the existing 25th to 75th percentile WACC range, as well as the 67th percentile point estimate. Submissions on this consultation are due by 14 November and cross submissions by 21 November 2014. A final decision is expected before the end of the year.

You can find the decision on the Commission’s website, as well as copies of submissions and the expert reports:www.comcom.govt.nz/regulated-industries/input-methodologies-2/further-work-on-wacc

Background
Part 4 regulatory regime
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 services at the quality consumers want, 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 (airport services provided by 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.

The relevant input methodologies must be applied by the Commission in its regulatory decisions ie, when it sets price-quality paths or information disclosure requirements.

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.

This latest decision by the Commission made a change to the percentile that is applied to the WACC for price-quality paths for electricity lines and gas pipelines. The decision shifted the percentile from the 75th percentile to the 67th percentile.

WACC percentile for information disclosure
The cost of capital input methodologies also currently 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.

Alongside today’s decision in respect of price-quality regulation, the Commission is proposing a change to the WACC percentiles for information disclosure for regulated electricity lines and gas pipeline services so that profitability is assessed against, the 25th, 75th and 67th percentile of WACC.

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 then released a peer review by Professor Vogelsang of Oxera’s analysis on the WACC percentile.

The draft decision on the percentile was released on 22 July. A number of submissions were received from regulated entities, and consumers, providing the Commission with a substantial amount of information to consider in coming to their final decision. The Commission also invited another round of submissions on further information that became available after submissions were due.

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

You can find the media release for the draft decision on the Commission’s website: www.comcom.govt.nz/the-commission/media-centre/media-releases/detail/2014/commission-releases-draft-decision-on-the-wacc-used-for-regulation-of-electricity-lines-and-gas-pipeline-services

Airports regulation is not covered by this decision
As notified in the process update paper on 23 June, this 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.
The Commission intends to notify parties before the end of the year of the timeframes for the review of the WACC percentile applied to airports.

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