Lining Up The Charges - Executive Summary

Lining Up The Charges

Executive Summary

 The report of the Ministerial Inquiry into the Electricity Industry failed to answer the question that motivated the inquiry: are prices fair? In particular, are electricity lines charges fair? The inquiry report does not adequately analyse whether overcharging is taking place, or the extent of it, and does not examine whether lines companies are using an appropriate pricing and valuation methodology.

 The inquiry proposes that the core issue of the pricing methodology be passed to an industry-elected board. We are not aware of any OECD jurisdiction that allows individual companies or industry bodies to be the final arbiter on electricity lines pricing methodology. While the Commerce Commission is to have the power to impose price control on individual companies, it is cast more in a backstop role and the inquiry does not recommend that final control over pricing methodology should rest with the Commission.

 The valuation placed on fixed assets is the main driver of a typical lines company’s costs, which are in turn reflected in customer charges. "If the valuations are wrong, then line charges are wrong" the inquiry report acknowledged.

 Since the time line companies were compelled to corporatise in 1993, these valuations have risen dramatically. In the past eight years, electricity lines companies have more than doubled the book value of their networks from $2 billion to $4.2 billion.

 This sharp rise in book values is not due to an extraordinary level of investment in their networks during the 1990s. Expenditure remained largely confined to routine maintenance and replacement. What happened was that existing asset values were simply written-up following introduction of a new valuation methodology – Optimised Deprival Valuation (ODV). The result was huge windfall gains to network owners.

 These gains can be measured in dollar terms by examining the rise in lines company operating surpluses. While the average line charge has remained just over 3 cents per kWh for the past decade, lines company operating costs have fallen considerably. As there is little incentive for a monopoly supplier to share these savings, gross operating surpluses have grown substantially. These have doubled over the past decade from 0.76¢/kWh to 1.47¢/kWh – an increase of about $200 million a year compared to the level pre-corporatisation.

 This means that consumers are currently paying around $200 million more each year than would have been required to properly sustain the lines companies if they had retained the valuations they commenced with when corporatised in April 1993.

 The lines companies have therefore overcollected about $1 billion during the past five years. While a considerable proportion of this money has made its way back to customers by way of rebates, there is nothing to ensure this will continue into the future and there are major leakages (such as tax on the surplus) even if all companies rebated overcollections. The degree to which these overcollected revenues are returned depends on the individual network each customer is connected to and its ownership structure.

 This overcollection can also be examined by estimating the rate of return on investment achieved. The true returns are calculated by combining operating surpluses with the capital gains from asset revaluations. For the six years following corporatisation, the rate of return was between 24% and 35% pre-tax, approximately 16%-23% post-tax. This range is more than double that which the Ministry of Economic Development (MED) considers appropriate for distribution companies - 7.5% to 10%.

 It compares very favourably with returns available from the New Zealand sharemarket over a similar period. If a basket of the top forty companies, factored according to their weights in the NZSE40, were purchased and held for eight years, these stocks would have generated a 14.2% post-tax rate of return.

 The issue at the heart of the fair pricing question is windfall capital gains – gains from revaluations. The inquiry report argues that revaluations ought not to be taken into account in the reporting of underlying profitability.

 We believe that on this issue the inquiry is wrong, as a matter both of economic theory and of international legal precedent. Capital gains obtained from revaluing assets are a source of income. For a natural monopoly, which prices its services directly from the value of its assets, the treatment of that capital gain is of great importance. If prices are raised in line with the increased asset value without any offsetting adjustment, the owner reaps windfall gains which are far more than just a one off boost. The owner can effectively earn a return on and of capital that it has never actually invested in the business. Consumers pay for these increased earnings through higher charges while receiving no improvement in the scope or level of service. Such earnings are pure monopoly rents.

 It is a well established principle in the economic and current-cost-accounting literature that real holding gains, whether or not realised as immediate cashflows, represent real income to the asset owners in the period when those gains accrue. This was established for subsequent regulatory practice in the US when the Supreme Court outlawed a range of practices under which utilities had inflated their asset values used for price setting. The issue was confronted in the UK during the introduction of the RPI-X incentive regulation and some consumer charges were reduced substantially to correct for asset revaluations before imposition of the new price cap.

 The key principle, that revaluation gains are indeed income, was also supported by a 1995 decision in the International Court of Justice. This principle was embodied in advice put forward by Ernst and Young as consultants to MED in 1994.

 The primary problem facing consumers is that lines businesses are able to write-up their assets using the ODV methodology and then use these much higher values as a justification for capturing monopoly rents.

 The ODV methodology was first introduced to New Zealand when the newly separated Transpower adopted it to value its national transmission assets. Soon after this, the regional lines companies were compelled to corporatise and the government established a light-handed regulatory regime, the key components of which are information disclosure and the threat of price regulation. As part of this, government required lines companies to provide ODV valuations simply for the purpose of performance comparison, not for the purpose of pricing. However, the lines companies have adopted the ODV valuations into their accounts and then priced their services on the basis of these much higher valuations.

 The ODV methodology relies on the deprival concept. Yet deprival was never suitable as the conceptual basis for rate base determination, was never proposed for that purpose by the original theorists who developed the concept, and has not established a successful track record in that role anywhere in the world.

 Deprival is a concept from the world of insurance and damages estimation. When applied to price setting for natural monopolies, it is inevitably circular. As deprival value rests on revenue expectations, it cannot at the same time be the basis for setting revenues. For this reason its use for rate base purposes was rejected by the US Supreme Court.

 A new pricing methodology is required and the financial adjustments required are manageable. Of the $6.4 billion currently recorded as invested in fixed assets of the 32 electricity transmission and distribution companies, a return to a fair pricing methodology could most likely be achieved with no transfers of wealth in respect of 28 of these which account for most of that combined valuation. For the four remaining lines companies, a reduction in book values to achieve fair pricing could indeed involve a loss of wealth by the private shareholders in those companies. It is a question of who suffers: investors or consumers?

 When considering the position of the lines companies, it must be noted that a 1997 survey recorded that 56% of lines company CEOs expected “the regulator to enforce the regulatory ‘cap’ on line revenues” by 1999 and a further 20% some time from the year 2000 onwards.

 There is no defined level of pricing explicitly approved by the Government. Instead, officially, there is just the threat of regulation. Given the large number of lines companies disclosing returns on investment for a single year which exceeded 28%, it should not come as a surprise if the government makes good its threat of regulation. This has been a recogised business risk for lines companies.

 The importance of confronting now the application of the ODV methodology goes beyond the issue of fair prices for electricity customers. Customers of all network utilities have a stake in the outcome. This is because of the progressive adoption of the ODV methodology by other monopoly utilities.

 Gas suppliers and major airports were early to revalue under ODV, following on the heels of electricity industry revaluations. As plans for reform of the water and possibly roading sectors advance, so does the question of whether these industries will also generally adopt some form of ODV valuation and pricing.

 The electricity industry tends to be used as the template for regulation of other network industries. Thus, if ODV gains formal acceptance following implementation of the reforms recommended by the inquiry report, this will set a strong precedent for its adoption elsewhere. ODV valuations may then become locked into the economy and customers of monopoly services will be permanently poorer, quite unnecessarily, by hundreds of millions of dollars a year if all network utilities adopt ODV pricing and do not rebate consumers.

 It is proposed in the inquiry report that government issue a statement of economic policy under Section 26 of the Commerce Act. We suggest that this statement be expanded, or a separate one issued, which gives direction to the Commerce Commission to design price setting apparatus within specified criteria. Through this statement, government could cast the general parameters of the pricing and valuation methodologies to be adopted while leaving the detailed design to the proposed new industry regulator.

Disclaimer: While every effort has been made to ensure the accuracy of information in this report, no liability is accepted for errors of fact or opinion, or for any loss or damage resulting from reliance on, or the use of, the information it contains.

Copies of the full report, Lining Up the Charges by Simon Terry Associates Ltd, may be obtained from FullStop: 04-473-4123 at a cost of $40. Simon Terry Associates may be contacted at sta@actrix.gen.nz.

(c) Simon Terry Associates Ltd

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