1. Commerce Commission Amendment to the WACC percentile
Briefing for financial market analysts
30 October 2014
Pat Duignan, Commissioner

2. Overview
Contents
Decision is to set the WACC uplift at the 67th percentile
Why we consider an uplift to WACC
Impact and application of our decision
Why we reviewed and amended the WACC percentile now
How we approached the review
Evidence gathered
Lower bound, upper bound, and percentile choice
Reasonableness checks and peer review
Revised draft decision on information disclosure

3. Our decision
We are setting the WACC uplift at the 67th percentile of the WACC range, down from the 75th percentile
The uplift (margin) is an increase over the best estimate of WACC (mid-point/50th percentile)
Our decision applies to electricity lines and gas pipelines only
Further analysis required for airports
Our decision applies to price-quality regulation only
We have issued a revised draft decision on WACC percentile for information disclosure regulation
Methodology and parameters for estimating WACC unchanged

4. Why consider an uplift to WACC?
Asymmetric consequences of getting WACC estimate wrong
The WACC is an estimate, because the actual cost of capital is unobservable
The mid-point estimate is our best, unbiased estimate of WACC
The net costs of setting WACC too low are greater than if we set it too high
Choosing a WACC from above the mid-point helps reduce the risk of under-investment and the resulting costs

5. Impact of our decision
Selection of WACC from 67th percentile of WACC distribution still results in significant uplift
Selection from 67th percentile results in a 47 basis points uplift to the electricity WACC (cf 72 basis points at 75th percentile)
25 basis points reduction
Selection from 67th percentile results in a 53 basis points uplift to the gas WACC (cf 81 basis points at 75th percentile)
28 basis points reduction

6. Impact of our decision
Illustration showing the impact on our WACC estimates for electricity as at 1 April 2014
Impact of using 67th percentile instead of 75th percentile on vanilla WACC for electricity
Moves from 7.60% to 7.36%
Impact of using 67th percentile instead of 75th percentile on post- tax WACC for electricity
Moves from 6.82% to 6.57%
1 September 2014 estimates of WACC to be released tomorrow

7. Impact of our decision
Change in WACC uplift affects consumers and suppliers*
Consumers will pay approx $45 million less per annum for gas and electricity
Small impact on consumers’ annual bills
Allowed return on capital for EDBs (excl. Orion) and Transpower subject to price-quality regulation will fall by approx $28 million per annum from 2015
Allowed return on capital for gas pipeline businesses will fall by approx $4.5 million per annum from 2017
* Note numbers are approximate because of assumptions that need to be made

8. Application of our decision
67th percentile will apply as price-quality paths are reset
EDBs’ default price-quality path (from 1 April 2015)
Transpower’s individual price-quality path (from 1 April 2015)
Gas pipelines’ default price-quality path (from 1 October 2017)
The WACC estimates for the EDB and Transpower price-quality path resets will be published tomorrow

9. Why review the WACC uplift?
The High Court questioned the evidence for the 75th percentile in the merits appeals of the input methodologies
The Court noted our 2010 decision on the WACC percentile relied primarily on judgements made by experts, rather than on analytical and empirical evidence
The Court noted there was insufficient evidence that an uplift was need to incentivise investment – little evidence for 75th, but little for any other percentile either (ie, 50th percentile supported by MEUG)
The Court expected the Commission to review the use of the 75th percentile and gather more evidence

10. Why did we review the WACC uplift now?
The Court’s comments led to heightened uncertainty about the future WACC percentile
The Court’s comments created an expectation that the WACC percentile was more likely to decrease than increase when reviewed
This uncertainty would remain until we reviewed the percentile
Uncertainty reduces the positive investment incentives associated with the 75th percentile, while consumers continue to pay for it

11. Why did we review the WACC uplift now?
Energy users requested that we review the WACC percentile urgently
Electricity and gas a significant input cost for business consumers
For example, Carter Holt Harvey submission: “Electricity and gas … is our highest input cost after wood cost so the price paid for electricity and gas impacts on the company’s operating costs and hence ability to compete in the international market”
Important cost for residential consumers

12. Why did we review the WACC percentile now?
Making a decision now avoids consumers continuing to pay for a level of uplift they are unlikely to benefit from
Price-quality paths for electricity lines services will be reset shortly and prices locked in for five years
It avoids prices continuing to reflect the 75th percentile, without an investment benefit being obtained
Reviewing now resolves uncertainty as quickly as possible

13. Why amend the percentile now?
We have sufficient evidence to make a decision
We have significant new analytical and empirical evidence (including market-based evidence)
The additional evidence allows us to make a more informed decision on the appropriate WACC percentile
The available evidence suggests that the 75th percentile is higher than warranted
In choosing the 67th percentile we have used our judgment in light of the evidence

14. How we approached the review
Outline of our review process
February 2014 – sought views on whether we should consider reviewing or amending the cost of capital input methodologies
March to May 2014 – published a notice of intention and sought evidence from interested parties. Received submissions, evidence and expert reports from a number of parties. Engaged our experts.
June & July 2014 – released expert reports we commissioned to assist in forming a view on the WACC percentile, and draft decision
August to October 2014 – received submissions and expert reports on draft decision, cross-submissions and further submissions on specific topics

15. Evidence gathered A range of evidence has been gathered
We obtained a number of reports from independent experts
Expert reports and submissions were provided by interested parties
We analysed the incentives provided by price-quality regulation
We reviewed investors’ behaviour since the 75th percentile of WACC was first applied
We now have significant, new evidence that was not available in when we initially set the 75th percentile

16. The types of evidence gathered
We gathered a range of evidence
We examined a range of evidence, including
Empirical
Analytical
We will expand on key pieces of evidence in this presentation
Oxera’s analysis
RAB multiples
Other

17. Oxera’s evidence Key findings of Oxera
Oxera used a form of the loss analysis supported by the Court
Empirical analysis of expected losses to consumers from under- and over-estimating the ‘true’ cost of capital at various percentiles
Highlighted the uplift’s primary role in mitigating reliability risks which may be increased by under-investment
Oxera recommended using a WACC between the 60th and 70th percentile estimate
Peer-reviewed by Professor Ingo Vogelsang

18. RAB multiple analysis RAB multiple analysis
We compared the implied enterprise values of regulated activities to the regulatory asset base (RAB)
We used information from recent Powerco, OtagoNet and The Lines Company transactions, as well as market information for Vector
We separated regulated from unregulated activities
A RAB multiple above 1.0 could imply regulatory WACC is too high, or businesses can outperform cost and tax assumptions

19. RAB multiple analysis
RAB multiple analysis suggests current WACC is too high
While other matters may influence the multiples, we consider the evidence suggests the 75th percentile uplift is too generous
Name of EDB
Date of transaction
RAB multiple (standard)
RAB multiple (adjusted)
Vector
June 2013
1.14
1.36
Powerco
July 2013
1.30
1.48
The Lines Company
December 2013
0.77
1.03
OtagoNet
September 2014
1.89
1.91
Average (simple)
1.28
1.45
Average (weighted)
1.20
1.40

20. The Dobbs model Loss analysis model developed by Professor Ian Dobbs
Dobbs model was applied by Frontier to NZ electricity industry
The Dobbs model helped inform our thinking, and was the only alternative quantitative model to Oxera put forward
But ultimately, as Dobbs himself noted, his model (and Frontier’s model that builds on it) is not directly relevant to the question at hand
Professor Dobbs: “This kind of model articulates why a significant uplift is warranted, but in my opinion, it is unclear how much quantitative significance should be placed on the model predictions.”

21. Case for WACC above the mid-point
The evidence supports a WACC above the mid-point
All experts except NZIER recommended using a WACC above the mid-point when setting price-quality paths for electricity and gas
Oxera’s analysis, and analysis using Dobbs’ model (Dr Lally, Frontier) supports using a WACC above the mid-point to mitigate risks of under-investment
The impact on downstream investment of using a WACC above the mid-point is subsumed into the analysis

22. Defining the appropriate range
In our view the 60th percentile is the lower bound
We consider that the 60th percentile is the minimum percentile that might balance the relative costs of over- or under-estimating WACC
The evidence we received points to a percentile above the mid- point for price-quality regulation
Oxera recommended the 60th percentile as a lower bound
We also note Professor Vogelsang’s observations about circumstances where a large uplift would not be justified
investment effect is small
investment is close to optimum
alternative approaches (eg quality standards) could be used

23. Defining the appropriate range
In our view the 75th percentile is the upper bound
We consider that using a percentile above the 75th would result in an allowed WACC that is too high
75th percentile was a reasonable option at start of regime
But observed investment behaviour suggests that the 75th percentile is (more than) sufficient to provide incentives for investment
RAB multiple analysis suggests shares trading above RAB value
The regulated businesses have undertaken significant investment
No evidence of declining service reliability

24. Defining the appropriate range
Further evidence that the 75th percentile is the upper bound
Oxera’s analysis suggests the 75th percentile provides a potentially excessive level of protection against under-investment
Businesses have other incentives to continue to invest (quality standards, desire to ensure “lights don’t go out”, price cap incentives provide scope to out-perform)

25. We have adopted the 67th percentile
We have adopted the 67th percentile for price-quality regulation
The evidence now available suggests that WACC should be below the 75th percentile but above the 60th
Although the evidence narrows the range of judgement, judgement is still necessary, given the ‘fundamental uncertainties’
We judge that the 67th percentile appropriately balances the relative costs to consumers of under- and over-investment

26. Reasonableness checks
The WACC at the 67th percentile is consistent with estimates from independent analysts
We standardise for risk free rates (regulatory period v long term)
WACC is within the range of independent broker WACC estimates for Transpower, Vector and Horizon

27. Prof Vogelsang’s peer review
Professor Vogelsang conducted an independent review of a near-final draft of our final decision
“In my review of the Commission’s draft decision I had stated that I was impressed by its even-handedness and was fully supportive of the overall result. I had added a few caveats about issues that did not change my overall assessment but, in my view, needed to be addressed. The current Reasons Paper successfully deals with these caveats, builds on and addresses new evidence and other information that have emerged after the Commission’s draft report”

28. Information disclosure regulation
Revised draft decision on information disclosure: keep the range from the 25th to the 75th and adopt the 67th
Our revised draft decision on the WACC percentile for information disclosure is:
Maintain the current range from the 25th to the 75th percentile; and
Introduce the 67th percentile
We invite submissions on our draft decision and intend to reach a final decision in December 2014
This proposal only applies to electricity lines and gas pipelines businesses – airports will be considered at a later date

29. Closing remarks
Exceptional review due to High Court’s comments – we do not anticipate having to undertake a similar process again
We are confident in the position we have reached based on the exploration of new evidence
Conclusion of this review is another important step in the bedding down of the Part 4 regime
It ties up the most significant remaining loose end following three years of IM appeals, and puts the WACC percentile on the same footing as other input methodologies

30. Any questions?

31. Contact us
Call: Write: Contact Centre, PO Box 2351, Wellington Website: comcom.govt.nz