1. Commerce Commission
Draft decision to amend the WACC percentile Briefing for financial market analysts
22 July 2014
Sue Begg, Deputy Chair

2. Overview Contents Scope of our draft decision
Why we are reviewing the weighted average cost of capital (WACC) percentile now
How we approached the review
Evidence gathered
Impact of our draft decision

3. Scope of our draft decision
We propose to select the WACC from the 67th rather than the 75th percentile of the WACC range
Draft decision applies to electricity lines (EDBs and Transpower) and gas pipelines
Further analysis required for airports
It applies to both price-quality regulation and information disclosure regulation
Methodology and parameters for estimating WACC unchanged

4. Why review the WACC percentile?
The High Court questioned the rationale for the 75th percentile in the merits appeals of the input methodologies
MEUG argued for the mid-point WACC estimate
The Court had some sympathy with MEUG's position and made a number of in-principle comments in favour of the mid-point
The Court did not overturn use of the 75th percentile, but suggested that we review the evidence, and our decision on this point

5. Why review the WACC percentile?
The Court’s comments created uncertainty
Uncertainty reduces the positive investment incentives associated with the 75th percentile
Price-quality paths for electricity lines services will be reset later this year and prices locked in for five years
A review now avoids prices continuing to reflect the 75th percentile, without an investment benefit being obtained
Consumer groups asked us to urgently review the WACC percentile

6. Why propose an amendment now?
We have sufficient evidence to make a decision
We have significant new theoretical and empirical 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 too high
In choosing the 67th percentile we have used our judgement

7. How we approached the review
We have sought to answer the Court’s concerns
The Court’s comments mean that the 75th percentile does not have any special standing as the status quo
We have, therefore, re-asked the fundamental questions
Are there good reasons to depart from the mid-point?
If so, what is the most appropriate percentile?
We have sought further evidence to help inform our judgement

8. How we approached the review
Process steps so far
February 2014 – sought views on whether we should consider reviewing or amending the cost of capital input methodologies
March 2014 – issued a notice of intention and sought evidence from interested parties
May 2014 – received submissions, evidence and expert reports from a number of parties
June & July 2014 – released expert reports we commissioned to assist in forming a view on the WACC percentile

9. Evidence gathered A range of evidence has been gathered
Expert reports and submissions were provided by interested parties
We commissioned several expert reports
We examined the incentives provided by price-quality regulation
We reviewed investors’ behaviour since the 75th percentile of WACC was first applied

10. Summary of our experts’ conclusions
Oxera
Using a form of loss analysis Oxera conclude a percentile between the 60th and 70th is appropriate.
Professor Ingo Vogelsang
If investment is close to optimal, the case for a large uplift is weak. More information can be found about the relationships considered in Oxera’s report.
Associate Professor Martin Lally
Using a total welfare approach, and adapting Dobbs’ loss analysis to New Zealand circumstances, suggests a 75th WACC percentile is likely to be too low.
Professor Julian Franks
Supports adopting a percentile above the mean. This may be different over time or across industries.
Economic Insights
The uplift in the WACC in New Zealand is high compared to other countries.

11. Case for WACC above the mid-point
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 (loss analysis)
Choosing a WACC from above the mid-point helps reduce risks and costs of under-investment

12. Case for WACC above the mid-point
The evidence supports a WACC above the mid-point
All experts recommended using a WACC above the mid-point when setting price-quality paths
For example Oxera’s and Dr Lally’s analysis indicates that using a WACC above the mid-point helps mitigate the risks of under- investment
The impact on downstream industries of using a WACC above the mid-point is unlikely to be material to our decision

13. Case for WACC above the mid-point
Catastrophic risk best dealt with through cash flows
We provide for businesses to recover additional prudent opex and capex incurred from time of a catastrophic event until a price reset
Price path reset transfers demand and cost risk to consumers
Damaged and stranded assets can remain in asset base
Businesses bear demand risk until reset
little demand risk for businesses on revenue paths
risk small for diversified investor

14. Defining the appropriate range
In our view the 60th percentile is the lower bound
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
Professor Vogelsang’s analysis suggests a large uplift would not be justified if investment effect is small, investment is close to optimum or alternative approaches (eg quality standards) could be used

15. Defining the appropriate range
In our view the 75th percentile is the upper bound
Dr Lally and some of the submitters recommended a percentile above the 75th
75th percentile was a reasonable option at start of regime
But observed investment behavior suggests that the 75th percentile is (more than) sufficient to provide incentives for investment
There was strong investor interest in 42% stake in Powerco
The regulated businesses have undertaken significant investment
No evidence of declining service reliability

16. Evidence 75th percentile too high
RAB multiple analysis
We compared the implied enterprise values of regulated activities to the regulatory asset base (RAB)
We used information from the Powerco transaction as well as market information for Vector
We separated regulated from unregulated activities
If a business delivers returns close to its ‘true’ cost of capital its RAB multiple will track 1.0
A RAB multiple above 1.0 could imply regulatory WACC is too high, or businesses can outperform cost and tax assumptions

17. Evidence 75th percentile too high
RAB multiple analysis suggests current WACC is too high
AMP’s acquisition of a 42% stake in Powerco implies a RAB multiple of 1.33x
Analysis of Vector’s regulated services implies a RAB multiple of between 1.09x to 1.16x
While other matters may influence the multiples, we consider the evidence suggests the 75th percentile estimate of WACC is too generous

18. Evidence 75th percentile too high
Other evidence suggests the 75th percentile too high
Oxera’s analysis suggests the 75th percentile provides a potentially excessive level of protection against under-investment
Professor Vogelsang identifies situations where under-investment is unlikely to have serious consequences
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)

19. We propose adopting 67th percentile
We propose adopting 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 social costs of under- and over-investment

20. 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
It is above PwC’s WACC estimates for Vector and Horizon
It is close to broker WACC estimates for Vector's entire business, including unregulated services

21. Information disclosure regulation
We propose using a range from the 33rd to the 67th percentile for information disclosure regulation
We consider that the range for information disclosure regulation should be symmetric around the mid-point
The amended range would only apply to electricity lines and gas pipelines businesses
Airports will be considered at a later date

22. Impact of our decision
The proposed amendment to the 67th percentile reduces WACC
25 basis points for EDBs and Transpower (eg reduces 1 April 2014 post-tax WACC estimate for EDBs from 6.82% to 6.57%)
28 basis points for GPBs

23. Impact of our decision
The proposed amendment to the 67th percentile would reduce payments and revenues
Consumer payments (and revenue to regulated businesses) would fall by approximately $32.8 million per annum
$16.7 million for EDBs subject price-quality regulation (excluding Orion), $11.6 million for Transpower and $4.5 million for gas businesses
Small impact on consumers’ monthly bills
A reduction of approximately $10 per year per connection for electricity lines charges

24. Next steps
We are seeking submissions on our draft decision and expert reports (already released)
Submissions are due on 29 August
Cross-submissions are due on 12 September
We will reach a final decision by 31 October
We will publish the WACC for the electricity prices paths using market data from August

25. Any Questions?

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