Funding efficient infrastructure investment

Miriam Dean QC leads the Electricity Pricing Review panel. Photo / Ted Baghurst

The ability to invest at a time of high growth is extremely dependent on cashflow.

A key focus of Vector's submissions and ongoing engagement with the Commerce Commission throughout the reset process is how forecasting inaccuracies, low interest rates and asset indexation are crystallising challenges within the existing regulatory model.

Since 2013, significant regulatory forecasting errors have resulted in a material $270 million of lost revenue for Vector with no ability to recover these amounts under the regulatory regime.

Under-recovery

Vector says the case to align regulatory settings with the investment needs of today has never been stronger. Even the Government's own Electricity Pricing Review panel (led by Miriam Dean QC) draws attention to the revenue under-recovery problem. To get the regulatory settings aligned, Vector is asking for two changes to the current regime:

Indexation of asset values

Indexing is whereby a regulated company's asset base is multiplied by forecast inflation each year. However, the resulting indexation amount is then treated as non-cash revenue.

This impacts cashflow as actual cash returns are lowered in the short to medium term.

Furthermore, because RBNZ inflation forecasts have systematically over-estimated inflation by a material margin for some time, and these are used as the index input, the cashflow from forecast inaccuracies are never received. The challenge to invest is compounded given the impact the current settings have on cashflows, and how this is observed by credit rating agencies for each five-year regulatory period.

Vector is advocating a switch to non-indexing asset which has the positive impact of delivering cashflow to support investment for growth when it's needed. Furthermore, non-indexing is NPV neutral - meaning customers would expect to pay the same amount over the life of the asset. The precedent already exists for other New Zealand regulated entities such as airports and Transpower - all of which have faced significant investment requirements. On this basis, Vector is saying there is a strong case for regulatory indifference. Vector is hopeful the change will be made when the Commerce Commission updates regulatory settings later this year.

Interest rates

The second change relates to today's current ultra-low interest rate environment. Vector says there is an urgent need for the Commerce Commission to amend the way it derives the cost of debt in its Weighted Average Cost of Capital (WACC) calculations.

Currently this cost of debt is worked out by applying the current risk-free rates observed in an extremely narrow three-month window ahead of the reset determination.

As interest rates are extremely low, the problem is that the actual cost of debt is much higher given efficient treasury management typically involves companies raising debt in tranches over an extended multi-year period.

International regulatory practice typically calculates debt costs based on a 10-year (Australia) or 20-year (UK) trailing average to better reflect efficient debt book management. Vector is advocating for New Zealand regulation to align with international practice.

Vector maintains these two specific changes to regulatory settings can be sensibly achieved within the current reset timeframe. This would enhance the ability of it and other electricity distributors to invest at the right level over the next five years and reflect cashflow realities and commercial treasury practice.

Source: Ministry of Business Innovation and Employment analysis of Commerce Commission data