Brian Fallow: Battle lines over power profits

Is there a rip-off built into our electricity bills?

Are power-line owners the robber barons of our day and age?

These questions are before the Commerce Commission as it conducts a public hearing into the design of a regime to control line companies' prices.

Not that the commission would put it like that.

It talks in terms of whether there should be a "profit threshold" among the tests for when a company should be controlled, or a threshold for sharing efficiency gains with consumers, or where the initial point of a regulated price path should be set.

But these questions come down to whether to accept the case for the prosecution. Economic analysts Simon Terry and Geoff Bertram contend that the lines companies, which are natural monopolies, are taking more than $200 million a year in excess profits.

One sign that the Government takes this claim seriously is to be found in the legislation, an amendment to Part IV of the Commerce Act, which requires the commission to undertake this task.

The purpose of such a regime includes "ensuring that suppliers are limited in their ability to extract excess profits and ... share the benefits of efficiency gains with consumers, including through lower prices."

Terry and Bertram say that line charges remained almost steady in real terms between 1990 and 2000.

But that masked a substantial decline in operating costs and a corresponding rise in operating profits. Operating profits doubled over the decade to 2000 from 0.76c a kilowatt hour to 1.47c, an increase of about $200 million a year compared with the level before corporatisation.

The companies have been able to get away with this, argue Terry and Bertram, because they revalued their networks. The assets they were vested with on corporatisation in 1993 were based on historic cost, and the companies moved to optimised deprival value (ODV) whose starting point is the replacement cost of the assets.



This doubled the book value of their networks, from $2 billion to $4.2 billion, and kept the return on investment looking reasonable.

Terry and Bertram contend that from a regulatory point of view, there is no reason for customers to pay more than the minimum required to ensure the financial viability of existing network services and to provide a full commercial return on prudent new investment.

"The central principle is that the owners of a monopoly utility ought not to secure more than a competitive return on the funds actually committed.

"If revaluations are to be taken onto the books, and sustained as market values by the prices set for service, then those revaluations and the associated incremental cashflows that sustain them must be purchased from customers by means either of upfront lump-sum transfers, or subsequently by means of rebates sufficient to protect customers against expropriation of their wealth by the monopoly."

Because the companies have never paid their customers for the revaluation gains they now wish to base their pricing on, any future price path set by a regulator must incorporate rebates sufficient to fully compensate customers, Terry and Bertram say.

When they appeared before the commission, they were asked whether a retrospective clawback would send dangerous signals, in terms of incentives for making efficiency gains.

"Not at all," said Bertram.

"It sends the signal that competitive markets send to all innovators: that you enjoy the fruits of your innovation only in the short run."

It would be a far more dangerous signal if the expectations were to take root among other utilities that uncompensated asset revaluations would continue to be tolerated, he said.

Naturally all this is anathema to the line companies.

Their national body, the Electricity Networks Association, disputes the suggestion that profits derived from efficiency gains have to be shared with consumers to avoid being regarded as excessive.

"After over a decade of reform the scope for efficiency gains is unlikely to be as wide as it once was, and whatever incentive the prospect of additional profits provides to promote efficiency should not be diluted by such a requirement."

The commission, in a discussion paper, has suggested defining excessive profits as anything over weighted average cost of capital (WACC) or possibly WACC plus a margin to reflect the need for extra profits at times to reward innovation.

But Auckland-based Vector says the legislation reference to excessive profits is "a subjective phrase that does not require definition or quantification".

The commission should focus on price and service outcomes for customers, its says, and not concern itself with profits or "inputs" like the weighted average cost of capital.

Vector chief executive Patrick Strange says attempts to measure or limit profits will encourage the manipulation of information, like allocating what should be capital expenditure to operating costs.

"Most importantly, it risks stifling innovation. In the market economy businesses need incentives, such as the ability to retain profits, to invest and innovate."

If rate-of-return regulation is anathema to the companies, another option, CPI-X, is also looked upon without joy.

Under CPI-X, initial prices are set and annual price rises are limited to increases in consumer price inflation minus an X factor to encourage efficiency gains.

Association spokesman Alan Jenkins said the lines industry would have to undertake around $1.5 billion in new investment over the next 10 years.

The industry would be deeply worried by a mandatory downward price path imposed via a universal CPI-X.

"Lines charges are moderate by world standards but the New Zealand lines industry faces many special problems, especially those related to low customer densities."

Strange said that instead of such a complex regime, "a simple but effective means of determining outliers would be to conduct a price comparison across the country from which a reasonable price target or threshold for urban and rural tariffs could be determined. Those whose prices are above this price threshold could then be targeted for further consideration."

UnitedNetworks has a particularly acute interest in the regulatory issue, not just because it is the largest lines company but also because its American majority shareholder is seeking to sell out.

It contends that to have a profit threshold would be inconsistent with the over-riding objective of the control regime - efficiency.

UnitedNetworks instead advocates international benchmarking. "[This] would enable the commission to ensure consumers are receiving fair value (at least as attractive prices and service levels as consumers in comparable jurisdictions) while not having to take a view on the appropriate level of profitability for any particular lines businesses."

This line of argument looks like the conjurer's trick of diverting attention from what he does not want the audience to notice.

Which in this case, Terry and Bertram would say, is more than $1 billion of accumulated excess profits.

They calculate that if revaluation gains are treated as income, the internal rate of return of the 32 lines businesses since 1993 has been 20 per cent a year, in real terms and after tax. That is likely to be more than double their WACC.

Confronted with evidence of excess profits, they say, the regulator has two options.

Either the new price path starts with a price cut to compensate consumers, or the X component of the CPI-X can be increased to include a compensatory rebate.

The commission aims to announce its conclusions by October.

Feature: Electricity

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