Brian Fallow: Officials' capital costings under fire

COMMENT

Dismay and scorn have greeted the Commerce Commission's estimates of the cost of capital in two recent cases.

The arguments about how to estimate the weighted average cost of capital in Telecom's Kiwi Share obligations or in designing regulations for electricity lines companies are arcane.

But the arguments matter, because the regulators have a fine line to tread.

If they set the rate too high, consumers pay more that they should; if they set it too low, they risk economically costly under-investment in vital areas of infrastructure.

Critics of the commission say these risks are not equal. Profiteering utilities or gold-plated networks are costly, but the cost of the lights going out or internet access slowing to a crawl would be greater.

The stock exchange says the commission has erred on the low side.

It says the 6 per cent weighted average cost of capital struck in the commission's draft determination on Telecom's local residential service obligations "fails the sanity test".

Infrastructure companies make up 45 per cent of the sharemarket by market capitalisation, it says. Attracting investment in them will be difficult where the commission determines a very low WACC.

And these are the companies in which the investment is needed if the economy is to prosper.

In a submission on behalf of Infratil, Vector and the stock exchange, Professor Tony van Zyl - a Victoria University colleague of Associate Professor Martin Lally, the commission's external expert on WACC - says the commission's decisions will cast a shadow beyond the regulated industries.

"Once regulation exists for one sector there will inevitably be other sectors which perceive themselves as being subject to the risk of also being regulated.

"These sectors will therefore tend towards behaviour that will avoid ... the very threat of regulation."

To avoid having regulation imposed on them, they will end up behaving in much the same way as the regulated industries must.

The WACC issue arises for Telecom because of its Kiwi Share obligations.

These include maintaining free local calling for all residential customers, limiting increases in line charges to the rate of inflation and meeting services quality standards.

It is able to recoup from other telecommunications companies a share of the cost of meeting those obligations, defined as the costs (including the cost of capital) which an efficient provider of those services would incur.

For electricity distribution businesses, the WACC issue arises because of the regulations being developed for them.

If a lines company attracts attention by increasing its charges too quickly - as defined by the commission - or not meeting quality standards the commission will look at whether to impose control.

Its profitability, relative to the commission's notion of a fair WACC, is likely to figure largely in that decision, and the control imposed might be rate of return regulation.

In an August draft assessment, the commission said it proposed to adopt Lally's estimate of WACC for lines companies.

He came up with a range of 5.8 to 8 per cent, with a most likely value of 6.8 per cent.

But the WACC turns out to be a slippery sort of number to estimate.

Several variables go into it, of which the three most contentious are the risk-free rate, the market risk premium and the beta.

It is the weighted average of the cost of debt and equity funding.

Both are at a some premium to a risk-free rate, taken to be the yield on Government stock.

But Government bond yields vary over time, and at any one time differ for different maturities or terms.

Despite submissions that it should take the longest maturity available, the 10-year Government bond, to reflect the long-lived nature of the assets concerned, the commission has gone for one-year stock as the risk-free rate in the Telecom case and three-year stock for lines companies.

In both cases, this reflects the interval between regulatory resets of the WACC.

The cost of equity capital is at a margin above the risk-free rate, driven mainly by the market risk premium and the asset beta.

The market risk premium is the compensation investors require for the greater risk associated with providing equity capital compared with debt. It applies to the sharemarket as a whole.

The commission's most recent published view on that is that the premium, adjusted for tax (another area of contention), is 7 per cent.

This is based on taking the simple average of half a dozen different methods of estimating the premium.

Van Zyl criticises an approach which treats all the alternative methods as equally valid, and comes up with a estimate of 9 per cent.

Most vexed of all the parameters is the asset beta, which reflects the fact that some companies or sectors are seen to be more or less risky than the sharemarket as a whole.

It is a measure of the degree to which the business, if funded entirely by equity, would rise and fall with the sharemarket generally.

Utilities are generally seen as less risky, implying a beta of less than 1 - that is, it would fall by less than 1 per cent if the market as a whole fell by 1 per cent.

But how much less? Again there is wide disagreement on how to estimate it.

Because the Kiwi Share-related part of Telecom's operations is not separately traded, its share history cannot resolve the matter. Some proxy has to be found.

The commission settled on United States electricity companies as a comparable group of enterprises.

Telecom disagrees, saying telephone services are more discretionary than electricity and their pace of technological change is faster.

The commission settled on an asset beta of 0.2 to 0.4, with a mid-point of 0.3, for Telecom and 0.3 to 0.5, with a mid-point of 0.4, for the lines companies.

But accountants PricewaterhouseCoopers estimated Telecom's range should be 0.73 to 0.83.

And brokerage JB Were's estimate of Telecom's "fundamental" beta, based on US industry betas adjusted for New Zealand circumstances, was 0.86.

The Business Roundtable says that because of the expert opinions to the contrary, it sees no way that Telecommunications Commissioner Douglas Webb could establish an objective basis for limiting the beta range to 0.2 to 0.4.

That is merely one indication, the Roundtable says, of the artificial, arbitrary and wrongheaded nature of the whole exercise.

"The commissioner has to determine what subsidy would be necessary to induce the company to invest in and supply those services voluntarily in the absence of the imposed obligation," it says.

"This is fundamentally a question about subjective entrepreneurial judgements."

It concludes that the commission has been given an impossible task because of the "deeply subjective and unknowable nature of the central issues at stake".

And it says the commission should tell the Government this.

How it works

The Government has expanded the Commerce Commission's regulatory role in telecommunications, electricity and gas.

The commission has to decide a fair cost of capital for providers of those services.

The companies and the stock exchange claim the commission's preliminary numbers are much too low and as a result will choke off investment in essential infrastructure.