Dialogue: How much is that asset in the window?

By BRIAN FALLOW

The Commerce Commission has sent a shock wave of consternation through the owners of monopoly infrastructure assets with its draft report on the price control of airports.

Normally, arcane theoretical debate about how such assets should be valued is eyes-glaze-over stuff.

But by one reckoning, that of economic analysts Simon Terry Associates, the prevailing methodology, optimised deprival value (ODV), means that electricity and gas consumers are paying about $260 million a year over the odds.

On the other side of the argument are the owners of infrastructure assets valued on an ODV basis.

Investors have bought, or bought into, electricity lines companies, gas pipelines and airports on an ODV basis.

"There's an edifice of value built up on that particular model," says Tim Brown of infrastructure investor Infratil. To undermine its foundations now would be wrong.

Usually ODV boils down to ODRC, the optimised depreciated replacement cost.

In crude terms the idea is that because these essential assets exist you avoid the cost of replacing them. However, eventually they have to be replaced, so depreciation reflects how far along their - usually long - economic lives they are.

If they were replaced there would typically be bits that would not be replaced, arising from past mistakes or miscalculations, which have to be lopped off the valuation. That's the optimised bit.

This month, the commission released a report outlining its preliminary findings from an inquiry initiated by the Government three years ago into whether price control should be imposed on "airfield activities" at Auckland, Wellington and Christchurch airports.

The thinking underlying the report is seen as menacing for the owners of other natural monopoly assets valued at ODV.

In competitive markets, the commission says, prices are set independently of asset values and the current value of a business reflects the present value of its future cashflows. Prices determine the value of the asset.

But where markets are not competitive, such as airports, it is the other way round.

"The higher the asset valuation, the higher the revenue needed to generate the required return on assets and the higher that prices need to be."

One of the principles underpinning the commission's analysis is that "Today's consumers should only bear today's costs."

Applying that principle to improvements on airfield land such as runways, taxiways and aprons, they conclude that those assets should be valued based on their historic cost.

"The use of replacement cost would run contrary to the commission's view that today's acquirers of airfield services should only bear today's costs. Historic cost ... provides investors with a return on the amounts invested and preserves incentives to invest in the future. Investors are compensated for inflation through the use of a nominal WACC."

WACC, the weighted average cost of capital, is seen as a benchmark for a reasonable rate of return on natural monopoly assets.

The principle of today's consumers bearing today's costs also leads the commission to conclude that airports should not be able to seek from airlines a return on land held for future developments, such as Auckland's second runway.

"The commission's preliminary view is that pre-financing of new investment is generally inappropriate. Only used and useful assets should be included in the asset base."

In the real world, however, that would have fundamental ramifications, according to Mr Brown.

"If Auckland [airport] is not able to generate a satisfactory rate of return on the land it is holding in reserve, then Auckland will not get a second runway."

Auckland airport has been in a state of almost perpetual reconstruction for a decade and will be for another decade, he says. "In a situation like that you have got to take a long-term view."

Auckland airport revalued its assets on an ORDC basis in 1999, boosting the book value of the company by $281 million to $813 million.

A report commissioned by Air New Zealand from Simon Terry Associates concludes that if the airport company were to seek a rate of return on the revaluation in line with that achieved historically (around 14 per cent) that would result in recurring charges of around $40 million a year.

It doesn't automatically follow that the airport will seek such a return.

But the company has set its landing charges for the next three years. The Commerce Commission, based on its own views of how the asset base should be valued and what a fair WACC would be, calculates that over the next three years the excess return will be $3.8 million, $5.4 million and $7 million.

Alan Jenkins of the Electricity Networks Association says, "For the commission to impose price control the first principle has to be that some consumer has been treated unreasonably. I don't think it has got a case for stepping in and saying, 'We don't like your valuation methodology, therefore we are imposing price control'."

It remains to be seen whether the commission's final report, following a second round of submissions and a public hearing in September, will stick with the preliminary views expressed in the draft report.

Even if it does, Commerce Minister Paul Swain will have to weigh the commission's view against whatever advice he receives from the Ministry for Economic Development. It drew up the ODV regime and is thought still to view it with a fond father's eye.

For Simon Terry, a longstanding critic of the ODV approach, the commission's airport study is "an important line in the sand for monopoly service providers".

His firm had used the same approach in estimating overpayments by electricity and gas consumers - $200 million and $60 million a year respectively.

A report by Mr Terry and Dr Geoff Bertram on the electricity lines companies last year said that while the average lien charge had remained at around 3c a kilowatt hour for the past year, the companies' operating costs had fallen considerably.

"As there is little incentive for a monopoly supplier to share these savings, gross operating surpluses have grown substantially. These have doubled over the past decade from 0.76c/kWh to 1.47c/kWh, an increase of about $200 million compared to the level before corporatisation."

For the six years since the companies were corporatised in 1993 their "true" rates of return (combining operating surpluses and the capital gains from asset revaluations) were between 16 and 23 per cent after tax. That is more than twice the range the MED indicated as appropriate.

This conclusion, and a similar one for gas released this week, depends on treating revaluation gains as income, which ought to be taken into account in calculating the companies' underlying profitability.

The Caygill inquiry last year took the view that they should not.

But Terry and Bertram argue that if prices are raised in line with the increased asset values without any offsetting adjustment, the owners reap windfall gains which are more than a one-off boost. They effectively earn a return on capital that has never been invested in the business.