Shocking rip-off

By Roger Armstrong

Tuesday 1st October 2002

New Zealand consumers feel ripped off by the changes to our electricity industry over the past decade. According to the inhabitants of talkback radio-land, the government has mucked it up.

To some extent, the grumblings are misinformed. Most price increases have come from eliminating the unfair cross-subsidisation of households by businesses. Other increases were caused by generators being allowed to make returns big enough to encourage more capacity to be built when needed. But the grumblers are spot on in one regard. It seems the major lines companies, which run the low-voltage cables around our cities, have been using their monopoly powers and taking advantage of our light-handed regulatory regime to rake in huge returns.

The amounts involved are not petty cash. The Major Electricity Users Group (MEUG), which has for some time fought against the powerful forces of the lines companies, reckons the three major lines companies between them ripped $171 million more out of consumers in 2001 than they should have.

And to think the Commerce Commission got all huffy with Auckland International Airport recently for allegedly making $4 million excess profits a year. Peanuts.

With only one set of lines along the streets and rural roads of New Zealand, the various electricity lines companies are true monopolies. As such, there is a large body of theory - and a heap of common sense - that suggests the industry should not be able to make more than an appropriate rate of return on capital employed. Enter New Zealand's regulations, which left lines companies to set their own charges but muttered vaguely about them not making "excess returns". Or else.

To most impartial observers, the obvious fair outcome is that the lines companies should not make more in profit than their weighted average cost of capital (WACC), multiplied by the capital employed in the business - as measured by the optimised deprival value (ODV) methodology. ODV is, in effect, depreciated replacement cost, assuming the network was built in the most efficient way possible.

The best part of our regulatory regime is that the 29 line companies have to disclose all their operating and profit statistics. While the average return of the industry is 7%, the three big companies affecting the majority of New Zealand consumers are doing far better than that.

Vector (in Auckland), UnitedNetworks (Auckland's North Shore, Wellington and Tauranga) and Orion (Christchurch) brazenly pushed returns on investment well above their WACC in 2001. The attached table suggests the three companies overcharged by a collective $171 million in 2001, based on the premise that the returns should be limited to WACC multiplied by ODV.

The lines companies will probably argue the toss about what is an appropriate WACC, but MEUG has used a rate similar to that published by Transpower; a good benchmark. Energy and utility consultants Simon Terry Associates (STA) - another to rail valiantly against the might of the lines companies - has calculated that on average the companies made 20% a year returns between 1993 and 2000. That's more than twice their WACC.

STA reckons the lines companies have over-collected about $1 billion from customers over that period. They have boosted their profits not by pumping prices, but by hogging the huge savings that have flowed from corporatisation and avoiding direct control by local bodies.

According to STA, line charges rose only slightly during the 90s. But the average cost to the lines companies of supplying each kilowatt-hour (kWh) of power has dropped from about 2.2 cents to 1.3 cents. As a result, profits have risen from about 1 cent per kWh to 2.4 cents. None of the benefits of the cost savings has been passed on to consumers - probably exactly what you would expect from a monopoly.

Contrast this with Carter Holt Harvey, which over the past decade has cut millions out of its cost base but was forced to give the savings back to customers because competitors have been achieving similar cost reductions.

Or contrast it with state-owned enterprise Transpower, owner/operator of the national electricity transmission grid that links generators to power distribution companies and major industrial users. Its target is to only make its cost of capital; if it earns more than this in any one year, it attempts to give the money back to customers the following year. Government-owned Airways Corporation does the same.

The good news for consumers is that the Commerce Commission, which now regulates lines companies, has begun an inquiry into the industry to examine the option of bringing in price controls.

The commission's initial discussion paper was "soft", in that it was not big on price controls based on capital employed. But since then the commission has produced a report on airports that is a lot harder, advocating price control to ensure Auckland International only makes WACC on the commission's view of asset value. That should have sent shivers up the lines industry's collective spine.

The commission has powerful foes. At recent public hearings, many of the lines companies turned up with huge teams of highly paid lawyers and consultants to argue the case for anything but the WACC/ODV methodology. The cost of all these experts is borne by the lines companies' customer bases, whose interests the consultants are in effect arguing against.

Many line networks have changed hands since the government made power companies separate line assets from retailing activities. Generally the networks have been sold at about twice their ODV values, as was the case with the recent sale of Otago Power, despite the threat of regulation hanging over the industry. At the time of writing, UnitedNetworks, which is effectively up for sale, trades on the share market at around twice its ODV value. These transaction and market values suggest industry participants are expecting continued returns higher than WACC.

Industry players appear to underestimate the regulatory risk. There must be a good chance that the commission will give consumers a break and the lines companies a good hard regulatory slap. If it does, the impact could be felt in the share price of any listed lines company. But the companies, and their investors, would only have themselves to blame.

Roger Armstrong, a former professional analyst, is now an independent financial adviser

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