Electricity nationalisation as an election issue

Stephen Franks

Labour has dumped its self damaging policies on GST exemptions. They should kill off one or two others before the election spotlight exposes them as similarly dumb. Prime candidate is the "NZ Power" nationalisation of generation, the most competitive, most risky, most capital intensive part of our industry. Adding political risk to the already daunting risks of investment decisions in generation where we have a world standard regime is nuttiness of the kind that resounds for decades.

Ask Max Bradford, and his was merely an early implementation of the regulatory separation that is now orthodox and respected around the world. In electricity, the economic consequences of wrong judgments last for decades, but the political consequences of unpopular changes last for the perpetrator's lifetime, and that is just when they are orthodox.

The best advice to a politician awaiting evisceration over a mistake is to spill all yourself. David Parker could earn respect in the long term if he said now that his brain-child was premature, and that after all the feed-back what he should have promoted was a resource rental charge on water through the turbines. The absence of such a charge is the only argument that even partially rescues his scheme.  To avoid distorting generation too far against hydro he could introduce it at the same time as Labour make the carbon charge bite, which they may be obliged to do by the Greens..

If he withdrew NZ Power shortly he could easily endure the mockery from National. The credit would outweigh it, as long as it did not appear to have been forced on him by David Cunliffe. At this stage of the cycle the mockery would be harmless by election time.

As a balancing position he could also undertake to over-ride any Commerce Commission failure to undertake an early review of the electricity distribution price control Input Methodologies on return on capital. That would ensure that at least part of any increase in the cost of electricity from a water price would be offset in the charge to consumers, by reducing the excess returns where there is a market structure (monopoly) problem.

For those who have not understood my earlier posts here and here on the High Court’s decision on Wellington International Airport Ltd & Ors v Commerce Commission, the 13 December edition of Energy News explains the issues. With their consent, here it is in full:

High Court urges ComCom to revisit energy sector WACC

Gavin Evans Fri, 13 Dec 2013 – published by Energy News www.energynews.co.nz

The Commerce Commission has been put on notice to reconsider how it uses the range of capital costs it calculates for the electricity sector.

The High Court has endorsed the input methodologies the commission uses in regulating electricity and gas distributors. But in a ruling issued late Wednesday, it says alternative proposals put up by the Major Electricity Users’ Group raised “significant doubt” about the commission’s decision to apply a weighted average cost of capital based on the 75th percentile of the industry range the regulator calculated.

MEUG had argued that the commission’s choice of the 75th percentile instead of the mid-point of the range showed an inappropriate bias in favour of suppliers and was unnecessarily generous. It calculated the difference between the two post-tax WACC estimates – 6.49 per cent and 7.22 per cent – would cost electricity consumers close to $129 million a year.

MEUG argued for a mid-point WACC, or for the commission to adopt a two-tier system with the higher return from the 75th percentile only available on new investments.

The court observed that it was probably understandable that the commission, establishing a new regulatory regime, would not want to risk deterring investment by providing too low a rate of return.

But the court – comprising Justice Denis Clifford and lay members Robin Davey and Rodney Shogren – doubted applying the higher WACC to a firm’s regulated asset base was necessary to promote investment and innovation.

Not rational

“The idea that greater revenues produced by higher allowed earnings on past investments (ie on the initial RAB) provide the wherewithal for more future investment is contrary to rational investment choice," the court said in its 661-page decision.

“Those existing higher earnings, once earned, are a given. The source of funds for future investments does not influence the riskiness of future investments; nor, therefore, does it influence their attractiveness. If anything, an abundance of capital is likely to lead to wasteful investment.”

But without more positive supporting evidence from MEUG, the court said it was not able to be sure that a mid-point WACC would have produced a `materially better’ input methodology – the standard to be met in a merits review appeal.

For the same reason it had no means of implementing the group’s `two-tier’ WACC suggestion and the commission’s doubts about it could not be addressed. Accordingly, the court left the commission’s 75th percentile choice unchanged.

“We are mindful that the IMs will be reviewed. At that time, we would expect that our scepticism about using a WACC substantially higher than the mid-point, as expressed above, will be considered by the commission.

“We would expect that consideration to include analysis – if practicable – of the type proposed by MEUG. We would also expect the commission to consider MEUG’s two-tier proposal in light of our observations. We acknowledge that further analysis and experience may support the commission’s original position. But they may not.”

Win for consumers

MEUG executive director Ralph Matthes says the decision is a win for the group and potentially for consumers. Next time the input methodologies are up for review, a move back to the 50th percentile will definitely be “on the table.”

But given the large sums involved – a reduction of about 4 per cent, or $20 million a year, in the gross revenue from Vector’s electricity business alone – the group will try to get early action from the commission, Matthes says.

Whether that could be achieved before the start of the next regulatory period starting in April 2015 is unclear, but the group will certainly investigate that.

“I think there’s an urgency to actually undertake that review,” he says. “We’re talking about some pretty big sums.”

MEUG was among nine parties that went to court in September last year to challenge the input methodologies the commission settled on in December 2010 to police the returns of electricity and gas distributors and some services provided by the Auckland Wellington and Christchurch airports.

Other appellants included Powerco, Transpower, Wellington Electricity Lines, Air New Zealand and the airports.

Leverage

The WACC range was one of four appeals MEUG lodged. Matthes says it was defeated on two minor claims relating to how debt issuance costs and asset betas should be applied in the cost of capital calculation.

But he says the court also gave some support on its argument around the commission’s treatment of leverage in the WACC calculation.

In setting the mid-point WACC at 6.49 per cent, the commission assumed a notional leverage of 44 per cent for Transpower and the electricity and gas distributors.

MEUG had argued the model the commission used should have either assumed no leverage, or should have had debt beta added to provide a more reasonable figure.

The court did not accept MEUG’s “novel” proposal, but nor was it satisfied that the commission had really addressed an anomaly in the capital asset pricing model it used in which WACC increased with leverage, when it should have fallen.

“The commission’s estimate may overstate the WACC. MEUG’s proposal certainly understates the WACC,” the court observed.

Matthes says the issues are complicated and MEUG’s proposal is at the leading edge of finance theory and regulatory practice. The group has gathered more information since 2010 and will keep working away at the issue.

 

“We’re not going to give up on bringing that one back into play.”

Stephen Franks is principal of Wellington commercial and public law firm Franks and Ogilvie.

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11 Comments & Questions

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Just another lawyer/politician who has no understanding of the bigger picture.

What high electricity prices has done has encouraged greater supply than demand. Artifical high price fixing has created this situation, and in turn encouraged more creation.

The business executives should have been aware of this situation, as they have all the statistics under the sun to determine that electricity demand is not going to be the same in the future, with advances in technology and energy efficiency. This suggests most running the current power companies arent very good at their job, or that they were only interested in short term bonuses. In truth, its probably a mix.

High power prices are fine, if all profits lead to Rome; i.e. NZ inc monetary system. They just become an indirect tax. Unfortunately, when you add Contact & Trustpower to the equation (& now MRP and Meridan), some 30-40% plus of this super profit made on engineered high power prices leaves the country on the back of dividends to overseas owners of shares. This excludes the byproduct of high prices being inflated share prices, which I see overseas interests have gotten rid of lately (probably to NZ inc).

This is why I am in favor of Labours plan to have a single pricing structure, which will take out market distortion. Give business executives an inch, the take a mile; tax minimisation being an example.

Most power companies now have a significant overseas interest, and over inflated power prices become just a private tax on a core need; not unlike the charges the banks get away with.

I should have worked this out before buying shares in MRP; thankfully not too many. I was, unfortunately driven by my heart, to try and keep as much shareholding local. Fool I was.

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Imagine how the rest of the world would view the wholesale nationalisation of NZ's entire electricity market. At the moment the world views NZ as almost a Utopian society, a place where progressive social ideology and business not only coexist but thrive.

Replacing this with a nationalisation on an unprecedented scale would terrify foreign businesses of doing business in this country and squash foreign direct investment.

I hope Labour reconsiders this as they have already achieved what they sought out to do which is cast the privatization of *minority* interests in SOE as a bad thing to do. National have already paid dearly for this and was politically silly and poorly executed. It may cost them the election. I suspect Labour's real interest is just in winning the election so lets hope they don't double down if they've already achieved what they set out to do.

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Labour will have a coalition partner who will push NZ Power through. Big state knows best.

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If great chunks of that bastion of free markets (the USA) is included in 'rest of the world' - then they use this centralised system now!

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Prices paid for water itself are different from water tariffs. They exist in a few countries and are called water abstraction charges or fees. Abstraction charges are not covered in this article, but in the article on water pricing http://en.wikipedia.org/wiki/Water_tariff

In most countries there is no charge for abstracting water directly from rivers, lakes and aquifers. However, some countries do levy volumetric charges or fees for water abstraction rights. These charges are typically levied on industries, utilities and farmers. Fees for water abstraction and discharge exist for example in France, where revenues are significant and are re-invested in the water sector by water agencies established in major basins. In Germany abstraction fees exist only for groundwater and only in some states, and their proceeds go into the general state budget. Mexico also charges for water abstraction and returns proceeds to utilities, but not to industries. Outside the OECD countries few countries charge water abstraction fees. Where they are applied the level of fees tends to be nominal, such as in Morocco, or enforcement is partial, such as for groundwater abstraction fees in Jordan. In almost all countries that have introduced abstraction fees agriculture, the major water user world wide, is exempted from abstraction fees. Some countries allow water rights to be traded, so that the price for water itself is formed in the market. Such water trading exist in parts of Australia, Chile and the Southwestern United States).
http://en.wikipedia.org/wiki/Water_pricing#Direct_abstraction
.

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Mr Parker will do what he sees as most likely to leave National looking like the loser. Nothing to do with what is best for the govt. or the consumer. Sad, sad politics which I expect from the Greens with their wacky ideas on state ownership, but an irresponsible stance from Labour.

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Stephen Franks, despite being an intelligent and nice guy, you are to me an unfortunate symbol of what is wrong with those who identify themselves with being on the free market end of the spectrum.

Sadly what it seems to boil down to is that in many cases you support the regulatory state almost as much as the next guy, you just stand for a more reasoned, analytic, principled and judicious management, government and operation of the regulatory state. If only we could have more high minded and commercially savvy people in Parliament, the government and the courts etc. things would be honky dory (competitive economy, investor confidence or whatever other rubric or catch phrase you like to describe it by).

What is sad about it is that it makes many people think that this is the social vision of personal and economic freedom. Personal and economic freedom stands for a structural change in society, not a change of people running the regulatory state. It is a social vision where social, personal and commercial problems are worked out by negotiation, selection, trial and error, profit and loss, and the building up of social and commercial norms or customs for how different issues or transactions are handled or resolved.

Competition, properly understood and in the free market social vision, is a process not an outcome, and not a quantity or level. Competition is not the result of the regulatory state. When the regulatory state mandates a particular industry structure, and mandates regulated terms of access and the like, although the result may appear to be a competitive market, the reality is that it is a distorted and inefficient artificial construct.

Competition is so much more than the elimination of economic profits through market entry and the elimination of economic losses through market exit. Although this is part of the meaning of the term competition, and presents a vivid spectacle, it is the hidden competition between different methods of production, different methods of delivery, different product bundles, different sales or procurement terms, and different business models that drive the discovery and development of socially beneficial practices and the elimination of socially wasteful practices.

There are many considerations in driving changes in market or industry structure: asset specificity, economies of scale, economies of scope, market power, financing sources and opportunities, and more. State monopoly and competition regulation use the regulatory state to address one concern (market power), and they address this concern by regulating major aspects of the market including industry and market structure. The opportunity cost of this form of state regulation of industry is seldom appreciated: it means that other drivers of efficient industry and market structure are impeded.

Back to Mr Frank's approach to the issue and what is wrong with it: the implication is that people as clever, well resourced and studied, can determine the optimal industry structure, and can mandate it, obviating the need for the messy trial and error process of the free market to discover or test it. The best argument for a free market in a product is not to show that it produces the most efficient structure and outcome: if it were possible to make such an argument it would be an argument not for a free market but for a state regulated market, where the state simply mandates the outcomes and practices it determines are optimal. We who advocate free markets do so not because we can show that they lead to the most socially efficient outcomes every time but because we believe that it is better to have outcomes discovered and implemented spontaneously driven by action in the market place. We believe the drivers of the market place are humane, civilised, and effective in delivering outcomes that are economically efficient even though not perfectly so. No matter how clever and nice he may be, and however useful as an adviser for those who have to engage with the regulatory state, please understand: he's not one of us. He does not represent freedom in any comprehensive or overall sense of the word.

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Unfortunately the electricity market has resulted in high prices for residential consumers - high enough to subsidise commercial and industrial users,according to the latest reports from the Electricity Authority. This reflects that lack of market power for residential consumers.

The EA is right to claim that many state hydro investments were subsidized by the taxpayer - but why should the taxpayer (residential consumers) now pay a commercial rate on renewables with low running costs?

Also why should the EA use the levy it collects from residential consumers to run an ideological campaign against the consumers interest? Is this legal? Or moral?

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This is a highly technical detail that will have little effect.

Let's have some articles on how electricity is purchased for residential consumers in the USA. My impression is that they recognise that residential consumers are easy meat in the open market....let them eat cake with pre-pay meters you say? Electoral suicide.

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Stephen - your comments appear to laud all of Bradford's reforms - is this was you meant?

Are you really suggesting that some 30+ retailers are providing effective market competition for electricity in such a small country as NZ? Are you suggesting that complete the separation of distributors and retailers has proven to be ideal?

An interesting contrast occurs in Victoria Australia where the initial Chair of Transpower, Peter Troughton, did the state's energy reforms and privatisation.

When he aggregated the market from the previous municipal authorities, he decided the optimal number of retail competitors was something like 6. He required privatisation purchasers to lower prices over 5 consecutive years, adjusting for the CPI. There is still a requirement for power companies to submit their financials to Government confidentially each year to ensure there is no rorting occurring. All done under a conservative (Kennett) government.

Victoria's power prices are now considerably cheaper than New Zealand, there is effective competition, and energy costs are a major factor encouraging manufacturers to move to the state (including from New Zealand).

What do we have? A major retailer fooling consumers by promising to hold prices for four years when internationally prices are dropping due to weaker demand!

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The fundamental problem with the current design of the electricity market is that the incentives do not line up with the objectives.

The objective has to be a reliable supply of electricity at the lowest possible price.

The reforms deprived the lines companies of an inducement to control peak demand. So our once world leading ripple control system is now in the collected and the peak demand is well above what it needs to be. The consumers pay. Instead of limiting lines cut the demand to minimise the need for system reinforcement, the lines companies spend millions of dollars expanding the system so that it can meet unrestricted demand. To them, it is profitable. To the consumer, it is a dead loss.

We need to keep reserve generation available to keep the lights on during dry years. The market does not pay anything to the generators who hold reserve generation. Reserve generation should be regarded as a national insurance policy.

The problem is that this market was devised by academic economists who did not – and still do not – understand the the complexities of electricity business. Until that is changed electricity will cost more than it needs to and the supply will be less reliable than it should be.

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