16 Aug 2006
Infratil's Email Update covering the latest activity figures for Infratil's Airports includes the following comment on the NZ Government Policy Statement on Energy Transmission.
For Infratil's shareholders (and prospective shareholders) the main event of the last week was the conflict between Government's Policy Statement (GPS) on energy transmission,
released on Monday, and the Commerce Commission's announcement of intended price controls on Vector, released
on Wednesday. The infrastructure industry took heart from the GPS which sent a strong message that Government wants infrastructure investment. The Commission's response brought the industry back to ground. For infrastructure companies the cost of capital is crucial. Behaviour by a regulator that increases investor risk will add to the cost of capital, and ultimately to consumers' costs. While the Commission's conflict with Government will add a risk premium, the decision to regulate is also based on some dubious algebra. The Commission's finding that Vector was over-earning was arrived at by deciding that anything better than a 7.35% per annum return on capital was a monopoly rent. It would be very hard to find any expert in the arcane field of cost of capital who would agree with such a low benchmark. Somehow the Commission and its WACC adviser, Dr Martin Lally, managed to achieve this.
Although Infratil's share price was swept along with the capital markets' dismay over the Commission's announcement it should be noted that Infratil sold out of energy distribution several years ago and has no direct exposure to this argument. Further, the proportion of Infratil's income that could ever be subject to this type of regulation is small. Nevertheless, all infrastructure investors support transparent, efficient and balanced economic regulation, and hopefully New Zealand's regulatory
authorities will learn, and improve, from their errors.
NZ Government Policy Statement on Energy Transmission
The Government released a Government Policy Statement (GPS)
on energy transmission last week, which was (perhaps coincidentally) shortly followed by the Commerce Commission
announcing intended price controls on Vector (after Transpower, New Zealand's largest energy distribution company). The GPS is an important indicator of Government policy objectives and will have long term ramifications. The Commerce Commission move shows that the Government's powers in this area are fettered, unless it resorts to legislation.
The GPS enunciated the Government's views on the roles of Transpower and the Electricity Commission in regard to planning the transmission system and the role of transmission in the development of renewable energy:
. Transpower is to undertake the detailed planning role and the Commission's role has been narrowed to an "accept or reject role", against a set of standards and evaluation criteria which are to be defined;
. The Commission's consideration of non transmission alternatives should not entail any security of supply risk;
. Transpower can purchase land corridors in advance and recover costs;
. The grid should be planned to facilitate potential contribution from renewables. Transmission is an important component of having more renewable energy sources (recognizing that a coal-fired station can be built almost anywhere, while wind farms can only work where there is wind, so the transmission link with consumers is important).
The upshot of all this is that New Zealand will plan to invest more in the grid and the Commission will have broader criteria to encourage and allow it to approve investments and that Transpower will be allowed to earn a return on those approved investments. Transmission investment should err on the side of over-capacity to ensure security (ie better to have back-up than a break-down). This is expected to mean a higher cost to users (the Government has effectively interpreted the electorate/users' mood and decided they would prefer to pay more for certainty).
In addition to indicating its preferences for transmission development, the Government also signaled that it hopes to see local energy companies investing in their networks. To this end it advised ComCom to make sure that its regulation of network pricing was not discouraging desirable investment.
The general interpretation of the GPS was that Government had become concerned that the Commerce Commission and the Electricity Commission were more interested in controlling prices than in making sure that investment was undertaken for secure supplies and a for renewable generation future and that generally the Commerce Commission should be willing to "cut infrastructure companies some slack" as under-investment is a worse outcome for the Nation than a small level of excess profits - especially as "excess profits" tends to be a function of some fairly dense algebra where even experts admit to the need for a margin of error.
However, no sooner had Government's GPS been welcomed by the market than the Commerce Commission released its draft decision to price control Vector. The Commission's Chair indicated that she had fully absorbed the GPS, but nevertheless found it should progress the regulation of Vector. A number of aspects of the Commission's justification for its decision have raised hackles. In particular its decision to use a very low cost of capital (7.35% pa) and a change in the treatment of Vector's tax circumstances. Most commentators feel these actions are not consistent with the GPS "cut some slack" message.
A key point with all this is that the Commerce Commission is independent of the Government. The latter can make policy statements, but the Commission is not bound by them. Ultimately the Government can bind the Commerce Commission by enacting law. It also appoints the commissioners (a key difference between the Commerce Commission and High Court is that Judges are appointed via a more independent process until they retire (by age 72), whereas commissioners are recommended for appointment by the Minister of Commerce for up to 5 year terms).
The GPS is important for infrastructure investors because it shows that the Government is putting service forward as the priority. However, as the Commerce Commission's decision over Vector shows, there can be "many a slip between cup and lip" when it is up to agencies to make their own interpretations of the Government's intentions.
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