Monday, 28 July 2014

WACCy thoughts

All right, it's a terrible title, but how else to tempt people into a topic that usually prompts reactions of the "Goodness, is that the time already? Must dash" variety.
WACC - the weighted average cost of capital - is, obviously enough, a key concept in regulation. WACC times the regulated asset base is what regulated companies are allowed to earn. And it's back in the spotlight since the Commerce Commission said it was minded to reduce the WACC it allows to electricity and gas lines businesses.
The quick potted history behind it is that the regulated companies challenged pretty much everything about the way that the Commission went about its regulatory business, a challenge which ended up in the most enormous bunfight in the High Court. The upshot was that in December last year the companies were routed on almost everything.
But along the way the High Court judgement (rather large 4.1Mb pdf here, the relevant bits are paras 1422 to 1492 on pp475-92) cast its beady eye (or three sets of beady eyes, since the judge was, understandably, assisted through the densely barbed economic undergrowth by two expert lay members) at one feature of the Commission's WACC setting. That feature was its practice, once it had established a sort-of-statistical-distribution of possible WACC estimates, of choosing a point estimate of WACC that lay three-quarters along the distribution (i.e. well above the mean).
This was known as the "75th percentile" approach, and was done with eyes wide open, on the basis that the costs of allowing too low a WACC were worse than the costs of allowing too high a WACC. Yes, allowing the regulated companies too high a WACC might enrich their profits at consumers' expense, but that was likely, even from consumers' perspective, to be a price worth paying, as the costs of too low a WACC (and so too little investment) could be catastrophically high in the long run as insufficiently maintained networks fell over.
You can gussy up the argument in various ways - asymmetric payoffs, dynamic efficiency trumps everything, the need to keep the lights on - but the Commission's approach looked sensible however you inspected it. I was certainly on board with it. For much of the same reasons, when I was involved, I was happy to go along with the 75th percentile of overseas benchmark estimates of domestic telco costs.
And then the High Court gave me - and, as it transpired, the Commission - pause for further thought.
First, it said, at [1462], "No supporting analysis was provided by the Commission. Indeed, the propositions advanced for choosing a point higher than the mid-point seemed to be considered almost axiomatic". But, the Court said, it's ain't necessarily so, and quoted at [1468] an Australian decision which had said that "We accept that it is possible that there may be asymmetric consequences
associated with setting a WACC too high or too low. However, it is not clear to us that the asymmetry would always imply that overestimation of the WACC led to a lesser social cost than underestimation of the WACC. The nature of the asymmetric consequences of incorrectly setting a WACC is likely to depend on the circumstances of a given matter" (I've italicised the always just to bring it out).
And then the Court asked ([1472-1477]) a series of rather unsettling rhetorical questions (otherwise described as "some tentative in-principle arguments counter to the Commission’s reasoning"). Why isn't a normal profit enough? What's to prevent lazy monopoly utilities from trousering the profits instead of investing or innovating? What about the costs to other parts of the economy of higher than necessary utility bills (an especially good question, I thought, given the potential dead weight on our exporters of uncompetitive domestic service industries, as discussed here and here)? And why do so few other regulators do this sort of thing?
Outcome: [1486], "we would expect ['expect' here being the judicial, royal or parental 'expect'] that our scepticism about using a WACC substantially higher than the mid-point, as expressed above, will be considered by the Commission...further analysis and experience may support the Commission’s original position. But they may not", and another quote from that Aussie decision: "there exists as a matter of theory the potential for asymmetrical consequences should the WACC be set too low or too high. Which of these consequences will carry with it the greatest social damage is not a matter solely for theory, however, but for robust empirical examination, well-guided by theory, of the actual facts of any particular case".
I'm sure the Commission's subsequent announcement that the 75th percentile was in play had utility CFOs and their boards having kittens. The Major Electricity Users' Group, for example, had estimated as part of the High Court hearings that going from the 75th percentile back down to the mean would transfer nearly $130 million from the utilities back to consumers, so big bikkies were at stake. And there were other potential downsides, too, including some collateral damage to the regulatory process itself, if key bits were to get changed midstream.
The current state of play - there's a media release here, and the full draft decision here - is that on July 22 the Commission  plumped for a WACC at the 67th percentile (the midpoint of a range from 60% to 75%). There's a whole bunch of supporting expert reports here if you like.
My own take on it? It's broadly a good outcome. There's (for me) the odd loose end - that point the High Court had, about the costs to the rest of the economy of higher than necessary utility bills, has been magicked away in ways I don't understand - but overall, it stacks up.
The Commission's original intuition may not have been very well documented or explicitly reasoned, but it felt right, and as it transpires, when you run formal models that attempt to measure the potential benefits against the potential costs of a WACC set a bit on the high side, the high side stacks up (there, that saved you reading most of the experts' stuff). But not too high, mind: if you take a "follow the money" approach, for example, investors seemed to be willing to pay well over the regulated asset value for some of these utilities when they were allowed the 75% percentile WACC, suggesting it's a bit on the generous side.
So the Commission's decision that you need at least some uplift to the mean (the 60th percentile is as good as any), but not too much (75% tops), split the difference, call it 67th percentile - it's not pretty, but it serves, and not least by avoiding abrupt and sizeable jumps to regulatory settings. There's no precision to be found here, and as usual in regulation, and a lot of other issues besides, getting to approximately right is a good day's work.

2 comments:

  1. It turns out that the consequences of taking a merit appeal are not always asymmetrical either...

    While I enjoy the irony, if I was a lines company shareholder I would be wondering about the money spent pursuing the merit appeals, only to (1) gain nothing and (2) have the High Court suggest the Commission lop a chunk off your WACC.

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  2. I agree. It may well have been that the companies looked at merit appeals as offering only potential upside to the status quo, and didn't factor in either the downside risks or the legal and other costs of the upside. And did any of them sit around their board tables and say, "listen lads, just between us, we could probably live with where the CC is at, let's get on with running the whelk stall"?

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