POWERCO’S SUBMISSION TO THE COMMERCE COMMISSION IN RESPONSE TO ITS DRAFT DECISION PAPERS OF 23 DECEMBER 2002 AND 31 JANUARY 2003 Introduction This document supplies Powerco’s submission to the Commerce Commission, in relation to its draft decisions relating to the Regulation of Electricity Lines Businesses (31 January 2003). Powerco has contributed at every stage of the Commerce Commission’s process in establishing a method of price control for electricity lines businesses. Powerco’s stance has been to support the development of a workable, fair and even- handed regulatory structure, that delivers long term benefit for consumers while still providing incentives to businesses to operate efficiently and effectively. However, Powerco has serious concerns about the proposals contained in the Commission’s January draft decisions. Our concerns relate primarily to: · The effectively universal nature of the control proposed; · The proposals’ inconsistency with achieving the purpose statement; · The likely impact of the proposals, including flight of capital from the sector, a loss of dynamic efficiency, and a deterioration of infrastructure due to reduced investment in maintenance and improvement. This submission includes a number of parts, namely: · The summary of our legal arguments; · Our responses to the Commerce Commission’s specific questions, and · Submissions from Powerco’s expert witnesses: o John Hagen – Chairman, Deloitte Touche Tohmatsu (NZ) o David Emanuel - Professor, University of Auckland o Barry Upson - Chairman, Powerco Limited o Kerrin Vautier – Research Economist o Alan Tregilgas – Practicing Utilities Regulator in Australia o UMS Group – International Utilities Benchmarking Consultancy o Steven Boulton – Chief Executive, Powerco Limited Each element of the submission deals with a different aspect of Powerco’s argument against the current Commerce Commission proposals. THRESHOLDS, ASSET VALUATION, AND INFORMATION DISCLOSURE Executive Summary 1 Powerco’s first argument is that the proposed thresholds are unlawful as they amount to universal price control. There are related arguments of unlawfulness as to components of the Commission’s proposed thresholds. 2 The second argument is that, lawfulness to one side, components of the proposed thresholds are inconsistent with Section 57E (and Section 1A) as to: (a) WACC (b) “X” factors (c) Point estimates as opposed to ranges of tolerances (d) Using a starting value of recalibrated ODV which is too low 3 Thirdly, there are substantial detriments inherent in the Commission’s proposal including: (a) There are no incentives for investment or efficiency improvement (b) There will be dynamic efficiency losses (c) There will be capital flight from this sector none of which has been assessed by the Commission as part of a regulatory impact assessment which is an implicit requirement of Section 57E, given the umbrella objective of “long term benefit of consumers”. Timeline 4 On 8 August 2001 Part 4A, Commerce Act 1986, was implemented. 5 On 21 March 2002 the Commission issued its first discussion paper. Particular aspects to be noted are these: - 2 - · The Commission gave considerable weight to the purpose statement in Section 57E (paragraphs 1.1 – 1.5). · The Commission noted (paragraph 1.6) that thresholds are intended to provide incentives to all regulated businesses to modify their behaviour and will affect all large electricity lines businesses. · The Commission proposed four possible thresholds (paragraphs 1.10 – 1.13, 8.2). · The Commission then analysed different mixes of the four thresholds, concluding that Option 1 best met the purpose statement of the Act (paragraphs 1.15, 1.18, 6.22, 6.36, 8.61 – 8.63). · Option 1 involved two components: an indexed price path and a benchmarking study with a quality criterion. · The Commission explicitly recognised deficiencies in other options (eg paragraph 8.49). · The Commission set out its proposals for control including price caps, the setting of P0 and X together with objective quality standards. 6 Powerco, and other lines businesses, set out their concerns that the proposed thresholds amounted, effectively, to universal control and were thus unlawful (eg see paragraph 2.15, UnitedNetworks submission May 2002; page 5, Powerco submission 9 August 2002). Lines businesses were particularly concerned that undue weight had been given to identifying and removing “excessive profits”, which was argued to have flowed from an overly mechanistic interpretation of Section 57E(a). 7 On 23 December 2002, effectively the last business day before Christmas, the Commission issued a paper on thresholds, asset - 3 - valuation methodology and information disclosure, which set out a bare bones proposal with very little reasoning (the December Draft Decisions). 8 On 31 January 2003 the Commission published a further paper, fleshing out some of the details in the December paper (the January Draft Decisions). The proposed thresholds had changed from those set out in the December paper. 9 Powerco argues that the Commission’s proposed thresholds now include proposals previously recognised as deficient by the Commission in its March 2002 discussion paper. Procedural Deficiencies in Consultation Process 10 While the December Draft Decisions established some broad outlines for the Commission’s proposed thresholds regime, these were significantly amended in the January Draft Decisions. With submissions due 28 February 2003, Powerco effectively has one month within which to address the significant issues and arrange for appropriate experts to give their opinions. That is simply insufficient time. These submissions (and the attached expert reports) reflect those circumstances. Powerco will continue to review these issues up to and including the conference in the week 10-14 March. 11 Nevertheless, it is Powerco’s submission that the Commission, by setting its own time line (there is nothing in the statute mandating that other than the direction in Section 57G(1)) is prejudicing the ability of Powerco to make a sufficient contribution to the Commission’s decision-making process. 12 Powerco also notes, with concern, that the two papers contain little or no explicit reasoning justifying certain key proposals. Moreover, there does not appear to be any serious engagement with the arguments raised by participants at earlier stages of the process. The Commission has not set out the statutory authority relied upon by it for all of its various proposals. The quality of the consultation process would have been - 4 - enhanced if the Commission’s discussion papers had been more comprehensive. 13 The Commission makes a number of assumptions about consumer preferences. There does not appear to be any evidence supporting these assumptions. The Commerce Commission’s Key Concept? 14 Apparently lying at the heart of the January Draft Decisions is the following: “The Commission’s proposed thresholds provide incentives for lines businesses to continue improving the quality of their services while reducing prices in real terms. The Commission expects these price reductions to flow transparently to electricity consumers.” (page 2) This appears to be the Commission’s paraphrase of Section 57E. 15 There are two particular flaws in this summary. First, the proposed thresholds will generate disincentives rather than incentives. Secondly, there is no apparent basis for the Commission’s expectation that price reductions will flow through to electricity consumers. Powerco now expands upon both arguments. 16 First, the lack of incentives. The purpose of regulation is to mirror competitive markets (March 2002 Discussion Paper, paragraph 4.28). The promotion of dynamic efficiency is a key factor in any regulatory regime. By contrast, the proposed thresholds provide none of the necessary incentives. A price path followed by an ex-post analysis of excess profits removes any incentives to management. There appears to be recognition by the Commission that “excessive profits” may actually include efficiency gains. However, the comments recorded in paragraphs 78 and 79 of the December Draft Decisions are insufficiently precise (and any event operate ex-post) to provide any comfort to Powerco. Certainly, they do not provide any incentives. Powerco, too, - 5 - takes no comfort from the suggestion that a profit threshold may only be short term (December Draft Decisions, paragraph 94). 17 As a particular example of the problem, Powerco says there will be no incentives for it to invest in additions and/or improvements to its electricity network (including for example, (1) the connection of embedded generation to its electricity network and (2) the construction of an electricity reticulation network in a new subdivision). This argument will be developed by its witnesses. In essence, this argument is that investment in additions and/or improvements to its electricity network requires Powerco to commit investors funds. Unless the additions and/or improvements have the potential to exceed the investor’s cost of capital, these investments will not proceed. Under the Commission’s proposed thresholds (in particular the profit thresholds), investment in additions and/or improvements to its electricity network will not proceed as Powerco’s cost of capital is materially higher than the upper limit of the Commission’s proposed WACC range (i.e., 8%). This will be the case, notwithstanding that it does not automatically follow that if Powerco breaches the Commission’s proposed thresholds it will be subject to