The economics of energy

A number of electricity lines companies have the potential to extract excess profits from consumers under the current New Zealand regulatory regime, an analysis by energy economist Jill Thomson indicates.   BY LINDSAY CLARK

Energy economist, Jill Thomson, told the International Association for Energy Economics conference in Wellington that “New Zealand’s ‘light-handed’ regulatory system appears to be as ineffective as the day it was introduced”.

Thomson, of Waikato-based energy research company Eclectic Energy, said that her analysis of the returns on investment of all the lines companies, which had natural monopoly characteristics, showed that over-generous targets seem to have been set for some of the ‘worst offenders’ among the businesses.

This would enable these companies to continue to extract excess profits without breaching the revenue cap thresholds that are meant to control prices.

Under the Commerce Commission’s targeted control regime based on a Consumer Price Index minus X threshold in the Commerce Act 1986, lines business are limited in their ability to extract excessive profits. They also face strong incentives to improve efficiency and services by sharing the efficiency gains with consumers through lower prices.

Under Thomson’s analysis one of a number of companies to enjoy very high returns is Nelson Electricity. Her analysis shows that Nelson Electricity had an average return on investment of 14.8 percent over the 12 years since the first regulation in 1994, compared with an industry wide average of 8 percent.

When the 1993 asset value of Nelson Electricity is used to calculate the return on investment, its 2006 return on investment was 177 percent. Thomson says she used 1993 as the base value for her calculations because Nelson Electricity had decreased its asset value by 43 percent in 1994.

Under the Commerce Commission’s current targeted control regime for line businesses Nelson Electricity received a “must do better” value for profitability — one of the factors along with relative efficiency and relative productivity that are used to judge its capped threshold decisions.

Nelson Electricity breached its price path threshold in 2005-06, but the Commerce Commission has taken no visible action under the Consumer Price Index-related threshold, Thomson said.

As a small urban network Nelson Electricity was sold by its city council to the two consumer trusts closest to it. Although technically in trust ownership, the trust is not accountable to the network’s consumers.

Thomson’s analysis showed most line businesses owned in whole, or in part, by the private sector or by local government (which historically used higher charges to subsidise rates), had higher returns on investment than solely trust-owned businesses.

The Commerce Commission, charged with regulation of the lines businesses since 2001, has issued ‘intention to declare control’ notices against only two lines companies, Unison and Vector. Yet Unison stated to the Court of Appeal that 22 of the 28 line companies had breached at least one of the thresholds for the price path or the quality of supply.

“This indicates a relatively high level of non-compliance,” Thomson says.

Aurora Energy, formerly Dunedin Electricity and Central Electric, was one of the other lines companies that had high returns. Aurora earned an average 11.91 percent return on investment over 13 years. But using the 1993 asset value as a base Aurora produced a return of 37 percent for the 2005-06 year. The 1993 base was used because Aurora increased the value of its assets by 89 percent between 1993 and 1994.

Yet the Commerce Commission had given Aurora a profitability assessment as not earning any excess profits and a ‘must do better’ rating for productivity.

OtagoNet joint venture (jointly owned by three network companies) in 12 years of disclosures indicated that its average return on investment is 14.3 percent a year. It has both a “not earning any excess profits” and a “good productivity assessment” for its line business.

Thomson’s analysis showed that there was a significant negative correlation for productivity between lines companies with different densities of customers and energy. Yet the Commission has said it had neutralised these density effects in making its calculations.

In contrast to some of the high profit companies, The Lines Company operating in the King Country has the lowest energy density and one of the lowest customer densities in the country. It has some of the most deprived rural population areas in the country according to the New Zealand Deprivation Index. Its average return on investment since 1994 is only 5.7 percent a year. It is one of the companies that potentially may be unable to maintain its assets at their existing level.

Thomson says the key to understanding return on investment data was the New Zealand industry’s use of a form of current cost accounting called Optimised Deprival Valuation or ODV. She described ODV as “Australia’s contribution to New Zealand’s electricity reforms”.

ODV was used to assess the financial performance of state assets in Australia prior to privatisation and research there had found that this greatly over-valued the assets compared to conventional techniques such as historic cost.

In Australia, when used for financial benchmarking, ODV showed that assets under state ownership were performing very poorly in revenue or profit terms.

But when the private sector bought the assets and measured their performance using conventional measures, the return on investment performance of the companies improved significantly, even if nothing else had been changed about the company.

Her research showed that when lines companies’ return on investment since 1994 was calculated using the more traditional historic cost basis, returns were approximately double that of using Optimised Deprival Value for asset valuation.

Thomson said that there should be some expectation that normal commercial returns under an ODV-based regime should be substantially less in percentage terms than under historic cost.