Australian privatised electricity distribution businesses are learning similar lessons to those of their UK counterparts about being hostage to the regulator. In September, the Victorian Regulator-General handed down his 2001 Price Determination for Victorian electricity distributors. This covers the basis for prices of the local distribution lines in the next five years. Four of the five distributors appealed the decision -- the only distributor acquiescing in it (AEP owned CitiPower) obtained a significant unexpected bonus in its allowable profit.
The method of regulation seeks to establish an efficient operating and maintenance, and capital cost base for each distribution business. It applies various cost of capital values to the firms' investment spending. Aside from CitiPower, Texas Utilities was also allowed increased profits in the 2001-2006 period. In both cases the bonus was based on the regulator's assessment of particularly strong efficiency gains years to 1995-2000.
These price re-sets call for an immense quantity of information to be collected from the regulated businesses and analysed. The outcome is far from transparent. It is difficult even to determine why two but not the other three suppliers merited efficiency bonuses. Unless such rewards are well understood, they lack the incentive stimulus they are intended to offer.
The Victorian regulatory approach departed from the spirit, and according to some, the letter, of legal requirements to apply a form of price-cap regulation. Most people previously took this to mean allowing profit levels emerge as an outcome of the regulatory procedures. Instead the regulator sought to specify efficient profits and setting prices accordingly.
The prices themselves were set to allow weighted-average-cost-of-capital (WACC) returns of 6.8% on a real after-tax basis. This is a considerable reduction from the WACC of 10-11% established at privatisation, but is not out of line with other regulatory determinations. It will bring average price reductions of 12-22%. Such reductions will be welcomed by consumers but do the profit outcomes offer the businesses sufficient reward for them to continue seeking efficiencies?
One means of answering this question, and a reality check available to the regulator, is share market transactions. In England, the electricity regulator's first industry price re-set in 1994 required price reductions not dissimilar to those stipulated by the Victorian regulator. This was followed by a considerable jump in share market values of the regulated businesses. That, in turn, led the regulator to revisit his decision and carve out more profit from the regulated businesses.
Such a check is also available in Australia since one the businesses changed hands. Powercor which Pacificorp (now owned by Scottish Power) sold to Hutchison Whampoa in August of this year.
The sale came between the Regulator-General's April 2000 draft determination and the final determination in September. Powercor saw its regulated prices reduced by 19.6% (a bit less that the 20.3% foreshadowed in the April 2000 draft determination).
Powercor reportedly sold at a premium of $150 million (7%) on its 1995 sale price. This is a prima facia indication that the draft decision has not resulted in regulatory "expropriation". However, a number of factors also need to be taken into consideration:
First, over the period that Pacificorp owned the business the All Ordinaries Index increased in value by 45% hence the premium compared to the market average was -38%, for a firm generally regarded to have shown good productivity growth.
Secondly, the business has been successful as a retailer and some premium would be warranted as a result.
Thirdly, in addition to this success, the firm won a lawsuit against Pacific Power, estimated to be valued at over $300 million. Although this was settled after the sale of the business, the settlement is thought to have involved "true ups" that factored in the anticipated legal win
Tempering the conclusion that regulation suppressed the business's values is the claim that the buyers overpaid for the assets in the first place. However, for the electricity lines businesses, information that has become available on the public record indicates that the underbidders valued most of the businesses sold at similar levels to the successful bidders. This would indicate that on the material available to the bidders in the Information Memoranda and from other sources, the prices bid at the time were indicative of the fair market value.
The price re-set has called forth an enormous amount of activity by the regulator and the regulated businesses alike. One unfortunate result is an electricity aggrieved enough to take legal action against the regulator. A worse repercussion would be if the process were to deflect these and other regulated businesses away from seeking out efficiencies and towards placing more emphasis on manipulating their books to mislead the regulator.
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