Assessment Approach
45. The Commission's approach to assessing NAB is described in Chapter 5 (Assessment Approach) and involves:
- identifying the potential benefits of control;
- identifying the potential costs of control. It is assumed in the main that such costs ultimately fall on consumers;
- balancing benefits against the costs; and
- taking account of the asymmetric risks associated with a decision to impose control.
Benefits of Control
46. The Commission considers the potential benefits of control separately from the potential costs. This approach has been adopted for clarity of exposition. The sources of potential benefits of control include:
- excess returns being reduced by control, with a transfer of wealth from suppliers to acquirers (being a net benefit to acquirers);
- allocative inefficiency being reduced by control. Inefficient levels of service quality for the price charged could also be addressed through control;
- productive inefficiency being reduced by control; and
- dynamic inefficiency being reduced by control, because of continued/improved availability of services.
Allocative Inefficiencies
47. The Commission has adopted a long-run model using an average cost pricing approach so allocative inefficiencies (which are measured by the deadweight loss of consumer surplus) are driven largely by the degree to which prices diverge from average costs (which include a normal return), and the price elasticity of demand for pipeline services. The Commission assumes an elasticity of -0.3 for the gas distribution services and -0.1 for transmission services.
Excess Returns
48. Any excess returns are measured as the difference between what the gas pipeline business is currently earning and what the Commission considers is a normal return for such a business. The calculation can be expressed mathematically as:
Excess returns ($) = Net Earnings ($) - (Asset base x WACC).
49. Net earnings equal the earnings before interest of the gas pipeline businesses less tax, depreciation and operating expenses plus any revaluation gains/losses and capital contributions from customers.
50. Where revaluations are only done periodically (e.g., every three years), the revaluation gains/losses calculated are spread back over the period to which they relate, and the asset base is also smoothed.
Productive Inefficiency
51. The Commission asked Meyrick & Associates to examine the productivity of the New Zealand gas pipeline businesses and the growth in productivity of NGCT. It was unable to draw conclusions from this analysis. However, the Commission considers that regulation could achieve productivity improvement in addition to the trend rate of 0.83% of total costs for all the gas businesses.
Dynamic Inefficiency
52. The Commission could not identify (absent control) any significant dynamic inefficiency with regard to gas pipeline businesses. Thus, benefits from control cannot be achieved.
Costs of Control
53. The costs of control can be broken down into two types: direct and indirect costs.
Direct Costs
54. The direct costs of control include those that fall on the gas pipeline businesses (compliance costs), and those borne by the regulator (regulator's costs).
55. The direct costs of control are those that would be additional to the costs of the existing regulatory regime. The Commission has used figures provided by the gas pipeline businesses to estimate their compliance costs, while it has used the costs of this Inquiry as the primary basis for determining the regulator's costs of control.
Indirect Costs
56. The Commission has modelled five indirect costs of control, in terms of:
- unrecoverable excess returns;
- unachievable allocative efficiencies;
- productive inefficiencies created by control;
- reductions in service quality; and
- deterred new investment.
57. Control would move towards but would not exactly replicate the competitive price. As a result, only a proportion of the potential allocative efficiency gains would be secured under the control scenario, the rest would be unrecoverable. The Commission has adopted a factor of 20% to discount the potential excess returns benefits of control (i.e., only 80% of excess returns would be recoverable). Allocative efficiency benefits are discounted by 36%.
58. The Commission considers that control could impose productive inefficiency in the order of 0 to 0.66% of total costs, to reflect the potential costs of control. The mid-point of 0.33% is used for the purposes of the modelling base case.
59. The Commission considers that dynamic inefficiency may be created by control. Control may cause under-investment that might result in reduced service quality for existing customers, or to a delay in supplying new customers by extension of the network (missing market).
Taking Account of the Asymmetric Risks of Imposing Control
60. The Commission recognises that the risks associated with imposing control are asymmetric: that is the costs of imposing control when it is not justified are higher than the cost of not imposing control when it is justified. Further, in assessing whether control is justified, the Commission needs to ensure consistency with its likely approach if control were declared.
61. The Commission is of the view that a WACC should be chosen from the upper end of the distribution in determining whether to impose control on the gas businesses but that the implicit margin on WACC provided by the costs of control needs to be taken into account. The implicit margins provided by the costs of control for each of the businesses are shown in Table 3.
Table 3: Implicit Margins Provided by the Costs of Control| | Direct costs margin | Indirect costs margin | Total implicit marginII |
| Wanganui Gas | 2.1% | 0.8% | 2.8% |
| NGCD | 0.5% | 0.8% | 1.3% |
| NGCT | 0.2% | 0.4% | 0.6% |
| Powerco | 0.5% | 1.3% | 1.8% |
| Vector | 0.3% | 1.4% | 1.6% |
Back to Top