The Energy Networks Association has recently released some modelling that suggests consumers will be worse off if stranded network assets are written off. The gist of its argument is that such revaluations are perceived negatively by investors, who then demand a higher rate of return on their investment to compensate them for the risk. Assuming they can convince the regulator of this, prices will therefore be higher than they otherwise would be.
The argument sounds plausible, at first sight at least. Consistency is a good thing. But you can have too much of a good thing. There are other factors to consider. Let's start by focusing the discussion.
Firstly, it seems difficult to argue that there is a significant asset revaluation issue with the privately-owned networks in Victoria or perhaps South Australia. The asset and expenditure data show that it is the government-owned network service providers in NSW, Queensland and Tasmania that have expanded capacity significantly over the last decade, just as demand plateaued and is now declining. As a result, network utilisation is trending down everywhere and is now far out of proportion to the installed network capacity for the state government owned network service providers.
We are seeing the same thing in generation capacity, though not as severe, and their owners are having to wear it, to some degree at least. Why should networks be treated differently?
The ENA’s argument seems fallible in a number of respects. Firstly, we need to question its assumption that networks investors have not already been compensated to bear asset-stranding risk. The regulatory calculation of the return on assets is based on an external 'benchmark'. It is not based on the firms’ actual cost of equity and debt. This benchmark in respect of both the cost of equity and debt is based on firms – such as AGL Energy, property trusts, supermarkets and insurers – that very clearly do bear stranding risk. In this case writedowns of the regulated networks will have no bearing on the regulators’ determination of the allowed rates of return.
Secondly, is it right to turn a blind eye to the fabulous profits that the networks have been making for many years? For example, SA Power Network’s regulatory accounts show pre-tax profits of $479 million for 2012-13 for its regulated business. This is equivalent to $566 per connection they serve. By comparison, UK Power Networks – which shares a common dominant shareholder with SA Power Networks – achieved pre-tax profits of $102 per connection. Should bygones be bygones, or should this be part of the reckoning? This is an equity argument, not an economic issue, but this should not mean it is to be swept under the carpet.
Thirdly, pervasive grid desertion, where economically inefficient, would be a tragic waste of resources. For many users, departure from the grid is becoming financially attractive. In some cases this reflects the ever-improving economics of distributed generation. But in many cases the network is pricing itself out of the market. This is precisely what the economic regulation of network monopolies was meant to prevent.
Finally, and perhaps more important than all the other arguments, future private owners of the networks in NSW and Queensland are likely to welcome asset writedowns, if it's done before they put their money on the table.
Whatever guarantees the vendor governments might provide about future investment certainty, regulatory stability and so on, those putting their hard-earned into these businesses should be worried that a large (and possibly growing) part of the business is being stranded by ever more distributed generation, consumption efficiency and industrial decline. Networks might find that to keep their remaining customers, they will have no option but to drop their prices. This is effectively equivalent to writing down asset values. Would you want to be the investor holding the can when this happens? Prospective private investors in the governments’ network businesses would almost certainly welcome the government writing down the regulated assets before they put their money on the table.
So the vendor governments will be taking the bitter medicine? Not necessarily. Investors may be willing to pay a premium to the regulated asset value if that value reduces stranding risk, and hence required returns. So what the government loses on the writedown, it may gain back on the premium to the regulated asset value that investors may pay.
This may be a marvellous win-win for the burghers and electricity consumers of NSW and Queensland, and also for the prospective future investors. Governments (and the people they represent) get satisfactory sales proceeds, electricity consumers get lower prices and the new private owners accept lower returns in exchange for lower revenue risk.
It would be helpful to put some flesh on the bones of this proposition. How much writedown is appropriate, how would future investors reflect this in expected rates of return, how will future electricity prices and privatisation proceeds be affected? And then, what is the best way to do this?
Prospective private investors, governments, consumer advocates, retailers (and the Energy Networks Association) might usefully focus on these questions. Better to get with the times than to try to hold back the tide.
Bruce Mountain is director of Carbon and Energy Markets.