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Input methodologies

The New Zealand Commerce Commission (the Commission) asked Oxera to provide evidence to support its response to the High Court’s challenge in respect of the choice of the ‘weighted average cost of capital (WACC) percentile’ to be applied within the WACC for electricity transmission and distribution.

Within the Input Methodologies (IMs) applied for electricity transmission and distribution, the Commission uses a WACC approach to set allowed returns for investment in the networks. This provides incentives to invest, as investors can expect to earn sufficient returns to cover their cost of capital.

In addition, given the uncertainty over the definition of the cost of capital, the Commission chose to assume a WACC based on the ‘75th percentile’ of the distribution of potential values supported by its technical analysis.1 This percentile was chosen based on the Commission’s judgement that setting the WACC too low would carry more risks than setting it too high.

Following a challenge of the 75th percentile from the Major Energy Users’ Group, the High Court asked for evidence to support the Commission’s approach, and why it would be better than the 50th percentile. While the Commission based its choice of a higher percentile on expert opinion, the choice of the 75th percentile was based largely on judgement. The Court highlighted alternative approaches that could be applied, and requested that the Commission obtain evidence to support any revised decision.

Oxera’s approach

The Commission asked Oxera to propose an approach to determining a WACC percentile for electricity businesses, applying relevant evidence and without taking either the 75th or the 50th percentile as a focal point, but assuming otherwise that the current regulatory framework continues to apply. Based on the Commission’s request, Oxera took the following steps.

  • Step 1: design an analytical framework. Drawing on precedent and submissions to the Commission, we identify relevant options for the Commission, and propose an analytical framework that is capable of being applied in practice in assessing those options.
  • Step 2: identify the relevant data sources. Drawing on evidence from both New Zealand and international comparisons, we propose a framework for estimating relevant parameters, including the impact of underinvestment, which can be used to populate the analytical framework.
  • Step 3: provide recommendations on the WACC percentile. This evidence should support the Commission in reaching a decision on the choice of the WACC percentile.

This approach appears to be consistent with the intention of the Commission in setting a percentile. In considering the evidence, it is important to reflect that there is a fundamental uncertainty over some of the relevant measures, and therefore it will not be practicable to seek to establish a single point value for the percentile. As with the WACC itself, the optimal percentile is subject to uncertainty.

However, this does not mean that evidence will not improve the Commission’s understanding of the right decision. Our approach is intended to provide the Commission with sufficient evidence to understand the implications of a particular percentile, and therefore to choose a percentile that correctly balances its objectives within the regulatory framework.

1 The ‘75th percentile’ relates to the level of WACC assumed in the price control, based on a distribution assessed by the Commission. The choice of the 75th percentile means that the Commission considers that there is a 75% probability that the assumed cost of capital is at least as high as the actual cost of capital.