08 May 2014

Selecting the Regulated WACC in the Presence of Market and Catastrophic Risks

A new report by Andrew Shelley Economic Consulting Ltd (ASEC) analyses issues relevant to the choice of the Weighted Average Cost of Capital (WACC) for regulated Electricity Distribution Businesses (EDBs) in the context of risks faced by those entities.[1] The report demonstrates that given key technological and catastrophic risks faced by EDBs, the economic costs of setting the WACC too high are likely to be less than the costs of setting it too low.

Key risks facing electricity distribution are technological change, which could render existing networks obsolete, and catastrophic events such as earthquakes, volcanic eruptions, and an increase in storm damage due to climate change. The regulatory regime currently in place means that In the best case scenario, EDB making investments now can expect that from regulatory period to regulatory period it will earn its WACC, such that in approximately 45 years’ time it will break even on the investment. These risks mean that it is not appropriate to set the regulated WACC at its mid-point value unless the risks are explicitly addressed through another mechanism. Absent such a mechanism, it is likely to be necessary to set the WACC at above its mid-point (above the 50th percentile).

ASEC estimates that setting the WACC at the 75th percentile of the WACC distribution results in average delivered electricity prices around 1.4% to 1.8% higher than if the WACC is set at the 50th percentile. Given a price elasticity of demand of -0.4, the difference in average delivered electricity prices will result in a deadweight loss of between $174,000 and $214,000 per year.

The same economic cost would arise with a loss of supply of just 14.36MWh per year, equivalent to an increase in SAIDI[2] of 15 just seconds over the weighted average SAIDI of 111 minutes and 35.5 seconds. This is a trivial increase compared to the higher long term SAIDI rate that could occur if EDBs did not undertake discretionary non-essential capital expenditure such as undergrounding or network reinforcement to build resilience.

Facing a lower WACC, EDBs could also increase the level of capital contributions required, shifting capital expenditure to customers who have a higher WACC. In aggregate, EDBs would only need to increase capital contributions by $18m to achieve the same economic cost as the deadweight loss from higher prices.

Refinement of the above estimates into a loss function requires considerable additional analysis, including the development of engineering studies on network performance under various catastrophic events given different levels of discretionary investment. Other complex issues will also require resolution and agreement, such as the relationship between the regulatory WACC and discretionary capital expenditure by EDBs, and how reductions in discretionary capital expenditure would translate into economic costs.

A copy of ASEC’s report can be downloaded here.

1. ASEC was retained by Unison Networks Ltd to prepare this report for submission to the New Zealand Commerce Commission's current process considering the appropriate WACC. The Commerce Commission's project page is here.
2. The System Average Interruption Duration Index or SAIDI is a commonly used measure of reliability for electricity networks. SAIDI measures the average outage duration for each customer served.