Estimating the WACC in a Regulatory Setting: An Assessment of Dr Martin Lally's paper 'The Weighted Average Cost of Capital for Electricity Lines Businesses' of 8 September 2005

Abstract

In September 2005 the New Zealand Commerce Commission (NZCC) released a document (TheWeighted Average Cost of Capital for Electricity Lines Businesses by Dr Martin Lally referred to as LINES hereafter) that estimates a weighted average cost of capital (WACC) for New Zealand electricity lines businesses and proposes a means for detecting future excess earnings. At about the same time the NZCC also began seeking submissions on another document (Draft Guide- lines: The Commerce Commission's Approach to Estimating the Cost of Capital 2005) that addresses the topic of an appropriate framework for the WACC in the New Zealand regulatory environment. Although no specific author is attributed to the latter its material content is drawn from LINES. In this paper we undertake a detailed analysis of the approach followed in LINES. We do so from the perspective of a referee who has been asked to provide a review of that report in order to assess its suitability for publication in an edited book or journal that adheres to conventional academic standards. Although LINES has not of course been submitted for publication orreview of this kind its contents and recommendations should nevertheless meet minimum standards of accuracy thoroughness and consistency. It is these criteria we use to assess LINES. Our report is motivated by a simple but important concern: although the cost of capital is a critical element of the revenue and price settings that materially determine the social net-benefit of income-control regulation there are presently no institutional arrangements in New Zealand that allow for reports such as LINES to be thoroughly reviewed and debated. On the basis of our review we conclude that such institutional arrangements are sorely needed. Our assessment of LINES comprises two parts. In Section I we provide an overview of what we consider to be the critical areas of concern in LINES. Section II then discusses specific errors in detail.