Ins and outs of input methodologies

The Commerce Commission has released papers detailing its emerging views on input methodologies for electricity distribution services, gas pipeline services and specified airport services supplied by Auckland, Wellington and Christchurch International Airports. Senior associate David Blacktop discusses the relevance of these input methodologies and their likely impact for the regulated industries, their consumers and New Zealand Inc.

Immediately before Christmas, the Commerce Commission released a series of documents setting out its "emerging views" on the input methodologies it will use in regulating goods and services which are controlled under Part IV of the Commerce Act – which are natural monopoly services such as electricity lines companies, owners of gas distribution and transmission pipelines and specified airports. The Commission's "emerging views" follow a lengthy submission and industry consultation process in 2009.

Why do the input methodologies matter?

Input methodologies are an important innovation introduced as part of the new regulatory regime; they form the building blocks on which the Commission will make decisions about price path thresholds (i.e., the rate at which firms can increase prices from year to year) and information disclosure obligations for regulated industries. The input methodologies cover:

• methodologies for evaluating or determining:

• cost of capital;

• valuation of assets, including depreciation, and treatment of revaluations;

• allocation of common costs, including between activities, businesses, consumer classes, and geographic areas;

• treatment of taxation;

• pricing methodologies;

• regulatory processes and rules; and

• matters relating to customised price-quality path proposals.

The object of input methodology is to deliver greater upfront certainty so as to create more predictable regulatory outcomes. It is thought this greater certainty will assist regulated suppliers to manage their businesses and foster and encourage efficient investment.

While separate methodologies must be set for each regulated industry, because the underlying rationale for regulation is similar across the industries, they will likely share many common features.

Impact of the input methodologies

Once set, the input methodologies will apply to the regulated industries for up to seven years before being reviewed. Any industry which later becomes subject to regulation will have new input methodologies set for that industry; however, in practice the methodologies set now will form a "base case" in any future analysis.

From a consumer's perspective, the methodologies will influence the amount they pay for regulated services. To illustrate, regulated prices for electricity lines businesses and gas distribution pipelines are heavily dependent on the value of the firm's asset base because, in a competitive market, a firm would earn a normal return on its assets. Therefore, the bigger the asset base, the greater the revenue the regulated firm will be able to earn without falling foul of the control regime. The input methodologies will provide the framework for firms to determine their regulated asset bases and therefore will have an impact on all of us.

Relevance of "New Zealand Inc"?

Under the old Part IV (and also under the Telecommunications Act) a key question had been whether economic regulation should be focused on improving New Zealand's overall efficiency or whether there should also be specific focus on protecting consumers from excessive prices.

The purpose statement in Part IV explicitly provides that the purpose of the regulatory regime is to "promote the long-term benefit of consumers in markets [where there is little or no competition and little or no likelihood of a substantial increase in competition]". This is achieved by:

... promoting outcomes that are consistent with outcomes produced in competitive markets such that suppliers of regulated goods or services:

• have incentives to innovate and to invest, including in replacement, upgraded, and new assets; and

• have incentives to improve efficiency and provide services at a quality that reflects consumer demands; and

• share with consumers the benefits of efficiency gains in the supply of the regulated goods or services, including through lower prices; and

• are limited in their ability to extract excessive profits.

The Commission has said that its approach in making decisions on input methodologies is to ask (i) whether the decision would promote outcomes consistent with those that would be expected in a competitive market and then (ii) to check that, in aggregate, the outcomes are ones which promote:

• innovation and investment (s 52A(1)(a));

• maintenance of quality standards demanded by consumers (s 52A(1)(b));

• prices which promote rational choice by consumers (s 52A(1)(c));

• profits which are sufficient to reward investment, innovation and efficiency but are not excessive (s 52A(1)(d)); and

• allocative, productive and dynamic efficiency (s 52A(1)(b)).

The Commission's view is that the "central purpose" of Part IV is to promote the long term interests of consumers in regulated markets. Rather than a New Zealand Inc focus, the purpose statement may be said to imply that the Commission should focus on the regulated market only and ignore effects on other non-regulated markets. Does this matter? Well, while it is difficult to predict the circumstances in which this may make a practical difference, decisions in the electricity lines markets might, for example, impact on lines companies' decisions regarding the roll out of telecommunications fibre.

Where to from here?

Originally, the Commission was required to publish the methodologies by 31 June 2010, although – sensibly given their importance – this timeframe has been extended by the Minister of Commerce to 31 December 2010 (and 1 January 2011 for airports).

The next 12 months will see further rounds of industry consultation and submissions, commencing very shortly with a number of workshops in February and March, with the Commission releasing draft determinations for submissions in the second quarter and input methodologies (at this stage) set to be finally determined around October and November.

By the end of 2010, the input methodologies will be set. Once set, the Commission will be in a position to move to establishing the information disclosure (for airports, electricity lines and gas distribution businesses) and price path thresholds (for non-consumer owned electricity lines businesses and gas distribution businesses) regimes, which will come into effect in 2011.

This article was first published in NZLawyer, 5 February 2010.

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For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.