Today I’m going to talk about ODV. The paper has three sections: 1. Theory 2. History

1. Asset Valuation, ODV, and Contestability TheoryGeoff BertramSchool of Economics and FinanceVictoria University of WellingtonGeoff.Bertram@vuw.ac.nz Paper for Brightstar 5th Annual Competition Law and Regulation Review Conference Wellington, 21-22 February 2005

2. Today I’m going to talk about ODV. The paper has three sections: • 1. Theory • 2. History • 3. Observations ODV and Contestability

3. A simple picture of a monopolist ODV and Contestability

4. The big question: what is P2 ? ODV and Contestability

5. P2 has to be greater than P1 for the enterprise to be profitable at all ODV and Contestability

6. One possibility: a regulator sets P2 such that ABDE is a “fair and reasonable return” ODV and Contestability

7. Note, by the way, that we are already talking about equity as much as efficiency. Neither “fairness” nor “reasonableness” are explained or defined in economic textbooks ODV and Contestability

8. If there is to be any serious economic content to justify transferring consumer wealth to a monopolist, it has to be something about the future – that elusive “dynamic efficiency”. ODV and Contestability

9. A regulator with an eye to the future, and a serious focus on consumer welfare in the long run, will want ABDE no bigger than necessary to ensure future supply (both quantity and quality) ODV and Contestability

10. This is especially so when we recall that the issue is the long-run benefit of consumers, which includes present as well as future ODV and Contestability

11. If there’s no regulator, P2 will be the monopolist’s profit maximising price, so ABDE will be as big as possible, subject only to the demand curve ODV and Contestability

12. If the service is an essential one, with very low demand elasticity, the sky is the limit…. (but in fact there will be a choke price somewhere up here) P1=v ODV and Contestability

13. The “Lerner Index” of market power: ODV and Contestability

14. The “Lerner Index” of market power: Variable cost Price ODV and Contestability

15. The “Lerner Index” of market power: Price-cost margin Elasticity of demand ODV and Contestability

16. The price-cost margin, of course, is the height of the profits rectangle, DE. Monopoly profit is the margin times the volume. ODV and Contestability

17. Carlton and Perloff Modern Industrial Organization (3rd ed, Addison-Wesley 2000) page 246 equation 8.4 ODV and Contestability

18. Price of capital equipment Physical inventory of capital equipment Variable (marginal) cost WACC Depreciation rate Volume of service Demand elasticity Price ODV and Contestability

19. Let p be fair and reasonable: To derive this price from the above equation a regulator has only to insert fair and reasonable values for the other seven variables in our equation. ODV and Contestability

20. First, “mimic competition” by setting Next, insert the known values of v, δ, K and Q. That leaves r, pK, and pfr. Set r = WACC. Now all we need is pK, and we have pfr. ODV and Contestability

21. Doing the same thing from a slightly different angle: Set then or (the usual regulator’s version) ODV and Contestability

22. which boils down to allowing the monopolist “WACC on pKK”. so assuming K is known or can be readily found out, the issue is entirely the value of a unit of capital, namely pK. ODV and Contestability

23. What are the limits on pK? • The lower limit is set by EXIT CONDITIONS: opportunity cost (value in best alternative use) • and with highly specific assets whose cost is sunk, that means scrap value. • The upper limit is set by ENTRY CONDITIONS: the limit price at which a competitor can come in and capture the market • which I shall call the “contestability ceiling” ODV and Contestability

24. Note that the contestability ceiling can coincide with ODV only under costless entry A new competitor will be tempted in only when the incumbent has priced on a valuation greater than DRC plus the value of barriers to entry Only when the incumbent has valued itself above the contestability limit would a rational investor enter by new capital investment rather than takeover of the incumbent ODV and Contestability

25. Contestability limit Market value of the firm Full replacement cost S million Depreciated Replacement Cost Costless-entry limit Optimised DRC/ODV Historic cost Net Realisable Value 0 ODV and Contestability

26. Contestability limit Market value of the firm Say 2.5 x ODV = $8.4 billion Full replacement cost S million Depreciated Replacement Cost Say 4.2 billion Costless-entry limit Optimised DRC/ODV Historic cost Say $2 billion Net Realisable Value 0 ODV and Contestability

27. Suppose you know that in the very long run, asset value must rise to ODV in order to provide a return on the assets which will be installed in the future to replace the existing ones And suppose that you are starting in 1992 with historic-cost = $2 billion whereas ODV = >$4 billion How can you get from here to there? ODV and Contestability

28. Recall that the price charged to users is closely and directly related with pK.K • So increasing pK must raise p • And someone will have to explain why pfr has gone up ODV and Contestability

29. One possibility is a ramped glide path: ODV and Contestability

30. That’s easy to justify and explain, because everyone knows and agrees that as new investments are made, they must have the clear expectation of earning a commercial return on their cost • and nobody is really going to lose too much sleep over a doubling of the real price of network service over half a century ODV and Contestability

31. Or, you could do a big bang: ODV and Contestability

32. Mid-life change in regulatory accounting methodology End of present asset stock’s life; ? 50 years out? $ million Replacement-cost-based revenue Rents on early revaluation (functionless) Initial pay-as-you-go revenue Revenues allowable under continued rate-of-return regulation 50 0 Time ODV and Contestability

33. Selling that is a real challenge So let me turn to some history of the electricity reforms of 1989 - 1994 ODV and Contestability

34. Minister of Energy David Butcher, media release 25 May 1990: “Lower real electricity prices resulting from the corporatisation of the electricity distribution industry is the motivation for the latest Government decisions on electricity which were announced today… “Savings in electricity bills represent an immediate improvement in living standards and help towards the restoration of full employment….” ODV and Contestability

35. "In 1990, Electricorp Marketing hosted an Asset Valuation Seminar to provide electricity distributors with an opportunity to consider the most appropriate method of valuing electricity distribution assets ... • “An accurate asset valuation would … impact directly on the pricing of distribution services and would ensure the depreciation amount adequately reflected the opening capacity used each year. • “Six different valuation methods were considered: From K. Cooper, "Valuation Techniques and Problems", Continuing Education Paper No 439, in Infrastructure Assets Forum, New Zealand Society of Accountants, 1995, pp.17-18. ODV and Contestability

36. "The first three were 'forward-looking' methodologies - methods which look forward in time by applying some form of discounting/capitalisation of net assets to derive a value. Forward-looking calculation methodologies are considered appropriate in the valuation of businesses that operate in contestable markets where external forces determine prices. The forward-looking methodologies considered were • discounting of future cash flows (DCF); • capitalisation of future sustainable earnings; and • dividend yield basis. …. From K. Cooper, "Valuation Techniques and Problems", Continuing Education Paper No 439, in Infrastructure Assets Forum, New Zealand Society of Accountants, 1995, pp.17-18. ODV and Contestability

37. “In a monopolistic business, where management retains significant discretion in determining its own price levels, the theoretical soundness of a forward-looking valuation approach is undermined. “Because of the high cost of duplicating distribution assets, it is anticipated that the distribution business will retain its monopoly status to a large extent and therefore forward looking valuation methods are not considered suitable… From K. Cooper, "Valuation Techniques and Problems", Continuing Education Paper No 439, in Infrastructure Assets Forum, New Zealand Society of Accountants, 1995, pp.17-18. ODV and Contestability

38. “….Three backward-looking valuation methodologies were also examined, namely Historical Cost, Modified Historical Cost and Optimised Depreciated Replacement Cost (ODRC). Of these, ODRC was considered the most satisfactory method for these reasons: • the method provides for the present business operation to be sustained without recourse to further capital inputs. Any expansion would require separate funding or the use of retained earnings. • if there was an efficient market for such assets, this method is likely to come closest to market values; • this will put strong pressure on management to minimise costs in order to meet the return requirements of shareholders. From K. Cooper, "Valuation Techniques and Problems", Continuing Education Paper No 439, in Infrastructure Assets Forum, New Zealand Society of Accountants, 1995, pp.17-18. ODV and Contestability

39. “The industry found the exercise useful in that it established an agreed methodology for the valuation of distribution assets within the industry. This selection of the ODRC method for the electricity distribution industry has been brought forward into the recently issued Handbook for Optimised Deprival Valuation of the Electricity Line Businesses that was released on 23 June 1994 by the Ministry of Commerce." From K. Cooper, "Valuation Techniques and Problems", Continuing Education Paper No 439, in Infrastructure Assets Forum, New Zealand Society of Accountants, 1995, pp.17-18. ODV and Contestability

40. Note the three reasons for going ODRC:First: • “the method provides for the present business operation to be sustained without recourse to further capital inputs. Any expansion would require separate funding or the use of retained earnings.” • If this meant that the business would be able to get through the next round of capital replacement with no lack of cash, then it’s certainly true – but as we’ve seen already it’s not the lowest-cost approach – the HC ramp covered replacement, whereas ODRC by big-bang provides management with a huge featherbed stack of cash until all the sunk-cost assets have gone. ODV and Contestability

41. What it really meant was that the managers of lines businesses would never need to borrow, hence would never face the discipline of their bank manager (or the capital market for new offerings) ODV and Contestability

42. Second: • “if there was an efficient market for such assets, this method is likely to come closest to market values” • That, as we’ve seen already, was simply wrong. The takeovers market values barriers to entry as well as machinery. ODV and Contestability

43. Third: • “this will put strong pressure on management to minimise costs in order to meet the return requirements of shareholders.” • That also, as we’ve seen already, was simply wrong. The takeovers market values barriers to entry as well as machinery. • The management of an ODV-valued company with good entry barriers can cruise – unless they’re fattening the business for sale at the contestability limit (two or three times ODV) ODV and Contestability

44. From ODRC to ODV • Everyone could see at once that moving asset values up to ODRC, pricing on that basis, and keeping revaluation income out of sight (more on that in a moment), would mean price increases. • First for the price shocks would be the farmers • A quiet survey carried out by officials came to the Cabinet State Agencies Committee in 1989-90: ODV and Contestability

45. Estimated Increases in Required Annual Rural Income[SAS (90) 31 13 March 1990 p.10] ODV and Contestability

46. Clearly to get the farmers’ vote it would be necessary to write-down rural line valuations to prevent rate shock • So ODV was born, in Treasury, out of political reality • But later that year National came to power, with the farmer vote, by promising to average prices over rural and urban ODV and Contestability

47. After that, it was really ODRC all the way, with EV hanging on behind for ad hoc use • Now the question arose: what is actually going to happen to prices if there is a switch to ODV (and revaluations are ignored, to be hidden away in reserves – of that, more later….) • The first shock came in October 1991 when MoC officials estimated that ODV would be double the existing book values. ODV and Contestability

48. In early 1992 officials began to ease their ministers into the pricing implications as then understood • Ernst Young were commissioned to analyse the issue. • On 14 April 1992 Ernst Young reported that ODV would be 2.5 times book value (using the internal MoC estimate) • The estimate revenue shock was between 19% ($390 million p.a.) and 22 ($460 million p.a. ODV and Contestability

49. On 16 April 1992 Mike Lear of MoC wrote to the Minister of Energy, John Luxton, with the news. • On 8 May 1992 Luxton was briefed for a meeting with the Minister of State-Owned Enterprises, the topic of which was the valuation at which ESAs were to be corporatised • Ernst-Young’s advice was that “cost/price pressures” would be 20% even “after 20% efficiency improvements have been made by ESAs.” • The long run goals of the reforms would be “jeopardised” by these increases ODV and Contestability

50. Treasury offered a “fix”; MoC didn’t like it • “The Ministry is particularly opposed to the option suggested by Treasury of vesting at book value but requiring ODVs for information disclosure purposes…. This would make information disclosure rather artificial….” (Luxton briefing document 8 May 1992 p.2.) ODV and Contestability