13 MARCH 2003 PRESENTATION BY ORION

Transcription

1 0 MARCH 00 PRESENTATION BY ORION CHAIR: I'm sorry for the short delay but Mr Sutton perhaps we'll start. I gather you'd prefer to do the WACC part first while Dr Lally's here with Dr van Zijl so with we'll start that way. MR SUTTON: I really just want to introduce Dr van Zijl to talk about the WACC issue. He's done this work on behalf of and then the Vector United group as well. Then following Tony's presentation the rest of the group will join me here and we can do the rest of the discussion. CHAIR: That's fine. Thank you. MR VAN ZIJL: Good morning. The presentation that I will be making will provide a summary of the paper that was filed, together with the submission by Vector Limited and United Networks and. The back-drop to the paper is that the companies are of the view that the price and quality thresholds should achieve the objectives of control and that the imposition of a threshold is (A) unnecessary and (B) likely to provide perverse incentives. Nevertheless, the companies are concerned that if the Commission does proceed to implement a profit threshold that it is aware of (A) the uncertainties associated with estimation of WACC, that there is at least room for debate as to the estimates that the Commission has formed so far and that the scheme would have severe difficulties in implementation. So, I'll be dealing with three topics. Firstly estimation of WACC, secondly the margin over WACC and thirdly the identification of excess profits. On terms of estimation of WACC the first issue is the cost of equity in terms of the model that is used to make the estimate. The Commission talks about using the Brennan Lally model but in fact makes simplifying assumption s that have the result of using a model better known in New Zealand as the "post tax" form of the CAPM, and I've stated that in equation of the summary paper that's been distributed this morning. That can also be restated in slightly shorter form, as in equation, where the market risk premium term is just summarised into one symbol as opposed to its separate components and with a bit of mathematical shuffling that can be turned into the form stated in equation. The point of making reference to this is that it's easy to mix up the different models in making estimates of the parameters, and in particular in the way that the Commission has approached its task, in terms of initially talking about the Brennan Lally model, it could be easy to slip into thinking that the appropriate market risk premium is the market risk premium appropriate to the Brennan Lally model. If that premium was to be substituted into, for example, equation then it's important

2 0 that the risk free rate and tax rate estimates are also consistent with that market risk premium. For example, if that was done, then the more appropriate estimate for the tax rate would be around %, instead of % and the effect of that would be that the estimate of the cost of equity would be understated by approximately 0.%, and while that may not seem significant in terms of percentages, clearly when it translates to an absolute number of dollars, it can be quite a large amount. The second issue is that of the market risk premium. Now for that I estimate %, with a concession towards a lower estimate of %, whereas the Commission estimates a range of to %. The estimate that I form is based on the data from the work by Dimson and others published last year, and then corrected for a tax factor of minus 0., which doesn't apply to the work done by Dimson. Now the relevant data is in table and it's on page of this summary paper. This data provides an arithmetic mean of the difference between the return on the market and long-term bonds. It provides data for the period 0 through to 000 and for a range of countries. Well, that sort of exercise has been done at various times in New Zealand. In earlier times it was done mainly by broking houses, in more recent times it's been done by PricewaterhouseCoopers, it's been done by researchers at Auckland University, led by Alistair Marsden and more recently it's been done by Alistair Marsden and Martin Lally. The question that might come to your minds is why would I want to use data from overseas rather than the data from those New Zealand studies? Well, let's take a similar situation. Imagine that we were in Russia and we were wanting to estimate the market risk premium applicable to Russia in the year 00 and onwards. Would anybody in their right mind think of going back to the data from before the fall of the Berlin Wall? You wouldn't possibly think of going back to the data from the highly controlled, planned economy that used to exist in those days, and use that data to make an estimate of the market risk premium that would apply in a relatively free economy. Well, the parallel that I draw is perhaps an extreme one, but prior to the New Zealand economy was also quite heavily controlled in a whole variety of ways. My view is that if we want an estimate of the market risk premium we shouldn't be looking at New Zealand data, because really all we've got in terms of our current environment is about to 0 years of relevant data, and that's far too short to form a basis for a projection of what the market risk premium might be. So my view is that the ideal basis would be to look at data from a well-known free economy, namely the United States and in terms of the Dimson data that shows a market risk premium of %. Now, if anyone thought that I'd chosen that as a cherry-picking exercise, well instead of taking the US, take the median for the

3 0 set and it's.%. Well, if you take that number of around, adjust it for the tax factor that's in the market risk premium as shown in equation, back on page one, then you end up with an estimate of around % for the market risk premium in New Zealand. A similar view has been expounded by Professor Bowman in respect of estimating the market risk premium for Australia. He holds the same view, that Australia has a track record of regulation and control in its past and which leads it to the situation where its historical data is not a good basis for estimation of the market risk premium relevant to Australia now. CHAIR: This is very much a lay person's question Dr van Zijl. It would be pretty evident, but I guess the changes in some of these other economies in those periods, where some of them go back to, I see Germany, has been excluded for obvious reasons, I suppose that was inflation, but I'm not sure how consistent policy has been in those countries either over that period. MR VAN ZIJL: I'd have to concede that, and hence my preference for taking the United States. But I offer the median as an alternative, if you thought that perhaps I'd chosen the United States because it provided an attractive number. CHAIR: Okay, thanks. MR VAN ZIJL: Now, there are other methods of estimating the market risk premium and these are described in the paper prepared by Dr Lally, and the concern that I have with those other methods is that typically they involve making assumptions that are often questionable and my preference in forecasting is that one would first of all look for a structural model in terms of trying to project the future values of a variable, but if that exercise involves a lot of questionable assumptions, then probably a simple time series projection is the preferred method to go forward, and that's what I have a strong preference for in this field of estimating the market risk premium. The second topic there is asset beta. There I estimate 0. with a range of 0. through to 0.. The Commission on the other hand has assigned a range of 0. to 0.. There I refer to the work of Dr Lally and his report for the Commission, and say that basically I'm happy with the analysis and certainly with the results, except for the fact that the estimate that Dr Lally uses for the asset beta for US electricity utilities is in fact a slightly outdated estimate now, in that Professor Damodaran -- the source of the data used by Dr Lally -- has issued a more recent estimate, and in contrast to the estimate used by Dr Lally, which was 0., the current estimate is 0.. Well, if we take that then as the lower end of the range and add to that the margin of 0. to 0. for the difference between the regulatory environment that could occur here and that exists in the US you come to a range of perhaps 0. to 0., particularly if you recognise that a regime that has the

4 0 threat of price control could well result in companies acting as if they are already subject to control. Next point is the risk free rate. The Commission adopts a five year Government bond as the basis for its estimate of the risk free rate. It was agreed in the Airfields inquiry that that estimate should in fact be adjusted for semi-annual compounding. So, firstly I feel that that should be done. Secondly, my preference would be for a year Government bond as the basis for estimating the risk free rate. I hold the view that its unlikely that in fact an entity would be fully compensated at the reset. Furthermore, in order to accept the arguments advanced by Dr Lally, the system of resetting would have to take place continuously. The Commission of course doesn't envisage continual rebalancing or resetting, rather it would be a five yearly reset. Even if the Commission had the resources for continuous resetting, that would of course also require the company to continuously reset its financing, and that of course would be extremely expensive in terms of transactions costs. Furthermore, the choice of years is also consistent with the risk free rate used in the market risk premium. The market risk premium is estimated relative to long-term bonds, not medium term bonds and in a mathematical sense it seems inconsistent to at one end of an equation use a medium term estimate of the risk free rate, and at the other end of the same equation use a long-term bond basis for estimating the risk free rate Dr Lally has also advanced arguments as to why such a procedure might be valid. I have doubts about the validity of the argument. It rests on a number of assumptions, one being the expectations hypothesis for the term structure of interest rates, another being that the market risk premium is constant over time, and the third is that the result that he posits holds only to an arithmetic approximation. It holds accurately if the product of the two spot rates is equal to the square of the two term rate The next point is that of leverage and the debt margin. There I suggest that the WACC, at least for companies who have relatively high leverage, be around % and that the appropriate debt margin then be set at.%. There is, of course, in theoretical terms no basis for preferring one capital structure over another. One can trot out the various factors that might provide some sort of basis for trade-off, in the sense that the more debt in the capital structure the greater the benefits in the sense of monitoring, but on the other hand the higher the risks of financial distress, and so clearly those factors operate in opposite directions and so one can at least in principle talk about there being some sort of trade-off, but in practise, whether that trade-off occurs at % or % we really don't know.

5 0 And so, probably the best thing to do is to look at what companies actually do and if they choose to operate say with % or % leverage, then that presumably is their assessment of what is optimal within their objective of earning a reasonable rate of return on shareholders investments Well, what the appropriate debt margin would be consistent with a particular level of leverage, is of course just a simple empirical issue. See what people have to pay in the market and if we look at the bond issue that TrustPower is planning, we see that in fact.%, % would be quite a reasonable margin. Doesn't actually have a huge impact on the weighted average cost of capital estimate and I provide there a formula which allows you to calculate that if leverage was to increase from % to % with associated debt margins of % and.% then the increase in WACC would be 0.% Well, what's the cumulative effect of all those proposed variations to the estimates made by the Commission? In mathematical terms it can be seen by the statement of WACC in equation, which is a restatement of the definition adopted by the Commission, but restated in a way so that one can get at least some idea as to where the change comes from. In the case of the comparison between the estimates that I've suggested and those adopted, or at least proposed by the Commission to date, there is an overall difference of.% in terms of a comparison of mid points, and that.% arises in part from the increase in the risk free rate from. to.%, which contributes 0.% of that.% difference. The increases in the market risk premium and the asset beta jointly contribute an increase of.%, and the increases in the debt margin in the leverage jointly contribute another 0.%. Well, the comparison as shown in table on page, where I list all of the parameters and then show the Commission's low and high points, the midpoint of those ranges, and similarly for the estimates that I suggest The last line in the table shows the cumulative effect, so that the Commission's range is. to. with a midpoint of 0., whereas the outcome to the estimates that I suggest is a range of. through to., with a midpoint of.. Now my midpoint is not symmetric, in that it's not the midpoint in the normal sense because of the view that I take on the dispersion of the estimate for the market risk premium. I attach very little probability to it being less than %, and so I take the midpoint as being the same as the high point of the range Now, given the sort of standard errors that apply to many of these estimates, in a statistical sense of course you couldn't actually distinguish between the Commission's estimates and my estimates. One rate as opposed to another rate set by a company of course could well translate through to big dollars, in terms of the difference Well, the second point that I comment on is the issue of

6 0 should there be a margin over WACC, and there are I guess three areas that one could talk about there. One is firstly the issue of asymmetric risk, secondly optimisation and thirdly departures from the assumptions that are made when the decision is made to use WACC for investment decision-making. Well, the Commission has rejected the need for a specific margin for asymmetric risk and has determined 0.% for optimisation. In terms of the appropriate numbers, I don't have any basis for agreeing or disagreeing with those results. In terms of the third area, departures from the assumptions underlying the use of WACC, there are two elements. Firstly that we assume that markets are perfect, so that there are no information asymmetries, no funding constraints, no financial distress costs, no regulatory uncertainty and so on, and also we assume that the investment opportunity set is static, so that there aren't dynamic investment opportunities Well, in particular in terms of real options, if there are significant real options the value of those options will be built into the market value of the company. If making an investment causes those options to be closed out that has a cost associated with it, therefore in order for the company to maintain its value it needs to earn more than WACC on the investment that it makes Well, the cumulative effect of all those factors is that there could be a case for adding a margin over and above WACC, and that margin has got nothing to do with the issue of uncertainty in estimation of WACC. The case for that margin is independent of the difficulties in say assigning a number to beta, to the market risk premium and so on The final area is that of actually making the assessment that an entity has earned excess profits. The Commission in substance proposes to identify excess profits by making a comparison of the average realised rate of return with WACC and it could be WACC plus a margin, and indeed the Commission has got the suggested margin of 0.% for optimisation. The trouble with that approach is that rates of return are in fact highly variable, and in making that comparison, the Commission would be in much the same position as a controller of quality in a production environment, where the production process in focus may have a certain say, mean characteristic for the product being produced, every now and then the quality controller goes along to the process, takes out a sample, calculates, say, the mean of the items in the sample, and makes a comparison between that mean and the specified mean for the product that's being produced. On the basis of that comparison the controller then decides is the process still in control; in other words does it seem to be operating with a mean as specified, or has something happened which has caused the process to go out of control? If the controller takes the latter view, then some investigation would

7 0 be undertaken to see whether that was just a statistical fluke that was observed, or whether indeed there was some underlying factors that needed to be remedied. Well, basically the same situation applies here, where the Commission would be looking at realised returns over a five year period and saying what's the average of those in comparison to the WACC, or whatever target rate was set? And then trying to determine that, if there is a difference, and let's say that for example the target rate was %, the observed rate is %, does that mean that the company was just lucky or does that mean that the company actually set out to make % or some other number well in excess of the Commission's target rate? Well, I've done a kind of back of the envelope calculation here and assumed that the standard deviation of rate of return is %. If we then assume that the successive rates are independent and make some other fairly high level abstractions perhaps from what's actually going on, then we can make some statements about the probability of making a type one error, or at certain levels, and for example we could say that if the difference between the target rate and the observed average was more than %, then that would be possible with only a probability of % if the process was still operating at a target rate of whatever it was that was set. Or in other words the Commission would be entitled in terms of its statistical exercise to say that the company had actually set out to do better than that target rate, providing that the observed average was more than % above the target rate. Now that's at a % level of significance, namely a % probability of concluding that things are out of control when in fact they're not out of control. If you vary that -- MS REBSTOCK: Can I ask you a question, sorry to interrupt you, the %, is that correct something you consider -- have you just picked % for the standard deviation of the rate or return, or is that based on some evidence? MR VAN ZIJL: Well in a practical situation one would estimate it from the sample, unless one had reason to believe in some particular number for the process generating the sample, but usually the knowledge of the underlying process is pretty scant, but in terms of some published work done in the mid 0s by Michael Firth and Ross Mear, for a profit rate similar to what's defined in this context as ROI, they found a standard deviation of around %, and in terms of the rates earned by the three companies here, Vector, UnitedNetworks and, as reported on the MED website, it seems that % is also a reasonable sort of estimate of what the standard deviation was, at least for those three companies. But it could well be that the Commission in designing this threshold has already done this sort of research and has got a better estimate than I've got. MS REBSTOCK: I just want to make sure I understand the implications of what you're saying here, and for that purpose

8 0 I'll simply take it as read that the analysis is the appropriate way to look at it, and your midpoint range of. is right. Am I right in assuming that that then suggests that a margin on WACC would be between 0. and. roughly, percentage points above WACC, is that about what it turns out? MR VAN ZIJL: I'm not with you. MS REBSTOCK: Does that translate into what you would see as a reasonable margin over WACC using this analysis? Do you use that then to go on -- MR VAN ZIJL: No no, what I'm saying is this. If say the Commission agreed to.% for example and also agreed that there was going to be some sort of margin in terms of the earlier discussion, that the target rate was say going to be %, well, the Commission would then look at a particular company over a five year period, calculate the average, and if that average was say, then on a statistical basis it could still rest with the assumption that the company is just trying to earn the target rate of %. And that's a huge margin above the target rate. So, you've got to be, in terms of that % assumption, % level of significance, you've got to be more than % away from your target, in order to reject the hypothesis that the company is merely trying to earn its target rate. Now, if you lower the significance level in the sense of higher probability of a type one error, or making the wrong conclusion out of your quality control assessment, then that margin decreases and at % it's only %. But it still means that say at a target rate of, Commission could observe 0, and still assume that the company's just doing what you had expected it to do but it's been lucky, you know, the environment has been kind to it in various ways, maybe cost efficiencies have poured on its plate out of heaven, volumes have been higher, whatever. But its pricing has been according to your formula. MS REBSTOCK: But this doesn't give us any guidance on what a reasonable margin over WACC would be? MR VAN ZIJL: Well, the margin over WACC is a separate issue. That's the issue of, if you were say conducting an investment decision-making exercise, what sort of WACC would the company be looking for. Well, you could argue that, say, in terms of my numbers that the company might be looking for or some other number up above -- over and above the.. The third issue that I've addressed is the one of the difficulty for the Commission of looking ex-post and saying has this company in fact been trying to earn monopoly profits or has it been trying to behave in the way that we would have hoped it would behave. MS REBSTOCK: So this isn't an argument at all about a margin over WACC, it's simply an argument against trying to do an ex-post assessment? MR VAN ZIJL: Exactly. And on top of that the threshold that the Commission has -- MS REBSTOCK: Can I just -- sorry for doing this to you, and I'm

9 0 sorry for misunderstanding your submission, but going back to the margin over WACC issue, we've had it suggested to us by at least one submitter that a reasonable margin over WACC to deal with some of the other issues that you've raised is to percentage points, and I did ask them for what evidence they had to support that and I believe they said they didn't have any specific evidence, and I just would like to ask you what do you -- where does your analysis lead you under the first, I think it was the first two points that you raised, or the second point you raised here, in terms of a margin over WACC. MR VAN ZIJL: I think there's a case for a margin but what the size of that margin would be I haven't really addressed and I don't think I know enough about the companies and the industry in order to form an assessment. MS REBSTOCK: Sure, how would you form that assessment though if you were to do it. MR VAN ZIJL: Very difficult, and I think eventually you would be kind of putting your finger in the air and hoping that you held it the right way. But clearly it would be a matter of great concern I think to the Commission, in the sense that clearly the Commission would be concerned that companies continue to exist, that the rate that you set for the companies is an appropriate rate, and -- MS REBSTOCK: I just wonder though in terms of just a general sense of reality -- it seems to me the suggestion of to percentage points is very significant, even on your measure, midpoint of., it's up to % of that above WACC. Does that surprise you at all, that the suggestion might be that it could be that great. MR VAN ZIJL: As I said earlier, I haven't addressed the question of what the margin might be, but just taking one of the sources of justification for such a margin, real options, I think these companies are indeed companies that would have significant real options, and killing off an option through an investment may in fact, you know, put a decent sort of dent in their value, in which case the investment by closing out the option would have to earn a rate well in excess of WACC in order to keep the value intact. MR CURTIN: I hear your argument about seeing a signal to a fog of stochastic noise, I can see where you're going with that, but on the real options point, wouldn't most of the compensation required for the investor already be in the market risk premium? Isn't that at least in part what the market risk premium is for. MR VAN ZIJL: The WACC estimate, there is some evidence that suggests that WACC is a little bit higher for companies that do have real options. There seems to be a positive relationship between beta and the existence of the options. So, it's kind of consistent with that. But we haven't specifically addressed that issue in setting the beta for these companies, and clearly that would vary a great deal also from one company to the next.

10 0 MS REBSTOCK: I just want to come back to your comment that it would be very hard to estimate what a reasonable margin over WACC would be. I guess I'm going to do that because even if we were to accept submissions from some interested parties that we should drop the profit threshold and that the price path in itself allows us to meet the purpose statement, including limiting excessive profits, it still seems to me that in setting Xs we may very well still have to come to a view on what is excessive, and so the issue doesn't entirely go away and this remains an important issue for us. Would you accept that view? MR VAN ZIJL: Yeah I think that is a very important issue, and clearly if you do go down the track of a profit threshold it's an issue that the Commission is going to have to address and make some empirical estimate. MS REBSTOCK: I guess what I'm putting to you is that it's not an issue that goes away even without a profit threshold. MR VAN ZIJL: In terms of the original price yes. MS REBSTOCK: And in that sense it's an important issue. It has been put to the Commission that the parties would be able to comment if we were to suggest an appropriate number and people could respond to it, but I guess my view on this is that the parties themselves are in the best place to understand what might influence a reasonable margin over WACC, and if there is a basis on which to do it then parties should provide those submissions, and I know it's up to your client whether they seek that input from you, but I guess my suggestion to is, is if there is a means to do this then I would suggest that it would be valuable for you to put it forward, because you are the ones that have the information to allow this to be done, not the Commission. I think the onus must be on submitters to provide suggestions on how this might be done, and the justification for it, if it is to be expected that the Commission do this, because I have yet to hear someone suggest the basis on which the Commission could do this, and I wonder then how submitters think we can justify it, if no-one can tell us the means by which it might be precisely justified, or even approximately justified. So, I'm really seeking your input on this matter. MR CURTIN: Just two quick points. You mentioned that Professor Bowman had followed your line of attack on Australian data, just by way of giving us a bit of extra information, what did he come up with the market risk premium for the Aussie market? MR VAN ZIJL: You've got me there. MR CURTIN: Perhaps if someone could just direct the staff to it, that would be good. MR VAN ZIJL: The reference to the paper is in my full paper. MR CURTIN: I see that and I just -- I haven't read the Bowman paper, but I thought you might carry it in your head, given that the Aussies are a bit like us if I can put it that way. The other point just on the volatility issue and being sure that you were picking up excess profits and just by way of

11 0 illustration you had that % standard deviation, I presume though if we were looking at a five year average of ROIs my feeling would be that that % would be on the high side for the volatility of a five year average given that you get overs and unders over a five year period and you did have a reference to some empirical data in the % territory. But would that have been a distribution of one year returns or five year returns? MR VAN ZIJL: I think it was a cross-sectional distribution, so one year, and as for all of the companies listed on the Stock Exchange at that time in New Zealand. There were various reasons for excluding certain of the companies like, for example predominantly finance companies, some companies that failed to qualify for the data set in other ways, and I think they ended up with something like about companies, but that was crosssectional so that was in a given year. But, as I also mentioned I just did a back of the envelope calculation for the three companies that I was concerned with here, and over the five years that I reported on the MED website at the present time for ROI, the standard deviations there I think from memory were sort of I think % in one case, about or % in another case, and about % in the third case. So, if you say imagined yourself that you were in the situation of looking at the case of a company with a standard deviation of, you're going to get a margin even bigger than the one that I've illustrated here. MR CURTIN: I understand that, but just following up on my colleague's point, if we were minded to put a margin over WACC to cut out the noise if you're fossicking around and you find any easy way of saying how the SE went or some other measure of aggregate profits on a five year basis, that could be quite helpful. CHAIR: I think just a couple of additional points, the comment that was made about the submission in relation to or percentage point margin over WACC to some degree was top of the head, it was I think Vector who, the Vector Chairman who sort of seized on the figure. So, I think anything else that's said that's empirically available would be useful, and secondly we've also had very strong submissions and it's on the record from a couple of groups that there should be no margin over WACC so we're going to have to make a judgment, based on whatever we can get our hands on, so it is a very critical point. Are there any other Commission questions? Perhaps I might ask Dr Lally while he's here to pick up any specific points. DR LALLY: Yes, just to start off with a side reference to an issue that you raised Donal about Bowman's analysis on Australia. As with Mr Van Zijl I don't have the Australian figure off the top of my head, but it is interesting to note that the NECG submission which will be appearing tomorrow, is clearly either written by Professor Bowman or draws upon that type of analysis and the results that they're generating through New Zealand, through that kind of analysis, there are some range in the

12 0 numbers from memory, but clearly at least as large as the % number that Dr van Zijl is suggesting. Turning to your analysis Dr van Zijl, if you were sitting in a Commission like this in the United States today and you were being asked what the market risk premium is for the United States, presumably the fact that you get the number for New Zealand by taking the % number for the US and making the tax correction for the difference in the CAPMs to get your number of, presumably if you were sitting in a Commission today in the US and debating the US market risk premium, presumably you would have said. MR VAN ZIJL: Indeed. DR LALLY: And in arriving at that number of you would be using historical data over the period 0 to 000. MR VAN ZIJL: Mmmhmm. DR LALLY: Now, as you are well aware there is an awful lot of debate in the United States about the market risk premium and there are regulatory hearings all the time on this question, and a wide range of evidence is put to those Commission's in the United States by academics like yourself and others, and some of the people who are presenting at those Commission's will point to the historical average type data, but the Ibbitson type stuff, there'll be some debate over the period, but other people will point to other studies like Seegill, to forward-looking methodologies and so forth, and the tendency in these other sources of information is to produce lower numbers than is produced by looking at historical averages. And to get some sort of sense about how significant people think these other sources of information are, one could go to the Welch type survey data, which asks academics what they think the MRP number is, and if you take Welsh's latest survey and you adjust it to measure the market risk premium relative to long-term bond rates, the number as indicated in my own paper here is about % for the US, being Welsh's. measured relative to short bonds, corrected for the difference between short and long bonds gives. It appears in my WACC paper for the Commission. And that % number in the US relative to the % number which you would have promoted if you were in front of a US Commission, presumably gives some indication to you that your professional and academic colleagues in the US think that a fair bit of weight should be put on these other approaches to the MRP, the Seegill type approach, the Murton type approach, the forward-looking approaches. So if you were to be in a Commission hearing in the US and promoting, you would be lying well into the right-hand tail of your professional colleagues. MR VAN ZIJL: Yes. The figure from the second Welch survey Martin I would need to check again. It's gone into the recesses of my memory. DR LALLY: It's.. MR VAN ZIJL: Is it, okay, and that's relevant to --

13 0 DR LALLY: Short bonds. MR VAN ZIJL: To bills. DR LALLY: Yes. MR VAN ZIJL: In that regard it's interesting to see how that survey has produced differing results, in that the first time that Ivo Welch conducted the survey, my memory is that at that stage he was reporting an average of around, and if you look at say the survey results that are currently sitting on Damodaran's website, have you looked at that? DR LALLY: Can't give you the number off the top of my head. MR VAN ZIJL: Well, if you look at the distribution there, and make reasonable assumptions about the midpoint of the intervals and so on, then the average being reported there is very close to %. Now he doesn't specify whether its bills, or medium term bonds, or long-term bonds and that's often a problem with looking at data from the States that you're not sure as to what the reference point in fact is. But in terms of the distribution that's posted there at the present time, and that's going on at the moment, it's live, you can push the button and you record your vote, I would sit -- my guess is at around about the sort of % off the top, around about the 0 percentile, but one has to take a view as to how you would do your forecasting and I concede that relative to many other people who would have an opinion on what the appropriate market risk premium is at the present time, I sit at the high end, but if I was having to spend my own money, I would sit with my estimate. DR LALLY: Okay. You started off with a very interesting analogy about Russia. I thought you were going to say, not so much that the historical data was not terribly indicative of the future, but simply that there wasn't any historical sharemarket data from and October onwards. Nevertheless, your point is taken that there are difficulties in projecting the future from the past and quite often if one looks back over past data one can see reasons why the past might be biased. And if you apply the same reasoning to the Ibbitson type study, many people have said one of the problems with the Ibbitson type approach of historical averaging is that there are good reasons to suppose that the results from that process are too high. For example, the volatility in the US market has come down over that period, that would suggest the market risk premium comes down, Seegill's analysis on real returns on bonds suggests that the real returns were considerably less than would have been anticipated. Do those kinds of arguments that, even with the Ibbitson type data, there are reasons to suppose the past is a biased indicator of the future, does that kind of reasoning suggest that some weight should be put on alternative approaches which are free of those problems? MR VAN ZIJL: I guess it depends on the significance that you attach to things that you've just referred to, such as Seegill's

14 0 finding or comments that are made say about the work of Ibbitson, and the extent to which the present approximates those particular characteristics, or whether you simply say well, I'm looking at data that covers a long period of 0 years, there's a whole raft of different kinds of elements of experience in there, I haven't the foggiest which of those is going to appear again next year or five years out, but a reasonable approach is to take the average across the whole range of that experience. DR LALLY: Okay, moving away from market risk premium. MR CURTIN: Just before we leave that, the Ibbitson thing reminded me of something. Do Ibbitson and other studies have a survivorship bias in them? MR VAN ZIJL: Ibbitson does, but the Dimson data wins on that score in that it's been cleaned up for survivor bias. DR LALLY: Moving away from market risk premium on to beta, your -- one of your principle comments in this area is that the beta estimate that is suggested in my paper is addressed to the current thresholds regime rather than a control regime, and your view is that the thresholds regime is pretty much the same as a control regime. MR VAN ZIJL: Well, I think I described it this way Martin, that I am not unhappy with the results that you got from your analysis. It's territory we went through in the Airfields inquiry, the approach is basically the same. I think the answer that you come up with in terms of the numbers that you start from in this case are quite reasonable, but as it turns out updating the numbers that you've used to current estimates leads you to a higher point, and for that reason I suggest that we've -- we should be looking at a point estimate of 0.. DR LALLY: It's always difficult to ask questions of someone who insists on describing me as reasonable. Nevertheless, if I were to draw an analogy, what you're doing is to say that locking a person up in jail produces the same results as threatening to lock them up. Would that be a reasonable analogy? MR VAN ZIJL: I haven't had personal experience of that, and I hope I don't get any either. But what I'm saying here in terms of beginning to behave as if you're already subject to control is, that if you are concerned about becoming subject to control, then clearly you're going to look at the drivers that are going to make you subject to control, and you're going to steer just clear of those drivers presumably, and steering just clear of those drivers presumably is the same place as you would be if you weren't subject to control. DR LALLY: There is of course some uncertainty on the part of the lines businesses just what the Commission is going to do in 00, in the same way that parking your car outside here this morning and not putting money into the meter, insofar as there's any possibility that the meter people won't come along you may be inclined not to put money in the meter. I'm not suggesting you'd do this personally, but you see the point that if there's

15 0 uncertainty about what's going to happen you might not drive just within the margin. MR VAN ZIJL: Well, you might form your own estimate as to how close you can sit to that margin, but it's not so much a case of you taking a risk in that sense it's more a case of I think, you know, the risk that somebody comes along and hits your car with a hammer. DR LALLY: Okay, well, moving on to the risk free rate, the kind of approach that I've taken to arrive at the conclusion that the five year rate or the rate corresponding to the regulatory term, is the one that matters rather than the year rate, the kind of approach I've taken is to say what choice of term would lead to the present value of the future cashflows matching the initial investment, and that leads, through my analysis, to the risk free rate term that matches the regulatory period. Are you comfortable with that philosophy, or is your point of departure before we even get -- MR VAN ZIJL: No. The model that you've constructed is like all models, in that it's an abstraction from a complex set of events and you've tried to isolate the key variables that you think are at play, and within the environment that you've constructed I agree with the logic of the model, there's nothing wrong with that. You deal in an environment of certainty, but the introduction of uncertainty would unnecessarily clutter the field so it's not important. But the trick is that we're not in fact looking at a simple two period world, where the Commission sets a price today and sets another price threshold tomorrow. We're looking at a world where in fact the Commission would do the resetting at five yearly intervals. I could agree with the implications of your model if the resetting was going on on a continuous basis, at every instant in time, the Commission came along and set a new price threshold, then at the same point in time the company could refinance, they could borrow for one instant, borrow for another instant and so on, and your model would work perfectly, but that isn't feasible. (A) The Commission wouldn't have the resources to do that and (B) it would be extremely costly to the entity in terms of transactions costs associated with its financing. What's more is that your model is also based on the assumption that there is the opportunity to be completely compensated for the new rate and there's no guarantee of that. You know, regulators don't always do what people think they're going to do on the basis of what they said at the outset DR LALLY: Right, but the model that's constructed is a discrete time model and there's no reason in a discrete time model why the time interval in a discrete time model could not be defined to be five years, or five days or any other term that you choose. MR VAN ZIJL: The point that I'm making is that the entity has also got concern about what happens within the five years and the

16 0 outcome of what I'm saying there is that I don't think five years is the right answer. I'm not saying that as a result of that disagreement that years is the right answer, or that two years is the right answer, but I'm saying that five years isn't the right answer. If you then say well, we've gone through a modelling exercise but we haven't ended up with an answer that seems to fit the actual real world circumstances, what do we then do? Well, traditionally people do things like finance assets for terms that are kind of consistent with the projected lives of those assets, and that can be justified in a whole variety of ways, but transaction costs is one of them, and avoidance of the risk of hold up by financiers etc DR LALLY: Is it reasonable to say that if the year bond rate which you're pointing to today was below the five year bond rate, would your prediction be that, leave aside your own personal position, would your prediction be that the lines businesses would lose enthusiasm for the duration argument which you're putting forward. MR VAN ZIJL: Well you're asking me to surmise what goes on in their minds and, although I'd like to be a clairvoyant, I can't do that. But I think I'm getting the drift of what you're aiming at, and that is that it could well be that because the term structure has the upward slope at the present time, that years looks more attractive, but if you say years this time you come back in five years with the same argument, but you now say that your conclusion is that it should be five years. You're going to look somewhat inconsistent aren't you, and the companies I don't think have come along at any stage and said you know that we now think it should be a different rate. I think the arguments from most of the utility companies have been fairly consistent over time that it's the long-term rate. They're dealing in long-term assets. DR LALLY: Okay thanks very much. MR CURTIN: Just on the same note I heard your point earlier, for consistency sake when the MRPs been calculated it was relevant to long bonds so I took that away. In Airfields I think there was clearly a pricing cycle of three years from memory, so that was kind of helpful there. There isn't an obvious pricing cycle here, but a thought did just occur to me based on something that Martin was saying. Why wouldn't you look at something like, given investor preferences in New Zealand, the typical debt issue by an investment grade corporate is a five year note issue, or a year note issue and just observe the modal duration of the typical bond is, let's say, seven years and use that just as a practical matter. MR VAN ZIJL: Yeah, I think I actually make a comment along those lines in my paper that in the -- in the full paper, that it's not an issue that I think really the Commission ought to be determining on. I think it should really be left to companies

17 0 in the same way as choice of leverage should be, and if the company wants to operate with seven years of debt, presumably they've got good reasons for it, and if you impose % you may in fact be driving them in a direction which just results in dead weight costs that doesn't make the community any better off. MR CURTIN: I understand that, thank you. DR LALLY: Could I just respond there with one question. Your suggestion here that one should just look to what companies are doing and work off that, if the regulatory process were simply to point a telescope at what companies were doing and then lever off that, the company's aware of the fact that the telescope would be pointing at them, would look at the term structure -- you're smiling so you know where I'm going -- would look at the term structure, choose the term which had the longest number and put that to the Commission and say there you go wouldn't they. MR VAN ZIJL: If they come along with arguments that they wanted years and if that appeared to be advantageous at the time, but then the experience is they all rush out and obtain two year financing then again you've got a credibility problem haven't you. DR LALLY: Exactly. MR VAN ZIJL: Maybe then you go to the point made by Commissioner Curtin, that you look at what companies actually do, and remember that this is on the cost side of the fence, it's not on the revenue side, you know, it's a bit hard to think of why companies would want to go and incur costs that are not really in their best interests. One final point that I was going to make before in the -- when I was having the discussion with Commissioner Rebstock, and that relates to the footnote that I've added to page. That relates to the method that the Commission proposes for accumulating the realised experience over the five years. It appears that the Commission has in mind compounding forward, at the Commission's WACC rate or whatever the target rate is, the excess profits identified, and I'm very surprised by that because these profits are ex-post amounts, and the only difference between something received, say two years ago for certain and now is time value of money. There is no risk involved. So, the compounding should surely be at the risk free rate. DR LALLY: That's the view at the time of the Airfields study and I've now been persuaded of the error of my ways. CHAIR: Thanks Dr van Zijl very much, particularly for answering those questions and the margin over WACC I'll leave with you. Many thanks. We'll take five minutes break while sets up for their other presentation. [Brief adjournment]

18 0 CHAIR: I think we might resume. So, the next submitter is and I'd ask Mr Roger Sutton to commence please. MR SUTTON: Good morning it's a pleasure to be back here again. CHAIR: Thank you. We didn't get quite the same impression yesterday from one or two submitters, but please. MR SUTTON: I might just introduce the rest of my team who I think you're familiar with. Greg Houston, across from Sydney; Rob Jamieson, who's part of our team at ; and Mark Berry, and Forrie Miller. So the order will be, Greg's going to talk about the core economic issues if you like, Rob and I will talk about if you like, some of the applied economic issues as we see them from our perspective and then we're going to finish off with the legal issues from Mark and Forrie. So, Greg. MR HOUSTON: Thank you Roger. Good morning Commissioners. I think you have a copy of our presentation. On the second page there's an outline of the things that I'll be covering in the sort of economic aspects of this, of my presentation here this morning. I'll just read these out quickly. First, the proposition that the Draft Decisions involve a sort of misalignment with the purpose statement, then some discussion about the excess profits thresholds and some of the quite serious problems that we see with that. The absence of incentives and certainty, which is another important sort of area, a point -- a discussion about excess profits, and the relationship between average returns and excessive returns, the interpretation of the X factor, problems with the WACC, which has mostly been discussed but I will make one or two contextual observations about the WACC and how it's proposed to be applied in this situation, and then finally from an economic perspective, the absence of detail and reasoning in the Commission's Draft Decisions as we have them. So, I want to start off on the next slide with some discussion about the purpose statement, and I'm sure you've heard about the purpose statement until you're sort of absolutely fed up with it, but it is a fundamental -- it's a foundation of what is trying to be done here, and so it's important to reiterate it and I think an important observation that came to us very quickly was that the Draft Decisions unusually, don't really contain any discussion of how those decisions fit with the purpose statement. It has been discussed in previous papers of the Commission, but at this point we're I think -- the decision s that are before us are a bit short on how the Commission sees those being referenced back to the purpose statement. There are -- I mean this is not a quote from the purpose statement, but it identifies five, what I see in economic terms, are five distinct features. First that the regime must operate through targeted control. It must focus on the long-term benefit of consumers. It must limit the ability to extract excess profits. It should also provide strong incentives for efficiency and ensure the