Asset Valuation, ODV, and Contestability Theory Geoff Bertram School of Economics and Finance Victoria University of Wellington [e-mail]

1
Asset Valuation, ODV, and Contestability
TheoryGeoff BertramSchool of Economics and
FinanceVictoria University of WellingtonGeoff.Be
rtram_at_vuw.ac.nz

• Paper for Brightstar 5th Annual Competition Law
  and Regulation Review Conference Wellington,
  21-22 February 2005

2

• Today Im going to talk about ODV. The paper has
  three sections
• 1. Theory
• 2. History
• 3. Observations

3
A simple picture of a monopolist
4
The big question what is P2 ?
5
P2 has to be greater than P1 for the enterprise
to be profitable at all
6
One possibility a regulator sets P2 such that
ABDE is a fair and reasonable return
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
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.
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)
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
11
If theres no regulator, P2 will be the
monopolists profit maximising price, so ABDE
will be as big as possible, subject only to the
demand curve
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)
P1v
13
The Lerner Index of market power
14
The Lerner Index of market power
Variable cost
Price
15
The Lerner Index of market power
Price-cost margin
Elasticity of demand
16
The price-cost margin, of course, is the height
of the profits rectangle, DE. Monopoly profit is
the margin times the volume.
17
Carlton and Perloff Modern Industrial
Organization (3rd ed, Addison-Wesley 2000) page
246 equation 8.4
18
Price of capital equipment
Physical inventory of capital equipment
Variable (marginal) cost
WACC
Depreciation rate
Volume of service
Demand elasticity
Price
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.
20
First, mimic competition by setting
Next, insert the known values of v, d, K and Q.
That leaves r, pK, and pfr.
Set r WACC.
Now all we need is pK, and we have pfr.
21
Doing the same thing from a slightly different
angle
Set
then
or (the usual regulators version)
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.
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

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

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Market value of the firm
Contestability limit
Full replacement cost
S million
Depreciated Replacement Cost
Optimised DRC/ODV
Costless-entry limit
Historic cost
Net Realisable Value
0
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Market value of the firm
Contestability limit
Say 2.5 x ODV 8.4 billion
Full replacement cost
S million
Depreciated Replacement Cost
Say 4.2 billion
Optimised DRC/ODV
Costless-entry limit
Historic cost
Say 2 billion
Net Realisable Value
0
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 gt4 billion

How can you get from here to there?
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

29
One possibility is a ramped glide path
30

• Thats 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

31

• Or, you could do a big bang

32
Mid-life change in regulatory accounting
methodology
End of present asset stocks 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
33
Selling that is a real challenge
So let me turn to some history of the electricity
reforms of 1989 - 1994
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.
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.
36
"The first three were 'forward-looking'
methodologies - methods which look forward in
time by applying some form of discounting/capitali
sation 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.
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.
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.
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.
40
Note the three reasons for going ODRCFirst

• 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 its certainly true
  but as weve seen already its 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.

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)

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Second

• if there was an efficient market for such
  assets, this method is likely to come closest to
  market values
• That, as weve seen already, was simply wrong.
  The takeovers market values barriers to entry as
  well as machinery.

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Third

• this will put strong pressure on management to
  minimise costs in order to meet the return
  requirements of shareholders.
• That also, as weve 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 theyre
  fattening the business for sale at the
  contestability limit (two or three times ODV)

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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

45
Estimated Increases in Required Annual Rural
IncomeSAS (90) 31 13 March 1990 p.10
ESA 1 ESA 2 ESA 3 ESA 4
Low density 60 20 35 -9
Very low density 93 122 108 54
Extremely low density 304 232 215 255
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• 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

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.

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.

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-Youngs 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

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Treasury offered a fix MoC didnt 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.)

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MoC opposed vesting at ODV because the costs in
terms of likely price rises appear to exceed the
benefits

• if ODVs are mandated by Government, many ESAs
  will have reduced incentives to minimise the
  impacts, and are likely to blame the consequent
  price increases on central Government
• Over time, assets will be properly valued in any
  event (a) as mergers and takeovers occur (b) as
  commercial pressures encourage a proper valuation
  of assets .. and (c) as assets are replaced. If
  ESAs undertake these revaluations themselves they
  will have the correct incentives to minimise the
  price impacts

(Luxton briefing document 8 May 1992 p.1.)
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Treasurys fix prevailed

• On 15 May the Ministers decided to vest at book
  value and require the ESAs to prepare their own
  ODVs.
• There was concern that the new electricity
  companies would use the requirement to revalue
  assets as a reason to blame price increases on
  the Government. That is, the Government would be
  seen as being responsible for the price increases
  as a result of directing ESAs to revalue their
  assets.
• (Cabinet State Sector Committee document STA (92)
  96)

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The idea sounded like the ramp model

• For this reason Ministers decided that the
  assets of the ESAs would be vested in the new
  electricity companies at book value.
• In the longer term the new electricity companies
  will replace assets and prices will move towards
  those consistent with ODV asset valuations.

(Cabinet State Sector Committee document STA (92)
96)
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So, the urge to evade political accountability
produced a mess

• Luxtons officials briefed him on how to answer
  FAQs
• Will the changes not result in price increases?
  
• Answer Not necessarily. Price changes will
  depend on a number of factors such as
• - whether ESAs have already rebalanced tariffs
  (many have done so)
• - The extent to which efficiency gains resulting
  from the reform process offset any tariff
  rebalancing.
• (Luxton briefing notes, 27 May 1992.)

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• Q Wont the requirement to operate commercially
  and to earn a return on realistically valued
  assets mean increased prices?
• Answer Not necessarily The incentives to
  adopt efficient and effective management
  practices result in cost reduc tions . Any
  price adjustments that may flow from this process
  will be phased, with decisions on such
  adjustments taken as part of the overall
  commercial decision-making process.
• (Luxton briefing notes, 27 May 1992.)

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• Meanwhile, behind the scenes but too late, Ernst
  Young had found a way to soften their finding of
  price increases of 300-400 million.
• They remembered that revaluations are income, and
  reworked the figures to take account of this.
• On 14 May 1992 they wrote to Mike Lear at MoC
• While valid for tax comparison purposes, in our
  view the base case results are not a valid
  indicator of the pricing implications of ODV
  valuations themselves.

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• Estimating price by applying WACC to ODV, they
  said,
• seriously overstates the revenue required to
  just sustain the operating capacity of the
  business.
• One reason was double-counting expense assets and
  depreciation. The other was revaluation.

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• Where the underlying assets are revalued, part
  of the required return is earned by this capital
  appreciation, so that to achieve the same overall
  return, less income need be earned from
  electricity sales revenues. This reduced the
  required revenues by around 100 million.
• (Ernst Young letter 14 May 1992.)
• But nobody was listening by then.
• The rest is history

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Asset values encapsulate the history of the
decade since deregulation
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• The Commerce Commission now takes for granted
  that revaluations are entered as income when
  calculating required revenue
• (Commerce Commission, Regulation of Electricity
  Lines Businesses Implementing Valuation Choice
  for System Fixed Assets - Draft Decisions and
  Discussion Paper 24 December 2004Paragraph 98
  p.34.)

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• The assessment of excess returns over time
  under the information disclosure regime implies
  an acceptable price level which is based on an
  acceptable regulatory asset valuation, together
  with acceptable values for the cost of capital,
  depreciation, operating expenses, and treatment
  of revaluations. The regulated (efficient)
  revenue model may be expressed as follows
• Rt (At-1 x WACCt) Dt Ot ?At-1
• where Rt is the efficient revenue in period t, At
  is the efficient regulatory asset value (base) at
  the end of period t, WACCt is the nominal
  Weighted Average Cost of Capital in period t, Dt
  is the efficient depreciation in period t, Ot is
  the efficient operating cost (including tax),
  ?At-1 is the revaluation of the regulatory asset
  base (if any), and each of the terms on the
  right-hand side of equation (1) represents a
  value that is considered acceptable for
  regulatory purposes. It can be seen that the
  presence of revaluation gains would have the
  effect of reducing the regulated allowable
  revenue of the business.
• (Commerce Commission, Regulation of Electricity
  Lines Businesses Implementing Valuation Choice
  for System Fixed Assets - Draft Decisions and
  Discussion Paper 24 December 2004 Paragraph 98
  p.34.)

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Are we therefore safe now?

• The answer is no, because the only monopoly
  utilities that are now told to price from the
  correct formula are the ones the Commerce
  Commission regulates.
• The rest are free to continue with GAAP.
• Take ports, for example.

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ODV
Including intangibles
HC fixed assets
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Revaluations
Historic cost
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Or airports