The ODV Draft Handbook Submisssion to the Commerce Commission on behalf of the Electricity Networks Association Stuart Shepherd 14 April 2004

2 Context The Commission has made a draft decision to allow lines businesses to use: –Valuations based on ODV for their “opening” positions –Either valuations based on ODV or DHC thereafter (but not the option to change from one to the other) The Commission has also stated it intends to use the valuations derived from the application of the ODV Handbook: –For the information disclosure regime (subpart 1, Part 4A) –For the targeted control regime, which includes investigating post breach if control should be imposed (subpart 3, Part 4A) It appears such valuations may also be used to determine price levels for goods and services that are controlled (Part 5)

3 Context (cont’d) When evaluating valuation methods in 2002 the Commission’s analysis assumed each method would be implemented consistent with that method’s principles –And the Commission based its draft decisions on that analysis Thus a key test for the ODV draft Handbook is whether or not it would implement the ODV method as assumed in the Commission’s original analysis I therefore consider whether the draft Handbook would implement the ODV method consistent with its principles

4 Two key issues I wish to focus on two key principles of the ODV method that the draft Handbook would not implement consistently 1.The ODV method starts with a service that is to be delivered, and then incorporates all assets required to deliver that service 2.The ODV method requires market prices to be used for asset values

5 Start with service, include all assets The ODV method: “assumes that the value of assets to a business is equal to the cost the business would incur if it were deprived of the use of its assets and then took action to restore its operating position to the pre- deprival situation by replacing its old asset base, at the lowest possible cost, with an asset base providing an equivalent service potential” (para 1.2 of draft Handbook) Thus the test as to which assets are included in the valuation is determiend by the requirement that the asset base must be capable of delivering the “equivalent service”

6 Start with service, include all assets (cont’d) The draft Handbook does not use this “equivalent service” test to determine the set of assets to be included in the valuation It covers “system fixed assets” only: –Some other “fixed assets” are covered by the current disclosure requirements, but these are not covered in the draft Handbook e.g. office buildings & equipment, asset management systems (GIS), and computing systems. It excludes assets on the basis of: –The ability to shift the assets geographically, e.g. mobile sub- stations and generators –The service the asset provides being contestable, e.g. generators –The asset being intangible in nature, e.g. some easements, databases and intellectual property None of these exclusions are consistent with the ODV method

7 Start with service, include all assets (cont’d) This issue could be addressed by modifying the Handbook: –To allow all types of assets to be included that are required to deliver the service, and not just “system fixed assets” –To ensure any tests for excluding assets are based directly on whether the asset is required to deliver the “equivalent service” –To remove the tests that exclude assets in a manner inconsistent with the ODV method

8 Market prices required for asset values The “lowest possible cost” aspect of the ODV method reflects the need to optimise the network from an engineeering and economic perspective –The cost for the optimised set of assets should be market prices The draft Handbook sets out maximum values that may be used for many assets However lines businesses have provided evidence that these draft maximum values are in many cases below the prices at which they themselves can purchase the assets –E.g. the PwC submission on behalf of 19 lines businesses, Orion and Vector –The Commission has not publicly responsed to those claims, and to date has revealed neither the method its advisers used to arrive at the draft maximum values, nor the actual prices they used or their sources Thus on the evidence so far it appears the draft schedule does not reflect market prices

9 Market prices required for asset values (cont’d) This situation raises two issues: 1.The extent to which a mandated schedule of prices is a reliable method for identifying market prices for the assets 2.To the extent that a schedule is used, whether the process relied upon by the Commission to date has delivered a credible result Regarding (1), we understand the reason for a schedule is to aid consistency of valuation across lines businesses: –For installations that are similar across lines businesses this consistency is probably desirable –Where the installations are not similar it is incorrect to expect the costs (or valuations) to be similar –This suggests there are limits to the extent to which a mandated schedule of prices will result in a reliable valuation

10 Market prices required for asset values (cont’d) The limits to the reliability of using a mandated schedule could be addressed by allowing lines businesses to also use their actual costs in the valuation, subject to appropriate audit criteria –We note some lines businesses have already adopted this approach in their statutory accounts, demonstrating it can in practice be used under FRS-3 –We also note that the use of actual costs would (presumably) be allowed under the DHC valuation method, and that (other than for optimisation reasons) there appears no good reason why the same approach could not be used under ODV

11 Market prices required for asset values (cont’d) Regarding (2), it is usual for the Commission to expose its quantitative estimates to public scrutiny: –And where there are confidentiality concerns, to restrict the flow of information appropriately However in developing the draft schedule neither the methodology nor the prices have been subjected to scrutiny: –There is evidence from lines businesses that the draft schedule is not a reliable reflection of the prices in practice available to lines businesses –And the Commission has not responded publicly to this evidence This procedural issue raises concern not only for the development of the current schedule, but also in relation to how the schedules will be revised in the future

12 Market prices required for asset values (cont’d) This procedural issue could be addressed by: –Documenting the methodology to be used to update the schedules and issuing it for comment –Documenting the prices used and their sources and issuing them (if necessary as restricted information) for comment –Revising the schedules, taking into account the comments received –Committing in advance to updating the schedules on a regular basis (e.g. every 5 years), and to following a well specified and transparent procedure when doing so

13 Summary & suggested way forward The ODV method starts with a service that is to be delivered, and then incorporates all assets required to deliver that service –But the draft ODV Handbook excludes assets that are required to deliver the electricity conveyance service The ODV method requires market prices to be used for asset values –But lines businesses appear unable in many cases to acquire and install assets at the stated prices in the draft ODV Handbook Thus in my view the Commission does not have at this stage a Handbook that would implement ODV in a manner consistent with its principles

14 Summary & suggested way forward (cont’d) In order to take the draft ODV Handbook forward I suggest the Commission consider the following approach: –Revise the draft Handbook to take account of the issues raised in submissions, at this conference, and in cross-submissions, and ensure that the Handbook would implement the ODV method consistent with its principles –Document how each issue raised in submissions has been addressed in the revised draft, or why it hasn’t been addressed –Document the method used to revise the schedules, and the actual prices used –Issue all the above for comment (recognising the prices used in the schedule may be restricted information) –Finalise the Handbook, taking into account the comments recevied from the above process