TELECOM NEW ZEALAND LIMITED V COMMERCE COMMISSION HC WN CIV 2008-485-2293

TELECOM NEW ZEALAND LIMITED V COMMERCE COMMISSION HC WN CIV 2008-485-2293 1 April 2010IN THE HIGH COURT OF NEW ZEALAND WELLINGTON REGISTRY CIV 2008-485-2293UNDER the Judicature Amendment Act 1972 IN THE MATTER OF the Telecommunications Act 2001 BETWEEN TELECOM NEW ZEALAND LIMITED Plaintiff AND COMMERCE COMMISSION DefendantCIV 2008-485-2205 CIV 2008-485-2206AND UNDER the Telecommunications Act 2001 BETWEEN TELECOM NEW ZEALAND LIMITED Appellant AND COMMERCE COMMISSION Respondent Hearing: 10-14 August 2009 Appearances: J E Hodder SC, L C James for Telecom M T Scholtens QC, B Hamlin for Commerce Commission B D Gray QC, A E Ferguson, F C Monteiro for Vodafone Judgment: 1 April 2010 at 3.00 pmJUDGMENT OF WINKELMANN JThis judgment was delivered by me on 1 April 2010 at 3.00 pm pursuant to Rule 11.5 of the High Court Rules. Registrar/ Deputy RegistrarWilson Harle, Auckland Chapman Tripp, Wellington Commerce Commission, Wellington[1] Telecom New Zealand Limited (Telecom) challenges two determinations made by the Commerce Commission under Part 3 of the Telecommunications Act 2001 (the Act). Part 3 of the Act requires the Commission to make determinations that spread the cost of providing telecommunications services to commercially non- viable customers (CNVC's) across 'liable persons' (other telecommunication service providers or 'TSP's"). Telecom provides the services at a regulated price pursuant to a deed entered into with the Crown. Telecom says that the Commission committed both legal and procedural errors in quantifying the amounts liable persons must contribute for the 2004-2005 and 2005-2006 years. [2] Telecom's challenges to the determinations are contained in three sets of proceedings (two appeals and one application for judicial review). The Commission opposes Telecom's challenges. Vodafone New Zealand Limited (Vodafone) has also filed appeals and its own application for judicial review in respect of the same determinations. Vodafone's proceedings were heard together with these proceedings, but are the subject of a separate judgment. Vodafone's position in the present proceedings is that the issues raised by Telecom cannot be logically isolated from errors alleged in the Vodafone proceedings, so that if any error is found, all issues should be referred back to the Commission for reconsideration.Background to the proceedings[3] Since its privatisation, Telecom has been obliged to maintain local residential telephone services at a regulated price. The obligation was originally part of the Kiwi Share Obligation contained within Telecom's Articles of Association and subsequently its Constitution. Since 2001 and the coming into force of the Telecommunications Act 2001, Telecom's obligation to provide those services has arisen under and been regulated by that Act. In December 2001 the Crown and Telecom entered into the Telecommunications Services Obligation Deed for Residential Telephone Services (the TSO Deed). The TSO Deed replaced the original Kiwi Share Obligation and is deemed by the Act to be a TSO instrument. Under the TSO Deed, Telecom is obliged, amongst other things, to:(i) maintain free local calling options for all residential customers; (ii) maintain in real terms the standard rental for residential customers at or below the level charged in 1989; (iii) charge rural customers no more than the standard rental; and (iv) meet a number of service quality standards. These services are commonly referred to as 'TSO services'. [4] The Commission is required to determine the net cost to an efficient service provider of providing the TSO services to CNVC's and then allocate that net cost amongst liable persons. The Telecommunications Act provides the framework for the Commission to do this. The Act defines net cost in s 5 as 'the unavoidable net incremental costs to an efficient service provider of providing the service required by the TSO instrument to [CNVC's]'. The expression CNVC is not defined, but the Commission's definition of that expression is not disputed. It defines a CNVC as 'a Telecom residential customer in respect of whom the incremental cost of providing the TSO services exceeds the standard residential line rental plus expected supplementary revenues'. [5] The Commission uses economic modelling to calculate net cost. In its first determination the Commission modelled a network in which the geographic location of Telecom's existing nodes was taken as fixed, but the network upstream of the nodes (the 'core network') and downstream of the nodes (the 'access network'), and the equipment used, were optimised using a range of best-in-use technology as at 2001. This was referred to by the Commission as a 'scorched node model'. [6] 'Nodes' are the points in Telecom's network where a switch or a remote line unit (RLU) was located at 20 December 2001. The switching network model is based on conventional public switched telephone network technology configured into a four-tiered architecture of nodes as follows:ƒ remote multiplexer/transmission sites providing [main distribution frame], line card and transport services across feeder links to local exchanges;ƒ RLUs which provide [main distribution frame], line card and traffic concentration services and are hosted by local exchanges;ƒ Local Exchanges (LX) providing [main distribution frame], line card, traffic concentration, RLU hosting, local switching and CCS #7 signalling; andƒ Tandem and Gateway switches, which provide inter-region and international switching of traffic. [7] In the subsequent determinations for the 2002-2003 and 2003-2004 years the asset valuation utilised was of the core network optimised as at 2001, and the access network, optimised each year using new technology and best practice. The 2004- 2005 and 2005-2006 determinations were a departure from the previous approach in that the Commission determined that it would no longer model new technologies in its optimisation of the access network. Vodafone has appealed those determinations on grounds including that it was an error of law for the Commission to exclude new technologies from its calculation of net cost. [8] Two of the critical inputs to the net cost calculation the Commission undertakes are the value of the assets or cost of capital and the appropriate return on capital. The asset valuation utilised by the Commission is the focus of the Vodafone proceeding; the cost of equity capital figure the subject of Telecom's challenges. [9] The Commission assesses the cost of capital using the weighted average cost of capital (WACC) formula. The cost of capital can be defined as 'the expected rate of return prevailing in capital markets on alternative investments of equivalent risk'. The cost of capital has four important characteristics:ƒ It is forward-looking. Investment returns are uncertain and the cost of capital is only an expected rate of return.ƒ It reflects the opportunity cost of investment. Investors face a variety of investment opportunities, so the expected rate of return on any investment must be sufficient to compensate for foregone (or the next best) investments.This is why the cost of capital is sometimes referred to as the 'required rate of return'.ƒ It is market-determined. In other words, it is determined by the balance between supply and demand for capital, so it is an equilibrium rate of return, and should therefore have reasonable regard to prevailing market circumstances.ƒ It reflects the risk of the investment. In particular, it is the expected rate of return that applies on investments with a similar risk profile (assuming markets are efficient and no arbitrage opportunities exist). The cost of capital reflects the risk of the project, not the risk of the firm that holds the rights to those projects. Finally, it is assumed that investors are rational and well- diversified, so the cost of capital compensates for systematic risk and not for firm specific/unsystematic risk. [10] Assessment of the cost of capital requires assessment of the costs of debt and equity for the regulated entity. The Commission assesses the cost of equity using the capital asset pricing methodology (CAPM). A key component of the CAPM is Telecom's 'asset beta'. The asset beta measures the sensitivity of a firm's returns relative to market returns when the firm has no debt. In the context of a CAPM, an expected rate of return on capital which exactly matches the expected rate of return for the market as a whole is 1.0. The 'beta' is the estimated multiplier of the expected return for the whole market that measures a particular firm's sensitivity to unexpected changes in the market. In the CAPM context, 'risk' relates to the possibility that expected returns may not materialise. [11] In the 2004-2005 and 2005-2006 determinations, the Commission assessed Telecom's asset beta as 0.2. In all previous TSO determinations the Commission had determined Telecom's asset beta to be 0.4. The Commission reduced the asset beta because of its decision to cease modelling new technologies as part of its optimisation process. The effect of the reduction in asset beta from 0.4 to 0.2 is a reduction in Telecom's post tax weighted average cost of capital - a significant part of the net cost calculation – from 7.1% to 5.7% for 2004-05 and from 7.4% to 6.0%for 2005-06. Telecom challenges the Commission's decision to halve the asset beta as a result of its separate decision to cease modelling new technologies.Arguments[12] Telecom contends that the asset beta reduction involved an unjustified departure from the CAPM reasoning consistently applied in previous years. Telecom's case can be stated in outline as follows: (a) In the CAPM, 'risk' relates to the possibility that expected returns may not materialise. Risk can be divided into systematic and unsystematic risk. Unsystematic risk is unique to an asset or firm and can be eliminated by diversification. Systematic risk is market risk, which is not unique to the firm but dependent on the state of the economy as a whole. It cannot be diversified. The more systematic risk present in the operations of a firm, the higher the cost of capital. (b) In its 2001-2004 determinations, the Commission consistently stated that the asset beta reflects only systematic risk, and that the risk of technological obsolescence (sometimes referred to as 'asset stranding') is an unsystematic risk in the sense that it is diversifiable. (c) For this reason the Commission's original asset beta valuation of 0.4 did not include a technology risk factor. The non-inclusion of the technology risk factor was reflected in and evidenced by the Commission's reliance on United States of America (US) electricity utilities that were subject to rate of return regulation as a proxy for Telecom's asset beta, together with recognition of the 'industry effect' difference between electricity utilities and telecommunications. The assets of US electricity utilities are measured with reference to historic cost, which by definition requires no compensation for technology risk.(d) The Commission cannot now remove a technology risk factor from its asset beta calculation as a result of its separate decision to cease modelling new technologies when no technology risk factor was included in the original 0.4 figure. To do so is inconsistent. The Commission has provided no (or no adequate) reconciliation between these two positions. The Commission has further compounded the inconsistency by dealing with technology risk as both a systematic and unsystematic risk in its 2004-2005 and 2005-2006 determinations. [13] In its judicial review proceedings Telecom contends that the inconsistency is so stark as to amount to a 'defiance of logic and deficit of intellectual coherence.' In short, it is a reviewable error, being unreasonable in the Wednesbury sense (seeAssociated Picture Houses v Wednesbury Corp [1948] 1 KB 223). Telecom further argues that the Commission's earlier emphatic statements that the risk of technology obsolescence is a non-systematic risk, are relevant considerations the Commission should have, but failed to take into account when it determined that it was a systematic risk, the removal of which justified a reduction in the asset beta. [14] Telecom also argues that by removing a technology risk factor from the asset beta of 0.4 when such a risk factor was not factored into the asset beta originally, the Commission under calculated Telecom's WACC. This, it says, is contrary to the purpose of Part 3 of the Act – that is, to facilitate the supply of TSO services to CNVC's and ensure fair compensation for the hypothetical efficient provision of those services. Removing a technological optimisation factor that did not exist meant that Telecom was undercompensated. [15] Alternatively Telecom argues that the determinations are flawed for procedural unfairness. It says that the Commission has either not explained its asset beta calculations of 0.4 and 0.2 properly, or has only done so for the first time in its 2004-2005 and 2005-2006 determinations, after all opportunities for consultation on the issues raised have passed.[16] Turning to Telecom's appeals. Appeal rights in respect of a TSO determination are limited to questions of law only (s 100(1)(a) of the Act). The grounds of appeal advanced by Telecom are as follows: (a) The Commission took matters into account it should not have or failed to take relevant matters into account (a ground that mirrors the judicial review grounds). (b) The Commission applied the wrong legal test. It removed a risk factor from the asset beta that was not present, it under calculated the WACC, and because it was using an incorrect WACC the Commission did not accurately calculate the 'net cost' to Telecom. In effect, the Commission asked itself the wrong question. (c) Finally, Telecom argues that the Commission came to its view without any evidence. That is because the only inference reasonably open to the Commission was that the 0.4 figure did not include a technology risk factor. [17] Vodafone agrees that the reduction in the asset beta as the result of the removal of technological optimisation is at odds with the Commission's previous statement that technological obsolescence is not a systematic risk. But Vodafone says that the Commission was correct to identify that the benefit that Telecom receives from the removal of the risk of the technological obsolescence must be reflected in the cost model in some way. If the change in the asset beta is to be reconsidered by the Commission, then the decision to abandon technological optimisation which underpins the asset beta change must also be reconsidered. Vodafone says that the Commission's decision to reduce the asset beta is so inextricably linked to the decision to remove the technological optimisation that the former cannot be considered in isolation. [18] The Commission says that at all times it has been consistent in its treatment of the asset beta. In each year the asset beta has been the Commission's best estimate of a figure that reflected the systematic risks to which Telecom wasexposed. In all determinations the Commission has acknowledged that technology change and optimisation entail risks that are partly systematic and partly unsystematic. Consistent with this, the Commission argues that its change to the asset beta in 2004-2005 and 2005-2006 reflected the removal of that component of risk associated with technological optimisation that could be described as systematic and that the asset beta selected was open to it on the evidence. [19] Moreover, the Commission rejects the suggestion it says is implicit in Telecom's submissions that the Commission's determination for the 2001-2002 year had some primacy over later decisions, and that subsequent determinations dealt principally with the timing of the return of capital. It says that such an approach is inconsistent with the statutory framework, which provides for separate annual determinations. As to procedural unfairness, it says that the process the Commission adopted and the final position reached were reasonable, fair and lawful.Statutory framework[20] Section 70 deals with the declaration of TSO instruments. Section 70(1) provides:The purpose of this section is to facilitate the supply of certain telecommunications services to groups of end-users within New Zealand to whom those telecommunications services may not otherwise be supplied on a commercial basis or at a price that is considered by the Minister to be affordable to those groups of end-users.[21] Sections 83 and 84 detail the information to be provided by the TSP, and weighed by the Commission in the process of making its determinations of the net cost. They provide:83 Calculations of net cost and auditor's report must be given to CommissionNot later than 60 working days after the end of each financial year of a [TSP] under a TSO instrument , the [TSP] must provide to the Commission – (a) calculations of the net cost of complying with the TSO instrument during the financial year; and(b) a report prepared by a qualified auditor (the auditor's report) that includes a statement of whether or not the calculations comply with – (i) any prescribed requirements relating to those calculations; or (ii) if there are no prescribed requirements, any requirements of the Commission.84 Considerations for determining net cost(1) Subject to subsections (2) and (3), in calculating the net cost under section 83, preparing a draft determination of the net cost under section 88, and determining the net cost under section 92, all of the following matters must be taken into account: (a) the range of direct and indirect revenues and associated benefits derived from providing telecommunications services to commercially non viable customers, less the costs of providing those telecommunications services to those customers: (b) the provision of a reasonable return on the incremental capital employed in providing the services to those customers. (2) In preparing a draft determination of the net cost under section 88 and determining the net cost under section 92, the Commission – (a) may choose to not include profits from any new telecommunications services that involve significant capital investment and that offer capabilities not available from established telecommunications services; and (b) must not include any losses from telecommunications services other than services that the TSO instrument requires the TSP to provide; and (c) must consider the purpose set out in section 18. (3) In calculating the net cost under section 83, the TSP must comply with any requirements of the Commission relating to the application of subsection (2)(a) to (c). (4) In this section, –established telecommunications services means telecommunications services that are not new telecommunications servicesnew telecommunications services means telecommunications services that were first provided in New Zealand within 5 years before the commencement of the financial year to which the calculation of the net cost relates.[22] Section 18 describes the purpose of Part 2. It is, however, relevant to the calculation of net cost under Part 3 because it is, by reason of s 84, one of the mandatory considerations for the Commission in preparing its draft determination of net cost. Section 18 materially provides:18 Purpose(1) The purpose of this Part and Schedules 1 to 3 is to promote competition in telecommunications markets for the long-term benefit of end-users of telecommunications services within New Zealand by regulating, and providing for the regulation of, the supply of certain telecommunications services between service providers. (2) In determining whether or not, or the extent to which, any act or omission will result, or will be likely to result, in competition in telecommunications markets for the long-term benefit of end-users of telecommunications services within New Zealand, the efficiencies that will result, or will be likely to result, from that act or omission must be considered.[23] Sub-part 2 of Part 3 of the Act prescribes the time limits and procedural requirements the Commission must comply with in preparing a draft determination, consulting with those who have a material interest in relation to the determination and preparing a final determination. [24] Although parts of the Act relevant to these determinations were amended in 2006, the amendments do not apply to the determinations or these proceedings. This is in accordance with the transitional provisions set out in s 63 of the Telecommunications Amendment Act (No 2) 2006.The determinations[25] Telecom's arguments depend upon the following propositions: (1) Prior to the 2004-2005 and 2005-2006 determinations the Commission consistently stated that the asset beta reflects only systematic risk, and that technology risk is an unsystematic risk; and (2) The Commission's original asset beta calculation of 0.4 did not include a risk factor for technological optimisation.2001-2002 determination[26] To assess whether these propositions are correct it is necessary to take some care over the 2001-2002 determination. This determination was issued by the Commission following a lengthy consultation process involving a number of discussion documents (including a paper recording the Commission's preliminary position in relation to the WACC) and the release of two draft determinations. [27] In its final determination for 2001-2002 the Commission defined beta in the following passage, a passage upon which Telecom places considerable reliance:[179] Beta measures the risk of an investment relative to the market risk. Risk relates to the volatility of returns – the possibility that expected returns may not actually materialise, or may be higher than expected. The total risk of an asset or business is made up of both diversifiable risk and undiversifiable risk:• Diversifiable (or unsystematic) risk is unique to the asset or firm and can be eliminated by diversification. The risks associated with technology obsolescence, increasing competition, patent approval, antitrust legislation, labour contracts, management styles, and geographic location are all examples of unique risks.• Undiversifiable (or systematic) risk is market risk, which is not unique to the firm. Such risk cannot be eliminated by diversification. It is related to, and dependent on, the state of the economy as a whole. The more systematic risk that is inherent in the operations of a firm, the higher is its cost of capital. [180] Under the framework of CAPM, only the undiversifiable risk is relevant in determining the cost of equity. Investors are not compensated through the CAPM for diversifiable risk. The CAPM assumes that investors hold a diversifiable portfolio that eliminates unsystematic risk.This passage appears in substantially identical form, in all subsequent determinations. [28] The Commission then discussed various factors which influence betas including the presence of price or rate of return regulation. The Commission said that firms subject to rate of return or price regulation should have lower sensitivity to unexpected changes in the economy if prices are regularly reset, because the regulatory process is geared toward achieving a 'fair' rate of return or price.Therefore, because the TSO services are subject to an annual determination of costs (including the cost of capital), that factor should lower the asset beta. [29] The impact of the regulatory framework on the asset beta was developed further in a section entitled 'TSO specific issues: impact of insurance effect andannual review of costs on TSO beta.' The 'insurance effect' referred to is the effect generated by sharing of the net cost amongst liable persons, including Telecom. By this mechanism, each year the calculated TSO net cost is funded or effectively 'insured'. The Commission said of the TSO specific issues:Under this insurance mechanism and with an annual review of costs (including the cost of capital), returns to the TSP (after receipt of payments from liable persons and the implicit contribution from Telecom) may be regarded as similar in nature to (almost guaranteed) returns for firms subject to rate of return regulation. At the end of each year, the WACC and estimates of forward-looking efficient costs for the following year are re- estimated. Shocks to the discount rate and cost shocks are therefore quickly passed on to liable persons and Telecom through higher or lower expected future "insurance" payments. However, unlike a firm subject to traditional rate of return regulation, the TSP bears less risk of demand uncertainty or volatility in revenues because actual ex-post revenues as opposed to expected ex-ante revenues are used to determine the TSO net cost. On the other hand, the TSP does bear the risks associated with asset optimisation and asset stranding that may not be borne by a rate of return regulated entity when the asset beta is measured with reference to historical cost, to the extent that the tilted annuity does not properly capture economic depreciation.[30] The Commission concluded that under the telecommunications services regulatory regime, the TSO asset beta was largely determined by:• the systematic risk associated with current year variability in revenue and cost, together with the systematic risk associated with default by liable persons;• the systematic risk associated with the process of re-setting costs and the discount rate (cost of capital) at the end of each year; and• the systematic risk associated with a valuation of the TSO assets at year end under the tilted annuity depreciation approach and the re-optimisation of existing assets.[31] In another section entitled '[t]he systematic risk associated with the valuation (optimisation) of the TSO assets' the Commission acknowledged that systematic risk might also arise in respect of the present value of the future cash flows beyond the current period, where the Commission re-optimises the cost of existing assets at the end of each year under the tilted depreciation formula. After considering submissions on the point it said:The Commission considers it is not clear that the act of optimisation and revaluation of the TSO's capital assets necessarily increases the systematic risk of the TSO (net of liable person payments and "insurance" from Telecom).[32] The Commission considered that a significant part of the risk of changes in the optimised replacement cost of the TSO assets from technology risk and asset stranding might be non-systematic or might be negatively correlated to the market. By negative correlation it meant that if the system moved negatively, that could have a positive impact upon the TSP. Conversely, if there was a positive movement in the system, that could have a negative impact on the TSP. [33] The Commission also considered it had adequately provided for the non- systematic risks of technology change and locational (consumer) redundancy that might lead to asset stranding in the future cashflows. For that reason, it said that only the systematic component of that risk should be taken into account in calculating the beta. The Commission concluded then that the regulated electricity firms might provide a reasonable proxy for the TSO asset beta. This was so notwithstanding that the US electricity firms' assets were valued with reference to historical cost. The Commission said that it was: not satisfied that the systematic component of the risks of asset optimisation and the risks of asset stranding warrant any increment to the TSO beta compared to assets valued with reference to historical cost.[34] In fixing the asset beta, the Commission said:Regulated firms in different industries subject to the same systematic risks in the re-setting of output prices and the same regulatory review period should have a similar asset beta, but with the TSP business the Commission considers that an increment to the asset beta of 0.1 is warranted in recognition of a small industry effect in addition to the regulatory effect.This means the asset beta for the TSP lies in a range of 0.3 to 0.5, with a mid-point of 0.4.[35] In the updated WACC paper attached to the determination as appendix 5, the Commission responded to a submission made on behalf of Vodafone that although US electricity businesses are good comparators, a lower asset beta is justified because of the insurance effect of the liable person contributions. Vodafone argued that the appropriate asset beta for TSP was 0.2. The Commission said:[r]eliable asset beta estimates of 0.2 or less for firms are rarely observed in practice. The Commission also considers that systematic risk to investors in the TSP may arise not only in respect of current year's cash flow but also in relation to systematic risks associated with the process of resetting the discount rate and expected (ex-ante) value of the firm at the end of each regulatory review period.[36] The regulatory effect in relation to the TSO regime had a number of facets, including the 'insurance' effect of having the net cost funded by large firms (liable persons) rather than individual customers. This tended to reduce the risk. It also included the potential for technology shocks and revaluations flowing through from the asset optimisation and valuation processes. Asset optimisation tended to increase the systematic capital risk faced by the TSP. The Commission was not however satisfied that the systematic risks associated with asset optimisation warranted an increment over the beta used for assets valued using historical costs. It did consider some adjustment was needed for the 'industry effect', based on the information it had that telecommunication companies have higher asset betas than electrical utility companies. It considered that this warranted an increase of 0.1 from that of comparable firms and settled on an asset beta of 0.42002-2003 determination[37] In its draft determination for 2002-2003 the Commission expressed the preliminary view that there had been no developments since its previous determination justifying a departure from the asset beta of 0.4. In submissions in response to that draft Vodafone agreed that there was no reason to increase the asset beta. In contrast Telecom submitted that the Commission's approach to determining the beta was flawed, because it did not have regard to data from thetelecommunications industry which suggested a much higher asset beta was appropriate. It argued that the betas of US electric utilities should be discarded, and estimated the asset beta of the TSO to be 0.8. [38] In its final determination the Commission described how it had arrived at the asset beta in its 2001-2002 determination. It said that in arriving at the estimate of 0.4 it had: placed some weight on beta estimates for overseas telecommunications companies, as well as US electric utilities. The range of telecommunications asset betas used in the 2001-02 determination was from 0.50 (the ACCC estimate of the asset beta for Telstra's fixed PSTN business) to 0.95 (the Oftel estimate of BT's asset beta). The Commission considered that the asset beta for the TSP business (prior to the insurance effect and the annual review of costs) is likely to lie in the lower end of the range, since the provision of access services has less variability and less systematic risk than value added services such as broadband internet access.[39] The Commission said that information from a range of considerations may assist in determining the appropriate asset beta for investments in the provision of TSO services. These considerations were:• the factors influencing betas,• the figure reached from a direct estimation of a firm's equity from market data; and• estimates of equity betas of comparable firms in New Zealand and other countries. [40] The Commission noted Telecom's criticisms of the comparators used by it in its 2001-2002 determination. It said that to explore the significance of Telecom's criticisms it had reconsidered its estimate of the asset beta by decomposing an estimate of Telecom's beta into its constituent elements. It did this as a cross check on the approach in the 2001-2002 determination. It used as a starting point Telecom's public switched telephone network business which, before regulation, was a reasonable proxy for the risks borne by Telecom as a TSP. Telecom's expert estimated the asset beta to be 0.8 for that. In terms of comparing this asset beta tothe asset beta for the TSO, the Commission said that it was necessary to determine what level of cash flow risk, and what level of capital risk was reflected in the beta. It stated:It is a difficult enough task to estimate an asset beta, let alone attempt to identify that part which reflects systematic cash flow risk and that part which reflects systematic capital risk. However, the importance in doing so stems from two important features of the regulatory framework: the TSO cost sharing mechanism, which mitigates cash flow risk but not capital risk, and periodic asset optimisation which "sheets home" capital risks to the TSP.[41] In dealing with the capital risk component of the asset beta the Commission said:Although capital risk is implicitly borne by the TSP over the regulatory period, its impact is not explicitly felt or "sheeted home" until the asset base is optimised and prices are reset at the end of the regulatory period. the underlying sources of capital risk include not just demand, technology and cost shocks (which competitive firms face), but also possible errors by the regulator in implementing the optimisation process.[42] The Commission observed that if the existing asset base was not subject to optimisation and new capital expenditure was automatically included into the asset base at cost then 'the TSP would bear almost no capital risk.' But, it said, that approach would be inconsistent with the efficiency objectives of the regulatory framework. [43] As to the cash flow risk the Commission said that: whilst expected depreciation is reflected in the cashflows, unexpected depreciation i.e. capital risk, is not. The extent to which the TSP bears systematic capital risk should therefore be taken into account in determining the asset beta of the TSO.[44] Telecom places emphasis upon the next passage which immediately follows the above quoted passages:Three related points are worth noting in this regard. First, only systematic capital risk should be compensated via the WAAC; total capital risk, which by definition includes unsystematic capital risk, is taken into account in determining the expected cashflows. Second, it is not clear that capital risk is as asymmetric as some parties may suggest. The Commission has previously noted that estimation errors in the tilted annuity parameters may lead to under or over recovery of capital costs ex-post, and that the effects of any such errors are likely to be limited owing to the short length of theregulatory period. Third, whilst it is true that the tilted annuity does not take into account capital risk associated with the current period, it may mitigate capital risk associated with future periods if expectations of the economic life of assets are reversed over time.[45] Telecom submits that this passage evidences that the Commission continued to include only systematic capital risk in its WACC/asset beta calculation, and not unsystematic capital risk, such as technology risk, which is reflected in the cashflows. But I consider that the Commission's observations in the passage merely set out the Commission's position that unsystematic capital risk is not factored into the asset beta. The passage does not support Telecom's argument that the Commission treated all technology risk as unsystematic. [46] Ultimately the Commission rejected the asset beta of 0.8 calculated by Telecom. It said that the decomposition exercise undertaken by it yielded an appropriate beta range of 0.3 to 0.59 (or 0.34 to 0.59). And because of the consistency of the range arrived at by this means with the range identified based on the US electricity firm comparators, the Commission was satisfied that the asset beta it had arrived at in its previous determination remained appropriate. [47] Telecom submits that there was no opportunity for Telecom or any interested party to make submissions to the Commission on the validity of this beta decomposition analysis. I do not consider that that argument has any merit, particularly advanced at this point in time. The Commission arrived at that analysis after taking into account the submissions that it received on its draft determination, and in any case, all parties were able to make submissions in response to that analysis in subsequent determinations.2003/2004 determination[48] In the draft determination for 2003/2004 the Commission again concluded there was no reason to change its asset beta of 0.4. For Telecom, NERA submitted that the Commission's approach to introducing new technology into the TSO cost modelling exercise violated the correct operation of the tilted annuity, by undercompensating Telecom. In its final determination the Commission summarised the approach NERA urged upon it as follows:The NERA submission on the draft TSO determination places significant weight on generating annuities that have a net present value equal to the initial cost of the assets associated with the most efficient technology. According to NERA, this can be achieved either by committing to a particular technology mix (i.e. determining the parameters for the tilted annuity formula at t=1, and remaining on the same profile), or by using an adjusted tilted annuity formula. NERA notes that the simplest way of achieving this would be to select today's least-cost technology, and to apply the tilted annuity to that technology in perpetuity.In this passage t=1 reflects the time parameter used to calculate the tilted annuity that models asset depreciation. [49] The Commission said that the suggested approach was inconsistent with its obligation to assess the net cost of an efficient service provider on an annual basis. It made the following observations relevant to the present issues:If the return of capital to the TSP was determined on an ex-post basis, as proposed by NERA, the capital risk faced by the TSP would be largely eliminated. In other words, the appropriate asset beta for the TSP would be close to zero, with the resulting WACC converging to the risk-free interest rate (reflecting the elimination of risk from the provision of the TSO).2004-2005 and 2005-2006 determinations[50] In its initial draft determinations for the 2004-2005 and 2005-2006 years, the Commission said that there was no reason to alter the asset beta of 0.4. Telecom's submissions in response to those draft determinations focused on the optimisation undertaken in the model, and in particular upon problems with the tilted annuity arising from the introduction of new technology. It said that while the original tilts were modelled on the basis of information supplied by Telecom, those tilts captured only the expected depreciation associated with the original technology: the fixed public switch and MAR technology. Such an asset valuation methodology meant that Telecom would not, looking forward, have an expectation that it would achieve NPV=0 (net present value = zero), that is to say that it would not have an expectation of, at least, earning a reasonable rate of return on its efficient investments. Telecom said that this situation could be remedied by providing for new tilts or expectedlevels of depreciation, or by committing to not changing the tilts and no longer introducing new technology. [51] After a consultation process, the Commission issued a revised draft determination. In that revised draft determination the Commission accepted, for the first time, Telecom's argument that Telecom was being under compensated for the risk of asset stranding created by the introduction of new technology into the model. It accepted that its modelling approach in employing the original tilts whilst continuing to introduce new technology might not provide Telecom with a reasonable return on its incremental capital. It concluded that the appropriate response was to end the modelling of new technology, whilst continuing to achieve some level of optimisation through use of existing technologies in the model and its method of valuing assets. The Commission addressed the likely impact of new technology on the asset beta, saying:41. The Commission noted in its TSO 2003/2004 decision that if it were to provide the TSP with ex post compensation this would also have some impact on the systematic risk, captured by the beta term used in the Capital Asset pricing Model (CAPM). The decision not to introduce any further new technologies into the modelling will consequently have an impact on the beta term 42. In its previous determinations the Commission has employed an asset beta value of 0.4 in its TSO calculations. This figure largely comprised the systematic capital risks associated with the TSO, as the systematic cash flow risks were generally considered negligible due to the industry funded nature of the scheme. 43. As systematic technology risk is an important consideration in telecommunications compared to many other industries, it is likely to represent a substantial component of the systematic capital risk faced by the TSP. Therefore, the removal of the introduction of any further new technology in the optimisation process by the Commission means that there should be a corresponding reduction in the asset beta. (footnotes omitted)[52] Because there remained some residual level of optimisation, the Commission considered that there remained some level of risk. The risk was not zero, and an asset beta of 0.2 was appropriate.[53] Telecom filed submissions in response to the revised draft. It argued that whilst it was correct for the Commission to remove technology change from its modelling, consequential amendments to the asset beta were inconsistent with the Commission's previous decisions. Vodafone and TelstraClear both submitted that if the Commission were to remove technology change, then it was appropriate to reduce the asset beta to reflect the lower risk. [54] In its final determination for 2004/2005, which on the removal of new technologies and reduction in WACC, was imported into the 2005/2006 determination, the Commission repeated the general explanation of asset beta that Telecom relies upon, identifying the risk of technological obsolescence as an unsystematic risk. It addressed the capital risk associated with asset optimisation in relation to the asset beta and referred to Telecom's submission that the approach it now proposed to take was inconsistent with earlier determinations. It maintained, with reference to passages in its earlier decisions, that it had consistently recognised that there was a systematic aspect to the risk associated with the introduction of new technology, but had concluded that the risk did not justify an increment above 0.4. [55] In terms of justifying its decision to reduce the asset beta, it said that once the introduction of new technology was removed from the modelling, changes to the model would be marginal, not substantive. It had already identified that because of the insurance effect in relation to payment of the assessed net costs, there was little cash flow risk. Removing new technology optimisation meant that Telecom had achieved what it had sought all along - that the Commission would simply be regulating the appropriate return upon the model of the network that it had created for the 2001-2002 year. There was, therefore, little capital risk of any nature. [56] The Commission referred to two experts, Professors Guthrie and Bowman, both of whom it said had extensive experience dealing with cost of capital and regulatory issues. The Commission noted that in Professor Guthrie's opinion the impact of new technologies such as wireless on systematic capital risk was uncertain. He said that they could lead to a higher or lower asset beta. However, Professor Bowman argued that new technologies have a systematic component. The Commission quoted the following passages from Professor Bowman's evidence:36 In my opinion, the investment in research and development that might lead to new technology will be related to the state of the economy. Further, decisions on introducing new technology will also be related to the state of the economy. 37 Therefore, I believe the risk of new technology to the TSP includes a systematic component. Elimination of risk of loss from the introduction of new technology would decrease the appropriate asset beta for the TSP. .. 39. .. based on my experience, I believe a reduction of 0.2 in the asset beta of the TSO to reflect the removal of the risk of loss from the introduction of new technology is reasonable.[57] The Commission referred to difficulties in estimating appropriate beta values given the nature of the TSO asset as 'an unobservable asset regulated on an ex post basis.' It said:In reality, no business is likely to be subject to the type of ex postcompensation that exists to ensure NPV = 0 is maintained in each period, so the systematic capital risks sheeted home to the TSP will be minimal.[58] The Commission concluded that an asset beta of 0.2, though unusual in practice, was appropriate.Telecom's application for Judicial ReviewAdmissibility of evidence of Professor Guthrie[59] Telecom seeks to rely upon an affidavit of Professor Graham Guthrie in support of its application for judicial review. Professor Guthrie has provided his opinion on the Commission's treatment of technology risk in calculation of the asset beta in its various determinations. The Commission objects to the admissibility of Professor Guthrie's evidence on the grounds that it is not relevant and not likely to be of assistance to me. The Commission argues that the affidavit is largely submission. It has, however, filed evidence in reply as a precaution should I be prepared to receive Professor Guthrie's evidence.[60] The admissibility of this evidence is to be determined under s 25 of the Evidence Act 2006. It materially provides:25 Admissibility of expert opinion evidence (1) An opinion by an expert that is part of expert evidence offered in a proceeding is admissible if the fact-finder is likely to obtain substantial help from the opinion in understanding other evidence in the proceeding or in ascertaining any fact that is of consequence to the determination of the proceeding. (2) An opinion by an expert is not inadmissible simply because it is about - (a) an ultimate issue to be determined in a proceeding; or (b) a matter of common knowledge. (3) If an opinion by an expert is based on a fact that is outside the general body of knowledge that makes up the expertise of the expert, the opinion may be relied on by the fact-finder only if that fact is or will be proved or judicially noticed in the proceeding. ..[61] I have read the evidence of Professor Guthrie and am satisfied that it consists of his analysis of the Commission's determinations, and in particular the 2001-2002 determination and the 2004-2005 determination. His evidence focuses upon how the Commission has defined both the asset beta and systematic risk, and on the Commission's treatment of new technology. Professor Guthrie does not purport to provide his own analysis of the impact of asset optimisation on the asset beta. He takes as his starting point the analytical framework the Commission has settled upon, and then comments on how it has applied that framework, focusing on inconsistencies he has identified. In substance then, the affidavit is made up of material more properly presented as submissions. [62] I am able to undertake the exercise Professor Guthrie has carried out myself. I have therefore concluded that this affidavit will not be of substantial help to me. Although it would be simple to admit the evidence of Professor Guthrie and the Commission's in reply, I have decided against that course of action. The Evidence Act regulates the admissibility of the evidence. I have determined that the affidavit is inadmissible in accordance with s 25, and the evidence should not therefore be admitted.Commission consistently stated that technology risk is an unsystematic risk[63] Although Telecom advanced detailed submissions on the availability of inconsistency as an independent ground of review, and its relationship to the other grounds of review relied upon, I need not address the legal aspects of Telecom's judicial review application. That is because Telecom cannot succeed with its application if the propositions set out at [25] above are not correct. I am satisfied that they are not. [64] Telecom is correct that the risk of technology obsolescence is consistently referred to in the various determinations as unsystematic but what is fatal to Telecom's argument is that the Commission also consistently identifies technology risk as having a systematic component. It is significant that the passage Telecom relies upon in each determination is part of the Commission's general discussion of the asset beta rather than part of the discussion of particular matters bearing upon the appropriate beta for TSO services. I have previously set out the passage relied upon that is replicated in all determinations from 2001-2002 to 2003-2004, but do so again for ease of reference. It states:Diversifiable (or unsystematic) risk is unique to the asset or firm and can be eliminated by diversification. The risk of obsolescence of its technology, the risk of reduced revenues caused by increasing competition, and the risks associated with patent approval, antitrust legislation, labour contract, management styles, and geographic location are all examples of unique risks....Only undiversifiable risk is relevant in determining the cost of equity.[65] That passage alone would support Telecom's case, but in their initial 2001- 2002 determination, the Commission also said when considering the TSO asset beta in more detail, that 'a significant part of the risk of changes in the optimised replacement cost of the TSO's assets from technology risk and asset stranding may be asset-specific and non-systematic risk...', and that:the Commission is not satisfied that the systematic component of the risks of asset optimisation and the risks of asset stranding warrant any increment to the TSO beta compared to assets valued with reference to historical cost.[66] There is then clear acceptance by the Commission of the existence of a systematic element to the risk of technology obsolescence in the very first determination that Telecom relies on to demonstrate inconsistency. It was open to the Commission to maintain that investment in research and development that might lead to new technology is related to the state of the economy, and thus, technology obsolescence is capable of being characterised as a systematic risk. Further, although often the Commission's discussion of technology obsolescence in the early determinations (2001/2002 and 2002/2003) is to the effect that the regulatory framework, through optimisation, poses a systematic risk, that is in part because that is when technology obsolescence is 'sheeted home' to the TSP. [67] Telecom is correct that the Commission stated that new technology risk did not warrant an increment in the asset beta above that for assets valued with reference to historical cost. This did not, however, amount to an acknowledgment that no technology risk was factored into the asset beta, merely that no increased recognition was required. It is clear that in determining the appropriate asset beta, the Commission was undertaking an essentially impressionistic exercise. That was inevitable when it was assessing the asset beta for an hypothetical entity. It considered different comparators, namely the US electricity regulated firms and telecommunication firms. It also considers the particular systematic risks associated with the TSO. These included the risk of new technology which is 'sheeted home' through asset optimisation. [68] In its first determination the Commission expressly identified that it had netted off various factors (see paragraph [31] above). Without representing that evaluative process in an equation it then settled upon an asset beta of 0.4. The fact that it did not attribute a numeric value to the technology risk factor does not mean that it was not weighed in that process. I am satisfied that it was. It was the removal of optimisation from the model used by the Commission that meant, taking into account the insurance effect of the regulatory system through contributions from liable parties, that capital risk was reduced. A reduction in capital risk justified a reduction in the asset beta.[69] I observe that had the Commission shifted its position as to the weight to be attached to the component of systematic risk associated with technological optimisation, from the first determination to the determinations that are the subject of these proceedings, that would not in itself amount to a reviewable error. The Act requires the Commission to undertake the net cost assessment on an annual basis. If the Commission reaches the view that it has been wrong in earlier determinations then it is open to it to take a different view in subsequent determinations. That, of course, is what it did with the decision to cease modelling new technology. [70] I am satisfied, however, that the Commission has not departed from the principles it settled upon in relation to asset optimisation and the asset beta and that the Commission has been consistent throughout in including technological risk in the asset beta. [71] Telecom's additional argument is that the Commission did not properly explain its calculations of asset beta, or that it did so for the first time only in the challenged determinations after opportunities for consultation had ended. That argument cannot succeed. I am satisfied that the Commission explained consistently that there was a systematic component to technology risk. Moreover in the 2002- 2003 determination the Commission made clear its view that if technological optimisation was abandoned Telecom would bear almost no capital risk. In the 2003-2004 determination, the Commission made matters even more plain – it would result in a reduction to the asset beta. I am satisfied that there is no merit in Telecom's argument that there was any procedural unfairness. [72] In summary, my findings on each of Telecom's arguments set out at paragraphs [12] to [15] above, are: (a) There is no inconsistency that can found an argument of unreasonableness. (b) Since technological risk was factored into the asset beta originally, Telecom cannot establish that the Commission has undercalculatedWACC simply on the basis that it has reduced the beta to reflect elimination of technology risk. (c) The determinations are not flawed for procedural fairness. [73] As such, Telecom's application for judicial review is declined. [74] Telecom submits that the approach on appeal should be different to that taken on review because on appeal the Court is acting to check and correct errors, and not simply in a supervisory capacity. I accept that as submitted by Telecom it is appropriate in this case that I satisfy myself that the Commission correctly interpreted the Act, took into account all relevant material in making its net cost determination and that I ought not to defer to the Commission's decisions in that respect. Construction of the words of the Act and what it requires of the Commission are not within the Commission's expertise and are properly matters that I ought to scrutinise closely. However, Telecom's appeal turns on it establishing one of the two propositions set out at [25]. Since it cannot do so, none of its grounds of appeal can succeed.Result[75] Telecom's application for judicial review is declined. All grounds of Telecom's appeals fail in respect of both determinations. The appeals are dismissed. If the parties are unable to agree costs, they may file memoranda. Winkelmann J