IPART’s cost of capital after the AER’s WACC review · A Presentation of the WACC 81 1...

Independent Pricing and Regulatory Tribunal

IPART’s cost of capital after the

AER’s WACC review

Lessons from the GFC

Other Industries — Discussion Paper

November 2009

IPART’s cost of capital after the AER’s WACC review Lessons from the GFC

Other Industries — Discussion Paper November 2009

ii IPART IPART’s cost of capital after the AER’s WACC review

© Independent Pricing and Regulatory Tribunal of New South Wales 2009

This work is copyright. The Copyright Act 1968 permits fair dealing for study, research, news reporting, criticism and review. Selected passages, tables or diagrams may be reproduced for such purposes provided acknowledgement of the source is included.

ISBN 978-1-921628-10-8 DP121

The Tribunal members for this review are:

Mr James Cox, Acting Chairman and Chief Executive Officer

Ms Sibylle Krieger, Part Time Member

Inquiries regarding this document should be directed to a staff member:

Alex Oeser (02) 9290 8434

Eric Groom (02) 9290 8475

Independent Pricing and Regulatory Tribunal of New South Wales PO Box Q290, QVB Post Office NSW 1230 Level 8, 1 Market Street, Sydney NSW 2000

T (02) 9290 8400 F (02) 9290 2061

www.ipart.nsw.gov.au

IPART’s cost of capital after the AER’s WACC review IPART iii

Invitation for submissions

IPART invites written comment on this document and encourages all interested parties to provide submissions addressing the matters discussed.

Submissions are due by 23 December 2009.

We would prefer to receive them by email [email protected].

You can also send comments by fax to (02) 9290 2061, or by mail to:

WACC Independent Pricing and Regulatory Tribunal PO Box Q290 QVB Post Office NSW 1230

Our normal practice is to make submissions publicly available on our website <www.ipart.nsw.gov.au>. If you wish to view copies of submissions but do not have access to the website, you can make alternative arrangements by telephoning one of the staff members listed on the previous page.

We may choose not to publish a submission—for example, if it contains confidential or commercially sensitive information. If your submission contains information that you do not wish to be publicly disclosed, please indicate this clearly at the time of making the submission. IPART will then make every effort to protect that information, but it could be subject to appeal under freedom of information legislation.

If you would like further information on making a submission, IPART’s submission policy is available on our website.

Contents

IPART’s cost of capital after the AER’s WACC review IPART v

Contents

Invitation for submissions iii

1 Introduction 1 1.1 IPART’s current approach to estimating the WACC 2 1.2 Why is IPART reviewing its WACC parameters in light of the AER’s final

decision? 3 1.3 Timetable for this review 4 1.4 Issues on which IPART particularly seeks comment 4 1.5 Structure of this paper 5

2 Objectives and decision criteria 6 2.1 Objectives in setting the WACC 6 2.2 Criteria for assessing options 6

3 The AER WACC review 9 3.1 Scope of the review 9 3.2 Matters the AER must consider in its review 9 3.3 The AER’s process and decisions 11

4 The global financial crisis and the cost of capital 14 4.1 Current financial market conditions 14 4.2 Consistency of cost of equity and cost of debt 18 4.1 The review of the Hunter Valley Coal Network 18 4.2 Forward looking estimates of the cost of equity 20 4.3 New and existing capital 23 4.4 The GFC and the equity beta 23 4.5 Volatility and averaging periods 26 4.6 Options for IPART 28 4.7 IPART’s preliminary view 29 4.8 Key issues for IPART 30

5 The market risk premium 31 5.1 What is the market risk premium? 31 5.2 Summary of AER decision 32 5.3 Summary of views presented to the AER 33 5.4 Implications and options for IPART’s market risk premium estimate 34 5.5 Key issues for IPART’s MRP estimate 38

Contents

vi IPART IPART’s cost of capital after the AER’s WACC review

5.6 Options for IPART’s market risk premium 39 5.7 IPART’s preliminary view 40 5.8 Key issues for IPART 40

6 The equity beta 41 6.1 What is the equity beta? 41 6.2 Summary of AER decision 42 6.3 Summary of views presented to the AER 42 6.4 Implications and options for IPART’s equity beta estimate 44 6.5 Key issues for IPART’s equity beta estimate 52 6.6 Options for IPART’s equity beta estimate for utilities 53 6.7 IPART’s preliminary view 53 6.8 Key issues for IPART 54

7 Imputation tax credits (gamma) 55 7.1 What are imputation tax credits? 55 7.2 Summary of AER decision 56 7.3 Summary of views presented to the AER 59 7.4 Implications for IPART’s gamma estimate 60 7.5 Key issues for IPART’s gamma estimate 61 7.6 Options for IPART’s gamma estimate 62 7.7 IPART’s preliminary view 62 7.8 Key issues for IPART 63

8 Nominal risk free rate 64 8.1 What is the risk free rate? 64 8.2 Summary of AER decision 64 8.3 Summary of views presented to the AER 65 8.4 Implications for IPART’s nominal risk free rate estimate 66 8.5 Options for IPART’s nominal risk free rate estimate 69 8.6 IPART’s preliminary view 70 8.7 Key issues for IPART 70

9 Gearing 71 9.1 What is the gearing level? 71 9.2 Summary of AER decision 72 9.3 Summary of views presented to the AER 73 9.4 Implications for IPART’s target gearing level for utilities 73 9.5 IPART’s preliminary view 74 9.6 Key issues for IPART 74

Contents

IPART’s cost of capital after the AER’s WACC review IPART vii

10 Credit rating 75 10.1 What is the credit rating 75 10.2 Summary of AER decision 75 10.3 Implications for IPART’s target credit rating for utilities 76 10.4 Options for IPART’s credit rating estimate 76 10.5 IPART’s preliminary view 77

Appendices 79 A Presentation of the WACC 81

1 Introduction

IPART’s cost of capital after the AER’s WACC review IPART 1

1 Introduction

IPART is currently undertaking a review of the way that it estimates the return on capital as part of its regulatory decisions. As part of this, IPART has released a number of discussion papers on specific aspects of the weighted average cost of capital (WACC). This discussion paper continues this theme, considering how the recent review of WACC parameters for electricity distribution and transmission undertaken by the Australian Energy Regulator (AER), impacts on IPART’s own WACC estimate. This paper also discusses how the global financial crisis (GFC) impacted on the way IPART estimates the WACC.

This paper reviews our WACC parameters in light of the AER’s review of the WACC for transmission and distribution and the GFC. We recognise that any change to the way we calculate the cost of equity may have substantial financial impacts on regulated utilities and their customers. We favour a predictable regulatory environment. However, if there is clear evidence that circumstances in financial markets have changed to a degree where we believe it to be necessary to review our WACC parameters, we will do so as part of a public consultation process. Chapter 2 of this paper sets our assessment criteria.

This discussion paper does not review the inflation adjustment to the WACC or the debt margin. These issues are dealt with in separate reviews:

in May of 2009, following stakeholder consultation, IPART changed the methodology to adjust the WACC for inflation

for any comments on the debt margin, please refer to IPART’s discussion paper Estimating the debt margin for the WACC which is available on IPART’s website1.

We are also releasing two other WACC discussion paper concurrently with this paper:

alternative approaches to the determination of the cost of capital

averaging the WACC parameters for the cost of capital.

Both discussion papers are available on IPART’s website.

1 http://www.ipart.nsw.gov.au/investigation_content.asp?industry=6&sector=17&inquiry=194

1 Introduction

2 IPART IPART’s cost of capital after the AER’s WACC review

1.1 IPART’s current approach to estimating the WACC

The cost of capital is weighted by the return required by the two sources of funding available to a business - equity and debt, and their proportion used by the business. Equity refers to funds raised from the owners of the business, the shareholders. Debt refers to any borrowings of the regulated business.2

1.1.1 Pre-tax real WACC or post-tax nominal WACC

The WACC can be calculated before or after tax, and can be expressed in real or nominal terms. Theoretically, the calculation of the WACC as pre-tax or post-tax should have little impact on the revenue outcome for the regulated business, provided the same tax rate is assumed.

In either case, the effective or statutory tax rate may be used. IPART has used the statutory tax rate of 30% in all previous determinations.

As Appendix 1 shows, regulators use various combinations of real or nominal and post-tax or pre-tax WACC. At this stage, IPART does not propose to review its current use of a real pre-tax WACC.

1.1.2 WACC parameters

There are a number of input parameters to consider in determining an appropriate WACC range. Some of these parameters are directly determined by the market, while others are determined by IPART according to a preferred theoretical approach.

The calculation of the cost of capital under the WACC framework requires the estimation of the following parameters:

1. Parameters determined by financial market data:

risk free rate (Rf)

debt margin (RD - Rf)

adjustment for expected inflation (Π).

2. Parameters determined through other methods:

the market risk premium (MRP) (Rm - Rf)3

the degree of systematic risk (βe - equity beta)

the level of gearing (D-debt, E - equity)

the value of imputation credits (γ - gamma).

2 In practice, sources of funding are more complicated than this distinction allows, with various

possible forms of debt and equity that take on different parts of the risk of the underlying asset. 3 The market risk premium is the excess return of the share market over the risk free rate.

1 Introduction


the return on equity ( eR )

The parameters of the WACC are related to each other. For instance, a higher level of gearing implies a higher debt margin and a higher equity beta than would otherwise be the case.

These parameters are combined through the formula below, to give the pre-tax real WACC.

11

).().(1.1

1

ED

ER

ED

E

t

R

WACCd

e

1.2 Why is IPART reviewing its WACC parameters in light of the AER’s final decision?

The AER undertook a substantial review of the WACC parameters used in its electricity distribution and transmission decisions. This has led to many quality submissions from industry and in its final decision, the AER:

changed its MRP from 6.0% to 6.5%

reduced the equity beta from 1.0 to 0.8

increased the gamma from 0.5 to 0.65.

This paper reviews each of the above issues in light of evidence from the AER review.

The AER undertook its review while financial markets experienced substantial volatility due to the GFC. It is now widely acknowledged that markets have returned to more normal conditions. We are not bound to review any of the WACC parameters because of the AER review. But, given the substantial changes in the AER WACC parameters, the quality of the consultation process, and that it is good practice to periodically review our methods, we are now considering how the AER WACC review impacts on our own WACC estimate, in conjunction with its review of other aspects of its setting of the WACC.

1 Introduction


Other regulators are also reviewing their cost of capital estimate in light of the GFC4. For example, the Canadian regulator, the Ontario Energy Board (OEB) is currently undertaking such a review5. It will release a final decision in December 2009 and this decision will apply for its 2010 electricity price review. The purpose of the Canadian review is to obtain more information in three key areas:

the potential need to adjust the established cost of capital methodology, based on the equity risk premium approach, to adapt to changes in financial market and economic conditions

to determine the reasonableness of the results based on formulaic approach for setting the cost of capital and

to guide the Board’s discretion to adjust those results, if appropriate.

1.3 Timetable for this review

Table 1.1 Review timetable

Date Event

11 November 2009 Release Discussion Paper

23 December 2009 Public submissions due

March 2010 Release of final decision

1.4 Issues on which IPART particularly seeks comment

IPART has reviewed all of the evidence submitted to the AER as part of their review of the WACC. The submissions to the AER review have been taken into account in the analysis provided in this discussion paper. We ask stakeholders to limit their submissions to new information available since the AER report or information relevant to differences between IPART and AER regulated industries.

IPART seeks comments on the following:

1 Is there additional evidence that would suggest that the global financial crisis change the way regulators estimate the WACC? If so how should this be done? Should any adjustments be temporary?

2 Is there any new evidence that would suggest that IPART should consider forward looking measures of the market risk premium? If so, what is the best approach to do this?

3 For the equity beta, how much weight should be given to evidence from overseas markets especially on the risk differential between industries?

4 These include OFWAT as part of their PR09 water review, the NZ Commerce Commission’s

WACC guidelines and the Ontario Energy Board. 5http://www.oeb.gov.on.ca/OEB/Industry+Relations/OEB+Key+Initiatives/Cost+of+Capital+Re

view

1 Introduction


4 Is there any additional evidence on the appropriate values of the payout ratio and theta to adopt the AER’s estimate of gamma of 0.65? Or, it is appropriate for IPART to maintain its value of gamma within the range of 0.5 to 0.3?

5 Whether the 10-year nominal Commonwealth Bond Index is an appropriate proxy for the risk free rate? If yes, should IPART use the Bloomberg 10-year nominal Commonwealth Bond Index?

6 Whether IPART’s proposed approach of setting the gearing with reference to industry-specific levels of debt and risk is appropriate?

1.5 Structure of this paper

This paper is structured in a way that allows readers to start reading the more general issues on the WACC and the impact of the GFC on the WACC and then follow this up with chapters of a more technical nature about the individual WACC parameters. The Chapters are structured in a way that allows readers to compare the views expressed as part of the AER review and IPART’s approach to calculating the WACC. Each chapter on the WACC parameters includes a set of options for the way forward and sets out our preliminary view.

Chapter 2 sets out the objectives and the assessment criteria for this review.

Chapter 3 discusses the AER review of the WACC, its outcomes and compares this to IPART’s own WACC.

Chapter 4 discusses the impacts of the GFC on the cost of capital and regulatory WACC decisions in general.

Chapters 5 to 10 discuss the AER’s decision on individual WACC parameters and the potential impact of IPART’s own WACC.

2 Objectives and decision criteria



In our WACC decisions, we use the same methodologies to estimate the input parameters across all businesses we regulate. This ensures that all businesses operate under the same incentives.

2.1 Objectives in setting the WACC

We consider that the cost of capital used in making regulatory determinations should reflect the commercial cost of capital for a similar, well-managed, privately owned business. This will lead to efficient investments and ensure prices fully reflect the efficient cost of providing the service. In practice, this means that we are setting prices that reflect the true cost of providing a particular service, regardless of whether a utility is owned by the public or the private sector.

IPART’s main objectives in setting the WACC parameters are:

they must be commensurate with current market conditions

they must reflect commercial costs, and

they must be transparent and replicable.

These objectives ensure that full commercial cost of providing a service is determined in a transparent way.

2.2 Criteria for assessing options

Taking into account the objectives set out in the previous section, we believe that the assessment criteria set out below are important in the determination of the WACC parameters to the regulatory context in which IPART operates.

Commensurate with current market conditions and reflecting commercial costs

The WACC parameters must be commensurate with prevailing market conditions.



Why this matters to us?

We want to ensure that the true cost of providing a service is reflected in prices. We want to ensure that the cost of capital reflects the commercial cost in financial markets regardless of whether a business is privately owned or is a government enterprise.

How we are assessing it?

We have to ensure that all the inputs into the determination of a WACC parameter are obtainable from publicly available sources. In addition, these sources must reflect current market data.

2.2.2 The WACC parameters must reflect commercial costs

The cost of capital model must be implementable. This is important to us because we believe that any model used by the regulator must be replicable by stakeholders.


This is good regulatory practice. If a model is not replicable by stakeholders, we would use a black box approach in determining the cost of equity capital. We want to avoid this as it is important to us that all stakeholders can fully understand how the cost of equity capital is calculated.


We must be convinced that all the inputs into a model are transparent – this means that any particular input into a model means the same thing to all stakeholders. This is not always obvious as some of the cost of equity models leave it up to the user to define certain inputs.

2.2.3 Consistency of approach

The WACC parameters must be consistent. This means that they must be consistent with the model used to determine the other WACC inputs.


The importance of the consistency of the approach may not be obvious. The CAPM draws a clear distinction between systematic and non-systematic risk. We have to ensure that only the risks relevant to particular WACC parameters are included in its value.




We are looking at what types of risk are priced into particular WACC parameters and then compare them to the overall level of risk of the investment. For example, under the CAPM, the equity beta accounts only for systematic (or economy-wide risks). We also make sure that no double counting occurs.

2.2.4 Transparency

We aim to deliver transparent decisions. This means that all the input data we are using should be readily available to all stakeholders.


We are making decisions that affect everybody in NSW. In making a decision we must ensure that anybody regardless of whether they are a government department, a business or an individual can access the information we used in coming to a decision.


The inputs into the determination of the WACC parameters must be clearly defined and be available to all stakeholders. In the case where we have to use subscription services to obtain data we will keep a record of this data.

3 The AER WACC review



The National Electricity Rules (NER) require the AER to review the WACC parameters to be adopted in determinations for electricity transmission and distribution network service providers (TNSPs and DNSPs). These reviews are to be conducted every 5 years for transmission and at least every five years for distribution. The AER completed its first such review on 1 May 2009.

This chapter summarises the outcomes of the AER WACC review and compares the final decision to IPART’s current approach.

3.1 Scope of the review

The NER prescribe an approach to calculating the WACC, methodologies for setting certain parameters and values for certain parameters. The NER limits the AER’s review to certain WACC parameters rather than a review of the overarching framework. The AER may review the values and the method for calculating the:

nominal risk-free rate (RFR)

equity beta

market risk premium (MRP)

gearing ratio

credit rating levels used to calculate the debt margin

gamma6.

3.2 Matters the AER must consider in its review

The NER require the AER to “have regard” to the following matters in its review:

the need for the rate of return to be:

– forward looking

– commensurate with prevailing conditions in the market for funds and the risk involved in providing the services

6 NER, s 6.5.4(d) (distribution) and s 6A.6.2(i), 6A.6.4(d) (transmission).



the need for the return on debt to reflect the current cost of borrowings for comparable debt

the need for the values/methodologies to be based on a benchmark efficient service provider

where there is no certainty in determining values/methodologies:

– the need to achieve an outcome that is consistent with the National Electricity Objective (NEO)7

– the need for persuasive evidence before adopting a value/methodology that differs from the previous value/methodology adopted.8

3.2.1 Application

TNSPS

For TNSPs, the outcomes of the AER’s review must be applied in all determinations where the regulatory proposal is submitted after 1 May 2009 and prior to the next WACC review being completed (in 5 years time).

DNSPs

For DNSPs, the AER can vary individual determinations from the outcomes of the review if there is persuasive evidence at the time of the determination.

7 The NEO is set out in the National Electricity Law (s 7). It is “to promote efficient investment

in, and efficient operation and use of, electricity services for the long term interests of consumers of electricity with respect to—

- price, quality, safety, reliability and security of supply of electricity; and - the reliability, safety and security of the national electricity system”. 8 NER s 6.5.4(e) and s 6A.6.2(j)



3.3 The AER’s process and decisions

The review process is depicted in Figure 3.1.

Figure 3.1 AER’s review process

Mar 2009Further submissions

received

Aug 2008AER releases Issues Paper Oct 2008

Roundtable discussionon submissions

Sep 2008Submissions received on

Issues Paper

Dec 2008AER releasesDraft Position

May 2009AER releasesFinal Position

Nov 2008Further submissions

received

Dec 2008Public forum onDraft Position

Jan 2009Submissions received

on Draft Position

Mar 2009AEMC approvesextension of time

Mar 2009Original date for

Final Position

3.3.1 Issues paper

The AER initiated the review with the release of an issues paper in August 20089. Fifteen submissions were received, representing the views of industry and consumer groups. Views of the electricity and gas10 transmission and distribution industry were represented through the Joint Industry Association (JIA)11. The JIA commissioned several expert reports to support its views. Some of the views presented in the JIA’s submission were also submitted by individual industry associations and their members.

The AER held a roundtable discussion on the more contentious theoretical issues when estimating the parameters. In attendance were AER staff, representatives from industry and consumer groups and the JIA’s and the AER’s consultants. The JIA’s consultant submitted further evidence after the roundtable.

9 AER, Review of the weighted average cost of capital (WACC) parameters for electricity transmission and

distribution – Issues Paper, August 2008. 10 The AER’s review does not apply to gas transmission and distribution. However, industry

recognised that it was likely that the AER would use the parameters and approaches set in this review as the basis for gas reviews.

11 The JIA is a joint association representing members of the Energy Network Association (ENA), GridAustralia and the Australian Pipeline Industry Association (APIA).



3.3.2 Draft position

The AER then released its draft position12 and supporting evidence from experts. A public forum was held, presenting the AER’s reasoning and the views of key stakeholders.

The AER received submissions from 16 stakeholders, mostly representing the views of industry. An extensive submission was received from the JIA, supported by nearly 30 consultant reports.

3.3.3 Final position

The AER was required under the NER to complete its review by 31 March 2009. However, the AER sought a rule change to extend the deadline due to the volume of submissions and the complexity of the issues. An extension was granted to 1 May. On this date, the AER released its final position and supporting documents.

3.3.4 Overview

This section briefly outlines the AER’s final position and the implications of the AER’s position to IPART’s approach. Table 3.1 presents an overview of the views expressed throughout the process, the AER’s final decision and IPART’s current approach.

12 The AER’s draft position is contained in:

- AER, Electricity transmission and distribution network service providers - Review of the weighted average cost of capital (WACC) parameters – Explanatory Statement, December 2008, and

- AER, Electricity transmission and distribution network service providers Statement of the revised WACC parameters (transmission) Statement of regulatory intent on the revised WACC parameters (distribution), - Proposed, December 2008.



Table 3.1 Overview of AER’s decisions and the views of key stakeholders

Parameter Previously adopted

AER Draft Position

JIA 13Response

MEU 14Response

AER Final Position

IPART’s general approach

10 year CGSa

5-year CGS 10-year CGS

10-year CGS

10 yr CGS 10 year CGS Nominal risk free rate

Business proposes length and timing of sampling period – 10-40 days

Business chooses length of sampling period – 10-40 days

- - Business proposes length and timing of sampling period – 10 to 40 days. Must be “as close as practically possible” to the start of the period

20 day sampling period, set by IPART. Practice is to select a period as close as practically possible to the start of the regulatory control period.

Market risk premium

6.0% 6.0% 7.0% 5.5% to 6.0%

6.5% 5.5% to 6.5%

Credit rating

BBB+ Fair value yield curve

A- BBB A+ BBB+ Fair value yield curve

Set debt margin with reference to a portfolio of proxy bonds rated BBB+ to BBB

Gearing 60% 60% 60% 65% 60% 60% Gamma 0.50 0.65 0.20 0.90 0.65 0.50 – 0.30 Equity beta 1.0 0.8 1.0 0.56 0.8 0.8 - 1.0

a Commonwealth Government Security.

13 Joint Industry Association. 14 Major Energy Users.

4 The global financial crisis and the cost of capital



As part of its review of the cost of capital for electricity distribution and transmission businesses, the AER considered the impact of the Global Financial Crisis (GFC) on WACC parameters. In its final decision, it adjusted the WACC parameters for the GFC in the following ways.

The AER used market based estimates of the risk-free rate and cost of debt that incorporated the effects of the GFC on financial markets.

The AER increased its estimate of the market risk premium from 6% to 6.5% to reflect the increased uncertainty on a forward looking basis associated with the global financial crisis. It noted that this MRP is above the long run historical average.

A number of submissions to the AER review commented on the impact of the global financial crisis on the cost of capital.

In this chapter, we review the changes in financial market conditions and the potential implications these have for the way we calculate the cost of capital for regulated businesses. We do acknowledge that financial markets change quickly and that the current view is that markets have largely returned to more normal levels. What is not yet clear is the extent to which there have been long-term shifts in financial risk, such as in the perceptions and valuation of risk.

4.1 Current financial market conditions

The GFC has been associated with significant changes in financial markets. These have included greater volatility in financial markets, significant changes in valuations of companies’ equity and debt and changes in the relative prices of financial assets. This section sets out some of these changes that are of particular interest to IPART and the extent to which financial market conditions have returned to conditions consistent with those prior to the GFC.



4.1.1 Reduction in price of government debt

IPART uses the yield on 10-year Commonwealth Government Securities (CGS) to set the risk free rate of interest.15 The yield on 10-year CGS (bonds) began to fall in mid-to-late 2008, in conjunction with falling official interest rate targets, as the financial crisis became evident (Figure 4.1).

Figure 4.1 Yield on government bonds and the cash rate target (%)

0

2

4

6

8

10

12

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Yie

ld

Financial crisis peak September/October 2008

Official cash rate

Yield on 10 year Treasury bonds

Source: Reserve Bank of Australia..

Figure 4.1 shows that the yield on government bonds has now recovered to a level close to the average from 1998 to 2007, while official interest rates remain low.

4.1.2 Increase in debt margins for businesses

Falling yields for Commonwealth Government Securities were not fully reflected in the interest rates facing businesses, leading to an increase in measures of the debt margin (Figure 4.2).

15 IPART uses the bond indicator rates reported by the Australian Financial Review. The data

from the Reserve Bank of Australia are used for the chart below as there is a longer time series for this data source.



Figure 4.2 Debt margins for corporate bond indices (%)16

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-

2002

Jul-2

002

Jan-

2003

Jul-2

003

Jan-

2004

Jul-2

004

Jan-

2005

Jul-2

005

Jan-

2006

Jul-2

006

Jan-

2007

Jul-2

007

Jan-

2008

Jul-2

008

Jan-

2009

Jul-2

009

Per

cent

age

poin

ts

Debt margin (BBB) Debt margin (A)

Note: Indices are 10 year index for A rated bonds and 8 year index for BBB rated bonds interpolated to 10 years using the difference between 10 year A and 8 year A rated bond indices.

Source: Bloomberg.

The debt margin has fallen back from the peaks reached of over 350 basis points (for BBB rated debt) and almost the same for A rated debt but remains well above average levels from 2002 to 2007.

The increase in the debt margin has also occurred for bonds issued by utility companies, such as Snowy Hydro and SPI AusNet.

4.1.3 Business sources of external financing

Businesses have shifted their sources of financing following the GFC. Businesses have raised much more finance from equity than debt than they have in the past.17 This reflects balance sheet restructuring as businesses deleverage.

Within the debt category there have also been shifts. Non-intermediated debt (ie, bonds) was virtually on hold for non financial businesses for a period following the GFC.18 This market has now reopened with a number of significant bond issuances from non-financial companies.

Australian capital markets did not close down to the extent experienced in other countries, with net external funding continuing to grow. This mainly reflected banks continuing to provide business lending and many companies undertaking equity raisings.19

16 The period from 2002 to 2009 is the longest period of consistent data available. 17 RBA 2009, Statement of Monetary Policy, August, p 63. 18 Deloitte 2008, Refinancing, debt markets and liquidity, prepared for the AER, November, p 5. 19 RBA 2009, Statement of Monetary Policy, August, p 62.



4.1.4 Falling equity market values

Equity prices of regulated and unregulated companies fell considerably from November 2007 to November 2008, although they regained a substantial amount of the losses by September 2009.20 Dividends have not fallen by as much or as quickly, leading to rising dividend yields following the GFC, although these have since fallen back towards historical averages. As of August 2009, the RBA reported that dividend yields were 5% compared to a historical average of close to 4%.21

4.1.5 Volatility of financial prices

Volatility in financial markets rose markedly during and in the immediate wake of the GFC.22 The RBA report that for share markets, the daily movement of Australian share indices has averaged just under 2% from July 2007 to March 2008, compared to a historical average prior to the GFC of 0.8%. Measures of share price volatility have fallen significantly since late 2008 but remain above the pre GFC levels.23

Increased volatility has not been confined to equity markets. Yields on Commonwealth Volatility in Commonwealth Government Securities and bond markets also increased during and immediately after the GFC and remain higher than pre GFC levels.

4.1.6 Summary

The GFC led to significant changes in financial market prices that could lead to concerns over the way that regulators approach the cost of capital in periods of financial volatility. Financial market conditions have stabilised to some extent over more recent periods but are still significantly different to conditions over 2002 to 2007.

These changes in financial markets suggest that regulatory approaches need to be robust to different financial market conditions. However, changing market conditions do not necessarily mean that past approaches need to change. Where past measures reflected market conditions, they may continue to do so. Where parameters are set on a basis of current market data, it raises questions of the volatility of the WACC and the adjustment for future changes in market rates. These issues are discussed in the accompanying Discussion Paper on the averaging periods of the WACC24. On the other hand, where parameters are set on the basis of long term averages, major market shifts may raise questions about the appropriateness of those long term averages.

20 RBA 2009, Statement of Monetary Policy, August, p 64. 21 RBA 2009, Statement of Monetary Policy, August, p 65. 22 RBA 2009, Financial Stability Report, March, p 26. 23 For instance the average daily movement in the ASX 200 was 1.1% in August 2009. 24 Available on IPART’s website.



4.2 Consistency of cost of equity and cost of debt

The methods used by IPART and most other regulators to calculate the cost of equity and the cost of debt have significant areas of difference. Most importantly, the cost of equity is calculated using a backward looking market risk premium based on long term averages of up to 100 years. The cost of debt, on the other hand, is a measure that is forward looking, in the sense that it is derived directly from financial markets.

The different approaches to the cost of equity and the cost of debt can lead to inconsistency in the cost of these components, particularly if there are significant changes in the market risk premium required by investors. A rising market risk premium would increase the estimated cost of equity, but would not impact on the cost of debt.25 A recent relevant example of this for IPART was the review of the Hunter Valley Coal Network (Box 4.1).

There are other reasons why the regulatory cost of equity and cost of debt could move closer together and further apart, apart from differences between a backward looking and forward looking market risk premium. For instance, generally poorer business conditions would increase the chances of company default on debt and hence increase the debt premiums required for debt.

4.1 The review of the Hunter Valley Coal Network

The tension between the (mostly) backward looking cost of equity and the forward looking cost of debt was evident in IPART’s recent review of the weighted average cost of capital for the Hunter Valley Coal Network.26

The pre-tax real WACC proposed by the Australian Rail Track Corporation was 8.84% to 10.53%27.

When making a decision on the cost of equity, IPART de- and re-levers the equity beta of a business to reflect the gearing level assumed in the WACC decision. Based on the ARTC submission and under standard de-leveraging assumptions, the WACC for the Hunter Valley Coal Network at zero debt would be around 40 to 50 basis points lower. It could be even lower if IPART’s own value of franking credits28 is used in the deleveraging formula. In this case, the reduction in the pre-tax real WACC from moving to 100% equity was more than 100 basis points.

The markedly lower WACC at zero gearing reflected the high debt margins at the time of the review. It is likely that this reflected the tension between the implied forward looking cost of debt and a (mostly) backward looking cost of equity.

25 The premium of the cost of equity over the cost of debt is equal to MRP. βe – DP, where MRP is

the market risk premium, βe is the equity beta and DP is the debt premium. 26 IPART, New South Wales Rail Access Undertaking - Review of the rate of return and remaining mine

life from 1 July 2009 - Final Report and Decision, August 2009.



The changes through time in the estimated regulatory cost of equity and cost of debt can be estimated for a hypothetical company. For instance, Figure 4.3 shows the premium of the nominal cost of equity to the nominal cost of debt for a company with an equity beta of 0.9.29 The market risk premium used is 6.0%. The cost of debt is calculated using the Bloomberg estimates for bonds with BBB ratings and A ratings and a 10 year maturity.

From 2002 to 2007, the premium of the regulatory cost of equity to the regulatory cost of debt was fairly constant at around 400 basis points. However, by March 2008, this premium had fallen to 200 basis points, using either BBB rated debt or A rated debt. Since then, the premium has moved back towards the average of 2002 to 2007. Using BBB rated debt, the current premium of the cost of equity to the cost of debt for the hypothetical company is currently 150 basis points below the average level of 2002 to 2007. Using A rated debt, the current premium of the cost of equity to the cost of debt is 70 basis points below the average level of 2002 to 2007.

Figure 4.3 Premium of regulatory cost of equity to cost of debt (%)

0.0

1.0

2.0

3.0

4.0

5.0

Jan-

2002

Jul-2

002

Jan-

2003

Jul-2

003

Jan-

2004

Jul-2

004

Jan-

2005

Jul-2

005

Jan-

2006

Jul-2

006

Jan-

2007

Jul-2

007

Jan-

2008

Jul-2

008

Jan-

2009

Jul-2

009

Per

cent

age

poin

ts

A rated debt

BBB rated debt

Source: IPART calculations, Bloomberg.

27 Based on a gearing level of 50 to 55 and a gamma of 0. 28 Deleveraging assumptions use the formula: βa = βe . E/(D+E) + βd . D/(D+E). The debt beta is

assumed to be zero. 29 Note that there are tax differences between equity and debt but these would not have changed

over the period shown. We are interested in changes to the premium rather than the level of the premium.



As noted earlier, the difference between the regulatory cost of equity over the cost of debt can change for reasons other than changes in the market risk premium. In particular:

Changes to the liquidity premium for debt could change the premium of the cost of equity to the cost of debt.

Changes to business specific risk could increase the probability of default and hence the cost of debt but would not necessarily lead to an increase in the required cost of equity.

There are no easy ways to distinguish between these competing explanations for changes in the premium of the cost of equity to the cost of debt. The UK Competition Commission found that approximately one third of the debt premium was due to the liquidity premium, one third due to default premium and one third due to the default risk premium (of which the market risk premium is a component).30 Each competing explanation could therefore be important in considering changes to the premium of the cost of equity over the cost of debt.

4.2 Forward looking estimates of the cost of equity

A common view is that the market is re-pricing risk in both debt and equity markets and this has led to a significant increase in the equity risk premium. However, this is a short term view of financial markets and does not take into account the long-term trend in asset prices. According to this view the market underpriced risk for a period up to the GFC leading to a relatively low forward-looking MRP. Further, the GFC has increased investors’ awareness of risk leading to a re-pricing of risky assets. The cost of equity may now be higher than estimated using backward looking regulatory approaches if the market risk premium has risen. In deciding on whether to adjust the market risk premium, regulators have to consider whether it is beneficial for the regulatory cost of capital to be constantly changing and whether there is any precise measure of the market risk premium that is forward looking.

To date, Australian regulators have used forward looking measures of the cost of equity as a cross-check only, rather than a central estimate of the market risk premium. IPART has maintained the same market risk premium range for its decisions over the past 4 years.

Changing the market risk premium

If the market risk premium estimate were to be adjusted upwards in response to the GFC, it would also have to be adjusted downwards when financial market conditions were benign, so that, on average, the regulatory market risk premium was equal to the long term historical average.

30 UK Competition Commission, BAA Ltd: A report on the economic regulation of the London airports

companies (Heathrow Airport Ltd and Gatwick Airport Ltd), September 2007, pp F24-F26.



Adjustments to the MRP could either be infrequent, such as for low probability events such as the GFC, or constant, reflecting continually changing perceptions of investors.

In May 2009, the AER adjusted upward its estimate of the market risk premium above the long term average to reflect uncertainty arising from the GFC. Since then conditions in financial markets have continued to return to more normal conditions.

Methods for estimating the forward looking market risk premium

The forward looking market risk premium can be estimated using surveys of market practitioners or the dividend growth model (DGM). Although when using the DGM model to estimate the MRP, it has to be acknowledged that there is considerable uncertainty about the estimates of future dividends and their growth rate.

The dividend growth model uses forecasts of a company’s dividends and its current share price to back out the discount rate applied by investors (ie, the cost of equity). The intuition behind this approach is that if the value of Australian shares falls by a large amount without a commensurate fall in the profitability of Australian companies, then this suggests that there has been a change in equity investors’ attitude to risk.

In its most common form a constant growth rate is used for the growth of dividends. In this case, the discount rate is equal to the forward dividend yield plus the assumed growth rate.31 However, the assumption of a constant growth rate seems unrealistic and may have substantial impacts on the results especially during volatile economic times.

This method could also be used for individual listed companies or for the market as a whole.

In using this method during or immediately after events such as the GFC, there are substantial caveats. Firstly, there is no fixed relationship between dividends and profitability. Companies can choose to retain profits within the company rather than issuing dividends in order to repair their balance sheets, as they have done over the past year. For some companies, dividends are relatively stable and do not react to changes in profitability. The weaker the link between dividends and profitability in the short term the greater the importance of accurate forecasts of future dividends.

In addition, dividend yields do not appear to have been strong predictors of the equity premium. If this is the case, there is a less compelling case for the DGM to be used to justify short-term changes to the MRP.32

31 That is, Re = D/P+G, Where Re is the cost of equity, D is the dividend, P is the share price and G

is the assumed constant growth rate. 32 Goyal, A. and I. Welch, “Predicting the equity premium (with dividend ratios)”, Management

Science, Vol. 49, No. 5, May 2003, pp 639-654.



Despite these limitations, there is value in the logic of this approach and many overseas regulators use the dividend growth model as a cross-check on CAPM estimates.

Estimates of the forward looking market risk premium

In its recent review, the AER considered alternative potentially forward-looking approaches to estimating the market risk premium such as the dividend growth model and surveys of market practitioners.33

The AER concluded that current market conditions reflected either a higher medium term MRP or a structural change to a higher long-term MRP. As such, the AER increased its estimate of the MRP from 6% to 6.5%.

In making this decision, the AER continued to place primary weight on long term historical estimates of the MRP. The 0.5% increase in the MRP in response to market conditions following the GFC reflected that the AER placed some weight on estimates from the dividend growth model, which suggested a MRP well above 6%.

The AER also reported Bloomberg estimates of the forward looking MRP based on the assessment of costs of equity of each individual company. For Australia, the estimated MRP from Bloomberg increased from 4.5% in 2004 to 8.6% in July 2008 and then moderated to 8.0% by January 2009.34 Value Advisor Associates reports that the Bloomberg estimate had fallen to 4.8% in June 2009.35 It has to be noted that forward–looking estimates of the market risk premium are of a short-term nature and may vary substantially over time. It is unclear whether forward-looking measures of the market risk premium are the best measures to use for a medium-term regulatory period.

There is a substantial uncertainty surrounding the validity and precision of estimates based on cash flows, such as the dividend growth model. But it can be taken from these estimates that the short term cost of equity was above the regulatory estimated cost of equity during and in the immediate aftermath of the GFC, although it is less clear that this is the case now.

The AER also reported surveys of the MRP used by market practitioners.36 These reflect pre-GFC conditions, rather than changes to the MRP used by market practitioners following the GFC. The estimates of MRP used by market practitioners in Australia prior to the GFC averaged about 6%, with the majority of respondents using a point estimate of 6%.

33 AER, Review of weighted average cost of capital for electricity network service providers, 2009, p 177. 34 AER, Review of WACC for Electricity network service providers, Final Decision, 2009, p 219. 35 Value Advisor Associates, Regulatory WACC for Australia Post, prepared for Australia Post, June

2009, p 12. 36 AER, Review of weighted average cost of capital for electricity network service providers, 2009, p 221.



However, surveys on the forward looking market risk premium are, under normal circumstances, not used by regulators. They are rather used by financial market participants in pricing immediate debt or equity issues. Besides in the US, regulators who determine price paths for utilities over a medium term period tend to find historical long term averages more appropriate.

4.3 New and existing capital

There are market frictions that could lead to short-term deviations between the cost of new and existing capital.

It would be possible to consider different weighted average costs of capital for existing and new capital for regulatory purposes if there was a temporary disruption to financial markets that led to divergence in these costs. This could involve considering embedded debt costs of the regulated business or comparator businesses for instance.

4.4 The GFC and the equity beta

The GFC represents a significant shock that impacted on most share prices and on other markets such as housing and debt.

Measures of the equity beta of companies may have changed significantly given the scale of the GFC and the exposure of the different companies to an event such as the GFC. This could either reflect changes in the gearing of companies relative to the market or changes in the underlying asset beta. IPART is interested mainly in the second of these possible changes.

IPART has estimated the asset betas for companies that were in the ASX 200 share index37 as of September 2009, based on the relationship between daily returns and market returns over a one year moving window and total debt to equity ratios.

37 As a proxy for the financial market in general. As a proxy, the ASX 200.



Figure 4.4 Average asset beta estimates for 200 largest companies (1-year estimates)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08

Average Stdev

Note: Estimation based on daily data for companies in the ASX 200 estimated over a one year period; start date reflects data availability. The number of companies in the estimation sample varies from 58 in 1998 to 195 in 2009.


Figure 4.4 shows that the average asset beta has remained fairly constant over the past two years, despite the turbulence in the market (Figure 4.4). However, the spread (or distribution) of estimated asset betas has fallen markedly since the share market began falling in November 2007. The fall in the spread of estimated asset betas indicates that fewer companies are considered to have very low or very high underlying risk than was previously the case.

Changes in the asset beta also reflect changes in financial leverage. Other things being equal, the lower the level of financial leverage, the higher the asset beta. We also note that during the GFC, the increase in corporate debt margins means, in principle, that the market value of existing debt also fell, so that using our measure of gearing (market value of equity/book value of debt) will overstate falls in the actual gearing level based on the market value of equity/market value of debt. One useful comparator is the number of companies that would fall below IPART’s minimum asset beta that we have used in previous reviews.38 In 2004, 5% of the ASX 200 companies for which data were available had implied asset betas lower than IPART’s lower bound (Figure 4.5). More recently, as much as 20% of companies have had estimated asset betas in this range.

38 The minimum implied asset beta in IPART’s previous reviews is 0.32, based on the equity beta

of 0.8, a debt to total assets ratio of 0.6 and an assumed debt beta of zero for calculation purposes.



Figure 4.5 Proportion of companies with asset beta less than IPART typical minimum

0.00

0.05

0.10

0.15

0.20

0.25

Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08

Note: Estimation based on daily data for companies in the ASX 200; start date reflects data availability.


This analysis is preliminary and could be affected by survivor bias and sample changes. In December 1998, data was available for 58 of the 200 companies, making this a significant issue. Despite this caveat, it is useful for regulators to benchmark the risk of regulated assets against the estimated distribution of risk for the market as a whole. A similar benchmarking exercise can be seen in the UK Competition Commission’s approach to estimating the equity betas for London airports, with airport asset betas considered against those of other asset classes.39

Between its peak in November 2007 and its trough in March 2009, the ASX 300 Index fell by 54% (Table 4.1). Of these 300 largest companies, those in the health care, energy40, telecommunications, consumer staples and information technology had the smallest falls. Those in the utilities41 and materials sectors had mid-range falls below the fall experienced by the overall market, while those in the financials, consumer discretionary and industrials sectors had the largest falls. This is consistent with our assumption of an equity beta for utilities below but close to 1. For this type of shock, this represents the spectrum of risk of the equity in these companies, given their current average gearing level.42

39 UK Competition Commission, BAA Ltd: A report on the economic regulation of the London airports

companies (Heathrow Airport Ltd and Gatwick Airport Ltd), September 2007, Appendix F, p F31. 40 `Oil etc. 41 Does not include telcos. 42 Note that this does not represent the spectrum of risk of the underlying assets as there could be

different levels of gearing of the companies in each sector.



Table 4.1 Changes in sectors from peak to trough relative to the market

Sector Change from date of ASX 300 peak

to trough

Relative to ASX 300

Change from ASX 300 trough

to now

Relative to ASX 300

% % % %

ASX 300 -54.2 100.0 50.3 100.0 Health care -14.1 26.0 11.6 23.1 Energy -21.6 39.8 43.0 85.4 Telecomm. -26.8 49.5 7.5 14.9 Consumer staples -29.3 54.0 31.4 62.4 Information technology -35.3 65.2 67.9 134.9 Utilities -43.6 80.3 23.3 46.3 Materials -49.0 90.4 47.4 94.2 Financials -60.0 110.7 79.3 157.5 Consumer discretionary -63.2 116.5 70.6 140.3 Industrials -67.4 124.2 81.5 162.0

Note: ASX300 peak was 1/11/2007 and trough was 6/3/2009.

Source: S&P total return indices from web site, IPART calculations.

4.5 Volatility and averaging periods

IPART and other regulators use market prices of financial assets to make decisions on the WACC. In doing this, regulators typically use an average of prices over the last 20 days, or some other period, rather than taking the price on a single day. This reduces the risk that the price taken on a single day is an anomaly and the company will not be able to access financial markets at that price. It introduces risk that the information used will be old and therefore the company will be unable to access financial markets at the average price.

The volatility in financial markets rose markedly at the start of the financial crisis and is still higher now than before the crisis for Bloomberg bond indices and CGS (Figure 4.6).



Figure 4.6 Average absolute change over previous 30 days

0

2

4

6

8

10

12

14

Jan-2003 Jan-2004 Jan-2005 Jan-2006 Jan-2007 Jan-2008 Jan-2009

Bas

is p

oint

s

10 year CGS

10 year BBB

10 year A


The AER, in its recent review of WACC, allows regulated companies to use an averaging period of between 10 and 40 days to calculate market based parameters such as the risk-free rate.43 In doing this, presumably regulated businesses would have to maintain consistency in their averaging period throughout the review rather than adopting the averaging period that provided the highest WACC each time the parameters were recalculated.

The AER’s approach allows companies to decide on their own willingness to trade-off what the AER calls volatility driven error and old information driven error.44 In this case regulated companies could use a greater averaging period for a review of their WACC during a period of high expected volatility, such as at the moment, if they so chose.

IPART is releasing a separate paper on averaging periods in conjunction with this paper45.

43 AER, Review of weighted average cost of capital parameters for the electricity transmission and

distribution network providers, Final report, 2009, p 171. 44 AER, Review of weighted average cost of capital parameters for the electricity transmission and

distribution network providers, Explanatory statement, December 2008, pp 132-133. 45 Available on IPART’s website: http://www.ipart.nsw.gov.au



4.6 Options for IPART

IPART has the option of:

Recognising the GFC in its choice within the estimated range for the WACC.

Recognising the GFC in the input parameters.

Assuming that the impacts of the GFC are already captured in the ranges of the input parameters.

The advantages and disadvantages of these options are summarised below.

1. Recognising the GFC in its choice within the estimated range for the WACC

Advantages

This is a straightforward adjustment to the WACC midpoint based on regulatory judgement.

Disadvantages

May be difficult to justify given the lack of transparent information

May lead to volatility in the WACC over time

May not be transparent and predictable, increasing investor uncertainty

2. Recognising the GFC in the input parameters

Advantages

Is more transparent than adjusting the WACC.

Can be applied to the cost of debt, the cost of equity or both.

Disadvantages

May be difficult to justify based on publicly available data.

May lock in a higher WACC over a regulatory period where actual rates are likely to fall again.

3. Assuming that the impacts of the GFC are already captured in the ranges of the input parameters

Advantages

Provides regulatory certainty

Is consistent with IPART’s assumption that uncertainty is reflected in the ranges f the input parameters.



Disadvantages

May underestimate the true cost of funds in the current circumstances and over-estimate it in other circumstances

4.7 IPART’s preliminary view

Our preliminary view is that the volatility arising out of the GFC is captured in the ranges of the input parameters of the WACC. In the past, we based our WACC decisions on the fact that there is considerable uncertainty in estimating most of the WACC parameters. This uncertainty arises among others, out of the estimation methodology, the quality and the availability of input data. Hence, we have adopted ranges for our WACC parameters that account for the uncertainties inherent in individual WACC parameters.

For example, for the market risk premium, the range represents the uncertainty arising out of the differences in risk premia between different historical estimates depending on the time frame chose. For example, the 100 years MRP is different form the 60 year MRP, but both would be considered as long term time series. For the equity beta, the range mainly accounts for the uncertainty arising out of the unavailability of good proxy businesses in the Australian market. At this stage, we believe that the market volatility arising out of the GFC is appropriately captured by our use of WACC parameter ranges.

We also note that it is generally not possible to infer information about systematic risk of individual shares form the GFC experience. Changes in individual share prices could reflect changes in expected cash flows, or changes in discount rates. Some part of the change in expected cash flows may be firm specific, such that covariance of individual share price movements with the market index over such a short period does not necessarily tell anything about systematic risk.

Nevertheless, there have been significant increases in risk premiums relative to just before the GFC. That is most apparent in the case of observable premia such as credit spreads on debt – which can be readily incorporated into the WACC via the debt margin figure used. In the case of the risk premium on equity (the expected MRP), it seems likely, with hindsight, that this has increased relative to the period of share price inflation immediately prior to the GFC. But whether it is now higher than the longer term average (or whether the pre GFC period involved an abnormally low MRP) is far from clear.

We therefore do not believe that it would be appropriate to undertake any temporary adjustments to the WACC parameters.



4.8 Key issues for IPART

IPART seeks comment on:

1 Is there additional evidence that would suggest that the global financial crisis change the way regulators estimate the WACC? If so how should this be done? Should any adjustments be temporary?

The market risk premium and the equity beta are discussed in more detail in the following two sections.

5 The market risk premium



The market risk premium (MRP) is the expected return over the risk free rate that investors would require for investing in a well diversified portfolio of risky assets.

In this chapter we review the market risk premium in light of the AER decision and the GFC. The chapter considers the AER review of the MRP, how it impacts on our own estimate and possible ways forward. We also conduct our own analysis on the appropriate value of the MRP. The final section of this chapter summarises our preliminary view on the appropriate value of the MRP in our future decisions.

5.1 What is the market risk premium?

The market risk premium represents the difference between the expected return on the market portfolio and the return on the risk-free rate (R

m – Rf). The MRP is one of

the components used to determine the return on equity, which is given by the CAPM formula.

The CAPM formula is: Re = Rf + βe . (E[Rm] –Rf)

Where:

Re is the return n equity

Rf is the risk free rate

βe is the equity beta

(E[Rm] –Rf) is the market risk premium.

The size of the risk premium for a business depends on the extent of covariation of returns on its stock with that on the market. For businesses with shares traded on the stock market, β is a measure of systematic risk calculated as the correlation of returns on the firm’s stock and that on the market overall, divided by the variance of returns on the market. The risk premium for the stock (the return required in excess of the risk free rate) is given by β(E[Rm]-Rf). If it is less volatile β will be less than 1 and the risk premium will be less than the market average.



In implementing the CAPM, IPART assesses the risk-free rate, equity beta and MRP. We currently estimate these parameters through a defined ‘market’ portfolio of equity in listed Australian companies.

Estimating the MRP based on historical averages involves several issues. These include:

how long a time period should be used for estimating the premium

whether to employ geometric or arithmetic averaging

which market instrument to use as the measure of the risk-free rate, and

how to measure the return to the market portfolio.

The appropriate length of estimation period is generally influenced by economic considerations. Estimates based on longer term data series may be unrepresentative of conditional expectations based on current information when there have been substantial changes in the market, but they may provide more precise unconditional estimates reflecting longer term averages not influenced by current specific information.

Shorter term data series, too may be unrepresentative because they only capture the present stage of business cycle. However, the shorter term data is more likely to be of higher quality as data sources improve over time, therefore providing a more accurate picture of investors’ current and near future expectations. Most commonly, the minimum period used to provide estimates is 30 years.46

5.2 Summary of AER decision

The AER’s final position is to increase the MRP from 6.0% to 6.5%. The AER placed most weight on long term historic returns (calculated using the arithmetic mean, with reference to 10 year CGS), and interpreted the data in light of the significant risk in the market that is likely to continue for the next 5 years.

In reaching its final position, the AER:

had regard to a range of measures of the MRP.

placed primary weight on long term historic estimates of the MRP. Long term historic estimates imply a value of around 6%.47

placed some weight on other considerations such as:

46 S Gray and R R Officer, A review of the market risk premium and commentary on two recent papers – a

report for the Energy Networks Association, 2005, p 21. 47 The AER notes that slight changes to years from which the data is selected can have a

substantial impact on the results. Therefore it is not appropriate to ‘mechanistically ’adopt historical estimates as the forward looking MRP.



– Survey measures, which strongly indicate that an MRP of 6% is the most commonly adopted value by market practitioners, although these surveys were conducted before the GFC.

– Cash flow based measures, which currently indicate a forward looking MRP well above 6%, however, up until 2008, these measures indicated a forward looking MRP well below 6%. The AER states that regulators did not revise the MRP downwards on this evidence due to issues with reliability of this measure. Similarly, the AER has not given regard to this evidence now that the measure is above 6%.

– The GFC, which may have resulted in a higher MRP (as a devaluation of equity prices may reflect the market’s expectations of lower future cash flows, a higher discount rate, including potentially a higher MRP). The AER considers that this is more likely associated with the short term MRP.

In its final decision, the AER considers that prior the onset of the GFC, an estimate of 6% was the best estimate of a forward-looking long term MRP. In recognition of the current instability in markets, the AER considers that an MRP above 6% may be reasonable. In the interests of promoting regulatory certainty and stability 6.5% was selected.

The AER also considers that it is appropriate to use a 10-year MRP as it is internally consistent with the 10-year RFR.

5.3 Summary of views presented to the AER

The AER considered the views of, and evidence provided by, stakeholders including the Joint Industry Association (JIA) which were also presented by members of this association and other investors in the industry, Consumers Roundtable (MEU), and the AER’s own consultant, Dr John Handley.

JIA

The JIA propose that:

The forward looking MRP is at least 7.0% with a gamma of at least 0.2. Given that the gamma proposed by the AER is 0.65, the JIA reaffirm its view that the most appropriate estimate for the forward looking MRP is 7%.48

The best proxy for a forward looking MRP is a long term average of historical MRPs.

Both debt and equity markets are risky in the current climate. Interest rate spreads are high and debt markets are ‘drying up’. A MRP of 6% does not recognise the increase risk, and therefore the increase in the cost, in the equity market.

48 JIA, AER Proposed Determination Review of the Weighted Average Cost of Capital (WACC) parameters

for electricity transmission and distribution, February 2009, p 76.



It is not possible that the forward looking MRP over the period of the AER’s review can be as low as 6%.

Over the period 1958 to 2007 the historical arithmetic average of the MRP was 6.7%, if there is no value placed on a return to investors for imputation tax benefits. With a gamma of 0.5, the best estimate of the MRP rises to 7%.

MEU

The MEU concludes that there is “probably insufficient market based evidence to justify a move from the currently accepted value of 6%”.49 In coming to this conclusion, the MEU notes:

there is evidence suggesting a value of between 5.5% and 6.0%

the values of all parameters, including an MRP of 6.0%, are conservative in favour of the service provider

with the increased globalization of the financial and stock markets in the medium term MRP will fall well below the currently used 6%.

The AER used a consultant for expert advice on the MRP. It engaged Dr John Handley50 from Melbourne University. In its report to the AER, Handley:

notes that the MRP has averaged 6.1%pa over the periods 1883-2008 and 1958-2008 (assuming a gamma of 0.5)

using a gamma of 0.65, calculates a MRP of 6.1% for 1883-2008 and 6.2% for 1958-2008

recommends the use of long term historical estimates.

Handley concludes that:

the MRP relative to 10-year bonds has averaged 6.1% over 1883 to 2008 and

6.1% over 1958 to 2008.

5.4 Implications and options for IPART’s market risk premium estimate

Comparison with IPART’s approach

IPART’s practice is to adopt an MRP in the range of 5.5% to 6.5%. This value is grounded in empirical estimates of the long term historic arithmetic mean, but also recognises the difficulties in precisely valuing the MRP by setting a range of values.

49 MEU (in conjunction with some members of National Consumers Roundtable on Energy), AER

Review of Parameters for Weighted average cost of capital (WACC) AER Draft Decision, January 2009, pp 22-23.

50 Handley, J, A Note on the Historical Equity Risk Premium, October 2008, and Handley, J, Memo to AER - Supplement to Historical Equity Risk Premium, 27 November 2008, and Handley, J, Further Comments on the Historical Equity Risk Premium, April 2009.



5.4.2 Implications to IPART’s approach

The AER’s review presents:

new empirical evidence supporting the view that the MRP is around 6%

a view that empirical data should be interpreted in light of the uncertainty that may prevail in the next few years due to the GFC

a precedent that the MRP should be valued at 6.5%.

In determining the MRP for calculating the WACC for the electricity transmission and distribution network service providers, the AER has considered the most recent long term historical average excess returns:

‘grossed-up’ for a utilisation rate of 0.65

estimated (for the most part) relative to the yield on 10-year CGS and

estimated over a range of long term estimation periods ending 2008 (1883-2008, 1937-2008, 1958-2008).

The MRP assessed by the AER falls into a range of 5.7% and 6.2%. In addition, the AER also has regard to the range of MRP based on estimation periods concluded at the end of 2007 immediately prior to the onset of the GFC. The range of MRP falls between 6.6%and 7.2%.

The AER concludes that as relatively stable market conditions do not currently exist and taking into account the uncertainty surrounding the global economic crisis (GFC), it does not consider that the weight of evidence suggests a MRP significantly above 6% should be set. Rather, a MRP of 6.5% is considered to be a reasonable estimate of a forward looking long term MRP commensurate with the conditions in the market for funds that are likely to prevail at the time of the reset determinations to which the review applies.

The AER is of the view that prior to the onset of the global financial crisis, an estimate of 6% was the best estimate of a forward looking MRP. However, given the impact of GFC, market conditions remain unstable. Due to the considerable uncertainty surrounding the global economic crisis, the AER considers that it is equally probable that:

the prevailing medium term MRP will return to the long term MRP over time, or

a structural break caused by the GFC will lift the long term MRP permanently. This suggests that a MRP above 6% at this time is reasonable.

The 6.5% MRP seems to lie between the lower bound of the 2008 range (5.7%) and the upper bound of the 2007 range (7.2%). This demonstrates that the AER’s decision has taken into account the prevailing excess returns of the market both before and after the onset of the GFC.



Our analysis indicates that the long term historical MRP (over the periods starting from 1883, 1937 and 1958 to August 2009) has slightly increased. The range is 6.1% to 6.9% compared with the corresponding MRP range ending 2008 of 5.7% to 6.2%.51 During the first 11 months of 2009, excess returns of the Australian market increased by almost 38% compared to the 10-year risk free rate.

Table 5.1 Historical long term MRP for periods ending 2008 and 23 October 2009

From To Handley (2009)

MRP From To IPART MRP

1883 2008 0.061 1883 Aug-09 0.064

1937 2008 0.057 1937 Aug-09 0.061

1958 2008 0.062 1958 Aug-09 0.068

1980 2008 0.058 1980 Aug-09 0.069

1988 2008 0.050 1988 Aug-09 0.065

Note: The MRP calculations use utilisation rate of 0.65.

Source: Handley, J C, A note on the historical equity risk premium, Final 17 October 2008, Table 4, p 13 and IPART calculations.

Figure 5.1 presents the distribution of the total return of the Australian market from 1900 to 2008. It shows that as a result of the GFC, the All Ordinaries Accumulation Index fell by 40% to 50%, the greatest fall that the Australian market has experienced since 1900. The impact is so substantial that even long term historical estimates of MRP (1883 to 2008) as demonstrated by the AER fall by 0.9% to 1.0%.

51 In calculating the MRP, the Secretariat has used utilisation rate of 0.65 for imputation credits

and average dividend yield of 4.7% (obtained from Comsec) for the ASX listed companies for 2009.



Figure 5.1 Annual calendar returns (1900-2008) Composite of All Ordinaries Accumulation Index and S&P/ASX All Ordinaries Accumulation Index

05

101520253035404550

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of

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Data source: IRESS-All Ordinaries Accumulation Index and S&P/ASX All Ordinaries Accumulation Index.

In its final decisions, the AER confirms that it is appropriate to maintain a 10-year term for the MRP, the same term that it adopts for estimating the risk free rate. Further investigation by the AER confirms that the Australian regulators did have regard to the value of imputation credits in initially setting a MRP of 6% and it continues to agree that the value of imputation credits should form part of the MRP. Consistent with the past regulatory practice, the AER placed primary weight on long term historical estimates of the MRP and have regard to other measures such as cash flow based measures and surveys of finance practitioners.

However, in its 2009 final decision, AER has sought to align the MRP estimate that it adopts with its gamma value (0.65). This has the advantage of transparently linking the gamma with the MRP in the calculation of the weighted average cost of capital.

The upper bound of the MRP range adopted by IPART in the ARTC decision coincides with the MRP of 6.5% determined by AER.

We also note that there is an ongoing academic debate around over whether it is possible to use currently available information to obtain a better prediction of the future MRP than by using the historical average MRP. Welch and Goyal (2008)52 find that no single, arguably relevant, economic variable has valuable predictive power.

52 Welch, I., and A. Goyal. (2008). “A Comprehensive Look at the Empirical Performance of Equity

Premium Prediction.” Review of Financial Studies 21:1455–508.



However, a forthcoming publication by Rapach, Strauss and Zhou (2009)53 finds evidence that combinations of forecasts from a large number of economic variables can provide some information about the future MRP and that this tends to support a higher MRP in periods of economic downturn. This may provide some basis for allowing some variability in the MRP related to economic conditions, rather than sole reliance on the historical average.

5.4.3 The market risk premium and gamma

In our past decisions we have not explicitly considered the impact of the imputation tax system on the market risk premium. However, IPART adopts a range for its market risk premium estimate based on the observation that there are many uncertain factors that impact on the forward looking value of the MRP.

We note that the analysis provided by Officer and Bishop as part of the AER review indicates that the imputation tax system increases the value of the MRP. If the marginal investor derives a benefit from imputation tax credits than this credit should form part of the overall return of an investment. Officer and Bishop’s analysis indicates that:

for a time series of 100 years, the difference between the MRP estimates in a system without and with an imputation tax credit is 0.3% and

for a time series of 10 years, the differential is 1.3%.

This implies that if gamma is 0.5, the maximum difference is 0.65% and the minimum difference is 0.12%. If gamma is valued at less than 0.5 (our gamma range is 0.5 to 0.3) then the impact of the imputation tax system is very likely to be less than 0.65%.

We acknowledge the fact that the imputation tax system is likely to have an impact on the MRP. Compared to the AER’s point estimate of the MRP, IPART uses a range of 5.5% to 6.5 %. Officer and Bishop’s analysis indicates that for a long term series of 100 years, the appropriate value gamma in the MRP is likely to be less than 0.65%. We believe that our range accurately captures the impact of the imputation tax system.

5.5 Key issues for IPART’s MRP estimate

We note that the AER increased its MRP estimate from a point estimate of 6.0% to a point estimate of 6.5%. This places the AER’s MRP estimate at the upper bound of IPART’s range of 5.5% to 6.5%.

53 David E. Rapach, Jack K. Strauss, and Guofu Zhou (2009) “Out-of-Sample Equity Premium

Prediction: Combination Forecasts and Links to the Real Economy” Review of Financial Studies Advance Access published on August 11, 2009; doi: doi:10.1093/rfs/hhp063. See also John Y. Campbell and Samuel B. Thompson (2008) “Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?” Review of Financial Studies July 2008; 21: 1509 - 1531.



In coming to its decision to increase the market risk premium, the AER considered long term historical time series indicating that the MRP is close to 6.0%. The AER also considered that the GFC may have increased the MRP albeit is it not clear whether such an increase is of a short term or permanent nature. In the end, the AER recognised that the market volatility during the GFC may create increased uncertainty surrounding the value of the MRP and it increased its MRP to 6.5%.

We have analysed and extended the historical time series on the MRP used by the AER and come to the conclusion that the long term historical MRP is currently between 6.1% and 6.9%. However, it is unclear whether there is a permanent shift in the value of the MRP. We believe that it is more likely that the higher MRP can be explained by the increase relative to the period of share price inflation immediately prior to the GFC. But whether it is now higher than the long term average or whether the pre-GFC period involved an abnormally low MRP is far less from clear. This could be tested using market surveys on the MRP. However, we are not inclined to place too much weight on these surveys as:

they are short-term forward looking estimates

they are generally published with a considerable lag – making them less relevant to market conditions at the time of their release; and

we believe the long term historical MRP is the appropriate estimate to be used for a 4 –year regulatory period.

We are aware of the academic debate around how to incorporate economic variables to determine a forward looking MRP. In the future, this may provide some basis for providing an additional measure for the MRP related to economic conditions.

However, if stakeholders believe that an adjustment to the MRP based on the most recent long term historical averages are justified they are invited to submit their comments and further evidence to this review. We note that even though current market conditions may indicate that the current MRP is higher than the MRP based on long term time series, this does not necessarily entail that this will be the case in the near future. We are making medium term pricing decisions and we have to ensure that the MRP is representative of the market risk premium during a regulatory period. If IPART decides to adjust its MRP estimate upwards based on the long term historical average, we will review our MRP at future decision dates based on the prevailing long term average MRP figures available.

5.6 Options for IPART’s market risk premium


maintaining the MRP at the current range of 5.5% to 6.5%

assume that there is a structural change in financial markets and increase the range to 6.0% to 7.0%.




1. Keep the MRP at the current range of 5.5 to 6.5%

Advantages

This is consistent with IPART’s past WACC decisions and provides regulatory certainty.

Disadvantages

This range may be at the lower end during a financial crisis and may underestimate the true cost of raising new equity

2. Increase the range to 6.0 to 7.0

Advantages

Recognises the current values of long term average MRP estimates

Recognises the current view of the forward looking MRP.

Places the AER MRP at the midpoint of the range.

Disadvantages

May in the long run overestimate the cost of raising new equity capital.


Our preliminary view is that, taking into account the lower gamma assumed by IPART, the current MRP range of 5.5% to 6.5% adequately represents the most likely MRP in the Australian market. On the other hand, IPART recognises that the forward looking MRP derived from surveys may be better placed to reflect short term changes in market conditions. However, taking these surveys into account would mean that the MRP has to be adjusted regularly to reflect any changes in short term perception. Given that financial markets can be quite volatile in the short-term, this may lead to significant variance in MRP estimates between regulatory WACC decisions.



2 Is there any new evidence that would suggest that IPART should consider forward looking measures of the market risk premium? If so, what is the best approach to do this?

6 The equity beta


6 The equity beta

The equity beta is the key measure of the riskiness of an investment. In this chapter we review our equity beta estimates in light of the AER decision and the GFC. The chapter considers the AER review of the equity beta, how it impacts on our own estimate and possible ways forward. We also conduct our own analysis on the appropriate value of the equity beta. The final section of this chapter summarises our preliminary view on the appropriate value of the equity beta in our future decisions.

6.1 What is the equity beta?

Under the CAPM, the systematic risk of an asset is measured by its ‘beta’ factor. In statistical terms, the beta factors reflect the extent to which future returns are expected to co-vary with the overall market. An equity beta of 1 means the equity in the asset has the same systematic risk as the market whereas higher risk equity will have a beta greater than one.

Beta as a standardised measure of systematic risk reflects how risky a company is relative to the market as a whole. Equity beta is used to estimate the equity return of a business by the CAPM formula:

Re = Rf + βe x (Rm –Rf).

Where:

Rf = risk free rate

βe = equity beta

Rm = market risk premium

If a firm is listed on a stock exchange, its equity beta can be estimated by analysing the movement of the firm’s share price relative to that of the market. Albeit, there may be significant estimation errors such that a long term time series is desirable and using a portfolio of similar stocks is also desirable to average out idiosyncratic effects. For a firm not listed on a stock exchange, proxy companies listed on the overseas stock exchange are used for the analysis. For different companies with different gearing levels, it is necessary to distinguish between asset and equity betas.

6 The equity beta


The higher the gearing, the higher the equity beta because shareholders will require higher returns to compensate for a greater financial risk. The adjustment is intended to reflect the underlying business risks the company faces, before financing is taken into account. Therefore, the adjustment allows the direct comparison of businesses with different gearing.

The common approach to determine the firm’s equity beta is to undertake the de/re-levering process based on observed equity beta of comparable firms that are listed on share markets. As comparator firms have different gearing levels the observed equity betas needs to be de-geared to produce an asset beta. In essence, the asset beta removes the effect of financial risk from the systematic risk. The equity beta for the regulated firm is then estimated by re-gearing the asset beta by the benchmark gearing level chosen for the regulated firm. The process is undertaken through the Monkhouse formula:

βe = βa + (βa – βd)*{1- [Rd/(1+Rd)]*[t*(1-γ)}*D/E

Where:

βa = asset beta

βd = debt beta

Rd = the cost of debt capital

t = corporate tax rate

γ = gamma

D/E = value of debt/value of equity


The AER’s final position is to decrease the value of equity beta from 1.0 to 0.8. The AER placed weight on empirical evidence from Australian data which indicated equity beta values proxy companies based on its own analysis to be in a range of 0.44 to 0.68. This empirical evidence was interpreted after considering the need to promote investment and maintain stability in the regulatory regime.


The AER considered the views of, and evidence provided by, stakeholders including the Joint Industry Association (JIA) which were also presented by members of this association and other investors in the industry, Consumers Roundtable (MEU), NSW Treasury, and the AER’s own consultant, Olan T. Henry.

6 The equity beta


JIA

JIA’s responses to the AER’s issues paper and draft position assert the view that the equity beta should be valued at 1.0.

The JIA argues that:

The empirical evidence relied on by the AER is not robust.

Ninety five% confidence intervals of empirical estimates indicate ‘that the true equity beta value could very well include 1.0’.

The business risk faced by the businesses may be lower than the rest of the market. However, the financial risk is higher due to the level of gearing. These two effects cancel each other out, resulting in an equity beta of 1.

The findings of a dividend growth model analysis indicate that either the AER’s equity beta estimates are too low, or that the equity beta inadequately explains the true cost of equity

NSW Treasury

NSW Treasury responds to the draft position that the equity beta for electricity transmission and distribution should be set at 1.54

Treasury notes that the business risk of regulated networks is “well below” the market average. However, the industry’s debt levels are around twice that of the market’s average (60% versus the market average of 30% to 35%, which may be even less now due to the credit crisis).

The low business risk is offset by the financial risk. This is consistent with the ‘null hypothesis’; companies trend towards the average risk position (ie, an equity beta of 1.0) by adjusting gearing kevels to reflect their relative systematic business risk.

Treasury is concerned with empirical estimates of equity betas as there are few energy utilities listed on the ASX. These have a relatively short listing period and are not always direct comparators to electricity transmission and distribution.

MEU

The MEU notes that the midpoint of the empirical estimate is 0.56. The MEU consider that the AER’s decision is to “build a conservatism of some 40% into the valuation of the equity beta”.55

54 NSW Treasury, Weighted Average Cost of Capital – Response to the Australian Energy Regulator

Review of Electricity Transmission and Distribution WACC Parameters, January 2009, p 5. 55 MEU, p 24.

6 The equity beta


Henry for the AER

Henry provided extensive econometric analysis on the equity beta from Australian data. A number of different methods were used, and tests on the stability of the data were also conducted.

Henry56 recommended that the balance of the evidence points towards the point estimate of β lying in the range 0.4 to 0.7. Henry uses different methodologies including:

proxy betas derived from individual companies

proxy betas derived from portfolio of companies.

He also applied number of adjustments to the equity beta to test whether these are appropriate.

6.4 Implications and options for IPART’s equity beta estimate

IPART has generally set a value for the equity beta within the range of 0.8 to 1.0 for the utilities it regulates57. In setting this value, we recognise of the uncertainty in the empirical evidence available.58 This range has been determined by considering data from the Australian stock market and other factors including regulatory precedent and the uncertainty of the empirical evidence.

6.4.1 Implications to IPART’s approach

The AER’s review presents:

new empirical evidence on Australian and overseas data

a precedent for an equity beta of 0.8.

IPART’s approach of adopting a range to value equity beta recognises the uncertainty that has again manifested in the attempts to measure this parameter. However, the midpoint of our range, 0.9, is above the equity betas suggested when analysing Australian market data.

56 Henry, O. Econometric advice and beta estimation, November 2008. 57 IPART uses a lower or higher range in some WACC determinations based on the analysis of

systematic risk it undertakes on individual industries. 58 In the recent draft methodology paper for electricity retail prices, the Tribunal has presented a

preliminary view that electricity retail and generation are riskier than the network businesses, which could warrant a higher equity beta than 0.8 to 1.0.

6 The equity beta


6.4.2 Rationale of AER’s beta value

In its 2009 decision, the AER considers that there is persuasive evidence to depart from the previously adopted equity betas of 1.00 or 0.90 and that an equity beta of 0.8 is appropriate.59

Prior to 2009, the NER deemed the initial value of the equity beta for all TNSPs and the NSW and ACT DNSPs to be 1.0.60

The AER concludes that the decision is supported by the most recent available and reliable empirical evidence, which it considers is persuasive in support of adopting a lower equity beta.

In determining the value of the equity beta, the AER has also taken into account the revenue and pricing principles under the current regulatory regime. It considers that the non-diversifiable business risk faced by the NSPs is generally lower, compared to the market. The lower degree of non-diversifiable business risk is driven by the relatively high demand inelasticity of electricity to price and by the features of the regulatory regime:

annual adjustment of prices by CPI-X which effectively eliminates almost all of the inflation risk

the roll forward of regulated businesses’ RAB (actual capex being rolled into the RAB) with no re-valuation or re-optimisation at each reset and

pass through provisions that allow the regulated businesses to recover certain unexpected and generally uncontrollable changes in costs (eg, change of tax rate).

The market data that AER has considered suggests a value of 0.41 to 0.68 which is substantially lower than 0.8. However, the AER is of the view that the equity beta value of 0.8 provides regulatory stability and above all achieves an outcome that is consistent with the NER (in particular, the need for efficient investment in electricity services for the long term interests of consumers of electricity).

6.4.3 The beta value adopted by IPART

We use an industry specific equity beta in our WACC decisions. This means that:

we use a range of 0.8 to 1.00 for water and energy utilities and

we determine a unique equity beta range for other industries we are regulating.

In past decisions, the equity beta range varied in terms of the scale of the range and the values used for different industries (Table 6.1).

59 AER, Electricity transmission and distribution network service providers - Review of the weighted

average cost of capital (WACC) parameters, Final Decision, May 2009, p 241. 60 NER, cl. 6A.6.2(b) and 6.5.2(b) of chapter 11, appendix 1.

6 The equity beta


Table 6.1 IPART Equity beta decisions

Year Equity beta

AGL access arrangement 2005 0.8-1.0

Sydney Water 2008 0.8-1.0

Sydney Catchment Authority 2009 0.8-1.0

CityRail 2008 0.8 1.0

ARTC 2009 0.7-1.0

Electrcity Retail (Issues Paper) 2009 0.9-1.1

Buses (draft) 2009 0.7-1.0

We use historical data to determine the equity beta. IPART is aware that there may be instances where the forward looking beta based on other models, such as the dividend growth model, may deviate from our equity beta. However, we determine a rate of return for a medium term regulatory period. We believe that short term estimates of the equity beta may not adequately reflect the equity beta that should be applied over a medium term period61. Short term estimate of the equity beta can be very volatile and this may reduce the reliability of the equity beta estimate over time.

6.4.4 Implications for IPART

In the light of the final AER decision, the key issue for IPART is that whether there is persuasive evidence that the equity beta for utilities has fallen since the GFC. We also explore whether there is any persuasive evidence that there is a material difference in systematic risk between energy and water utilities.

Beta for utilities

We estimated the equity beta of a portfolio of water utilities in the UK based 2-year periods62. This is consistent with Henry’s work for the AER. Although it may be more appropriate to use longer term periods for the beta estimate, this is not always possible in the Australian market where data is not always available beyond two years. The portfolio has an average equity beta of 0.65 (Table 6.2).

61 This issue is discussed in more detail in our separate Discussion Paper on alternative CAPM

models which is available on IPART’s website. 62 We would generally prefer to use longer term time series. We note that this may not always be

possible in Australia due to a lack of data points.

6 The equity beta


Table 6.2 Re-levered equity beta estimates – UK water utilities63

Country Asset beta Equity beta with 60% gearing

Pennon Group UK 0.27 0.69

Northumbrian Water UK 0.20 0.50

Severn Trent UK 0.26 0.64

United Utilitiesa UK 0.32 0.80

Average - 0.26 0.65

a Also operates electricity distribution network.

Note: These water utilities are currently listed on the FTSE. Dee Valley Group plc which has a negative beta is excluded. Water utilities with foreign parents not listed on FTSE are excluded.

Source: 13 October 2009. Bloomberg data and IPART calculations.

The analysis in Table 6.2 shows that the average equity beta for UK water utilities at the 60% gearing level is 0.65. This is slightly below our equity beta range of 0.8 to 1.0 but it has to be stressed that the UK data is not directly comparable to Australian businesses.

What can be done with the UK data is to compare the relative level of risk of water businesses to energy businesses (Figure 6.3). Traditionally IPART adopted the same range in its energy and water utility decisions (0.8 to 1.0).

Table 6.3 Re-levered equity beta estimates – UK energy utilities64


National Grid UK 0.28 0.71

Centrica UK 0.47 1.18

Scottish & Southern Energy UK 0.46 1.15

Average - 0.40 1.01

Note: Energy utilities generally operate in more activities than just networks.

Source: Bloomberg data and IPART calculations.

Table 6.2 and 6.3 indicate that the equity betas for UK energy companies are around 30 basis points higher than the equity betas of water businesses. This implies that the systematic risks faced by water utilities in the UK are materially lower than those faced by the energy utilities. We currently use an equity beta range of 20 basis points for our network decisions and the analysis of UK utilities indicates that this range may not accurately capture the risk differential between water and energy utilities.

63 As the UK does not have an imputation tax system, a simple leveraging and de-leveraging

formula is used as compared to the use of the Monkhouse formula in the Australian market. 64 As the UK does not have an imputation tax system, a simple leveraging and de-leveraging

formula is used as compared to the use of the Monkhouse formula in the Australian market.

6 The equity beta


The comparison between water and energy utilities in the UK gives an interesting insight to the market’s assessment of the relative risk of these sectors. Effectively this comparison standardises for the impact of country and regulatory risk. In the UK, OFWAT commissioned Europe Economics65 to advise on the cost of capital for its 2009 water review. As part of its advice, Europe Economics undertook a similar comparison of the UK water and energy utilities industries equity betas. Their analysis also indicates that water utilities face less systematic risk than energy utilities in general.

Europe Economics’ analysis of the equity beta was based on share market data only. Their analysis does not take into account the specific risk differences that exist between the water and energy sectors. It is also difficult to assess how the UK and the Australian water industries compare as their systematic risk is likely to be affected by their respective regulatory environments.

Figure 6.1 OFWAT comparison of UK utility betas

Data source: Europe Economics, LBS.

Figure 6.1 indicates that on average, water and multiutilities face substantially lower systematic risk than electricity or gas distribution utilities. It is interesting to note that the equity betas of utilities in general seem to have fallen during the GFC. This may be an indication that these investments are perceived as safe havens during times of financial crisis.

Figure 6.2 presents a longer term time series for a portfolio of UK water utilities as presented by Europe Economics in their report to OFWAT66.

65 Europe Economics, Cost of Capital and Financeability at PR09, July 2009. 66 Europe Economics, Cost of Capital and Financeability at PR09, July 2009.

6 The equity beta


Figure 6.2 2 years rolling average equity beta - portfolio of UK water utilities (December 2002 to December 2008)

Data source: Europe Economic, Blomberg, includes all UK water utilities listed at the time of point estimations.

Interestingly, Figure 6.2 shows that the equity beta of the UK water utility portfolio steadily increased from mid 2004 to late 2007. It then clearly shows that equity betas decreased during the GFC.

However, noting that the AER has placed limited weight on the UK equity betas in its 2009 WACC decision due to incomparability with the Australian estimates, the key issue for IPART is how much weight that it should place on these overseas estimates in deriving absolute estimates for the equity beta.

At the industry level in Australia, we observe that there is some correlation between the ASX utility index and ASX 200 index during the last 12 months form August 2008 to August 2009 (Figure 6.3). We note that the Utility index fell by 32% in March 2009 while the ASX 200 retracted by almost 38%. By the end of September 2009, stock prices have generally recovered previous losses. However, the recovery rate of the ASX 200 index is greater than that of the ASX Utilities index. This demonstrates that prices of utilities stocks (in aggregate) fall and rise to a lesser extent relative to the overall market.

The beta value of the utility sector is 0.82, based on the weekly observations of returns over the period from July 2005 to September 2009. The empirical beta of 0.82 suggests that generally the sector has lower risk than the overall market which has beta value of 1. Noting that some of the ASX utilities include businesses with elements of unregulated activities and none of them involves water distribution, the

6 The equity beta


ASX utilities Index may not be directly comparable to the water utilities regulated by IPART.

Figure 6.3 Relative returns of the ASX 200 index and the ASX Utility index (August 2008 to August 2009, weekly observations)67

ASX200 vs ASX Utilities index

-50%

-40%

-30%

-20%

-10%

0%

10%

week ending

AS51 Index AS51UTIL Index

Transport

We undertook further analysis to estimate equity betas for the transport operators using comparable companies listed in overseas stock exchanges. The results are presented in Table 6.4.

67 The utilities index includes 10 securities: AGL, APA Group, Infigen Energy, Energy World,

Duet Group, Envestra, SP AusNet, Hastings Diversified Utilities, Spark Infrastructure and Babcock & Brown

6 The equity beta


Table 6.4 Re-levered equity beta estimates –transport (buses and passenger railway)a


Stagecoach Group UK 0.54 1.34

Arriva PLC UK 0.35 0.88

Go-Ahead Group UK 0.41 1.03

Steady Safe TBK Indonesia 0.13 0.31

Hokkaido Chuo BU Japan 0.32 0.78

AMS Public Hong Kong 0.14 0.34

Transport Intl Hong Kong 0.41 1.03

MTR (train only)b Honk Kong 0.53 1.32

Average - 0.35 0.88

Average buses only (excl. MTR) - 0.33 0.81

a A simple leveraging and de-leveraging formula is used as compared to the use of the Monkhouse formula in the Australian market. Note that the regulatory regime in each of the countries may have an impact on the equity betas.

b MTR does not provide bus services but only train services. It has been included as a comparator between public transport train and bus services.

Source: Bloomberg data and IPART calculations.

Table 6.4 demonstrates that on average, the equity beta of international transport companies is:

within IPART’s utility equity beta range of 0.8 to 1.0

above the average equity beta of UK water utilities

below the average equity beta of UK energy businesses.

6.4.5 Methodology applied for estimating market equity beta

In estimating equity betas, the AER’s 2009 decision has established a comprehensive approach that IPART may adopt as guiding principles in estimating equity beta for calculating the cost of equity for the regulated utilities within its jurisdiction.

In summary, the AER has formed the following views on the approach in estimating equity beta:

the Sharpe CAPM is a reasonable predictor of equity returns, though it is not without limitations

monthly estimates as well as weekly estimates should be considered in forming its views about the range of empirical equity beta estimates

it is appropriate to use the continuous returns as opposed to the discrete returns approach

it is appropriate to examine Australian data from the post ‘technology bubble’ period onwards

6 The equity beta


limited weight is placed on the overseas (United States) equity beta estimates which are required to be adjusted to ensure the estimates are comparable with the Australian equity beta estimates

more weight has been given to an average of individual equity beta estimates but it has also placed weight on portfolio estimates of equity betas

no adjustments for thin trading or other phenomena should be applied in a regulatory context as either adjustment is likely to introduce an upwards bias in the beta estimates.

6.5 Key issues for IPART’s equity beta estimate

We note that the AER decreased its equity beta estimate from a point estimate of 1.0 to a point estimate of 0.8. This places the AER’s equity beta estimate at the lower bound of IPART’s range of 0.8 to 1.068.

In coming to its decision to decrease the equity beta the AER considered Australian and overseas data on equity betas. The market data on equity betas that the AER considered suggests a value of 0.41 to 0.68 which is substantially lower than the AER’s final decision of 0.8. However, the AER is of the view that the equity beta value of 0.8 provides regulatory stability and above all achieves an outcome that is consistent with the NER (in particular, the need for efficient investment in electricity services for the long term interests of consumers of electricity).

We have conducted our own analysis and we concur with the AER that the equity beta of Australian utilities is likely to be lower than one. We have then conducted further analysis to analyse the differential in systematic risk between water and energy utilities. Our analysis based on UK data shows that the systematic risk faced by water utilities is lower than that faced by energy utilities. Hence, a lower equity beta may be warranted for water utilities compared to energy utilities. On the other hand we are well aware that the risks faced by Australian water businesses may be fundamentally different to the risks faced by UK water businesses.

Overall, we agree with the AER that the market data on equity betas for utilities based on Australian proxy companies indicates that the equity beta should be substantially lower than 1. However, in past decision, and consistent with what the AER decided, we used an equity beta higher than what the market data suggested. We did this to take into account the uncertainties involved in estimating an equity beta based on imperfect proxy businesses. Most utilities in Australia are either diversified or integrate more than one activity (for example generation and retail). Our analysis of Australian equity betas for utilities presented in this chapter indicates that:

68 IPART may use a lower or higher range in some WACC determinations based on the analysis of

systematic risk it undertakes on individual industries.

6 The equity beta


since mid 2008, the relative return of the Australian utility index has steadily decreased

the gap between the relative return of the utilities index against the wider share market has widened and

the equity beta of the Australian utilities sector is currently around 0.8.

We believe that the AER’s decision to decrease the equity beta from 1.0 to 0.8 is justified based on their own analysis. The question for IPART now is whether there is sufficient evidence for IPART to maintain its equity beta range of 0.8 to 1.0 which is applied in most utility related decision, or whether there is strong case for lowering this range.

Secondly, there seems to be some evidence that the equity betas vary substantially between industries (for example energy, water and transport) and this give us confidence that we should continue assessing the equity beta on an industry by industry basis in the future.

6.6 Options for IPART’s equity beta estimate for utilities

We determine the equity beta for the sectors we regulate based on the systematic risks the sector as a whole faces. This equity beta is then applied to all businesses operating in a particular sector. The main issues we face can be summarised in the following questions:

Is our approach appropriate and consistent with regulatory practice elsewhere?

Is there conclusive evidence that that our approach has generated biased estimates of the equity beta?

Are there better broadly accepted alternatives available?

We invite stakeholder to comment on the impact of the AER’s decision to change the equity beta. We are particularly interested in any new evidence since the AER’s final decision and differences between the IPART and AER regulated industries.


Our preliminary view is that compared to the observed equity betas of Australian utilities, our equity beta range is towards the upper end. However, it is often difficult to ascertain which part of a business contributes what to the overall level of risk. For example, most electricity utilities provide at least two different activities such as retail and generation and it is difficult to determine the equity beta of individual business divisions. We are regulating only parts of these businesses so it is important to understand that we have to be cautious when assessing the proxy betas we are using in our equity beta decisions.

6 The equity beta


We favour the determination of a separate equity beta for the different industries we are regulating. However, Australian data is sparse and it may be necessary to draw on international data where appropriate. For example, there are no publicly traded water companies in Australia and few worldwide which would allow us to compare the water against the electricity industries.

Our preliminary view is we will continue to assess industry equity betas on a case by case basis. The AER WACC review has provided a substantial body of research on the equity beta values for Australian electricity distribution and transmission businesses. If there is strong evidence that equity betas have moved for some industries we are regulating, we may in the future adjust our equity beta estimate to reflect these changes.



3 For the equity beta, how much weight should be given to evidence from overseas markets especially on the risk differential between industries?

7 Imputation tax credits (gamma)



Under the Australian dividend imputation system, Australian resident shareholders receive credit (franking credit) for taxation paid at the corporate level. This ensures that the investor is not taxed twice on their investment returns, ie, once at the company level and once at the personal tax level.

In this chapter, we review our gamma estimate in light of the AER decision and the GFC. The chapter considers the AER review of the gamma, how it impacts on our own estimate and possible ways forward. We also conduct our own analysis on the appropriate value of the gamma. The final section of this chapter summarises our preliminary view on the appropriate value of gamma in our future decisions.

7.1 What are imputation tax credits?

The value behind the imputation tax credits is represented in the CAPM by ‘gamma’. The rationale for including gamma in the CAPM is that investors are receiving a tax credit from their investment, therefore they would accept an investment with a lower return than if there were no tax credits attached to the investment. Gamma has a range of possible values, from zero to one. The value of gamma is defined as the product of the imputation credit payout ratio (F) and the utilisation rate (theta).

In our past decisions, we determined a gamma value without explicitly locking in separate values for the imputation payout ratio and the utilisation rate. Implicit in this assumption is that the imputation credit payout ratio is equal to 1 and the utilisation rate is the unknown. We have used a number of studies to assist us in determining the appropriate value for the utilisation rate in the past. A summary of these studies can be found in section 7.4.




The AER determined that gamma should be valued at 0.65. This decision departs from the value originally ascribed in the National Electricity Rules of 0.5. The AER sought advice from Handley on gamma in coming to its draft and final position69.70 Based on this advice, the AER determined a value of 0.65 by setting:

the payout ratio at 1, consistent with the Officer WACC framework

the lower bound of theta at 0.57, which was inferred empirically from market prices, from a study by Beggs and Skeels71

the upper bound of theta at 0.74, which was inferred from tax statistics, from a study by Handley and Maheswaran.72

In arriving at this position, the AER considered a number of empirical results on the payout ratio and theta and theoretical issues relevant to the estimation of gamma.

Empirical considerations

The empirical studies on the payout ratio and theta as reported by the AER are shown in Tables 7.1 and 7.2.

Table 7.1 Recent estimates of the payout ratio considered by the AER73

Study Method Payout Ratio

Lally (2003) Financial accounts 1.00

Hathaway & Officer (2004) Tax estimates 0.71

Envestra (2006) Financial accounts 0.39a

0.82b

Essential Services Commission (2008) Forecast revenues 1.0 a Based on tax expense. b Based on tax paid.

Source: Lally, M., Regulation and the cost of equity capital in Australia, Journal of Law and Financial Management, vol. 2, no. 1, November 2003, p 33; Hathaway & Officer, The Value of Imputation Tax Credits – Update 2004, Capital Research, November 2004, p 11; Envestra, Comments on the review of Martin Lally of the ‘The value of imputation credits for regulatory purposes’, Submission to the QCA, February 2006, p 9; Essential Services Commission, Gas access arrangement review 2008-2012 - Draft decision, 28 August 2007, pp 427-430.

69 Handley, John C., A Note on the Valuation of Imputation Credits, November 2008. 70 Handley, John C., Further Comments on the Valuation of Imputation Credits, April 2009. 71 Beggs, D. and C. L. Skeels, “Market arbitrage of cash dividends and franking credits”, The Economic

Record, vol.82, no. 258, September 2006. 72 Handley, John C., and K. Maheswaran, “A measure of the efficacy of the Australian imputation tax

system”, The Economic Record, vol. 84, no. 264, March 2008. 73 A problem with many estimates of the payout ratio is that many large companies have utilised

off-market buyback schemes to distribute franking credits. This practice suggests a desire to distribute available franking credits, supporting an assumption of a payout ratio of 1.



Table 7.2 Recent estimates of theta considered by the AER

Study Method Theta

Cannavan, Finn & Gray (2002) Inference from derivatives ~0.50 (pre 45-day rule)

~0.00 (post 45-day rule)

Hathaway & Officer (2004) Dividend drop-off

ATO statistics

0.5 (1986-2004)

0.6 (post-2000)

~0.40

Beggs & Skeels (2006) Dividend drop-off 0.57

SFG (2007) Dividend drop-off 0.20 - 0.40

Handley & Maheswaran (2008) ATO statistics 0.71 (1990-2004)

0.81 (2001-2004)

Source: Cannavan, Finn & Gray, The value of dividend imputation tax credits in Australia, Journal of Financial Economics, vol. 73, 2004, p 192; Hathaway & Officer, The Value of Imputation Tax Credits – Update 2004, Capital Research Pty Ltd, November 2004, pp 13 – 24; Beggs & Skeels, Market arbitrage of cash dividends and franking credits, The Economic Record, vol. 82, no. 258, September 2006, p 247; SFG, The impact of franking credits on the cost of capital of Australian companies - Report prepared for Envestra, Multinet and SP AusNet, 25 October 2007, p 45; Handley & Maheswaran, A measure of the efficacy of the Australian imputation tax system, The Economic Record, vol. 84, no. 264, March 2008, p 90.

Theoretical considerations

The AER considered a number of theoretical issues including:

market practice

estimating the payout ratio

theoretical issues with theta

the relevant time period for estimating theta

inferring theta from market prices

inferring theta from tax statistics.

Importantly, we note that there is no consensus among financial experts on any of these issues, and each issue is central to the estimation of gamma. The AER’s final position on these issues is summarised in turn.

Market practice

The AER considers that there is no evidence supporting the view that market practitioners believe that imputation credits have no value. There are a number of reasons that market practitioners do not adjust for imputation credits, such as for simplicity and uncertainty in valuing gamma.74 74 AER, Electricity transmission and distribution network service providers - Review of the weighted

average cost of capital (WACC) parameters – Final decision, May 2009, p 404.



Estimating the payout ratio

Based on Handley’s advice regarding the distribution of free cash flows under the standard approach to valuation and the Officer WACC framework, the AER concluded that the best estimate of the payout ratio was 1.0.75 The AER assessed the extent of the reduction in value for retained credits due to delays in distribution and considers that these did not warrant a reduction in the payout ratio.

Theoretical issues with theta

The AER has adopted a conceptual framework that defines the relevant market as the domestic Australian capital market with foreign investors recognised to the extent they invest in the market.76 This is contrary to views of the JIA and its consultant, who consider that foreign investors should be weighted by their aggregate wealth.

Time period for estimating theta

The AER has based its estimates of theta on data from after July 2000 only. Data before this time is rejected as a change to the Australian tax system was introduced in July 2000 which allowed a full cash rebate to resident investors for unused imputation credits. The AER therefore has relied on results from Beggs and Skeels from 2001 to 2004. The JIA’s consultant, SFG has provided updated empirical data on the value of theta, drawn from data from 2001 to 2006. The AER rejects the view that this longer time period provides more reliable results; it considers that results from SFG may not be as reliable as data from Beggs and Skeels due to sample size, methodological and sampling problems.77

Inferring theta from market prices

The AER has set the lower bound for theta with reference to empirical evidence from market prices. The AER concludes that the best estimate of theta based on market prices is 0.57, as demonstrated by Beggs and Skeels for the period 2001 to 2004.78

Inferring theta from tax statistics

The AER has set the upper bound for theta with reference to tax statistics. The AER concludes that the best estimate of theta based on tax statistics, is 0.74.79 This value is a point estimate from a range of 0.67 to 0.81 from data after 2000 from Handley and Maheswaran.

75 Ibid., p 410. 76 Ibid., p 426. 77 Ibid., p 430. 78 Ibid., p 448. 79 Ibid., p 456.




The AER considered the views of, and evidence provided by, stakeholders including the Joint Industry Association (JIA) which were also presented by members of this association and other investors in the industry, the Major Energy Users and Consumers Roundtable (MEU), and NSW Treasury.

JIA

The JIA proposes that gamma should be valued at 0.2.80 The JIA has responded to the AER’s methodological and theoretical approach to calculating gamma. The JIA’s position is supported with several consultant reports from SFG Consulting (SFG), NERA and Synergies.

SFG has provided several written and verbal submissions to the AER on the each of the issues relevant to estimating gamma. SFG responded to the AER’s and its consultant’s empirical method and theoretical assumptions and provided evidence suggesting that gamma should be valued in the range of 0.35 to 0.0 as:

the most recent and comprehensive empirical results show that theta is in the range of 0.2 to 0.35 of face value

if the payout ratio is assumed to be one, gamma is estimated to be in the range of 0.2 to 0.35

assuming a distribution rate of 0.7, gamma is in the range of 0.14 to 0.25.

In support of its view, SFG:

Updates empirical analysis.

Notes the standard practice of financial practitioners, who do not ascribe a value to gamma.

Presents results of US dividend drop off analysis.

Notes problems with consistency. It is inconsistent to value a $1 cash dividend at $1 when estimating the return on equity and then value it at 75-80 cents when estimating the effect of the franking credit. Resolving this inconsistency leads to a gamma of close to zero.

NERA presents evidence supporting a gamma of (or close to) zero. NERA critiques the AER’s theoretical and empirical approach to calculating gamma. Particularly, NERA argues that a representative investor is most likely to resemble a foreign investor because foreign investors have greater “weight”. This is because their aggregate wealth exceeds the aggregate wealth of domestic investors.

80 JIA, AER Proposed Determination Review of the Weighted Average Cost of Capital (WACC) parameters

for electricity transmission and distribution, February 2009, p 136.



NERA also considers there to be a number of methodological errors made by the AER in determining the payout ratio and theta.

MEU

The MEU proposes that gamma should be valued at 0.9. The MEU notes that two thirds of the assets regulated by the AER are government owned.

The MEU considers that if the AER’s draft position of 0.65 is correct for publicly owned assets, when adjusted to reflect actual ownership, gamma should be valued at nearly 0.90.81

NSW Treasury

NSW Treasury notes that there was a wide degree of divergence among finance experts on the value and the method of calculating the value of gamma. The AER is required to satisfy the ‘persuasive evidence’ test in the National Electricity Rules82 to change its value of gamma from 0.5 to 0.65. NSW Treasury submits that there needs to be greater consensus between the experts to satisfy the ‘persuasive evidence test’.83

7.4 Implications for IPART’s gamma estimate

As Table 7.3 shows, IPART’s past practice is to value gamma in a range of 0.5 to 0.3. IPART’s range of values recognises the empirical and theoretical uncertainty in estimating a precise value for gamma. In determining this range, IPART has in the past considered:

theoretical issues such as whether the market should be assumed to be segregated, influenced by foreign investors, or a hybrid of the two

empirical studies, which value gamma within the full spectrum of possible values, ie, between zero and one, as shown in Table 7.3

the practice of financial experts, who generally ascribe no value to gamma.

81 MEU, AER Review of Parameters for Weighted Average Cost of Capital (WACC) - AER Draft Decision,

January 2009, p 20. 82 National Electricity Rules, s. 6.5.4(e) and s. 6A.6.2(j). 83 NSW Treasury, Weighted Average Cost of Capital - Response to the Australian Energy Regulator

Review of Electricity Transmission and Distribution WACC Parameters, January 2009, p 8.



Table 7.3 Empirical estimates of gamma

Study Method Gamma

Hathaway & Offficer (2004) Analysis of tax statistics ~0.40

Cannavan, Finn & Gray (2004) Inference from value of individual share futures and low exercise price options

0.36 (pre 45-day rule)

0.00 (post 45-day rule

Bellamy & Gray (2004) Dividend drop-off (adjusted), 1995-2002

0.00

Beggs and Skeels (2006) Dividend drop-off (1987 – 2000) 0.41

Feuerherdt, Gray & Hall (2007) Dividend drop-off, hybrid securities 0.00

Handley and Mahesawaran (2008)

Analysis of tax statistics 0.58

Source: Hathaway and Officer, The value of imputation tax credits – Updated 2004, Capital Research Pty Ltd, November 2004, p 26; Cannavan, Finn and Gray, The value of dividend imputation tax credits in Australia, 73 Journal of Financial Economics, 2004, p 192.; Beggs and Skeels, Market arbitrage of cash dividends and franking credits, 82 The Economic Record 258, 2006, p 252; SFG, The impact of franking credits on the cost of capital of Australian companies, Report prepared for Envestra, Multinet and SP AustNet, October 2007, p 45; Feuerherdt, Gray & Hall, The Value of Imputation Credits on Australian Hybrid Securities, International Review of Finance, 2007, p 3; Handley and Mahesawaran, A measure of the efficacy of the Australian imputation tax system, The Economic Record, Vol. 84, No. 264, March, 2008, pp 82-94.

IPART has reviewed the updated empirical and theoretical evidence presented by the AER, stakeholders and consultants in this review and recognises the important precedent that the AER’s review represents. IPART also recognises a number of problems with changing its current value. For example, changing the current value could create uncertainty for investors in the businesses regulated by IPART. Further, there are a number of important issues to estimating a value for gamma that have yet to be resolved. Ultimately, a regulator is faced with a range of imperfect and conflicting estimates but must choose a point estimate or range for the parameter. At this stage we are not convinced that there is conclusive evidence underpinning the values adopted by the AER for the payout ratio and theta. The uncertainty evident in the wide divergence of views among financial experts may warrant IPART maintaining its current approach.

7.5 Key issues for IPART’s gamma estimate

Our approach differs from the AER’s approach who assigns a higher value to gamma. In our past decisions, we have recognised that the available evidence on gamma indicates that gamma lies somewhere between 1 and 0, with the greater amount of studies indicating that gamma should be towards the lower end of this range. We also took into account evidence from the financial markets indicating that professional valuations do not assign a value to gamma. Our position is different from the AER’s in that we:

place greater weight on the evidence indicating that gamma should be towards the lower bound of the range and

financial markets evidence indicating that gamma should be set at zero.



We recognise that there is substantial uncertainty involved in estimating the appropriate gamma value to be used in the regulatory context. While the available evidence indicates that gamma could lie anywhere between zero and one, it is less clear how much weight should be given to the individual academic studies.

7.6 Options for IPART’s gamma estimate


maintaining its estimate of 0.5 to 0.3 in light of the uncertainty of empirical evidence

increasing its estimate in line with the AER’s value of 0.65.


1. Maintain the current gamma estimate of 0.5 to 0.3

Advantages


Takes into account the fact that a gamma of zero is used in professional valuations.

Disadvantages

May be inconsistent with some of the evidence provided in academic studies.

2. Increase the gamma estimate to 0.65 in line with the AER

Advantages

Would align IPART’s gamma estimate with the AER

Disadvantages

May seem excessive given the evidence previously used by IPART in gamma decisions.


We will monitor the new evidence that was presented as part of the AER review, but at this stage we do not believe that there is sufficient new evidence that would warrant a shift from our current gamma value. Due to the considerable uncertainty in estimating gamma, our preliminary view is that it is appropriate to maintain a gamma range of 0.5 – 0.3 in future decisions.





4 Is there any additional evidence on the appropriate values of the payout ratio and theta to adopt the AER’s estimate of gamma of 0.65? Or, it is appropriate for IPART to maintain its value of gamma within the range of 0.5 to 0.3?

8 Nominal risk free rate



The nominal risk-free rate is used to calculate the return on equity and the return on debt.

In this chapter we review the methodology we use to compute the risk free rate in light of the AER decision and the GFC. The chapter considers the AER review of the risk free rate, how it impacts on our own estimate and possible ways forward. We also conduct our own analysis on the appropriate methodology for estimating the risk free rate. The final section of this chapter summarises our preliminary view on our preferred methodology to estimate the risk free rate in our future decisions.

8.1 What is the risk free rate?

The risk free rate is the rate at which investors can invest money with an assumed theoretical 0% probability of default and free of market risk over the holding period concerned. Thus, a 10-year Government Bond, while arguably default-risk free, is not risk free if the holding period is less than 10-years (because the price of the bond can change).

As the risk free rate is not directly observable and a proxy must be chosen. Australian regulators generally considered the yield to maturity on Australian Commonwealth Government Securities (CGS) to be the best proxy in the Australian economy. This is because these bonds are essentially default free (government guaranteed returns) with high liquidity and yields that are transparent and published.

IPART currently uses the 20-day average on Commonwealth Government 10-year Bond Index sourced from the Australian Financial Review.


The AER’s Final Position is to maintain the term of the risk free rate of 10 years. This reverses the AER’s draft position, in which a 5-year term was adopted. The AER’s final position also requires that the sampling period is “as close as practically possible to the commencement of the regulatory control period” if proposed by the service provider. In coming to its final decision the AER in particular considered the



appropriateness of Commonwealth Government Securities (CGS) as a risk free rate proxy and the term of the risk free rate.

The appropriateness of CGS

In its submission to the AER CEG84 claims that the nominal CGS displays a bias. The AER did not consider that the evidence provided met the NER’s hurdle of being ‘persuasive evidence’. Each of the alternative proxies proposed by CEG has been considered by the AER

Commonwealth Government guaranteed bank debt is not entirely free from default risk. One reason for this is that there is uncertainty over how long the guarantee is for.

State Government bonds: the AER suggests that instead of the yield on CGS being downwards biased, it could be the case that State Govt bonds are upwards biased.

Indexed vs nominal CGS: The AER responds to CEG’s claims that the nominal and indexed CGS yields have diverged, therefore the nominal CGSs are unreliable. The AER notes that it has previously recognised that indexed bonds may be unreliable. Therefore, the divergence could be attributed to problems in the indexed CGS market rather than in the nominal CGS market.


The AER considered the views of, and evidence provided by, stakeholders including the Joint Industry Association (JIA). Most of the discussion relating to the risk free rate relates to the use of the risk free rate in determining the appropriate cost of debt. The cost of debt is the sum of the risk free rate and the debt margin.

CEG

CEG proposes alternatives to the CGS as a proxy for the risk free rate. The proposed proxies include:

yields on state govt debt

fixed for floating swaps and

yields on CDS (credit default swap) insured products.

CEG also propose an option (that would require consultation) whereby an estimate of the cost of equity is adopted that does not vary the CGS.

84 CEG, CGS as a proxy for the risk free rate - A report for the JIA, January 2009.



CEG respond to the AER’s draft position by examining the premium that investors are willing to pay for liquidity85:

Commonwealth Government guaranteed bank debt: the creation of the Commonwealth Government guaranteed bank debt yielding 178bp to 248bp above CGS yields.

State Govt bonds: an increase in the spread between yields on CGS and State Government debt – ie, State governments have to offer investors 100+bp more than the yields on CGSs despite having a default probability that is imperceptibly different to the Commonwealth Govt.

Indexed vs nominal CGS: CEG notes a dramatic reduction in the spread between indexed and nominal CGS.

CEG state that what was previously strong evidence for the existence of a historically high gap between CGS yields and other riskless assets has now become “undeniable”.

CEG’s recommendation is that the NER continue to set the risk free rate equal to the yield on CGS as the default option, and the AER should have the ability to add an increment, based on then prevailing evidence from the yields on other zero or very low risk instruments.

8.4 Implications for IPART’s nominal risk free rate estimate

IPART has considered the views of the AER and stakeholders in the submissions to the AER’s WACC review. We are not convinced that changing the proxy for the risk free rate would deliver a more appropriate estimate of the nominal risk free rate, or would deliver an estimate that is consistent with common market practice. We are also of the view that the term of the risk free rate should match the target term of the investment, in this case 10 years. While there may have been some possible merit in the argument that a shortage of CGS built a liquidity premium into the CGS rate (thus causing it to understate a ‘true’ risk free rate), the expansion of government borrowing since the GFC makes that argument now irrelevant.

We also note at the outset of this chapter that we do not believe that the use of swap rates or CDSs is appropriate for estimating the risk free rate.

The swap rate is calculated by reference to a floating rate index (BBSW) which includes a default risk component related to the risk of banks. If such a rate were to be used, it would be necessary to reduce the margins applied over that rate (MRP, debt margin) in an offsetting manner.

85 CEG, CGS as a proxy for the risk free rate - A report for the JIA, January 2009.



The yield on a corporate bonds minus the credit default swap premium does not give a pure risk free rate, because the buyer of the bond who pays the CDS premium is still exposed to the risk that the bond issuer defaults and the CDS seller also defaults.

IPART has considered the alternative risk free rate proxies presented to the AER in stakeholders submissions.

Using fixed for floating swaps

IPART noted the submission to the AER review arguing that swap rates would provide a better proxy of the risk free rate. Figure 8.1 shows the 9-year differential between yields on 10-year swaps and CGSs.

Figure 8.1 10-year swap rates and 10-year Commonwealth Government bond index – weekly quotes

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10-year swap index10-year nominal risk free rate indexdifferential

Data source: Bloomberg.

We note that the proposed swap rates are derived from fixed for floating swaps where at least two counterparties exchange fixed for floating interest payments. The swap rates are calculated by reference to a floating rate index (BBSW), and hence the use of swap rates to determine a fixed risk free rate for a four year regulatory period is questionable.

Figure 8.1 also shows that swap rates increased at a relatively higher pace than CGS yields at the onset of the GFC. This seems to represent investors views that interest rates will fall because of the GFC and hence floating rate payments are valued higher than fixed rate payments rather than implying that the 10-year risk free rate is increasing.



Using state government bonds

IPART noted submissions to the AER review arguing that state government bonds would provide a better proxy of the risk free rate. Figure 8.2 shows the 9-year differential between yields on 10-year NSW Government bonds and CGSs.

Figure 8.2 10-year NSW government bonds and 10-year Commonwealth Government bond index – weekly quotes

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10-year NSW government bond10-year Commonwealth Government bonddifferential

Data source: Bloomberg.

Figure 8.2 shows that over the last 9 years the yield differential between Commonwealth and state government issued bonds has been relatively stable with few exceptions. Currently, the differential is close to the long term average. State government issued bonds have consistently traded at a higher yield than Commonwealth Government issued bonds. This does not come as a surprise, as the financial credibility of the Commonwealth Government is likely to be higher in financial markets than that of the NSW Government even though both carry an AAA credit rating.

Using credit default swaps

Albeit the AER did not ask for comments on using credit default swaps and the corresponding corporate bonds as a proxy for the risk free rate, CEG mentions this methodology in its submissions. Credit default swaps (CDS) are a financial instrument that allows investors to trade the credit risk of an investment. In layman’s terms, this means that if one deducts the price of a credit default swap from a risky investment, one should obtain its risk neutral return. The return on the risky investment is then simply made up of the maturity and the liquidity premium. Given that the risk free rate relating to a bond investment may be different (in terms



of maturity and liquidity) than an equity investment, this methodology in theory seems reasonable. However, there are a few caveats which have to be considered:

This methodology does not seem to be appropriate for valuing equity investments as CDSs value the credit risk relating to corporate debt and not equity.

There are no CDSs issued in Australian dollar. All Australian CDSs are issued in USD. Thus, CDSs are inappropriate as a proxy for an Australian risk free rate.

Most importantly however, as previously mentioned, the yield on a corporate bonds minus the credit default swap premium does not give a pure risk free rate, because the buyer of the bond who pays the CDS premium is still exposed to the risk that the bond issuer defaults and the CDS seller also defaults.

We are not convinced that CDSs are appropriate as a proxy for an Australian risk free rate.

At this stage, we do not believe that there is material evidence that the 10-year CGS bond index is not the correct proxy for the Australian nominal risk free rate. In particular, we are not convinced that over time, any of the securities proposed in the submissions to the AER review display the attributes of a risk free rate. Financial markets seem to have returned to more normal levels recently and there seem to be little in indication that a structural change occurred in the Australian government bond market. It seems to be more likely that the differentials between CGS and swap rates and CGS and State issued bonds will return to pre-crisis levels.

IPART is not inclined to changing its risk free rate proxy or the term of the risk free rate but invites stakeholders to submit any additional evidence on the risk free rate they may have.

Sourcing the Australian 10-year risk free rate from Bloomberg

If IPART maintains its current methodology of determining the risk free rate, it could use the 10-year Commonwealth Government bond index provided by Bloomberg. This Index is readily available.

8.5 Options for IPART’s nominal risk free rate estimate


Assume that Commonwealth Government bond rates are an unbiased estimate of the risk free rate and maintain the use of the 10-year nominal Commonwealth Government Bond (CGS) Index to estimate the nominal risk free rate.

Assume that there is a bias in the Commonwealth Government bond rates that impact on an unbiased estimate of the risk free rate and undertake more research on alternative risk free rate estimates such as the swap rates.




1. Continue using the 10-year CGS Index to estimate that risk fee rate

Advantages


This seems to be the most commonly used source of the risk free rate in Australia

Disadvantages

It has been suggested that the that 10-year CGS is a biased proxy of the risk free rate

2. Undertake more research on alternative risk free rate estimates such as the swap rates

Advantages

Using swap rates would be more consistent of what is used in financial markets to price debt

Disadvantages

Swap prices may be biased as investors and issuers place a value on swapping rates form floating to fixed.


Our preliminary view is that the best proxy for a regulatory risk free rate remains the 10-year Commonwealth government bond index. For consistency purposes, we are inclined to start using the 10-year Commonwealth government bond index provided by Bloomberg instead of using the index quoted in the AFR. This would ensure that the estimates of the risk free rate and the debt margin are sourced from the same data provider.



5 Whether the 10-year nominal Commonwealth Bond Index is an appropriate proxy for the risk free rate? If yes, should IPART use the Bloomberg 10-year nominal Commonwealth Bond Index?

9 Gearing


9 Gearing

Gearing is the proportion of debt a business uses to finance its assets and operations.

In this chapter we review our gearing level estimates in light of the AER decision and the GFC. The chapter considers the AER review of gearing, how it impacts on our own estimate and possible ways forward. The final section of this chapter summarises our preliminary view on the appropriate estimate of gearing levels in our future decisions.

9.1 What is the gearing level?

Gearing refers to the capital structure of an entity measured as the proportion of total assets that are funded by debt. Gearing is used to weigh the costs of debt and equity when estimating the WACC. The level of gearing is also used to determine the credit rating and debt premium and to re-lever asset betas into equity betas. Generally, a higher gearing level implies higher the financial risk and thus a higher the equity beta.

It is common practice for regulators in Australia (including IPART and the AER) to adopt a benchmark capital structure, by reference to gearing levels of businesses operating in similar industries rather than using the regulated business’s actual capital structure. In doing this, the regulator aims to approximate the optimal capital structure of the business. This ensures that customers do not bear the cost associated with an inefficient capital structure.

9 Gearing



The AER considers that the appropriate gearing level for the benchmark efficient business is 60%.86

The AER analysed data from Bloomberg and Standards & Poor’s for a sample of comparable energy businesses. The AER excluded companies that did not operate an energy network, have substantial merger and acquisition activities or have extensive involvement in unregulated activities. Government owned businesses were included in the comparator sample as the AER considered them to be sufficiently comparable to the benchmark energy network business.

The sample of comparator businesses used for the market analysis using data from Bloomberg and the book value analysis using data from Standard and Poor’s is set out in Table 9.1 below.

Table 9.1 Comparator businesses for AER’s analysis on gearing levels

Data source Bloomberg Standards & Poor’s

Sample of comparator businesses

APA Group

Diversified Utility and Energy Trusts

Envestra

GasNet

SP AusNet

Spark Infrastructure.

CitiPower

Country Energy

Dampier Bunbury Natural Gas Pipeline Trust

ElectraNet

Energy Australia

Energy Partnership (Gas)

Envestra Victoria

Ergon Energy Corporation

ETSA Utilities

Integral Energy

Powercor

United Energy.

Source: AER, Electricity transmission and distribution network service providers Review of the weighted average cost of capital (WACC) parameters – Final Decision, May 2009, pp 121 - 122.

The AER’s analysis indicates that the average level of gearing from 2002 to 2007 is within the range of 62.1% to 65.4%, depending on the source of data and method.87

Based on this analysis and the views of stakeholders, the AER did not consider that there was persuasive evidence to depart from a gearing level of 60%.


average cost of capital (WACC) parameters – Final Decision, May 2009, p 126. 87 AER, op. cit., p 124.

9 Gearing



The AER considered the views of, and evidence provided by, stakeholders including the Joint Industry Association (JIA) which were also presented by members of this association and other investors in the industry, the Major Energy Users and Consumers Roundtable (MEU), and NSW Treasury.

JIA

The JIA supports the AER’s draft position of a gearing level of 60%. However, the JIA notes some issues in the AER’s methodology in arriving at this gearing level. These issues are supported by evidence from ACG88.89

The JIA submit that the AER should adopt a “see through” approach to gearing analysis which takes into account differing layers of debt. The JIA considers that AER’s reliance on Bloomberg’s market gearing is a concern unless the structures and nature of the securities which underpin Bloomberg’s reported numbers are also investigated.90

The JIA submits that government owned businesses should be excluded from the comparator business sample for the purposes of calculating the benchmark level of gearing. The rationale for this is that it is not possible to observe the market value of a government owned business’s equity. Further, government owned businesses may also be subject to constraints which limit their ability to achieve commercial levels of gearing.91

MEU

The MEU consider that the gearing level for energy businesses should be set at around 65%.92 The MEU proposes that the AER’s analysis in the draft position supports a higher value than previously in the National Electricity Rules.

9.4 Implications for IPART’s target gearing level for utilities

In past WACC, IPART has set a gearing level of 60% for most of the network businesses it regulates. We also considered that it is appropriate to adjust the level of gearing for other industries that it regulates, after considering the level of business risk faced by the firm and the levels of gearing for businesses operating in similar industries. 88 ACG, Review of gearing issues raised in AER Issues Paper - Report to Energy Networks Association,

Grid Australia and APIA, September 2008. 89 ACG, Commentary on the AER’s analysis of gearing levels - Report to Energy Networks Association,

Grid Australia and APIA, January 2009. 90 JIA, op. cit., p 47. 91 JIA, op. cit., p 49. 92 MEU, AER Review of Parameters for Weighted average cost of capital (WACC) - AER Draft Decision,

January 2009, p 22.

9 Gearing


While the AER’s decision applies to energy transmission and distribution businesses, we regulate businesses from a range of industries, including the water, electricity retail and transport industries. The AER’s analysis of the capital structure of energy businesses therefore has limited applicability to the businesses IPART regulates. IPART considers that there is merit in maintaining a more flexible approach to determining the appropriate capital structure dependent on the industry of the business in question and the risks for that industry.

Notwithstanding this, IPART recognises that the gearing level of 60% has strong precedent value in Australian regulatory decisions. Maintaining a consistent approach promotes the level of confidence that investors have in the regulatory regime.


Given support for current gearing assumptions for electricity networks, IPART proposes to:

continue to use an assumed gearing of 60% for industries with similar risk levels and

adjust the gearing assumptions for other industries by reference to this and relative risk levels as well as observed gearing (where available) for that industry.



6 Whether IPART’s proposed approach of setting the gearing with reference to industry-specific levels of debt and risk is appropriate?

10 Credit rating


10 Credit rating

In this chapter, we review our target credit rating in light of the AER decision and the GFC. The chapter considers the AER review of the credit rating, how it impacts on our own estimate and possible ways forward.

10.1 What is the credit rating

The credit rating assumption is an input into estimating the debt margin. The debt margin represents the spread between the cost of corporate debt and the nominal risk free rate. In addition to the credit rating assumption, the debt margin is also related to current market interest rates on corporate bonds, the term to maturity of the debt, the assumed capital structure and the activities undertaken by the issuing firm.


The National Electricity Rules required the AER to review the credit rating level for the benchmark efficient service provider. Other issues relevant to the calculation of the debt margin, such as the term to maturity, suitable proxies, data sources and debt raising costs, were not reviewed.

The AER’s final position is that the appropriate credit rating assumption is BBB+ for electricity transmission and distribution assets. This decision retains the original credit rating assumption in the National Electricity Rules.

Before finalising its view, the AER’s draft position was that an appropriate credit rating level was A-. The draft position was based on a statistical analysis conducted by the AER on the credit ratings of energy network businesses, yielding a median credit rating of A-. The AER considered that examining median credit ratings of sample businesses was the most appropriate approach to determine the credit rating of a benchmark service provider.93

The AER reconsidered its approach for the final decision. The AER reconsidered the evidence on the ‘best comparators’ proposed by JIA and ACG and gave significant weight to this approach. The ‘best comparators’ approach includes gas businesses in the analysis and suggests that a credit rating of a benchmark efficient network


average cost of capital (WACC) parameters - Explanatory Statement, December 2008, p 283.

10 Credit rating


service provider is BBB+. The AER also considered that the median credit rating of sample businesses was an appropriate approach to determine the benchmark credit rating.

The two approaches provide a range of credit ratings from BBB+ to A-.94 The AER concluded from its analysis that the evidence was not persuasive to justify a move from a BBB+ rating.

10.3 Implications for IPART’s target credit rating for utilities

IPART typically sets the debt margin with reference to yields on a set of BBB and BBB+ rated bonds and the BBB rated fair value yield. Yields are sourced from Bloomberg.95

In May 2009, IPART commenced a consultation on an alternative portfolio of proxies, the ‘new universe of securities’, to set the debt margin.96 IPART’s consultation has arisen from its concerns that market conditions in the Australian corporate bond market may not reflect the actual cost of debt a utility would face in a competitive market. Instead of placing importance on the credit rating or the term to maturity, the proxies in the new universe of securities are aligned to the activities of the businesses that IPART regulates. IPART’s analysis indicates that the activity of the business is a better indicator of the cost of debt than the credit rating or the term to maturity.

We have received five submissions to this Discussion Paper97 which all argue that we should not move away from our current approach to estimating the debt margin.

10.4 Options for IPART’s credit rating estimate

This issue is discussed in length in our discussion paper on the debt margin98. The two options presented in this paper are:

use a higher credit rating based on a basket of utility issued debt or

continue using the BBB+ to BBB benchmark credit rating.


94 AER, Electricity transmission and distribution network service providers Review of the weighted average

cost of capital (WACC) parameters – Final Decision, May 2009, p 389. 95 IPART relied on CBASpectrum fair value yields until access to this service was revoked for

some non-bank customers including IPART. 96 IPART, Estimating the debt margin for the weighted average cost of capital – Discussion Paper, May

2009. 97 Submissions are available on IPART’s webpage:. 98 IPART, Estimating the debt margin for the weighted average cost of capital – Discussion Paper, May

2009

10 Credit rating


1. Use a higher credit rating based on a basket of utility issued debt

Advantages

This is consistent with the financial market cost of debt for utilities.

Does not include any companies that do not operate in the utilities sector

Disadvantages

Not always possible to achieve a 10-year maturity

Debt margin may be lower than the debt margin based on a BBB+ to BBB benchmark

2. Continue using the BBB+ to BBB benchmark credit rating

Advantages

Provides regulatory certainty.

Is the most conservative estimate possible based on market data.

Disadvantages

May in the long run overestimate the cost debt.

Not always possible to achieve a 10-year maturity.

Includes companies operating in very diverse industries.


IPART considers that it is appropriate for the issue of the credit rating and debt margin to be dealt with in the consultation already underway.99

99 Documents related to the consultation are available on IPART’s website.

http://www.ipart.nsw.gov.au/investigation_content.asp?industry=6&sector=17&inquiry=194

10 Credit rating


Appendices

10 Credit rating


A Presentation of the WACC


A Presentation of the WACC

Table A.1 WACC presentations

Nominal Real

Pr-tax MTN (Italy) IPART

ERA (WA)

ORR (UK)

CAA (UK)

DTe (Netherlands)

CRE (France)

Post-tax AER/ACCC (AU)

QCA (QLD)

ESC (Victoria)

CC (NZ)

NIAUR (Northern Ireland)

PostCom (UK)

OFWAT (UK)

OFGEM (UK)

In the US it is common practice to use a nominal post-tax approach.

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