Estonian Competition Authority Guidelines for the Determination of Weighted Average Cost of Capital

Transcription

1 Estonian Competition Authority 2013 Guidelines for the Determination of Weighted Average Cost of Capital Tallinn 2013

2 Introduction Weighted average cost of capital (WACC) is the cost of all interest-bearing debt capital (borrowed capital) and equity capital, which is determined considering the proportional weight of both capital components. The Competition Authority uses WACC for calculation of the justified return included in the prices of goods and services sold by. According to the long term regulatory practice it is assumed that if the justified return or operating profit of an undertaking does not exceed the WACC, then the profit earned by the undertaking is within a reasonable limit. Thus, the WACC is the rate of return allowed by the regulator. In the preparation of these guidelines the Competition Authority has relied primarily on the following sources: the ERRA 1 handbook Price Regulation and Tariffs, the analysis Cost of Capital and Financeability at PR09, Report by Europe Economics 2, The World Bank handbook 3 Resetting Price Controls for Privatized Utilities. A Manual for Regulators, the database of the CEER countries 4. According to the Competition Authority s Methodologies for the evaluation of the justifiability of energy and water prices and the Minister of Economic Affairs and Communications regulation nr 51 Imposition of Temporary Prices for Heating 12 and regulation nr 95 The Rules and Conditions for the Imposition of Temporary Prices for Water Services 9 the undertaking s justified return or operating profit consists of the multiplication of the cost of the property used for the provision of the certain service with WACC. In regulatory applications the WACC 5 is determined by the following formula (see Formula 1): Formula 1: WACC EC k DC ke DC EC d DC EC Where: k e is the cost of equity capital (%); k d is the cost of debt capital (also referred to as borrowed capital) (%); EC is the share of equity capital determined by the regulator (%); DC is the share of debt capital determined by the regulator (%); DC + EC is the sum of the shares of equity capital and debt capital determined by regulator (%). 1 Energy Regulators Regional Association (ERRA). Price Regulation and Tariffs. June Analysis prepared by the Europe Economics Chancery House Chancery Lane London WC2A 1QU, 21.July Green, Richard; Pardina, Martin Rodriguez. Resetting Price Controls for Privatized Utilities. A Manual for Regulators. Washington", D.C.: The World Bank CEER Council of European Energy Regulators 5 The formula does not reflect the tax shield, as due to specifics of the Estonian income tax regulation the corporate income tax is imposed only on dividend payments. 2

3 Interest rate % The variables DC/DC+EC and EC/DC+EC in Formula 1 reflect the structure of capital, i.e. the ratio between debt capital and equity capital and the total capital, where the total capital is the sum of the shares of equity capital and debt capital. For example, if the share of debt capital is 50% and the share of equity capital is 50%, then the total is 100% and thus the ratio of both equity and debt capital to the total capital is 0,5 or 50% (50%/100%=0,5). In the following the basics of WACC components formation in Formula 1 is dealt with. 1. Formation of the cost of debt The cost of debt capital is formed as the sum of the nominal risk-free rate, the Estonian country risk premium and the debt risk premium of an undertaking. 1.1 Nominal risk-free rate and Estonian country risk premium The nominal risk-free rate is the income which excludes risk and the investor expects a riskfree profit. The calculation of the nominal risk-free rate is based on the profit level of government bonds. For the calculation of the nominal risk free rate 6 the Competition Authority (hereinafter the CA) uses the 5-year ( ) average interest rate of the German government 10-year bonds to which it adds the Estonian country risk premium. The reason for using the German bonds is the circumstance that the Estonian state has not issued long term bonds so far. The German bond is appropriate as it is the biggest Euro-zone country. Also, the 10-year bonds are much more similar to company shares rather than the 1-year bonds. Annual interest rates of German 10-year bonds 6,00 5,27 4,50 3,00 4,58 4,50 4,80 4,78 4,07 4,04 3,35 3,76 4,22 3,98 3,22 2,74 2,61 1, ,50 Years Figure 1 - Interest rates of German government 10-year bonds The annual interest rates of the German 10-year bonds presented in Drawing 1 are published at: 6 The source of the risk free rate estimates is data from the OSCD web site. 3

4 The average interest rate for the years is 2,810% ((3,98+3,22+2,74+2,61+1,50)/5 = 2,810%). Since the annual interest rates of the German bonds change over time, the cost of debt and equity capital and the WACC also changes in time. According to an evaluation by the Bank of Estonia in May 2006 the country risk is determined by the relative amount of money that the Estonian state has to pay in excess compared to the countries with higher credit rating (e.g. Germany), when it borrows from international markets. Most simple way is to compare the differences in the interest rates of governmental bonds. The Government of Estonia has no such bonds and therefore the country risk can be evaluated by the comparison of the differences in money markets, basing on the difference between Talibor and Euribor quotations. In relation to the introduction of euro in 1 January 2011 the Estonian Bank has stopped publishing the Talibor of debt and deposit interest rates between banks since 30 December For that reason the CA has contacted the Estonian Bank with the following question: Which indicator can justifiably be used for the measurement of the Estonian country risk premium instead of the comparison of the Talibor and Euribor money market interest rates? On 27 December 2011 the Estonian Bank gave the following reply: As in Estonia no aftermarket exists for long-term government bonds there is no direct way to evaluate the Estonian country risk premium. It can be done by an indirect comparison of Estonia with countries that have issued government bonds. The results depend on the presumptions made in regards to the chosen methodology as well as the indicators taken into consideration. Due to the tensions on markets of the government bonds of developed countries the level of uncertainty is very high and it is difficult to give quantitative evaluations. Currently, based on our evaluation, national credit ratings express the country risk premiums the best and presently the Estonian country risk premium should be based on that. Since autumn of 2011 the Ministry of Finance deals with credit ratings in Estonia. Therefore we suggest you to approach the Ministry of Finance for a reply to your question. On 14 December 2012 CA approached the Ministry of Finance and on 3 January 2013 received the following reply: As of the end of 2012 no aftermarket exists in Estonia for government bonds and therefore it is impossible to give a direct quantitative evaluation to the Estonian country risk premium. Last year (year 2012) we based our evaluation of country risk premiums on the credit country rating published by the rating agencies. At that time there where many countries in Europe (Slovakia, Slovenia, Czech Republic) whose credit ratings where similar to Estonia and who had issued government bonds. As of the end of 2012 those countries had the following long-term credit ratings: Estonia (S&P/Moody s/fitch): AA-/ A1/ A+; Slovakia (S&P/Moody s/fitch): A/ A2/ A+; Slovenia (S&P/Moody s/fitch): A/ Baa2/ A-; Czech Republic (S&P/Moody s/fitch): AA-/ A1/ A+; 4

5 Many of the aforementioned countries credit ratings have been decreased and currently only Czech Republic has a similar credit rating with Estonia. The interest rate of Czech Republic government 10-year bonds in 2012 was 3,005 %. Therefore, based on the Czech Republic example, the Estonian country risk premium would be 3,005 % minus the average interest rate of the German government bonds. (The information about Czech Republic derives from Bloomberg; the appropriate graph is attached below). Figure 2 - Interest rates of Czech Republic government 10-year bonds in 2012 (source: Bloomberg) Based on the data from Figure 1 and the information received from the Ministry of Finance (see Figure 2) we obtain the Estonian country risk premium which is the difference between the Czech Republic government bonds average interest rate in 2012 of 3,005% and the average interest rate of the German government 10-year bonds of 1,495%. As the result the Estonian country risk premium is 1,510% (3,005 1,495 = 1,510). Due to the aforementioned the CA considers as the Estonian country risk premium 1,510% for the year As the credit ratings change in time, the cost of debt capital and equity capital and WACC change in time as well. 1.3 Company debt risk premium The CA uses the experience of other EU Member States for determining the debt risk premium of an undertaking. 5

6 Particularly, the CA has determined the company debt risk premium under the average level applied by the regulatory authorities of other countries. The CA has access to the CEER countries 7 database for electricity and gas networks. No data for district heat supply networks is available, but in Estonia these networks are natural monopolies operating in conditions which are similar to the conditions of gas supply networks. In Western Europe district heat supply is not spread and for space heating purpose mainly individual natural gas fired facilities is used and for that reason there is no database for district heating. Thus, the district heat supply can be compared with gas networks. The electricity, gas and district heat supply are comparable for the similarities of their services. In Estonia the district heat supply are in a market dominant position for several reasons: conversion to another type of heat supply is technically complicated and often even impossible; installation of an individual source of heat requires obtaining of an emission licence; an extra power capacity is not available due to electricity supply system limitations and alike. In addition to above most local municipal authorities have established district heat supply areas that makes local district heating a monopoly with exclusive rights in which a change of the type of heat supply is totally impossible. For district heat supply the energy average debt capital risk premium shall indicate the debt capital risk premium of district heat supply. In Estonia an undertaking that operates public water and sewerage system is also in market dominant position. It is very difficult for a customer in a supply of public water and sewerage services area to obtain a licence from the local municipal authority for constructing a personal water abstraction point (at first, the possibility of using the public water system will be assessed) and to organise the treatment of waste water up to the required standard (the waste water collection areas are approved with a directive of the Minister of the Environment). In waste water collection areas with pollution load of more than 2000 population equivalent it is obligatory to construct a public sewerage system (Water Act 24 1 (4)) except in cases where the construction of the public sewerage system would inflict unjustified costs. Therefore if a public sewerage system exists and the consumer is located in an area with a pollution load of more than 2000 population equivalent then the new consumers are not allowed to construct a personal water abstraction point nor clean the waste water. For the reasons named above water and energy are operating in a dominant position and are comparable due to the nature of their services and therefore the risks bared by those can also be compared. Thus, the debt capital risk premium for water is the average energy debt capital risk premium. The CA will use the CEER countries arithmetic mean indicators to secure equal treatment. CA believes that by using the average indicators of other EU Member States an adequate result will be achieved. The following Table 1 presents the arithmetic mean indicators based on the CEER countries debt capital risk premium. As CEER countries consider the national indicator to be 7 CEER. IBP 5 Internal Report on Investment Conditions in European Countries: September 16,

7 confidential 8 countries. the Table 1 does not present the debt capital risk premium indicators by Table 1 - CEER countries debt capital average risk premiums Electricity transmission undertaking Debt Capital Risk Electricity distribution Gas transmission undertaking Gas distribution Arithmetic mean 1,03% 1,07% 1,12% 1,07% Energy average 1,07% According to the amendment of Natural Gas Act 7 (2) 9 in 2012 the transmission of gas within the meaning of the act is the transport of gas through a high pressure pipeline to a consumer installation or an agreed supply point. The use of an upstream pipeline network and the use of high-pressure pipelines for local distribution of gas are not regarded as transmission of gas. Therefore it is not justified to use the uniform average risk premium for the gas transmission system operator and the gas distribution system operator, but they will be used separately for each group. Based on the data presented in Table 1 the CA will apply for the debt capital risk premiums the following arithmetic means: Electricity Transmission Undertaking 1,03%; Electricity Distribution Undertakings 1,07%; Gas Transmission Undertaking 1,12%; Gas Distribution Undertakings 1,07%; District Heat Supply Undertakings 1,07%; Water Undertakings 1,07%. 2. Formation of cost of equity The cost of equity can be determined by either historical data or monetary-theoretical models. Most regulatory authorities use capital assets pricing model, hereinafter the CAPM, which is the basis for evaluation of financial assets of companies. In order to use the CAPM model for equity cost estimates for a company that is not quoted in stock exchange the beta coefficients of similar companies shall be used. The cost of equity that is determined by the CAPM is expressed by the following formula: Formula 2: k e = R f + R c + (ß*R m ) Where: k e is the cost of equity; R f is the risk-free rate of return; 8 In a letter sent to the CA on 16 February 2012 CEER asked CA not to publish the named indicators. 9 [RT I, , 2 entry into force ] 7

8 R c is the country risk premium; R m is the equity market risk premium or the market rate of return; ß is the beta coefficient. 2.1 Nominal risk-free rate and Estonian country risk premium The formation of nominal risk-free rate and the Estonian country risk premium is dealt with in section Equity market risk premium The equity market risk premium indicates how much investors can earn in addition to the riskfree rate of return. Thus, the equity market risk premium is a compensation for taking a systematic risk. Two approaches can be used to determine the equity market risk premium: either on the basis of historical data or by an expected risk premium. Regarding historical data shorter or longer historical periods can be considered. Such options are referred to in the analysis carried out by the market regulatory authority of Great Britain. 10 The CA has studied the equity market risk premiums applied in various CEER countries. 11 For comparison, in Table 2 below the arithmetic mean based on the CEER countries equity market risk premiums is presented. As CEER countries consider this indicator to be confidential, Table 2 does not present the equity market risk premium indicators by countries. Table 2 - Equity market risk premiums applied in CEER countries Equity market risk premium Arithmetic mean 4,72% Table 2 shows that the arithmetic mean of the different equity market premiums applied by EU regulators is 4,72%. The CA has taken in its regulation practice for the equity market risk premium the value of 5%, which corresponds to the recommendations of McKinsey 12 and also takes into account the experience of the market regulators of other EU Member States. The arithmetic mean presented in Table 2 provides a similar result as the 5% value applied by the CA. 10 A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K.Stephen Wright Birkbeck College and Smithers & Co, Robin Mason, University of Southampton and CEPR, David Miles, Imperial College and CEPR On Behalf Of: Smithers & Co Ltd 20 St Dunstan's Hill London EC3R 8HY February 13, CEER. IBP 5 Internal Report on Investment Conditions in European Countries: September 16, Copeland, Tom; Koller, Tim; Murrin, Jack (2000). Valuation Measuring and Managing the Values of Companies. 3 rd Ed. New York etc.: John Wiley & Sons 8

9 2.3 Beta coefficient and capital structure Beta coefficient (hereinafter beta) indicates whether a company s risk level on the market is lower or higher than the risk level of an average company. The market index beta is one (Kõomägi 2006: ). If a beta of a share is below one, then the risk of the share is below the market average. If a beta of a share is above one, then the risk of the share is above the market average. Beta is a relative measure of a systematic risk of a share. Systematic risk is the part of a security-related risk that cannot be mitigated through portfolio diversification. There is no comparable stock exchange quoted energy in Estonia whose data could be used. For the which are not quoted in stock exchange the solution is the using of a comparative method where the beta estimate is based on an average beta for stock exchange quoted operating in the same field of activity. (Kõomägi 2006: ). For beta estimates an equity capital beta shall be determined, which is either unlevered beta β a with zero debt capital or levered beta β e. An unlevered beta of the branch of economy is used as the basis, which is corrected by an average financial leverage of respective sector. To that end Miller s formula is used by most CEER regulators. Herewith it is assumed that an increase in the proportion of debt capital raises the undertaking s risk. Thus, the more an undertaking uses debt capital the higher is the systematic risk related to its shares. The Miller s formula (see Formula 3) is expressed as follows: Formula 3 15 : β e = β a * (1+DC/EC) Where: β e is a levered beta of the undertaking, β a is an unlevered beta of the branch of economy, DC/EC is the regulatory determined ratio of debt and equity capital. It appears from Formula 3 that the CA does not use balance sheet data of the. In market regulatory practice the regulators may intervene in the financing related decisions of an undertaking and require certain capital structure or alternatively, calculate service prices with certain capital structure which may differ from the actual structure employed in an undertaking (Pedell 2006: ). Specialists of the faculty of economics of Tartu University are of the opinion that the structure of capital (50% of debt and 50% of equity capital) has a very little impact on WACC as the ratio does not affect significantly the value of WACC. First of all WACC is determined by a business risk of an undertaking and risk-free rate of return of the markets. On the basis of the aforementioned for calculating WACC the CA uses the capital structure in which 50% is debt capital and 50% is equity capital (the same structure is used, for example, in the electricity transmission and distribution networks and gas transmission in Luxembourg 13 M. Kõomägi. Ärirahandus. Tartu Ülikooli Kirjastus, M. Kõomägi. Ärirahandus. Tartu Ülikooli Kirjastus, The formula does not reflect tax shield, as due to the Estonian income tax regulation the tax shield is not present 16 B. Pedell. Regulatory Risk and the Cost of Capital. Springer,

10 and gas distribution networks in Luxembourg and Portugal. Thus, the above Miller s formula simplifies to the following Formula 4: Formula 4: β e = β a * Beta for gas and electricity Finnish energy market regulator is in a similar position to Estonia as the number of regulated is over a hundred and most of them are not quoted in a stock exchange which means that there is no statistical data. Accordingly, for finding out beta the Finnish energy market regulator has been analysing the indicators of similar companies in Europe and USA. 17 Analogous approach for finding out beta has been used by the energy market regulator in the United Kingdom, for the latter has observed the quoted energy but also analysed from other infrastructures and the statistical indicators of betas of the operating in other sectors. 18 Thereat both of the regulators have brought out the range of betas of regulated by statistical data. For the making of the final decision the risks of the specific sector have also been taken into account. In Table 3 below the arithmetic means of electricity and gas networks unlevered betas which are based on the indicators of CEER 19 countries, are presented for comparison. As the countries consider the named indicator to be confidential, 20 Table 3 does not present the unlevered betas by countries. Table 3 Arithmetic means of unlevered betas of CEER countries Electricity transmission undertaking Unlevered beta (ß a ) Electricity distribution Gas transmission undertaking Gas distribution Arithmetic mean 0,38 0,38 0,45 0,43 Due to the amendments of Natural Gas Act which came into force on 8 July 2012 it is not justified to use the same uniform average beta for gas transmission undertaking and gas distribution in year 2013, but they must be used separately for each group. The CA uses the CEER countries database in relation to electricity and gas networks because of the small number of companies operating only on the network market. Most of the companies belong to a big concern. The CA uses the following unlevered betas (β a ): 17 Electricity Distribution Price Control Review Background information on the cost of capital March A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K.Stephen Wright Birkbeck College and Smithers & Co, Robin Mason, University of Southampton and CEPR, David Miles, Imperial College and CEPR On Behalf Of: Smithers & Co Ltd 20 St Dunstan's Hill London EC3R 8HY February 13, CEER. IBP 5 Internal Report on Investment Conditions in European Countries: September 16, In a letter sent to the CA on 16 February 2012 CEER asked CA not to publish the named indicators. 10

11 Electricity transmission undertaking 0,38; Electricity distribution 0,38; Gas transmission undertaking 0,45; Gas distribution 0,43. Provided that for determining the WACC a financial leverage of 50/50 and Formula 4 have been used then the levered betas (β e ) are the following: Electricity transmission undertaking 0,76; Electricity distribution 0,76; Gas transmission undertaking 0,90; Gas distribution 0, Beta for District Heat Supply Undertakings As it is difficult to find district heat supply that are quoted in a stock exchange, because district heating is spread only in Northern countries and mid- and Eastern-Europe, the CA determined the beta for district heat supply based on the energy manufacturing (93 ) average levered beta of 1,35 as presented by professor Aswath Damodaran (Stern School of Business, New York University) in his database ( 21, last update 24 January 2013, see also Appendix 1 of the present Guidelines). In A. Damodaran s database the aforementioned 93 average financial leverage (DC) is 59,81%, the average share of equity capital (EC) is 40,19%, the ratio between average financial leverage and average share of equity capital (DC/EC) is 148,82%, that is 1,4882 (59,81 / 40,19 = 1,4882) and the average income tax rate is 8,66%, that is 0,0866 (8,66 / 100 = 0,0866). For the conversion of levered beta =1,35 to unlevered beta ( ) the following Miller s formula with a tax shield is used (see Formula 5): Formula 5: [ ( ) ] Where: (1-T) is the tax shield, where T is the income tax rate. Unlevered beta is found with the following formula (see Formula 6) that derives from Formula 5: Formula 6: [ ( ) ] Based on Formula 6 and provided that the income tax rate is 8,66% the average unlevered beta for the aforementioned 93 energy manufacturing is 1,126, because βa=1,35/[1+(1-0,866)*1,4882]=1,126. If the income tax rate is 0 (in Estonia the tax shield 21 Database: Cost of Capital by Industry Sector 11

12 does not come up) then the average unlevered beta is 0,543, because βa=1,35/[1+(1-0)*1,4882]=0,543. By using Formula 4, the capital structure (50% of debt capital and 50% of equity capital) that is accepted by the CA and the average unlevered beta of 0,543 for 93 energy manufacturing (with an income tax rate of 0) the levered beta for district heat supply is 1,09 because βe = 0,543*2=1, Beta for Water Undertakings The CA based the finding of water beta on professor Aswath Damodaran s (Stern School of Business, New York University) latest data in his database ( 22, last update 24 January 2013, see also Appendix 2 of the present Guidelines) on water sector (11 ) average levered beta which is 0,66. In professor A. Damodaran s database the aforementioned 11 average financial leverage (DC) is 44,88%, average share of equity capital (EC) is 55,12%, the average ratio between financial leverage and average share of equity capital (DC/EC) is 81,42%, that is 0,8142 (44,88 / 55,12 = 0,8142) and the average income tax rate is 35,22%, that is 0,3522 (35,22 / 100 = 0,3522). For the conversion of levered beta =0,66 to unlevered beta ( ) the following Miller s formula with a tax shield is used (see Formula 5): Formula 5: [ ( ) ] Where: (1-T) is the tax shield, where T is the income tax rate. Unlevered beta is found with the following formula (see Formula 6) that derives from Formula 5: Formula 6: [ ( ) ] Based on Formula 6 and provided that the income tax rate is 35,22% the average unlevered beta for the aforementioned 11 water is 0,432, because βa = 0,66 / [1+(1-0,3522)*0,8142] = 0,432. If the income tax rate is 0 (in Estonia the tax shield does not come up) then the average unlevered beta is 0,364, because βa = 0,66 / [1+(1-0)*0,8142] = 0,364. By using Formula 4, the capital structure (50% of debt capital and 50% of equity capital) that is accepted by the CA and the average unlevered beta of 0,364 for the 11 water 22 Database: Cost of Capital by Industry Sector 12

13 (with an income tax rate of 0) then the levered beta for water is 0,73 because βe = 0,364*2 = 0, Formation of WACC For WACC calculation the CA uses the following Formula 1, which was given in the introduction part of these guidelines: WACC DC k EC ke DC EC d DC EC Where: k e is the cost of equity capital (%); k d is the cost of debt capital (also referred to as borrowed capital) (%); DC is the share of equity capital determined by the regulator (%); EC is the share of debt capital determined by the regulator (%); DC + EC is the sum of the shares of equity capital and debt capital determined by regulator (%). Resulting WACC values by various sectors which will be used by the CA in 2013 are presented in Table 4 below. Table 4 - Formation of WACC in 2013 WACC accounting (in % ) Nominal risk-free interest rate of German 10-year bonds (R f ) District heat supply Electricity transmission undertaking Electricity distribution Gas transmission undertaking Gas distribution Water 2,81 2,81 2,81 2,81 2,81 2,81 Estonia country risk premium (R c ) 1,51 1,51 1,51 1,51 1,51 1,51 Debt capital risk premium 1,07 1,03 1,07 1,12 1,07 1,07 Cost of debt capital (k d ) 5,39 5,35 5,39 5,44 5,39 5,39 Nominal risk-free interest rate of German 10-year bonds (R f ) 2,81 2,81 2,81 2,81 2,81 2,81 Estonia country risk premium (R c ) 1,51 1,51 1,51 1,51 1,51 1,51 Market risk premium (McKinsey) (R m ) Levered beta (β e ) 1,09 0,76 0,76 0,9 0,86 0,73 Cost of equity capital (k e ) 9,77 8,12 8,12 8,82 8,62 7,97 Share of debt capital (w d ) 0,5 0,5 0,5 0,5 0,5 0,5 Share of equity capital (w e ) 0,5 0,5 0,5 0,5 0,5 0,5 WACC (% ) 7,58 6,74 6,76 7,13 7,01 6,68 13

14 Appendix 1 - Extract from Professor A. Damodaran s database (last update 24 January 2013) Industry Name Number of Firms Beta Cost of Equity E/(D+E) Std Dev in Stock Cost of Debt Tax Rate After-tax Cost of Debt D/(D+E) Cost of Capital Power 93 1,35 10,03% 40,19% 97,19% 4,87% 8,66% 4,45% 59,81% 6,69% Source: Cost of Capital by Industry Sector. Appendix 2 - Extract from Professor A. Damodaran s database (last update 24 January 2013) Industry Name Number of Firms Beta Cost of Equity E/(D+E) Std Dev in Stock Cost of Debt Tax Rate After-tax Cost of Debt D/(D+E) Cost of Capital Water Utility 11 0,66 5,85% 55,12% 18,89% 2,37% 35,22% 1,54% 44,88% 3,91% Source: Cost of Capital by Industry Sector. 14