Analysis of the cost of debt and other factors in ESB Networks WACC

Transcription

1 Analysis of the cost of debt and other factors in ESB Networks WACC A report for ESB Networks Prepared by 11 August2010

2 Contents Page Executive summary 1 1 Introduction 6 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland Checks on the cost of debt Insufficient treatment of Irish sovereign risk in the cost of debt Inconsistent treatment of inflation risk in the cost of debt Subtraction of default risk from the debt premium Conclusions regarding inconsistent debt premium estimation 21 3 Insufficient account of the financial crisis in Ireland Overview of the impact of the financial crisis on ESB financing costs Recent outlook for sovereign bonds spreads in Europe Determinants of yields on sovereign bonds The case of Irish sovereign bonds Recent developments in Irish sovereign yields, spreads and long-term interest rates Other determinants of sovereign risk spreads for Ireland Other Analysis - Sovereign interest rate spreads and yields Relationship between sovereign and corporate yields Impact on cost of borrowing, Irish firms and the cost of capital 31 4 Treatment of inflation in the formula Conclusions regarding inconsistent use of inflation forecasts and indexation 43 5 Conclusions 44 Annex 1 Lists of bonds outstanding 46 Annex 2 References 48 Annex 3 Additional information 50 ESB Networks WACC

3 Tables figures and boxes Page Table 1.1: Recommended WACC Range 6 Table 2.1: Spreads for comparator corporate bonds ( ) 12 Table 2.2: Selected bond spreads (bps)-default BB methodology 13 Table 2.3: Difference in spreads table 7.1 less BB default (bps) 14 Table 2.4: Bond spreads table 7.1 default BB method (bps) 14 Table 2.5: Bond spreads by BB methodology (bps- spot spread on 26/02/2010) 15 Table 3.1: ESRI Quarterly Economic Commentary Selected Projections 26 Table 3.2: Harmonised long-term interest rates - Ireland Germany Spread Table 4.1: German nominal government bond yields 35 Table 4.2 Real government bond yields 36 Table 4.3: Comparison of EFN forecasts with alternative forecasts 38 Table 4.4: Comparison of EFN forecasts with alternative forecasts 38 Table 4.5: CPI inflation forecasts for Ireland (%aagr) 42 Table 4.6: HICP inflation forecasts for Ireland (%aagr) 42 Figure 3.1: Ratio of Irish Financial/Overall Equity Index, January 2010 June Figure 3.2: Irish Public Finances: Debt/GDP ratio, Figure 3.3: Harmonised long-term interest rates - Ireland Germany Spread 30 Figure 3.4: Relationship between historical equity market returns and volatility 33 Figure 5.1: Financial and Overall Equity Indicies in Ireland, January 2010 June ESB Networks WACC

4 Executive Summary Executive summary This independent report was completed by (Ireland) and was commissioned by ESB. The objective of the study was to independently consider aspects of the draft proposals on WACC for ESB Networks recently published by CER and which were based on advice from UK firm Europe Economics. Europe Economics had undertaken a study to estimate the WACC of ESBN for the purposes of the next price control (PR3). Their analysis came to a conclusion on the WACC for ESB Networks (ESBN) which believes do not sufficiently take account of the current and expected characteristics of the Irish economy and of the radical changes in the cost of sovereign debt in Ireland. As a result of giving insufficient weight to Irish issues, believes that Europe Economics estimate of the WACC is too low. also notes that the level of uncertainty in this WACC determination is probably greater than for any previous review undertaken by CER. The decision by CER to seek views as part of the consultation process on how to deal with uncertainty is therefore an appropriate response. While there are many points in Europe Economics estimates of the WACC which might be disputable, believes it may be reasonable to accept the regulator s advisor s judgement on certain technical issues, unless it is clear that they are manifestly wrong or unless there is persuasive evidence that insufficient attention has been paid to Irish circumstances. We believe, however, that there are a small number of points where we believe that insufficient account of Irish circumstances or inconsistencies of methodology have led to a WACC estimate that is too low. We have excluded from our analysis any areas of technical disagreement where we believe the issue is open to reasonable judgement. The two most important issues which we believe are beyond mere differences in judgment concern an inconsistent methodology used for estimating risk-free rate and debt spread 1 for Ireland and insufficient account of the financial crisis in Ireland and existing uncertainty. These points are summarised below: Inconsistent methodology between risk-free-rate and debt spread for Ireland leads to cost of debt too low: Taking premiums out of the risk-free rate does not eliminate them from the overall cost of debt. The analysis undertaken by Europe Economics does not explicitly include sovereign and 1 While the focus of this report is on the cost of debt, we note that a lower risk free rate will reduce both the cost of debt and the cost of equity. It is easier to demonstrate the impacts of reducing the risk free rate by premia and then not putting them back into the cost of debt because the cost of debt, is often observable. These same issues implicitly show up in the cost of equity as well. ESB Networks WACC 1

5 Executive Summary inflation premiums in their debt spread for Ireland, however, they exclude them from the government bond rates: o The analysis by Europe Economics argues for the elimination of the Irish Government sovereign risk premium from their estimate of the risk-free rate. While this point has some merits what is not justified is the decision by European Economies not to put the sovereign premium back into their estimate of the debt premium. o EE also further explicitly subtracts an inflation risk premium from their risk free rate, but does not add this back in when estimating the debt spread. Insufficient account of the financial crisis in Ireland and existing uncertainty: In estimating the WACC, the Europe Economics analysis has not sufficiently accounted for risk and uncertainty surrounding the financial crisis and the current situation in Ireland. o EE document the economic crisis, but does not take account of this in the WACC, although it is clear that the impact of the crisis continues to impact finance costs and availability of funds in Ireland. o Some of the EE analysis is out-of-date, such as their equity risk premium but also their bond risk premiums appear to only go until 02/26/2010. This is significant as it is missing the Euro sovereign crisis of spring o The majority of studies and research suggest that Irish sovereign premiums will remain high for the price control. This is likely to have a knock on effect for the cost of capital for ESBN. In addition to these two key points there is an additional issue which we would like to raise concerning the use of specific inflation index. Inconsistent inflation indexation leads to formula that is inconsistent with the WACC: The use by EE of European inflation and inflation expectation forecasts is not consistent with ESBN s major cost drivers indexation or with the price control formula indexation. o EE opts for the HICP over the CPI arguing that it is less volatile, but the more relevant concept is the correlation with cost drivers. Most of ESBN s cost base tends to be indexed or correlated to CPI rather than HICP in Ireland. o EE deflates nominal bond rates with Euro-area-wide inflation expectations of 2.25% (including the inflation premium), but the price control formula will be based on Irish CPI or HICP. Further, the inflation forecast seems to be based on a 2% inflation rate for the Eurozone, while most evidence suggests a lower rate. We note the latest Quarterly Summer Commentary from ESRI which forecasts HICP at -1.5% for 2010 and 0.25% for 2011, varies considerably from this. ESB Networks WACC 2

6 Executive Summary, however, accepts that use of HICP rather than CPI can be a legitimate instrument by a regulator to incentivise cost reductions even if it is accepted that it is not the appropriate price inflator for ESB costs. However, we understand that a separate cost reduction incentive initiative has been introduced by CER for ESBN and using both mechanisms would not seem to be appropriate. Conclusion While we have not undertaken a comprehensive examination of what is the appropriate WACC for ESB, it is clear to us that it is higher than estimated by CER s advisors Europe Economics. Our preliminary estimates are that a nominal cost of debt for ESB should be in the region of 5.5% or higher This would be consistent with either a real risk free rate of 2.5% and a debt spread of 200bps or a real risk free rate of 2.0% and a debt spread of 250bps. An analysis of international spreads are interesting when compared with the selected debt premium of 1.2%, and the range of 1.0% to 1.4% used by EE. It seems that the averages across all the bonds are in all cases but one above the 1.2% used by EE. Further, the minimums are never below EE s minimum, and the maximums are all above EE s maximum from their range and point estimates used in the executive summary of their report. In the WACC analysis undertaken by Europe Economics there is reference to Bord Gáis but it is not used as a comparator for ESBN s borrowing cost, in spite of the existence of traded Bord Gáis debt. The evidence on the previous regulators decisions should be interpreted carefully and with caution as subtracting the risk-free rate other regulators used might give too low a result on the spread (if the risk free rate is higher as in the case of CAR, for example). The pre-financial crisis numbers are of little relevance since the financial crisis continues-very few decisions have come out that reflect the financial crisis. It seems the analysis takes the effects of the crisis away, but does not consider the possibility that the effects of the crisis are lingering and should be included in the WACC of ESBN. The possibility of a continuing impact on Irish Government bond spreads, and thus on Irish corporate spreads, has not been given sufficient weight. Many international forecasters, official and private, are predicting a medium-term impact on the Irish economy. While the approach taken by Europe Economics may not result in any significant error in the overall cost of WACC in countries such as UK, we believe it is not appropriate for Ireland. ESBN will have a very challenging capital investment programme over the course of the price control. This will require raising funds in the debt markets, most likely by ESB Networks WACC 3

7 Executive Summary bond placements, and the likely timing for this is in the beginning half of the price control. Since the sovereign debt crisis is likely to have long-lasting impacts on the cost of borrowing to ESBN, it is worthwhile to study the determinants of sovereign yields, and study whether these factors are also likely to be long-lasting. In a European Central Bank (ECB) Report assessing the determinants of yields on sovereign bonds, Attinasi et al. (2009) find that sovereign bond spreads in the euro area broadly reflect concerns about a country s credit risk, which is based on fiscal balance, liquidity risk and higher international risk aversion. More precisely, the report finds that each explanatory variable contributes to the change in daily sovereign bond yield spreads in the following maximum proportions: 56% the international risk aversion; 21% the expected fiscal position (budget balance and debt); 14% the liquidity proxy; and 9% the announcement of bank rescue packages. Given the positive empirical correlation between the above macroeconomic variables and sovereign risk spreads, the emerging developments in Ireland are likely to indicate that there will be higher borrowing costs for Ireland in the future. In any event, a robust assessment of the average sovereign spread in Ireland, or indeed in any country, both now and in the future must first carefully diagnose the economic health of the country in terms of its risk, liquidity and fiscal positions. The CER should consider the WACC allowed. Our view is that an overall nominal cost of debt similar to the currently existing Irish government rates should be the starting point. This, along with a 25bps company debt spread would give a nominal cost of debt of 5.5%. We note that recent Government 10-year bond were sold at an average of 5.537% which would indicate a higher estimate. This is, however, a lot of volatility in spreads and it is difficult for us in this report to arrive at a fixed determination. The Irish Government 10-year bond yields should be seen as the minimum or lower bound to the cost of funds for any semi-state entity in Ireland, but especially a government-owned semi-state such as the ESB; it is very unlikely ESB s cost of funds could be lower than this for any sustained period of time. The WACC should also take account of the likely cost of borrowings. At present with inflation in Ireland negative, and current nominal borrowing rates for companies such as Bord Gáis or the Government around 5 5.5%, this indicates a real cost of borrowing closer to 6 6.5%. The cost of debt as estimated by Europe Economics for ESBN, either nominal or real, has been estimated to be below the cost of debt to the Irish Government. This is ESB Networks WACC 4

8 Executive Summary unlikely to be appropriate and we know of no regulated WACC determination where the estimated figure for the regulated entity is below the cost of sovereign debt. While there are many points in Europe Economics estimates of the WACC which might be disputable, believes it may be reasonable to accept the regulator s advisor s judgement on certain technical issues unless it is clear that they are manifestly wrong or unless there is persuasive evidence that insufficient attention has been paid to Irish circumstances. We believe, however, that there are a small number of points where insufficient account of Irish circumstances or inconsistencies of methodology have led to a WACC estimate that is too low. We have excluded from our analysis any areas of technical disagreement where we believe the issue is open to reasonable judgement. The two most important issues concern an inconsistent methodology used for estimating risk-free rate and debt spread for Ireland and insufficient account of the financial crisis in Ireland and existing uncertainty. It is our assessment that the WACC analysis used by Europe Economics has also implicitly assumed that the impact of the Eurozone financial crisis on Ireland will be of short duration. The evidence supports the opposite view; the crisis continues, and the crisis will have a lagging effect on the cost of capital to Irish firms. We also believe that CER should consider how to structure the WACC for ESBN to take account of the unprecedented level of uncertainty facing the Irish economy and markets for Irish debt. understand that CER is cautious about agreeing a WACC which if the premium on Irish sovereign debt is removed, would provide too high a return to ESB. However, it may be worthwhile for CER to examine allocation of a WACC which reflects the realties of the current markets for Irish debt but having a mechanism to claw this back if the outturn on sovereign debt in Ireland is more positive than expected. ESB Networks WACC 5

9 Section 1 Introduction 1 Introduction This is a report for ESB Networks (ESBN) by Economics consultants. The report represents an assessment of the report of Europe Economics for the CER in the context of the estimation of the weighted average cost of capital (WACC), needed for the next networks price control ( ). While much of our discussion focuses on the cost of debt, issues such as an inflation premium and the indexation of the formula to Irish or European inflation are likely to impact the cost of debt and the cost of equity. The estimation of the WACC has been based on the capital asset pricing model (CAPM), and the related underlying parameters. The CER consulted on the use of CAPM previously, and no stakeholders submitted any responses suggesting an alternative or better methodology. supports the overall approach used by CER and its advisors Europe Economics to use the CAPM Model. The key issue is whether the underlying assumptions adequately reflect Irish circumstances and whether all the underlying assumptions of the model have been implemented consistently. The table below is reproduced from the EE WACC estimation main document, and sets out the key values for the WACC estimates. Most fundamentally, we believe the estimated real cost of debt is too low, at 3.2%, and this does not take account of the realities of the Irish economy and of markets for Irish debt. With inflation in Ireland negative, and current nominal borrowing rates for companies such as Bord Gáis or the Government around 5-5.5%, this indicates a real cost of borrowing closer to 6-6.5%. Table 1.1: Recommended WACC Range The remainder of this document is set out as follows. Section 2 details our concerns about how the debt spread and the risk free rate have been calculated for Ireland. Section 3 gives our assessment of whether the Irish implications of the financial crisis has been sufficiently accounted for in the WACC analysis, and also on whether the financial crisis will continue to have a lingering impact on the cost of finance for the ESBN. Section 4 details issues regarding the calculation of the inflation indices and ESB Networks WACC 6

10 Section 1 Introduction forecasts used. Section 5 gives our conclusions. Additional information is included in the annexes. ESB Networks WACC 7

11 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland While the general methodology for estimating the cost of debt used by CER s advisers is in s view appropriate, we believe they have come up with an estimate of the cost of debt that is well below the actual cost of debt that will be achievable by ESBN. This is for a variety of reasons, but the major ones are due to their choice of the risk-free rate (RFR) and their methodology for taking out premiums for Irish sovereign risk and inflation risk from the risk free rate, but then not putting them back into the company-specific debt premium. This does not reflect the reality of Irish circumstances. 2.1 Checks on the cost of debt The financial markets appetite for the debt will be reflected in the selling price of the bonds issued (for bond markets the most likely source of debt for ESBN). The estimation of the cost of capital (debt) is based on this foundation. What is observable in relation to the reality of the cost of debt for Irish corporates is the selling price of the bond and the bond characteristics (face value, maturity, coupon, etc), and then the nominal yield from that bond is just a calculation. 2 Current yields for Irish Corporate Debt, including Bord Gáis, and Irish Government Debt are observable and so it is important to check any cost of capital estimation against observable data. The recent bond auction results, from 15 June, from NTMA gives a 4.5% coupon 2018 maturing bond with weighted average yield from the sale at 5.088%. Interpolating the yield curve out to 10 years would give a 10 year yield (which is pretty standard for benchmark bonds) or about 5.2%. A 2016 bond was sold at an average yield of 4.521%. More recently, the 20 July auction gave results that were similar. Two bonds were sold a 2016 bond and a 2020 bond. The 2016 bond was sold at an average yield of 4.496% while the 2020 bond was sold at an average yield of 5.537%. (Note that the part of the increase in the yield is based on the longer maturity and the yield curve, which may have steepened in the previous month). In any case, we can conclude that interest rates on longer term borrowing in the State are likely to be marginally higher than a month ago. 2 The yield can be seen as the internal rate of return of all the cash-flows of the bond. ESB Networks WACC 8

12 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland The Irish Government 10-year bond yields should be seen as the minimum or lower bound to the cost of funds for any semi-state entity in Ireland, but especially a government=owned semi-state such as the ESB; it is very unlikely ESB s cost of funds could be lower than this for any sustained period of time. 3 From Table 1 in the EE report, the calculated nominal cost of debt will be about 5.2% (i.e., adding the implicit assumption on inflation expectations used by EE, namely 2%, to the real cost of debt of 3.2%). However, if one adds the figure of 1.5% inflation which is the expectation for the Euro zone for the next year, to EE s real cost of debt point estimate of 3.2%, then the estimated nominal cost of debt used by EE is only 4.7%. Even if one takes 5.2% to be the estimated nominal cost of debt for ESBN (based on the higher-than-expected inflation forecast), it can be seen that this is likely give a nominal cost of debt which is too low as there is effectively no spread over the Irish government debt, even on the calculated nominal cost, based on the EE methodology. In the case of the more likely inflation expectation which is lower than 2%, the actual nominal cost of debt would be even lower (so the effective spread would be negative). In order to examine whether the Europe Economics estimates are a reasonable reflection of the Irish circumstances it is useful to compare the real cost of debt from the most recent NTMA auctions with the real cost of debt estimated by EE, by subtracting inflation from the NTMA results. EE estimates the real cost of debt at about 3.2%. The real cost of debt for the Irish Government will be based on the nominal yield less inflation, based on actual inflation rate, in the Euro zone, of about 1.5%, or in Ireland, of about -0.9% (for 2010). If one takes a 5.2% yield and subtracts even 1.5%, one gets a real yield of 3.7%. If one uses the Irish inflation rate (which is negative), one gets a higher figure. 4 The above clearly shows that the cost of debt as estimated by Europe Economics for ESBN, either nominal or real, has been estimated to be below the cost of debt to the Irish Government. This is unlikely to be appropriate and we know of no regulated WACC determination where the estimated figure for the regulated entity is below the cost of sovereign debt. There are a number of reasons why the cost of debt numbers estimated by Europe Economics give such implausibly low results, and we discuss these below. 3 Differences in liquidity and trading may make this untrue over short time periods. 4 This section is just presenting some high-level tests. We therefore ignore discussion of which inflation rate to use, etc, and take this up later. ESB Networks WACC 9

13 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland 2.2 Insufficient treatment of Irish sovereign risk in the cost of debt 5 The analysis undertaken by Europe Economics argues that Irish Government debt is not risk free and therefore yields on Irish Government Bonds should not be used as the risk-free rate. While this point is probably true, the focus should have been on the overall cost of debt: the sum of the risk-free rate and the debt spread. Practically it doesn t matter whether the sovereign premium is in the risk-free rate, or in the debt-premium but what does matter is whether the estimation is consistent. In other words, if the premium has been taken out of the risk-free rate, has it be sufficiently accounted for in the debt premium. In paragraph 3.66, EE explicitly recognize this fact for the relationship between the RFR and the equity risk premium (ERP); they state, It should be noted that the estimate of the RFR has an effect on the ERP if one is to place some weight on the Smithers & Co view, and the view expressed in the recent Competition Commission (CC) recommendations on the cost of capital for the UK s Stansted airport, that the sum of the RFR and ERP is more stable than the individual components. This rationale 6 should hold for the debt premium as well as the equity premium EE should have focused on the less volatile sum of the RFR and the debt premium. The sum should include sovereign risk, as this risk premium must go in either one or the other. It should be noted, that in common practice, in academic circles, and in regulatory decisions, common approach is the use the home country benchmark bond as the estimate of the risk free rate. The rationale for this is more practical than academic; by taking the home-country benchmark bond as the standard for the risk-free cost of debt, and then corporate spreads can be interpreted as company-specific default spreads. There is little doubt that sovereign risk should be added back into the debt premium, if it has been taken out of the risk-free rate. This is because: It is the most common practice, and market players take this into account when assessing corporate debt. This practice is advocated by leading academics ESBN is a semi-state enterprise Evidence on spreads supports this (consider the ESB and Bord Gáis spreads) 5 This issue arises in the cost of equity estimation as well; a sovereign premium will either be in the risk-free rate or in the equity risk premium, but always in the cost of equity. While EE have ignored this too, they may have adjusted for this implicitly by taking the upper end of their range for the cost of equity. 6 (that it is the net effect of two additive factors, which tend to be volatile in isolation, but less volatile when taken together) ESB Networks WACC 10

14 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland Has Europe Economics used a consistent methodology when considering the evidence on the debt spread for Ireland? It appears that the methodology used by Europe Economics when calculating the debt spread may not have been the same as that used when calculating the risk free rate. The point is material because if one uses a particular methodology to calculate the spread, and another methodology to calculate the risk free rate, then things such as their ad hoc inflation risk premium and the sovereign risk premium may get lost in the shuffle, lowering the WACC beyond what is justified. The debt spread is generally calculated as the actual nominal cost of debt (which is observable), less the nominal risk free rate. The point is that unless EE takes out any premia of the risk free rate they used for the debt spread, consistent with how they did the formula risk free rate, then the spread will be biased downward. While EE has not been explicit in the report concerning aspects of their methodology for estimating the corporate debt spread 7, it appears that their approach has been to take a range of utility companies current yields on bonds over a time period, and subtract off the prevailing government bond yield as the risk-free rate. The key question is consistency; has EE used a methodology consistent with their own view of the risk-free rate when calculating all their debt spreads? We recall that to be consistent, the cost of debt should include the sovereign risk premium and the inflation premium that have been explicitly subtracted out of the risk free rate. These should be included in the debt spread (or if these are not included in the debt spread, they should be added back into the cost of debt ad hoc. 8 We suspect the analysis may have omitted part of the sovereign risk premium and the inflation risk premium from their cost of debt because they do not mention adding these back in, nor are they specific as to how they calculate their spreads. The data from the tables such as table 7.1 is listed as from Bloomberg. We note that the default Bloomberg methodology for reporting the spread allows the Bloomberg terminal to pick a benchmark risk-free bond of similar type and maturity. It isn t clear whether the spreads presented by EE used this methodology. We might agree with the default BB methodology as the most correct way to calculate the spreads for current bonds, a different methodology would be most appropriate for tracking historical spreads. We also note that BB will automatically report spreads based on 16 different alternative methodologies that can be selected by the user one must guess that EE used the default methodology. For the 7 The lack of clarity being exactly what did they use as the benchmark bond, over which corporate spreads were calculated. How did they account for the inflation premium they ve taken out, sovereign risk, etc? How did they match maturities for corporates and benchmark bonds on a like-for-like basis? 8 Or at the very least a detailed, plausible and defensible economic argument should be made for why a company like ESBN should be able to issue bonds that avoid the sovereign debt premium and the inflation risk premium (note, the existence of a premium means that the price of the bonds at sale/placement will be depressed, all else equal.) ESB Networks WACC 11

15 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland historical data, the best methodology to use would be based on the spread 3 methodology, which is the spread-to-mid between the yields of the corporate bond and the benchmark bond on the day. The main table on spreads from EE is reproduced below. Table 2.1: Spreads for comparator corporate bonds ( ) We have obtained the spreads reported by BB for selected bonds in the above tables based on the default methodology. These data are presented in table 2.2. The table presents the spreads averaged over a number of ranges, and also the spot spread for the date selected by EE. In general, the spreads from the default BB method are higher than the EE method. An analysis of internal spreads are interesting when compared with the selected debt premium of 1.2%, and the range of 1.0% to 1.4% used by EE. It seems that the averages across all the bonds are in all cases but one, the 2010 average for National Grid, above the 1.2%. Further, the minimums are never below EE s minimum, and ESB Networks WACC 12

16 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland the maximums are all above EE s maximum from their range and point estimates in Table 1 of the executive summary of their report. Table 2.2: Selected bond spreads (bps)-default BB methodology Company EDF Red Electrica Viridian TERNA National Grid ENEL Dong Energy Default BB Spread Benchmark Bond UK Treasury 15yr, maturing 03/2025 German sovereign bond 3 yr, maturing 04/2013 UK Treasury 8yr, maturing 03/2018 German sovereign bond 10yr, maturing 07/20 UK Treasury 15yr, maturing 03/2025 French sovereign bond 15yr, maturing 04/26 German sovereign bond 2yr, maturing 06/12 avg max min /02/ avg avg avg July Note: Source: analysis of BB data From the table above, it is clear that the spreads for selected bonds (from EE s selected list) the spreads, based on the BB default methodology, are significantly higher than the spreads reported in the Europe Economics Report. A first item to note is that the spreads as reported by the default BB methodology are found by taking the difference in the yield on the corporate bond and a selected benchmark bond. The benchmark bond, as selected by BB, is found in the first line of our table. Note then, for example, that if sovereign spreads in Italy, or Spain, impacted the cost of borrowing for ENEL, or for Red Electrica, then this would show up in their spread, based on the BB methodology, because the cost of borrowing to the company would go up, but the benchmark bond would tend to be stable. Comparing just the average over the period and the spot spread presented in table 7.1 of the EE Report, versus the BB default spreads we present above, shows that the methodology used by Europe Economics for table 7.1 appears to have significantly underestimated the spreads. The comparison, which is the table 7.1 spread less the spread in the table above, is found in the table overleaf. ESB Networks WACC 13

17 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland Table 2.3: Difference in spreads table 7.1 less BB default (bps) Company EDF Red Electrica Viridian TERNA National Grid ENEL Dong Energy Avg across bonds 26/02/20 10 avg max min Note: Source: analysis of BB and EE data Given the differences in the spreads between our selected bonds and the spreads in table 7.1, we obtained additional data on spreads from BB. Table 2.4: Bond spreads table 7.1 default BB method (bps) GDF Suez RWE Centrica Yorkshire Scottish United Utilities Spot 26/02/2010 avg Avg Note: Source: analysis of BB data Given the spreads above, it appears that in general, the BB spreads based on the default methodology, with the exception of RWE, tend to be bigger than the spreads presented in the Europe Economics Report. The question is then how did EE estimate their spreads? One source of difference may be that we are not certain what bonds precisely EE has chosen for inclusion in table 7.1 of their report and it is possible that they used a more restrictive sample than what is available. As just an example of the numbers of outstanding bonds for many big companies, a list of bonds outstanding for EdF is found in the annex. There are in fact many bonds for the selected companies why EE chose a particular bond for a particular company to estimate the spread is unclear. We note the selection does not appear to be based on maturity, as different maturities show up in EE s selection of bonds. This question could be ESB Networks WACC 14

18 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland made more general: Why did EE not base their analysis on more bonds when selecting so few could introduce bias? We further compared the spreads based on the range of possibilities from the BB methodologies. The data are found below. It seems to matter significantly what methodology is chosen. Further, for some bonds/companies, only one methodology seems to be available. Thus, it may be that EE relied on different methodologies for different bond spread estimates within their selected sample. Table 2.5: Bond spreads by BB methodology (bps- spot spread on 26/02/2010) Com pan y/b ond Spre ad 1 Spre ad 2 Spre ad 3 Spre ad 4 Spre ad 5 Spre ad 6 Spre ad 7 Spre ad 8 Spre ad 9 Spre ad 10 Spre ad 11 Spre ad 12 Spre ad 13 Spre ad 14 Spre ad 15 Spre ad 16 EdF Viri dian Red Elec trica TER NA Nati onal Grid ENE L 105 Don g Ener gy Avg acro ss bon ds Note: Source: analysis of BB data Europe Economics do not outline in detail in their report how they came up with their spread methodology, but it appears that the spreads, as reported are not based on the methodology reported, and that based on the BB methodology, the spreads would have been higher. The Europe Economics report seems to accept that there is apparently a wide range of variation in the spreads, but offers no explanation or effort to explain in para ESB Networks WACC 15

19 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland Further, according to our research, many of the spread methodologies for the BB terminal are only valid from 2006 for historical data. In other words, Bloomberg data service, database, and terminal, do not have the pre-2006 historical data to calculate the spreads based on many of the methodologies. Thus, it may be that the historical data presented by EE is using a different spread methodology than the default or than the preferred (for historical spread calculation) (Spread 3 in the BB terminology), or from the spot rates offered by EE for 26 Feb Spreads are impacted by a number of factors besides credit rating (which Europe Economics to some limited extent account for in table 7.1), including: Company size Time-to-maturity Coupon values/timing of payments (more technically, duration) Other factors (bond seniority, callability, convertibility, optionality, etc). Consideration of additional factors on spreads would have been and should have been more precise, and if these factors where considered (as they should have been) EE should give account of how. Many of the so-called comparator bonds are from some of the sector s largest companies, which are among some of the largest companies in the world. Spreads tend to vary by company size. Spreads should also be matched to maturities (i.e., the corporate bond with 20yr maturity is matched to the nearest home country government bond with 20yr maturity). There should be a term structure to spreads as well as to yields, and EE makes no mention of this and apparently benchmark comparator bonds of very different maturities, but this does not appear to be taken into account when looking at the spreads. Bonds with very different maturities appear to be part of EE s selected bonds. Since the yields on the corporate debt and the yields on the government debt fluctuate over time, and the maturities change over time, it would be a difficult task to get the yields of the corporates, and take, the yield of the German bond as the benchmark, and calculate the new spread over time. Bloomberg will perform this task automatically when choosing the spread3 methodology for historical spreads, but it is not very clear that this is what EE did. Further, it appears that the data from BB are not available pre The cost of debt from ESB Group has not been considered based on existing data. ESB has borrowed money in the international debt markets and borrowed by issuing bonds to financial institutions in February According the The Irish Times, 27 Feb. 2010, The [ESB] confirmed that it had raised 275 million ( 307 million) through a bond issue to a number of European financial institutions. The issue was ESB Networks WACC 16

20 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland the first tranche of the 3 billion total. the bonds would mature in 10 years, and carry interest of 6.5 per cent a year, which is in line with what the company expected to pay. The money will be used to fund the ESB s expansion plan up to 2020 At the time, the 10 year Gilt rate on sterling was 403 basis points on February 25, according to Bloomberg online edition. Thus the spread for ESB was about 247bps. This is well above the spread that Europe Economics estimates of 120bps. In the WACC analysis undertaken by Europe Economics there is reference to Bord Gáis but it is not used as a comparator for ESBN s borrowing cost, in spite of the existence of traded Bord Gáis debt. Note also, that the sampling is not representative, in that big countries utilities will be over-represented in their sample of European corporate utilities, and that these will naturally have a bias towards a low sovereign risk (smaller countries tend to have more sovereign risk). This is not appropriate to Irish circumstances. The Europe Economics report also mentions that higher spreads on bonds have been found recently (para. 7, 17). It is well known that spot spreads on bonds can be misleading as many bonds, especially in Euro, tend to be somewhat illiquid. The result is that the amount of sovereign risk for Ireland, which should be included in the cost of debt is too small than to reflect the reality of ESBN s borrowing needs and capacity. EE presents their own estimate of the debt spread from the CAR 2009 decision as 1.6%. What one must look closely to the footnotes for is that this is based on a riskfree rate of 2.5%, so the overall cost of debt is 4.1%, higher than the EE cost of debt of 3.6%, because the CAR did not use the 2.0% risk free rate. It should be noted that CAR s previous decisions on the debt spread did not account for the financial crisis the 2009 CAR decision updates the previous ones. A similar thing is done regarding the Ofgem decisions. EE also note that the risk-free rate for Ofgem was 2.55% (page 77 footnote 4), and then they calculate Ofgem debt spread at 1-1.5%; but the overall cost of debt for Ofgem is higher than EE s. This is a reflection of the insufficient weight given to Irish circumstances and a similar inconsistency in totalling up the debt spread and the risk free rate ESB Networks WACC 17

21 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland 2.3 Inconsistent treatment of inflation risk in the cost of debt 9 Similar to the sovereign risk premium, EE is not consistent when taking an inflation risk premium of 25bps out of the risk free rate; it would be OK to take this out of the risk-free rate, but only if it is explicitly added back into the debt premium Deflating by uncertain inflation premium It is rather unusual, in terms of regulatory practice and in terms of corporate practice, to estimate an inflation risk-premium and subtract it from the risk-free rate. It is even more unusual to deflate the nominal risk-free rate by what, by EE s own claims, is a risk premium under this logic, should they not deflate the nominal riskfree rate by other premia sovereign default premia, for example? Has this been a means of treating a premium as if it were inflation, to avoid the possibility of the premium showing up in the debt spread? Again, while there has been some academic interest and academic research on the subject, and while in theory there is no reason to expect an inflation risk premium should not be taken out of the risk-free rate, for the purposes of setting WACC, it is mostly academic theory. For practical purposes, the premium exists and either can go into the RFR or the debt premium but should be in the total cost of debt. The net result is the same, however, as in practice; it doesn t matter where it goes within the cost of debt 10 (as long as it goes in somewhere). As stated before in our discussion of the debt spread and sovereign risk, a very common practice is to simply use the home-country long bond as the estimate of the risk-free rate. While we take no issue with the discussion of using the German bond over the Irish bond as an estimate of the risk-free rate, the point we make is that any inflation risk premiums subtracted out should show up in the debt spread, as they exist in the total cost of borrowing. 9 This issue arises in the cost of equity estimation as well; an inflation premium will either be in the risk-free rate or in the equity risk premium, and thus always in the cost of equity. While EE have ignored this too, they may have adjusted for this implicitly by taking the upper end of their range for the cost of equity. 10 Again, this will also impact the cost of equity via the risk free rate. It should be noted that in general, it could be argued that risk premia that are in bonds, such as sovereign risk, inflation risk, etc, should be in equity risk too. ESB Networks WACC 18

22 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland Because of the particular developments in the Irish economy and in the cost of sovereign debt in Ireland, the effect on the cost of debt is a cost of debt figure which is too low. According to page 65 of the EE document: believes that EE should have added back in an inflation risk-premium to the company-specific cost of debt (since they took it out of the risk-free rate). ESBN will not be able to issue bonds that are perfectly insured against inflation risk, and thus not require an inflation risk premium. In our view, EE should have added back a sovereign risk premium, consistent with the Irish Government bond data, for a Semistate utility operating in only one market (Ireland)? 2.4 Subtraction of default risk from the debt premium Europe Economics spends considerable effort to justify the subtraction of a default risk premium from the debt premium for Ireland. This is not in line with standard practice to subtract default risk from the debt premium. Apparently, in their final determination, EE does not subtract this premium. Since EE have spent so much time justifying this, we believe it is worthwhile considering whether it should be included, as we believe it should not. It is odd that EE spends so much time justifying a subtraction of a premium, that in the end, is not taken out. The debt premium reflects the risk of default. As a company s risk of default goes up, so does their cost of borrowing; this is reflected in the spread they pay over the risk-free rate. EE applied theory over practice on this point and they state: ESB Networks WACC 19

23 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland It is arguable whether this is theoretically defensible; we would argue it is not. The argument that default risk is somehow not deserving of a risk premium, because it is diversifiable, is inconsistent with observed facts. Companys in risk of default see their spreads go up; countrys in risk of default see their spreads (over an alternative risk free rate) go up (all of EE s discussion of the risk free rate and why Ireland s yields are not risk free is based on this assumption). ESB Networks WACC 20

24 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland The analysis, which goes into the appendices, seems to indicate that the theoretical defense for subtracting the default premium is the difference between the expected return to bond holders and the expected cost of the bond to the bond sellers. We do not accept this and it is not in line with best regulatory practice. This is particularly important given the current developments in the Irish economy. Consider if one were in the process of estimating the cost of capital for a company with a very high risk of default say, such that the probability of default premium was 5%, so that their overall cost of debt would be say, 10%. In Europe Economics view, the regulator should not give that to the company as the cost of capital they would give them a cost of debt of 5%. Assume the company s only revenue streams are from their regulated business. It is easy and plain to see that the company would never be able to raise debt or simply would be put into further financial stress, as they would nonetheless have to sell bonds with a price discount reflective of the 10%, which is the overall cost of debt, but their revenues allowed wouldn t cover this. For the above reasons, the practice suggested by EE is certainly not part of regulatory best practice, nor part of corporate finance actual practice. 2.5 Conclusions regarding inconsistent debt premium estimation The final conclusions on the debt spread in para 7.34 suggest that the reasoning has been affected by these inconsistencies. The conclusions state: a) The mere existence of two bonds with spreads of 1.09 and 1.25 does give one sufficient information on which to base a judgment what size are these companies, what were the maturities, the nature of the bonds (coupon, zero, convertible, etc); b) Most importantly, what countries were they in and what was the average yield on these bonds over the few months, and then what yield of what benchmark bond did they subtract? believes that this is not appropriate to Irish circumstances. In EE s report they state the following: ESB Networks WACC 21

25 Section 2 Inconsistent methodology between risk-free-rate and debt spread for Ireland a) What methodology did EE use to calculate the spread; how did they treat the risk-free rate for the spread calculation was it the same risk free rate they used (2.0%)? b) EE s use of comparator bonds is not transparent what criterion did they use to get comparators? Why were obvious comparators such as Bord Gáis bonds not included? a) What methodology did EE use to calculate the spread; how did they treat the risk-free rate for the spread calculation was it the same risk free rate they used (2.0%)? b) How did EE adjust the spot rate for random-noise, company size, maturity and other factors, such as local country? The sample is further not likely to be representative, as companies that are highly rated issue more bonds. a) The evidence on the previous regulators decisions should be interpreted carefully and with caution as subtracting the risk-free rate other regulators used might give too low a result on the spread (if the risk free rate is higher as in the case of CAR, for example). b) The pre-financial crisis numbers are of little relevance since the financial crisis continues-very few decisions have come out that reflect the financial crisis. Our conclusions are that EE has incorporated a number of internal inconsistencies to their cost of debt calculation, which results in an underestimation of the realties of the Irish economy and of Irish debt market. This has led to an overall cost of debt figure which is too low. The CER in their final determination should consider an overall nominal cost of debt which is a little bit over the current cost of debt to the Irish Government. ESB Networks WACC 22

26 Section 3 Insufficient account of the financial crisis in Ireland 3 Insufficient account of the financial crisis in Ireland The analysis on WACC undertaken by Europe Economics does not take sufficient account of the financial crisis in Ireland which will have material impact on ESBN s funding costs in the next few years. It seems the analysis takes the effects of the crisis away, but does not consider the possibility that the effects of the crisis are lingering and should be included in the WACC of ESBN. The possibility of a continuing impact on Irish Government bond spreads, and thus on Irish corporate spreads, has not been given sufficient weight. Many international forecasters, official and private, are predicting a medium-term impact on the Irish economy. While the approach taken by Europe Economics may not result in any significant error in the overall cost of WACC in countries such as UK, we believe it is not appropriate for Ireland. ESBN will have a very challenging capital investment programme over the course of the price control. This will require raising funds in the debt markets, most likely by bond placements, and the likely timing for this is in the beginning half of the price control. The importance of the impacts of the financial crisis is referred to in various elements of the EE report as follows [from page 20]: therefore supports the CER in seeking views on how to respond to the universal level of uncertainty which exists. However, the EE analysis does not take account of this. ESB Networks WACC 23

27 Section 3 Insufficient account of the financial crisis in Ireland 3.1 Overview of the impact of the financial crisis on ESB financing costs The impact of the financial crisis on the funding costs of ESBN over the course of the price control review period is not likely to be trivial, nor end any time soon. Any hopes for the ending of the crisis swiftly and cleanly have been dashed by the recent sovereign crisis in the Eurozone. Besides just the Eurozone-wide crisis, Irish sovereign debt will have a particularly difficult period, and costs will not abate any time in the near future. There is little to no doubt that a) the crisis will linger, especially with regards to the Irish situation b) there will be a knock-on effect from Irish sovereign spreads to Irish corporate borrowing costs. The international economic and financial environment has seen additional turmoil in the European sovereign debt crisis in recent months. The evidence of the sovereign crisis is directly linked to the health of the macro economies of the EU nations, and has a direct link to the financial sector and the public finances. In fact, according to some recent research, part of the crisis can be partly explained by the current high level of financial sector stress being experienced in the Eurozone where markets have anticipated the rise in public debt and the spreads on sovereign debt have risen accordingly. In the third week of July 2007, before the financial crisis, the yield on the 10-year maturity Irish sovereign bond was lower than the yield on an equivalent German sovereign bond. By the start of January 2009, the Irish sovereign bonds paid about 260 points more than the German bond. This spread has fluctuated since but has remained near its highest level. For the purposes of most analyses, the German Bund is considered to be the risk free rate over which each country s spreads are computed. As a result, higher expected government deficits and higher expect government debt relative to Germany have contributed to higher government bond yield spreads other Eurozone countries including Ireland between 2007 and Recent outlook for sovereign bonds spreads in Europe Attention has been focused towards the recent rise in sovereign bond yields in the euro area during the spring of Broadly, this has been a result of the economic outlook which has been weak in recent months, particularly reflecting market concern over the fiscal position in Greece and to a lesser extent in Spain, Portugal, Italy and Ireland. Investor sentiment was also notably negative during this period and, according to one quarterly poll of Bloomberg subscribers, about 75% of analysts expect some government in the region to default or the 16-nation euro area to break up. While historically the spread of ten-year bond yields against Germany averaged 15 basis points between the introduction of the euro in January 1999 and August 2008, during the recent financial crisis, sovereign bond yields have risen sharply, most notably in the cases of Ireland and Greece. ESB Networks WACC 24

28 Section 3 Insufficient account of the financial crisis in Ireland The Barclays Capital Corporate Bond Index indicated that the spread over government debt for bank bonds widened by more than 70 basis points this May. Furthermore, by the end of June 2010, German bunds rose, which placed the yield to its lowest in the previous two weeks, amid concern that the regions debt crisis may deepen. According to Bloomberg data, the yield on Ireland s 10-year sovereign bonds rose from steadily from 4.9% to 5.5% over the course of the month of June. In addition, there were a range of other negative financial indicators this June; again reflecting investor concern over Europe s sovereign debt crisis and its potential to obstruct growth and economic activity. For example, Barclays Capital Index showed that yields on investment-grade bonds in euros rose to a 10-month high of 239 basis points more than corresponding government debt. Moreover, according to Bloomberg, the risk of owning Europe s corporate bonds was the highest on record relative to U.S. company debt, as based on the yield spreads. 3.3 Determinants of yields on sovereign bonds Since the sovereign debt crisis is likely to have long-lasting impacts on the cost of borrowing to ESBN, it is worthwhile to study the determinants of sovereign yields, and study whether these factors are also likely to be long-lasting. In a European Central Bank (ECB) Report assessing the determinants of yields on sovereign bonds, Attinasi et al. (2009) find that sovereign bond spreads in the euro area broadly reflect concerns about a country s credit risk, which is based on fiscal balance, liquidity risk and higher international risk aversion. More precisely, the report finds that each explanatory variable contributes to the change in daily sovereign bond yield spreads in the following maximum proportions: 56% the international risk aversion; 21% the expected fiscal position (budget balance and debt); 14% the liquidity proxy; and 9% the announcement of bank rescue packages. In another study, Mody (2009) analysed determinants of weekly changes in the sovereign spreads of Ireland along with other EU countries for the period January 2006 to January The findings, which are presented according to the phase that they arise in throughout the crisis, suggest that sovereign spreads are determined by: The extent of financial sector stability: After the Bear Stearns rescue, global factors became less relevant and the prospects of the domestic financial sector became prominent in explaining spreads. In particular, when financial stocks fell faster than the overall equity index, sovereign spreads have a tendency to rise. This link proved to hold for Ireland. ESB Networks WACC 25

29 Section 3 Insufficient account of the financial crisis in Ireland The extent of public debt-gdp ratios: After the failure of Lehman, risk aversion heightened, and a further source of differentiation emerged, as countries suffering long-term damage to competitiveness with high public debt-to-gdp ratios led to a more rapid increase in sovereign spreads. According to Attinsai et al. (2009) there are at least four determinants of government bond yield spreads that have been identified in the research literature. First, a given country s credit risk is assessed by international markets on the basis of its fiscal strength. Second, liquidity risk is factor. Third, government bond spreads reflect international risk aversion and investor sentiment. Finally, macroeconomic news and government plans also play a role. Culha et al. (2006) find that the extent of investor risk taking is the most important common determinant of spreads. The study also finds that total public debt, net foreign assets and total exports all as ratios to GDP, are found to be important determinants of spreads. According to Mati et al. (2008), both fiscal and political factors impact on credit risk while fiscal consolidation can result in narrowing credit spreads. In another study, Hilscher and Nosbsuch (2010) find that the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. 3.4 The case of Irish sovereign bonds The Irish exchequer finances continue to be in difficult conditions. Confirming the likelihood of this continuing, the ESRI, in its most recent Quarterly Economic Commentary, forecast that the exchequer balance will further worsen in 2011 (depending on future budget cuts). These difficulties in Irish public finances are also compounded by the reduction in income tax receipts and the associated issue of high unemployment, which was forecast to remain above 13% in Table 3.1: ESRI Quarterly Economic Commentary Selected Projections Output Exchequer Balance General Government Debt (% of GDP) Source: ESRI Even more significantly, Ireland continues to suffer banking challenges. On this issue, Reinhart and Rogoff (2008) point out that banking crises are typically followed by increases in the public debt-to-gdp ratios, and this has been shown to be particularly true in the Irish case. Recent data in Ireland (above) shows year-on-year increases to 2010 in the ratio of debt to GDP and additionally, the same ratio is forecast to further increase in 2011, reaching 93.5%. ESB Networks WACC 26

30 Section 3 Insufficient account of the financial crisis in Ireland Various strands in the literature find a robust link between a country s debt-to-gdp ratio (and other outputs such as government balances) and its sovereign bond spread. For example, in an International Monetary Fund Working Paper, Mody (2009) finds that countries with high debt-to-gdp ratios, which have also experienced declines in competitiveness, tend to see increased yields on sovereign spreads. Futhermore, Ming (1998) finds that liquidity and solvency variables such as debt-to-gdp ratio, debt-serviceratio, net foreign assets are found to have a significant impact on spreads. In another study undertaken in the US, Goldstein and Woglom (1992) find that the debt level of U.S. states has a positive impact on their bond yield relative to other states. Overall, the analysis suggests that Irish sovereign spreads may continue to remain high and potentially increase now and in Figure 3.1 provides the ratio of financial to overall ISEQ equity indices since January It shows a substantial decline in the financial/overall equity index (financial stocks falling faster than overall stocks) in recent months. The analysis provided the aforementioned IMF report (above), by extension, would suggest that Irish sovereign debt should also increase over this period. Furthermore, the report finds that there is a lagged effect whereby observed weakness in financial sector prospects is only reflected in higher sovereign spreads after three weeks. All in all, this may indicate that Irish sovereign spreads are likely to increase or, at least, unlikely to fall. Figure 3.1: Ratio of Irish Financial/Overall Equity Index, January 2010 June % 43% 41% 39% 37% 35% 33% 31% 29% 27% 25% 31/05/ /05/ /05/ /05/ /05/ /04/ /04/ /04/ /04/ /03/ /03/ /03/ /03/ /03/ /02/ /02/ /02/ /02/ /01/ /01/ /01/ /01/2010 Financial/Overall Equity Index Source: NTMA ESB Networks WACC 27

31 Section 3 Insufficient account of the financial crisis in Ireland Figure 3.2 considers the public debt-to-gdp ratio in Ireland, which has grown steadily since This trend represents a domestic vulnerability which, as discussed above, is correlated with the yield on sovereign debt. Figure 3.2: Irish Public Finances: Debt/GDP ratio, * 2010** General Government Debt % of GDP *Latest estimate **Forecast Source: NTMA Ireland Information Memorandum Recent developments in Irish sovereign yields, spreads and long-term interest rates The Central Bank of Ireland s Monetary and Financial Market Developments Report (2010) assesses, inter alia, the general outlook for the sovereign debt market in Ireland in Q According to the report, ten-year Irish government bond yields averaged 4.8% and five-year yields averaged 3.2% in that period. In addition, spreads of ten-year government bonds over their German equivalents reached 270 basis points in March 2009 and although they did decline since then, there have been both increases and declines and they remain among the highest in the euro area. According to more recent data provided by Bloomberg, since 2010, the yield on Irish government debt has rose to 5.9% in early May 2010 before falling to a low of 4.6% in mid-may. Since then, the yield on sovereign debt has steadily increased, reaching 5.6% in June. ESB Networks WACC 28

32 Section 3 Insufficient account of the financial crisis in Ireland In a recent development on 19 th July, Moody s downwardly revised Ireland s credit rating from Aa1 to Aa2, citing a significant loss in financial strength. In the research literature, it is well established that sovereign bond ratings are strongly related to the cost of borrowing (Butler and Fauver, 2006). Bloomberg data shows a steady increase over the past number of months in the ten-year yield on Irish government debt, reaching 5.5% on July 19 th. Similarly, harmonised long-term Irish interest rates over German rates have also increased in 2010, as outlined in Table 3.2. Since the start of 2010, the data shows that spreads of harmonised long-term interest rates have jumped by 76%. Moreover, the most recently available monthly data from the European Central Bank indicates that the spread on harmonised long-term interest rates has increased by 30% between May and June. Table 3.2: Harmonised long-term interest rates - Ireland Germany Spread 2010 Spread Jan. 10 Feb. 10 Mar. 10 Apr. 10 May-10 Jun-10 % difference Note: Data ECB. The harmonized long term rates are based on Government debt yields and ECB interpolation of the yield curve. Source: /LE analysis European Central Bank 3.6 Other determinants of sovereign risk spreads for Ireland Hallerberg and Wolff (2008) find that fiscal conditions also impact on bond yields. In another study, Favero et al. (2009) find both theoretical and empirical evidence that liquidity plays a part in determining sovereign risk spreads. In the context of Ireland then, the current fiscal outlook is difficult with high levels of unemployment and the associated low levels of income tax returns. Furthermore, banking losses for the government are currently estimated to be very significant. Given the positive empirical correlation between the above macroeconomic variables and sovereign risk spreads, the emerging developments in Ireland are likely to indicate that there will be higher borrowing costs for Ireland in the future. In any event, a robust assessment of the average sovereign spread in Ireland, or indeed in any country, both now and in the future must first carefully diagnose the economic health of the country in terms of its risk, liquidity and fiscal positions. ESB Networks WACC 29

33 Section 3 Insufficient account of the financial crisis in Ireland 3.7 Other Analysis - Sovereign interest rate spreads and yields Figure 3.3 below shows the historical spread of Irish over German harmonised long-term interest rates. The relatively recent jump in the spread during spring 2010 reflects the increasing levels of market uncertainty and risk aversion that investors are attaching to Ireland s weakened fiscal and liquidity positions. Figure 3.3: Harmonised long-term interest rates - Ireland Germany Spread Jun 2010Feb 2009Oct 2009Jun 2009Feb 2008Oct 2008Jun 2008Feb 2007Oct 2007Jun 2007Feb 2006Oct 2006Jun 2006Feb 2005Oct 2005Jun 2005Feb 2004Oct 2004Jun 2004Feb 2003Oct 2003Jun 2003Feb 2002Oct 2002Jun 2002Feb 2001Oct 2001Jun 2001Feb 2000Oct 2000Jun 2000Feb 1999Oct 1999Jun 1999Feb 1998Oct 1998Jun 1998Feb 1997Oct 1997Jun 1997Feb 1996Oct 1996Jun 1996Feb 1995Oct 1995Jun 1995Feb 1994Oct 1994Jun 1994Feb 1993Oct 1993Jun 1993Feb 0-50 Note: Dashed vertical line represents date of irrevocable fixed exchange rates for the original Eurozone countries. Source: European Central Bank (ECB) 3.8 Relationship between sovereign and corporate yields The general consensus of both practitioners and academics is that sovereign spreads tend to drive the cost of corporate borrowing. According to Borenstein et al. (2007), when the sovereign has a credit rating that is not on a high scale, credit ratings for firms from that country will tend to suffer, and this is holds regardless of a firm s financial health. This therefore represents a negative externality effect on firms and corporations, whose bond yields can be thought of as the cost of finance, where higher spreads indicate that the cost of capital is higher and therefore investment opportunities are lower. In line with this, Peter and Grandes (2005) studied yields of local-currency corporate bonds in South Africa and found that sovereign risk was an important determinant of yields. Moreover, Ferri, Lui and Majnoni (2001) regress changes in private credit ratings of banks and non-financial corporations on changes in sovereign ratings and find a positive and significant correlation. In another slightly different study, Alesina et al. (1992) analyse the yield ESB Networks WACC 30

34 Section 3 Insufficient account of the financial crisis in Ireland differential between sovereign and corporate bonds and find that it depends positively on the public debt level. In order to measure the impact of sovereign risk on corporate spreads it is important to compare bonds of similar characteristics such as maturity and cash flow. However, different bonds have different dimensions which are not always comparable. To solve this problem, Cavallo and Valenzuela (2007) use Option Adjusted Spread analysis from Bloomberg in an analysis to compare bonds with different characteristics, find, inter alia, that transfer risk between sovereign spreads and corporate risk is positive and significant, but less than a ratio of one-to-one. 3.9 Impact on cost of borrowing, Irish firms and the cost of capital The credit risk and spread on sovereign debt is an important economic consideration and it has real economic consequences, particularly for firms within the country in question and their ability to access international capital markets. In general, there are at least two ways that sovereign debt distresses can spillover into the wider economy, and thus into corporate spreads which would impact the cost of borrowing for ESBN. On the demand side, default periods often lead to reduced levels of output and domestic demand (Borrenzstein and Panizza, 2008) and an associated reduction in investment, profit. These impacts may be intensified by banking sector instability. Overall, firms may become more risk adverse, demand less credit and reduce their cost base. On the supply side, increases in sovereign debt spreads may worsen the overall perceived level of country risk leading to, inter alia, reductions in private sector debt issuance. Another way of examining the impact of sovereign spreads on corporate debt, provided by one Paper at the South Western Finance Conference 11, is that rating agencies generally do not assign ratings to debt issuers that are higher than their home country s sovereign rating, therefore, sovereign ratings influence the ratings given to provincial governments, and the firms headquartered in the same country. Alternatively, the sovereign rating could reduce the availability of the company to access the credit markets via a rated bond issue. This directly impacts the ability of firms in that country to access international capital markets (Martell, 2005). 11 Examining the relationship between sovereign credit ratings and economic freedom, conference paper, south western finance, available from: ESB Networks WACC 31

35 Section 3 Insufficient account of the financial crisis in Ireland Some research has investigated the link between sovereign default and costs for the domestic economy (Cole and Kehoe, 1998; Alfaro and Kanczuk, 2005; Sandleris, 2006; and Mendoza and Yue, 2008). In a recent IMF working paper, The cost of aggressive sovereign debt policies: how much is the private sector affected, Trebesch (2009) finds that aggressive debt policies (i.e., fiscal spending via debt) cause a reduction in credit for the private sector of 57% per month relative to what it would have been otherwise. This impact also appears to be lasting and the study also finds that debt policies which are in default have a strong impact for up to two years after the crisis. Moreover, Arteta and Hale (2008) find that sovereign debt crises have a strong negative impact on private sector access to international debt markets; controlling for fundamentals and external shocks, the study shows that foreign loans and bond issuance by domestic firms falls by more than 20%. The study also finds that the decline in foreign credit to domestic private firms is concentrated in the non-financial sector. Furthermore, sovereign debt difficulties can result in risk spillovers whereby aggressive debt policies have adverse consequences across a range of economic agents within the country. One explanation is the role of reputation; and this has been pointed out previously in the literature (Sandleris, 2006; Cole and Kehoe, 1998). According to the Paper from the South Western Finance Conference, one further implication of sovereign credit ratings in terms of the spillover affect into the real economy is that they partly determine the level of foreign direct investment (FDI). This is particularly important for Ireland given the crucial importance of Ireland s competitive position in the global FDI markets (Barry and Bergin, 2010). As an FDI-intensive country, Irish economic recovery will be determined, in part, by its ability to continue to attract FDI. Therefore, the recent downward revisions in Irish sovereign debt may have longer lasting impacts on the cost of corporate borrowing in the Irish case. In order to take account of the financial crisis and the uncertainty this involves, two things should have been done. Taking account of uncertainty could have proceeded via the riskfree rate or via the risk-premia; of the debt spread and the ERP. A practical approach would have been to take account of the crisis by using the Irish government bond yield as an estimate of the risk free rate, although we accept that such bonds are not perceived as risk free. We take no issue with the approach adopted by Europe Economics that the Irish government rate might not be risk-free, but then any additional risk premia should be reflected in the risk premiums for debt and equity of Irish companies. Explicit account should have been taken of the financial crisis, and the medium term impacts of this on the overall cost of debt in Ireland, and then a methodology consistent with the German bond rate as the risk free rate should have been used to estimate the debt spread. ESB Networks WACC 32

36 Section 3 Insufficient account of the financial crisis in Ireland Second, data on ERP should be made as up-to-date as possible, and any sovereign risk premium should show up in the equity risk premium. If the equity markets are inherently more volatile, then some adjustment to the cost of equity should be made. Based on the data from table 4.1, there is clearly a relationship between volatility and equity risk premium. Figure 3.4: Relationship between historical equity market returns and volatility ERP by Country versus Standard Deviation ERP % Returns 6 4 y = x R 2 = Arith mean Linear (Arith mean) Standard Deviation Returns Note: Source: /LE analysis of data from Dimson, Marsh and Staunton, which was presented by Europe Economics As a result of not taking sufficient account of the ongoing higher costs of debt in Ireland, Europe Economics underestimates the cost of WACC. ESB Networks WACC 33

37 Section 4 Treatment of inflation in the formula 4 Treatment of inflation in the formula There are two issues regarding EE s WACC estimates and the actual practice of how ESBN s cost drivers and the formula: the choice of HICP as an inflation index over CPI and the use of Euro-area-wide inflation expectation versus Irish inflation expectations. These choices are inconsistent with how the cost drivers and formula will actually work. ESBN costs tend to be indexed to Irish CPI, rather than Eurozone HICP, and the actual price control formula is indexed to Irish inflation, rather than Euro-area-wide inflation. Further, even if Euroarea-wide inflation expectations were correct, the estimates of Euro-area-wide inflation seem to conflict with the most recent evidence and forecasts. Thus deflating the observable nominal debt rates with an inflation expectation which is too high underestimates the real cost of debt., however, accepts that to use HICP rather than CPI can be a legitimate initiative by a regulator to incentivise cost reductions even if it is accepted that this is not the appropriate price inflator for ESB costs. However, we understand that a separate cost reduction incentive initiative has been introduced by CER for ESBN and using both mechanisms would not seem appropriate Indexation to HICP versus CPI The price control formula, as proposed, is to be indexed to Irish HICP rather than Irish CPI. There are many arguments as to which index is a better representation of inflation or changes in purchasing power. However, CPI may be a better reflection of cost drivers facing ESB. The existing analysis seems to indicate that the choice of HICP over CPI was based on a lower volatility of the former over the latter. Potential and existing bond holders could easily see any potential divergence between CPI and HICP as a risk to ESBN, and thus this could impact on yields on ESBNdebt. Thus, this factor could have wider implications for the cost of finance for ESBN Use of Euro-area-wide versus Irish inflation expectations Since the actual price control formula is indexed to inflation, it is normal that the WACC should be in real terms (deflated). Since the formula for the WACC is prospective, but the indexation will be based on actual inflation, then it is also normal that the nominal WACC (using observable market values, such as the cost of borrowing), should be deflated by inflation expectations. ESB Networks WACC 34

38 Section 4 Treatment of inflation in the formula Our understanding of the methodology is that it arrives at a real risk free rate by deflating nominal yields on Irish, German, and French bonds, and making a judgment across these and the term structure after deflating the nominal yields for expected inflation and the inflation risk premium of 0.25%. 12 It should be recalled that only nominal yields are observable (in general.) 13 According to the analysis in the tables 3.6 and 3.7, going from nominal to real yields, we can calculate what estimate of inflation expectations was used, and while how they arrive at this is not entirely transparent, apparently the net result is to deflate by something between 2.20% to 2.25% the nominal yields of the government bonds. Focusing on the 5- year bond, and looking at the bottom line of the table (as the price control is 5-years), for example, we get 2.99% % = 2.20% -- which is Nominal Real = inflation. (See the Bottom lines of Tables 3.6 and 3.7). Looking at the Spot rate as of Feb (top lines of Tables 3.6 and 3.7), we find that the difference is 2.25%--(taking 2.13% - (-0.12%) = 2.25%. Table 4.1: German nominal government bond yields 12 The EE document doesn t exactly say they do this for all bond, only Irish bonds, but it appears the difference between the nominal and real yields is 2.25% in the cases we checked. It would be even odder to find they treated the Irish bonds differently on this account. 13 Index-linked bonds, being somewhat of an exception, but in general these bonds still pay a yield based on inflation-so the effective yield is still nominal. ESB Networks WACC 35

39 Section 4 Treatment of inflation in the formula Table 4.2 Real government bond yields While it is not entirely clear 14, it seems that the above 2.25% is the sum of Euro-areawide inflation expectations (over the next five years?-average annual growth rate?) plus an inflation risk premium. We note that Euro-area-wide inflation even when estimated will be done so with considerable uncertainty. According to Figure 3.5, the arrival at the real risk free rate was most likely based on an ECB 5-year inflation forecasts finishing in Q They do not give a precise number, nor do they give a precise source. The reference to Gilts is unclear whether this means Irish Government Bonds or UK Government bonds, but we assume the former, in spite of the fact that they are not called Gilts to our knowledge. We have not been able to replicate Europe Economics forecast of 2% (based on the differences in the numbers between the tables). Note: Source: ECB 14 Footnotes on the Irish tables seem to indicate this, but not for the German and French. ESB Networks WACC 36

40 Section 4 Treatment of inflation in the formula In general, a number of official international agencies undertake Euro-area and EU wide forecasts for inflation and related macro-economic variables. The European Commission has funded the European Forecasting Network (EFN) which is a consortium of top universities and economists. The EFN has been producing their own forecasts and analysis of alternative forecasts for a number of years. We present below the forecasts for winter (which we believe would have been the best available information when the analysis of the price control was underway around January 2010), along with more recent updates in the spring 2010, and summer The figures in the EFN tables are for the euro-area, which are reproduced below. From the winter EFN 2009 forecast summary, the average for 2011 over the forecasts that were available was 1.325%. It is not clear that the trend is for rising or falling inflation, as the numbers from 2010 to 2011 are both rising and falling across forecasts. ESB Networks WACC 37

41 Section 4 Treatment of inflation in the formula Table 4.3: Comparison of EFN forecasts with alternative forecasts From the Spring EFN report, more forecasts are available and they seem to be revising inflation downwards; that is, as more information becomes available, the forecasts are predicting less inflation, with the average now about 1.26%. By the spring the EFN, the European forecasting network was forecasting 2011 HICP inflation below 2.0%, and for a fall, rather than a rise in euro-area inflation. Table 4.4: Comparison of EFN forecasts with alternative forecasts ESB Networks WACC 38

42 Section 4 Treatment of inflation in the formula Finally, by the summer of 2010, there has been a slight revision upwards, but the average is still only 1.43%, well below the 2.0% apparently used to deflate the nominal yields on German and French Government bonds. Even if one took the winter 2009 forecast of 1.325% and then assumed that Euro-area wide inflation stabilized at the target rate of 2.0% in every year thereafter, one would be an average annual growth rate of 1.86%, well below the figure used to deflate the nominal bonds. Further out inflation forecasts are harder to come by. Some indication can be gotten from the language of official reports, all of which are indicating an expectation of tame inflation and low inflation expectations for the Euro-zone. The EC DG ECFin publishes some additional information and graphics indicating forecasts beyond 2011; while official figures are not published (the Figure is from the latest spring/summer 2010 forecast). The indication of these figures is that inflation is expected to diminish slightly and stabilize, i.e., with no expected acceleration. ESB Networks WACC 39

43 Section 4 Treatment of inflation in the formula Further, from the Summer EFN forecast (2010) a graphic indicates that the expected trend for is downward. It also indicates that the mean for the 13-year period was 1.93%; so also based on long-run historical values the 2.0% figure used looks high. ESB Networks WACC 40

44 Section 4 Treatment of inflation in the formula While the nominal yield is the observable element of the cost of debt, the most common regulatory practice is to gross up total allowed revenue by some inflation factor every year during the course of the formula and this is the way the proposed ESBN formula will work. According to section 11.4 of CER 10/XXX 15, the form of the control will be as follows: The idea of using a real WACC versus a nominal WACC can be largely academic, unless one does inconsistent things when going from the data to the actual formula, having chosen the one over the other and this is what EE has done again. The price control formula will be indexed to Irish CPI (or HICP-should that be the determination of the CER we ve discussed this previously). The likely difference between using the euro-area and the Irish inflation expectations is material, according to the analysis in the paper. 15 The CER consultation document we received from ESBN had this numbering. ESB Networks WACC 41

45 Section 4 Treatment of inflation in the formula ESBN, or any other corporate borrower, only ever sees nominal borrowing costs. There will simply be some actual yield that they pay on their debt based on the selling price of the bonds at auction/placement. Thus, the only thing that will be actually observable is the nominal cost of debt when ESBN actually issues debt or borrows cash. Thus, the actual nominal borrowing costs should be the final benchmark or consideration for the cost of capital. The way the price control formula works is that ESBN is given the cash-flow consistent with the real cost of debt, as estimated by the WACC, and then the formula is indexed to Irish inflation. But in arriving at this real cost, EE has subtracted euro-area-wide inflation expectations from current bond yields. However, in the medium term, Irish inflation is likely to be much lower than the long-run euro-area-wide inflation expectation. The best and most recent available inflation forecasts suggest that in the first years of the control, Irish CPI inflation will be negative, or near zero. Irish inflation forecasts are found below. Table 4.5: CPI inflation forecasts for Ireland (%aagr) ESRI-QEC OECD Note: Table from Source: data from ESRI and OECD Table 4.6: HICP inflation forecasts for Ireland (%aagr) ESRI-QEC EC OECD Irish Central Bank ESB Networks WACC 42