International comparison of WACC decisions

Transcription

1 International comparison of WACC decisions Submission to the Productivity Commission Review of the Gas Access Regime from the Network Economics Consulting Group September Canberra Sydney Brisbane Auckland New Orleans NETWORK ECONOMICS CONSULTING GROUP PTY LTD ACN ABN

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3 Contents Executive summary 5 1 Introduction 7 2 Key methodological issues for WACC comparison 10 3 Treatment of WACC in international jurisdictions UK Rest of Europe New Zealand United States Canada 32 4 Use of international comparisons by Australian regulators NERA review of UK and US rates of return for the ACCC Shortfalls of analysis ACG Report on Proxy Beta Estimates Overview of report Shortfalls of analysis 40 5 Analysis of key decisions Key comparator measures Margin of the vanilla WACC above the risk free rate Asset beta Key assumptions Risk free rate Rounding or adjustments in decisions Australian decisions specified in pre-tax real terms Asset beta Explicitly adjusting the vanilla WACC margin for market risk 54 6 Results 66 September 2003:International comparison of WACC decisions Page 3 of 102

4 6.1 Airports Electricity distribution Electricity transmission Gas distribution Gas transmission Rail Telecommunications Water Summary of results 84 7 Regulatory context to results Expectational factors Treatment of asset valuation Relative degree of certainty over the WACC Expectation of earning above the WACC Outcomes Experience of the UK water sector Electricity blackouts in the US, Canada and the UK Railtrack 99 8 Conclusions 101 September 2003:International comparison of WACC decisions Page 4 of 102

5 Executive summary As part of the process to advance debate on weighted average cost of capital (WACC) issues in Australia, this paper undertakes a comparison of international WACC decisions. There are a number of key methodological issues that need to be considered in any comparison. In particular these include consideration of the estimation model used to estimate the WACC, and the approach to the risk free rate, market risk premium and beta. It is critically important that WACC allowances are considered in relation to the regulatory environment in which the regulated business operates. This requires that factors such as the treatment of asset valuation, the ability of the firm to earn more than the WACC, the certainty in the approach taken to WACC, and the impact of WACC allowances be considered in addition to other factors that expose investors to regulatory risk. Our analysis has focused on two key components of a regulatory decision: the margin of the vanilla WACC over the risk free rate and the asset beta provided. These variables have been considered after normalising for: the effect of different bond maturities in the risk free rate; the approach to the debt beta; the specification of the initial decision (whether in nominal or real terms and post-or pre-tax); and for the fact that the CAPM is not the prime model used to determine the WACC in the US and Canada. We have also considered the impact of adjusting the results to reflect different market risk across countries. Our sample covers over 100 regulated decisions in Australia, US, UK, Canada, France, Ireland, the Netherlands and New Zealand in the airports, electricity, gas, rail, telecommunications and water sectors, primarily considering decisions that adopt a WACC as part of the building block approach to regulation. Our key findings are: ΠΠAcross all sectors, regulated decisions are less generous in Australia than the US. As regulatory decisions in the US do not explicitly reference WACC allowances to the risk free rate, the vanilla WACC margin is strongly influenced by changes in the risk free rate. However, throughout the period studied ( ) the difference in allowances is so substantial that a significant increase in the risk free rate from current levels would not alter this conclusion; and The UK is an outlier on the market risk premium (MRP). As a result it is not surprising that in some sectors the WACC margin provided (unadjusted for market risk) is not significantly higher than in Australia. However, if adjustment for difference in market risk between Australia and UK is included, in all sectors with September 2003:International comparison of WACC decisions Page 5 of 102

6 the possible exception of gas distribution and transmission the WACC margin is noticeably higher than that in Australia. These findings imply that the ACCC s claims that regulated returns in Australia compare favourably to those in the UK and US are misleading. There is also little evidence to suggest that the regulatory environment in Australia provides offsetting benefits to the businesses. There is still greater uncertainty in Australia associated with the application of optimisation-based approaches to asset valuation than in other countries. In addition, there is significant uncertainty over various WACC parameters, notably the risk free rate, where the ACCC (and the New Zealand Commerce Commission) continue to adopt a position contrary to that of all other regulators in Australia or overseas. The impact of WACC outcomes is a complex area. Where the WACC is set too low, companies may not be able to respond by delaying or reducing investment because of service obligations contained in operating licences. When this is the case, the impact of a low WACC may initially be seen through declining equity values (and increased gearing) rather than lower standards of service. In addition, the counterfactual (for example, a world with greater investment) cannot easily be verified. Evidence from the UK water sector (where some firms have substantially increased gearing), the US energy sector with its recent blackouts, and the UK rail sector (where Railtrack was forced into liquidation) highlight potentially adverse outcomes that can arise when the regulatory environment does not provide sufficient incentives for investment. These cases suggest that higher WACC allowances will be required to attract investment in the future to compensate for the increased regulatory risk created. An independent review of the WACC can assist in minimising uncertainty for investors. Additionally, regulatory frameworks can provide greater certainty on the approach the regulator should adopt for the WACC, as well as areas such as asset valuation that impact on investment. NECG and the parties supporting this submission believe the Commission has an opportunity within this current inquiry to put in place a framework for the cost of capital that can act as a template for other access regimes. We look forward to corresponding further with the Commission on these matters. September 2003:International comparison of WACC decisions Page 6 of 102

7 1 Introduction The Network Economics Consulting Group (NECG) welcomes the opportunity to provide this submission, on international regulated rates of return, to the Productivity Commission Review of the Gas Access Regime. The following major Australian organisations have supported production of this paper: AGL Australian Gas Association Energex Multinet /Alinta QR Network Access Rail Infrastructure Corporation Sunwater Telstra Corporation These parties represent infrastructure providers across a number of sectors, including electricity, rail, water and telecommunications, in addition to the gas sector. All of these providers, operating under a wide range of access regimes, are keen to ensure that a best practice framework for the weighted average cost of capital (WACC) is developed for Australian regulation, with this framework acknowledging the impact of the interaction of the WACC with the wider regulatory framework. WACC has been, and continues to be, an especially contentious part of the Australian regulatory environment. To some extent, this is not surprising given the inherently uncertain nature of the WACC. Regulators have selectively exploited this uncertainty in choosing particular parameter values, with the treatment of the risk free rate, asset beta, debt beta and the market risk premium especially contentious. 1 In addition, there has been little 1 In addition, access seekers and access providers have also tried to exploit this uncertainty in arguing positions in regulatory submissions and proceedings. September 2003:International comparison of WACC decisions Page 7 of 102

8 progress in addressing necessary adjustments to regulatory allowances to reflect the limitations of the capital asset pricing model (CAPM) and the WACC as tools to determine the required cost of capital for regulated businesses. While uncertainty will continue to be a feature of the WACC, we believe that a framework for the WACC can be developed that will reduce uncertainty over regulated WACC allowances. As part of the process to advance debate on WACC issues in Australia, this paper undertakes a comparison of international WACC decisions. We have undertaken this study for a number of reasons: ΠΠΠto assess if investors in Australian infrastructure companies are receiving ex-ante returns comparable to investors in regulatory infrastructure overseas an important driver in attracting investment into Australian regulated businesses in the long run; to consider how the regulated environments in different countries impact on the necessary WACC allowance, including whether this has implications for the Australian regulatory environment; and to consider whether features of other regulatory regimes could be incorporated into the consideration of WACC in Australia in a way that will provide greater certainty to investors and enhance social welfare. It is critically important that WACC allowances are considered in relation to the regulatory environment in which the regulated business operates. Therefore, empirical results drawn in this paper must be seen in relation to the regulatory risk to which the business is exposed. This requires factors to be considered such as the treatment of asset valuation, the ability of the firm to earn more than the WACC, the certainty in approach taken to the WACC, and the impact of WACC allowances, in addition to other factors that expose investors to regulatory risk. Structure of this paper This paper is structured as follows: ΠIn section 2 we outline factors that need to be considered in a WACC comparison by reference to the treatment of WACC in Australia (excluding any wider context to the decision); September 2003:International comparison of WACC decisions Page 8 of 102

9 ΠΠΠΠΠΠin section 3 we outline how WACC is treated in regulatory decisions in various jurisdictions ; in section 4 we consider studies that have been commissioned by the ACCC using cross-country comparisons and draw implications for this study; in section 5 we set out our approach to analysing regulatory decisions; in section 6 we set out our results; in section 7 we consider the regulatory context to the WACC allowances; and in section 8 we set out our conclusions. September 2003:International comparison of WACC decisions Page 9 of 102

10 2 Key methodological issues for WACC comparison This section highlights some key methodological issues that need to be considered in comparing WACC allowances. These key issues are highlighted through reference to the Australian market. Estimation model Regulators in Australia have consistently adopted the WACC model, with the cost of equity capital determined using the capital asset pricing model (CAPM). The WACC determined with this approach is strongly influenced by the underlying bond rates used to determine the risk free rate, against which the cost of debt and equity are estimated. The CAPM is not the only model that can be used to estimate the required cost of equity capital. As seen in section 3.4, regulators in the United States have adopted other approaches including discounted cash flow and risk premium analysis, which have the feature of typically weakening the link between required returns and underlying bond rates. Specification of the WACC There are a number of formulations of the WACC, in particular depending on whether the result is to be in nominal or real terms and whether it is to be expressed before or after tax. Given that there are alternative approaches to measuring costs and valuing the asset base, a key issue is that the definition of costs (that is, the implicit cash flows) and the measurement of the asset base must be completely consistent with the definition of the WACC model. Australian regulators, such as the ACCC, ESC, QCA and ESCOSA, have moved to specifying the WACC in its vanilla form, with the WACC a weighted average of the (pre-tax) cost of debt and the (post-tax) cost of equity. In this framework the impact of taxation is captured in the cash flows. As the CAPM is strictly a nominal post-tax framework, if the WACC is specified in real pretax terms there is a need to account for taxation and inflation in the WACC. There is no single correct way of transforming a nominal post-tax WACC into a real pre-tax WACC. As the business impact of transformation varies depending on the order with which tax and inflation are adjusted, and is also influenced by the value of and approach to including dividend imputation credits, a WACC specified in pre-tax real terms is sensitive to the September 2003:International comparison of WACC decisions Page 10 of 102

11 transformation approach used. As a result, assumptions need to be made in comparing decisions specified in different forms. For example, in section 6 we estimate that the difference in the equivalent vanilla WACC for the IPART and QCA rail decisions, each with similar asset betas and other parameters, but with the IPART decision expressed in pre-tax real terms and the QCA decision in a post-tax (vanilla) form, was 60 basis points, partly due to the value of imputation credits adopted by IPART in the transformation from a nominal post-tax WACC to a pre-tax real WACC and partly due to the exercise of discretion in choosing a value within a plausible range. 2 Risk free rate Where the CAPM model is used, there is a need to reference returns off a risk free rate, and this is commonly assessed by reference to a government bond rate. In Australia the most contentious area is the appropriate bond maturity to adopt. In Australia, all jurisdictional regulators have consistently adopted the 10-year Commonwealth bond as the risk free rate since, amongst other things, it is the longest dated liquid bond. This has been further justified on the grounds that it corresponds to the practice of investors in long-term assets in unregulated environments. For example the Office of the Regulator General noted: In other relevant jurisdictions, there is recognition that amortisation of relevant assets must be over their full economic life which implies that investors must have an expectation that they will be compensated for making long term investments before they commit to the investment. Therefore, even though regulators may review investment returns at regular intervals, it would be a mistake to believe investors planning horizons only extend to the next review. Models of expected returns and any regulation of those returns must reflect and take account of the investors planning horizons. The reapplication of the prevailing long term rate 2 An example of how sensitive a transformed pre-tax real WACC is to the assumption on gamma can be seen in Offgar s 2003 decision on Dampier Bunbury, which resulted in a pretax real WACC of 7.4% based on the market transformation and a gamma of If the regulator had employed a gamma of zero the resulting pre-tax real WACC would have been 8.7%. September 2003:International comparison of WACC decisions Page 11 of 102

12 every five years is sufficient to achieve this, as the owners of the project make their investment decision based on the life of the project, using the appropriate discount rate determined with reference to the prevailing yield curve. 3 Adopting the 10-year bond yield is also consistent with estimates of the market risk premium in the CAPM. 4 However, the ACCC is isolated both domestically and internationally 5 in that it has consistently applied the bond maturity corresponding to the length of the regulatory period. 6 We believe this position is theoretically flawed. 7 By adopting its position the ACCC has created significant uncertainty over the risk free rate, raised regulatory costs as significant resources have been used in arguing the appropriate position and, most importantly, has reduced the allowed return below that which would have arisen had the more appropriate 10-year bond rate been adopted. 3 Office of the Regulator General, Weighted Average Cost of Capital for Revenue Determination: Gas Distribution, Staff Paper Number 1, May 1998, p A simple example highlights why this is important. The CAPM is generally written as follows: E(Re) = Rf + b* [E(Rm) - Rf], where Re is the return on equity, Rm is the market risk premium, b is beta and Rf the risk free rate. E() represents an expectation. Assume that we are going to apply the CAPM for a company that has a beta of one. Therefore, E(Re) = Rf + 1 * [E(Rm) - Rf] = E(Rm) + [Rf - Rf]. Since the company has the same beta as the market, it must be that - E(Re) = E(Rm). But this can only be the case if [Rf - Rf] = 0, which of course implies that Rf = Rf namely the bond maturity of the risk free rate applied to estimating the market risk premium must be of the same as that of the risk free rate included in the CAPM. 5 The one exception is the New Zealand Commerce Commission, which currently uses the same advisor on WACC as the ACCC. 6 An exception was the ACCC s decision on Transgrid, where it adopted the bond maturity assumed by the jurisdictional regulator. 7 For example, see NECG paper, Determining the risk free rate for regulated companies: Comments on paper by Associate Professor Lally, November September 2003:International comparison of WACC decisions Page 12 of 102

13 This issue highlights that a common form of the risk free rate should be used in an international comparison. Equity and asset betas The equity beta of a firm measures the covariance between the price of its stock and the price of the market as a whole in which it operates. The asset beta represents the risk arising from the sensitivity of the operating cash flows generated by a firm s assets compared with the market in general, that is, the market risk associated with a firm s business. Australian regulators have recently taken a more aggressive stance on asset beta. For example, in its 2002 decision on GasNet, the ACCC reduced the equity beta by around 20% for an equivalent gearing level, when compared to their previous 1998 decision on the same business. 8 Estimation of asset betas in Australia remains an important area of debate, especially given the volatility in beta values of listed companies. 9 Typically, reported beta values are obtained by regressing the business returns on a domestic market index for example, the beta value of a US business is typically estimated by reference to the US market. Such a beta value for the US business need not be the same if that business return was regressed on the Australian market, or if the firm were to operate in the Australian market. This is because of differences in market structure and for a regulated business differences in regulation across countries. There is no generally accepted adjustment factor for comparing asset betas across countries. 10 However, for the purpose of this report we believe that assuming betas can be transferred 8 In 1998 the ACCC provided an asset beta of 0.55 with debt beta of 0.12 (equity beta 1.20), while in 2002 the corresponding values were 0.50 and 0.18 (equity beta 0.98). 9 See section 4.2 for a discussion of this issue. 10 One suggested approach to comparing Australian and US beta values is to adopt: β i,oz = β US,OZ * β i,us + cov(r i,e OZ,US) / var(r OZ), where β i,oz is the domestic beta of an Australian company; β US,OZ is the beta of the US index regressed against an Australian index; β i,us is the domestic beta of a US company; and cov(r i,e OZ,US) / var(r OZ) measures the relationship between the return of company i and the return on the Australian market that is September 2003:International comparison of WACC decisions Page 13 of 102

14 across markets will not introduce any upward bias to the Australian results. If anything it may understate Australian beta values. To the extent that markets such as the US and UK are more diversified than Australia s, beta values in Australia for a comparable company may be higher, assuming the regulatory arrangements are similar. Debt beta The technique of de-levering requires estimating the systematic risk of the debt of the company. This is referred to as the debt beta. There is not a consistent practice adopted on the debt beta by Australian regulators. 11 Two main approaches that have been taken on the debt beta are: ΠΠestimating the debt beta using the debt risk premium (DRP) and the CAPM structure, or assuming the debt beta is zero or a value materially lower than the DRP would imply. The first approach is premised on the assumption that the risk of debt is systematic risk, and is the approach adopted by the QCA. This approach to the debt beta can have perverse effects. For example, in the QCA s electricity distribution decision the implied cost of equity was below the cost of debt. It is possible to use the CAPM structure with an assumption as to the proportion of the debt risk that is systematic (for example, that 50% of its risk premium is a reward for systematic risk). This approach was considered by the ESC in its Victorian gas decision, where it subtracted 30 basis points from the debt margin for default risk based on the findings of a study by Elton, Gruber, Agrawal and Mann. 12 As there is uncorrelated with the return on the US market. However, this approach provides an estimate of a foreign company s beta if it were listed in Australia. It does not estimate its beta if it was operating in Australia. 11 Note that the debt beta is not a contentious issue in other markets, where, if it is used, a value of zero is typically applied. 12 E. Elton, M. Gruber, D. Agrawal, and C. Mann, Explaining the Rate Spread on Corporate Bonds, Journal of Finance, vol. 56(1), 2001, pp September 2003:International comparison of WACC decisions Page 14 of 102

15 reason to believe that default risk is common across countries with developed financial markets this approach could be adopted for comparative purposes. The second approach assumes that debt risk is not systematic, or has a very low level of systematic risk. The two approaches to the debt beta are not easily comparable. However, of critical importance is the adoption of a consistent approach to de-levering and re-levering asset betas. Given that all other countries in our comparison adopt a debt beta of zero where one is used, we have adopted this approach in our analysis. Market risk premium The market risk premium (MRP) is the amount an investor expects to earn from an investment in the market above the return earned on a risk-free investment. The key difficulty in estimating the MRP arises from it being an expectation and therefore not being directly observable. As a result the choice of an appropriate rate is inevitably ad hoc. Typically significant weight is given to historic estimates of MRP in determining the MRP to be included in the CAPM. However, as returns are volatile a time series in excess of 30 years is usually required to produce statistically significant results. Any comparison of regulated returns needs to reflect differences in market risk between countries and ideally regulators perceptions of this risk. In Australia there is significant regulatory consistency in the allowances for market risk premium (MRP), with most regulators adopting 6%. The exceptions are IPART and IPARC/ICRC that have each adopted a range of 5 6%. However, debate on MRP is not settled: regulatory values are at or below the lower end of the generally accepted range among corporate finance professionals in Australia of 6% to 8%; 13 and regulators have recently suggested the appropriate value may be even lower than 6% based on short term data on MRP 14 and evidence from surveys For example, see R. Officer, Rates of Return to Shares, Bond Yields and Inflation Rates: An Historical Perspective, in Share Markets and Portfolio Theory, 2nd ed, University of Queensland Press, St Lucia, 1989, pp For example, during the bull market of the late 1990s the ex-post MRP observed in Australia dropped significantly. However, there is evidence that the ex-post MRP is now significantly September 2003:International comparison of WACC decisions Page 15 of 102

16 Imputation credits (gamma) The dividend imputation mechanism used in Australia is intended to ensure that profits are taxed only once for Australian resident taxpayers but this benefit is not intended for foreign shareholders. Dividends that are paid out of after-corporate-tax profits can be accompanied with a franking credit to the extent of the corporate tax paid. Unlike other countries that do not have as substantial a dividend imputation system (for example, the UK) the value of franking credits needs to be reflected in the required regulated returns in Australia. The value of franking credits will be determined at the level of the investor and will be influenced by the investor s tax circumstances. The value of franking credits as a proportion of currently created credits is known as gamma. This depends on the value to individual investors and the proportion of credits that are distributed. As these will differ across investors, the result will be a value of the franking credit between nil and full value (that is, a gamma value between zero and one). There has been an increasing body of literature focused on estimating the value of gamma. Debate in Australia has become increasingly polarised between those arguing for zero and those arguing for one. Regulators have responded to this uncertainty by setting a value of 0.50 or below. In a vanilla WACC framework the impact of changes in and uncertainty over gamma is reflected in the cash flows. However, in a real pre-tax framework, changes in gamma can have a significant impact on the conversion between a post-tax nominal to a pre-tax real WACC. higher highlighting the danger of considering short time periods that do not produce statistically significant results. 15 For example, as part of its 2002 gas distribution decision, the ESC commissioned advice from Mercer on the value that brokers considered appropriate, producing a range of 3.0% to 6.0%. While it could be argued that these people would be both knowledgeable and interested in the topic, basing MRP estimates on the views of brokers is dangerous as they are not likely to be particularly knowledgeable of the theoretical and empirical research on the issue; and their time horizon can be questioned such that their forward-looking assessments are strongly correlated with the recent past but have no predictive power. September 2003:International comparison of WACC decisions Page 16 of 102

17 Regulatory risk / asymmetric returns The wider regulatory environment needs to be considered in any comparative analysis. In Australia, there is increasing acceptance by regulators that regulated businesses are exposed to a range of risks, such as stranding risk, in which the potential upside return for the firm is much less than the potential downside. These risks are referred to as asymmetric risks. When risks cannot be mitigated either through diversification in a wide portfolio of assets or with insurance, the business is forced to bear such risks. The CAPM is premised on symmetric returns, and as such the cost of equity determined from the CAPM does not include allowance for such risks. Therefore, there is a strong argument that regulated firms should be permitted a return that explicitly includes the actuarially-fair premium for insuring against these risks. While there is increasing acceptance of these risks, there is disagreement on the size of the risks and how they should be treated. The 1998 Victorian Gas decision reflected asymmetric risk by using the upper limit of the range of beta estimates. In its 2002 decision, the ACCC permitted GasNet to earn little more than $20,000 for the cost of non-insurable risks. The ACCC has also recently agreed that certain of these risks (for example, terrorist attacks) will be permitted as pass-throughs if they occur. September 2003:International comparison of WACC decisions Page 17 of 102

18 3 Treatment of WACC in international jurisdictions The primary focus of this report is on the comparison of regulatory decisions that use the building-block approach to regulation, which involves applying a WACC to a regulated asset base to determine an explicit return on assets employed for the utility. The countries and regions considered in this report are those that have the most developed approaches to applying a WACC as part of a building block approach to regulation. 3.1 UK Regulators in the UK have exclusively relied on the WACC model and building block methodology in determining price paths for regulated businesses. As part of this approach, the CAPM has been adopted as the prime method in determining the rate of return on equity within the WACC. There is little evidence of uncertainty over the determination of the regulatory asset base and in particular, the treatment of existing assets as part of regulated review processes. With the introduction of specific economic regulation of many businesses (water, electricity, gas) coinciding with privatisation timetables, the regulated asset base has often been determined based on a moving average of initial float values. 16 In reviews, regulators have rolled this value forward to take account of depreciation, prudent new capital expenditure and capital redundancy without introducing risk of optimisation of existing assets through approaches such as the depreciated optimised replacement cost (DORC) methodology. As can be seen in Table 1, there is no consensus on the appropriate specification of the WACC, reflecting the different modelling approaches of the various regulators. With the exception of Oftel, all UK regulators have chosen to express WACC in real terms, with the WACC in these cases derived from the real risk free rate. This partly reflects the presence of 16 Regulators adopting this approach included uplift on the initial market value of between 5% and 26%. This value was typically still less than the depreciated optimised replacement cost of the assets. September 2003:International comparison of WACC decisions Page 18 of 102

19 a liquid market for retail inflation index linked bonds in the UK, with bond rates of up to 20- year maturity regularly considered by regulators. Table 1: WACC form and asset valuation: Different UK regulators Regulator WACC Asset valuation specification Oftel Pre-tax nominal LRIC-LLU Ofwat Post-tax real Rolled forward IMV Ofgem Pre-tax real Rolled forward IMV Office of the Rail Regulator Pre-tax real Rolled forward IMV Civil Aviation Authority Pre-tax real Rolled forward IMV Competition Commission (water) Real vanilla Rolled forward IMV Competition Commission (airports) Pre-tax real Rolled forward IMV Source: Regulatory decisions. LRIC-LLU - Long run incremental cost-local loop unbundling, IMV - Initial market value In regulatory decisions, UK regulators have adopted a range of values for the real risk free rate, reflecting yields on different bond maturities, which may be adjusted to reflect uncertainty over whether any inflation expectations are built into real bond yields. In reaching a decision on the WACC, in all cases regulators have chosen the mid-point from this range. A key area of uncertainty in UK regulatory decision-making is the appropriate value of the long term MRP. As shown in Table 2, estimates of plausible ranges used for decisions range from 2.5% to 5.0%, with the resulting value chosen for price setting purposes ranging from 3.5% to 5.0%. 17 The values provided imply that regulators in Australia believe that 17 Note also that there is no evidence that the differences between regulators is narrowing over time, with the decisions since the start of 2001 including a range of 3.5% to 5.0% for the MRP. September 2003:International comparison of WACC decisions Page 19 of 102

20 market risk in Australia is somewhat higher in Australia than UK regulators believe is the case there. 18 Table 2: Market risk premium: Ranges and values adopted by UK regulators 19 Regulator Ranges specified Value adopted Oftel (2001) 5% 5% Ofwat (1999) 3% 4% 3.5% Ofgem ( ) 3.25% 3.75% 3.5% Office of the Rail Regulator (2000) 4% 4% Civil Aviation Authority (2002) 3.5% 4.5% 4% and 4.5% Competition Commission (water, 2000) 4% 4% Competition Commission (airports, 2002) 2.5% 4.5% 3.5% Source: Regulatory decisions In all UK decisions, regulators have adjusted for taxation using the statutory tax rate. Given the lack of accelerated depreciation for tax purposes, the effective rate is equivalent to the statutory tax rate. 20 As the UK only has a partial system of dividend imputation, 21 regulators have chosen not to build this into their analysis. This means that conversion between preand post-tax and real/nominal entails less distortion than in Australia. 18 This is backed up by historic estimates of MRP. For example, see estimates from Dimson, Marsh and Staunton (E. Dimson, P. Marsh and M. Staunton, ABN Amro Global Investment Yearbook 2002) included in section The practice of always adopting a mid-range value suggests that future values may be influenced by changes in the extremes of the range. 20 This provides incentives for shifting the timing of taxes contrary to most Australian decisions. 21 For example, the Finance Act 1997 abolished the right of pension funds the largest holders of equity in the UK to be repaid the imputation tax credit on dividends paid. September 2003:International comparison of WACC decisions Page 20 of 102

21 Other relevant features of the UK system of regulation are that: ΠΠregulators have typically estimated a benchmark value for the equity beta directly rather than estimate a benchmark asset beta, which is then converted into an equity beta using an assumed level of gearing; 22 and regulators have adopted different approaches to the cost of debt, with some using actual debt costs (for example, the Civil Aviation Authority) and others adopting benchmarks (for example, Ofgem). Some regulators also incorporate allowance for the cost of embedded debt that is long-term debt that was issued during periods of higher interest rates and prior to floatation Rest of Europe There is limited use of the WACC model in the rest of Europe. The country that is most active in using the WACC model is Ireland, where the Commission of Energy Regulation and the Commission of Aviation Regulation have adopted the WACC model and the CAPM in their decisions. These regulators have followed the lead of UK energy and aviation regulators and expressed decisions in a pre-tax real form, adjusting for tax using the statutory tax rate (12.5%). Limited use of the WACC model is evident in the French telecommunications sector, and the Italian and Dutch energy sectors, though in some cases not at the level of rigour or with the level of information release as in Ireland. 22 Assuming that the cost of equity is invariant to small changes in gearing is likely to be inconsistent with the Modigliani-Miller assumption that changed gearing will not affect the WACC. 23 For example, Ofwat allowed many water and sewerage companies an increment of 0.40% on the real post tax cost of capital for the cost of embedded debt. This does not appear to be an issue in Australia where long-term maturities on debt (that is, greater than ten years) are not generally available. Note that in subsequent analysis we have not included the embedded debt premium provided by Ofwat. September 2003:International comparison of WACC decisions Page 21 of 102

22 The French telecommunications regulator (ART l'autorité de régulation des telecommunications) has used the WACC model to estimate the cost of capital for France Telecom s interconnection rates and universal service offerings. However, it has not provided details on the values adopted for gearing or taxation. 24 The Dutch energy regulator, DTe, estimated a WACC for the electricity distribution businesses initially by assuming 100% equity financing. While this approach to the WACC could theoretically be defensible, the required circumstances are not evident in the Netherlands. 25 In Italy, the energy regulator (L Autorita per l energia elettrica e il gas) has estimated the cost of equity in electricity distribution decisions but has not used the WACC. In Germany there is no clear guide as to how the cost of capital is applied in pricing decisions and even less transparency on how charges are determined. Where the WACC methodology has been applied, all regulators have determined the risk free rate based on the yield to maturity of the 10-year Government bond. In Ireland, the German Government bond has been adopted given that this is a major reference point for investors. The transition to the Euro and the expectation that the Euro zone would reflect German economic conditions adds credence to this benchmark. The Irish aviation regulator has considered historical data on 10-year bond yields dating back to the mid 1980s in reaching its decision on the appropriate risk free rate. 3.3 New Zealand In New Zealand the most recent decisions on WACC cover the airports and telecom sectors. WACC allowances were determined by the Commerce Commission for Auckland, 24 In the absence of information on these variables, in subsequent calculations in this report we have assumed taxation at the corporate rate and solved for gearing to result in the WACC values included in the ART decisions. 25 For example, conditions that would make this approach most appropriate are where corporate and personal tax rates are the same, and there is full dividend imputation and no tax on capital gains. September 2003:International comparison of WACC decisions Page 22 of 102

23 Christchurch and Wellington airports as part of its Inquiry Report into whether the airports should be subject to price control. 26 However, given that the Government subsequently chose not to introduce price control, these allowances have not been incorporated into revenue streams. The Commission also recently issued a draft decision on the cost of capital to be applied for the Telecommunications Service Obligation (TSO) for the period December 2001 to June The Commerce Commission has chosen to specify the CAPM in the Brennan-Lally form. In this framework, the market risk premium is a tax adjusted (post investor tax) MRP. If it is assumed that the investors tax on dividends and capital gains are equal, an approximation of the equivalent values that would be obtained from the standard CAPM can be obtained by assuming that the derived cost of equity is the same under both models. Then the following relationship holds (the standard CAPM is on the left and the simplified Brennan-Lally CAPM is on the right): 5I 053 5IW 7$035 where Rf is the risk free rate; MRP is the standard MRP; TAMRP is the tax adjusted MRP; t is WKHPDUJLQDOLQYHVWRU VWD[UDWHDQG LVWKHHTXLW\EHWD A notable feature of the recent Commerce Commission approach to WACC is that the risk free rate has been determined consistently with the length of the regulatory period. For example, the TSO draft decision is notable in that the WACC is derived using a risk free rate maturity of just one year Commerce Commission, Final Report, Part IV Inquiry into Airfield Activities at Auckland, Wellington, and Christchurch International Airports, August This reflects the influence of Associate Professor Lally, who has also advised the ACCC on its approach to the risk free rate. September 2003:International comparison of WACC decisions Page 23 of 102

24 3.4 United States In the US the need for utilities to be able to earn an appropriate cost of capital has been entrenched by two key Supreme Court rulings the 1923 Bluefield Water Works case and the 1944 Hope Natural Gas case. In the Bluefield Water Works case, the Court stated: A public utility is entitled to such rates as will permit it to earn a return upon the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility, and should be adequate, under efficient and economical management, to maintain and support its credit, and enable it to raise the money necessary for the proper discharge of its public duties. 28 In the Hope Natural Gas case the Court stated: From the investor or company point of view it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital. 29 In the US there is not primary reliance on the WACC model in regulatory proceedings. In rate setting for telecommunications providers in the US, the Federal Communications Commission (FCC) relies heavily on a price cap formula rather than company-specific 28 Bluefield Water Works and Improvement Co. v. Public Service Commission 262 U.S. 679, 692 (1923). 29 Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944). September 2003:International comparison of WACC decisions Page 24 of 102

25 determinations of WACC components in its analysis. For example, in setting rates for local exchange carriers (LECs), the FCC sets price caps based on a measure of inflation less an X factor derived using total factor productivity (TFP) analysis. When introducing this approach, the FCC described its method for LECs as follows: Generally under price caps, the ceiling or maximum price LECs can charge for access services are adjusted annually by a measure of inflation minus an X-Factor. Under the Commission's revised price cap plan, the X-Factor represents the expected difference between the increase in LECs' productivity and the increase in productivity of the U.S. national economy generally, and the expected difference in the growth of LEC input prices compared to the growth rate of prices for the U.S. generally. The X-Factor also retains the 0.5 percent consumer productivity dividend, which ensures that access customers benefit from the increased incentives for productivity growth that the Commission s plan creates for incumbent LECs. 30 However, the cost of capital is an input into the various benchmarking models used to determine interconnection tariffs and the price of universal service obligations. In 1990 the FCC determined that the prescribed rate of return for interstate access would be 11.25%. 31 While the FCC has initiated review proceedings on the appropriate rate of return that should apply, 32 it is still the most quoted benchmark for associated regulatory purposes in the US. Similarly, cost of capital proceedings do not always accompany changes in tariffs in the gas transmission sector. Pipeline operators are required to file a schedule of rates with the Federal Energy Regulatory Commission (FERC). Under section 717c of the Natural Gas Act the onus is placed on the companies to demonstrate that the rates are fair and reasonable, a 30 FCC News Release, Commission Reforms its Price Cap Plan, 7 May FCC, Re-prescribing the Authorized Rate of Return for Interstate Services of Local Exchange Carriers, Order, CC Docket No , 5 FCC Rcd 7507, 7509 para. 13, See FCC , In the Matter of Prescribing the Authorized Unitary Rate of Return for Interstate Services of Local Exchange Carriers (Docket No ): Notice Initiating a Prescription Proceeding and Notice of Proposed Rulemaking, October September 2003:International comparison of WACC decisions Page 25 of 102

26 process that does not necessitate use of the WACC model. 33 However, FERC has made rulings on the cost of capital since this decision. In its March 2000 decision on Transcontinental Gas Pipeline Corporation, it ruled that a cost of capital of 10.73%, derived from a return on equity of 12.40% was appropriate for updating its tariffs. 34 In recent months, a number of businesses have made filings for tariffs to be based on a cost of capital in the range to 12.50%. 35 Use of the WACC model is common in electricity and gas distribution, water and rail decisions, and in some state-based telecom decisions both in standard regulatory cases and also during negotiation or arbitration proceedings. Typically the WACC is specified in its nominal vanilla form, with tax considered in the regulated cash flows. While most US businesses are predominately regulated using rate of return regulation, earnings sharing mechanisms are increasingly common, allowing sharing of returns above the regulatorydetermined cost of capital between customers and shareholders, and thereby allowing the business to earn more than the regulatory-determined cost of capital. An example is the following sliding scale earnings sharing formulae approved by the California Public Utilities Commission (CPUC): 33 Further, in 1996 FERC permitted interstate pipelines, under Part 284 of the Commission s regulations, to negotiate rates with a shipper that vary from the otherwise applicable cost of service pipeline tariff, subject to certain limitations such as the Commission s prohibition against pipelines negotiating terms and conditions of service [FERC Docket No. PL , Modification of Negotiated Rate Policy (Issued July 25, 2003) pp.1 2]. 34 See 90 FERC 61,279 Transcontinental Gas Pipeline Corporation Docket No. RP , Order on Initial Decision (Issued March 17, 2000). 35 Submissions filed in 2003 by Northern, Vector, Trailblazer and High Island Offshore argue for cost of capital allowances between 10.37% and 12.45%. September 2003:International comparison of WACC decisions Page 26 of 102

27 Table 3: Earnings sharing mechanisms in place in California (business share) 36 Amount earnings in excess of SDG&E SCE SoCalGas approved rate of return 0 25 basis points 100% 100% 100% % 100% 25% % 25% 35% % 35% 45% % 45% 55% % 55% 65% % 65% 75% % 75% 75% % 85% 85% % 95% 95% % 100% 100% Note that where the ex-post rate of return is 300 basis points higher than the regulatory cost of capital in any year (SDG&E) or on two successive years (SoCalGas), the earnings sharing mechanism is automatically suspended and the rate case reopened. The threshold for SCE is 600 basis points. Cost of equity Regulators use a wide range of methods and approaches to set the cost of equity component in the WACC. The most common approaches are discounted cash flow (DCF) analysis and risk premium analysis. Discounted cash flow method 36 Source: CPUC, Electric and Gas Utility Performance Based Ratemaking Mechanisms (September 2000 Update), As an example of how this applies, if SDG&E were to earn 1% over its regulatory-determined cost of capital, it would keep 46.25% of this (0.4625%) calculated as the sum of 100%*25 basis points, 25%*50 basis points and 35%*25 basis points, with the remainder passed on to customers. September 2003:International comparison of WACC decisions Page 27 of 102

28 Under the DCF method, the cost of common equity is the discount rate that makes the present value of expected returns from holding a stock (dividends and price appreciation) equal to the current market value of that stock. The DCF method considers two variables dividend yield and expected growth in earnings per share. In US rail decisions, use of the following DCF formula, first developed by the Interstate Commerce Commission in 1982, is common: 37 K = [D(o) x (1 +g/2)/p(o)] + g, where K is the cost of common equity; D(o) the annual dividend; P(o) the current stock price; and g the expected growth rate of dividends. Risk premium analysis The risk premium analysis method is based on the notion that the required cost of equity can be estimated by determining the prospective costs of long-term debt and adding a risk premium to recognise that equity holders only have a residual claim on assets and earnings. Role of CAPM Use of the CAPM has typically been restricted to a crosscheck on the results of the above approaches. As neither the DCF nor risk premium approaches reference the cost of equity to a risk free rate, there is little if any regulatory debate on the appropriate value of the risk free rate for pricing purposes. While there is significant uncertainty with respect to the parameters in DCF and risk premium analysis, state regulators have provided remarkably consistent nominal return on equity (ROE) allowances across sectors. Table 4 sets out recent ROE allowances provided by State Utility regulators in energy decisions. 37 This formula assumes that, at the start of the year, an investor would require a return on equity (K) equal to [D(o)/P(o)] + g, where D(o)/P(o) represents the average dividend yield expected for the year and g represents an estimate of the expected growth rate. At the end of the year, the investor would be concerned with projected returns for the following year and would require a K equal to [D(o) x (1+g)/P(o)] + g, which would allow for dividend growth for the following year. The average of these two formulas produces this DCF formula. [Source: Surface Transportation Board Ex Parte No. 558 (Sub-No. 5), Railroad Cost of Capital 2001 (June 2002), p6.] September 2003:International comparison of WACC decisions Page 28 of 102

29 Table 4: ROE allowances: Recent US energy decisions Decision Approach Value adopted Oregon NW Natural Gas (Nov-99) DCF and CAPM 10.25% Utah Pacificorp (Jun-00) DCF and risk premium 11.00% Mass Fitchbury (Oct-01) Predominately DCF 10.50% Conn CNG and Southern Gas (Feb-02) Various inc risk premium 10.71% and 10.80% CPUC PG&E, SCE, Sierra, SGD&E (Nov-02) Consideration of plausible value from all methods presented % Utah Questar Gas (Dec-02) DCF 11.20% Colorado Public Service Co gas and DCF 10.75% to 11.00% electricity (May-03) Colorado Aquila (Jun-03) DCF 10.75% Source: US regulatory decisions The stability of the absolute value of the return on equity allowances can be seen when these decisions are compared against the 10-year Treasury bond. September 2003:International comparison of WACC decisions Page 29 of 102

30 Figure 1: 10 year bond and return on equity decisions in the energy sector Nov 99 Jun Nov-99 Feb-00 May-00 Aug-00 Nov-00 Feb-01 May-01 Aug-01 Nov-01 Feb-02 May-02 Aug-02 Nov-02 Feb-03 May yr bond ROE decision Decisions included are those listed in Table 4. Data on 10-year bond from Federal Reserve Bank. Stability in rate allowances is sometimes an explicit goal of the regulator. The California Public Utilities Commission (CPUC) notes: We consistently consider the current estimate and anomalous behaviour of interest rates when making a final decision on authorizing a fair ROE. In PG&E s 1997 cost of capital proceeding we stated Our consistent practice has been to moderate changes in ROE relative to changes in interest rates in order to increase the stability of ROE over time. That consistent practice has also resulted in the practice of only September 2003:International comparison of WACC decisions Page 30 of 102

31 adjusting rate of return by one half to two thirds of the change in the benchmark interest rate. 38 At the federal level, the Federal Energy Regulatory Commission (FERC) provides electricity transmission companies incentives to engage in behaviour considered to be conducive to wider market benefits through provisions of increments on the return on equity. Where transmission operators are able to demonstrate that they lack market power and meet specific independence standards, the following increments are available: 39 ΠΠΠ50 basis point addition to the ROE for transfer of operational control of assets to a Commission-approved Regional Transmission Operator (RTO); 150 basis point addition to the book value return of facilities for Independent Transmission Companies (ITCs) that participate in RTOs and meet independence criteria; and a generic 100 basis point addition to the ROE for investment in new transmission facilities that are deemed pursuant to the RTO planning process. Resulting return on equity allowances are in some cases significantly higher than the state based distribution decisions. For example, FERC recently authorised International Transmission Company to transfer jurisdictional transmission facilities to ITC Holdings, concluding that ITC Holdings is independent, with FERC approving the companies proposed 13.88% rate of return on equity CPUC Decision , Application of Pacific Gas and Electric Company for Authority to Establish Its Authorized rates of return on Common Equity for Electric Utility Operations and Gas Distribution for Test Year 2003, Interim Opinion on Returns of Return on Equity for Test Year 2003, November 7, 2002, p Proposed Pricing Policy for Efficient Operation and Expansion of Transmission Grid. FERC has proposed a deadline of December 31, 2004, to qualify for these incentives. 40 FERC, Order Authorising Disposition of Jurisdictional Facilities, Accepting for filing proposed agreements, requiring compliance filing, and accepting in part and rejecting in part proposed transmission rates, February 20, September 2003:International comparison of WACC decisions Page 31 of 102

32 Treatment of debt Contrary to the approach in Australia, many US energy regulators have considered whether the utility s proposed finance costs are appropriate, rather than determine a benchmark debt finance allowance. However, benchmark debt allowances have been used in the water, rail and telecommunications sectors. There is no standard approach to the determination of gearing. In its recent decisions on Californian energy companies, the CPUC determined gearing on the basis of what it considered necessary to attract capital to the businesses. In Colorado, the gearing for energy companies has been determined on the basis of negotiation between the companies and consumer advocates, while in Massachusetts, actual gearing has been adopted. Benchmark gearing has been determined in other decisions in the rail (Surface Transportation Board), water (Massachusetts) and telecommunications (Utah, Vermont) sectors. 3.5 Canada The approach to WACC in Canada bears a number of similarities to the US. Where the WACC model is used, decisions are typically provided in the vanilla form of the WACC. Similarly, the CAPM is not the predominant methodology to determine the appropriate cost of equity capital in the WACC. There is also evidence of mechanistic approaches to the assessment of WACC in Canada, where some jurisdictions apply standard methodologies for determining the cost of equity capital: Πthe Canadian National Energy Board Multi-Pipeline Cost of Capital decision (RH-2-94) concluded that the cost of equity capital for a benchmark pipeline should be 300 basis points above the yield on long-term Government of Canada bonds, 41 with this decision setting gearing levels for the major gas pipelines; while 41 The long term bond is determined as the average of the 3-months-out and 12-months-out 10- year Government of Canada forecast published in the previous year s November issue of Consensus Forecasts (Consensus Economics Inc., London, England) plus the actual 10-year to 30-year bond yield spread in October of that year. September 2003:International comparison of WACC decisions Page 32 of 102

33 Πthe British Columbia Utilities Commission Return on Common Equity Decision, June 10, 1994 specifies that the return on common equity for a low risk gas utility will be 3.5% above an estimate of the 30-year bond rate derived from the 10-year bond rate. These decisions specified the capital structure for the pipelines in question and set out an adjustment approach. In the case of the National Energy Board decision, the rate in subsequent years would be adjusted by 75% of the change in the bond yield at a specific point in the year. This decision was recently challenged by TransCanada pipelines, which failed to overturn the key features of the existing methodology National Energy Board, TransCanada PipeLines Limited, RH September 2003:International comparison of WACC decisions Page 33 of 102

34 4 Use of international comparisons by Australian regulators This section analyses how regulators in Australia have considered comparative international material to date. The purpose of looking at this is to highlight the factors that need to be considered in undertaking a comparative study and to set out any limitations of such findings. 4.1 NERA review of UK and US rates of return for the ACCC In 2001, the ACCC commissioned NERA to survey declared post-tax regulatory rates of return for gas and electricity transmission and distribution businesses across various jurisdictions in the United Kingdom and North America. 43 NERA considered the real vanilla WACC provided in five Australian, four US and seven UK regulatory decisions in these sectors (plus the UK water sector) between 1995 and NERA s summary results are repeated in Table 5: Table 5: NERA Table 1.1: Average post-tax real rates of return across jurisdictions 44 North America United Kingdom Australia Return on equity 8.8% 6.9% 10.1% Return on debt 4.8% 4.4% 4.6% Vanilla WACC 6.6% 5.6% 6.8% 43 NERA, International Comparison of Utilities Regulated Post Tax Rates of Return in: North America, the UK and Australia, March 2001, p Ibid, p2. September 2003:International comparison of WACC decisions Page 34 of 102

35 Based on these findings NERA concluded that regulators in Australia were awarding regulatory rates of return higher than in the UK and approximately the same as in the US: Australian regulators are, if anything, declaring higher vanilla post tax WACCs than in other jurisdictions examined. Purely based on the declared returns examined in this survey, Australian regulators appear to offer approximately the same or higher returns than North American regulators who in turn appear to offer significantly higher rates of return than in the United Kingdom. 45 The ACCC has drawn on these findings to make a number of statements claiming that Australian investors are receiving relatively generous incentives to invest in regulated assets: Recent ACCC decisions relating to the gas industry have established forward looking returns on equity of around per cent per annum. This compares favourably with returns allowed by overseas regulators and domestic stock market returns. 46 The investments undertaken by airport operators to date suggest that the Commission s pricing decisions have not deterred investment in airports. In particular the experience suggests that the Commission has adequately allowed for the risks facing the airport operators. In relation to rates of return the Commission notes that the returns on equity used by the Commission in its decisions on new airport investment range from 14 to 16 per cent. This compares favourably with the 11.3 per cent average for the Australian share market over the past 10 years. Research by NERA also shows that the rates of return adopted by the Commission more generally compare favourably with rates used in North America and the U.K Ibid, p2. 46 ACCC/NCC, Regional development of natural gas transmission pipelines: a guide for regional areas considering alternatives for progressing the supply of natural gas, October 2002, p ACCC, Submission to the Productivity Commission s Inquiry into Price Regulation of Airport Services, May 2001, p.29. September 2003:International comparison of WACC decisions Page 35 of 102

36 The Draft Decision will give NT Gas a benchmark return on equity of per cent. This compares favourably to average returns earned on the Australian share market and by regulated energy businesses internationally. 48 The Commission determined the WACC parameter values in 1998 after carefully considering available information. It has applied this approach consistently across subsequent regulatory decisions consistent with industry benchmarks. The Commission has considered arguments to depart from this approach but has not found them persuasive. In particular, it has assessed the ex ante rate of return outcomes against relevant benchmarks and found them to be reasonable. For example, a 2001 study by NERA for the Commission concluded that Australian utilities regulated post tax rates of return compared favourably with those in North America and the UK Shortfalls of analysis The NERA study suffers from a number of shortfalls. 50 Most notably, the report s conclusions are simplistic and reflect three key analytical failings. Selection issues The study only considered a small sample of regulatory decisions. For example, NERA only considered UK decisions in the water and energy sectors. 51 While NERA included the Ofwat 48 ACCC, Draft Decision Amadeus Basin to Darwin Pipeline Access Arrangement, May 2001, p.xiv. 49 ACCC, Issues Paper Revisions to the Victorian natural gas transmission access arrangements, April 2002, p These are highlighted in greater detail in NECG s response to NERA s paper, available at: September 2003:International comparison of WACC decisions Page 36 of 102

37 and Competition Commission decisions on the England & Wales water businesses (simple average vanilla WACC of 5.7%), it did not include IPART s decision on the NSW water businesses, which provided a similar real vanilla WACC (5.9%) using the approach adopted by NERA. 52 Widening the sample to include the telecommunications, rail and aviation sectors would have revealed far higher market-based parameters adopted by other UK regulators. For example, the real vanilla WACC provided by Oftel for BT in February 2001 was 7.6%, while the real vanilla WACC provided by the ACCC for Telstra s PSTN in 2000 was 6.3%. 53 Failure to account for country-specific market parameters The report did not attempt to adjust for country-specific market conditions, such as the risk free rate and the market risk premium. For example, a higher risk-free rate has historically been more evident in Australia than in the UK or the US. These trends were evident during the period considered by NERA, and have continued up to the present day, as seen in Figure 2 51 Exclusion of telecom, rail and airports decisions is consistent with NERA s claim that its terms of reference were to consider gas and electricity decisions. However, this cannot explain inclusion of UK decisions in the water and sewerage sector. 52 These figures have been calculated using a simple average of the vanilla WACC determined using a real risk free rate and an average of the upper and lower bound parameters where appropriate. 53 While there is a difference in the services covered by these decisions, this cannot explain all the differences in WACC allowances, which are greater than shown if the impact of risk free rate and market risk premium is considered. For example, the ACCC decision was based on a risk free rate 1.3% higher than Oftel s, while Oftel s view of the UK MRP (5%) was only 1 percentage point lower than the ACCC s view of the Australian MRP (6%). September 2003:International comparison of WACC decisions Page 37 of 102

38 Figure 2: Yield on nominal Government bonds with 10-year maturity Australia, US, UK Australia UK US Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Source: Reserve Bank of Australia, Federal Reserve Bank and Bank of England data. In addition, the market risk premium varies between countries in line with differences in market composition, country risk, taxation and estimation time horizon. The report failed to recognise that regulators in the UK have consistently considered the required market risk premium in the UK to be lower than Australian regulators believe is the case in Australia a view that has a logical plausibility given the UK economy is more diversified than the Australian economy. Insufficient consideration of regulatory regimes NERA failed to give sufficient weight to differences in the three countries regulatory regimes. Different treatment of asset valuation exposes investors to differing risk over the return on asset component of the regulated revenue stream. For example, optimisationbased approaches that some regulators periodically use to calculate the regulatory asset base (RAB) can expose investors to asymmetric risks that investors are unable to avoid through diversification. Therefore, comparisons at the level of detail of the NERA study are unlikely to be particularly informative or helpful for policy purposes. Use of such results to justify a September 2003:International comparison of WACC decisions Page 38 of 102

39 particular approach to, or decision on, the appropriate rate of return can have damaging impacts on social welfare where the assumptions underpinning the analysis are flawed. 4.2 ACG Report on Proxy Beta Estimates Overview of report In July 2002 the ACCC commissioned the Allen Consulting Group (ACG) to review available empirical evidence on equity betas for the ACCC to draw upon when deriving a proxy beta for regulated gas transmission companies in Australia. In its report, ACG examined proxy betas for US, Canadian and UK companies, which were generally very low compared to the ACG beta estimates for Australian firms. The ACG summary results are shown in Table 6. Table 6: ACG Table 1.1: Re-levered equity betas (60% gearing), debt beta = Negative betas included Negative betas excluded Australian companies US companies Canadian companies UK companies ACG contend that these results suggest Australian regulators [adopting equity betas around 1] presently use excessively high beta estimates in their building block calculations for regulated revenue requirements. For example, ACG states: 54 Allen Consulting Group, Empirical Evidence on Proxy Beta Values for Regulated Gas Transmission Activities, July 2002, p.5. Note that these results are based on the tax term being included in the levering formula. September 2003:International comparison of WACC decisions Page 39 of 102

40 Exclusive reliance on the latest Australian market evidence would imply adopting a proxy equity beta (re-levered for the regulatory-standard gearing level) of 0.7 (rounded-up) for these activities. Moreover, regard to evidence from North American or UK firms as a secondary source of information does not provide any rationale for believing that such a proxy beta would understate the beta risk of the regulated activities. Rather, the latest evidence from these markets would be more supportive of a view that the Australian estimates overstate the true betas for these activities, although concerns are expressed with the reliability of the beta estimates from these other countries. 55 While ACG recommend a conservative approach to the exercise of discretion by the ACCC, their clear implication is that the ACCC has systematically favoured the regulated businesses in applying equity beta values of 1 and above: Accordingly, while it inevitably is a matter for the Commission to decide how it exercises its discretion, it is recommended that, in the near term, it adopt a conservative approach, and not assume a proxy equity beta that is too far from the range of previous, relevant regulatory decisions. As noted above, these decisions typically have assumed a proxy beta (for the regulatory standard gearing assumption) of around 1. That said, this report has demonstrated that no implication can be drawn from current market evidence that the proxy betas that Australian regulators have adopted are likely to understate the true beta rather, as noted above, the current evidence suggests regulators systematically have erred in the favour of the regulated entities Shortfalls of analysis We believe that reliance on such analysis as a key input into determining the required exante return for equity holders is dangerous, and risks introducing significant regulatory error. In particular, the belief that empirical analysis alone can provide reliable or certain 55 Ibid, p5. 56 Ibid, p43. September 2003:International comparison of WACC decisions Page 40 of 102

41 estimates of beta for setting a forward-looking price path for a period of 5 or more years is mistaken for a number of reasons. Reliability of estimates Beta estimates are inevitably subject to high standard error. The presence of companies with negative beta values or values close to zero is likely to reflect a lack of statistical significance with the results. There is no information in ACG report on the statistical significance of the beta estimates and no reported procedure for excluding estimates that were not statistically significant. Therefore, no valid conclusions can be drawn from comparisons between the results. This can be illustrated by considering recent beta estimates of the Australian companies included in the ACG report. Table 7: AGSM estimates of asset beta March 2003 (debt beta = 0.00) 57 Company Australian Gas & Light Australian Pipeline Trust Envestra United Energy Adjusted equity beta Gearing Asset beta R-squared T-stat 36% % % % Source: AGSM Risk Management Service, March The statistical significance and fit of these results is very poor. Both the R-squareds and the t-statistics are zero or close to zero in all cases. The implication of such low values of R- squared is that the beta value will tend to zero. It is a statistical property of beta estimation that if the R-squared goes to zero, the beta will follow. This can be shown below from Sharpe s CAPM: 57 Note that the Blume adjustment has been applied to the beta estimates, consistent with common practice. September 2003:International comparison of WACC decisions Page 41 of 102

42 = Cov(R i, R m)/var(r m) where Cov(R i, R m) is the covariance of stock i with the market, and var(r m) is the market variance. Statistically we know: Corr(R i, R m) = Cov(R i, R m)/(sd i*sd m) Where Corr(R i, R m) is the correlation between stock i and the market. Therefore, beta can also be represented as follows, where sd is the standard deviation of the stock and the market respectively: = [Corr(R i, R m) * (sd i/sd m)] / var(r m) As R-squared represents the fraction of the squared error that is explained by the model, as the correlation tends to zero then so will beta. 58 The AGSM results, which show the beta changing with each quarterly estimate, suggest that the underlying relationship with beta is not stable. This indicates that the assumptions of the ordinary least squares regressions that are used to calculate beta are violated. In essence, where the R-squared of a beta is close to zero, there is no evidence of any statistical relationship between the returns on a particular stock and the market as a whole. In our view, little reliance can be placed on such beta estimates as they contain little or no information This is not to exclude the possibility of a low beta with a high R-squared. 59 In the case of the ACG sample, it is likely that half or more of the US proxy group of 21 companies are not statistically significant with the equity beta estimates for 10 of these companies being in the range of 0.1 to 0.1. For the UK proxy group the beta estimates for four of the 11 companies were in the range of 0.01 to 0.07 and an additional three were negative. It is also likely to be the case that negative estimates or relatively large positive estimates are also unreliable and one would normally look more carefully at the statistical properties of the regression and the particular circumstances of the company in question before using such estimates. September 2003:International comparison of WACC decisions Page 42 of 102

43 Selection bias The choice of companies and the time period of analysis inevitably affect the results obtained from comparative beta studies. For example, in its choice of US comparators, ACG excludes beta estimates of diversified US pipeline companies. The impact on the results is significant, as seen in Table 8. Table 8: ACG beta estimates (negative betas excluded) 60 Debt beta = 0 Debt beta = 0.15 Australian companies (ACG table 4.7) US companies (ACG table 4.7) US diversified pipelines (ACG table 4.8) While ACG expresses some reservations about the use of the diversified pipeline firms as proxies, the selection of proxy companies inevitably contains a degree of subjective judgement. ACG have exercised subjective judgement in preferring the US companies with very low betas. However, someone else could exercise subjective judgement differently to reasonably conclude that pipeline companies were appropriate proxies, and on that basis form a view that Australian proxy beta estimates understated the true systematic risk for gas transmission pipelines. Similarly, the time period of analysis can significantly affect the results of a beta study, a point noted by ACG: In reality, where beta estimates vary over time as the sampling window is moved forward in time, there is no way of testing which of the estimates is the correct (sic). Hence, while a commitment to use the latest evidence may imply that the 60 Note these results assume the tax term is included in the levering formula. September 2003:International comparison of WACC decisions Page 43 of 102

44 proxy beta used to assess reference tariffs may vary over time, the rule nevertheless should lead to a proxy beta that is unbiased. 61 This can be seen in the following graph, which depicts movements in industry average betas over time. Note that individual beta estimates can vary considerably more than suggested in this figure, and moreover, regulated businesses cannot hedge against this volatility. Figure 3: Volatility in industry average betas over time May-97 Sep-97 Diversified resources Energy Infrastructure Food & Household Goods Transport Jan-98 May-98 Sep-98 Source: NECG analysis from Bloomberg data Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Very low betas often reflect poor statistical properties of the underlying estimation model. Also, if computed betas vary over time it is indicative of instability in the relationship between the returns to the company and the returns to the market. Given these properties of the estimation technique, we dispute that such estimates will in fact be unbiased. 61 Ibid, p41. September 2003:International comparison of WACC decisions Page 44 of 102

45 Leaving this aside, adopting current beta values can have significant long-term consequences when that beta value is not revisited for five years. The ACG report provides grounds to believe that its beta estimates are substantially lower than the long-term average. ACG make the following statement: The re-levered equity betas for the US firms, in particular, are substantially lower than the estimates that have been obtained from past time sampling windows. It could be hypothesised that the recent events on US share markets such as the large surge in the values of high-technology stocks and then their subsequent fall may have affected the beta estimates, and which may have biased the estimate of the forward-looking beta risk of these firms if those events were not considered by investors to be normal events. However, it is impossible to prove or disprove such a conjecture. 62 The following footnote from the same page in the ACG report provides evidence that in a past sampling window, US equity betas of 0.8 were obtained: In a submission (commissioned by BHP) to the Commission and the then Office of the Regulator-General in 1998, Dr Jeff Makholm of NERA noted that the average beta of the gas companies he included in his sample at that time was 0.66 for an average gearing level of 34 per cent debt-to-assets, which implied an equity beta of 0.81 for the regulatory-standard gearing level of 60 per cent: Makholm, J., 1998, The Cost of Capital for Gas Transmission and Distribution in Victoria, p.18. This re-levered equity beta is almost identical to that reported for all US gas distributors for an earlier period: Morin, R., Regulatory Finance: Utilities Cost of Capital, Public Utilities Reports, Virginia, p Implications While the CAPM is a well-established model, it is important to appreciate its weaknesses. Betas even when considered on an industry basis typically have high standard errors 62 Ibid, p ACG, p42, footnote 66. September 2003:International comparison of WACC decisions Page 45 of 102

46 and can be volatile. This means that for decision makers (regulators) involved in decisions with significant asymmetric implications, considerable caution is required. Businesses cannot hedge against beta volatility (as they can with debt and interest rates) and given that a beta value is often applied over a five-year Access Arrangement period any errors can have lasting impacts. Such considerations must be taken into account when comparative material is used as an input into the decision-making process. We believe that this is a flaw in both the ACG and NERA analyses. Failure to adequately elucidate the weaknesses of any approach raises a real danger of regulators being deluded by their perceived omniscience and, in consequence, increasing the potential for regulatory error. September 2003:International comparison of WACC decisions Page 46 of 102

47 5 Analysis of key decisions This section sets out the approach taken in comparing WACC decisions across jurisdictions. 5.1 Key comparator measures In comparing WACC allowances we have focused on two key parameters: ΠΠthe margin of the vanilla WACC over the risk free rate; and the asset beta Margin of the vanilla WACC above the risk free rate The margin of the vanilla WACC above the risk free rate is represented by the following expression: Margin = (debt margin) * (D/V) + (equity margin)*(e/v), where the debt margin is the difference between the cost of debt capital and the risk free rate, 64 and the equity margin is the difference between the cost of equity capital and the risk free rate. In a CAPM framework the equity margin is equivalent to the equity beta multiplied by the market risk premium. We have chosen to look at this measure for a number of reasons. ΠWACC decisions are primarily expressed in the vanilla form in the US and Canada, with this specification adopted by a significant proportion of regulators in Australia; Where the cost of debt is inclusive of issuance costs. 65 Note that the ACCC, ESC, QCA and ESCOSA have all recently issued determinations based on a vanilla WACC. September 2003:International comparison of WACC decisions Page 47 of 102

48 ΠΠΠthe margin can be applied to decisions where the risk free rate used is specified in nominal or real terms; in other countries that typically do not apply a vanilla WACC, such as the UK and Ireland, an equivalent vanilla WACC can be readily determined from the final decisions given that tax is consistently applied at the statutory rates; and there is readily available data on the risk free rate in countries where regulators do not explicitly include the rate as part of its WACC determination (US). As the margin of the vanilla WACC is likely to be influenced by the market risk premium, we have also considered the impact of explicitly adjusting the vanilla WACC margin in regulatory decisions to account for differences in market risk between Australia and the country in question Asset beta While the asset beta is a key input factor in the vanilla WACC margin, we have also explicitly considered the asset beta in our comparisons, as it is a key decision-specific variable affecting a regulatory allowance. As we noted in section 2, we believe that adjustments to the asset beta to reflect different markets is not required for the purpose of an exercise of this kind. 5.2 Key assumptions In comparing the implied margin and asset beta provided in all the regulatory decisions the following assumptions have been made: 66 Note that while there is a high degree of regulatory consistency on the appropriate value of the MRP in Australia, this is not the case in the UK where regulators adopt substantially different values. September 2003:International comparison of WACC decisions Page 48 of 102

49 5.2.1 Risk free rate The analysis has been standardised around the 10-year Government bond in the country in question. This bond has been chosen given that the majority of international (and Australian) regulators consider bond maturity of at least 10 years in decisions. Where a regulator has explicitly adopted a 10-year risk free rate as is the case for jurisdictional regulators in Australia and regulators in Europe this value has been used for comparative purposes. 67 In the US and Canada, where the regulator has either not explicitly adopted a risk free rate (US), or specified a risk free rate of up to 30 years (Canada), the average of the daily observations of the relevant 10-year Government bond in the month of the regulator s decision has been adopted for comparative purposes. In decisions by the ACCC and New Zealand Commerce Commission that use a bond rate of less than 10 years, we have adopted the equivalent 10-year bond over the averaging period adopted by the regulator for the shorter length bond. 68 The differences between the two bond rates, which are translated directly into the vanilla WACC margin, are shown in Table In the case of the UK we have adopted the risk free rate figures determined by the regulator. Given use of bond rates between 5 and 20 years by UK regulators in determining the risk free rate, we do not believe such a practice will introduce any bias to the results. In addition, given the widespread adoption of a real risk free rate by regulators, adopting the regulators (real) risk free rate avoids the need to make assumptions on the appropriate inflation rate where a real rate is derived from nominal bonds. 68 In some cases it has not been possible to precisely recreate the figures adopted by the ACCC, given that the final date of the averaging period used in decisions is not always specified. September 2003:International comparison of WACC decisions Page 49 of 102

50 Table 9: Adjustments to risk free rate where bond maturity adopted less than 10 years Australian and NZ decisions Decision Date Bond maturity adopted by regulator ACCC decisions Bond rate in decision Estimate of comparable 10- year bond Impact on WACC margin Victoria gas Oct-98 5-year 6.02% Similar Nil Telstra Jul-00 2 year 6.40% 7.06% -0.66% Moomba-Sydney (draft) Dec-00 5-year 6.00% 6.10% -0.10% Snowy Mountains Hydro Feb-01 5-year 5.19% 5.40% -0.21% Sydney Airport May-01 5-year 4.98% 5.28% -0.30% Moomba-Adelaide Sep-01 5-year 5.61% 5.85% -0.24% Powerlink Nov-01 5-year 5.65% 5.81% -0.16% ARTC May-02 5-year 5.90% 6.29% -0.39% GasNet Nov-02 5-year 5.31% 5.52% -0.21% ElectraNet Dec-02 5-year 5.17% 5.59% -0.42% SPI Powernet Dec-02 5-year 5.12% 5.59% -0.47% Commerce Commission decisions Auckland Airport Aug-02 5-year 6.33% 6.57% -0.24% Christchurch Airport Aug-02 3-year 7.04% Similar Nil Wellington Airport Aug-02 5-year 7.62% Similar Nil TSO (draft) Jun-03 1-year 4.80% 6.56% -1.76% Note that the bond rates for the New Zealand airports decisions are not referenced off the same time period. The risk free rate for the Wellington airport decision is averaged over the period January June 1997, for Auckland airport over the period April September 2001 and for Christchurch, February August Rounding or adjustments in decisions We have made adjustments to the vanilla WACC to take account of rounding. Regulators commonly round their WACC decisions for example, the UK Civil Aviation Authority (CAA) rounded its pre-tax real WACC assessment for Manchester Airport from the calculated 7.61% to 7.5%. The CAA did not use the vanilla WACC, which leaves open the question of what rounding would be appropriate had they done so. In this analysis, we use a September 2003:International comparison of WACC decisions Page 50 of 102

51 consistent quantum of rounding when estimating the vanilla WACC. In this case, we adjusted the vanilla WACC from 5.63% to 5.54% Australian decisions specified in pre-tax real terms Australian decisions specified in pre-tax real terms have been converted to a margin over the risk free rate by back-solving the forward (market) transformation with gamma of 0.50 and using the tax rate assumed by the regulator. A value of 0.50 has been adopted as this is the predominant value used in all regulatory decisions in Australia. This approach is as follows: Step 1: Note that the real pre-tax WACC (WACC RPT) can be expressed as: WACC RPT ZKHUHUGDQGUHDUHUHDOUHWXUQVWRGHEWDQGHTXLW\UHVSHFWLYHO\DQG LVJDPPD Step 2: Multiply out the above equation and substitute the real vanilla WACC (WACC RV) for rd*d/v + re*e/v to give: WACC RV RPTW UG'9 Step 3: Assume for this exercise that gamma is 0.5: WACC RV = (1-0.5t)* WACC RPT + 0.5t*rd*(D/V). Step 4: Subtract the real risk free rate to get the margin of the real vanilla WACC over the real risk free rate (rf): WACC RV rf = (1-0.5t)* WACC RPT + 0.5t*rd*(D/V) rf. Use of this formula does not create downward bias in the Australian results. This approach provides an identical vanilla WACC to that derived from weighting the costs of debt and equity where gamma is 0.5 and the regulator adopts the market transformation (Offgar). In cases where a gamma of less than 0.5 has been used in the transformation (IPART/ICRC) the approach provides a higher vanilla WACC than would be the case if the vanilla WACC were calculated directly from debt and equity costs. September 2003:International comparison of WACC decisions Page 51 of 102

52 5.2.4 Asset beta The approach to the asset beta depends on whether or not the decision employs the CAPM framework. In decisions using the CAPM framework (Australia, New Zealand, UK, Ireland) we have derived a comparable asset beta by setting the debt beta at zero and solving for the asset beta based on the equity beta provided in the decision. In doing so, we have used the levering approach adopted by the regulator in their decision. In Australian decisions, after applying a range for the asset and equity beta, we have reported the average of the lower and upper bound equivalent asset betas calculated with a debt beta of zero. 69 Where the decision does not use the CAPM (Canada, US) we have undertaken the following steps: Step 1: Estimate an equivalent equity beta based on the following relationship: H UH²UIU053 Step 2: Convert the equity beta to an asset beta. For simplicity we have applied the following relationship: 70 D H(9 Consistent with the approach set out in section we have adopted the equivalent 10-year bond rate at the time of the decision for the risk free rate. We have estimated a proxy value for the MRP in Canada and the US by considering regulatory statements on MRP, which have typically been made in the context of using the CAPM as a cross-check on other approaches to estimating the cost of equity capital. In Canada, statements of the Canadian Radio-television and Telecommunications Commission (CRTC) are consistent with a value for the MRP of around 5.0%. In its 1994 decision on the 69 This has been applied to all IPART decisions. 70 Note that the results are not sensitive to adopting this assumption. September 2003:International comparison of WACC decisions Page 52 of 102

53 Maritime Telegraph and Telephone company, 71 the CRTC noted that a proposed range of 5.9% to 6.9% overstates investors' expectations as to the market risk premium. More recently, in its 2000 decision on Northwestel, 72 the CRTC adopted a range of 5 5.5% for the MRP, and subsequently rolled forward the return on equity determined from these values in While we have adopted a value of 5% in our calculations, it is possible that other regulators may have a more conservative view on the MRP to apply in the CAPM. For example, recent expert testimony on behalf of Enmax Corporation in proceedings with the Alberta Energy & Utilities Board argued that the MRP in Canada was 3.9%. 73 In the US we have estimated a regulatory MRP of 6.0% from the limited decisions that have stated a MRP. 74 While the following regulatory statements on MRP, set out in table 12, suggest a higher figure, we have adopted a figure at the bottom of the range of these decisions. This is because estimates of the MRP in the US, including the Ibbotson estimate typically relate to a short-term bond, and that such results should be adjusted downwards by around 1.5% to reflect differences in short and long-term bond yields. 71 CRTC, Telecom Decision CRTC 94-9 Maritime Telegraph and Telephone Company Limited Revenue Requirement for CRTC , Ottawa, Long-distance competition and improved service for Northwestel customers, 30 November John Neri, Capital Structure and Return on Equity evidence, submitted to Alberta Energy & Utilities Board on behalf of Enmax Power Corporation, July 2003, p A value of 6% is towards the upper bound of US estimates of the MRP based on long-term bonds (typically 3.0 to 6.5%). Note that few regulatory decisions actually consider the MRP. September 2003:International comparison of WACC decisions Page 53 of 102

54 Table 10: US MRP values considered appropriate by regulators Regulator Decision Value Context Connecticut Public Utilities Commission Southern Connecticut Gas (2000) 6.1% Based on CAPM one of a range of methods used Maine Public Utilities Commission Oregon Public Utilities Commission Kentucky Public Utilities Commission Consumers Maine Water 7.5% Ibbotson estimate Company (2000) 75 CAPM used as cross-check Northwest Natural Gas 8.5% One of a number of approaches (1999) 76 considered Bell South (2001) 7% Commission applied CAPM. MRP of 7% provides cost of equity range with Commission assumptions on beta and gearing. Source: US regulatory decisions. In the case of France, where there is not any regulatory statements on MRP we have adopted a value of 6% for simplicity Explicitly adjusting the vanilla WACC margin for market risk The market risk premium (MRP) varies between countries. As differences in the assessment of market risk can materially influence the allowance provided in a regulated decision, there is a need to account for these differences in any comparative analysis. However, a key problem that arises in estimating the MRP is that it is an expectation and therefore is not directly observable. As a result the choice of an appropriate rate is inevitably ad hoc, regardless of whether historical material is relied upon or forward looking estimates made. Given the imprecise nature of any estimates, there is no single correct approach to accounting for differences in market risk between countries. 75 State of Maine Public Utilities Commission, Order (Part 2), Docket , Docket , 26 September, 2000, p Oregon Public Utilities Commission, Order No , 12 November September 2003:International comparison of WACC decisions Page 54 of 102

55 There are a number of alternative approaches available to estimate differences in MRPs between countries. These include: ΠΠΠΠuse of historical estimates of MRP based on a comparable methodology and timeframe; development of a composite world market index, with differences in market risk estimated from regressing a particular market index on the world index; consideration of regulatory statements; and first principles. Historical estimates Dimson, Marsh and Staunton study The most widely respected cross-country documentary evidence on historical market risk premia is the recent study by Dimson, Marsh and Staunton. 77 In this study, they estimated the premium of equity returns over bond (and bills) for the period These estimates, and the difference between these returns and those in Australia are set out in Table E. Dimson, P. Marsh, M. Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, Princeton University Press, September 2003:International comparison of WACC decisions Page 55 of 102

56 Table 11: Dimson, Marsh and Staunton estimates of annual market risk premium Country Premium over bonds Difference to Australia Australia 7.9% - Canada 5.7% -2.2% France 6.7% -1.2% Ireland 4.5% -3.4% Netherlands 6.4% -1.5% UK 5.5% -2.4% US 6.7% -1.2% There are limitations on the extent to which such data can be used to determine forwardlooking relativities in MRP. While historic data are often considered the most robust data to use in estimating the MRP for a particular country, the fact that many of the world s economies have only been integrated with world securities markets for a period of years means that cross-country comparisons based on this approach may not be accurate in portraying forward looking estimates of MRP. For example, we do not believe it is reasonable to assume that the US MRP going forward is higher than that expected from Canada, Ireland, and the Netherlands. In the case of Australia, the debt and equity markets, until fairly recently, were subject to controls and intervention with little direct influence from international markets. The markets were domestic, and foreign investment was not able to flow freely into and out of Australia. Now investment funds move freely into and out of the country and the currency. This is a fundamental difference and is the basis for challenging the relevance of the historical evidence for a forward-looking MRP. New Zealand was not included in the Dimson, Marsh and Staunton study. PWC estimates that in the period the Sharpe-Lintner MRP was 5.1%. 79 However, as the 78 Data from E. Dimson, P. Marsh and M. Staunton, ABN Amro Global Investment Yearbook 2002, p20. We report the arithmetic returns data. 79 PriceWaterhouseCoopers, New Zealand Equity Market Risk Premium, September September 2003:International comparison of WACC decisions Page 56 of 102

57 methodology and sample period of this study differs from the Dimson, Marsh and Staunton study these results cannot be easily compared. Given the smaller size of companies on the New Zealand stock exchange compared to those in the US, we would expect the New Zealand market to show a premium on the US (and possibly Australian) markets. This is consistent with a study by Lally quoted by McCulloch, 80 which estimates MRP from the volatility of returns showing a higher MRP in New Zealand (7.6%) than in Australia (6.2%) and the US (4.2%). Estimation of MRP through development of a global market index By regressing returns on foreign market portfolios on a composite world market index, Harvey estimated beta values for various country portfolios, which could then be used to calculate relative MRP values between countries. 81 To indicate how these data can be used to derive MRPs, Table 12 shows the beta values determined and the resulting MRP values and differences assuming a world index MRP of 5% a value that should be seen as indicative. Table 12: Harvey estimates of Risk Measures of Foreign Market Portfolios Country Beta value (multiple on world MRP) Implied MRP if world MRP = 5% Difference to Australia (world MRP of 5%) Netherlands % -1.9% United Kingdom % -0.1% France % -3.5% Australia % - Canada % -1.8% United States % -2.1% World % -2.0% 80 B. McCulloch, Estimating the Market Equity Risk Premium, working paper, December 2002, p C. Harvey, The World Price of Covariance Risk, Journal of Finance, vol 46(1), 1991, pp September 2003:International comparison of WACC decisions Page 57 of 102

58 Only values for countries included in this comparison are listed. Ireland and New Zealand are not included in Harvey s study. Whilst this approach is useful in understanding the relativities of various markets, it suffers from the data being only from a limited time period: that is, 1970 to There is no practical resolution of the problem as any such analysis based on less than a range of 40 or 50 years will be suspect, and data prior to a market becoming integrated into world markets are also of questionable relevance. Harvey s results also need to be subjected to a basic test of reasonableness. In that regard, some of the results seem quite sensible. However, the one that clearly is not reasonable as an estimate of relative forward looking MRP is France. It is simply not plausible that the MRP for France should be expected to be lower than the US, and certainly not by over one percent. As with the historical data, the usefulness of Harvey s results must be considered carefully. It is relevant to developing an understanding of relative MRPs but is not credible alone as a basis for estimating forward-looking MRPs. Regulatory decisions on MRP Table 13 sets out the minimum and maximum values for the MRP considered appropriate by regulators, and typical values allowed. For example, the range of 2.5% to 5.0% has been derived from considering (at the low end) the Competition Commission s view that the MRP was in the range 2.5% to 4.5% and (at the upper end) the 5% value considered appropriate by Oftel. September 2003:International comparison of WACC decisions Page 58 of 102

59 Country Table 13: Regulatory statements on MRP Range bounded by minimum lower bound and maximum upper bound for MRP in decisions MRP based on most typical MRP provided Difference to Australia Australia % 6% - Canada % 5% -1.0% France Ireland % 5.5% -0.5% Netherlands % 5.5% -0.5% New Zealand % 5.5% -0.5% UK 2.5% 5.0% 3.5% -2.5% US % 6.0% - Note that the estimates of the MRP for Canada and the US are those adopted in section based on regulatory statements, including in cases where the CAPM was not used as the primary tool to determine the cost of equity capital. There are at least two obvious problems with considering cross-country regulatory decisions on MRP. MRP is set within the context of the regulatory regime in place, in particular the valuation method and the regulatory framework (that is, price cap, rate of return, etc.). Furthermore, making regulatory decisions based upon previous regulatory decisions will simply perpetuate any distortions that may exist. In considering the reasonableness of the comparative MRPs in the table above, the two that stand out are the UK and the US. In our opinion, neither of these results are reasonable with respect to the others nor with respect to each other. For example, it appears implausible that the MRP in the US is as high as or higher than that in all the other countries, and that it is 2% higher than the UK. 82 NECG estimates of equivalent MRP in the traditional CAPM. September 2003:International comparison of WACC decisions Page 59 of 102

60 In our view, the regulatory information is interesting but of little use in determining an appropriate MRP for Australia. First principles We would expect that for reasonably developed markets such as those included in our study the key factors that would affect the comparative levels of market risk are: 83 ΠΠdifferences in market structure; and taxation. Difference in market structure The impact of diversity and industry composition on market returns was considered in a 1992 study by Roll. 84 Over the period , Roll showed that the Australian and most European stock market indexes had less than 100 stocks represented on the FT Actuaries/Goldman Sachs National Equity Markets index, with the exceptions being France with 125 companies and the UK with 310. These can be compared with Japan (455) and the US (553). Roll estimated that around 50% of the equity returns in these markets on average over the period sampled could be explained by the industry composition of the market index. The US has the most developed equity market in the world, and is noted for its many hightech and leading edge companies. However, most estimates of its MRP use the Standard & Poor s 500 Index that comprises a highly diverse set of companies. In other words, it does not have an over representation of high-risk companies. By contrast, resource companies influence the Australian equity market to a greater extent than in the US and other countries 83 For the purpose of this exercise we have not considered country risk. If less-developed economies were also included, differences in country risk may also be manifest in the MRP as well as in the risk free rate. 84 R. Roll, Industrial Structure and the Comparative Behavior of International Stock Market Indexes, Journal of Finance, vol 47(1), 1992, pp September 2003:International comparison of WACC decisions Page 60 of 102

61 in the sample considered. Resource companies tend to have high levels of systematic risk, which is consistent with a higher MRP for Australia. It is well known that the betas of firms are negatively correlated with their size. 85 Smaller firms tend to have higher betas. 86 Translating this finding to countries implies that a country with smaller companies listed on its equity market should have a higher MRP than a country with larger companies listed. Table 14: Market capitalisation comparator countries, 1999 Country Market capitalisation Percentage of (billion US) world market Australia Canada France Ireland Netherlands New Zealand UK US Source: McKinsey & Company Inc, Valuation: Measuring and Managing the Value of Companies, (3 rd ed), 2000, John Wiley & Sons, p There is much evidence, particularly through the research of Rolf Banz, Eugene Fama and Kenneth French that the investment returns to small companies are greater than would be expected based upon the measured beta using CAPM. For example, see R. W. Banz, The Relationship Between Market Value and Return of Common Stocks, Journal of Financial Economics, November 1981, E. Fama and K. French, The Cross-Section of Expected Stock Returns, Journal of Finance, June 1992, pp ; Common Risk Factors in the Returns on Stocks and Bonds, Journal of Financial Economics, February 1993, pp.3-56; and Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance, March 1996, pp Note that in the March 2003 AGSM database there is a negative correlation of 0.08 between market capitalisation of equity and beta for firms with a positive beta. September 2003:International comparison of WACC decisions Page 61 of 102

62 Consider a firm listed in a national market containing relatively small companies and with a beta equal to 1.0. If that firm were to be listed on the US market, its relative size would suggest its beta would be above 1.0, say 1.2. If we assume the risk free rate in the US is 5% and the US MRP is 6%, the cost of equity to the firm in the US would be 12.2% (5%+1.2*6%). The risk premium for the company is 7.2%. If we then express this risk premium in the home market with the home market beta of 1.0, the home market MRP would be 7.2%. Differences in taxation The key aspects in relation to taxation that will impact on the required returns that investors in markets will seek are the effective tax rates for dividends and capital gains. The structure and rates of personal taxes vary in the countries chosen. The top rate of income taxation, inclusive of all central and sub-central income taxes for countries in our comparison ranges from 39% in New Zealand to 52% in the Netherlands. 87 However, these rates by themselves do not give a full picture of tax concessions available. For example, preferential taxation treatment of trusts means that for many New Zealand investors the top rate of taxation is 33%. The tax treatment of dividends and capital gains is also a complex area. Dividends in the US are no longer taxed implying US investors do not require compensation for dividend taxation to be built into market returns, while domestic investors in Australia receive a tax credit against the value of corporation tax paid on dividends. In virtually every country, capital gains receive some form of favourable tax treatment. In considering the impact of the tax treatment of dividends and capital gains on MRP it is important to consider the tax situation of the appropriate investor being considered namely the (price setting) marginal investor. There is evidence to support the notion that in some (relatively) smaller markets this investor may be an international investor. For example, non-resident investors own around 37.5% of the value of the Australian Stock Exchange, the largest single shareholder group by far. 88 Therefore if the marginal investor is not a domestic 87 Source OECD This table also shows the top marginal rate to be: UK - 40%, Canada %, US 47.5%, Ireland 48.0%, France 48.1%, and Australia 48.5%. 88 Information provided by Australian Stock Exchange. Figures for 19 September September 2003:International comparison of WACC decisions Page 62 of 102

63 investor, it is the (unknown) tax treatment in the country of origin that is relevant for this analysis. Summary on first principles We believe that factors such as market structure and size are key drivers of differences in MRP between countries. In our view, the evidence suggests that both the composition and size of its market supports the position that the forward looking MRP for Australia would be at least as high if not higher than the comparison countries studied here, with New Zealand being the likely exception. Our cursory view on comparative systems of taxation indicates that, because of the underlying complexity, it is difficult to conclude that the observed differences will result in substantive differences in MRP. Giving consideration to the foregoing discussion of first principles as well as the empirical data on comparative MRPs, our estimates of the differences in market risk premiums are as follows: Table 15: NECG estimates of cross-country differences in MRP Country NECG estimate of differences in market risk Australia - Canada -1.0% France -1.5% Ireland 0 to -0.5% Netherlands -0.5% New Zealand 0 to slightly positive UK -2.0% US -2.0% September 2003:International comparison of WACC decisions Page 63 of 102

64 Adjustment proposed All estimates of MRP differences have limitations, and therefore any adjustments require an element of judgement, particularly where applied to estimate differences in forward looking MRPs. Given the limitations of the various approaches, we have chosen to adjust for market risk by considering a relatively simple approach that is the vanilla WACC margin that would have applied in each of the countries had the regulator adopted the value for the MRP of 6% in its decision(s). Adopting this adjustment does not mean that we support a value of 6% for the Australian MRP on the contrary, and as noted in section 2, the historical evidence supports a value closer to 7% (mid point of the historical range of 6.0 to 8.0%), while consideration of benchmarking the Australian MRP against the US market also supports a value close to 7%. 89 Applying a uniform 6% value for the MRP is equivalent to making the following adjustments for market risk between the countries in the study and Australia. 89 For example, Bowman estimated the Australian MRP at 7.8% by benchmarking the Australian MRP against the US market [R. Bowman Estimating the Market Risk Premium, JASSA, Spring 2001, pp ] Professor Bowman has since revised his benchmarked estimate of the market risk premium in Australia to 7%. September 2003:International comparison of WACC decisions Page 64 of 102

65 Table 16: Adjustments applied to MRP Country Range corresponding to actual MRP Increment on MRP required to give MRP of 6% values adopted in regulatory decisions Canada 5.0% +1.0% France 6.0% Nil Ireland % 0 to +1.0% Netherlands 5.5% +0.5% New Zealand % Nil UK 3.5% 5.0% +1.0 to +2.5% US 6.0 Nil NECG imputed values are shown for France, Canada and the US. No adjustment has been made to the market risk premium provided in New Zealand, given the uncertainty in converting from the TAMRP to a standard CAPM, and as we do not believe there is a case to assume lower market risk in New Zealand than Australia. The adjustments applied are broadly consistent with our assessment of plausible MRP differences between countries. The two main exceptions are France and the US, where the adjustments applied are less than we consider plausible. However, as we have imputed values for the MRP for both these countries, this difference may partly reflect our assumptions. For each decision, the impact on the vanilla WACC margin from assuming an MRP of 6% is as follows: Vanilla WACC increment = (6% - MRP d) * equity beta * (E/V), where MRP d is the MRP actually provided by the regulator in its decision. 90 NECG estimates of equivalent MRP in the traditional CAPM. September 2003:International comparison of WACC decisions Page 65 of 102

66 6 Results A sample of over 100 network decisions in the gas, electricity, telecom, rail, water and airports sectors has been assembled. This sample has been restricted to decisions taken after 1 July 1998, thus incorporating all major Australian decisions. The decisions chosen are those where a regulator has explicitly determined a WACC as part of a wider determination of regulatory revenue requirements, and the key parameters are either explicitly provided or can be readily estimated. This has resulted in excluding the following: ΠΠΠCPI-X decisions where the X factor has been determined using approaches such as benchmarking (for example, many US FCC telecom decisions) though an indication of the WACC applied in the benchmarking models is included; US gas transmission tariffs that have been approved without the regulator determining required rates of return; and decisions where the regulator has set a WACC or return on equity, but provided insufficient information to fully evaluate the form of the WACC or back-solve the key parameters (for example, Italian energy). The sample of North American decisions includes those that were most readily available through web-based searches. However, we believe that the sample of decisions in this region is sufficiently large, and decisions in North America relatively consistent between regulators and over time, to avoid problems of sample selection error. For the decisions collated in each of the airports, electricity, gas, rail, telecommunications and water sectors, this section sets out the vanilla WACC margin calculated in the decision, the increment applied to the MRP to give a value of 6%, the revised vanilla WACC margin based on a MRP of 6%, and the asset beta (or equivalent asset beta) used in the regulatory decision. September 2003:International comparison of WACC decisions Page 66 of 102

67 6.1 Airports Summary results for the airports sector are set out in Table 17. Table 17: Summary of airports decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia ACCC SACL May % % 0.55 UK CAA BAA Heathrow Mar % 2.00% 3.25% 0.53 UK CAA Manchester Mar % 2.00% 3.74% 0.53 UK CAA BAA Stansted Gatwick Mar % 2.00% 3.74% 0.60 UK CAA BAA Heathrow new I Mar % 1.50% 4.54% 0.72 UK CC Manchester Dec % 2.50% 4.54% 0.68 UK CC BAA London Dec % 2.50% 4.48% 0.70 Ireland CAR Airport charges Aug % % 0.47 Ireland CAR Terminal charges Feb % % 0.61 NZ CC Wellington airport Aug % % 0.50 NZ CC Auckland Aug % % 0.50 NZ CC Christchurch Aug % % 0.50 The addition to the WACC margin for market risk is (6%-decision MRP) * equity beta * (1-gearing). As shown in figures 4 and 5, application of the market adjustment results in a relatively linear relationship between the vanilla WACC margin and the asset beta. Combining the WACC margin and the asset beta shows the Commerce Commission recommendations for the New Zealand airports to provide the least generous allowance. To some extent these decisions need to be treated with care, as they involve recommendations on WACC rather than actual values provided to the businesses. While the decisions cover a wide range of services from airport and terminal charges to risky new investment (as is the case for Heathrow Terminal 5), the ACCC decision on SACL does not appear particularly generous in relation to its comparators on either the asset beta or adjusted vanilla WACC margin basis. September 2003:International comparison of WACC decisions Page 67 of 102

68 Figure 4: Comparison unadjusted WACC margin and asset beta Increasing generosity Australia UK Ireland NZ % 2.50% 3.00% 3.50% 4.00% 4.50% Figure 5: Comparison of adjusted vanilla WACC margin and asset beta Australia UK Ireland NZ % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 6.2 Electricity distribution Table 18 summarises the results for the electricity distribution businesses. September 2003:International comparison of WACC decisions Page 68 of 102

69 Table 18: Summary of electricity distribution decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia IPARC ActewAGL May % % 0.32 Australia OTTER Aurora distribution Nov % % 0.38 Australia IPART NSW electricity DBs Dec % % 0.39 Australia ORG Vic electricity DBs Sep % % 0.40 Australia QCA Qld electricity DBs Oct % % 0.29 Ireland CER ESB Sep % 0.60% 3.15% 0.40 Netherlands Dte Dutch electricity distribution % 0.50% 2.55% 0.40 UK Ofgem PES Dec % 2.50% 3.94% 0.50 US Utah Pacificorp May % % 0.37 US Mass Fitchbury Oct % % 0.43 US CPUC SGD&E Nov % % 0.56 US CPUC PG&E Nov % % 0.57 US CPUC Sierra Nov % % 0.48 US CPUC SCE Nov % % 0.60 US Colorado Public Service Co May % % 0.62 US Colorado Aquila Jun % % 0.59 As seen in Figures 6 and 7 the Australian decisions provide significantly lower margins above the risk free rate than those in the US. 91 The only exception is the decision by the Public Service Commission of Utah, which has a relatively low calculated vanilla WACC margin and asset beta due to the relatively high value of the 10-year bond at the time of the decision. The decision by Ofgem on the UK electricity distributors provided a higher asset beta than all the Australian decisions, and also results in a higher adjusted vanilla WACC margin than all the Australian decisions. 91 If company-specific factors are considered, the difference may be even greater. For example, the allowance for the Queensland electricity distributors overstates the effective WACC provided. The QCA s failure to NPV the transitional pricing path penalised the distributors and resulted in a lower return being earned. This effect was exacerbated by the adoption of a post-tax approach that took into account the effect of accumulated losses. This effectively penalised the distributors twice, as it meant that prices were lower under the regulatory approach, for the only reason that they were too low in the past (which generated the tax losses). September 2003:International comparison of WACC decisions Page 69 of 102

70 Figure 6: Electricity distribution unadjusted vanilla WACC margin and asset beta % 3.00% 4.00% 5.00% 6.00% Australia UK US Ireland Netherlands Figure 7: Electricity distribution adjusted vanilla WACC margin and asset beta % 3.00% 4.00% 5.00% 6.00% Australia UK US Ireland Netherlands 6.3 Electricity transmission Table 19 summarises the results for electricity transmission companies studied. September 2003:International comparison of WACC decisions Page 70 of 102

71 Table 19: Summary of electricity transmission decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia ACCC Transgrid Jan % % 0.39 Australia ACCC SMHEA Feb % % 0.40 Australia ACCC Powerlink Nov % % 0.40 Australia ACCC SPI Powernet Dec % % 0.40 Australia ACCC ElectraNet Dec % % 0.40 UK Ofgem Scot transmission Dec % 2.50% 3.94% 0.50 UK Ofgem NGC Sep % 2.50% 3.42% 0.40 Ireland CER ESB Sep % 0.60% 3.15% 0.40 Canada NB New Brunswick trans Mar % 1.00% 3.78% 0.38 These decisions show a concentration of decisions providing an asset beta of around While the sample of non-australian countries is small, the adjusted results show the ACCC s decisions to be less generous than those in the UK and Ireland, while the transmission decision in New Brunswick provides the lowest estimated asset beta, but a relatively high vanilla WACC margin partly due to the allowable cost of debt being over 2.3% above the 10- year bond at the time of the decision. However, note that the above table excludes the US electricity transmission sector, where FERC is providing return on equity allowances significantly higher than those in the decisions shown in this table. These have been excluded as the absence of cost of debt allowances in the decisions means that it is not possible to calculate a vanilla WACC. However, an indicative vanilla WACC margin and asset beta can be estimated for the MidWest ISO, where FERC allowed a return on equity of 12.88%. If we assume 50% gearing and a cost of debt 150 basis points above a risk free rate of 4.03% (as of December 2001 the date of application to FERC), this translates to a vanilla WACC margin of 5.18% and an asset beta of 0.74 (assuming 6% MRP). This value is shown in the second figure. September 2003:International comparison of WACC decisions Page 71 of 102

72 Figure 8: Electricity transmission unadjusted vanilla WACC margin and asset beta Australia UK Ireland Canada % 2.50% 3.00% 3.50% Figure 9: Electricity transmission adjusted vanilla WACC margin and asset beta % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% Australia UK US (FERC est) Ireland Canada September 2003:International comparison of WACC decisions Page 72 of 102

73 6.4 Gas distribution Table 20 summarises the decisions considered in the gas distribution sector. Table 20: Summary of gas distribution decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia ORG Vic DBs Oct % % 0.48 Australia IPART Great Southern Mar % % 0.41 Australia IPART Albury Dec % % 0.41 Australia IPART AGLGN Jun % % 0.41 Australia ICRC ActewAGL Nov % % 0.41 Australia Offgar Alinta Dec % % 0.43 Australia QCA Qld gas DBs Oct % % 0.40 Australia SAIPAR Envestra Dec % % 0.43 Australia ESC Vic DBs Oct % % 0.40 UK Ofgem Transco Sep % 2.50% 3.44% 0.38 Ireland CER BGE Sep % 0.60% 3.15% 0.40 Canada NB Enbridge Jun % 1.00% 5.21% 0.71 Canada Alberta ATCO-AGS Dec % 1.00% 3.45% 0.32 Canada Alberta ATCO-APS Dec % 1.00% 3.80% 0.39 Canada BC Aquila (2002) Feb % 1.00% 3.28% 0.34 Canada BC Aquila (2003) Feb % 1.00% 4.07% 0.39 Canada BC BG Gas Feb % 1.00% 2.16% 0.30 US Oregon NW Natural gas Nov % % 0.34 US Conn CNG Gas Feb % % 0.49 US Conn Southern Gas Feb % % 0.52 US CPUC SGD&E Nov % % 0.56 US CPUC PG&E Nov % % 0.57 US Utah Questar gas Dec % % 0.63 US Colorado Public Service Co May % % 0.64 Figures 10 and 11 show the Australian decisions in general provide (unadjusted) margins over the risk free rate that are broadly equivalent to those calculated for Canada, but significantly lower than those in the US. The Irish and UK decisions are broadly comparable to the Australian decisions when the adjustment factor is applied. September 2003:International comparison of WACC decisions Page 73 of 102

74 Figure 10: Gas distribution unadjusted vanilla WACC and asset beta Australia UK US Ireland Canada % 2.00% 3.00% 4.00% 5.00% 6.00% Figure 11: Gas distribution adjusted vanilla WACC and asset beta Australia UK US Ireland Canada % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% September 2003:International comparison of WACC decisions Page 74 of 102

75 6.5 Gas transmission A summary of the gas transmission decisions that adopt the WACC methodology is set out in Table 21. Table 21: Summary of gas transmission decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia ACCC TPA (Vic) Oct % % 0.48 Australia ACCC Central West Pipeline Jun % % 0.60 Australia Offgar Parmelia Oct % % 0.53 Australia ACCC Moomba Sydney (draft) Dec % % 0.46 Australia Offgar Goldfields Apr % % 0.48 Australia ACCC Moomba Adelaide Sep % % 0.46 Australia Offgar Tubridgi Oct % % 0.53 Australia ACCC GasNet Nov % % 0.39 Australia ACCC Amadeus Basin Darwin Dec % % 0.41 Australia Offgar Dampier Bunbury May % % 0.48 UK Ofgem Transco Sep % 2.50% 3.44% 0.38 US FERC Transcontinental pipeline Mar % % 0.62 Ireland CER BGT Jun % 1.00% 3.17% 0.40 Canada NEB TransCanada Jun % 1.00% 4.06% 0.25 Canada BC Pacific Northern (I) Jul % 1.00% 3.96% 0.32 Canada BC Pacific Northern (II) Jul % 1.00% 4.07% 0.33 While the data represented in figures 12 and 13 suggest that Australian regulators have provided more generous WACC allowances in this sector than all but FERC, it must be noted that the nature of some of the pipelines considered differ significantly from those overseas. For example, the Australian decisions include greenfields investment such as the Central West Pipeline and pipelines that are directly competing with other pipelines and are hence subject to revocation decisions (for example, Moomba to Sydney pipeline, for which the ACCC provided a draft decision). September 2003:International comparison of WACC decisions Page 75 of 102

76 Figure 12: Gas transmission unadjusted vanilla WACC margin and asset beta Australia UK US Ireland Canada % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% Figure 13: Gas transmission adjusted vanilla WACC margin and asset beta Australia UK US Ireland Canada % 3.20% 3.40% 3.60% 3.80% 4.00% 4.20% 4.40% 4.60% September 2003:International comparison of WACC decisions Page 76 of 102

77 6.6 Rail Table 22 summarises decisions in the rail sector. Table 22: Summary of rail decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia IPART Rail Access Corporation Apr % % 0.37 Australia QCA Queensland Rail Jul % % 0.34 Australia ACCC ARTC May % % 0.51 Australia ESCOSA Tarcoola-Darwin Jul % % 0.51 Australia ESCOSA Tarcoola-Darwin (project spec) Jul % % 0.54 Australia ORAR WestNet Rail Jul % % 0.45 Australia ORAR WAGR Jul % % 0.30 UK ORR Railtrack Oct % 2.00% 4.62% 0.65 US STB US Railroad Jun % % 0.73 US STB US Railroad Jun % % 0.76 Note that while ESCOSA determined a project-specific WACC for the Tarcoola-Darwin railway based on actual debt costs, it also provided an industry-specific WACC based on a benchmark provider. Significant care needs to be taken in comparing rail decisions given that the systematic risk of business cash flows is likely to be strongly influenced by the traffic on the network whether passenger or freight (and whether demand for freight is domestically driven or is export oriented) as well as contractual relationships. The asset beta provided by the QCA in its decision on Queensland Rail was based exclusively on the QCA s understanding of the systematic risk of QR s below rail coal network cash flows. This was also the case in IPART s decision on the then Rail Access Corporation, despite coal accounting for less than 30% of revenue, because of the importance of access prices (rather than negotiation) in determining charges for the transport of coal. Differences in the asset beta provided by ORAR in its decisions on WestNet and WAGR can be attributed to contractual relationships between WAGR and the Western Australian Government that removed cost, price and volume risk from the cash flows. In the US, the Surface Transportation Board (STB) bases its analysis of the appropriate return for rail providers on their interstate traffic on the basis of applying the dividend growth model to companies that meet the following criteria: (1) the company is listed on either the September 2003:International comparison of WACC decisions Page 77 of 102

78 New York or American Stock Exchange; (2) the company paid dividends throughout the year; (3) the company s rail assets are greater than 50% of its total assets; and (4) the company has a debt rating of at least BBB (Standard & Poor s) and Baa (Moody s). Companies meeting these criteria are: Burlington Northern Santa Fe Corporation (BNSF), CSX Corporation (CSX), Norfolk Southern Corporation (NSC), and the Union Pacific Corporation (UPC). The STB decision relates to interstate trade, which is expected to have high correlation with domestic economic activity. It is true that not all of the Australian rail providers considered necessarily exhibit this high correlation with domestic economic activity. For example, whilst the US rail providers carry significant coal freight, that traffic is expected to have relatively high correlation with domestic economic activity on account of it being driven principally by electricity generation. This contrasts with coal haulage in Australia, which is principally driven by export demand (and hence tends to be far less correlated with domestic economic activity). However, regardless of traffic, with the exception of the project-specific decision on the Tarcoola-Darwin railway, the US decisions provide a significantly higher margin over the vanilla WACC and asset beta than either the UK or Australian decisions. In turn, the decision on Railtrack (UK) uses a higher asset beta and results in a higher (adjusted) margin over the vanilla WACC than the Australian decisions. The high WACC margin for the project-specific Tarcoola-Darwin decision can be accounted for by the high debt costs provided by the regulator reflecting actual costs to APT of financing the project. In its decision, ESCOSA notes that the margin on debt at the time of financing suggested the project was effectively considered of speculative grade credit rating Essential Services Commission of South Australia, Tarcoola-Darwin Railway, Regulated Rates of Return, Provisional Determination, July 2003, p.31. September 2003:International comparison of WACC decisions Page 78 of 102

79 Figure 14: Rail unadjusted vanilla WACC margin and asset beta Australia UK US % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% Figure 15: Rail adjusted vanilla WACC margin and asset beta Australia UK US % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.7 Telecommunications Table 23 summarises decisions in the telecommunications sector. September 2003:International comparison of WACC decisions Page 79 of 102

80 Table 23: Summary of telecommunications decisions Country Regulator Decision Date Vanilla WACC margin Increase applied to MRP to give 6% MRP Revised vanilla WACC margin (MRP=6%) Asset beta (debt beta = 0) Australia ACCC Telstra PSTN Jul % % 0.50 UK Oftel BT Feb % 1.00% 5.93% 0.90 US Utah Manti Apr % % 0.61 US Vermont NET Apr % % 0.59 US Utah Gunnison Jul % % 0.54 NZ CC TSO (draft) Jun % % 0.30 France ART Interconnect (2001) Sep % 1.00% 3.18% 0.50 France ART Interconnect (2002) Oct % 1.00% 3.72% 0.54 France ART Universal Service (2002) Oct % 1.00% 4.58% 0.71 The above table does not include interstate decisions in the US given the FCC does not adopt the cost of service model in its deliberations. However, over the period January 1998 to June 2003 the setting of a value of 11.25% for the cost of capital in benchmark models is equivalent to a margin over the vanilla WACC of between 4.6 and 7.9%, depending on the prevalent risk free rate. These decisions are not all directly comparable. For example, the New Zealand Commerce Commission s draft decision on Telecom TSO is clearly an outlier, providing a return of little more than 0.60% above the 10-year risk free rate. The Commission partly justified such a low WACC on the grounds of the cost sharing mechanism with other carriers, which it claims acts as an insurance premium guaranteeing returns to the TSO businesses, regardless of variations in economic activity. In addition, the ACCC decision on Telstra s PSTN and the French USO decisions are at a greater sub-firm level than others, including Oftel s decision on BT. However, differences in the WACC provided by Oftel to BT is of such a magnitude higher than that provided by the ACCC for Telstra-PSTN (over twice the level) that difference in scope can be ruled out as the prime contributing factor. September 2003:International comparison of WACC decisions Page 80 of 102

81 Figure 16: Telecommunications unadjusted vanilla WACC and asset beta Lower bound FCC (4.6%) Australia UK US NZ France % 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% Figure 17: Telecommunications adjusted vanilla WACC and asset beta Lower bound FCC (4.6%) % 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% Australia UK US NZ France 6.8 Water Table 24 summarises decisions in the water sector. September 2003:International comparison of WACC decisions Page 81 of 102

82 Table 24: Summary of water decisions Country Regulator Decision Date Vanilla WACC margin Increase Revised vanilla applied to WACC margin MRP to give (MRP=6%) 6% MRP Asset beta (debt beta = 0) Australia IPART NSW water businesses Sep % % 0.34 Australia GPOC Tasmanian Water Jul % % 0.39 Australia QCA Gladstone Area WB Sep % % 0.32 Australia QCA Burdekin Haughton Apr % % 0.20 UK Ofwat Water & Sewerage Co s Nov % 2.50% 3.28% 0.40 UK Ofwat Three largest water only co Nov % 2.50% 3.68% 0.40 UK Ofwat Other water only companies Nov % 2.50% 4.03% 0.40 UK CC Sutton & East Surrey Water Sep % 2.00% 4.05% 0.49 UK CC Mid Kent Water Sep % 2.00% 4.17% 0.49 US Maine CMWC Sep % % 0.35 US Conn Valley Water Dec % % 0.60 US Mass Pinehills May % % 0.51 The Ofwat decisions allowed companies that only provide water services a premium on the cost of capital of 0.75% to reflect their limited ability to access capital markets. For the three largest wateronly companies a premium of 0.40% was provided. Ofwat allowances in this table exclude any allowances provided for the cost of embedded debt (up to 0.40%). The QCA decision on Burdekin Haughton Irrigation Area was published as a draft report, with the QCA indicating in the final report that it may revisit these values in the future. While the Ofwat decisions provide similar (unadjusted) margins over the vanilla WACC to the Australian decisions, the asset betas provided are typically higher, indicating that the reason for similar unadjusted allowances is the difference in market risk. On the basis of our analysis, the two companies that appealed Ofwat s decision to the Competition Commission namely Sutton & East Surrey and Mid Kent Water companies received slightly higher WACC allowances than was achieved from Ofwat. In absolute terms this difference is greater given the Competition Commission adopted a real risk free rate of 3% compared with 2.75% by Ofwat. We believe that some of the decisions in Australia should be seen as outliers. For example, the QCA s draft decision on the Burdekin River Irrigation Area provided the lowest WACC allowance of any decision in Australia. The QCA itself may have recognised the severity of this allowance when it noted in its decision that it may subsequently revisit the approach to beta, market risk premium and comparisons with regulatory decisions in a way that could increase the WACC. September 2003:International comparison of WACC decisions Page 82 of 102

83 However, all these allowances are significantly out of line with the decisions in the US. Figure 18: Water unadjusted vanilla WACC and asset beta Australia UK US % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% Figure 19: Water adjusted vanilla WACC and asset beta Australia UK US % 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% September 2003:International comparison of WACC decisions Page 83 of 102

84 6.9 Summary of results While it is appropriate to be cautious in drawing conclusions, particularly for sectors with few decisions, the decisions studied exhibit the following features: ΠΠΠIn the rail, telecommunications and water sectors, regulators in Australia (and New Zealand) have provided lower WACC allowances than in the other countries; there is no evidence of excessively generous returns in the electricity distribution and transmission sector, nor in the gas distribution sector particularly against the US; and across all sectors where there are US comparators, US decisions provide higher margins above the risk free rate than those in Australia and other countries. September 2003:International comparison of WACC decisions Page 84 of 102

85 7 Regulatory context to results For implications to be drawn on the climate facing investors in the various countries, the results need to be considered in relation to the regulatory environment in which the relevant investment is to take place. Some of the key factors to be considered are: ΠΠexpectational factors such as treatment of asset valuation, relative degree of certainty over future WACC allowances and expectations of being able to earn above the WACC; and outcomes including evidence of regulatory risk and whether WACC allowances have been contributing factors. 7.1 Expectational factors Treatment of asset valuation In Australia there is a much greater reliance on asset valuation methodologies that involve optimisation than in the other countries included in this report. Table 25 compares the major asset valuation approaches adopted in Australia, Canada, UK and the US in the key sectors considered in this report. September 2003:International comparison of WACC decisions Page 85 of 102

86 Table 25: Major asset valuation methodologies used, by regulatory sector Sector Australia Canada UK US Airports Mostly DORC IMV Gas For initial valuation can include ODV, DORC, purchase price DHC IMV DHC Electricity Deprival value/dorc DHC IMV DHC Rail Typically DORC DHC IMV DHC Telecom TSLRIC LRIC TELRIC/DHC (where regulator using building blocks) Water DORC and ODV used IMV DHC The acronyms used are: DORC depreciated optimised replacement cost; ODV optimised deprival value; TSLRIC total service long run incremental cost; IMV initial market value; LRIC long run incremental cost; DHC depreciated historic cost; and TELRIC total element long run incremental cost. The application of a wide range of methodologies by itself does not necessarily create regulatory risk. However, the degree of discretion given to Australian regulators has created significant uncertainty. This uncertainty has been particularly evident for existing gas pipelines being regulated for the first time. Section 8.10 of the Gas Code requires the relevant regulator to consider all reasonable approaches to asset valuation as part of its assessment of proposed tariffs. However, the requirement to consider a wide range of asset valuation approaches, including some that are inherently uncertain, can magnify uncertainty. For example, figure 20 sets out the various estimates of the depreciated optimised replacement cost (DORC) value of AGL s gas distribution assets in NSW that were performed by various consultants as an input to its 2000 review by IPART with these estimates ranging from $1.5bn to $3.3bn. September 2003:International comparison of WACC decisions Page 86 of 102

87 Figure 20: Estimates of DORC cited in IPART s decision on AGLGN (2000) upper and lower ranges AGLGN CW (new CW PPK/Kinhill GCI/Kenny CW (rev) (RAAI) entrant) (incumbent owner) While IPART accepted AGLGN s DORC proposal as appropriate, this was not reflected in the opening asset value as the regulator was also required to consider other valuation approaches, with this resulting in the range of possible values set out in figure 21. Figure 21: AGLGN decision IPART estimates of asset valuation ($m) DAC DORC (AGL proposal) ODV DIHC Decision September 2003:International comparison of WACC decisions Page 87 of 102

88 While the Gas Code provisions result in significant uncertainty with respect to existing pipelines when first subject to the Code, the Code does provide a relatively high degree of certainty for these assets in subsequent access arrangements. However, optimisation risk is not exclusively an issue in gas. Asset valuation, including the treatment of land, was a key issue in the ACCC s decision on Sydney airport. Telstra is subject to asset optimisation through the ACCC s TSLRIC methodology. In addition, the scope for asset optimisation is likely to increase in the electricity sector as the scope for the ACCC and other regulators to optimise the regulatory asset base increases over time as jurisdictional derogations expire. By contrast, a relatively high degree of protection for investors has been built into the regulatory frameworks in more developed regulatory regimes. For example, in the UK the decision of most regulators to adopt an initial market valuation approach (plus uplift) to asset valuation in the first regulatory decisions, while not aligning prices to their full economic value, ensured that the price paid by investors who bought equity in a firm at the time of the float would be reflected in the initial asset valuation. Subsequent decisions in the UK have typically rolled such assets forward without optimisation of existing assets. In the electricity sector the risk of asset optimisation is further minimised by Ofgem allowing the UK electricity businesses to depreciate vesting assets over a year period, and tilting the depreciation on assets constructed after vesting to prevent a sharp drop in depreciation allowances when the vesting assets are fully depreciated for price setting purposes. For US network businesses, optimisation risk has been limited outside the telecommunications sector. Avoidance of the impact of optimisation risk has been a key plank of electricity restructuring, with electricity network businesses not only subject to limited (if any) stranding on their system assets, but protected against stranding risk on generation assets. As part of deregulation many US utilities have been required to divest ownership of generation assets and terminate long-term contracts with small independent generators (qualifying facilities). In many cases the economic value of such assets was significantly below the depreciated historic cost, particularly where the utility had invested in nuclear energy or had entered into long run contracts with (marginal) renewable energy suppliers. Competition Transition Charges introduced in several states provided the utility with the equivalent of an accelerated depreciation provision, providing significant benefits to September 2003:International comparison of WACC decisions Page 88 of 102

89 the utilities. For example in California it has been estimated that the Competition Transition Charge payments provided benefit to the utilities of around $28 billion over 4 years Relative degree of certainty over the WACC As the WACC is an imprecise measure, it is inevitable that there is an element of uncertainty in WACC allowances. As can be seen above, some countries have introduced measures to minimise this uncertainty. The methodologies applied in Canadian gas decisions provide a high degree of certainty over how the regulatory return on equity will change over time, while in the US there has been remarkable consistency in the cost of equity capital allowances provided by regulators over time, despite wide variations in the required returns if different methodologies are applied. This in part is likely to reflect lesser reliance on current estimates of bond yields at the time of the regulatory decision due to the adoption of methodologies other than the CAPM for estimating the cost of equity capital. Uncertainty over WACC parameters is prevalent in other countries whose approach to WACC is similar to Australia s. For example, in the UK there is little consensus on the appropriate value of the MRP and regulators adopt a range for the risk free rate. Although regulators in Australia have reached broad consensus on the MRP, the extent of uncertainty in Australia (and New Zealand) is arguably at least as high because: ΠΠΠthe methodological approach to the risk free rate has not been resolved in Australian and New Zealand. By contrast, uncertainty in the UK refers to the actual value of the long term bond, which includes averaging that minimises rate shock; the threat of movement in relation to WACC is asymmetric in that regulators have been flagging shifts in approach to MRP, gamma and beta all of which are in the direction that would reduce WACC, with no corresponding upside; and the WACC, particularly if specified in pre-tax real terms, has greater degrees of uncertainty than in other countries due to the inclusion of gamma in the WACC, the impact of accelerated depreciation providing a wedge between the effective and 93 California ISO, Comprehensive Market Redesign, Cost Impact Analysis, November 3, 2000, p4. September 2003:International comparison of WACC decisions Page 89 of 102

90 statutory tax rate and the widely differing results of WACCs derived from the forward and reverse transformation methods Expectation of earning above the WACC The extent to which a firm could earn above its WACC will depend on the form of price control in place. The ability to earn more (or less) than the WACC is typically higher where a firm is subject to either a price cap or a revenue yield form of price control. By contrast, revenue caps provide less upside benefit. While revenue caps may provide greater protection for revenue against demand shocks, they may expose the business to the impact of higher than anticipated cost increases. 94 Typically, ex post returns to firms operating under cost of service regulation have been capped at the WACC. However, in the US and Canada, increased use of earnings sharing mechanisms and other forms of performance-based ratemaking are permitting returns above the WACC to be earned over a longer period. Given a wide range of pricing methodologies in place across countries we do not believe that at a country-level this is a major distinguishing factor in comparative decisions, except that the US and Canadian decisions still provide greater certainty over ex post WACC even with performance-based ratemaking initiatives. 7.2 Outcomes The impact of WACC allowances on investment and observed service performance is complex. If the WACC is too high, firms will have incentives to bring investment forward as early as can be justified. Under cost of service regulation firms may have incentives to respond to excessive WACC allowances by over-investing or gold-plating assets, often referred to as the Averch-Johnson effect. 94 The revenue cap used by IPART for the NSW electricity distribution businesses has been subject to this criticism. September 2003:International comparison of WACC decisions Page 90 of 102

91 Where the WACC is set too low, companies may not be able to respond by delaying or reducing investment because of service obligations contained in operating licences. 95 When this is the case, the impact of a low WACC may initially be seen through declining equity values (and increased gearing) rather than lower standards of service. The impact of WACC on investment is also complicated as the counterfactual (for example, a world with greater investment) cannot easily be verified, except in cases where the regulator has explicitly turned down proposed investment. 96 In addition, it is often difficult to disentangle the impact of WACC on investment from the wider impact of regulatory uncertainty and risk. The role of cost of capital allowances and broader incentives for investment have been cited in various regulatory developments. This section considers the financing of the UK water and sewerage businesses since Ofwat s 1999 determination, recent electricity blackouts in the US, Canada and the UK and the liquidation of Railtrack in the UK Experience of the UK water sector Our analysis of Ofwat s 1999 determination shows that the allowed cost of capital compares favourably with water decisions in Australia, even before differences in market risk are taken into account. However, there have been claims that Ofwat s WACC allowance has been a key contributory factor in developments since its 1999 determination namely assets being sold at less than the regulatory capital value, 97 a sharp increase in gearing by a significant subset of water businesses and a decrease in the number of listed companies due to delistings. 95 In such cases the impact may be seen in diminishing equity value and a gradual increase in gearing. 96 An example sometimes cited is the decision by the Victorian Office of the Regulator General to prohibit United Energy from undertaking a program of undergrounding cables to be funded from customers outside the regulated price cap. 97 For example, Glas purchased Welsh Water at 93% of the regulatory capital value. September 2003:International comparison of WACC decisions Page 91 of 102

92 Recent cases of financial restructuring, as listed in a report for Ofwat by OXERA 98 are set out in table 26. Table 26: Examples of Financial Restructuring in England & Wales water and sewerage sector Case Gearing Type of deal (% RAB) Glas Cymru acquisition of Welsh Water 93 Acquisition by non-profit company Sutton & East Surrey Water 75 Leveraged recapitalisation Swan Capital Group acquisition of Mid Kent 99 Leveraged buy-out Holdings Drummond Capital acquisition of Brockhampton 85 Leveraged buy-out Holdings Acquisition by First Aqua of Southern Water Na Leveraged buy-out Anglian Water 85 Leveraged recapitalisation South Staffordshire Water 70 Leveraged recapitalisation Source: OXERA (2002) table 2.4 While there is debate as to whether or not these developments are partly a response to the WACC allowance provided by Ofwat, 99 there is a strong perception of regulatory risk in the sector despite a relatively well-developed regulatory framework. As shown in Figure 22, a recent survey of investors commissioned by Water UK 100 found that the key issue facing investors in the UK water sector was regulatory risk. 98 OXERA, The capital structure of water companies, Report for Ofwat, October This was 4.75% post-tax real for the water and sewerage providers. 100 Dr Angela Whelan, Water UK Investor Survey, Key Findings, 7 April September 2003:International comparison of WACC decisions Page 92 of 102

93 Figure 22: Water UK survey investors view of risk profile of UK water industry 101 A key contributory factor to the regulatory risk was seen as the cost of capital allowances: One of the main reasons given was that a harsh review in 1999 left the companies with an insufficient return relative to the risks of investing in the sector. Looking ahead, the main risk facing the sector is uncertainty over PR04 and concerns that future returns will be below the cost of capital and not adequately compensate for the risks associated with investing in the sector. Most investors would not pay a premium to RAV because of these risks. 102 A strong view expressed in the investor survey was that in addition to higher cost of capital allowances there was a need for increased dialogue between the regulator and the businesses and greater transparency about cost of capital assumptions: 101 Ibid, p Ibid, p12. September 2003:International comparison of WACC decisions Page 93 of 102

94 Equity investors are looking for even greater transparency and would prefer greater disclosure and as one respondent put it less vagueness. A request for consistent, open and clear communication to investor groups, clear guidelines (as to what investors should expect at the next review) and the need to maintain and continue the dialogue with investors sums up the views of equity investors with regard to Ofwat s communication strategy with regard to investors. On the issue of increased transparency respondents mentioned the cost of capital assumptions and the future capital programme as important areas for consideration. 103 There is divergence of opinion in the UK on whether the increases seen in gearing are a rational response to low risk in the sector, or whether the provision of low cost of capital allowances by the regulator has forced companies to shift to a debt-financed model. However, what is indisputable is that this is a significant departure from accepted practice and therefore represents a real-life experiment with uncertainty over the final result. The UK water survey backs up the view that this is not without risk. For example, debt investors summarised the sector as follows: The main attraction for debt investors is stable and predictable cash flows. Other attractions include the fact that water is an essential industry, which is regulated. A main downside for debt investor s [sic] is the uncertainty over PR04, particularly in light of the 1999 review, which was perceived as harsh. Other negatives include uncertainty over the capital structure, in particular the risk that if returns to equity investors are inadequate the regulator will effectively force companies to move to a debt-financed model. 104 The mechanisms involved are complex. If the regulator sets too low a WACC, the equity value in the firm will drop and hence the gearing will rise. If we assume the company was at an optimal capital structure before the low WACC, then any change in its gearing will be sub-optimal and further erode equity value. Since it is sub-optimal and value destroying for 103 Ibid, p Ibid, p9. September 2003:International comparison of WACC decisions Page 94 of 102

95 a company to have excessive debt, then it would be expected that the firm should actually reduce debt (to maintain its optimal gearing) in response to the reduced equity value, rather than increase it. If the company uses more debt, it is actually increasing its WACC. Therefore, it is not clear that the type of company action arising in the UK will reduce WACC. However, adopting higher levels of gearing may provide a business with a degree of comfort against regulatory risk if it is perceived that the regulator will respond by increasing required returns when businesses are unable to meet obligations to lenders. The uncertainty surrounding future developments in the England & Wales water and sewerage sector suggests it is dangerous to argue that comparable returns to the UK water and sewerage sector would represent an appropriate regulatory return for Australian companies. If the investor survey is reflective of the actions of investors, it suggests that cost of capital allowances are too low. Furthermore, the regulatory developments have led to changes in financing structure for which the long-term benefit is likely to be negative. The key findings of the Water UK survey - that measures to reduce regulatory risk are critical are equally applicable in Australia, particularly given the less developed regulatory regime here Electricity blackouts in the US, Canada and the UK There have been a number of high profile electricity blackouts in August 2003 in the US and Canada (affecting 50 million customers) and the UK (affecting 250,000 customers in London). While the causes of the US and Canadian blackouts are currently being investigated, there is evidence to suggest that insufficient investment in the transmission network was a key driver of the outages despite the cost of equity incentives provided by FERC to electricity transmission companies to join Regional Transmission Organisations. The state of underinvestment can be seen in the following figures. Figure 23 shows the substantial differential between peak demand growth in the US and the quantum of new transmission: September 2003:International comparison of WACC decisions Page 95 of 102

96 Figure 23: Peak demand growth and new transmission investment Index of Transmission Miles and Annual Load Growth, 1990 = Total Annual Load Indexed, 1990 = 100 Miles of transmission lines >230kv Indexed, 1990= Year Figure 24 sets out the difference between construction expenditure and depreciation of investor owned electricity utilities in the US between 1980 and 2000 September 2003:International comparison of WACC decisions Page 96 of 102

97 Figure 24: Capital expenditure and depreciation investor owned utilities Source: EPRI, Electricity Sector Framework for the Future, Volume 1, Achieving the 21 st Century Transformation, August 2003, p17. The need for investment (and greater co-operation) has been highlighted in many places. By NERC, for example: Federal legislation is required to establish an independent, industry-led electric reliability organization to ensure the continued reliability of the interconnected, high-voltage transmission grid in North America. The existing scheme of voluntary compliance with NERC reliability rules is no longer adequate for today s competitive electricity market. The grid is now being used in ways for which it was not designed, and there has been a quantum leap in the number and complexity of transactions. The users and operators of the transmission system, who used to cooperate voluntarily on reliability matters, are now competitors without the same incentives to cooperate with each other or to comply with voluntary reliability rules. As a result, there has been a marked increase in the number and seriousness of violations of these rules. September 2003:International comparison of WACC decisions Page 97 of 102

98 All of these changes are jeopardizing the very stability of the electric system upon which our economy and our society depends and there is little or no effective recourse today to correct such behaviour. 105 And by informed commentators such as the Edison Electric Institute: To maintain transmission capacity.. relative to summer peak demand would require utilities to construct 54,000 GW-miles during this decade, [at an estimated cost of] $56 billion The deficit in past transmission investment poses large challenges to transmission planners. Not only must they plan for incremental needs, they must also plan to make up for transmission investments that did not occur during the 1990s. 106 Some commentators have also noted the link between the lack of investment and uncertainty over returns. Frank Wolak, Chairman of the Market Monitoring Committee at the California Independent System Operator, notes: the transmission network needed for a wholesale market should be much larger, The utilities said, if we don t know what kind of returns we ll be getting or whether we get to keep our assets, then don t build it. So leading up to restructuring, they didn t build transmission. 107 Two concurrent regulatory failures conspired to cause the hugely costly blackouts. First, local (state-based) regulators were reluctant to approve transmission investment because of a blind focus on short-term lower retail rates at almost all costs, difficulties in assessing the longer-term benefits of transmission and transmission pricing models that did not allocate 105 NERC, Legislative Action is Needed to Maintain Electric System Reliability, August Eric Hirst and Brendan Kirby, Transmission Planning for a Restructuring US Electricity Industry, Edison Electric Institute, June N. Banerjee and D. Firestone, New Kind of Electricity Market Strains Old Wires Beyond Limit, New York Times, 24 August, September 2003:International comparison of WACC decisions Page 98 of 102

99 the costs of new transmission to the grid users that benefit from them. 108 In addition, allowed rates of returns were insufficient for investor-owned utilities to take on the enormous and costly regulatory imposts involved in developing new transmission. FERC is currently seeking to reduce these problems by exerting jurisdiction over the transmission network, encouraging larger transmission operators to evolve that cross utility and state boundaries, and by giving rate increases to transmission owners that fall into line. But these are recent initiatives. The most compelling lesson from the US is that the long-term costs of under-investment, whether caused by insufficient allowed return, other regulatory barriers to investment, or both, are likely to emerge slowly. However, when they do emerge they are likely to be very costly, and to take a long time to rectify. 109 The recent blackout in a large proportion of London is likely to indicate that the sector has similar issues. The fact that these occurred in a network with a single transmission network suggests focus may shift to the regulated rates of return earned by the transmission owner, National Grid Railtrack The Office of the Rail Regulator (ORR) decision on Railtrack provided Railtrack with one of the highest cost of capital allowances made by UK regulators (pre-tax real of 8% based on 50% gearing). However, this did not prevent, within the space of little more than two years, Railtrack from moving to administration and subsequently liquidation, as investors were not prepared to fund necessary investment during a period of significant rail crashes, attributed in part to ageing infrastructure. This experience is consistent with the suggestion that one of 108 For example, the costs of transmission fall upon the rate payers close to where transmission is built. As a result, regulators are reluctant to approve transmission investment in one area that benefits rate payers elsewhere. 109 The events suggest that the first manifestation of insufficient investment is that the risk of low probability catastrophic events increases. September 2003:International comparison of WACC decisions Page 99 of 102

100 the first implications of insufficient investment is that the risk of low probability catastrophic events increases. As a result of these events, it appears likely that the regulator will have to provide National Rail Railtrack s successor with higher capital charges on existing infrastructure. While National Rail is an exclusively debt financed company limited by guarantee, in its recent consultation paper ORR has flagged that the required cost of capital is likely to be in a similar range to that provided to Railtrack. However, the asset base to which this will apply is likely to rise because of one-off adjustments to the regulatory asset base for additional debt that the network business has accumulated over the three years since April 2001: The value of Network Rail s RAB will approximately double as a result of the principles set out by the Regulator at the last periodic review and in previous regulatory statements. In particular, the Regulator confirms in this document his intention to make a one-off addition to the RAB to reflect the additional debt that the network business has accumulated over the three years since April 2001 through its overspending Office of the Rail Regulator, Interim Review of Track Access Charges: Third Consultation Paper, July 2003, p.4. September 2003:International comparison of WACC decisions Page 100 of 102

101 8 Conclusions Our results show that WACC allowances in Australia are not generous in international terms, and certainly not excessively so. The results do not support the assertions of the ACCC that returns compare favourably with those in the UK and US, especially if these decisions are seen in relation to approaches to asset valuation and the overall level of uncertainty in the WACC in Australia and overseas. Even if Australian rates were comparable with overseas rates, the evidence in some key sectors namely in UK rail and water and the US electricity transmission sector supports the view that comparability is not a sufficient condition for ensuring appropriate levels of investment. There is evidence that investment has not occurred in some sectors as required and that investors are seeking to shift away from a partial equity financed model. This evidence is indicative of inadequate rates of return. If WACC allowances are provided to regulated businesses in Australia that are lower than a firm s cost of capital, the impact will ultimately be borne by consumers through inadequate investment and lower service quality. While, in the short run, reductions in service quality may not be evident, because of obligations to supply for example, over time investors will be increasingly unwilling to finance otherwise efficient investments. The examples of the US blackouts and the performance of Railtrack in the UK suggest that the impact of underinvestment will be seen in an increase in the risk of low probability catastrophic events, which are the most economically harmful form of service degradation in that they leave no opportunity for customers to adapt. There is still significant uncertainty over the appropriate value of the WACC in Australia despite a large body of regulatory precedent. The appropriate bond maturity of the risk free rate is a key case in point where the only other country with a similar level of uncertainty is New Zealand. 111 An independent review of the WACC can assist in minimising uncertainty for investors. Additionally, regulatory frameworks can provide greater certainty on the approach the regulator should adopt for the WACC as well as areas such as asset valuation 111 The New Zealand Commerce Commission has based its position on analysis by the same advisor as the ACCC. September 2003:International comparison of WACC decisions Page 101 of 102

102 that impact on investment. The ACCC recognises that the regulatory framework is not as well accepted in Australia as in the UK or the US. In its GasNet decision it noted: However, the Commission is mindful that the regulatory regime in Australia is not as developed and accepted as in the UK and US. 112 NECG believes the Commission has an opportunity within this current inquiry to put in place a framework for the cost of capital, which can act as a template for other access regimes. We look forward to corresponding further with the Commission on these matters. 112 ACCC, Final Decision, GasNet Australia access arrangement revisions for the Principal Transmission System, 13 November September 2003:International comparison of WACC decisions Page 102 of 102