re: wacc methodology research draft report...ipart’s wacc methodology: research – draft report...

4 November 2013

Ms Fiona Towers

Acting Chief Executive Officer Independent Pricing and Regulatory Tribunal

PO Box Q290

QVB Post Office NSW 1230

By email: [email protected]

Copy to: [email protected]

[email protected]

Dear Ms Towers

Re: WACC methodology – Research Draft Report

Please find attached our submission and a report by NERA, on behalf of Sydney Water, that

responds to IPART’s draft report on the WACC methodology.

If you have any questions or queries in relation to our submission, please contact Kris Funston

on 88494856 or [email protected].

Yours sincerely

Sandra Gamble

General Manager, Business Strategy & Resilience

mailto:[email protected]




WACC methodology Sydney Water submission to IPART Draft Report – November 2013

Sydney Water – Submission to the IPART Draft Report on the WACC Methodology

Table of Contents

1 Introduction 5

2 Objectives for setting the WACC 6

2.1 Regulatory objectives of setting the WACC 6

2.2 The overall regulatory framework 7

3 Cost of debt 8

3.1 The term-to-maturity 8

3.2 Averaging short and long-term debt estimates 9

4 Cost of equity 10

4.1 Cost of equity models 10

4.2 Estimating the implied MRP 10

4.3 Equity beta 10

5 WACC determination process 12

5.1 The uncertainty index 12

5.2 Six monthly market updates 12

6 Implied inflation 14

7 Conclusion 15

Sydney Water – Submission to the IPART Draft Report on the WACC Methodology Page | 3

Executive summary The weighted average cost of capital (WACC) is an important component of the overall building block model used by the Independent Pricing and Regulatory Tribunal (IPART) to set regulated prices. Sydney Water agrees with IPART that it is timely to review the method by which it sets the WACC for price regulated businesses. We therefore welcome the opportunity to respond to the IPART’s WACC Methodology: Research – Draft Report issued in September 2013 (Draft Report). In support of our submission we have also provided an independent expert report on key aspects of IPART’s Draft Report by NERA.

IPART’s review of the WACC methodology

The WACC estimates undertaken by regulators since the global financial crisis (GFC) have highlighted issues with the ongoing use of spot market rates and short term parameter estimates. In recent times, the continued decline in the estimate of the risk-free rate has led to concern that the estimated WACC outcome from using short term estimates could deviate significantly from the efficiently incurred debt costs, and reasonable returns to equity. In light of this, Sydney Water commends IPART for being proactive in seeking to resolve this issue and looking to develop a more robust WACC estimation methodology.

In setting a WACC for each price determination, Sydney Water considers in principle any methodology for estimating the WACC must:

encourage and not distort debt raising practices adopted by businesses from sourcing efficient capital markets;

not drive unnecessary refinancing and/or hedging costs;

provide a return on equity consistent with businesses subject to similar economic risks, using a method more robust to the economic cycle;

ensure regulatory discretion is exercised by IPART in a reasoned manner, based on a transparent and consistent framework; and

provide for greater regulatory certainty, allowing regulated businesses to confidently estimate the WACC (within established bounds) that it is likely to receive in a pricing submission to IPART.

Sydney Water’s position on IPART’s draft report

Sydney Water considers the IPART Draft Report on the WACC methodology represents a significant improvement to the approach it previously used. We consider it is likely to avoid some of the issues with the previous methodology, whilst providing for a more robust WACC estimate.

Our position on the key issues in the Draft Report is driven by the overarching objective that the cost of capital and its components, the cost of debt and cost of equity, should be set at benchmark efficient levels and comparable to businesses operating in a competitive market facing similar risks. On that basis, Sydney Water maintains that:

It is appropriate for the regulatory objective to set a benchmark efficient WACC consistent with that of a firm operating in a competitive market facing similar risks. The objective implies that a regulated business that is operating efficiently should expect to have the opportunity to earn a rate of return equal to the estimated cost of capital. Conversely, a business outperforming (or underperforming) its efficiency targets, should be able to earn a return in excess of (or lower than) the estimated cost of capital. However, Sydney Water is concerned that despite the stated objective of the WACC methodology, the overall regulatory framework remains prescriptive, has weak incentive mechanisms, and presently does not support the ability of the businesses to earn commercial rates of return in excess of the estimated WACC.

The term-to-maturity assumption should be ten years, rather than the five years proposed by IPART. The five year term-to-maturity used by IPART is inconsistent with the


debt profile of infrastructure service providers with long lived assets, like Sydney Water, who have average debt tenors of closer to ten years. Further, the use of five year term to maturity estimates ignores significant refinancing risks associated with debt finance.

If IPART chooses not to adopt a trailing average approach to estimate the cost of debt it should consider increasing the weighting on long-term estimates, instead of its proposed simple averaging of the short- and long-term estimates. A trailing average approach represents a ‘benchmark’ cost of debt which reflects that prudent financing practices limit the concentration of debt in any one maturity. Sydney Water though acknowledges the complexity associated with estimating a trailing average. On that basis, rather than adopting a simple average, which we believe does not reflect the debt financing practices of benchmark efficient businesses investing in long-lived infrastructure, we consider applying increased weighting to long-term debt estimates would be more appropriate (e.g. 80% weighting of the long term estimate). Sydney Water maintains that this would more closely reflect the stock and flow capital of infrastructure providers with long-lived assets.

We support the proposal to use other models (where applicable) and other financial market information while continuing to use the Sharpe-Lintner capital asset pricing model (CAPM) as the primary model. If done properly, we believe it will possible to account and adjust for the recognised problem of the downward bias of the CAPM in estimating low beta stocks (i.e. stocks with a beta less than one).

Further consideration should be given to how IPART selects comparable companies and benchmarks for estimating the equity beta. The issues around estimation of the equity beta have not been addressed in sufficient detail in the Draft Report. Estimating an appropriate equity beta is particularly important given the potential for the equity betas of infrastructure assets to be under-estimated when using the Sharpe-Lintner CAPM.

With a number of refinements we believe the proposed new approach for estimating the implied MRP using the six dividend discount models (DDMs) appears to be a positive development that should support more robust estimates of the cost of equity. The proposed refinements are outlined in NERA’s report and are required to avoid potential under-estimation and internal inconsistency in the estimation process. The recommendations by NERA relate to adjusting the dividend yield to take into account the value of imputation credits; measuring the dividend yield on an end of month basis rather than a monthly average; and estimating the MRP within the CAPM rather than within the DDMs.

In principle we support moves to adopt an analytical approach to determine the appropriate WACC point estimate, but have concerns about the current formulation of the proposed uncertainty index and how it will be applied. The proposed uncertainty index would use data that covers periods of instability. This could lead to future periods of uncertainty being incorrectly treated as normal and could therefore result in a downward bias in the WACC point estimate chosen. We would recommend that in order to enable a robust and transparent estimate process, IPART should as part of its proposed six-monthly market update of the WACC estimate, look to provide detail about how the uncertainty index is being used to choose the point estimate.

The estimate of inflationary expectations should be the best estimate of inflation over the course of the regulatory period. This is the only estimate that will provide an efficient business with a reasonable expectation of earning the targeted WACC. Estimating inflation using the approach that is proposed by IPART, will result in an efficient regulated business having an expectation that it will either earn above or below the nominal WACC. The inflation estimate should avoid creating outcomes with such systemic biases.


1 Introduction

This submission has been prepared by Sydney Water in response to the IPART Draft Report released in September 2013 titled WACC Methodology: Research – Draft Report. The Draft Report outlines IPART’s proposed approach in setting values for a number of components and parameters of the WACC. IPART intends to use this methodology for setting the value of WACC in future price determinations.

Key aspects of IPART’s Draft Report include:

A regulatory objective that the cost of capital estimate should represent the efficient cost of capital for a ‘benchmark entity’ that operates in a competitive market and faces similar risks to the regulated business.

A cost of debt estimate based on averaging current market data (i.e. a 40-day average) and long-term averages (i.e. a 10-year average) and using a five-year term-to-maturity.

A cost of equity calculated on the basis of,

o using the standard Sharpe-Lintner CAPM as the primary model for estimation, and where applicable, using other models and financial information;

o a market risk premium (MRP) based on a long-term estimate MRP of 5.5% to 6.5%, and a short-term estimate based on the implied MRP using six different dividend discount models (DDM);

o an equity beta estimate for regulated service providers.

Estimating a point estimate of the WACC by establishing a range based on the short- and long-run estimates; conducting an internal consistency test; and assessing the appropriateness of the WACC mid-point estimate based on an economic uncertainty index.

A hybrid approach to estimating expected inflation.

In our view, IPART’s proposed approach for estimating the WACC represents a significant improvement from the previous method used. We believe that it should avoid some of the issues that the previous approach created and should in principle offer a more robust WACC estimation process that provides greater transparency and certainty for regulated entities. To highlight our current views Sydney Water has structured our current submission as follows:

section 2 assesses the regulatory objectives in setting the WACC;

section 3 examines the cost of debt estimate;

section 4 addresses the cost of equity estimate;

section 5 discusses the proposed method for choosing the WACC point estimate;

section 6 looks at the estimate of expected inflation; and

section 7 concludes the discussion.

The views in this submission reinforce the arguments already made by Sydney Water in previous engagements with IPART, which has included; a submission to the Discussion Paper in December 2012; participation at a workshop in March 2013 and a follow up submission; and a submission to the Interim Report released in June 2013.

Finally, in support of our submission we have also attached an independent expert report by NERA. This examines the estimated cost of debt and the maturity assumptions; the DDM-based implied MRP estimates; the data and assumptions underlying the equity beta estimate; the proposed economic uncertainty index; and the estimation of implied inflation for regulatory adjustments.


2 Objectives for setting the WACC

Sydney Water believes that identifying the right objectives that should be pursued by regulators is central to an effective regulatory regime. As a general proposition, we consider that the WACC objectives should be aligned with broader regulatory objectives that seek to promote the long-term interests of consumers and ensure the long term financial viability of entities providing consumers with essential services.

Sydney Water is generally supportive of the WACC objective proposed by IPART in its Draft Report. We consider that the WACC objective proposed in the Draft Report is appropriately aligned with the broader regulatory objective of promoting the long-term interests of consumers.

2.1 Regulatory objectives of setting the WACC

IPART’s stated objective in the Draft Report, (and in the Interim Report), is that the cost of capital estimate should be consistent with the efficient financing costs that would be faced by a firm operating in a competitive market and facing similar risks to the regulated business. We see the proposed objective having three important features:

first, the relevant benchmark is a firm operating in a competitive market. We agree that this is important, since the financing strategies of regulated business will ultimately be dependent on the rate of return framework set by the regulator (thus creating circularity where the benchmark set is restricted to regulated firms);

second, the relevant benchmark must face similar risks to the regulated business. This is clearly important to ensure that the cost of capital appropriately compensates the regulated business for the risks it faces; and

third, the cost of capital should reflect the efficient financing costs that would be faced by the benchmark firm.

IPART considers that, in practice, the cost of capital and expected return on investment for this benchmark are likely to reflect a mix of current market rates and long-term averages.

The objective in IPART’s original discussion paper had also made reference to the cost of capital for a ‘new entrant’. However, the ‘new entrant’ concept does not feature in the objective set out in the Draft Report, and was also not a feature of the Interim Report.

In Sydney Water’s view, the move away from reliance upon the ‘new entrant’ objective that was outlined in the WACC Discussion Paper1 is a positive step. This approach would have potentially restricted IPART to use of spot rates in determining some market parameters, and could have given rise to significant financeability risks associated with volatility in these spot market rates. This was most recently highlighted in the Hunter Water Pricing Determination.2

Sydney Water considers that the WACC objective set out in the Draft Report is consistent with the broader objectives of the regulatory regime to promote the long-term interest of consumers. As noted in Sydney Water’s submission to IPART’s Draft Decision on financeability tests, building block regulation is fundamentally premised on compensating businesses not for their actual costs, but for the costs that would be incurred by a notionally efficient business.3 In relation to the cost of capital, this implies that the business should be compensated based on a benchmark efficient capital structure, and assuming efficient financing practices. This provides the business with appropriate incentives to seek out efficiencies in its ongoing operations.

1 IPART, IPART Review of method for determining the WACC: Other Industries – Discussion Paper, December

2012, p 12.

2 IPART, IPART Hunter Water Corporation’s water, sewerage, stormwater drainage and other services

Review of prices from 1 July 2013 to 30 June 2017, June 2013.

3 Sydney Water, Financeability tests in price regulation: Response to IPART draft decision, p 20.


Setting the cost of capital based on the efficient costs that would be incurred by a benchmark business is also consistent with providing the right incentives for efficiency. It implies that if the business undertakes innovations that result in superior performance and efficiencies being realised, it can generate a return above the WACC for at least the duration of the regulatory period.

2.2 The overall regulatory framework

Sydney Water agrees with the philosophy underpinning the proposed WACC objective. However, we continue to believe that there are other aspects of the regulatory regime which in practice limit our ability to realise the benefits of efficiency gains and earn a return above the regulated WACC.

The extent to which Sydney Water can in fact achieve efficiency gains and earn above-benchmark rates of return ultimately depends on the “power” of the overall regulatory regime.

The current regime is more prescriptive in terms of pricing and is a “low powered” or “weak” incentive regime. Sydney Water cannot derive the same type of rewards a firm in an effectively competitive market would get from superior performance and from successfully adopting innovations that achieve capital and operating efficiencies. For example, there is no efficiency carryover mechanism in place, meaning that any efficiency gains can only be ‘kept’ by Sydney Water for the remainder of a regulatory period. The absence of an efficiency carryover mechanism potentially creates perverse timing incentives for a regulated business when attempting to realise efficiencies within a regulatory period.

Sydney Water would therefore encourage IPART to consider more broadly how it can enhance the incentives associated with its overall regulatory regime. We would be keen to engage further with IPART on this important issue of examining the form of regulation (e.g. price-cap regulation, revenue-cap regulation, weighted-average price-cap regulation) and increased incentive mechanisms (e.g. capex efficiency benchmarks, a UK-style totex model, efficiency carryover mechanisms) it could look to adopt.


3 Cost of debt

The Draft Report gives rise to a number of issues in regard to estimating the notional cost of debt. This includes the term-to-maturity assumed by IPART and the proposed averaging of a short- and long-term estimates. These issues are discussed below.

3.1 The term-to-maturity

The Draft Report in adopting a five-year term-to-maturity assumption in estimating the cost of debt, relies on the advice of Professor Davis (and similar advice from Dr Lally), which is to match the term of debt to the length of the regulatory cycle.

Sydney Water considers that Davis and Lally approach of matching the term of debt to the length of the regulatory cycle and using a five-year term-to-maturity assumption in estimating the cost of debt, is not consistent with IPART’s WACC objective. In order to be consistent with the WACC objective, the term-to-maturity assumption should reflect the efficient financing practice of firms operating in a competitive market and facing similar risks to the regulated business. This is the approach proposed by the Australian Energy Regulator (AER), who has looked to establish its term-to-maturity assumption for the cost of debt by identifying the term of debt that would be issued by an efficient benchmark entity.

We believe that based upon evidence of both competitive and regulated firms facing similar risks, the term-to-maturity assumption for debt should be set to 10 years. In support of this we note that:

IPART has acknowledged in its Draft Report that there is evidence that the actual debt raising practice of firms in a competitive market involves raising debt with maturity periods of 10 years or longer;4 and

as outlined by NERA, there is evidence that Australian regulated businesses issue debt with a term of approximately 10 years.5

As a shorter term-to-maturity assumption (such as 5 years) does not reflect efficient financing practices, it is also unlikely to compensate the regulated businesses properly for the costs incurred by a notional efficient business in servicing debt. This risks distorting financing practices among regulated businesses, away from what is most efficient. NERA highlights in its report that Professor Davis and Dr Lally in recommending a shorter term cost of debt, have not properly accounted for the significantly higher refinancing risk associated with issuing shorter term debt. NERA states that:6

In our opinion, the analysis presented by Davis and Lally is deficient because it does not consider an important risk arising in the debt financing long lived assets. The relevant risk is that which businesses confront when refinancing debt. Refinancing risk refers to the possibility that conditions in the market for debt are such they do not permit the issuance of debt. During such periods, a firm with substantial refinancing requirements would immediately become financially distressed.

…

4 IPART, IPART WACC methodology: Research-Draft Report, September 2013, p 12.

5 NERA, Response to IPART’s WACC Methodology – Draft Report : A Report for Sydney Water Corporation,

November 2013, p 3.

6 IPART, Response to IPART’s WACC Methodology – Draft Report: A Report for Sydney Water Corporation,

November 2013, pp 2-3


In our opinion, the existence of refinancing risk – and its absence from consideration – is a significant flaw in the analysis presented by Davis and Lally. It also provides a compelling explanation as to why a benchmark regulated businesses would issue debt of a term longer than the regulatory period.

3.2 Averaging short and long-term debt estimates

Sydney Water has previously argued for the use of a trailing average approach to measuring the cost of debt. However we acknowledge the difficulties involved in IPART implementing a trailing average approach, at least in the short term.

We consider that an approach which involves taking into account both the short- and long-term cost of debt estimates would be the next-best alternative to a trailing average approach. It represents significant improvement on the previous approach used by IPART, where the cost of debt was set by reference to spot market rates.

The previous approach did not reflect the efficient financing practices of businesses in competitive markets, as it effectively assumed that it was possible for 100% of debt to be refinanced at the beginning of each regulatory period. IPART’s new approach, as proposed in the Draft Report, is likely to better reflect financing strategies of efficiently managed businesses, whereby only part of the debt portfolio is refinanced at any point in time – meaning that the debt portfolio reflects a mixture of debt vintages.

Sydney Water does however have concerns about the proposed simple averaging of the prevailing cost and its long term average cost in estimating the cost of debt. The proposed 50/50 weighting between the prevailing cost of debt and the long-term average appears arbitrary. It implicitly assumes that approximately half of a business’ debt portfolio is refinanced at any point in time, which may not reflect a business’ efficient financing practice.

Sydney Water considers that the weighting of current and long-term estimates should reflect, on average, the ratio between current debt financing requirements (i.e. the amount to be refinanced in the current period or flow requirements) and the total notional debt in the capital structure (i.e. the stock requirements). If this approach were applied to infrastructure assets, in the absence of large growth in investment being required, we believe that it would result in more weighting being given to the longer term estimates.

For Sydney Water, the relevant ratio would be approximately 20/80 – i.e. 20% weight to be given to the current cost of debt, and 80% weight to historic measures. This is based on Sydney Water’s total notional debt being approximately $8.4 billion (i.e. 60% of the $14 billion regulatory asset base), while the notional debt financing requirement associated with estimated capital investment in the current regulatory period would be approximately $1.56 billon.7

7 Both the total notional debt amount and the new financing requirement estimate assume that 60% of

total capital requirements are debt funded.


4 Cost of equity

4.1 Cost of equity models

Sydney Water supports using other models (where applicable) and other financial market information to determine the cost of equity, while continuing to use the Sharpe-Lintner capital asset pricing model (SL-CAPM) as the primary model. If done properly, we believe it will possible to account and adjust for the recognised problem of the downward bias of the CAPM in estimating low beta stocks (i.e. stocks with a beta less than one).

Sydney Water has previously argued that IPART should avoid relying wholly on the CAPM to estimate the cost of equity. Rather, IPART should acknowledge the weaknesses inherent in its preferred financial model, and have regard to a wider set of relevant approaches to estimating the cost of equity, including information contained in independent expert valuation reports.

The NERA report submitted by Sydney Water in response to IPART’s Discussion Paper identified both strengths and weaknesses associated with the SL-CAPM.8 Among the key weaknesses of this model is that it systematically underestimates the return on low beta stocks and overstates the return on high beta stocks.

We would therefore again encourage IPART to place real weight on alternative models and other financial market information in determining the cost of equity. We would anticipate that in the six-monthly market updates of the WACC (see section 5), IPART would provide clear guidance about how alternative models and other financial information was being incorporated into the estimate.

4.2 Estimating the implied MRP

We believe that IPART’s proposal to use six dividend discount models (DDMs) to estimate the implied MRP is a significant positive step. This approach is likely to provide for a more robust estimate of the implied MRP. The proposed approach is also supported by NERA.

NERA though recommends a number of refinements to IPART’s proposed approach, which Sydney Water supports. These are described in detail in the accompanying expert report and can be summarised as:9

the cost of equity estimate produced by the DDMs should be adjusted to reflect the value of imputation credits;

IPART should use an end-of-month dividend yield in conjunction with an end-of-month market price to avoid internal inconsistency; and

the MRP estimate should ultimately be derived using the CAPM (as the difference between the market return derived from dividend discount models, and the risk-free rate) to avoid inconsistency within the CAPM formula.

4.3 Equity beta

The Draft Report only briefly addresses the important issue of setting the equity beta. Sydney Water has previously indicated the equity beta is an important parameter in estimating the cost equity, and one which deserves careful consideration and analysis.10

NERA notes that the Draft Report does not discuss the critical question of how IPART intends to select a group of comparable companies for the purposes of estimating the equity beta.11 Clearly the choice of the benchmark set will heavily influence the outcome of any beta estimation exercise.

8 NERA, IPART’s WACC Methodology Discussion Paper: A Report for Sydney Water, 14 March 2013, p 12.

9 NERA, Response to IPART’s WACC Methodology – Draft Report: A Report for Sydney Water Corporation,

November 2013, pp 8-11.

10 Sydney Water, Sydney Water follow up submission to IPART discussion paper: Review of method for determining the WACC, 2 April 2013.


The Draft Report also does not indicate how estimates for certain firm (or types of firms) will be weighted, and what other considerations might be taken into account. NERA notes that in this regard, it would be helpful for IPART to signal a clear intention to take into account:12

the effect of known biases in the SL-CAPM; and

the implied equity beta estimates derived from the dividend discount model.

Sydney Water would welcome further engagement with IPART on the process for determining the

equity beta. All stakeholders would benefit from there being increased transparency around IPART’s approach to estimating this important parameter.


November 2013, p 5.




5 WACC determination process

In principle, Sydney Water supports IPART’s proposal to adopt a systematic and analytical approach to determining the point estimate for the WACC and to provide six-monthly market updates. We consider this to be a positive step towards providing increased transparency and robustness around the determination of the WACC point estimate. Over time it should provide regulated businesses with the ability to more accurately estimate the benchmark WACC that IPART is likely to apply in any future pricing determinations.

Given the proposed approach is new, we would therefore encourage IPART to initially provide as much detail as possible in relation to how the WACC point estimate has been chosen. We believe that this could be appropriately done through the planned six monthly update processes.

Sydney Water has provides further comments below on both the proposed uncertainty index and the six monthly update process.

5.1 The uncertainty index

NERA notes that IPART’s proposed use of a Bank of England-developed measure of the extent of economic uncertainty to guide the decision on WACC point estimate has considerable merit.13 However, NERA expresses concern in relation to the potential for this index to be misleading, due to limitations imposed by the period for which data are available.

NERA notes that the period over which the index is measured covers two periods of major financial instability, which implies that using the index going forward may lead to future periods of instability incorrectly being classified as ‘normal’.14 If unstable periods are falsely classified as ‘normal’ due to the way in which the uncertainty index is constructed, this may potentially mask the need to depart from the midpoint WACC, and thus lead to a systematic downward bias in WACC estimates.

Sydney Water therefore supports NERA’s recommendation that the baseline for the uncertainty index be amended so as to exclude periods affected by major market instability.15

5.2 Six monthly market updates

We consider that the proposal to issue regular financial market updates is a positive step by IPART that will increase transparency around the WACC determination process and promote regulatory certainty.

In order to maximise the utility of these regular updates, Sydney Water would encourage IPART to include as much detail as possible on the process that has been undertaken for estimating the WACC at the relevant point in time. In particular, in the WACC market updates IPART should look to demonstrate and provide commentary on how it has applied:

the economic uncertainty index to decide on the WACC point estimate; and

the internal consistency testing to assess the economic sensibility of the cost of equity and the cost of debt estimates.

In relation to the application of the uncertainty index, IPART should provide guidance on:

13 NERA, Response to IPART’s WACC Methodology – Draft Report: A Report for Sydney Water Corporation

November 2013, p 12.






how it will construct the index (including any adjustments to exclude periods affected by major market instability);

what threshold level of uncertainty would need to be reached before a deviation from the mid-point WACC would be justified; and

how adjustments will be made to the WACC estimate or underlying parameters where the index indicates a certain level of market uncertainty.

Similarly, in relation to the internal consistency test, IPART should provide clear guidance on:

how close the estimates of the cost of equity and cost of debt would need to be before any adjustment is made;16 and

how adjustments will be made to each of the underlying parameters estimates where the relevant threshold is reached.

Ideally, the regular updates should include sufficient detail on these and other aspects of the WACC determination process to allow businesses such as Sydney Water to estimate the WACC that would be determined at any point in time.

If this level of detail can be provided by IPART in its regular updates, this will provide stakeholders with a high degree of certainty around the process for determining the WACC that will be adopted in future regulatory processes.

16 We assume that a cost of debt estimate either equal to or above the cost of equity would be considered

problematic by IPART. Assuming both use the same risk-free rate, then it would either mean that the debt margin was too high relative to the overall equity margin (equity beta times the market risk premium), or that the overall equity margin was set too low relative to the debt margin.


6 Implied inflation

In its Draft Report, IPART proposes to adopt a hybrid approach to estimating inflationary expectations, which combines: 17

all available swap market implied inflation expectations from 2 January 2009 to date; and

break-even inflation expectations for the period over which the swap market implied inflation is not available (ie. prior to 31 December 2008).

Sydney Water is concerned that this approach will result in a systematic bias in estimates of the inflation expectation. This means that an efficient regulated business will have an expectation that it will either earn above or below the nominal WACC over the regulatory period.

The estimate of inflationary expectations should be the best estimate of inflation over the course of the regulatory period. This is the only estimate that will provide an efficient business with a reasonable expectation of earning the targeted WACC. Applying a higher (or lower) inflation expectation in determining the WACC will result in a lower (or higher) return on capital than expected.

IPART’s proposed approach is not directed at estimating inflation over the course of the regulatory period. Rather, it involves estimating long-term inflation expectations using historic data. To the extent that inflation over the course of the regulatory period is expected to deviate from the long-term average, then clearly IPART’s approach would deliver a biased estimate of inflationary expectations.

As noted above, a biased estimate of inflationary expectations will mean that an efficient business may expect to under- or over-recover its revenue requirement. If a business expects to under- or over-recover its revenue requirement, then this is likely to distort incentives for efficient investment and efficient ongoing performance.

Sydney Water supports NERA’s recommendation that IPART use an estimate of inflationary expectations which reflects the best estimate of inflation over the course of the regulatory period.18 NERA strongly recommends against using a long term forecast of inflation expectations, and notes that adopting a long-term average would be inconsistent with IPART’s WACC objective.19

17 IPART, IPART WACC methodology: Research-Draft Report, September 2013, p 46.






7 Conclusion

Sydney Water considers the IPART Draft Report on the WACC methodology represents a significant improvement to the approach it previously used. We consider it is likely to avoid some of the issues with the previous methodology, whilst providing for a more robust WACC estimate. We maintain in relation to the WACC that:

It is appropriate for the regulatory objective to set a benchmark efficient WACC consistent with that of a firm operating in a competitive market facing similar risks. The objective implies that a regulated business that is operating efficiently should expect to have the opportunity to earn a rate of return equal to the estimated cost of capital. Conversely, a business outperforming its efficiency targets should be able to earn a return in excess of the estimated cost of capital. However, Sydney Water is concerned that despite the stated objective of the WACC methodology, the overall regulatory framework remains prescriptive, has weak incentive mechanisms, and presently does not support the ability of the businesses to earn commercial rates of return in excess of the estimated WACC.

The term-to-maturity assumption should be ten years, rather than the five years proposed by IPART. The five year term-to-maturity used by IPART is inconsistent with the debt profile of infrastructure service providers with long lived assets, like Sydney Water, who have average debt tenors of closer to ten years. Further, the use of five year term to maturity estimates ignores significant refinancing risks.

If IPART chooses not to adopt a trailing average approach to estimate the cost of debt, it should consider increasing the weighting on long-term estimates, instead of its proposed simple averaging of the short- and long-term estimates. A trailing average approach represents a ‘benchmark’ cost of debt which reflects that prudent financing practices limit the concentration of debt in any one maturity. Sydney Water though acknowledges the complexity associated with estimating a trailing average. On that basis, rather than adopting a simple average, which we believe does not reflect the debt financing practices of benchmark efficient businesses investing in long-lived infrastructure, we consider applying increased weighting to long-term debt estimates is more appropriate (e.g. 80% weighting of the long term estimate).

We support the proposal to use other models (where applicable) and other financial market information while continuing to use the Sharpe-Lintner capital asset pricing model (CAPM) as the primary model. If done properly, we believe it will possible to account and adjust for the recognised problem of the downward bias of the CAPM in estimating low beta stocks (i.e. stocks with a beta less than one).

Further consideration should be given to how IPART selects comparable companies and benchmarks for estimating the equity beta. The issues around estimation of the equity beta have not been addressed in sufficient detail in the Draft Report. Estimating an appropriate equity beta is particularly important given the potential for the equity betas of infrastructure assets to be under-estimated when using the Sharpe-Lintner CAPM.

With a number of refinements we believe the proposed new approach for estimating the implied MRP using the six dividend discount models (DDMs) appears to be a positive development that should support more robust estimates of the cost of equity. The proposed refinements are outlined in NERA’s report and relate to adjusting the dividend yield to take into account the value of imputation credits; measuring the dividend yield on an end of month basis rather than a monthly average; and estimating the MRP within the CAPM rather than within the DDMs.

In principle we support moves to adopt an analytical approach to determine the appropriate WACC point estimate, but have concerns about the current formulation of the proposed uncertainty index and how it will be applied. The proposed uncertainty index would use data that covers periods of instability. This could lead to future periods of uncertainty


being incorrectly treated as normal and could therefore result in a downward bias in the WACC point estimate chosen. We would recommend that in order to enable a robust and transparent estimate process, IPART should as part of its proposed six-monthly market update of the WACC estimate, look to provide detail about how the uncertainty index is being used to choose the point estimate.

The estimate of inflationary expectations should be the best estimate of inflation over the course of the regulatory period. This is the only estimate that will provide an efficient business with a reasonable expectation of earning the targeted WACC. Estimating inflation using the approach that is proposed by IPART, will result in an efficient regulated business having an expectation that it will either earn above or below the nominal WACC. The inflation estimate should avoid creating outcomes with such systemic biases.


Attachment 1 – NERA Report

IPART’s Draft WACC Methodology –

Comments

A report for Sydney Water Corporation

November 2013

Project Team

Greg Houston

Brendan Quach

NERA Economic Consulting

Darling Park Tower 3

201 Sussex Street

Sydney NSW 2000

Tel: 61 2 8864 6500 Fax: 61 2 8864 6549

www.nera.com


CONFIDENTIALITY

We understand that the maintenance of confidentiality with respect to our clients’ plans and

data is critical to their interests. NERA Economic Consulting rigorously applies internal

confidentiality practices to protect the confidentiality of all client information.

Similarly, our approaches and insights are proprietary and so we look to our clients to protect

our interests in our proposals, presentations, methodologies and analytical techniques. Under

no circumstances should this material be shared with any third party without the prior written

consent of NERA Economic Consulting.

© NERA Economic Consulting

IPART's Draft WACC Methodology - Comments Contents


Contents

Executive Summary i

1. Introduction 1

2. Term of Debt 2

3. Equity Beta 5

4. Market Risk Premium 8

4.1. Value of imputation credits 8

4.2. Monthly average dividend yield 10

4.3. Return on the Market 11

5. Measures of Economic Uncertainty 12

6. Expected Inflation 14

IPART's Draft WACC Methodology - Comments Executive Summary

NERA Economic Consulting i

Executive Summary

This report has been prepared by NERA Economic Consulting at the request of Sydney

Water Corporation. Its purpose is to comment on aspects of the Independent Pricing and

Regulatory Tribunal’s September 2013 report entitled the ‘WACC Methodology – Draft

Report’ (the Tribunal’s report). The Tribunal’s report sets out its draft decisions on the

weighted average cost of capital (WACC) methodology to be applied in determining prices

for regulated infrastructure services.

In our opinion, the Tribunal’s report represents a substantial and welcome development of the

current framework for determining the rate of return for regulated businesses.

Notwithstanding, there remain a number of areas where further refinements are warranted. In

this report we set out a number of suggested modifications to the following elements of the

Tribunal’s proposed WACC methodology:

the adoption of a debt benchmark for regulated water service providers with a five year

term to maturity;

the methodology for establishing an equity beta for a regulated infrastructure service

provider;

the estimation of the prevailing market risk premium for use in the cost of equity; and

the application of the proposed indicator of economic uncertainty.

In section 2 we explain why the analysis underpinning the Tribunal’s draft decision to

continue adopting a debt benchmark for regulated water service providers with a five year

term to maturity is misdirected, and so why we believe this aspect of the Tribunal’s decision

is unsafe. Principally, the Tribunal’s report does not give sufficient (or any) recognition to the

refinancing risks associated with debt finance. The existence of refinancing risks provides a

compelling explanation as to why a benchmark regulated businesses issue debt of a term

longer than the regulatory period.

Consistent with the existence of such risks, if the Tribunal were to have regard to the

financing practices of a number of Australian regulated businesses it would note that the term

of debt at issuance is typically ten years, rather than the regulatory period of five years.1

In section 3 we note that the Tribunal’s discussion of the equity beta overlooks a number of

critical methodological issues. In particular, we provide a number of suggestions for selecting

a group of comparable companies for estimating the equity beta. Further, when interpreting

the equity betas estimated from market data, in our opinion the Tribunal should also have

regard to:

1 Using publically available information PwC has estimated that the term at issuance for debt of privately owned energy

network firms in Australia is between 10.21 years.

See PwC, Benchmark debt period assumption: A report for the Energy Networks Association, June 2013, page ii.

IPART's Draft WACC Methodology - Comments Executive Summary

NERA Economic Consulting ii

the effect of known biases in the CAPM, such as that the expected returns for stocks with

a beta less than one have a strong tendency to be underestimated, while the expected

returns for stocks with a beta greater have a strong tendency to be overestimated;2 and

the implied equity beta estimates derived from the dividend discount model (DDM) based

estimates of the cost of equity, as routinely undertaken at the firm level by US regulators.

Section 4 of our report assesses the six DDMs proposed to be relied on by the Tribunal to

estimate the prevailing market risk premium (MRP). Although we welcome the use of DDMs

for use in estimating the MRP, three methodological aspects of the Tribunal’s analysis

warrant refinement, ie:

observed dividend yields need to be adjusted for the assumed value of imputation

franking credits;

the measurement of dividend yields on an average monthly basis should amended so as to

be brought on an end of month basis, so as to bring these into line with the applicable risk

free rate; and

the use of DDMs to estimate a MRP rather than an estimated return on the market

requires care to ensure that there is no inconsistency in the risk free rates being used in

the DDM and CAPM.

Section 5 sets out our concern that the baseline for the Tribunal’s indicator of economic

uncertainty is estimated over a period when two significant financial crises occurred. The

inclusion of such periods of instability into the baseline calculation will introduce a

downward bias in the extent to which the uncertainty indicator captures the degree of future

heightened uncertainty. To remove this potential bias, we suggest that the baseline for the

uncertainty index be amended so as to exclude periods that are clearly affected by the global

financial crisis and the European sovereign debt crisis.

Finally, in section 6 we note that a regulated business should have a reasonable expectation of

achieving the target WACC. We demonstrate that only through the adoption of a best

estimate of inflation over the regulatory period can this objective be achieved. In other words,

the use of long term inflation expectations will provide investors with an expected return of

return that is:

higher than the nominal WACC when inflation expectations over the regulatory period

are higher than long run expectations; and

lower than the nominal WACC when inflation expectations over the regulatory period are

lower than long run expectations.

2 As noted on page 29 of the Tribunal’s report.

IPART's Draft WACC Methodology - Comments Introduction

NERA Economic Consulting 1

1. Introduction

This report has been prepared by NERA Economic Consulting at the request of Sydney

Water Corporation. Its purpose is to comment on aspects of the Independent Pricing and

Regulatory Tribunal’s September 2013 report entitled the ‘WACC Methodology – Draft

Report’ (the Tribunal’s Report). The Tribunal’s report sets out its draft decisions on the

weighted average cost of capital (WACC) methodology to be applied in determining prices

for regulated infrastructure services.

Our report should be read in conjunction with our two previous reports, entitled:

‘IPART’s WACC methodology discussion paper’, 14 March 2013, which commented on

various aspects of the Tribunal’s discussion paper; and

‘IPART’s WACC Methodology – Response to Interim Report’, July 2013, which

commented on the interim WACC methodology applied by the Tribunal in a number of

recent price decisions for various NSW water businesses.

The Tribunal’s report sets out its intention:

to modify the objective for setting the WACC so as to set a value that reflects the efficient

cost of capital for a ‘benchmark entity’;

to establish a WACC range from the mid-points of the ranges estimated using current

market data and long term averages;

to estimate the market risk premium (MRP) used to calculate the cost of equity using

current market data on the basis of six dividend discount models; and

to construct an indicator of economic uncertainty that would be used to determine

whether to adopt a default position above/below the midpoint WACC.

Our report is structured as follows:

section 2 critiques the rationale for adopting a term to maturity of 5-years for regulated

water utilities;

section 3 comments on the proposed approach to estimating the equity beta;

section 4 sets out a number of concerns with the proposed approach to estimating the

market risk premium for the prevailing cost of equity; and

section 5 discusses the Tribunal’s proposed indicator of economic uncertainty.

We have prepared this paper by reference to our experience in advising regulators, service

providers and other stakeholders on how best to determine the WACC to promote efficiency-

related objectives.

IPART's Draft WACC Methodology - Comments Term of Debt


2. Term of Debt

The Tribunal’s report restates its intention to continue to set the cost of debt by reference to

5-year corporate debt,3 with the decision to shorten the term of benchmark debt from 10 years

to 5 years relying substantially on advice provided by Professor Kevin Davis.4

Professor Davis argued that:

the revenues generated by regulatory are reset each a regulatory determination and so the

duration of the real assets involved in access pricing is equal to the length of the

regulatory period (ie, five years), rather than the assets’ economic life;

setting the debt term equal to the length of the regulatory period would result in a NPV=0

outcome, ie, the present value costs of providing the service would equal the present

value of the revenues provided; and

that setting the debt term different from the length of the regulatory period would not

result in a NPV=0 outcome.

The Tribunal’s report also notes that Associate Professor Martin Lally put forward a similar

argument regarding the NPV=0 principle and concludes that, for utilities that are regulated by

way of a building block model:5

Achieving NPV neutrality within our regulatory model means that owners will not be under-

or over-compensated.

In our opinion, the analysis on which the Tribunal relies is misdirected, and so the conclusion

that the debt term should be set equal to the length of the regulatory period is unsafe.

The principal problem with the analysis relied on by the Tribunal is the contention that if the

cash flows generated by an asset are periodically reset during the asset’s economic life, then a

benchmark efficient business would finance this asset with debt of an term equal to and

coincident with the resetting period.

In our opinion, the analysis presented by Davis and Lally is deficient because it does not

consider an important risk arising in the debt financing long lived assets. The relevant risk is

that which businesses confront when refinancing debt. Refinancing risk refers to the

possibility that conditions in the market for debt are such they do not permit the issuance of

debt.6 During such periods, a firm with substantial refinancing requirements would

immediately become financially distressed.

3 Tribunal’s report, page 12.

4 Professor Kevin Davis, Determining debt costs in access pricing, December 2010.

5 Tribunal’s report, page 13.

6 A recent stark example of such an event was the period following the Lehman Brother’s default, when global credit

markets effectively seized up.



To illustrate, consider a regulated utility with a single asset with an economic life of 10 years,

for which the revenues generated by that asset are reset every year. Davis and Lally contend

that such a business would finance its asset with one year debt. In other words, the

benchmark efficient utility would seek debt finance in the market ten times. Although as a

matter of principle adopting a debt term of one year would result in a NPV=0 outcome, such

an approach exposes the utility to material refinancing risk. In other words, if any of the ten

instances in which the utility issues debt fails to raise sufficient finance the utility would

immediately become financially distressed. In practice no business (let alone an efficient

business) would finances long term assets by raising all its debt every year because of the

existence of refinancing risk.

Utilities manage their exposure to refinancing risks by:

limiting the amount of debt that has to be refinanced in any given period, ie, by staggering

their debt issues; and

issuing long term debt.

By contrast, a consequence of the Tribunal’s decision to adopt a five year term is the implied

assumption that a benchmark efficient utility in a competitive market would refinance 1/5th

of

its debt each year (assuming a constant RAB and an optimal debt staggering strategy). In

contrast, a 10 year debt term would imply substantially less refinancing risk since only 1/10th

of its debt requirements would be assumed to be refinanced each year.

It follows that, when deciding on the term of debt to issue, a benchmark efficient utility

would have regard to two competing objectives, ie:

to align the costs of debt financing and the allowed return on debt contained in regulated

revenues; and

to minimise its exposure to refinancing risk.

In our opinion, the existence of refinancing risk – and its absence from consideration – is a

significant flaw in the analysis presented by Davis and Lally. It also provides a compelling

explanation as to why a benchmark regulated businesses would issue debt of a term longer

than the regulatory period.

Further, if the Tribunal were to have had regard to the financing practices of a number of

Australian regulated businesses it would note that the term of debt at issuance is

approximately 10 years rather than the regulatory period of 5 years.7

Further, it is important to note that the use of swaps or other derivative transactions cannot

shorten the term of debt issued by utilities. The use of swaps is common with privately

owned regulated energy network businesses that issue variable rate debt. Variable rate debt

requires the business to pay a fixed margin over the Bank Bill Swap Reference Rate (BBSW).

7 Using publically available information PwC has estimated that the term at issuance for debt of privately owned energy

network firms in Australia is between 10.21 years.

See PwC, Benchmark debt period assumption: A report for the Energy Networks Association, June 2013, page ii.



This type of debt provides the businesses with the opportunity to use fixed rate swaps to lock

in the risk free rate element of its debt costs that corresponds to the level of the risk free rate

used to determine the regulatory WACC. In other words, swaps are a risk management tool

that allows a business to manage the risk of a movement in the risk free rate over time. Since

such a business is, on average, still issuing ten year debt, it must pay a ten year debt premium

(ie, the fixed margin above the BBSW). Further, swaps cannot convert the yield paid by a

business on 10 year debt to a yield that corresponds to five year debt.

Finally, the use of a 10 year debt maturity benchmark years would not over-compensate a

benchmark efficient utility operating in a regulatory framework that resets the debt allowance

every five years. Rather, in this scenario:

the benchmark efficient utility will periodically issue 10 year debt (consistent with the

debt benchmark) to stagger its refinancing requirements to minimise refinancing risks;

the average cost of debt for the benchmark efficient utility at any point in time will be a

historical trailing average of the yield on 10 year debt; and

the allowance for the cost of debt is to be periodically set every five years by reference to

the debt benchmark (ie, debt with a term of 10 years).

Under these arrangements, the benchmark efficient utility would have a reasonable

opportunity to recover the actual debt costs. This is because the yield on 10 year debt

sampled every five years should in the long term be equivalent to the long term average yield

on 10 year debt.

Notwithstanding this conclusion, in any given regulatory period the allowance for the cost of

debt may differ substantially from benchmark efficient utility’s actual debt costs. The

magnitude of this difference would potentially be greater if averaging period used to set the

allowance for the cost of debt every five years is short.8 For this reason, we have previously

recommended that the Tribunal set the allowance for the cost of debt by reference to a long

term average, since this approach minimises potential difference between the return on debt

allowance and the expected required return on debt of the benchmark efficient utility.

8 We note that the possibility of a divergence between the cost of debt allowance set by reference to prevailing debt costs

and a regulated utility’s actual debt costs was the reason that the AER has proposed to adopt a trailing average.

See AER, Explanatory statement: Draft rate of return guideline, August 2013, page 83.

IPART's Draft WACC Methodology - Comments Equity Beta


3. Equity Beta

The Tribunal’s report provides a high level description of the method by which it intends to

estimate the equity beta for regulated businesses. In particular, the Tribunal states it intention:

to use ordinary least squares (OLS) regression analysis of the covariance of individual

stocks and the market portfolio;

to adopt a broad market value-weighted index, such as the S&P 500 for the US stocks, as

a proxy for the market portfolio;

to undertake such analysis using monthly return data, rather than daily, weekly or annual

returns, over a period of around 5-years; and

to adopt a single beta value to be used for the cost of equity using both current market

data and long-term averages.

In our opinion, the elements of the approach outlined in the Tribunal’s report are reasonable.

Notwithstanding, the Tribunal’s report does not discuss the critical question of how it intends

to select a group of comparable companies. The section of comparable companies involves a

series of steps, including the need:

to identify the largest reasonable set of publicly listed companies that might be useful

comparators;

to exclude from this identified group those companies whose equity beta could not be

reliably estimated, such as where the company stock suffers from illiquidity or where the

relevant entity has been subject to a take-over offer; and

to identify those firms that are most comparable to the benchmark firm for which a beta is

to be established, ie those with:

− a significant proportion of assets that are subject to economic regulation;

− similarities in the regulatory regime; and

− the same or similar business activity.

Further, when assessing the estimated equity betas, it would be helpful for the Tribunal to

indicate its intention to place greater weight on those companies that are most comparable to

the regulated entity.

Finally, when interpreting the equity betas estimated from market data, it would be helpful

for the Tribunal to indicate its intention to have regard to:

the effect of known biases in the capital asset pricing mode (CAPM), such as that the

expected returns for stocks with a beta less than one have a strong tendency to be

underestimated, while the expected returns for stocks with a beta greater have a strong

tendency to be overestimated;9 and

9 As noted on page 29 of the Tribunal’s report.



the implied equity beta estimates derived from the dividend discount model (DDM) based

estimates of the cost of equity, as routinely undertaken at the firm level by US regulators.

We note that our recent empirical analysis of the Black CAPM10

demonstrated that there is no

association between beta estimates from regression analysis and subsequently realised stock

returns.11

In other words, empirical evidence shows that stocks with low beta estimates do not

systematically earn lower returns than the market/average firm, while stocks with high beta

estimates do not systematically earn higher returns than the market/average firm.

One consequence of this analysis is that, where the estimated equity beta range is

substantially lower than one, the Tribunal should consider setting an equity beta materially

above the mid-point.

Finally, when determining the equity beta to be applied in its WACC decisions, it would be

helpful for the Tribunal to indicate its willingness to have regard to the implied equity betas

that can be derived from US regulatory decisions, which are predominantly derived by

reference to the DDM estimates. The relevance of such evidence arises because US regulators

are in the advantageous position of being able to draw on data derived from much deeper

capital markets, which allows DDM estimates to be derived with a much higher degree of

confidence than is the case in Australia.

The end result of such estimates is that the returns allowed by US regulators are substantially

above those that would be implied by the strict application of the CAPM.

Table 3.1 below sets out the equity beta estimates provided by SFG in its report for Sydney

Desalination Plant12

and the allowed return on equity published in the AUS Utility Report13

.

10 The Black CAPM relaxes one of the restrictive assumptions of the Sharpe-Lintner CAPM, ie, that all investors can

borrow or lend as much as they like at the risk-free rate. As a result, the yield on a portfolio with a beta of zero would

be above the yield that an investor would earn on a risk free bond.

11 NERA, Estimates of the zero beta premium, June 2013, page 14.

12 SFG, Cost of capital parameters for Sydney Desalination Plant, 10 August 2011, page 12.

13 AUS Utility Report “the investor’s edge”, May 2013, page 18.



Table 3.1

US Water Betas and Allowed ROE

Company SFG(+ market conditions)

a SFG(- market conditions)

b Allowed ROE

American States Water 0.28 0.28 9.99%

American Water Works 0.18 0.57 9.61%

Aqua America 0.50 0.23 10.33%

Artesian Resources 0.01 0.39 10.00%

California Water Services 0.47 0.11 9.99%

Connecticut Water Services 0.38 0.29 9.75%

Middlesex Water 0.36 0.37 10.15%

SJW Corp 0.17 0.66 9.99%

Average 0.29 0.36 9.98%

a OLS Returns-based estimates during months when excess market returns are positive.

b OLS Returns-based estimates during months when excess market returns are negative.

The data in Table 3.1 shows that US regulatory decisions on the allowed return on equity for

regulated water utilities are:

relatively homogeneous and, for the eight decisions listed in the AUS Utility Report,

range from 9.61% to 10.33% - a spread of just 74 basis points; and

substantially above the return on equity that would be implied by each company’s equity

beta, particularly given that US treasury yields at the end of May 2013 were 2.16 per

cent.14

14 See www.treasury.gov.

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2013

IPART's Draft WACC Methodology - Comments Market Risk Premium


4. Market Risk Premium

The Tribunal’s draft decision is to estimate the market risk premium by reference to both a

current, forward-looking estimate as well as to a long term average return on equity, ie:15

for the cost of equity using current market data, the Tribunal proposes to use the six

dividend discount models (DDMs) presented in Table 5.2 which, in June 2013, implied a

MRP range of 6.5% to 7.7%, with a midpoint of 7.1%; and

for the cost of equity using long term averages, the Tribunal proposes to continue to use a

MRP range of 5.5% to 6.5%, based on the historical arithmetic average.

The six DDM models proposed to be used to estimate the current cost of equity are:

Damodaran (2013);

Bank of England (2002);

Bank of England (2010);

SFG analysis-implied;

SFG market-wide indicators; and

Bloomberg.

In estimating these models, the Tribunal has indicated that it will rely on the SFG paper

entitled Market risk premium, which was attached to the Tribunal’s May 2013 Interim Report.

For the first three of these models, the Tribunal intends to use the S&P/ASX 200 index as

being representative of the Australian stock market. Further, we understand that, when

estimating these models, the Tribunal has used the following common parameters:

P0 is the end of month level of the S&P/ASX 200 index;

D0 is the monthly average dividend yield on the S&P/ASX 200 index;

risk free rate (rf) is the monthly average yield on 10-year CGS; and

the long term constant growth rate of dividends (g) of 5.5%.

In our opinion, the Tribunal’s proposed approach to the use of DDMs to estimate the

prevailing cost of equity is a significant and positive step. Notwithstanding, there are three

aspects of the Tribunal’s draft proposals that warrant refinement. We discuss these in turn

below.

4.1. Value of imputation credits

Since 1 July 1987 Australia has had an imputation tax system. Under this system, franking

credits are created when a company pays Australian corporate taxes on its profits. Companies

15 Tribunal’s report, pages 15-16.



with franking credits are then able to attach these credits to dividends. Under the current

company tax rate, a fully franked dividend carries 30 cents of imputation credits for every 70

cents of cash dividends. Distributed credits may then be used by those receiving dividends to

offset any individual or institutional Australian tax liabilities.

In keeping with the approach adopted by all other Australian regulators, the Tribunal reduces

the allowed revenues of regulated businesses to take account of the benefit that equity owners

receive from the ability of a regulated entity to provide franked dividends. The extent of the

downward adjustment (expressed as a proportion) to the estimated cost of corporate taxes to

be paid by an infrastructure service provider is called gamma.

Gamma represents the value that equity investors place on the franking credits created

through the payment of company income tax and is generally estimated as the product of two

elements:

1. the payout ratio, being the proportion of created credits distributed by companies to their

shareholders; and

2. theta, being the market value of distributed imputation credits as a proportion of their face

value.

The most commonly used value for gamma is 0.25, which was determined by the Australian

Competition Tribunal (ACT) in the appeal by ETSA Utilities, Ergon Energy and Energex of a

determination by the Australian Energy Regulator (AER) that determined the value of gamma to

be 0.65 (a higher value representing a larger, proportionate downward adjustment in the

allowance for the cost of tax).

The ACT determined the appropriate payout ratio to be 0.7, and an appropriate level of theta to be

0.35, the combination of which gives rise to a gamma value of 0.25.16 The gamma value of 0.25

determined by the ACT is also the value that the Tribunal proposes to use.17

One consequence of the framework for incorporating the value of imputation credits into the

revenue determination process is that, if imputation credits have value to equity owners, then

this value needs to be incorporated into any DDM estimate of the cost of equity.

One method for achieving this is to use the relationship set out in the Tribunal’s post-tax

WACC where:

[

]

[

]

16 Application by Energex Limited (Gamma) (No 5) [2011] ACompT 9 (12 May 2011), paragraph 42.

17 IPART, Discussion Paper, 14 March 2013, page 19.



An alternative method is to apply a scaling factor of 1.1125 to the observed dividend yield.

This scaling factor is derived from:18

a corporate tax rate of 30%;

the value of imputation credits distributed (theta), being 35% of their face value; and

the proportion of dividends that are franked, being 75%.19

The value of 1.1125 is calculated as:

Both approaches result in similar adjustments to the DDM estimates of the return on the

market.

4.2. Monthly average dividend yield

The Tribunal proposes to use month average dividend yield together with an end of month

share price.

In our opinion, this approach has potential to be internally inconsistent. This is because the

dividend yield is calculated by dividing earnings per share (EPS) forecasts by the relevant

market price. In other words, since the dividend yield is a function of the market price it is

internally inconsistent to use a monthly average of the market price to determine the dividend

yield together with an end-of-month market price in the DDM.

By way of example, consider a scenario where the price of shares in the S&P/ASX 200

consistently fell over a month, but where the market wide EPS remained constant. In this

scenario the market dividend yield will increase over the month, and the monthly average

dividend yield will reflect prices in the middle of the month. If an end-of-month share price is

then used to derive the monthly dividend yield, the resulting estimate will be downwardly

biased, since the dividend yield at the end of the month will be higher than the monthly

average. In our opinion, it would be preferable to use an end-of-month dividend yield in

conjunction with an end-of-month market price.

18 See CEG, Internal Consistency of Risk Free Rate and MRP in the CAPM, March 2012, page 17.

19 Brailsford, T., J. Handley and K. Maheswaran, Re-examination of the historical equity risk premium in Australia,

Accounting and Finance 48, 2008, page 85.



4.3. Return on the Market

DDMs can be used to derive estimates of the return on the market. In our opinion, the

Tribunal’s estimation of the prevailing MRP within its DDMs is unnecessary and can

potentially give rise to an inconsistent application of the CAPM.

Rather, the MRP should be estimated within the CAPM as the difference between the

expected return on the market (derived from the DDM estimates) and the CAPM risk free

rate.

Calculating the MRP within the DDM has the potential for inconsistency between the risk

free rate used in the DDM and that used in the CAPM. The chance of inconsistency is very

high for regulated water utilities were the Tribunal to adopt:

a five year risk free rate in the CAPM; and

a 10 year risk free rate in the DDM to estimate the MRP.

The use of both a five year and a ten year risk free rate would mean that the CAPM formula

would be:

])[E()E( 105 yr

fmj

yr

fj RRRR

The use of different risk free rates would be inconsistent with the theory of the CAPM.

Furthermore, an asset with an equity beta of one would not earn the expected return on the

market due to the difference in the yields on 5 and 10 year CGS yields.

IPART's Draft WACC Methodology - Comments Measures of Economic Uncertainty


5. Measures of Economic Uncertainty

IPART’s draft proposal to use an Australian application of a Bank of England-developed

measure of the extent of economic uncertainty has considerable merit. Our understanding is

that this indicator of economic uncertainty will inform Tribunal decisions as to whether or not

to depart from the midpoint of the WACC range. In other words, the Tribunal will consider

departing from the midpoint WACC if the index exhibits:

a spike above zero, in which case the Tribunal will consider selecting a point estimate

above the midpoint of the WACC range; and

a spike below zero, in which case the Tribunal will consider selecting a point estimate

below the midpoint of the WACC range.

The index is constructed from three series, being:

S&P/ASX 200 VIX derived from the S&P/ASX 200 index option prices, which provide

insights into the anticipated levels of near-term volatility in the Australian equity market;

the dispersion in analysts’ forecasts of earnings for companies in the S&P/ASX 200,

which provides an indicator of the degree of consensus amongst analysts reported by

Thomson Reuters Datastream; and

the difference between UBS Australian all maturities credit yields and UBS Australian

Treasury all maturities yield.

The Tribunal’s indicator of economic uncertainty is calculated monthly from November 2000,

before which data on analysts’ forecasts of earnings is not available from Datastream.20

The

uncertainty index is therefore normalised over the period since November 2000.

Although we believe the estimation and application by IPART of the uncertainty index as

one of the decision making tools for determining the WACC point estimate amounts to a

significant and positive step, account needs to be taken of the limitation imposed by the

period for which data are available. In particular, the period over which index is measured

includes two significant financial crises – the global financial crisis as indicated by the failure

of Lehman Brothers on 15 September 2008, and the European sovereign debt crisis that

manifested in late 2009.

As a matter of principle, if the objective of the uncertainty index is to assess when market

conditions are abnormal, then the baseline should exclude periods of considerable financial

instability. The inclusion of such periods of instability into the baseline calculation introduces

a downward bias in the extent to which the uncertainty indicator will capture the implications

of future heightened uncertainty. The potential risk is that the indicator will mask the need to

depart from the midpoint WACC because conditions are falsely assessed to be ‘normal’,

when in fact a value above the mid-point should be adopted because what appears ‘normal’

amounts to a period of heightened economic uncertainty.

20 We understand that that the S&P/ASX 200 VIX series is extrapolated back to November 2000 using observed volatility

in the S&P/ASX 200 Index.

IPART's Draft WACC Methodology - Comments Measures of Economic Uncertainty


To remove this potential bias we suggest that the baseline for the uncertainty index be

amended so as to exclude periods affected by the global financial crisis and the European

sovereign debt crisis.

IPART's Draft WACC Methodology - Comments Expected Inflation


6. Expected Inflation

This section responds to the Tribunal’s draft approach for estimating long-term inflation

expectations.21

The Tribunal proposes to estimate 10 year inflation expectations using a

combination of methods. We do not offer any comment on whether the approach proposed by

the Tribunal to estimate inflation expectations is appropriate. Rather, we assess the

appropriateness of using long term inflation expectations instead of a best estimate of

expected inflation over the regulatory period.

The draft objective for the WACC is to establish a value that reflects the efficient cost of

capital for a benchmark entity. The Tribunal’s proposes to set this rate having regard to

estimates of prevailing and long term nominal returns on debt and equity. Although we have

a number of suggested modifications, we believe that the proposed approach represents a

substantial enhancement on the current method for determining the rate of return for

regulated businesses. Nevertheless, in our opinion, the Tribunal’s approach to setting

inflation expectations is inconsistent with its stated WACC objective.

The reason the proposed approach to inflation expectations is inconsistent with its stated

WACC objective is evident when one considers the role of inflation expectations in the

determination of allowed revenues in the process of setting regulated prices. Within the

Tribunal’s regulatory price/revenue modelling, inflation expectations determine how the

nominal WACC will be recovered, ie, the proportion that is expected to be recovered from:

an appreciation in the nominal value of the RAB through indexation; and

the amount that will be recovered during the regulatory period from customers through

the return on capital building block.

In other words, since inflation expectations form the basis for the expected appreciation of

the RAB due to indexation, the amount that needs to be included in regulated revenues is the

target rate of return less the expected appreciation of regulated assets. Further, since the RAB

at the end of the regulatory control period is rolled forward on the basis of actual inflation

rather than forecast inflation, the regulated regime protects the business from inflation risk, ie,

unanticipated inflation outcomes.

In our opinion, the Tribunal has wrongly adopted the presumption that it should adopt a long

term forecast of inflation expectations. This approach is problematic when the long term

inflation expectations differ substantially from the forecast of inflation over the regulatory

period. Using inflation expectations measured over a different period from that for which

prices are to be determined will lead to an over- or under-recovery of revenue. This outcome

can be demonstrated by the following example.

Adopting the simplifying assumptions that:

there is no company income tax;

21 IPART, WACC Methodology: Research – Draft Report, September 2013, pp.45-47.



the regulatory period is four years;

the ten year nominal WACC is 8.0%;

forecast inflation is 3.3% over four years of the regulatory control period; and

the long term average inflation forecast is 2.7%.

In this scenario, adopting a long term average inflation forecast means that the return on

capital earned on the RAB is 5.3%22

over the five year regulatory period. However, the

expected indexation of the RAB during the four years of the regulatory period is 3.3%.

Consequently, the expected total return (in revenues and indexation) would be 8.6% (ie, 5.3%

in revenue plus 3.3% through indexation). Therefore, using a long term estimate of expected

inflation means that, at the start of the regulatory period, the return that the business expects

to earn over the regulatory period is greater than the nominal WACC assessed by the

Tribunal, ie, 8.6% expected return vs an efficient return on capital of 8%.

In contrast, if inflation expectations are set on the basis of the expected inflation over the four

years of the regulatory control period then the return on capital earned on the RAB is 4.7%.23

Since, the RAB is expected to appreciate by 3.3% per annum over the regulatory period the

expected rate of return over the regulatory period is equal to the nominal WACC, ie, 8.0%.

Using a long term inflation forecast will provide investors with an expected return of return

that is:

higher than the nominal WACC when inflation expectations over the regulatory period

are higher than long run expectations; and

lower than the nominal WACC when inflation expectations over the regulatory period are

lower than long run expectations.

We note that using a best estimate of inflation over the regulatory period is consistent with

adopting a debt term of ten years. This is because, in the Tribunal’s financial model, inflation

expectations determine the proportion of total returns that a business receives as between

expected current revenues and expected capital appreciation. In other words, using a best

estimate of inflation over the regulatory period is necessary to ensure that a regulated

business has an expectation of earning (through revenues and capital appreciation) the target

return required by debt and equity owners.

In light of these observations, we believe it would be helpful if the Tribunal were to estimate

and apply an assessment of inflation expectations that is the best estimate of inflation over the

regulatory period. This would ensure that the amount that the regulated business expects to

22 We note that with inflation expectation of 2.7% the real WACC would be 5.16%, however when determining the return

on capital building block revenue we understand that the Tribunal indexes the opening RAB by (1+ expected inflation)

this effectively means that the regulated business earns 5.3% - ie, 5.3% = 5.16%*(1+2.7%) - on the opening RAB each

year.

23 Again, we note that with inflation expectation of 3.3% the real WACC would be 4.55%. However, when determining

the return on capital building block revenue we understand that the Tribunal indexes the opening RAB by (1+ expected

inflation) this effectively means that the regulated business earns 4.7% - ie, 4.7% = 4.55%*(1+3.3%) - on the opening

RAB each year.



earn at the start of the regulatory period through revenue and asset appreciation equals the

nominal WACC.

IPART's Draft WACC Methodology - Comments


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