AER INFLATION REVIEW
Public Forum
14 June 2017
1
Regulatory treatment of inflation
Two key issues:
• Best estimate of expected inflation rate?
• Mismatch between expected inflation and inflation outcomes
2
ISSUE 1
Best estimate of expected inflation
3
Best estimate of expected inflation rate
Four possible approaches:
• RBA forecasts and target band (current approach)
• Bond break-even
• Inflation swaps
• Surveys
4
RBA forecasts & target band approach
Year
Inflation rate
Source
1
2.00%
RBA forecast
2
2.00%
RBA forecast
3
2.50%
Mid-point of RBA’s target band
4
2.50%
Mid-point of RBA’s target band
5
2.50%
Mid-point of RBA’s target band
6
2.50%
Mid-point of RBA’s target band
7
2.50%
Mid-point of RBA’s target band
8
2.50%
Mid-point of RBA’s target band
9
2.50%
Mid-point of RBA’s target band
10
2.50%
Mid-point of RBA’s target band
Average
2.45%
Geometric average
5
Bond break-even
Fisher equation:
(1+ nominal interest rate) = (1+ real interest rate) * (1+ expected inflation rate)
Re-arranged:
Expected inflation rate = (1+ nominal interest rate) – 1
(1+ real interest rate)
6
Inflation swaps
7
Survey estimates of inflation
•
•
•
•
•
Consensus Economics
The RBA survey of economists
Sydney Uni survey of union officials
Melbourne Institute survey of consumers
The AGE survey
8
Evaluation of different approaches
Current evidence suggests long-term inflation expectations:
• Are anchored to the RBA target band
• Are relatively stable over time
• Do not respond to surprises in short-term inflation outcomes
Gillitzer and Simon (2015)
Kuttner and Robinson (2010)
Paradiso and Rao (2012)
Mallick (2015)
Finlay and Wende (2011)
Jaaskela and McKibbin (2010)
Leu and Sheen (2006)
9
Evaluation of different approaches
On stability / volatility:
Market-based measures
(swaps & break-even)
Less stable, more volatile
RBA forecasts &
target band
More stable, less volatile
10
Evaluation of different approaches
11
Evaluation of different approaches
12
Evaluation of different approaches
13
Evaluation of different approaches
Potential limitations of RBA approach:
• RBA forecasts are also a policy tool
• Unbiased if expectations remain anchored
• Evidence supports a relatively stable, anchored estimate - but how stable?
• How much should the estimate deviate from RBA target (2.5%) as a
reflection of current economic conditions?
• Currently informed by RBA short term forecasts
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Market measures – potential biases and risk premia
Bond break-even
Inflation swaps
Liquidity premia
Hedging costs
Inflation risk premia
Inflation risk premia
Convexity bias
Inflation indexation lag
Inflation indexation lag
Liquidity premia
Inflation risk premia in indexed bond yields: indexation lag
premia
Counterparty default risk
premia
Inflation risk premia in indexed bond yields: post-tax variability
of indexed bond cash flows
Mismatched pattern of cash flows
Changes to the demand for and supply of indexed and nominal
CGS that are unrelated
to changes to inflation expectations
Sensitivity of the BBIR to short term inflation expectations when
calculated from coupon-paying bonds
The effect of the deflation floor on the yields of indexed CGS
Personal price indices and the substitution effect
15
Evaluation of different approaches
• Bond break-even subject to numerous biases that are hard to adjust for
• Scale and sign of biases unlikely to be robust to different studies
• Uncertainty of net effect
• Evidence that biases and premia are time-varying
• Historical estimates may not be reflected in current bond prices
• Swaps may be subject to bias
• Less potential biases, may be immaterial
• But Australia-specific evidence is limited
• Surveys
• Academic studies often use surveys as benchmark
• Limited supply of 10yr surveys, not public, not disaggregated
• RBA forecasts likely encapsulate survey data
16
Best estimate – next steps
• Are expectations still stable & anchored?
• Does the RBA approach get the ‘right’ short-term variation around the
2.5% target?
• Are biases and risk premia in market measures material?
• Can we reliably adjust for biases and risk premia?
• Which market measure is most reliable?
• If concerned about de-anchoring, are market measures or surveys more
reliable?
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ISSUE 2
Mismatch between inflation
inflation expectations
and
inflation outcomes
18
Mismatch between expectations and outcomes
Inflation outcomes can vary from even the best expectations
Does this lead to over or under compensation?
Depends:
• Over/under relative to benchmark
• On what term is the benchmark set – nominal or real?
• Is level of benchmark commensurate with risk?
Currently we provide (in effect) a real allowance, with an inflation passthrough
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Regulatory treatment of inflation
Regulatory process:
• Revenue determinations
• Set first year revenue allowance
• Set X Factors (amount of real change in revenue allowance from year
to year)
• Annual pricing determinations (gas: tariff variations)
• Set prices by:
• Beginning with first year revenue allowance
• Implementing X Factors
• Adding actual inflation outcomes
• Adding other revenue factors (incentive payments, etc)
• Roll-forward asset values
• At end of period
• Inflate asset values to reflect actual inflation
outcomes
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Regulatory treatment of inflation
Example:
Initial revenue allowance in PTRM
• Change in nominal allowance from year 1 to year 2
• Expected inflation rate
• Change in real allowance from year 1 to year 2
• X factor*
3.70%
2.50%
1.17%
-1.17%
Final revenue allowance from annual pricing
• X factor*
• Actual inflation rate (CPI)
• Change in nominal allowance from year 1 to year 2 #
-1.17%
1.90%
3.10%
Actual nominal revenue allowance is 60 basis points lower than initial PTRM
Because actual inflation was 60 basis points lower than initial PTRM
* framework is CPI minus X, so a real increase is negative X factor
# calculated as (1+CPI)*(1–X)
21
Real return + inflation pass-through
So, in general:
• Provide a real return
• Ensure revenue each year reflects
• real return
• + actual inflation outcomes
• Ensure residual value (RAB) reflects
• Actual inflation outcomes
 Real return + inflation pass-through
Based on a real return benchmark, no over or under compensation due to
inflation surprises
22
Regulatory treatment of inflation
Real return and inflation ‘pass-through’
This is the general principle of the ‘CPI minus X’ regime
But there are some ‘complications’
• First year revenue allowance set based on inflation projection (no pass
through)
• Lagged CPI used for actual inflation outcomes (overall effect in long run?)
• Trailing average cost of debt with ‘on-the-day’ inflation expectations
23
Inflation and risk
Business proposals: depreciation values based on actual inflation outcomes
(instead of expectations) to match RFM
Result:
• actual inflation used to set prices = expected inflation in PTRM
• real return + inflation in PTRM = real return + inflation in pricing and RFM
• X-factors (real return) will vary to be residual of nominal return and actual
inflation
 nominal return is set, rather than real return
If we change to setting nominal return, how does this change risk and efficient
compensation for risk?
24
Inflation risk and network businesses
We set revenue allowance – ultimate returns depend on cost performance
Some costs fixed nominal terms, some change with inflation
Setting real revenue/return in the presence of fixed nominal costs may
introduce default risk
Setting nominal revenue/return in the presence of inflation-linked costs may
introduce inflation risk for equity investors
Third option: hybrid approach
• Set return based partially on nominal amount, partially on real amount
• Weights based on portion of costs that are fixed in nominal $
• Removes inflation risk?
25
Inflation risk and network businesses
Benchmark rate of return :
• Nominal bond markets
• Investors risk inflation eroding real value of returns – include risk premium
• We do not remove this inflation risk premium
Is the premium from bond markets commensurate with risks faced by
regulated network businesses?
What if we change approach?
26
Inflation risk and network businesses
Inflation and rate of return
• Default risk – reflected in credit rating?
• Default risk – impact on benchmark efficient gearing?
• Inflation risk and equity beta?
• Overall effects?
• Likelihood of robust estimation?
• Value of regime stability?
27
Inflation risk and consumers
• Currently, we set X factors, reflecting real change in revenue / prices
• Ultimate price changes will reflect set X factors and actual inflation
outcomes
• For consumers: uncertainty over ultimate nominal price/bill
• If we change to a set nominal return, in effect, we will set the nominal
change in revenue prices
• For consumers: risk that income inflation doesn’t align with our
projected inflation (built into energy prices)
• Uncertainty over affordability
28
Inflation risk and consumers
What do consumers value most?
• Certainty of ultimate nominal price / bill?
• Certainty of affordability of price / bill?
What if one of these options came with a lower rate of return, resulting in
lower real bills?
Consumer value of regime stability?
Note: certainty of ultimate nominal price / bill refers to network charges
• Network charges ≠ retail prices
• Network charges are more than CPI minus X
• Incentive payments, licence fee true-ups, pass-throughs, DMIS, etc
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Regulatory treatment of inflation
Overall:
• Should the regulatory allowance, set up front, be denominated as:
• Final nominal value of revenue / price?
• Real value of revenue / price with an inflation pass-through?
• Some hybrid of real & nominal?
• If we change approach:
• How does this change risk? For consumers? For the regulated
business?
• What is the efficient rate of return?
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