Review of the WACC/discount rate
Electricity Commission
Draft decision on Transpower’s Auckland
400kV grid investment proposal
A report prepared by Marsden Jacob Associates
for Mighty River Power
22 June 2006
This report has been prepared in accordance with the scope of services described in the contract or
agreement between Marsden Jacob Associates Pty Ltd ACN 072 233 204 (MJA) and the Client. Any
findings, conclusions or recommendations only apply to the aforementioned circumstances and no
greater reliance should be assumed or drawn by the Client. Furthermore, the report has been prepared
solely for use by the Client and Marsden Jacob Associates accepts no responsibility for its use by other
parties.
CONTACT:
Dr. Jeff Washusen
Mr. Jasper Boe Mikkelsen
[email protected]
[email protected]
Financial & Economic Consultants
Level 3, 683 Burke Road, Camberwell, Victoria 3124
Tel: (03) 9882 1600 Fax: (03) 9882 1300
Email : [email protected]
TABLE OF CONTENTS
Page
1.Introduction and Summary .................................................................................................1
2.Background ..........................................................................................................................4
3.Update of WACC over time ...............................................................................................12
4.Use of CC WACC................................................................................................................14
4.1.The CC’s approach ....................................................................................................14
4.2.Changes needed to the WACC .................................................................................16
4.2.1. Treatment of tax ............................................................................................16
4.2.2. Nominal vs. real.............................................................................................19
4.2.3. Conversion from nominal post tax to real pre-tax .........................................20
4.3.Estimation of the WACC ............................................................................................21
5.MJA adjustments to CC WACC ........................................................................................25
5.1.PTMRP.......................................................................................................................26
5.2.Beta............................................................................................................................32
5.3.Leverage ....................................................................................................................34
5.4.Debt Premium ............................................................................................................35
5.5.Summary of estimates ...............................................................................................38
6.Additional adjustments .....................................................................................................40
Mighty River Power
Comments on the WACC / discount factor
1. Introduction and Summary
1.
Marsden Jacob Associates (MJA) has been requested by Mighty River Power
to provide comments on the discount rate to be used for application of the
Grid Investment Test (GIT). This request arises from discussion relating to
electricity transmission investments in the Electricity Commission’s (EC)
Draft decision on Transpower’s Auckland 400kV grid investment proposal
for the purposes of consultation under section III of part F of the Electricity
Governance Rules 2003 (26 April 2006).
2.
Specifically, Mighty River Power has requested comment in relation to four
issues:
ƒ
the impact on the 7.0% real, pre-tax discount rate adopted by the EC
arising from changes in interest rates since 2004;
ƒ
whether extrapolation of the WACC value determined by the Commerce
Commission (CC) for Unison’s electricity lines business (ELB) to a GIT
discount rate is appropriate;
ƒ
adjustments that could be made to the CC’s Unison WACC value to
determine an appropriate WACC for Transpower; and
ƒ
adjustment that could be made to reflect (i) differences between the
WACC for a transmission and ELBs; and (ii) differences between the
regulatory context of price control (Unison) and application of the GIT.
3.
The comments and opinions expressed in this paper are those of MJA and do
not necessarily reflect those of Mighty River Power. No part of this
submission is confidential and MJA has no objection to it being made
publicly available.
4.
Our findings and recommendation are summarised below:
ƒ
We note that the EC's focus is not on WACC per se as it would be
applied in revenue and pricing determinations. However, once the GIT
has been approved, the resulting network investment will be subject to
Section 17 of Part F of the Electricity Governance Rules (EGRs), which
allows Transpower to recover the investment cost including the cost of
capital.
ƒ
We agree with the EC (and its consultants) that the prime function of the
discount rate in a GIT analysis is to assist in ranking investment options
with differing cost/benefit value streams. The value of the discount rate
will make substantial changes to numerical outcome of an NPV analysis.
1
Mighty River Power
Comments on the WACC / discount factor
ƒ
There is no fundamental reason why a GIT discount rate need be the
same value as an 'efficient WACC', even though it is sensible to
undertake analysis of investment options using a discount rate that has a
value that is not too dissimilar to an 'efficient WACC'. However, it is our
view that the GIT should use a ‘default’ discount rate with the same
value as an ‘efficient WACC’. This is clearly the simplest approach. It
is our view that adopting such an approach should assist in improving
transparency (and reducing the obvious confusion) that surrounds
selection of a WACC/discount rate value in both the GIT and the
revenue/pricing process.
ƒ
We believe it would be sensible, and reasonably transparent, to conduct
sensitivity analyses using discount rates lower and higher than an
'efficient WACC’. We acknowledge that this view is different to that
adopted by the ACCC which determined that the regulated WACC
should be the minimum value of the discount rate to be applied in the
ACCC regulatory test, which has many attributes that are identical to the
GIT.
ƒ
Having said that, we also believe it would be prudent for the EC to
explicitly commit to determination of an 'efficient WACC' for
Transpower, which would be subsequently adopted as the 'default'
discount rate in the GIT - especially given that a value of 7% real, pre-tax
appears to be above the 'cautious and conservative' values adopted by
Australian regulators using parameter values at the high end of plausible
ranges.
ƒ
It is our view that an ‘efficient WACC’ should be:
ƒ
•
consistent with reasonable capital market expectations that reflect
the relatively low risk of Transpower's regulated activities;
•
consistent across Transpower's business/assets, reflecting the
relatively low risk of asset stranding for investment decisions subject
to detailed regulatory scrutiny (and application of the GIT); and
•
based on average or mid-range estimates of parameter values
developed by the EC taking into consideration all available relevant
information.
On the above basis, we estimate an appropriate ‘efficient WACC’ for
Transpower would be no more than 6.05% real, pre-tax assuming
2
Mighty River Power
Comments on the WACC / discount factor
inflation at 3.00%1. We also suggest the EC use 5.1% and 7.0% as the
upper and lower bound discount rates in its sensitivity analysis.
ƒ
1
We consider this to be a conservative (i.e. erring on the high side)
estimate of the WACC. If the result of the GIT analysis is accepted by
the EC, Section 17 of Part F of the EGRs guarantees recovery of the
approved costs. This form of ‘regulatory guarantee’ may have the effect
of reducing the investment risk faced by Transpower compared to
investments not subject to a GIT analysis. The consequence of this is
that the asset Beta for Transpower’s new investments may well be lower
than the asset beta in the context of price control and hence lead to a
lower WACC. Assuming a reduction of the asset Beta by 0.1 we
estimate a real pre-tax WACC of 5.15%, however more analysis would
be needed before such an estimate could be relied on.
We assume 3% based on the latest available statistics and forecasts from NBNZ Business Outlook.
According to the National Bank NZ survey expectations over the twelve months to May 2007 are for prices
to rise 3.3%. Inflation expectations have been over 2.8% since August 2004. Source: National Bank
Business Outlook April 2006 : http://www.nbnz.co.nz/economics/outlook/060426/default.htm Inflation
expectation data from: http://www.nbnz.co.nz/economics/outlook/NBNZ_Business_Outlook_Data.xls ; both
accessed 20 June 2006
3
Mighty River Power
Comments on the WACC / discount factor
2. Background
5.
The EC has responsibilities under the EGRs to develop the GIT and apply it
to Transpower’s Grid Update Plans (GUPs).
6.
Reports prepared by the EC’s consultants (Frontier Economics and SAHA
International)2 confirm that the GIT developed by the EC is closely related to
the ACCC’s regulatory test,3 which is required to be used in Australia to
assess major investment options in all electricity networks. These consultant
reports, and the EC’s own documents,4 confirm that the GIT is based on a
cost-benefit approach that requires, inter alia, reasonable forecasts of costs
and benefits for alternative options that can be compared using a standard
NPV analysis with a discount rate that reflects, among other things, the
scarcity of capital.
7.
The EC has committed substantial time and resources to development of the
GIT, approval of Transpower’s GUP and application of the GIT. Most
interestingly, the EC has taken a very active role in developing alternatives
for Transpower to consider - even producing a 'Short-Short List' of
alternatives consisting of seven generation options, four demand-side
initiatives and four alternative transmission solutions.5 The EC has also
required Transpower to assess the viability of the four specific transmission
alternatives (“alternative projects”) using the GIT.
8.
In respect of quantifying costs and benefits that can be used as input data in a
GIT analysis, we note that paragraph 6.5.6 of the EC draft decision says in the
assessment/ranking of alternative transmission investment options:
2
Draft Grid Investment Test – Final Draft Discussion Paper, Frontier Economics, June 2004; Discount Rate
for Application in Grid Investment Test – Final Report, SAHA International, 30 November 2004.
3
The EC (and its consultants) make reference to difficulties encountered with application of the regulatory
test in some circumstances. In particular, we note that Frontier Economics has suggested these difficulties
can be overcome by more detailed prescription (by the EC) of matters that must be considered in applying
the GIT. While we agree that clarity about such matters is essential, we also note it is essential that the
‘mechanics’ of the GIT be made entirely consistent with the fundamental discipline of Cost Benefit
Analysis on which both the GIT and regulatory test are based. It is beyond the scope of this report to
address these issues, although, we have done so in a recent paper prepared for submission to the Australian
Energy Markets Commission’s review of the Regulatory Test principles. (see: Comment on MCE Proposal
for a ‘Regulatory Test’ Rule Change - A report prepared for the Energy Users’ Association of Australia,
Marsden Jacob Associates, 20 June 2006).
4
Explanatory Paper - Grid Investment Test, Electricity Commission, 3 December 2004 (EC GIT Explanatory
Paper) and Draft decision on Transpower’s Auckland 400kV grid investment proposal for the purposes of
consultation under section III of part F of the Electricity Governance Rules 2003, Electricity Commission,
27 April 2006 (EC Draft Decision).
5
EC Draft decision, p. 15.
4
Mighty River Power
Comments on the WACC / discount factor
As the future is by definition uncertain, the expected net market benefit
(or the expected net market cost) is an “expected” (or “averaged”)
quantity.
9.
The EC does not advance any arguments to demonstrate why an "averaged"
value is any more robust than any other. But this view suggests that a factor
in assessing/ranking the proposals (i.e. the discount rate) should also be based
on the "averaged" value of parameters used to estimate the discount rate rather than "cautious/conservative/upper range" values traditionally adopted
by regulators/utilities elsewhere when developing their estimates for WACC.
10.
The EC makes no comment on this particular issue. In respect of the discount
rate, the EC says:6
6.10.1 The GIT requires the discount rate to be used in all NPV
calculations to be:
(a) a discount rate determined by the Commission; or
(b) if the Commission has not determined a rate, equivalent to a
pre-tax real rate of 7%.
6.10.2 In the GIT Explanatory Paper, the Commission set out reasons
why a default value of 7% was chosen.
6.10.3 Transpower has applied a discount rate of 7% in its Proposal.
6.10.4 The Commission considers that 7% is an appropriate discount
rate to be applied to NPV calculations in this application of the GIT
and has therefore applied that rate to the NPV analysis. Under the
assumptions used in applying the GIT, this translates to an
approximately 10% pre-tax nominal discount rate. This discount rate
is subjected to a sensitivity analysis by applying the alternative rates
of 5% and 9%.
11.
The EC’s GIT Explanatory Paper says:7
The Commission proposed using Transpower’s weighted average cost
of capital (WACC) as the initial discount rate to be used in the GIT.
This was due to concern at the practical difficulties associated with
unambiguously determining appropriate figures for particular
projects and the limited time available to research alternative private
WACC figures.
6
EC Draft Decision, p. 43.
7
GIT Explanatory Paper, p. 19.
5
Mighty River Power
Comments on the WACC / discount factor
12.
However, we note that neither the EC nor Transpower has provided any
details of how the 7% figure was derived. There is no reference to the capital
asset pricing model (CAPM) in the EC’s draft decision, much less any
mention of the version of pre-tax CAPM or input parameter values used to
derive this figure.
13.
In its October 2004 submission on the draft GIT, Transpower offers the
following explanation related to derivation of the 7% value:8
Transpower recommends that initially a long run pre-tax real
equivalent of Transpower’s cost of capital should be used as the
discount rate for the GIT. Transpower has applied a discount rate of
7% as an estimate of this figure in its analysis to date. Ultimately, the
Commission should be endeavouring to establish a number of
discount rates to be applied to the cost and benefit streams of various
investments.
14.
15.
Transpower also offers limited information relating to derivation of this
value. It was based on:9
ƒ
an annual WACC calculation based upon observed rates for government
bonds in March/April of the prior year (i.e. it is a backward looking
estimate based on actual government bond rates, which is presumably
used as a proxy for the risk free rate);
ƒ
the expanded Brennan-Lally version of the CAPM;
ƒ
unspecified assumptions regarding Transpower’s leverage and debt
margins;
ƒ
factors important to a private investor such as taxation and funding
mechanisms being irrelevant – meaning that project costs and benefits
should be prepared on a pre-tax basis and that the discount rate should be
estimated in pre-tax terms;
ƒ
costs and benefits expressed in real terms, with the discount rate also
expressed in real terms, to avoid the GIT systematically undervaluing
proposals.
In respect of application of the discount rate, Transpower offers the following
suggestions and recommendations:10
8
Submission to the Electricity Commission on the draft Grid Investment Test, Transpower New Zealand Ltd,
October, p. 16,
9
Transpower 2004, pp. 16-17.
10
Transpower 2004, pp.. 16-17
6
Mighty River Power
Comments on the WACC / discount factor
ƒ initially a long-run pre-tax real equivalent of Transpower’s cost of capital
should be used as the discount rate for the GIT (although Transpower did
not make such an estimate);
ƒ the EC should be endeavouring to establish a number of discount rates to
be applied to the cost and benefit streams of various investments which
meant that applying a single discount rate will introduce selection bias11;
and
ƒ using a historical measure of the cost of capital creates some problems
for the GIT analysis – because the point in time nature of the estimate
makes it volatile – and an alternative approach is to establish a long-run
forward view of the discount rate that does not vary year on year due to
short-term movements in debt markets.12
16.
In effect, Transpower suggested the EC adopt a discount rate with a value of
7% on the basis that this was ‘pragmatic’ given the EC’s timetable for
approval of the first GUP and no other value was available.
17.
We note that Frontier Economics used the quote below in respect of the actual
value of the Discount Rate: 13
It should be noted that the use of a private rate of return will typically
not change project rankings. As noted by Mishan in his seminal text
on cost-benefit analysis:
'... the use of a market rate of return on private investment, rather
than the social rate ..., though it will of course affect the magnitudes
of the terminal (or present) values, it is not very likely to make any
difference to the resultant ranking of the public projects ... the
alternative investments profiles would have to be markedly different,
and the divergence between the ideal [social rate of return] and the
market rate of return on private investment would have to the quite
startling, for the use of the market rate of return to generate a
different ranking of public projects than that which would result from
the use of [social rate of return].'.
18.
We accept that Mishan’s view typically reflects practical outcomes from
application of cost-benefit principles to investment analysis – provided
11
Although Transpower makes no suggestions about what range of discount rate values could be adopted, it
does note that the GIT involves comparison of projects that involve fundamentally different assets
(including large-scale generation, transmission, distribution, renewable energy sources etc.
12
Transpower suggested the 10-year view provided by using Government Bonds as the risk free rate is not a
sufficiently long term view, as it covers only 50% of the EC’s proposed planning horizon – but Transpower
did not indicate how a longer term discount rate might be developed.
13
Draft Grid Investment Test – Final Draft Discussion Paper, Frontier Economics, June 2004, p. 28 – with
quote sourced from p. 235, Cost-Benefit Analysis, EJ Mishan, 1976, Praeger Special Studies, New York.
7
Mighty River Power
Comments on the WACC / discount factor
adequate attention is given to ensuring these principles also guide preparation
of cost/benefit value streams and ‘competing’ alternative options are
reasonably comparable.
19.
Frontier also expressed a view that: 14
Under this approach (application of modern finance theory to address
uncertainty), the discount rate would be the private discount rate
applying to an investor in electricity transmission assets. This is likely
to be higher that the regulatory weighted average cost of capital
(WACC) applicable to Transpower, which may not reflect the risk of
transmission investment to customers.
20.
This is consistent with the ACCC's view, which is that the discount rate lower
boundary should be the regulated cost of capital.15
21.
The ACCC also said:16
On the use of either a real, nominal, pre-tax or post-tax discount rate,
the ACCC believes that, in line with VENCorp’s suggestion, the
guiding principle should be that the discount rate must be consistent
with the cash flows being discounted. This is consistent with generally
accepted finance principles.
The ACCC disagrees with Transend that the discount rate used in the
regulatory test should reflect the regulatory WACC for the respective
TNSPs. The ACCC considers that the discount rate adopted for the
purposes of a regulatory test evaluation should be a commercial
discount rate in order to ensure network and non-network investments
are compared on a competitively neutral basis. The discount rate used
in an assessment should be consistent with the opportunity cost of
capital of an investment in electricity infrastructure. The ACCC
believes that the regulatory WACC might reasonably be considered
the lower boundary of the discount rate but not the mean value around
which sensitivity testing is conducted. The ACCC has amended the
regulatory test to ensure that it the regulatory WACC can only be
considered a lower boundary in a regulatory test assessment.
22.
This view is not held by the EC’s consultant SAHA International, which
proffered the view that:17
14
Draft Grid Investment Test – Final draft Discussion Paper, Frontier Economics, June 2004, p. 29.
15
Clause 15(c), ACCC Regulatory Test.
16
Decision - Review of the Regulatory Test for Network Augmentations, 11 August 2004, p 48.
17
Discount Rate for Application in Grid Investment Test – Final Report, SAHA International, 30 November
2004, p. 5.
8
Mighty River Power
Comments on the WACC / discount factor
the use of an investor centric WACC (taking into account the riskiness
of future income streams) is appropriate for the GIT.
23.
However, SAHA qualified this view by referring to ‘challenges’ associated
with effort involved in consultation to derive an ‘appropriate rate’ for a
private sector WACC and cautioned that the additional effort required to
develop (presumably a ‘formal’ estimate) of multiple rates may have
negligible benefit18 (in the context of the GIT).
24.
Notwithstanding this expression of caution, SAHA noted that the discount
rate: 19
has a simple, twofold purpose:
o Ranking of projects; and
o Ensuring the net benefit of the selected project is positive.
and recommended that the EC adopt Transpower’s WACC (in effect as a
proxy value that reflected a weighting of social and commercial objectives)
as the ‘default’ discount rate.20
25.
As noted above, SAHA in effect, took a ‘bet each way’ by noting that
selection bias will be addressed by sensitivity testing21 and also noting that
development of multiple rates may foster unproductive debate.
26.
Our view represents an amalgam of the views expressed by Frontier, SAHA
and the ACCC and effectively supports the position adopted by the EC. The
discount rate is an important parameter in cost benefit analysis. The
derivation of a value for a discount rate requires substantial and inevitable
judgement to be exercised. We believe it is important to select a ‘default’
discount rate for the GIT with reference to an ‘efficient WACC’ applicable to
Transpower – and adopt a range of values that might be reasonably judged by
the EC to appropriately test the sensitivity of differing cost/benefit value
streams to changes in that rate. Accordingly, we would recommend that the
18
SAHA 2005, p. 5
19
SAHA 2005, p. 9
20
SAHA’s rational for this recommendation was that
• GIT rankings are not overly sensitive to discount rates;
• the use of Transpower WACC is consistent with the objectives of the GIT and GPS;
• the Transpower WACC is a good approximation of such a rate (a weighted average of the social
opportunity cost and social rate of time preference) given Transpower’s numerous roles in the
electricity sector as set out in its Statement of Corporate Intent. We would also note it complies with
the GPS by not discriminating against Transpower;
• its use would be consistent with a suitable level of funding if transmission alternatives were to receive
regulated income; and
• its use is supported on the grounds of pragmatism given the imperatives of grid planning and
investment. (see: SAHA 2005, p. 10).
SAHA 2005, p. 10
21
9
Mighty River Power
Comments on the WACC / discount factor
EC adopt a ‘default’ discount rate that is equivalent to its estimate of an
‘efficient’ WACC applicable to Transpower.22
27.
We note that the EC has not so far considered the cost recovery issues that
arise once the GUP is approved. However, Section 17 of Part F of the
Electricity Governance Rules (EGRs) “Consequence of approval of grid
investment or expenditure” specifies:
17.1 Recovery of investment costs by Transpower
Approved costs incurred by Transpower in relation to an approved
economic or reliability investment, or interim grid expenditure
approved under rule 16, (irrespective of when they were incurred) are
recoverable by Transpower from designated transmission customers
on the basis of the transmission pricing methodology and are to be
paid by designated transmission customers accordingly.
17.2 No review of investment or expenditure decisions
Approval by the Board of grid investment or expenditure may not be
revoked or amended except with the consent of Transpower.
17.3 Board to give notification to the Commerce Commission
Within not less than 10 Business Days of approving an economic or
reliability investment, or interim grid expenditure approved under
rule 16, the Board must advise the Commerce Commission of its
decision.
28.
22
That is, Section 17 provides an explicit ‘regulatory guarantee’ for recovery of
the costs of Transpower’s GUPs (if the EC approves the GUP). This form of
‘regulatory guarantee’ is consistent with practices in Australia (arising from
application of the regulatory test) where the ACCC has generally allowed
resulting investments to be rolled into the regulatory asset base without
further scrutiny – provided the relevant network service provider can
We note that the choice of discount rate in a cost benefit analysis is a potentially contentious subject. Lind,
R. (1990) A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy
Options, in R. C. Lind, ed., Discounting for Time and Risk in Energy Policy (Washington, D.C., The Johns
Hopkins University Press) provides an overview of problems and issues that may arise. In the simplest
theories the choice of a discount rate is straightforward: it is the consumer's rate of time preference equal to
the marginal productivity of capital, in which case the market rate of interest is the appropriate rate of
discount. Depending the type of project the discount rate could be anywhere between the ‘social’ cost of
capital applicable to the public sector and a ‘commercial cost of capital’ applicable to private sector nonnetwork investment alternatives. A 'social' cost of capital might be no higher than the risk-free rate
(adjusted appropriately for tax and inflation). The WACC of a non-network option investor would be a lot
higher, particularly when some of the 'options' could be investments that deliver only a 'window' of value
(as an alternative to a 'regulatory guaranteed' investment by Transpower), with recovery of the remaining
investment value being in a fully competitive market environment. Such an example might be (say) a large
co-gen plant that could defer investment by Transpower for (say) 3-5 years.
10
Mighty River Power
Comments on the WACC / discount factor
demonstrate that the actual investment was prudent (and, in effect, consistent
with ‘good electricity industry practice’).23
29.
However, we also note that in respect of other investments in regulated
energy assets, there have been no specific examples where Australian
regulators have ‘re-optimised’ new investments downward.24 Regulators
have generally accepted (either explicitly or implicitly) that actual
expenditure was ‘prudent and efficient’ and allowed the full actual investment
cost to be rolled into the ‘opening’ regulated asset values – even where actual
expenditure has been substantially above forecast levels.25 This also provides
a substantial form of ‘regulatory guarantee’ that the full actual investment
cost will be recovered through prices (through both a cost of capital and
depreciation). In one case at least, an Australian regulator has gone further by
providing an explicit guarantee that all investment costs that were deemed to
be ‘prudent’ at the time the investment decision was made would be
recoverable – even if the asset was subsequently stranded by changes in
usage.26
30.
In the next sections of this paper we suggest appropriate values that could
reasonably adopted by the EC to estimate an ‘efficient WACC’ for
Transpower – and provide logical arguments to demonstrate why these values
are consistent with the EC’s contention that inputs to the GIT analysis should
be based on “averaged” values.
23
There has, however, been one notable exception, which was TransGrid’s investment in the Sydney
MetroGrid project. The investment analysis (i.e. application of the regulatory test) for this project was
undertaken by TransGrid to identify a particular option estimated to cost $142.5 million (1999 AU dollars).
The actual cost of the project was $276.5 million (nominal) excluding claims against TransGrid that totalled
around $40 million. The ACCC’s opinion was that, for the MetroGrid project, TransGrid conducted
inadequate analysis of the investment choices available to efficiently meet the investment need. In addition,
TransGrid failed to respond appropriately to information that the actual project would cost considerably
more than envisaged at the time of the regulatory test assessment. Therefore, the ACCC concluded that
TransGrid did not demonstrate that all of the investment in the MetroGrid project was prudent; and
subsequently ‘re-optimised’ the allowed cost downward by $30.84 million (nominal) (See, pp. 13-14, NSW
and ACT Transmission Network Revenue Cap TransGrid 2004–05 to 2008–09, ACCC, 27 April 2005).
24
By contrast, there have been some cases where initial regulatory asset values were ‘re-optimised’ downward
in application of a depreciated, optimised replacement cost (DORC) asset value methodology.
25
A reasonable (and short) summary of the various regulators’ treatment of this issue is contained in the
Queensland Competition Authority 2005 decision on electricity distribution pricing (See: pp. 58-59,
Regulation of Electricity Distribution – Final Determination, QCA, April 2005). We also note that this
practice (of effectively providing ‘regulatory guarantee’ for full recovery of initially ‘prudent’ investment)
is consistent with that of UK regulators in the energy and water sectors.
26
Review of Gas Access Arrangements - Final Decision, Victorian Essential Services Commission, October
2002, p. 147.
11
Mighty River Power
Comments on the WACC / discount factor
3. Update of WACC over time
31.
Before discussing how the WACC may be updated over time, it is useful to
briefly set it out in its most basic formulation. The WACC is commonly
calculated as the weighted cost of debt and equity:
WACC =
E
D
ke +
( 1 − T)k d
E+D
E+D
(1)
where:
–
–
–
–
–
–
E is the market value of equity,
D the market value of debt,
E+D is the market value of the company,
ke the cost of equity,
T the effective tax rate, and
kd the cost of debt.
32.
The cost of debt, kd, should reflect the interest rate that lenders would require
for lending their money, i.e. the risk free-rate adjusted to reward lenders for
the risk that the borrower will default. The cost of debt is normally estimated
as the sum of the risk-free rate and debt premium, i.e. the premium that
should be added to the risk free rate to achieve and estimate of the cost of
debt.
33.
The amount of debt relative to the market value of the firm is called the
leverage ratio or level of gearing. As interest is paid before tax, the cost of
debt is normally quoted before tax or pre-tax. When calculating the post-tax
cost of debt, the tax deductibility of interest payment must be taken into
account. To adjust for this effect (commonly referred to as the tax shield) the
cost of debt is multiplied by one minus the tax rate in the formula above.
34.
According to CAPM, the cost of equity can be calculated as
[
k e = E ( R j ) = R f + β j E ( Rm ) − R f
]
(2)
where:
– E(Rj) is the expected return on asset j;
– Rf is the risk-free rate;
– βj measures how sensitive asset j is to movements in the market
portfolio; and
– E(Rm) is the expected return on the market portfolio. [E(Rm) – Rf] is the
market risk premium, in practice often referred to as the Market Risk
Premium (MRP).
12
Mighty River Power
Comments on the WACC / discount factor
35.
We therefore have a wide array of different parameters that may vary over
time, including the risk-free rate, beta value, leverage ratio, tax rate and MRP.
As the financial market fluctuates, so will many of these input parameters.
Hence, a case could be made for re-estimating the cost of capital regularly to
ensure decisions are taken on the most up-to-date data. However, to update
and collect information on all these parameters is no small task and some of
them are unlikely to change much in the short to medium term. This is
particularly the case of the MRP. Likewise, there may also be other
considerations such as to provide businesses with a stable and predictable
framework on which they can base their investment decisions and hence a
reluctance to revise estimates too often.
36.
Notwithstanding the above, we believe that any estimated discount rate for
the GIT should be based on the most recent estimate. That means that as a
minimum the most recent risk-free rate and debt premium should be used. In
addition, recent benchmark estimates of beta values should be consulted and
compared with historic values. We do not believe that the MRP need be reestimated. Likewise the optimal leverage ratio27 is unlikely to change much
over time, although this should ideally be investigated.
27
The optimal leverage ratio is the capital structure that minimises the cost of capital and hence maximises the
value of the company.
13
Mighty River Power
Comments on the WACC / discount factor
4. Use of CC WACC
37.
In our view it would be appropriate for the EC to have regard to the CC’s
deliberations on the WACC. First, the CC has applied a fairly consistent
approach to estimate the WACC across its area of operation. Secondly, much
analysis has been conducted in the development of the framework. MJA has
on several occasions since 2003 been involved in consultations related to the
estimation of the WACC. Each time the WACC has been a hotly-debated
topic and over time the CC has made many refinements to the methodology.
As such, the CC’s approach represents a rational starting point for the
estimation of the WACC for the GIT and adoption of the approach by the EC
ensures regulatory consistency and certainty across all forms of electricity
assets.28
4.1.
The CC’s approach
38.
The CC adopts the following nominal post-tax definition of WACC:
WACC = k e (1 − L) + k d (1 − Tc ) L
(3)
where
–
–
–
–
39.
ke is the cost of equity capital,
kd the interest rate on debt capital,
Tc the corporate tax rate (assumed to be 33%), and
L the leverage ratio (or gearing level).
In addition, kd is estimated as the sum of the current risk-free rate (Rf) and a
premium (p) to reflect marketability and exposure to the possibility of default,
i.e.,
kd = R f + p
(4)
40.
Thus, the WACC is defined as a weighted average of the cost of equity and
the (after tax) cost of debt.29
41.
There is no unique definition of WACC but the definition adopted by the CC
is that commonly applied in regulation, valuation and investment decisionmaking in New Zealand.
28
The CC has also published Draft Guidelines on the calculation of the cost of capital. The intention of these
guidelines is to help parties understand the CC’s approach to estimating the cost of capital in performing its
regulatory responsibilities.
29
As note in the previous section, as interest is paid before tax, the cost of debt is normally quoted pre-tax.
14
Mighty River Power
Comments on the WACC / discount factor
42.
Estimation of the cost of equity is the most difficult and most disputed
element in the estimation of the WACC. The CC uses the simplified
‘Brennan-Lally’ form of the CAPM. It is a ‘simplified version’ because the
CC adopts simplifying assumptions with respect to tax that have the effect of
reducing that the CAPM to the following formula:30
k e = R f (1 − TI ) + ϕβ e ,
(5)
where
–
–
–
43.
TI is the average (across equity investors) of their marginal tax rates on
ordinary income,
φ the market risk premium, and
βe the beta of equity capital.
This is referred to in New Zealand as the ‘post-tax’ form of the CAPM in
which the market risk premium, MRP, is given by:
ϕ = k m − R f (1 − TI ) ,
(6)
where km is the expected rate of return on the market portfolio.
44.
According to Lally (2005, p. 9) equation (5) is also used by most ELBs, with
Transpower using a modest variant on equation (3) along with a value for TI
of 0.20. As noted in section 2, no specific information has been provided on
the variant used by Transpower.
45.
By using the expression ‘post-tax’, the CC means its estimates of the WACC
are estimates of the returns that investors would expect to receive from
investments in a firm (for which the WACC is calculated) after it has paid tax
on its profits. Nevertheless, these returns as estimated by the post-tax CAPM
reflect the underlying structure of personal taxes.
46.
It is important to recognise which particular form of the CAPM is being used,
as different forms have different formulas for the MRP and failure to
recognise this can lead to mismatching in estimation of the MRP. The MRP
used in the Brennan-Lally framework is generally higher than that used in
CAPM used in Australia.
47.
Although we acknowledge that the CC’s framework model is generally
theoretically sound, we note that the CC’s application of Brennan-Lally
model fails to recognise that New Zealand is now increasingly integrated with
world capital markets. The implication being that any assessment based
30
It is assumed that capital gains taxes are zero, that firms attached maximum imputation credits to their
dividends, and that shareholders can fully utilise the imputation credits.
15
Mighty River Power
Comments on the WACC / discount factor
solely on a domestic model will inflate that WACC estimate if no judgements
are made of the likely effects of increased integration.
48.
We also note that regulators in Australia and the UK are increasingly moving
to the ‘Vanilla’ WACC formula, which ignores tax impacts within the
CAPM, as discussed below.
4.2.
Changes needed to the WACC
49.
The discount rate specified by the EC is real, pre-tax. This differs from the
CC’s approach in that it is specified in nominal, post-tax terms.
50.
In order to compare the two versions of the WACC, we therefore need to
establish some common ground. As we discuss below, conversion between
different WACC specifications is no easy task and has been subject to much
dispute. This is particularly the case for the treatment of tax. In the following
we discuss the treatment of taxation and real and nominal values and provide
some examples of simple conversion formula that have been used in other
jurisdictions.
4.2.1. Treatment of tax
51.
Post-tax forms of the WACC assume that company taxes are treated as a cost
separate to the cost of capital. Pre-tax forms of WACC account for the cost
of taxation directly in the WACC estimate and hence company tax liabilities
are included in the return on capital.
52.
A pre-tax WACC will have a higher value than a post-tax WACC. Since
taxes are levied on profits, a company must have higher rate of return on its
assets pre-tax in order to provide the required post tax returns. In theory, both
definitions will yield the same results provided that the definition of cash
flows or costs and benefits are consistent with the definition of WACC
applied and the tax rate used to gross up the required post-tax return to the
required pre-tax return is the effective tax rate paid by the entity. However,
practical application suggests that this is far from the case due to the
complexity of tax systems and how they are applied.
53.
In Australia, regulators have adopted two broad approaches to date:
ƒ
transform the post-tax WACC into a pre-tax WACC (reflecting an
assumption about the effective tax rate of the entity), thus making an
allowance for tax by using a higher regulated WACC.
ƒ
include an allowance for the cost of tax directly in the cash flows (or
revenue) of the regulated entity, based upon an explicit projection of the
16
Mighty River Power
Comments on the WACC / discount factor
taxation liabilities for the activity under consideration and use the
‘Vanilla’ WACC formula which excludes tax impacts from the CAPM.
54.
The first methodology has the benefit of computational simplicity and has
been advocated on the grounds that it avoids the need to explicitly add into
the cost of service calculation an amount to compensate for tax obligations of
the business. It is therefore less intrusive, leaving the business to manage its
own tax affairs.
55.
It does, however, have a number of problems, the most important of which is
that no simple transformation method can capture the complexities of the
New Zealand tax system. For example, it must take account of rules on the
treatment of tax returns to debt, tax returns to equity and detailed provisions
of the tax system for capital allowances, investment credits, imputation etc.
There has also been substantial controversy about which of the numerous
alternative transformation methods provide the best estimate (see below).
Moreover, it is very difficult to deduce the assumptions made about the
taxation system from the simple transformations, which has further
exacerbated the controversy.
56.
For these reasons the ‘Vanilla’ WACC has gained popularity among
Australian and UK regulators. The ‘Vanilla’ WACC has the advantage of
(relative) simplicity and (relative) transparency because it allows the cost of
tax to be estimated separately and treated externally to the CAPM/WACC
formulae. This allows simpler formulae to be employed in the estimation of
WACC and more ‘transparent’ treatment of tax costs, particularly where tax
laws allow regulated utilities to gain significant efficient tax benefits.
57.
The ‘Vanilla’, post-tax WACC approach was adopted by the UK water
regulator Ofwat in the lead-up to the first independent price review in 1994
because, at that time, the newly privatised water companies were exempt
from income taxes. The Office of the Regulator-General in Victoria (now the
Essential Services Commission) adopted the ‘Vanilla’ WACC approach in the
lead-up to the first independent review of electricity distribution prices in
2000 – having initially adopted the more complex pre-tax approach for the
initial review of gas distribution prices.
58.
The ‘Vanilla’ WACC approach was subsequently adopted by the Queensland
Competition Authority in 2000, the ACCC in 2000, the Office of the
Tasmanian Energy Regulator in 2003, the UK energy regulator Ofgem in
2004 and the Essential Services Commission of South Australia in 2005.31
31
Despite adopting a more-or-less common (and relatively simple) approach, differences remain in the
presentation of results. For example, the Victorian ESC retains the use of real, post-tax ‘Vanilla’ WACC
17
Mighty River Power
Comments on the WACC / discount factor
59.
Nevertheless various conversion formulae exist that try to reconcile pre-tax
and post-tax WACC calculations. One of the most simple, called the forward
transformation, is:
Pre - tax WACC =
Post - tax WACC
1−T
(7)
where T is the effective tax rate.
60.
Clearly, to estimate a pre-tax WACC using this method requires a single
effective company tax rate. This is problematic as it is difficult to accurately
estimate a single effective tax rate that will reflect a company’s taxation
liabilities. In addition, what we need ideally for the cost benefit analysis is
also the tax profile looking forward which will inevitably vary from year to
year. On the other hand, the use a post-tax WACC necessarily entails a direct
estimation of the tax liabilities that could create additional complexity in the
cost-benefit analysis that may be unwarranted given the primary objective of
such analysis is to rank alternative options through a process that is not
generally highly sensitive to changes in the discount rate.
61.
To summarise, there is necessarily a trade off between the additional
information requirements and analysis necessary in the post-tax version
compared with using the simple transformation shown above. An alternative
could be to introduce more complex formulae to attempt to overcome some of
the shortcomings of the simple formula.
62.
Davis (2004)32 shows that the process of generating a pre-tax discount rate is
complex and liable to error. In addition, to our knowledge, none of the
conversion formulae commonly proposed are complex enough to account for
all of the effects discussed above and may ultimately simply create additional
fruitless discussion.
63.
For example, in the lead-up to the 1994 water industry price review in the
UK, Ofwat put forward a complex tax wedge model that would take account
of capital allowances, inflation and the dividend cover ratio. Considerable
debate ensued between Ofwat and the water industry about the inputs in the
tax wedge model and in particular the appropriate assumptions about
dividend cover and gearing. The debate was never really resolved because
Ofwat decided not to use the model in its 1994 review.
values, the ACCC and ESCoSA report nominal, post-tax ‘Vanilla’ values and the QCA reports its results in
nominal post-tax terms but uses the name ‘Officer WACC3’, which refers to the version (number 3) of the
CAPM formula contained in a paper developed for QCA by Professor Bob Officer.
32
Davis (2004), The Design of Regulatory Pricing Models for Access Arrangements: Inflation, Tax and
Depreciation Considerations, Accounting Research Journal, Vol 17 No. 1.
18
Mighty River Power
Comments on the WACC / discount factor
64.
For the purpose of this report we adopt the formula 7 above.
4.2.2. Nominal vs. real
65.
The choice to use either a nominal or real WACC depends upon whether the
model using the WACC is specified in real or nominal terms.
66.
Under the nominal approach, values of all costs (including asset values) are
expressed in ‘money of the day’ terms and a nominal WACC is used to
calculate returns on assets. Under a real approach, values of all costs are
expressed in constant price terms and a real WACC is used. All other things
being equal, the two approaches are mathematically equivalent and the choice
is one of preference for modelling.
67.
Returns on equity and debt can be converted from real to nominal values (and
vice versa) using the relationship between nominal and real interest rates
given by Fisher Equation:
1 + nominal WACC = (1 + real WACC) × (1 + inflation rate)
68.
(8)
Different views exist on the appropriateness of real and nominal
specifications. An argument for a nominal specification is that many costs
are fixed in nominal terms, most particularly depreciation and interest and the
tax system is defined in nominal rather than real terms. However, as
Transpower notes (in respect of the forecasts needed to undertake the GIT):33
Real values are easier to estimate, model and evaluate so the
approach is more transparent during the assessment phase. However,
capital expenditure approved would differ from that included in the
GIT, and ultimately recovered from consumers, so transparency is
harder to achieve during later phases of the project. Nominal values
are more complex to model, and do not completely address
transparency concerns during implementation and operation of a
project because of the difficulty of isolating nominal price movements.
69.
33
Essentially the same difficulty faces regulators during price reviews, and their
responses are (approximately) equally mixed. In Australia, some regulators
undertake the price review using real values (e.g. the Victorian Essential
Services Commission (ESC)) and some using nominal values (e.g. the
Queensland Competition Authority (QCA)). In our view, the ESC’s
deliberations are easier to understand and follow (i.e. more transparent) than
the QCA’s, but the ESC requires financial performance information to be
Submission to the Electricity Commission on the draft Grid Investment Test, Transpower, October 2004, p.
18.
19
Mighty River Power
Comments on the WACC / discount factor
reported in real terms which makes comparisons between forecasts and
actuals more confusing (i.e. less transparent).
70.
Accordingly, we are inclined to endorse Transpower’s view on this particular
issue. Use of either nominal or real values WACC, or the discount rate, will
make no difference to the outcome of the GIT provided all inputs are
expressed in the appropriate terms. The chosen discount rate(s) must be
consistent with the cost and benefit streams being analysed. If costs and
benefits are expressed in real terms, then the discount rate should also be
expressed in real terms, otherwise the GIT will systematically undervalue
proposals.34
4.2.3. Conversion from nominal post tax to real pre-tax
71.
To convert a post-tax nominal WACC to a pre-tax version two steps are
required: conversion from post-tax to pre-tax and from nominal to real.
72.
Assume a 6% post-tax nominal WACC. To calculate a pre-tax real term we
would gross up by the factor 1 minus the corporate tax rate. Assuming the
tax rate is 33% (i.e. the effective tax rate is identical to the statutory tax rate)
this would yield a nominal pre-tax WACC of 8.96%. The next step would be
to adjust the nominal pre-tax WACC as follows to derive a real pre-tax
WACC:35
real pre - tax WACC =
1 + nominal pre - tax WACC
−1
1 + inflation rate
(9)
If the expected inflation rate is 3%, then the real pre-tax WACC is 5.78%
using the number above. While 3% represents the upper limit of the Reserve
Bank’s target over the medium term, current inflation is now 3.3%.36
73.
An alternative approach is the ‘reverse transformation’, under which the posttax nominal WACC is first deflated to obtain a post-tax real WACC, and then
converted to a pre-tax real WACC by grossing by a factor of one minus the
tax rate. The reverse transformation results in a lower WACC. Assuming a
6% post-tax nominal WACC as above, the reverse transformation results in a
pre-tax real rate of 4.53% which is considerably lower than 5.78%.
74.
The confusion created by use of these WACC ‘transformations’ has not been
dealt with well by Australian or UK regulators, and has been one of the
34
Op Cit, p. 17
35
This is essentially a re-write of the Fisher equation.
36
See current Policy Target Agreement, 17 September 2002. Current inflation is 3.3% (March quarter 2006).
RBNZ A3 Incomes and Prices : http://www.rbnz.govt.nz/statistics/econind/a3/data.html , last updated 18
May 2006, accessed 20 June 2006.
20
Mighty River Power
Comments on the WACC / discount factor
drivers for the switch to the ‘Vanilla’ WACC approach. Rather than
explaining this outcome in a transparent manner, Australian regulators have
generally ignored the difference and selected the ‘forward transformation’
value.
75.
Neither approach will produce the ‘correct’ value as they are approximations,
but the forward transformation is likely to overstate the true value while the
opposite is true of the reverse transformation.
4.3.
Estimation of the WACC
76.
In the following we summarise the parameters used by the CC to estimate a
WACC for Unison’s ELB and convert this estimate to pre-tax and post-tax
values using the above formulae considering updated parameters where
relevant.
77.
We note that in order to properly compare the CC’s WACC for Unison with
the real pre-tax discount rate of 7% we would need to understand how
Transpower originally derived its WACC value to begin with, including the
formulae and parameter values. However, as noted in previous sections we
have been unable to find this information. Transpower has indicated that it
derives an estimate of WACC on a yearly basis based upon observed rates for
government bonds in March/April of the prior year using the expanded
Brennan-Lally version of the CAPM, but this is insufficient to derive an
estimate.37
78.
The CC used the following input parameters to derive a WACC for Unison.
37
Submission to the Electricity Commission on the draft Grid Investment Test, Transpower, October 2004, p.
17.
21
Mighty River Power
Comments on the WACC / discount factor
TABLE 1: CC ESTIMATES FOR UNISON*
Unison
Risk-free Rate
6.31%
Post-Tax MRP
7.0%
Equity Beta
0.667
Asset Beta
0.4
Cost of Equity
Debt Premium
8.89%
1.20%
Cost of Debt (pre-tax)
7.51%
Gearing
40.0%
Corporate Tax Rate
33.0%
Investor Tax Rate
33.0%
Post-tax Nominal WACC
7.35%
* Table cells shaded grey are input values.
Source: MJA Analysis of CC (2005)
79.
As indicated in section 3, we believe the risk-free rate and debt premium
should as a minimum be updated. However, as noted below update of the
risk-free rate requires little judgement on the basis that regulators (in the UK,
Australia and NZ) universally adopt a recent average of the (relevant) multiyear Government Bond Rate as a proxy for the risk-free rate.38 Considerable
judgement is required to establish values for other parameters and it would be
inappropriate for us to attempt to judge the CC’s position today for Unison or
Transpower. Rather, in section 5 we offer our own view and updates to the
parameters for Unison.
80.
The CAPM provides no guidance as to the appropriate maturity of the riskfree rate. Regulators have typically chosen a maturity that matches:
ƒ the technical or economic life of the assets used in providing the regulated
service, on the basis that this reflects the planning horizon of investors in
those assets; or
ƒ the duration of the regulator’s determination (‘the regulatory period’),
given that the risk-free rate will be adjusted in any subsequent reset.
81.
38
The CC uses the risk-free rate equivalent to the price setting period of 3 years,
i.e. a three-year maturity is chosen (as linear interpolation between the two
We note that Transpower has expressed a view that a ‘long-run equivalent to Transpower’s cost of capital’
should be used as a discount rate for the GIT. Transpower is also of the view that the 10-year view
provided by using Government Bonds as the risk-free rate is not a sufficiently long-term view, as it covers
only 50% of the Commissions proposed planning horizon. (See p. 16 and Footnote 9, p. 17, Op Cit).
However, Transpower does not explain how it might derive an estimate for a longer term risk-free rate for
which no NZ Government Bond market exists. Given the primary objective of a GIT analysis (to rank
alternative investment options), we do not see much value in looking beyond current Bond market data.
22
Mighty River Power
Comments on the WACC / discount factor
and five-year Government Bond rate). The point estimate in Table 1 above is
based on the rate available in April 2005. The equivalent value for April
2006 is 6.10%.
82.
Although we generally agree with this methodology for the regulatory setting
in which the Unison WACC was determined, the purpose is different for the
GIT where, ideally, consideration may need to be given to the relevance or
otherwise of any impacts that arise because of differences between long-term
investment period and a much shorter regulatory control period. Hence it
may be appropriate to estimate the risk-free rate using a 10-year Bond yield.
83.
In addition, section 17 of the EGRs provides yet another possible alternative
for setting the maturity of the risk-free rate reflecting the length of the
regulatory determination in the transmission pricing methodology.
84.
For the purpose of this report and consistency we retain the 3-year estimate
(reflecting the regulatory period) used by the CC.
85.
During the past two years, the 10-year government bond has followed a
pattern as illustrated in the figure below.
FIGURE 1: DEVELOPMENT IN 10-YR AND IMPLIED 3 YR GOVERNMENT BOND
6.80%
6.60%
6.40%
6.20%
6.00%
5.80%
5.60%
5.40%
3 yr implied
10 yr
A
pr
-0
M 4
ay
-0
Ju 4
n0
Ju 4
l-0
A 4
ug
-0
Se 4
p0
O 4
ct
-0
N 4
ov
-0
D 4
ec
-0
Ja 4
n0
Fe 5
b0
M 5
ar
-0
A 5
pr
-0
M 5
ay
-0
Ju 5
n0
Ju 5
l-0
A 5
ug
-0
Se 5
p0
O 5
ct
-0
N 5
ov
-0
D 5
ec
-0
Ja 5
n0
Fe 6
b0
M 6
ar
-0
A 6
pr
-0
6
5.20%
86.
The figure shows that the yields for the bond have roughly fluctuated between
6.4% and 5.8% during the past two years and currently lies around 5.8%,
some 30 basis points lower than the interpolated three-year rate. An updated
estimated of the risk-free rate for the Unison is therefore 6.10%.
23
Mighty River Power
Comments on the WACC / discount factor
87.
Below we have calculated an updated post-tax nominal WACC for Unison
using the CC parameters and an updated risk-free rate. In addition we have
calculated two versions of the pre-tax real WACC assuming an inflation rate
of 3.0%.
TABLE 2: UPDATED AND TRANSFORMED CC ESTIMATE*
Risk free Rate
Post Tax MRP
Equity Beta
Asset Beta
Cost of Equity
Debt Premium
Cost of Debt (pre-tax)
Gearing
Corporate Tax Rate
Investor Tax Rate
Post-tax Nominal WACC
Inflation rate
Pre-tax Real WACC (forward transformation)
Pre-tax Real WACC (reverse transformation)
6.10%
7.0%
0.667
0.4
8.75%
1.20%
7.30%
40.0%
33.0%
33.0%
7.21%
3.0%
7.53%
6.10%
* Table cells shaded grey are input values.
Source: MJA analysis
24
Mighty River Power
Comments on the WACC / discount factor
5. MJA adjustments to CC WACC
88.
Estimation of the WACC requires consideration of the individual parameters.
The following table summarises our comments on the specific components of
the WACC.
TABLE 3: SUMMARY OF COMMENTS TO WACC COMPONENTS
CC Approach
Risk-Free Rate
Use the risk-free rate equivalent to the price
setting period of 3 years, i.e. a three-year
maturity is chosen (as linear relationship
between the two and five-year government
stock rate).
Post-Tax Market Risk Premium (PTMRP)
The CC uses the same range of estimates as in
other investigations and determinations.
Equity Beta / Asset beta
The CC applies an asset beta of 0.4. The
analysis on which the CC relies, Lally (2005),
concludes that there is a difference between
asset beta values for energy utilities in the US
and UK that is largely attributed to differences
in regulatory arrangements; and that the regime
administered by the CC constitutes a
‘regulatory risk’ intermediate between these
other jurisdictions. On this basis, Lally has
proposed the CC adopt an asset beta value of
0.4, mid-way between values estimated for US
and UK energy utilities.
MJA Comments
We generally agree with the CC methodology
and note that the adopted transmission pricing
methodology under Section 17 of Part F of the
EGRs may dictate a similar maturity. For the
GIT, however, we are concerned with a
long-term investment and not a regulatory
control period and hence may be appropriate to
rely on the 10 year yield, i.e. a value of 5.8%.
We believe the selected range adopted by the
CC should be adjusted. In particular, it is our
view that more weight should be given to
forward-looking estimates (obtained from
credible, independent financial market
observers) or adjusted historical estimates of
the PTMRP and that this results in a preferred
estimate of 6% compared with 7% used by the
CC.
While we are largely in agreement with the
analysis provided by Lally (2005), we consider
the value that is finally selected should be
lower. In particular, we reject the final step in
Lally’s analysis, which appears to arbitrarily
raise the asset value from 0.37 to 0.4.
However, according to Section 17 of Part F the
EGRs, Transpower may recover the approved
costs of its GUPs (and the recovery is exempt
from Part IVA of the Commerce Act). This
effectively means that Transpower is
guaranteed recovery even if – ex-post – the EC
determined that it had erred in its decision. The
consequence of this is that the asset beta for
Transpower’s new investments may well be
lower than the asset beta in the context of price
control (on Transpower’s sunk investment).
We analyse the beta value more closely in
section 6.
Debt Premium
The CC applies a debt premium value of 1.2%.
We disagree with the estimate. In our view, the
debt premium should be 1.05% based on an
evaluation of debt premiums appropriate for
BBB+ credit rating. This approach is taken
because a regulated business’s actual debt
25
Mighty River Power
Comments on the WACC / discount factor
CC Approach
MJA Comments
costs may be influenced by historical debt costs
that do not reflect the borrowing costs of an
efficiently financed electricity business.
Leverage
A leverage level of 40% is used.
Corporate and Investor Tax Rates
33% is used for both.
We have no objection to the arguments or
analysis and believe a leverage ratio of 40%
may also be used for Transpower. However,
we note that UK and Australian regulators have
generally adopted a higher gearing ratio of 60%
as an ‘efficient benchmark’ for regulated utilities
in the energy and water sectors.
We agree that this represents the Statutory Tax
rate, but prefer the improved transparency
offered through consideration of tax impacts
external to CAPM – combined with use of a
‘Vanilla’, post-tax WACC estimate.
89.
In the following, we comment on the Post-Tax Market Risk Premium
(PTMRP), beta value and debt premium.
5.1.
PTMRP
90.
The CC uses a post-tax version of the market risk premium. The PTMRP is
the additional return expected by investors for accepting the systemic risk
associated with investing in the market portfolio instead of a risk-free asset.39
91.
Of all the components of the WACC, the magnitude of the market risk
premium attracts most disagreement by practitioners and academics alike. In
particular we note that the size of this premium has been highly disputed in
the previous regulatory processes by the CC – as it has also in Australia and
the UK. This is to be expected and much academic argument has been
presented about the merits of alternative methods for deriving a value for
such a premium. Different methods produce very different values. For
example, the MRP can be calculated on an arithmetic or geometric basis. In
addition, the MRP is very sensitive to the time period over which it is
calculated.
92.
Due to the fact that political and economic conditions have changed over the
past century, some analysts prefer to emphasise recent data as being reflective
of future expectations. Others take the view that many historical market
events are likely to be repeated in the future such that the MRP averaged over
a long period of time would be most appropriate. For these reasons it is
common to see studies evaluating equity market performance using time
39
In the following we use ‘MRP’ when generically referring to the premium.
26
Mighty River Power
Comments on the WACC / discount factor
periods ranging from over a decade to a century. It is therefore clear that
widely different results can be reached.
93.
It has also become common practice for regulators to use increasingly diverse
sources of information to inform their judgements on the value of the MRP.
Regulators in Australia and the UK frequently refer to views expressed by
market practitioners, market analysts and surveys of investors’ expectations
in their discussions of factors affecting their judgements. UK regulators
make it clear that they are inclined to place as much, if not more, weight on
the views of respected market sources about investors’ expectations as they
are on analysis of historical data; and UK regulators in the electricity, gas,
water and other sectors all adopt MRP values lower than those indicated in
analysis of historical data.
94.
Proponents of the view that inferences on the MRP need to be taken using a
long period of time typically refer to the MRP’s variability40 at any given
point in time and the need to consider long time-series to ensure a stable
estimate. Proponents of the opposite view argue that averaging over these
long time-series takes no account of fundamental changes to financial
markets that have occurred since the early 1980s, does not provide a
reasonable estimate of the MRP looking forward and that averaging over a
long time period is only a consequence of the statistical inadequacy of the
approach.
95.
We endorse the latter view. We do not believe that the historical MRP is an
appropriate indicator of the forward-looking MRP which is what the CAPM
requires.41 The historical approach seeks to establish how much equities have
typically outperformed bonds to calculate a historical, or “backwardlooking”, MRP. However, investors recognise they can do nothing to
influence historical returns and make investments based on their expectations
of expected returns, not historical returns. Historical data cannot measure the
expectations of investors. In our view, the MRP should therefore be
estimated on a forward-looking basis or at least be based on historical data
that is appropriately adjusted to reflect a forward-looking approach.
96.
In addition and more importantly there are reasons to believe the historical
approach overestimates the return required by investors:
40
The MRP may even be negative in some years.
41
In addition, we note that the use of historical data is inconsistent with the theoretical underpinnings of the
CAPM. The theory of the MRP is based on additional expected returns that investors require over and
above the risk-free rate in order to invest in equities. The main problem with this is that historical data
cannot measure the expectation of investors.
27
Mighty River Power
Comments on the WACC / discount factor
i)
evidence from forward-looking studies tend to show that these
estimates, on average, are lower than those determined by statistical
analysis of historical data where it is assumed that historical returns
provide an unbiased estimate of the expected MRP.42
ii)
historical studies are typically based on long time periods, but capital
markets have changed substantially since 1900 and 1930 – and
particularly in the past few decades. Financial markets have been
liberalised, barriers to international investment have been removed,
the New Zealand dollar floated (in 1985), capital markets around the
world have become less segmented and more integrated43 with world
markets and the scope to diversify has increased substantially.44
iii)
ex-post historical studies may be criticised for the likelihood of
survivorship bias, i.e. the tendency to include disproportionately
investments that succeed or survive.45
iv)
a downward shift in the MRP may be caused by improved regulatory
and legal infrastructures to protect investors, lower trading costs and
improved market liquidity.
v)
it has been suggested that the nature of investors changes over time.
For example, investors may have observed (learned) that stocks outperform bonds in the long run and do not require as high a premium or
investors may have developed perceptions that the business cycle is
less severe over time, hence reducing the required equity return.46
vi)
the risk-free rate was controlled in the period prior to 1985. Lally
(2005) speculates that the risk-free rate would have been higher
42
See for example the overview of MRP estimates using a number of ex ante and ex post approaches, in
Ofcom (2005), Ofcom’s approach to risk in the assessment of the cost of capital, An Ofcom consultation,
Document amended on 02/02/05 due to a transcription error.
43
In terms of integration vs. segmentation, see e.g. Ragunathan, V. (1999), “The effect of financial
deregulation on Integration: An Australian Perspective”, Journal of Economics and Business, 51, pp 505674.
44
We note that there are two counteracting processes at work when barriers to international investment are
removed and trade between countries increases interdependence: low correlation of returns between markets
results in benefits to be gained from international diversification, however, with increasing correlation of
returns between countries, the benefits of international diversification are reduced. The net effect is
however expected to be positive. See for example, Stulz, Rene, (1995)
45
Survivorship bias can distort the conclusions made from historical analysis since the observation of superior
market returns over a long period may be impacted by the presence of unusually positive factors and or
absence of negative factors that are not necessarily repeatable. Hence the observation of a high historical
MRP is an indicator of returns that investors received, not an (unbiased) indicator of what they expected to
get. For example, US and UK investors who had bought into the German, Japanese, Russian or Argentine
markets in 1900 would have been wiped out along the way. See AMP Henderson (2003). The equity risk
premium – what is it and is it enough?
46
Dimson, Marsh and Stauton have also suggested that there is correlation between wealth and MRP, i.e.
when wealth rises over time investors will lower their risk aversion, resulting in a fall in the MRP. See
Dimson, Marsh and Staunton (2002) p 188.
28
Mighty River Power
Comments on the WACC / discount factor
without the control and hence will influence certain types of historical
approaches to the estimation of the MRP by inflating the estimate.
97.
It is therefore our view that the EC should exercise care when relying on
(long-run) historical estimates of the MRP when considering an estimate of
the current or recent situation, as such estimates will tend to overestimate the
PTMRP.
98.
In addition, we note that the historical estimates differ considerably
depending on the averaging technique and time period used. The arithmetic
mean is typically around two percentage points higher than the geometric
mean, depending on volatility and time period47 and the statistical nature of
the problem is such that an arithmetic average is likely to overestimate the
PTMRP.48 In our view, little weight should be placed on historical estimates
if they are not appropriately corrected for quantifiable biases. Ideally
forward-looking approaches are preferred. Moreover, we acknowledge the
merit of selecting a value using judgement informed by the broadest possible
range of reputable sources.
99.
We note that MRP estimates typically are referenced to a 10-year maturity
risk-free investment. Given the normal upward-sloping yield curve and the
fact that the annual market return is stable, the MRP relative to a maturity
shorter than 10 years is likely to be higher although this would need to be
tested. However, we note that the CC, in its determination for the
Telecommunications Service Obligation, argued that:49
On balance, the Commission considers that an assumption that the
PTMRP is invariant to the period is reasonable and practicable.
Thus, the PTMRP would yield approximately the same value using a
ten-year or a one-year horizon for both the Rm and the Rf. An
advantage of this approach is that it uses the same market risk
premium irrespective of the investment horizon.
47
See e.g. Wright, Mason and Miles (2003), A study into certain aspects of the cost of capital for regulated
utilities in the U.K., p 4.
48
In terms of the issues related to averaging we refer the Commission to MJA (2004), Comments on the TSO
Cost of Capital TSO Draft Determination 2002/2003, 10 August, where this issue is discussed in more
detail. We also note the recent statement by Ofcom on this issue where they state:
“…there are arguments in favour of using both of these methods in the context in which Ofcom
applies its cost of capital estimates. The geometric average return is a useful measure of the
return actually earned by investors, whilst the arithmetic average return additionally reflects the
historically experienced volatility of returns. .. Ofcom notes that the arithmetic mean is more
widely used in an investment appraisal context, and consequently places more weight on
estimates calculated using this method. However, Ofcom continues to put some (albeit a smaller
amount) weight on the geometric average.”
49
CC (2005a), Determination for TSO Instrument for Local Residential Service for period between 1 July
2002 and 30 June 2003, March, p 54
29
Mighty River Power
Comments on the WACC / discount factor
100.
We accept this comment although noting that we would prefer a purely
forward-looking approach for estimating the PTMRP. With such an
approach, problems of data limitation and consistency could be eliminated.50
101.
To sum up, we are concerned that the CC’s choice of 7% based on Lally
(2005) is higher than it should be; and higher than it need be to attract
reasonable, efficient investors/lenders. In our view, the CC and the EC
should put more weight on a prospective or forward-looking estimate of the
PTMRP (either estimated directly or indirectly through adjustments of
historical approaches or by using information from financial market sources
about future expectations to inform the judgement required in this important
matter).
102.
In our view, the EC is faced with three options:
(a)
use a “firmly estimated” but inappropriate historical measure;
(b)
use the “less firm” measure, but appropriate forward-looking concept or
adjusted historical estimates; or
(c)
rely on a range of estimates as is currently the practice but to interpret
the range of estimates in the light of the insights from the forwardlooking results, hence applying more weight to forward-looking
estimates or adjusted historical estimates.
103.
While we would favour a truly prospective and forward-looking approach, we
acknowledge that no such robust approach exists currently. The second best
solution is to explicitly place greater weight on the available forward-looking
estimates when making the inevitable judgements needed to establish a range
of values for the PTMRP.
104.
The most recent PTMRP estimate for the New Zealand on which the
Commission has relied is found in Lally (2005). Lally concludes that a point
estimate of 0.07 is appropriate. However, his choice of point estimate is not
based on any formal method. In particular, Lally notes that the appropriate
weighting for these estimates are debatable.51
105.
In the table below, Lally’s evidence is ordered by methodology. We have
also added the results from a survey conducted by Goldman Sachs in 2002
under ‘Other/World’. The Goldman Sachs paper was a survey of over 100 of
50
The prospective method requires an assessment of expectation of the future equity market return and is
calculated by subtracting the risk-free rate from the expected future market return. As such it can overcome
the problem of consistency between the risk-free rate and PTMRP.
51
Lally (2005), p 18.
30
Mighty River Power
Comments on the WACC / discount factor
its international clients globally, which revealed an average MRP of 0.03952
(with most responses clustered in the 0.035 – 0.045 range).
TABLE 4: EVIDENCE ON PTMRP
Siegel
Ibbotson
Merton
Cornell
Survey evidence
NZ
0.060 – 0.068
0.077
0.081
0.060
0.073 – 0.088
US
0.075
0.089
Other / World
0.066
0.086
0.055
0.055
0.059
Source: Lally (2005) and MJA analysis
106.
In order to guide us in an estimate of the MRP based on this data we have
applied weights to the different estimates:
ƒ
equal weight is applied to estimates of New Zealand, the US and Other;
ƒ
we place a weight of 75% on the forward-looking estimates and 25% on
historical estimates; and
ƒ
equal weight is applied internally between the different estimation
methodologies.
107.
We discarded the Merton estimate because of the uncertainty and difficulties
surrounding this approach.53 Further, New Zealand survey estimates
provided by Lally have been reduced by 0.005 as these may be biased
upwards.54
108.
No further adjustments are made although we note that:
ƒ
Ibbotson-type estimates are likely to be biased upwards as noted by
Lally (2005); and
ƒ
other academics have achieved lower forward-looking MRP estimates
than that of Cornell, including for example Gebhardt and Swaminathan
(2001)55, Claus and Thomas (2001)56 and Fama and French (2002)57.
52
O'Neill, Wilson and Masih (2002), The equity risk premium from an economics perspective, Goldman
Sachs, Global Economics Paper No. 84, 25 October 2002, corrected for differences in MRP, this yields an
estimate of 0.059 in table 4.
53
For a discussion see Lally (2005), p. 13.
54
Lally (2005) p 14 notes that the survey evidence from practitioners may be biased upwards due to some
mistakenly supplying an estimate of the MRP for the MRP equation in the Brennan-Lally CAPM and not
the standard CAPM. Assuming that half of the survey participants where practitioners the adjustment of
0.005 reflects the assumption that half of those participating would have provided the “wrong” MRP.
55
Gebhardt, Lee and Swaminathan (2001) Toward an implied cost of capital, Journal of Accounting Research
39(1), pp 135-176.
56
Claus and Thomas (2001), Equity premia as low as three percent? Empirical evidence from analysts'
earnings forecasts for domestic and international stock markets, Journal of Finance 56(5), pp 1629-1666.
31
Mighty River Power
Comments on the WACC / discount factor
109.
In the table below we have summarised the estimates prior to final
weighting.58
TABLE 5: SUMMARY OF PTMRP EVIDENCE
Weight
25%
75%
Historical
Forward-looking
Weighted
Point estimate: 0.064
33.33%
NZ
0.071
0.068
0.068
33.33%
US
0.082
0.055
0.062
33.33%
Other / World
0.076
0.059
0.063
Source: MJA analysis
110.
If we solely rely on New Zealand estimates we reach a value of 0.068. If we
rely on the world estimates we reach 0.063.
111.
Sensitivity analysis shows that applying a weight of 100% to the historical
estimate results in a point estimate of 0.076. However, to make the estimate
forward-looking would require a downward adjustment. Based on evidence
presented by Dimson et al. (2002) we suggest such an adjustment could
reasonably be between 0.010 – 0.020 and hence resulting in an estimate close
to 0.060. If instead 100% weight is placed on the forward-looking estimates
we reach 0.061. Finally, if we exclude the US evidence the PTMRP increases
to 0.066.
112.
Based on this analysis we recommend a PTMRP estimate of 0.06.
5.2.
Beta
113.
The term ‘beta’ refers to the relative risk of a return producing asset
expressed as a ratio of the covariance of income from the particular asset and
a well-diversified portfolio and the variance of the income from the
diversified portfolio. Beta should be estimated on the basis of the same
portfolio of assets as is used for estimating the MRP.59
114.
The equity beta measures the relative risk to shareholders in the particular
company or project and this reflects both the underlying risk of the project
and the risk to shareholders as a result of the higher claims of debt holders
resulting from having leveraged the balance sheet.60 In other words, the beta
57
Fama and French (2002), The Equity Premium, The Journal of Finance, vol. 57, pp 637-659.
58
We also note that there is an issue of averaging that would result in lowering the historical estimates.
59
The underlying rationale for CAPM is that asset/company specific risk can be eliminated by investors
through diversification in the market portfolio. The expected return on a specific asset should therefore only
depend on the correlation between the returns on the asset and the return on the portfolio. Hence, the two
figures are linked.
60
The debt beta is similarly a measure of the systematic, i.e., non-diversifiable, risks facing debt holders.
32
Mighty River Power
Comments on the WACC / discount factor
value shows whether an operator is more or less risky than the market. A
(equity) beta of 1.5 means that the share moves 1.5% for every 1.0% move in
the market index, outperforming the index in a bull market and
underperforming in a bear market. Conversely, a beta of 0.5 means that the
share's return is more stable than the market as a whole. The higher the beta,
the riskier the share and the higher the return required to compensate for this
higher risk.
115.
We note that an important role for the EC is to make an assessment, or
judgement, on the risk faced by Transpower before it can apply the CAPM to
estimate WACC. The difficulty in estimating beta is that there are relatively
few listed companies in New Zealand or elsewhere that are comparable to
Transpower.
116.
Lally’s commentary on beta values directly addresses these challenges for the
ELB by presenting detailed analysis of data for UK and US electricity and gas
utilities and comparing this with the limited data available for New Zealand
ELBs. Lally’s presentation of the available data is rational, reasonable and
thorough and we have no objections to the essential elements of his analysis.
117.
Lally also provides a qualitative comparison of the differences between the
regulatory arrangements in the UK and the US and argues the New Zealand
arrangements create greater risk for ELBs than the US arrangements but less
risk than the UK arrangements. In essence, Lally’s assessment appears to
hinge on the relative ease with which utilities are able to adjust prices to
reflect changes in cost and the frequency of regulatory reviews; and he
concludes that the differences exist in the regulatory arrangements between
the UK, US and New Zealand that justifies treating beta estimates differently
in each jurisdiction.
118.
However, the final step in his analysis is weak as described in the following
terms:61
“In summary, I use US electric utilities and gas distribution firms as a
base, and estimate their asset beta (β ) at .30. I then add a margin of
Ea
.10 to reflect the difference in regulatory regimes between New
Zealand and the US. This represents a margin (Δ) of .20 for five year
price-cap regulation, subject to an adjustment factor (Q) of .50 to
reflect the fact that the New Zealand lines businesses are more risky
than the US firms but less risky than a five year price-cap situation.
The result is a point estimate of .40.”
61
Lally (2005), p 47.
33
Mighty River Power
Comments on the WACC / discount factor
119.
It is clear that Lally has arbitrarily chosen a mid-way point between two
values but no evidence or argument is presented to support the use of 0.50 for
his ‘adjustment factor’. In fact, the evidence related to how the ELBs
perceive their own asset betas suggests that a lower value should be adopted.
Lally notes that these values range from 0.25 to 0.4, with a median of 0.37,
but dismisses this lower value on the basis that it is “close to the point
estimate of 0.4”,62 thereby increasing the estimate of WACC by some 20
basis points.
120.
In our view a mid-point value of no more than 0.3 equivalent to that estimated
by Lally for US energy utilities is appropriate for the ELBs. For Transpower,
Lally would appear to favour the same estimate of 0.3. Specifically, Lally
notes:63
Lines businesses that operate in a more cost-plus fashion would have
asset betas towards the lower end of the scale (.30), and those which
are not embedded within private sector firms may be of this type.
These include Transpower, community trusts, consumer trusts and
councils.
121.
In addition Lally refers to evidence provided to him by Transpower of an
asset beta of 0.25.64 Without additional confirmation of this value we are
reluctant to place much weight on it in our analysis, but note that it suggests
an asset beta of 0.3 may be a conservative estimate for Transpower.
122.
To conclude, we suggest a mid-point estimate of 0.3 with high and low range
estimates of 0.4 and 0.2 respectively. In terms of the specific adjustments
necessary for Transpower we refer to section 6.
5.3.
Leverage
123.
In the simple Brennan-Lally model used by the CC, the WACC will not
change materially from small changes to leverage. The lowest WACC figure
is obtained when the leverage ratio is zero since the advantage of lower cost
debt is more than offset by increases in the cost of equity. As Lally notes, the
effect of varying gearing within the range of ‘admissible values of actual
leverage’ is not large, affecting the estimated WACC by less than 30 bps65
using the Brennan-Lally formulae.
62
Lally (2005), p 49.
63
Lally (2005), p48, footnote 56.
64
Lally (2005). p. 49.
65
Lally (2005), p 54.
34
Mighty River Power
Comments on the WACC / discount factor
124.
Lally (2005) argues that it would be consistent to use optimal rather than
actual levels of gearing in conjunction with the use of efficient costs and
actual levels of gearing with actual costs. The use of optimal or ‘efficient
benchmark’ costs and gearing is universally adopted in both Australia and the
UK on the basis that it provides a direct commercial incentive for regulated
business to ‘beat the benchmarks’ by maximising efficiency of financial
arrangements and operations. Lally also suggests that the optimal level of
leverage may be determined by considering similar unregulated firms and on
this basis suggests a gearing of 40% for ELB.
125.
We have no objection to the arguments or analysis presented by Lally and
endorse an approach that seeks to set the WACC based on an optimum
gearing level. In addition the analysis conducted by Lally would appear to be
equally relevant to Transpower. Accordingly, we have retained a leverage
level equivalent to that of the CC. However, we note, for example, that
Australian and UK regulators have adopted markedly higher gearing levels
(in the 50% to 60% range) and generally argued that this produces optimal
outcomes for consumers, particularly with bond yields at historically low
levels.66
5.4.
Debt Premium
126.
The debt premium refers to the interest premium demanded by lenders and
bond markets for debt issued by a company compared with the rate for
risk-free debt, (i.e. the risk-free rate). As an empirically calculated estimate,
the debt margin requires no theory such as CAPM from which to derive an
estimate. The debt premium is therefore inserted into the WACC formula
directly.
127.
The debt premium can be estimated by observing published credit ratings,
which in turn are based on financial fundamentals such as market
capitalisation, earnings volatility, the free cash flow of a business and
business risks specific to the company and/or the sector. Credit rating
agencies consider a wide range of financial indicators that inform on a
different but related aspect of a business’ debt service capacity. For example,
a company with low interest coverage67 is less likely to maintain a premium
66
We note, however, that Australian and UK regulators may be responding to circumstances where some
privately owned, regulated businesses are very heavily geared – occasionally to levels in excess of 100% of
regulatory asset values. A key point that Australian and UK regulators make is that gearing up to 60% is
not likely to produce credit ratings below investment grade. We believe it would be entirely appropriate for
the CC and EC to investigate incentives for electricity lines businesses to pursue efficiency gains through
financing arrangements, particularly if any efficiency benefits from higher gearing can be passed through to
consumers.
67
The number of times a company can meet its interest payments out of its earnings.
35
Mighty River Power
Comments on the WACC / discount factor
credit rating since the probability of default on its interest payments will be
relatively high. Likewise, a company with a high gearing is also less likely to
maintain a high credit rating, as the probability of default on interest
payments will be higher. Hence credit ratings are closely related to the
capital structure and should be determined with consistent reference to the
gearing level.
128.
In our view, most weight should be put on observations of debt premium that
are consistent with the maturity period of the risk-free rate and that best
reflect a credit rating consistent with an optimal (or ‘efficient benchmark’)
gearing level.
129.
The CC uses a debt premium of 0.012 based on Lally (2005). We believe this
estimate is too high for a prudently managed, efficiently operated regulated
utility business.
130.
Lally (2005) argues that that the debt premium used in the Airfields Inquiry
of 0.01 is towards the low range for this parameter. He notes that a higher
gearing for the ELB suggests a higher debt premium for the ELB. Based on
an evaluation of very limited information from Powerco and Vector, he
concludes that a debt premium of 0.012 is appropriate.
131.
We take another approach which is used commonly in Australian regulatory
practice, i.e. establish a debt premium appropriate to the credit rating assigned
to an ‘efficiently financed’ regulated utility. This approach is taken because a
regulated business’s actual debt costs may be influenced by historical debt
costs, actual gearing and credit rating levels and hence may not reflect the
borrowing costs of an efficiently financed electricity network business.
132.
For the purpose of the WACC calculation, we suggest that a rating of A is
reasonable for Transpower. This is slightly below Transpower’s current
rating of AA-, and above the benchmark credit ratings of BBB+ for electricity
distribution68 used in Australia by the Independent Pricing and Regulatory
Tribunal of New South Wales (IPART) and the Essential Services
Commission of South Australia (ESCoSA).
133.
The figure below shows the margins over the New Zealand Government
Securities (NZGS) for differently rated debt issues and maturities.
68
For a gearing of 60%.
36
Mighty River Power
Comments on the WACC / discount factor
FIGURE 2: MARGIN OVER NZGS FOR SELECTED CORPORATE BONDS69
0.013
0.012
0.011
Margin over NZGS
0.010
0.009
0.008
0.007
0.006
0.005
0.004
10-Feb-06
24-Feb-06
10-Mar-06
24-Mar-06
Mighty River 5+5 Q# 15-May-08 (BBB+)
BNZ 15-Sep-08 (AA-)
AIAL 29-Jul-09 (A)
BNZ 15-Sep-09 (AA-)
07-Apr-06
21-Apr-06
05-May-06
19-May-06
02-Jun-06
NBNZ 5+5 Sub# 20-Aug-08 (A+)
AIAL 15-Nov-08 (A)
Vector Q 4-Mar-09 (BBB+)
Transpower 15-Dec-10 (AA-)
Source: MJA analysis of ABN-AMRO Craigs “Fixed Interest Wholesale Rates” various
134.
We note that the figure above only represents a selection of corporate bonds.
In March 2006, margins fell to around the 70-80 bp level and have since risen
slightly.
135.
The evidence presented above, suggests a fairly wide range when we consider
the whole time period. Based on this data we suggest an estimate of 80 bps.
This is similar to Australian estimates. However, due to the uncertainty in the
estimate we add 10 bps to our estimate to reach a final estimate of 90 bps.
136.
Lally (2005) also discussed the issue of adding an allowance for transaction
costs and other costs to raise debt. While we acknowledge that it is a
legitimate cost item it is our view that the figure of 30 bps suggested by Lally
is too high.
137.
In the ACCC’s 2005 decision for TransGrid, it considered that 8 bps be
allowed for debt raising.70 For Energy Australia the ACCC includes an
69
The NZGS is in each case aligned with the maturity of the corporate bond (by interpolation between
different NZGS maturities).
70
ACCC (2005a), NSW and ACT Transmission Network Revenue Cap TransGrid 2004/5 to 2008/9: Decision,
27 April, p 145.
The ACCC make use of study by The Allen Consulting Group (Debt and Equity Raising Transaction Costs:
Final Report, December 2004), indicating that the benchmark debt-raising transaction cost based on one
bond issue of $175 million would be around 10.4 bps, while six issues totalling $1,050 million would cost
about 8 bps. These estimates were based upon a debt maturity of 7 years, and so would understate the
transactions cost associated with 3-year debt (i.e. when converted into basis point terms).
37
Mighty River Power
Comments on the WACC / discount factor
allowance of 9 bps.71. While the Australian Competition Tribunal has ruled
for an allowance of 25 bps per annum,72 no detailed empirical work has been
published to support this level of costs. In this respect we also note that
debt-raising costs are affected by scale economies and hence should be
evaluated on a case-by-case basis.
138.
In the UK, utility regulators assess the applicable debt premium by analysing
observed bond margins and forming a view on a reasonable benchmark rate
for the regulated utility. No specific allowance for debt-raising costs is
provided. The UK regulators argue that the basis points provided for any
debt premium errs on the side of caution and any debt-raising costs are within
their estimated range or point estimate.
139.
In our view, this evidence suggests that issue costs would add no more than
10 bps to the debt premium. However, we note that the Australian figures are
based on a longer bond term than is assumed here and hence should be
adjusted. Applying the same methodology as Lally to adjust for the price
resetting frequency we estimate the issue costs would add no more than 20
bps to the debt premium.
140.
To summarise, we believe a reasonable estimate for debt premium to be
0.0090. Adding a 20 bps margin for debt-raising costs results in an estimate
of 0.0110.
5.5.
Summary of estimates
141.
Below we have provided a summary of WACC estimates using our preferred
parameters.
71
ACCC (2005b), NSW and ACT Transmission Network Revenue Cap EnergyAustralia 2004–05 to 2008–09:
Decision, 27 April, p82.
72
Application by GasNet Australia (Operations) Pty Ltd [2003], ACompT 6 (23 December 2003). The
GasNet decision concerned the National Third Party Access Code for Natural Gas Pipeline Systems (Code).
Decision available at [5 June]:
http://www.austlii.edu.au/cgi-bin/disp.pl/au/cases/cth/ACompT/2003/6.html?query=gasnet
38
Mighty River Power
Comments on the WACC / discount factor
TABLE 6: MJA PREFERED ESTIMATES FOR TRANSPOWER*
Risk free Rate
Post Tax MRP
Equity Beta
Asset Beta
Cost of Equity
Debt Premium**
Cost of Debt (pre-tax)
Gearing
Corporate Tax Rate
Investor Tax Rate
Post-tax Nominal WACC
Inflation rate
Pre-tax Real WACC (forward transformation)
Pre-tax Real WACC (reverse transformation)
Low
6.10%
6.0%
0.333
0.2
6.09%
0.90%
7.00%
40.0%
33.0%
33.0%
5.53%
3.0%
5.10%
3.66%
High
6.10%
6.0%
0.667
0.4
8.09%
1.30%
7.40%
40.0%
33.0%
33.0%
6.84%
3.0%
6.99%
5.56%
Mid-point
6.10%
6.0%
0.500
0.3
7.09%
1.10%
7.20%
40.0%
33.0%
33.0%
6.18%
3.0%
6.05%
4.61%
*Table cells shaded grey are input values.
** includes debt issue costs
Source: MJA analysis
142.
73
The results in the table above indicate the real, pre-tax discount rate used by
the EC, which is based on Transpower’s unexplained and unsupported
estimate of real, pre-tax WACC of 7.0%, is too high. In our view a value no
higher of 6.05% would be appropriate. We also consider that the EC should
use 5.1% and 7.0% in its sensitivity analysis.73 We consider this to be a
conservative estimate i.e., erring on the high side.
As we have argued above, we believe it is appropriate to use an efficient WACC as the discount rate and as
such prefer to use the high and low values that are outputs from our analysis.
39
Mighty River Power
Comments on the WACC / discount factor
6. Additional adjustments
143.
Finally, we consider further adjustments to reflect:
ƒ
differences between the WACC for a transmission and distribution
business; and
ƒ
differences between the regulatory context of price control (Unison) and
application of the GIT.
144.
Material presented in sections 3 through 5 above assumes, in effect, that there
is no fundamental difference that need be given to consideration of issues
related to selection of the preferred WACC methodology or selection of
parameter values (except for the risk-free rate) that can be used to develop an
estimate of WACC for electricity distribution (ELBs) or electricity
transmission.
145.
This view is pragmatic and reflects prevailing regulatory practice in the UK
and Australia. In turn, this pragmatism and practice reflects:
ƒ
the inevitable judgements that are required to estimate any WACC values
because none of the input parameters are capable or direct observation,
because all should desirably be related to future outcomes that are – by
definition – unmeasurable;
ƒ
the relatively low levels of undiversifiable risk inherent in utility
businesses that have long-lived assets facing relatively low risk of asset
stranding from:
ƒ
•
changes in usage patterns due to the inherently ‘essential’ nature of
the services those assets provide; and
•
technological innovations that are likely to cause ‘redundancy’ of the
assets prior to reaching any reasonable technical life.74
the fact that, as a pragmatic response to lack of ‘market data’ from which
parameter value estimates can be made, economic regulators in
Australia75 and the UK routinely assemble ‘comparable’ data from a
74
Note that this is different to the telecommunications market, where we have previously argued for a
divisionalised beta approach, i.e. different asset betas for different services. Telecommunications operators
provide a wide range of services that operate under different competitive and technological conditions. For
example, TSO services have a very different risk profile to say mobile services, but both are provided by
Telecom New Zealand. Hence even if separate betas cannot be directly observed for each of these services,
separate beta estimates should be used. Here telecommunications has the “luxury” of benchmark data to
make these corrections. Very limited data of this type exists for the electricity sector.
75
For example, in their most recent determinations, the ACCC and Australian jurisdictional regulators
compare regulatory precedents and market data analyses for electricity and gas transmission and
distribution. In addition, the Chairman of the Western Australian Economic Regulatory Authority has
40
Mighty River Power
Comments on the WACC / discount factor
range of energy utilities (and for some parameters, ‘non-energy and nonutility, infrastructure’ industries such as airports, railroads, ports and
water industries). Implicitly, it is obvious that there are substantially
greater physical and market differences between (say) gas distribution
assets and electricity transmission assets than exists between electricity
transmission and electricity distribution (ELBs) assets.
146.
Accordingly, and in the absence of significant volumes of data on the market
performance of directly comparable businesses, it is our view that there is
currently no transparently defendable justification for adopting different beta
parameter values for electricity transmission and electricity distribution
(ELBs) business. That is not to say the EC should adopt the same WACC in
Part F of the EGRs as the CC would adopt for Part IVA of the Commerce
Act. The EC should not simply adopt the CC’s WACC, but should apply the
CC’s methodology for calculation of WACC.
147.
On the other hand, and as noted in other parts of this paper, there are
fundamental differences between the function of an ‘efficient WACC’ in the
determination of regulated revenue and/or prices and as a GIT discount rate.
ƒ
The objective of an ‘efficient WACC’ in a revenue/price determination
process is to provide an estimate of the ‘cost of capital’ that reasonable,
informed financial market investors might expect from investing in an
efficient, prudently-managed business operating in an effectively and
efficiently regulated industry.
ƒ
The objective assigned to the discount rate in the GIT analyses (or any
form of cost-benefit analysis) is to assist in ranking alternative options
with differing cost/benefit value streams.
148.
As such we agree with EC (and its consultants) that the prime function of the
discount rate in a GIT analysis is to assist in ranking investment options with
differing cost/benefit value streams. This is different to the regulatory
function of an 'efficient' WACC in the determination of revenue/pricing
arrangements. A GIT discount rate need therefore not be the same value as
an 'efficient WACC', even though it is sensible to undertake analysis of
investment options using a discount rate that has a value that is not too
dissimilar to an 'efficient WACC'.
149.
Nevertheless, if the GUP is accepted by the EC, Section 17 of Part F of the
EGRs guarantees recovery of the approved costs of Transpower’s GUP
prepared a summary of regulatory decision relating the WACC parameter values for the electricity, gas, rail
and water industries and argued that his Authority can be seen to be making decisions that are entirely
consistent with other regulators.
41
Mighty River Power
Comments on the WACC / discount factor
investments and the recovery is exempt from Part IVA (price control
provisions) of the Commerce Act. Transpower is guaranteed this recover
even if – ex-post – the EC determined that it had erred in its decision.76 The
consequence of this is that the asset Beta for Transpower’s new GUP
investments may well be lower than the asset Beta in the context of price
control.
150.
Accordingly, the WACC would, in principle, be expected to be lower for any
investments undertaken consistent with the GUP.
151.
With no data to support a selective allocation of different beta values to
individual assets or prospective projects within a single transmission
business, a possible compromise is to set the asset beta for any GUP
investments equal to the lower range estimate of 0.2 in our analysis. This
would yield an estimate of the real pre-tax WACC (using the forward
transformation and input parameters as in Table 6) of 5.18%. However, more
analysis would be needed before such an estimate could be relied upon. We
recommend that the EC undertake this research.
152.
In addition, to this adjustment it may also be necessary to adjust the risk-free
rate. We have assumed a period of 3 years equal to that used by the CC.
However, the final value may either reflect the time period that is applicable
for the regulatory decision or the time period for the investment and should be
updated to reflect the most recent data.
76
The EC could initiate action preventing Transpower’s recovery of the initial investment cost (assuming of
course that Transpower was demonstrably able to undertake the actual investment in a prudent and efficient
manner that was demonstrably consistent with ‘good electricity industry practice’).
42