Draft Statement of Regulatory Principles Consultation ‘Fostering a Stable Investment Environment’

1. Draft Statement of Regulatory Principles Consultation ‘Fostering a Stable Investment Environment’ Philip Gall, Manager/Regulatory Affairs TransGrid March 2004

2. Introduction Part 1 – Asset Valuation • Incentives Depend on the Package – Asset Valuation Principles, Capex Recognition Process, Opex carry over, Level of Regulated Rates of Return • Roll Forward Approach – supported in principle but details matter • Regulatory stability vital for long life infrastructure businesses Part 2 – Setting WACC • Cessation to Hostilities – a ‘Win/Win’! • Beta - A key Parameter!

3. Roll Forward Makes Sense • Replacement cost is judgemental – do it once and move on • Actual expenditure easier to measure • Optimisation doesn’t really make sense • Impossible to administer – ACCC methodology still not specified • Imposes risks for which TNSPs are not rewarded • Difficult risk for TNSPs to manage – limited value in influencing behaviour • ‘Recognition’ of capex during a regulatory period still an issue – difficult to assess whether efficient or not

4. Details Matter • Adopt principle of preservation of financial capital? • Proper process for ‘recognising’ efficient investments • Does the regulatory regime create inflation risk? • NEC and DSoRP implies that TNSPs do not bear forecasting discrepancy (inflation) risk (i.e. the risk arising when outturn CPI is greater than forecast CPI). • 2003 DSoRP states… “the TNSP does not face inflation risk within the regulatory period”. • TransGrid believes that the regulatory framework does not create inflation risk • TransGrid roll forward proposal: Real Post Tax WACC calculating for roll forward and adjust for annual outturn CPI.

5. Need to Consult on Details • ACCC has given some consideration to the details • This needs to be shared with stakeholders • Suggest that this includes ‘worked examples’ to settle any confusion

6. Locking In? • What does this mean – will this be reviewed again in 5 years by a new ACCC/AER team? • How will ‘locking in’ be achieved? • Correct obvious valuation anomalies first? • Is a Code change good enough? • Improved certainty of asset valuation vital to: • Avoid a cost ‘premium’ for customers and TNSPs • Allow regulatory regime to focus on getting incentives for future decisions right

7. The WACC – A Cessation in Hostilities? • TransGrid believes that the nature of the debate in Australia surrounding the regulatory WACC has been detrimental to good regulatory outcomes. • Incentives to invest in long lived assets depend as much on the expected future WACC as on the currently prevailing WACC. • Statements by the ACCC that its allowed WACC is ‘conservative’ or ‘too high’ hurt investment the same as actually reducing the WACC. • Businesses are not blameless in eliciting such comments from the ACCC. • Customers are the losers as they pay one WACC but don’t receive the full benefits of that in terms of incentives for businesses to make necessary investments

8. The WACC – A Cessation in Hostilities? Cont’d • The DRP discussion paper opens up a whole new front in the debate by flagging a reduction in the TNSP’s beta based on market evidence – evidence that is claimed to support beta values as low as 0.2. • As discussed in the following slides TransGrid believes that the discussion paper analysis of beta is flawed on a number of levels. • However, the most important point TransGrid wishes to make is that the uncertainty about future WACC parameters hurts investment today. • The best contribution the ACCC could make to the current debate is to commit to maintaining current parameter values unless there is a compelling case for change. • Businesses could be equally cautious in making counter claims about the lack of generosity implicit in the ACCC’s current parameter values.

9. Beta - the Discussion Paper Proposed Approach • The ACCC’s preferred position is for ‘a move towards benchmarking an equity beta from current market evidence and incorporating an upper confidence interval’ • This involves a number of methodological steps: • Identify comparable (independent) firms • Define returns (for firms and market portfolio) • Define the relevant historical period • Calculate beta for each comparable firm • Adjust these to uniform gearing • Calculate the mean of these adjusted betas • Define the desired confidence interval (90%,95%,99%?) • Calculate the desired upper bound • All of these steps are problematic. But imagine that you resolve enough of them to arrive at the calculation of confidence intervals

10. Beta – the Estimation of Confidence Intervals • Estimating a 95% confidence interval appears reasonable • However, the confidence interval for what? For each TNSP’s beta? Or for the mean population beta? • The ACCC discussion paper did not deal with this question explicitly. However, it implicitly estimated the former (based on a sample of ‘infrastructure’ businesses). • TransGrid does not believe this is a sensible use of confidence intervals in the context of setting the WACC for regulated businesses. • A 95% confidence that the population mean beta is withina given range does not imply 95% probability that each firm’s beta is within that range. • In fact, as the sample size increases the discussion paper’s (implicit) approach is consistent with setting a 50% probability that the WACC for a TNSP will be set below the true WACC

11. Distribution of individual firm s Distribution of the sample mean  Mean  95% confidence for population mean  95% confidence for individual  Beta – the Estimation of Confidence Intervals

12. Beta – the Estimation of Confidence Intervals • 95% upper bound for ‘population mean’ Beta versus 95% upper bound for TNSP’s beta • Note the average of the combined sample is greater than 1. • Note also that the ACCC figures derived using two tailed test (true upper bound is less than this)

13. Concluding Remarks • ACCC opened up unnecessary uncertainty over WACC • Closer inspection of ACCC proposal shows that beta above 1 still justified • Adopting a policy of WACC parameter change only when case for change is compelling has benefits for all