The Australian Consumers' Dilemma: Lack of Regulatory Transparency in WACC Decisions

1. ACCCStatement of Regulatory Principles WorkshopMelbourne 2 April 2004 WACCAustralian consumers’ dilemma Dr Jeff Washusen

2. This is about regulatory transparency • The presentation is not intended to express or support an advocacy position on a value of WACC. • Clauses 6.2.2(i) and 6.10.2(i) of the Code require regulators to “seek to achieve reasonable regulatory accountability through transparency and public disclosure of regulatory processes and the basis of regulatory decisions.” • From the perspective of consumers, not one Australian regulator has succeeded in meeting this requirement in WACC decisions. WACC - Australian consumers’ dilemma

3. Background • The following plots of WACC, Cost of Debt (CoD) and Return on Equity (RoE): • present a comparison of AUS and UK regulators’ judgements. • first presented to ACCC in June 2002 on behalf of BHP-Billiton. • US data included for reference. • subsequent regulatory decisions added. • use CAPM and WACC parameter values adopted by regulators. • are based on simpler ‘Vanilla’ real, post-tax WACC formula: • ‘normalises’ for inflation and tax treatment; • eliminates incomprehensible forward/reverse transformations, which AUS regulators occasionally get wrong; and • provides ‘like-for-like’ values for WACC, CoD and RoE. WACC - Australian consumers’ dilemma

4. Which WACC? What WACC? WACC - Australian consumers’ dilemma

5. Observations on WACC • UK regulators set WACC at similar levels for electricity, gas and water (and rail and airports) - for whole industries. • slightly lower values for very large companies • slightly higher values for very small companies. • AUS regulators set much more varied and much higher WACC – even the same regulator for one segment of single industries. • These are not small differences. For electricity consumers, the cost is in the order of $400-450 million/year compared to adopting UK approach to setting WACC. • A reasonable question to ask is: Why? (Not to mention all the questions about the relevance of esoteric arguments on the relative level of risk of utility industries.) WACC - Australian consumers’ dilemma

6. It is not the Cost of Debt Methods essentially identical. UK & AUS values overlap. WACC - Australian consumers’ dilemma

7. It is the Return on Equity Noting that the vertical scale in the RoE diagram is twice that of the WACC and CoD diagrams. WACC - Australian consumers’ dilemma

8. Observations on RoE • RoE values higher and more varied in AUS than UK • ‘Out-turn’ RoE in the UK appear similar to ‘capped’ values in the US • RoE values in AUS set even higher than ‘capped’ values for ‘cost of service’ regimes in the US, even though: • ‘incentives’ in UK & AUS regimes provide opportunities for efficient, well-managed utilities to out-perform building block benchmarks • which, allows ‘out-turn’ RoE higher than regulators’ values • Efficient, well-managed AUS utilities possibly achieve ‘out-turn’ RoE very much higher than US utilities. • Again it is reasonable to ask: Why? WACC - Australian consumers’ dilemma

9. Put aside econometricians & statisticians view of WACC and CAPM. • It is not true, as the ACCC asserted in 1998, that “(s)ince the WACC has been established on the basis of a CAPM framework, the regulatory return, by definition, does not incorporate any significant level of monopoly rents.”1 • UK regulators accept that CAPM is just a convenient model: • not one parameter is directly measurable • proxy data is highly variable • individual parameter values not as important as the outcome • judgement is essential 1: p. 65, Victorian Gas Transmission Access Arrangements - Final Decision, ACCC, 06Oct98 WACC - Australian consumers’ dilemma

10. Single biggest difference is that AUS regulators adopt 6.0% for the Market Risk Premium, while UK regulators accept 3.0% to 4.0%. • All UK regulators agree that Beta value of 1.0 is very generous for utility shareholders; and • Debt margin also provides incentive for financing ‘efficiency’. WACC - Australian consumers’ dilemma

11. A simple comparison of analysis in UK regulators’ decisions shows: • UK MRP from 1919 to 1989 of just under 6.0% (geometric mean – and around 2% higher for arithmetic mean).1 • Long-run UK MRPin the range 4.7%-6.5% relative to bills, or 4.4%-5.6% relative to bond returns, depending on whether geometric or arithmetic means are used.2 • Over the 1900-2000 period, US MRP estimates in the range of 5.6%-7.5% relative to bills, again depending on whether geometric or arithmetic means are used.2 1: p. 36, Cost of Capital, OFWAT, Jul91 2: p. 19, Economic regulation and the Cost of Capital. Annex, UK Civil Aviation Authority, Nov01 WACC - Australian consumers’ dilemma

12. ACCC’s view is that AUS MRP still between 5% - 7%, based on backward-looking analysis of long-term historical data, even though: • clauses 6.2.2(b)(2) and 6.10.2(b)(2) of the Code requires regulators ‘to seek to achieve an incentive-based regulatory regime which provides for, on a prospective basis, a sustainable commercial revenue stream which includes a fair and reasonable rate of return on efficient investment’ • the ACCC notes that the Jardine Fleming capital markets survey found the expected MRPto be no more than 4.9%3 • and even this statement is not as transparent as it could be: ESCoSA shows the Jardine Fleming survey yielding expected MRP of: • 3.13% from Asset Consultants/Trustees; 4.50% from Brokers; 4.92% from Academics; 5.27% from Corporate Managers • with an average value of 4.73%.4 3: p. 83, Tasmanian Transmission Network Revenue Cap: Decision, ACCC, 10Dec03. 4: p. 63, Electricity Distribution Price Review: Return on Assets – Preliminary Views, ESCoSA, Jan04. WACC - Australian consumers’ dilemma

13. Observations on MRP • UK regulators say historical values for MRP in the UK lie between 4.4% and 8.0% and in the US between 5.6% and 7.5%; • and a comparison of regulatory decisions over the last decade suggests evidence that long-term historical values are falling. • The ACCC says historical MRP in AUS lies between 5% and 7%. • Yet UK regulators adopt values of 3.0% to 4.0% - and this yields lower values of WACC. • Why? • BecauseUK regulators accept credible independent financial market view that expectedMRP will be lower than analysis of historical data suggests. WACC - Australian consumers’ dilemma

14. The ACCC justified its Transend decision by saying: • “it is satisfied that the MRP in Australia will be different because: • despite global markets, a perception of segmented stock markets still exists and investors may require a higher premium to invest in the Australian market • a domestic CAPM version is used in estimating the required cost of equity • the UK adopts a ‘real’ CAPM, therefore direct comparisons are not as straight forward.”1 • What does that mean? • Consumers are justified in asking: Is this transparent regulation? 1: p. 83, Tasmanian Transmission Network Revenue Cap: Decision, ACCC, 10Dec03. WACC - Australian consumers’ dilemma

15. UK Judgements and Outcomes • UK regulators judge that financial markets will voluntarily support utilities with lower WACC than history suggests – and WACC should be set for efficient, well-managed industries. • UK regulators accept that ‘inefficient’ utilities should financially re-structure to become efficient. • Outcome shows UK regulators’ judgement correct. Since privatisation, more than £16 billion has been invested in the electricity transmission and distribution networks.1 • Voluntary financial market support also clear in gas and water (and rail and airports) – with similar WACC. 1. OFGEM Media release R/20 10 March 2004. WACC - Australian consumers’ dilemma

16. The UK View • International financial markets that support AUS and UK utilities see UK regulated electricity, gas and water utilities as safe, reliable, efficient ‘earners’. • There is not that much difference in UK & AUS regulatory regimes – except the UK has demonstrably independent, more far-sighted regulators and more transparent financial markets. • Commonly held views of UK regulators are demonstrated in the following: • “The cost of capital is the level of return required by the financial markets in order to provide capital to a firm.” 1 • “In contrast to their product markets, all utilities can reasonably be assumed to face fully competitive capital markets. In such markets, asset prices will always ensure that a new investor in the firm will simply earn the competitive (risk-adjusted) return.” 2 1: p. 4, Economic regulation and the Cost of Capital. Annex, UK Civil Aviation Authority, Nov01 2. p. 1, A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K., Report commissioned by the U.K. economic regulators and the Office of Fair Trading, Wright, Mason & Miles, 13Feb03 WACC - Australian consumers’ dilemma

17. Questions for Australian regulators • How do consumers benefit from financing ‘efficiency’ if regulators consistently make ‘conservative’ judgements on CAPM parameter values in consecutive reviews? • What is the basis for regulatory judgements that international financial markets see Australian regulated utilities as being less ‘efficient’ (i.e. more costly to finance) than their UK counterparts? • If financial markets judge the Australian economy to be less efficient than overseas counterparts (the Henry Curve), and this justifies higher WACC than the UK, why are Australia’s non-regulated, capital intensive industries competitive in international markets? • Why do Australian regulators still use backward-looking analysis of CAPM parameter data to derive values of expected parameters when UK regulators avoid this inconsistency by making informed judgements on the future value of those same parameters? WACC - Australian consumers’ dilemma

18. Is Australia less efficient? The Henry Curve1 UK US 1: Naming rights courtesy Dr John Tamblyn, Chairman ESC. WACC - Australian consumers’ dilemma

19. Is Australia less efficient? The Henry Curve WACC - Australian consumers’ dilemma

20. Is Australia less efficient? The Henry Curve WACC - Australian consumers’ dilemma

21. Is Australia less efficient? The Henry Curve WACC - Australian consumers’ dilemma

22. Is Australia less efficient? The Henry Curve • Henry Ergas included the first of these diagrams in a presentation made to the SPI PowerNet, ElectraNet SA, GasNet Australia WACC seminar in late June 2002. • The diagram appeared to suggest that financial markets expect higher returns in AUS than either the UK or US, but: • the diagram represents predictions of expected returns for non-market economies from one of three models presented by Erb et al (1996). • Erb et almade no claim that their models predict expected returns in market economies like AUS. • actual market data used by Erb et al shows expected returns for AUS (between 1979-1995) slightly below those for the US and UK. • If the data presented by Erb et al is and remains valid, financial markets would expect AUS to deliver the same returns as (or slightly less than) the UK and the US economies. WACC - Australian consumers’ dilemma

23. Conclusions • There is uncertainty about WACC. • But ignoring complex issues and difficult judgements is not the answer. • Regulators have a duty and responsibility to deliver balanced, transparent judgements. • It is time to move the debate on and address the issues. • Australia’s competitiveness could be compromised by failure to resolve these issues. • Australian consumers are waiting with bated breath. WACC - Australian consumers’ dilemma