The Australian Energy Regulator today issued its final decision on the weighted average cost of capital (WACC) for regulated electricity networks.
The decision includes the rate of return values and methods to be adopted in future electricity network pricing determinations by the AER. The weighted average cost of capital represents the cost of debt and equity required by an efficient benchmark electricity network business to supply regulated electricity services.
"This is the first review of the WACC under the National Electricity Rules and it has coincided with extraordinary conditions in world economies and financial markets," AER Chairman, Mr Steve Edwell, said today.
"While this has made the process of determining WACC values particularly difficult, the AER has undertaken an extensive consideration of relevant issues and submissions from interested parties to the AER's earlier draft position. We have looked at the latest empirical evidence and other information and have assessed the robustness and reliability of all the evidence provided.
"As a result, the AER has revised a number of the WACC parameters from the currently deemed values, including some changes from those set out in its draft position," Mr Edwell said.
This final decision on revised WACC parameters (based on a longer term nominal risk free rate, given the historically low rates at this point in time) results in a weighted average cost of capital of 8.8 per cent. This represents an increase from AER's draft position (8.5 per cent on a comparable basis).
The AER has necessarily taken a long-term perspective, but reflective of current market conditions to the extent these conditions may prevail over the period the revised WACC parameters apply.
"Importantly, under this decision the longer term return on equity is likely to remain around 11 per cent, close to its historical average, which promotes relative stability in equity returns despite greater volatility in returns across the economy. This is an increase from the cost of equity proposed in the AER's draft position (10.5 per cent on a comparable basis)."
While the AER is mindful of current conditions in financial markets, it should be noted the cost of borrowings incorporated in AER decisions reflects the market cost of debt at the time of each regulatory decision. In other words, the regulatory regime will continue to compensate businesses for the actual cost of debt financing prevailing at the time of each decision.
The AER, after an exhaustive investigation of the new evidence, has increased the premium for equity risk and reverted (from its draft position) to a 10 year term for the risk free rate. It has also maintained the credit rating to BBB+ for the benchmark electricity business. These changes from the draft position better reflect both current and ongoing conditions in credit markets and ensure that businesses are fully compensated for the costs of debt.
"In reviewing each WACC parameter the AER has taken a balanced approach to the interpretation of evidence from market data by having regard to the strengths and weaknesses of market data.
"In a practical sense this means that the AER has not mechanistically determined the proposed WACC parameters solely on the basis of empirical estimates. This approach has been adopted consistently across the WACC parameters subject to the review," Mr Edwell said.
For example, in reviewing the empirical evidence, the AER considers a prudent response to current uncertainties about financial conditions is to increase the market risk premium from its historical average of 6 per cent to 6.5 per cent. This is based on a cautious interpretation of the historical evidence.
Similarly, the AER has taken a cautious interpretation of empirical evidence on the equity beta of a benchmark electricity network business by adopting a value that is above the reasonable range indicated by empirical estimates.
The AER's revised values, methods and credit rating are listed in the background note below.
Mr Edwell said the AER considers the proposed WACC parameters are more reflective of a forward-looking rate of return, commensurate with prevailing conditions in the market for funds and the risk involved in providing regulated services, than the current WACC values and methods.
"The AER's revised WACC parameter values and methods are expected to provide an overall rate of return that is likely to contribute to and achieve an outcome which is consistent with the national electricity objective of promoting efficient investment in electricity networks for the long-term interests of consumers."
Background
The National Electricity Rules provide that the Australian Energy Regulator may review the WACC parameters to be adopted in determinations for electricity transmission and distribution network service providers (TNSPs and DNSPs).
Reviews are to be conducted every five years, for transmission, and at least every five years for distribution. The first review is to be concluded by 1 May 2009, at which time the AER will release a final decision to apply to both transmission and distribution determinations.
For transmission determinations, the outcomes of this review are 'locked-in' for all determinations where the regulatory proposal is submitted after 1 May 2009 and prior to the next review being completed. For distribution determinations, the outcomes of this review also apply to all determinations where the regulatory proposal is submitted after 1 May 2009 and prior to the next review being completed, unless there is persuasive evidence to depart from the outcomes of this review at the time of the determination.
On 6 August 2008, the AER released an issues paper seeking comments on a range of issues relevant to this review. On 10 October 2008, the AER held a 'round table' of finance experts to seek clarification on matters raised in the consultant reports submitted by the industry associations. On 11 December 2008, the AER released its statement of proposed WACC parameters and its accompanying explanatory statement. The AER had regard to the submissions received and comments at the round table in forming its proposed WACC parameter values, methods and credit rating.
Among other requirements, the NER provide that where a parameter cannot be determined with certainty, the AER must have regard to the need for persuasive evidence before adopting a value or method that differs from the previously adopted value or method.
The AER has concluded that there is persuasive evidence to change the following WACC parameters as follows:
- The equity beta should fall from 1.0 or 0.90 (as the case may be) to 0.8 for a benchmark efficient network electricity service provider
- The gamma value should increase from 0.50 to 0.65 for a benchmark efficient electricity network service provider
- The market risk premium should increase from 6 per cent to 6.5 per cent for a benchmark efficient electricity network service provider.
There is insufficient persuasive evidence to change the following parameters:
- The level of gearing should remain unchanged at 60 per cent for a benchmark efficient electricity network service provider
- The term of the risk free rate should remain unchanged at 10 years for a benchmark efficient electricity network service provider
- The credit rating should remain unchanged at BBB+ for a benchmark efficient electricity network service provider.