The Australian Energy Regulator today issued its proposed statement on the weighted average cost of capital (WACC) values and methods it proposes to adopt in future electricity network determinations.
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.
The proposed statement of revised WACC parameters for transmission and distribution businesses and accompanying explanatory statement has been issued for formal consultation with interested parties under the National Electricity Rules (NER). A final decision by the AER is due by 31 March 2009.
Under the NER, the AER is required to review the current WACC parameter values and methods and may choose to revise individual parameter values or methods, having regard, amongst other factors, to whether there is persuasive evidence to depart from the current value or method.
"Following a detailed consideration of relevant issues and input from interested parties to the AER's issues paper, and having regard to the latest empirical evidence and other information, the AER proposes to revise a number of the WACC parameters," AER Chairman, Mr Steve Edwell said today.
The indicative effect of all proposed changes to WACC parameters would reduce the weighted average cost of capital in current market conditions from 9.56 per cent for transmission and some distribution businesses, or 9.32 per cent for other distribution businesses to 8.60 per cent. The AER's proposed values and methods are listed in the background below.
"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.
"In particular, the AER has had regard to broader considerations within the national electricity market objectives and the current financial market environment. Consequently, the AER does not propose to revise the WACC to the full extent that market data, taken in isolation, would suggest."
Mr Edwell said the AER considers the proposed rate of return is 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 proposed 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."
While the AER is mindful of current conditions in financial markets, it should be noted that the cost of borrowings incorporated in AER decisions reflect market cost of debt at the time of the decision. In other words, the regulatory regime will continue to compensate businesses for the actual cost of debt financing prevailing at the time of the decision. This means the regulatory regime tends to insulate regulated network businesses from market volatility. More generally, it is important to take a long-term perspective in setting rates of return which will be generally applicable over the 2010-2018 period.
Interested parties are invited to make written submissions to the AER's proposed WACC positions statement by 28 January 2009. The explanatory statement and supporting documentation will be available from the AER's website.
A public forum to outline the AER's proposed positions is to be held at the Melbourne Airport Hilton on Wednesday 17 December 2008.
The National Electricity Rules (NER) provide that the Australian Energy Regulator may review the weighted average cost of capital (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 31 March 2009, at which time the AER will issue 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 31 March 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 31 March 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. Fourteen submissions were received in response to the issues paper. 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. The AER has had regard to the submissions received and comments at the round table in forming its proposed WACC parameter values and methods.
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.
As part of this review, the AER has undertaken a detailed analysis of all the available evidence from submissions and expert consultants, and generated a 'best estimate' or range of estimates for each of the individual WACC parameters subject to review, taking into account conceptual considerations and empirical evidence. Consideration is then given to broader issues to ensure consistency with NEL objectives (e.g. efficient investment incentives, regulatory certainty, etc.) in determining the extent to which these individual estimates for each of the WACC parameters are relied upon in generating the overall rate of return.
The AER has concluded that there is persuasive evidence to change the following WACC parameters as follows:
- The benchmark equity beta should fall from 1.0 or 0.90 (as the case may be) to 0.8
- The gamma value should increase from 0.50 to 0.65
- The benchmark credit rating should increase from BBB+ to A-
- The risk free rate period should match the term of the regulatory period.
There is insufficient persuasive evidence to change the following parameters:
- The benchmark level of gearing should remain unchanged at 60 per cent
- The market risk premium should remain unchanged at 6 per cent
An indicative effect of these proposed changes would reduce the weighted average cost of capital points in current market conditions from 9.56 per cent to 8.95 per cent, a reduction of 61 basis points. This overall WACC is indicative as it will reflect the market conditions prevailing at the time of a transmission and distribution determination.
The following figure illustrates which determinations the outcomes of this review will apply to. Also illustrated the determinations which the current WACC parameters apply to, and which determinations the outcomes of the AER's second review, to be completed in 2014, will apply to.
The above figure assumes a five year regulatory period for all future determinations. Under the NER, five years is the minimum length of a regulatory period, however network businesses may propose a longer period.