Transcript The Victorian Crematoria Industry A Financial Viability Review

ACCC
Statement of Regulatory
Principles Workshop
Melbourne 2 April 2004
WACC
Australian consumers’ dilemma
Dr Jeff Washusen
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.”

2 April 2004
From the perspective of consumers, not one Australian regulator
has succeeded in meeting this requirement in WACC decisions.
WACC - Australian consumers’ dilemma
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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:
•
•
•
2 April 2004
‘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.
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Which WACC? What WACC?
8.0%
ESTIMATED WACC ("Vanilla" Real, post-tax)
Gas - ACCC 1998 (Trans)
Gas - IPART 2000 (Dist)
Gas - OFFGAR 2000 (Dist)
7.0%
Gas - OFFGAR 2003 (Final)
ORG - Elec Dist
Gas - ESC 2002
Elec - IPART 1999 (Dist)
ACCC
TPA
Elec - ORG 2000 (Dist)
ACCC Transgrid
ACCC
Powerlink
Elec - QCA 2000 (Dist)
Elec - ACCC 2000 (Transgrid)
Elec - ACCC 2002 (ElectraNet))
IPART - Gas
Elec - ACCC 2001 (Powerlink)
ACCC Transend
IPART - Elec
Elec - ACCC 2002 (SPI PowerNet))
6.0%
ACCC
ElectraNet
Elec - ACCC 2003 (Transend)
IPART Draft
ACCC
SPI PowerNet
QCA - Elec Dist
Elec - IPART 2004 (Dist-Draft-Mid)
Water - IPART 2000
NERA
(Too high?)
IPART - Water
UK Gas - OFGEM 2001 (Transco)
UK Gas - OFGEM 2002 (Ind Trans)
UK Water Range
UK Elec - OFFER 1994 (Dist SHE Mid-range)
UK Elec - UKMMS 1994 (Dist SHE Appeal Mid-range)
UK Elec - OFGEM 1999 (Dist)
5.0%
UK Elec - OFGEM 2000 (NGC)
OFWAT
(Not less than)
UK Elec - OFGEM 2004 (Mid-range)
UK W&SCo - OFWAT 1999 (Large Co)
UK WoC - OFWAT 1999 (Small Co)
US Gas - Average by year
US Elec - Average by year
US RoR estimated real, post-tax @ 60% gearing
YEAR
4.0%
91
2 April 2004
92
93
94
95
96
97
98
99
00
01
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03
04
05
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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.)
2 April 2004
WACC - Australian consumers’ dilemma
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It is not the Cost of Debt
6%
ESTIMATED COST OF DEBT (Real)
Gas - ACCC 1998 (Trans)
Gas - IPART 2000 (Dist)
Gas - OFFGAR 2000 (Dist)
Gas - OFFGAR 2003 (Final)
Gas - ESC 2002
5%
Elec - IPART 1999 (Dist)
Elec - ORG 2000 (Dist)
Elec - QCA 2000 (Dist)
IPART Draft - 4.47%
Elec - ACCC 2000 (Transgrid)
Elec - ACCC 2001 (Powerlink)
ACCC - Transend - 4.35%
ACCC - ElectraNet SA - 4.23%
Elec - ACCC 2002 (ElectraNet))
ACCC - SPI PowerNet - 4.19%
Elec - ACCC 2002 (SPI PowerNet))
4%
Elec - ACCC 2003 (Transend)
Elec - IPART 2004 (Dist-Draft-Mid)
Water - IPART 2000
UK Gas - OFGEM 2001 (Transco)
UK Gas - OFGEM 2002 (Ind Trans)
UK Elec - OFFER 1994 (Dist SHE Mid-range)
UK Elec - UKMMS 1994 (Dist SHE Appeal Mid-range)
3%
UK Elec - OFGEM 1999 (Dist)
UK Elec - OFGEM 2000 (NGC)
Methods essentially identical.
UK & AUS values overlap.
UK Elec - OFGEM 2004 (Mid-range)
UK W&SCo - OFWAT 1999 (Large Co)
UK WoC - OFWAT 1999 (Small Co)
US Gas - Average by year
YEAR
US Elec - Average by year
2%
91
2 April 2004
92
93
94
95
96
97
98
99
00
01
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It is the Return on Equity
12%
ESTIMATED RETURN ON EQUITY (Real, post-tax)
11%
ACCC
TPA
Gas - ACCC 1998 (Trans)
Gas - IPART 2000 (Dist)
ACCC
Transgrid
Gas - OFFGAR 2000 (Dist)
Gas - OFFGAR 2003 (Final)
10%
Fact,
monopoly
rent or
regulatory
error???
Elec - IPART 1999 (Dist)
Elec - ORG 2000 (Dist)
Elec - QCA 2000 (Dist)
9%
OFFGAR (Final)
10.00%
OFFGAR (Dist)
Gas - ESC 2002
Water - IPART 2000
Elec - ACCC 2000 (Transgrid)
Gas - ESC 2002
ORG - Elec Dist
ACCC - Transend - 9.30%
ACCC - ElectraNet SA - 8.92%
ACCC - SPI PowerNet - 8.90%
ACCC
IPART Gas Powerlink
IPART - Elec Dist
IPART Draft - 8.31%
Elec - ACCC 2001 (Powerlink)
Elec - ACCC 2002 (ElectraNet))
8%
IPART - Water
Elec - ACCC 2003 (Transend)
Elec - IPART 2004 (Dist-Draft-Mid)
QCA - Elec Dist
Elec - ACCC 2002 (SPI PowerNet))
UK Gas - OFGEM 2001 (Transco)
7%
Incentive
regulation
"efficiency
bonus"
UK Gas - OFGEM 2002 (Ind Trans)
UK Elec - OFFER 1994 (Dist SHE Mid-range)
UK Elec - UKMMS 1994 (Dist SHE Appeal Mid-range)
UK Elec - OFGEM 1999 (Dist)
6%
UK Elec - OFGEM 2000 (NGC)
UK Elec - OFGEM 2004 (Mid-range)
UK W&SCo - OFWAT 1999 (Large Co)
UK WoC - OFWAT 1999 (Small Co)
5%
US Gas - Average by year
US RoE are permitted "out-turn" values.
Generally, utilities cannot do better.
US Elec - Average by year
YEAR
4%
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
Noting that the vertical scale in the RoE diagram is
twice that of the WACC and CoD diagrams.
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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?
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 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
2 April 2004
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 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’.
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 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 MRP in 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
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 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 MRP to 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.
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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?

2 April 2004
Because UK regulators accept credible independent
financial market view that expected MRP will be lower
than analysis of historical data suggests.
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 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.
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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.
2 April 2004
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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
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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?
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Is Australia less efficient?
The Henry Curve1
120%
Expected & Actual Return
100%
80%
60%
The Henry Curve
Australia
UK
40%
US
20%
0%
0
20
40
60
80
100
-20%
Country Credit Rating (Mar-95)
1: Naming rights courtesy Dr John Tamblyn, Chairman ESC.
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Is Australia less efficient?
The Henry Curve
120%
Expected Returns Risk Model (After Ergas 2002)
Monthly Arithmetic Mean Return Annualized
Expected & Actual Return
100%
Monthly Geometric Mean Return Annualized
80%
Source: Expected returns and volatility in 135 countries, Journal of Portfolio
Management, C. Erb, C. Harvey, T. Viskanta, Spring 1996, pp. 46-58. Tables
1 (actual returns) and 3 (expected returns).
60%
The Henry Curve
UK
Australia
40%
US
20%
0%
0
20
40
60
80
100
-20%
Country Credit Rating (Mar-95)
2 April 2004
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Is Australia less efficient?
The Henry Curve
120%
Expected Returns Risk Model (After Ergas 2002)
Monthly Arithmetic Mean Return Annualized
Monthly Geometric Mean Return Annualized
Linear (US/UK/AUS Arithmetic Mean Return)
Expected & Actual Return
100%
80%
Source: Expected returns and volatility in 135 countries, Journal of Portfolio
Management, C. Erb, C. Harvey, T. Viskanta, Spring 1996, pp. 46-58. Tables
1 (actual returns) and 3 (expected returns).
60%
The Henry Curve
UK
Australia
40%
US
20%
0%
0
20
40
60
80
100
-20%
Country Credit Rating (Mar-95)
2 April 2004
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Is Australia less efficient?
The Henry Curve
120%
Expected Returns Risk Model (After Ergas 2002)
Monthly Arithmetic Mean Return Annualized
Monthly Geometric Mean Return Annualized
Linear (US/UK/AUS Arithmetic Mean Return)
Linear (US/UK/AUS Geometric Mean Return)
Expected & Actual Return
100%
80%
Source: Expected returns and volatility in 135 countries, Journal of Portfolio
Management, C. Erb, C. Harvey, T. Viskanta, Spring 1996, pp. 46-58. Tables
1 (actual returns) and 3 (expected returns).
60%
The Henry Curve
UK
Australia
40%
US
20%
0%
0
20
40
60
80
100
-20%
Country Credit Rating (Mar-95)
2 April 2004
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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 al made 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.
2 April 2004
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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.
2 April 2004
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