The AER incorrectly combines the 'spot' risk free rate from method 1 with the long-term average MRP from method 2. Either of the two methods would be appropriate, but mixing the two is not. Attachment 5 Appendix B.3.1 Current market circumstances are unusual; there is a 'flight to quality' effect on the CGS. Appendix B.3.1 AER’s MRP estimate is a long term historic average. Attachment 5.3.3 Appendix B.5 Survey results used by the AER reflect a period when the risk free rate was substantially higher than the current spot rate. Appendix B.5.2 It is commonly accepted the MRP varies over time, however, the AER’s MRP estimates do not change. Attachment 5.3.3 Appendix B.5 Fund managers noted the AER’s overly mechanistic approach produced unprecedentedly low cost of equity estimates and they do not meet the current market conditions. Appendix B.5 Regulatory precedent from IPART and the UK suggests that the adoption of a long-term average is appropriate. Appendix B.8 The AER's reasonableness checks are out of date and provide no meaningful information about the relationship between investors' required returns and the AER's estimate of the cost of capital. Appendix B.7.2 The present value principle as described by Lally relies on overly simplistic assumptions that do not apply in practice. Appendix B.3.1 AER has given no consideration to the asymmetric and adverse consequences that would arise if the cost of capital were set too low. Attachment 5.2.1
I agree that these two versions of the present Value principle exist, with the first version merely being that one used by a regulator to operationalise the second version. See section 5.3 of that report for further discussion of this proposal. Consistency with the building block model The NGR prescribe the use of the building block model when the AER is calculating the total revenue allowance. The building block model has a long history in regulation in Australia. An important principle of the building block model is the present value principle. In a 2011 paper on public utility regulation in Australia, Dr Darryl Biggar explained the origins of the building block model and its goals. Lally states: ...the Building Block model requires use of the risk free rate at the beginning of the regulatory period and therefore the rate should be averaged over a short period as close as practical to the start of the regulatory period. Rates averaged over a much longer historical period would be inconsistent with the Building Block model. As this decision is consistent with the present value principle, it is also consistent with the building block model. Consistency with the Capital Asset Pricing Model (CAPM) The AER has applied the CAPM consistently. Envestra proposed the Sharpe-Lintner CAPM be applied for this decision. The AER accepts that proposal. The AER has also ensured that there is consistency within the CAPM. The Sharpe-Lintner CAPM is described by the following equation: (1) E(Ri) = Rf + β.[E(Rm) - Rf] Where: E(Ri) is the return on the investment Rf is the risk free rate β is the equity beta E(Rm) is the expected market return The term in the [ ] brackets can also be simplified to:
Opening capital base 1000 1040 1080 1120 1160 – Plus actual net capex 50 50 50 50 50 250 Minus forecast depreciation 10 10 10 10 10 50 Closing capital base 1040 1080 1120 1160 1200 – Table D.2 Stylised capital base roll forward under actual depreciation approach (underspend) ($m, nominal) 2013 2014 2015 2016 2017 Total Opening capital base 1000 1045 1090 1135 1180 – Plus actual net capex 50 50 50 50 50 250 Minus actual depreciation 5 5 5 5 5 25 Closing capital base 1045 1090 1135 1180 1225 – Table D.3 Summary of differences in the event of an underspend ($m, nominal) Forecast depreciation approach Actual depreciation approach Depreciation recovered through tariffs from 2013–17 $50 $50 Return on capital recovered through tariffs from 2013–17 $400 $400 Total capex added to capital base $250 $250