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Draft Statement of Regulatory Principles Consultation

‘Fostering a Stable Investment Environment’

Philip Gall, Manager/Regulatory Affairs

TransGrid

March 2004

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Introduction

Part 1 – Asset Valuation Incentives Depend on the Package – Asset Valuation Principles, Capex

Recognition Process, Opex carry over, Level of Regulated Rates of Return

Roll Forward Approach – supported in principle but details matter

Regulatory stability vital for long life infrastructure businesses

Part 2 – Setting WACC Cessation to Hostilities – a ‘Win/Win’!

Beta - A key Parameter!

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Roll Forward Makes Sense

Replacement cost is judgemental – do it once and move on

Actual expenditure easier to measure

Optimisation doesn’t really make sense

Impossible to administer – ACCC methodology still not specified

Imposes risks for which TNSPs are not rewarded

Difficult risk for TNSPs to manage – limited value in influencing behaviour

‘Recognition’ of capex during a regulatory period still an issue – difficult to assess whether efficient or not

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Details Matter

Adopt principle of preservation of financial capital?

Proper process for ‘recognising’ efficient investments

Does the regulatory regime create inflation risk?

NEC and DSoRP implies that TNSPs do not bear forecasting discrepancy (inflation) risk (i.e. the risk arising when outturn CPI is greater than forecast CPI).

2003 DSoRP states… “the TNSP does not face inflation risk within the regulatory period”.

TransGrid believes that the regulatory framework does not create inflation risk

TransGrid roll forward proposal: Real Post Tax WACC calculating for roll forward and adjust for annual outturn CPI.

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Need to Consult on Details

ACCC has given some consideration to the details

This needs to be shared with stakeholders

Suggest that this includes ‘worked examples’ to settle any confusion

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Locking In?

What does this mean – will this be reviewed again in 5 years by a new ACCC/AER team?

How will ‘locking in’ be achieved?

Correct obvious valuation anomalies first?

Is a Code change good enough?

Improved certainty of asset valuation vital to:

Avoid a cost ‘premium’ for customers and TNSPs

Allow regulatory regime to focus on getting incentives for future decisions right

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The WACC – A Cessation in Hostilities?

TransGrid believes that the nature of the debate in Australia surrounding the regulatory WACC has been detrimental to good regulatory outcomes.

Incentives to invest in long lived assets depend as much on the expected future WACC as on the currently prevailing WACC.

Statements by the ACCC that its allowed WACC is ‘conservative’ or ‘too high’ hurt investment the same as actually reducing the WACC.

Businesses are not blameless in eliciting such comments from the ACCC.

Customers are the losers as they pay one WACC but don’t receive the full benefits of that in terms of incentives for businesses to make necessary investments

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The DRP discussion paper opens up a whole new front in the debate by flagging a reduction in the TNSP’s beta based on market evidence – evidence that is claimed to support beta values as low as 0.2.

As discussed in the following slides TransGrid believes that the discussion paper analysis of beta is flawed on a number of levels.

However, the most important point TransGrid wishes to make is that the uncertainty about future WACC parameters hurts investment today.

The best contribution the ACCC could make to the current debate is to commit to maintaining current parameter values unless there is a compelling case for change.

Businesses could be equally cautious in making counter claims about the lack of generosity implicit in the ACCC’s current parameter values.

The WACC – A Cessation in Hostilities? Cont’d

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Beta - the Discussion Paper Proposed Approach

The ACCC’s preferred position is for ‘a move towards benchmarking an equity beta from current market evidence and incorporating an upper confidence interval’

This involves a number of methodological steps: Identify comparable (independent) firms Define returns (for firms and market portfolio) Define the relevant historical period Calculate beta for each comparable firm Adjust these to uniform gearing Calculate the mean of these adjusted betas Define the desired confidence interval (90%, 95%,99%?) Calculate the desired upper bound

All of these steps are problematic. But imagine that you resolve enough of them to arrive at the calculation of confidence intervals

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Beta – the Estimation of Confidence Intervals

Estimating a 95% confidence interval appears reasonable

However, the confidence interval for what? For each TNSP’s beta? Or for the mean population beta?

The ACCC discussion paper did not deal with this question explicitly. However, it implicitly estimated the former (based on a sample of ‘infrastructure’ businesses).

TransGrid does not believe this is a sensible use of confidence intervals in the context of setting the WACC for regulated businesses.

A 95% confidence that the population mean beta is within a given range does not imply 95% probability that each firm’s beta is within that range.

In fact, as the sample size increases the discussion paper’s (implicit) approach is consistent with setting a 50% probability that the WACC for a TNSP will be set below the true WACC

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Beta – the Estimation of Confidence Intervals

Mean

95% confidence for population mean

95% confidence for individual

Distribution of the sample mean

Distribution of individual firm s

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Beta – the Estimation of Confidence Intervals

95% upper bound for ‘population mean’ Beta versus 95% upper bound for TNSP’s beta

June 2002 AGSM

Sep 2002 AGSM

Dec 2002 AGSM

Core sample mean 0.30 0.17 0.19

ACCC Popn mean upper bound 0.44 0.24 0.30TNSP beta upper bound 0.56 0.31 0.40

Combined sample mean 0.51 0.36 0.33ACCC Popn mean upper bound 0.83 0.60 0.83TNSP beta upper bound 1.33 0.97 0.89Note the average of the combined sample is greater than 1.

Note also that the ACCC figures derived using two tailed test (true upper bound is less than this)

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Concluding Remarks

ACCC opened up unnecessary uncertainty over WACC

Closer inspection of ACCC proposal shows that beta above 1 still justified

Adopting a policy of WACC parameter change only when case for change is compelling has benefits for all