risk sharing arrangements in australian regulatory access pricing kevin davis colonial professor of...
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Risk Sharing Arrangements in Australian Regulatory Access Pricing
Kevin Davis
Colonial Professor of Finance
Centre of Financial Studies
The University of Melbourne
http://www.ecom.unimelb.edu.au/accwww
Ph: 03 9344 5098
fax: 03 9349 2397
Overview Australian Access Pricing Regulation
an overview the “building block” approach and target
revenue modelling Regulatory Design and Risk Sharing Risk Assessment and the Pricing of Risk
systematic versus non systematic risk non systematic risk issues
» asymmetric risks, asset stranding
systematic risk issues» CAPM parameters, effective tax rates and franking
credit valuation, leverage, real and nominal returns
The “Building Block” Approach
Target Revenue = Operating Costs + Return of Capital + Return on Capital
revenue is expected to cover expected operating and maintenance costs plus an expected “fair” rate of return on capital invested plus expectation of return of capital invested
Investment should be zero NPV existing assets brought into regulatory
framework should have market value equal to replacement cost
Building Block Approach: Total RevenueTen Year Asset - Straight Line Depreciation$100 cost, 10% rate of return, $15 O&M p.a.
0
5
10
15
20
25
30
35
40
0 1 2 3 4 5 6 7 8 9 10
Year
To
tal R
ev
en
ue
Return on Capital
Return of Capital(Deprec-iation)
Operating and Mainten-ance
Building Block Approach: Total RevenueTen Year Asset - "Annuity" Depreciation
$100 cost, 10% rate of return, $15 O&M p.a.
0
5
10
15
20
25
30
35
0 1 2 3 4 5 6 7 8 9 10
Year
To
tal R
ev
en
ue
Return on Capital
Return of Capital(Deprec-ation)
Operating and Mainten-ance
The Building Block Approach
For simplicity of exposition, focus on Net Revenue (cash flow)
» = Target Revenue - Operating Costs
» = Return of Capital + Return on Capital
Temporarily ignore issues of taxation, real v nominal, equity v entity
» assume no tax, nominal required rate of return, entity basis (required return is WACC)
Zero NPV Modelling
Year 0 1 2 …
…..
N
Cash
Flow
-K0 rK0+D1 rK1+D2 …
….
rKN-1 +DN
NPV -K0 (rK0+D1)/(1+r) (rK1+D2)/(1+r)2 …
….
(rKN-1 +DN)/(1+r)N
Net cash flow = return of capital D and a return on capital rK,
Substitute Dt = Kt-1 - KtYear 0 1 2 …
…..
N
NPV -K0 K0-K1/(1+r) K1/(1+r) -K2/(1+r)2 …
….
KN-1/(1+r)N-1 -KN/(1+r)N
Zero NPV Modelling
Provided that D1 + ….+DN = K0, ie that the allowed depreciation (return of capital) equals the initial investment, the NPV=0 and assuming that the allowed rate of return
equals that used to discount the cash flows! The precise shape of the depreciation schedule
is irrelevant to this result but it will affect the pattern of the cash flows
The Regulatory Model
Determine target revenue stream for 5 year horizon, based on Projections of volume Revenue to cover (efficient) operating costs, return on
capital, return of capital (depreciation) Initial price determined from year 1 target revenue and
volume projections Subsequent prices for 5 year horizon set using CPI – X
rule, where X set to give Present Value of resulting revenue stream equal to that of target revenue stream
To extent operating efficiencies can be achieved, extra demand induced etc, utility retains benefit for some period and earns a higher rate of return.
Note: for electricity & gas utilities etc, approximately 50% of target revenue is return on and of capital
The Regulatory Model
The allowable cash flow pattern must be achievable - should reflect projected
demand will involve a “desired” path for regulated
prices CPI-X smoothing of maximum average (or total)
revenue is applied such that PV of 5 year model revenues equals
PV of 5 year revenues from regulated price growing at CPI-X
» X has nothing to do with productivity improvements - depends on depreciation schedule properties
Fundamental Decisions real versus nominal
is inflation reflected in return of or return on capital?
post tax versus pre tax is tax component of target revenues implicit in
(pre tax) return on capital or identified explicitly from (post tax) return on capital?
entity versus equity is focus on return to all providers of funds or only
owners? ACCC has indicated a move from real pre tax WACC
to nominal post tax return on equity framework
Regulatory Pricing Risk!
Access prices should mimic a (hypothetical) competitive outcome Market value of business should be close to
replacement value of assets Privatization sale prices of Victoria gas utilities were over
twice the replacement value of assets Cannot be explained by potential operating efficiency
gains or synergy Unlikely to be largely due to “winner’s curse” Unlikely to be due to underestimation of asset
replacement value Indicative of use of excessively high cost of capital in
regulatory determination
Regulatory Design and Risk Sharing
How does regulatory design affect risk of the regulated entity rate of return versus price cap regulation
» possibly greater risk under latter style of regulation
Australian regulation is much like rate of return regulation despite CPI-X appearance
Regulatory Design and Risk Sharing
Relevant risk is that faced by suppliers of funds depends on market characteristics and
regulatory pricing scheme, not on the inherent characteristics of physical assets
» example - Provision of USO’s
• pre 2000 scheme implied a cost of capital possibly below risk free rate
» example - inflation risk
• ex ante cost of (return on) capital set for 5 years in either real or nominal terms in determining target revenue. Latter suggests inflation risk to service provider.
• ex post adjustment of revenue using actual CPI - X shifts inflation risk to customers
Non systematic risk and the cost of capital CAPM only prices systematic risk Resulting cost of capital should be used in
conjunction with expected cash flows Practitioners often add (or argue for) a “fudge
factor” to CAPM estimate to compensate for non systematic risk but such risk involves both upside and
downside! creates significant inter-temporal distortions such risks may be allowed for in cash flow
estimation
“Asymmetric” Risks
Concern often expressed that CAPM rate of return does not allow for bearing one-sided risks catastrophes etc which prevent output or
create additional costs» may be “self insured”
Difficulty is that cash flow figures used are often those viewed as most likely (modal), and cash flow distribution is skewed such that “expected” (mean) figure is lower solution - adjust cash flows for “insurance”
cost of downside risk
“Stranded Asset” Risk
Ex ante, the zero NPV requirement is that expected return of capital is 100% of original cost, however if asset becomes stranded (no demand for
the service) required cash flow will not be generated
if asset is not stranded, maximum return of capital is 100%
Stranded Asset Risk - Possible Approaches
Assign probabilities to stranding outcome and allow for depreciation schedule involving return of capital in excess of 100%
Provide ex post compensation to regulated businesses suffering stranding
Adjust allowable revenue streams prior to stranding following recognition of future possible stranding
Rely on diversification of service providers across assets, such that users of other assets bear price risk arising from stranding of one asset.
Regulatory Problems: Cost of Capital Estimation
Cost of capital “built up” from component parts many “unknowns”
» WACC formula commonly used is
» CAPM parameters, tax issues, leverage & debt costs
“cherry picking” of parameter estimates by participants in decision making process
participant bias to overstatement of WACC
)1.(.))1(1(
)1(. T
V
Dr
T
T
V
Err de
io
Company Tax RateEffectiveCompany Tax
Rate
NominalPost TaxWACCReal
Pre Tax WACC
NominalPost TaxCost of Equity
Equity B
Leverage
Asset “Comparables”
Equity
Market Risk Premium
Valuationof Franking
Credits
Risk Free Rate
Credit Rating
Real RiskFree Rate
Cost of Debt
Inflation
Dividend Policy
Estimating CAPM parameters
Risk free rate Theory suggests short term rate Practitioners use long term rate Compromise: use current long term rate
less historical “long - short” risk premium to get expected long run average of short term rate
Does “duration” of activity matter? Should current day rate or historical
average be used?
The Market Risk Premium
“Conventional Wisdom” suggests MRP of 6-8 per cent
Theory and the “Equity Premium Puzzle” 6-8 per cent not compatible with “normal”
risk aversion parameters What is historical evidence?
For Australia post WW2, arguably < 6% p.a.» compare return on equity with risk free rate for
same holding period
How is return on market (and thus MRP) measured post imputation?
» Partially/ fully grossed up?
Estimating Beta
Directly - regression of past returns on particular stock against past returns on market
Purchase estimates Accounting information / cash flow analysis Comparables - identify similar risk companies
and adapt the beta estimates for those systematic risk needs to be the same
» is “market” portfolio the same
» how does regulation affect risk
leverage adjustment needs to be made» “unlever” and “relever” beta
Delevering - Levering
Equity beta reflects underlying asset (unlevered) beta leverage
To calculate beta for similar company(ie similar business risk) with different leverage calculate asset beta (ie delever) and then
relever to get equity beta for desired leverage
Issues tax adjustments and appropriate formula beta of debt
Conclusions
Still a way to go in designing optimal risk sharing arrangement
in access pricing identifying appropriate pricing of risks
Simple issues, which are often taken for granted have engendered significant controversy
One topic warranting further study is that of the impact of the regulatory arrangements on agency problems in such regulated utilities and thus on performance, financing choices, and cost of capital.