Internal consistency of risk free rate and MRP in the CAPM

19. Material increases in demand for CGS from foreigners and the banking system can
also be expected to raise this baseline ‘scarcity premium’ for the foreseeable future.
As noted by the RBA, foreign holdings of CGS have risen to 75% of the market in
recent months reflecting, in part, the shrinking pool of AAA rated sovereign debt due to
downgrades of US debt in August 2011 and, most recently, French debt in January
2012. Similarly, the RBA has pointed to Basel III liquidity requirements as raising the
demand for CGS (indeed, the pre-existing scarcity of CGS in Australia is an issue
explicitly acknowledged in the development of Basel III).
AER methodology not consistent with NGR 87(1)
20. Based on the evidence summarised above, I conclude that the AER’s methodology is
not valid in current market conditions. Specifically, the assumption, implicit in the AER
methodology, that the cost of equity has moved one-for-one with CGS yields and is
currently at historically low levels is invalid. Moreover, it is likely to be invalid in the
medium term due to supply and demand dynamics in the market for CGS.
Alternatives to the AER methodology
21. I propose three alternatives to the AER’s methodology that implement the CAPM. I
consider that each of these methodologies would comply with Rule 87(1) of the NGR if
applied in the current market circumstances. I do not consider that the same is true for
the AER’s methodology. My three alternatives are:
i. Directly estimating the prevailing cost of equity for regulated utilities using the
dividend growth model (involving a simultaneous estimate of all parameters of the
CAPM).
ii. Directly estimating the prevailing MRP relative to the prevailing CGS yield being
used as the risk free rate. This eliminates potential for error from the AER’s
methodology - in which there is no attempt to estimate the MRP relative to the
prevailing risk free rate. In this methodology the AER’s proposed value of 0.8 for
beta is adopted.
iii. Estimating a ‘normal’ cost of equity for regulated businesses by estimating each of
the CAPM parameters using suitable historical time periods. This provides a proxy
for the prevailing cost of equity if the prevailing cost of equity is relatively stable over
time (an assumption supported by the evidence in this report). It also provides a
minimum estimate of the cost of equity if one believes that current market
conditions are such that the cost of equity is more likely above its long term average
than below (a view that is supported by the evidence in this report). A departure
from this historical norm could be justified if there was some threshold level of
evidence to the effect that currently prevailing market conditions were sufficiently
different from the normal market conditions. Whether this threshold was satisfied
could be assessed by, for example, application of methodologies i) and ii) above.
22. In the table below (from section 6 of my report) I summarise the results of application
of these methodologies.
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