Internal consistency of risk free rate and MRP in the CAPM

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130. The context of that proceeding was such that the Australian Competition Tribunal had open to it to direct the AER to use an earlier averaging period, as proposed by EnergyAustralia, that did not reflect the prevailing conditions in the CGS market during the AER averaging period. This is what the Tribunal directed should occur. 131. It is relevant to note that, as I understand the legal constraints, the Australian Competition Tribunal did not have open to it the option of varying the market risk premium parameter that was to apply. This is because as a consequence of transitional provisions in the Rules for the regulatory determination processes to apply to the NSW electricity distributors, the market risk premium was fixed at 6 per cent with no ability to depart from that fixed value. For the transmission network operators, the value was similarly fixed at 6 per cent with no ability to depart from that fixed value. 6.2. UK regulators 132. UK regulators have considered the problems associated with using a volatile estimate of the prevailing risk free rate alongside a stable estimate of the market risk premium. As a group, they commissioned Smithers and Co to address this and other issues. The advice from Smithers and Co was that movements in the MRP would tend to move to offset any change in the risk free rate: 42 Given our preferred strategy of fixing on an estimate of the equity return, any higher (or lower) desired figure for the safe rate would be precisely offset by a lower (or higher) equity premium, thus leaving the central estimate of the cost of equity capital unaffected. 133. UK regulators have largely accepted this advice and they do not, as a rule, use a prevailing estimate of the risk free rate when applying the CAPM. For example, in an annexure report entitled “Decision on strategy for the next transmission and gas distribution price controls - RIIO-T1 and GD1 Financial issues” Ofgem adopted the following approach, in March 2011: 43 3.69. Market measures of the real risk-free rate, such as the yield on ILGs, have risen slightly since the data cut-off point for EE's December report. However, they remain near historical lows, partly due to the Bank of England's official interest rate being held at 0.5 per cent and the impact of Quantitative Easing. We, therefore, do not consider it appropriate to rely on spot rates or short-term averages to set the risk-free rate. 3.70. Our revised range for the risk-free rate is, therefore, 1.7-2.0 per cent. The lower bound matches the 10-year average yield on 10-year ILGs, while the upper bound corresponds to regulatory precedent in the UK. 42 Smithers and Co, A Study into Certain Aspects of the Cost of Capital for Regulated Utilities in the U.K., A report commissioned by the U.K. economic regulators and the Office of Fair Trading, 2003, p. 49. 43 Available at: http://www.ofgem.gov.uk/Networks/Trans/PriceControls/RIIO-T1/ConRes/Documents1/T1decisionfinance.pdf Competition Economists Group www.CEG-AP.COM 35
134. The market level of the ILG’s (Index Linked Gilts) reported in the EE report (and referred to above) were around 0.4%. Consequently, Ofgem’s decision involved an increase of between 1.3% and 1.6% relative to these values. 135. In 2006 Ofgem similarly set the risk free rate above market rates. On the basis of Smithers and Co’s advice referred to above, Ofgem, in its 26 June 2006 Initial Proposals, stated: In DPCR4, as described above, we observed that the CAPM model gave a wide range of estimates for the cost of equity, reflecting a significant variation between long term average values for the cost of equity and observed market data at a given point in time. We concluded that we could not rely on observed market data due to exceptional factors pushing down interest rates and the instability of the equity beta. (p. 30) 136. Ofcom stated: 44 Taking account of both current and recent historical evidence, Ofcom’s view is that it is appropriate to use a value of 4.6% for the nominal risk free rate. This is somewhat higher than the current rate of about 4.2% to 4.3% (which are lower than historic averages), but consistent with a longer term averages and a real risk free rate of 2.0% and a rate of inflation of 2.5%. 137. Similarly, Ofwat, the UK water regulator, concluded: 45 The proposed range is consistent with regulatory precedent. Recent regulatory determinations have placed little weight on low gilt rates [Government bond rates]. The Competition Commission, eg BAA plc (2002), has also noted that current yields should be used with caution when estimating the risk free rate because of market volatility. The Smithers & Co study (February 2003) undertaken on behalf of the regulators concludes that a reasonable assumption for the [real] risk-free rate is 2.5%. 6.3. US regulators 138. Energy regulators, along with most other monopoly regulators in the US, do not tend to reflect variations in the risk free rates, proxied by 10 year Treasury bond rates, in the allowed cost of equity for a regulated business. This reflects the fact that the US regulators attempt to estimate the cost of equity using a wholly forward looking methodology. As a result, any fall in Government bond yields due to a rise in risk aversion will tend to be automatically offset by higher allowed risk premiums. 44 Office of Communications, Ofcom’s approach to risk in the assessment of the cost of capital, 23 June 2005, p. 15 45 Ofwat, Future water and sewerage charges 2005-10: Final determinations, Appendix 5, Cost of Capital Competition Economists Group www.CEG-AP.COM 36
Page 1 and 2: Internal consistency of risk free r
Page 3 and 4: 7.2. Methodology ii) 43 7.3. Method
Page 5 and 6: Table of Tables Table 1: AAA to BBB
Page 7 and 8: (or higher) equity premium, thus le
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Page 13 and 14: Conclusion 23. I consider that the
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Page 21 and 22: In fact, we know from earlier studi
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Page 25 and 26: Figure 4: Spread between AAA corpor
Page 27 and 28: Table 1: AAA to BBB spreads at 1 ye
Page 29 and 30: 64. It is also common practice to u
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Page 33 and 34: 5. Why required returns on riskier
Page 35 and 36: iii. Indeed, the increase in risk p
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Page 39 and 40: Figure 11: Risk premiums on listed
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Page 43 and 44: Reserve Bank assistant governor Guy
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Page 47: … The Tribunal considers that an
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Page 67 and 68: 2009 Chapman Tripp, New Zealand Exp
Page 69 and 70: Providing Optus advice on a confide
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Page 73 and 74: Cost of Capital Advising on the cos
Page 75 and 76: General Regulatory Analysis 2011 Si
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