Internal consistency of risk free rate and MRP in the CAPM

Figure 14: US regulatory return on equity decisions over 20 years – average per
year
14%
12%
10%
8%
6%
4%
2%
0%
Source: SNL Financial Business Intelligence Services, CEG analysis
141. An additional potential source of information on normal required returns for regulated
businesses comes from US regulatory precedent involving the application of the DGM
model. For the US regulatory decisions from 2005 to 2011 described previously, I
have estimated the average ROE is 10.38% (11.01% over the last 20 years). The
average equity premium is 6.57% and average 10 year US Treasury rate is 3.80%.
Note that this is based on DGM analysis performed by regulators. However, this is for
an average gearing of 47.98%. Adjusting this to 60% gearing gives an average cost
of equity of 12.36%. 46
6.4. Australian regulatory practice
142. There is also recent and older Australian regulatory precedent for not setting the risk
free rate based on observations that are affected by abnormal conditions in the
Government bond market.
143. In a recent decision in relation to the Sydney Desalination Plant, IPART has stated:
46 12.36% = 3.805% + (1-0.4798)/(1-0.600)*6.575%
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