Internal consistency of risk free rate and MRP in the CAPM

Multi net Group Holdings Pty ltd
ACN 104 036 937
24(5) A reference tariff should allow for a return commensurate with the
regulatory and commercial risks involved in providing the reference
service to which that tariff relates."
In estimating the cost of equity using the CAPM, it has become standard practice in
regulatory decisions to combine:
• An estimate of the market risk premium based on annual historic data over various
periods from 1883 to the present day, occasionally adjusted to some extent; and
• A current-day estimate of the risk-free rate typically based on the observed yields on
Commonwealth Government bonds over the 20 trading days immediately prior to the
decision.
Questions
The Victorian gas distribution and transmission businesses (APA Group, Envestra, Multinet
and SP AusNet) have sought your opinion on an approach to measuring the cost of equity
that is consistent with Rule 87. The purpose of these questions is to obtain an expert opinion
which will assist the businesses in formulating th.eir approach for estimating the cost of equity
and the weighted average cost of capital, (WACC), in their forthcoming access arrangement
proposals.
1. In your op1n1on does the standard regulatory approach to CAPM noted above
presently produce an estimate of the cost of equity that meets the requirements of
Rule 87? Please provide evidence to support your opinion.
2. How should the cost of equity be estimated in today's market conditions in
accordance with rule 87?
3. Please provide your estimates of the cost of equity and of the market risk premium in
accordance with your suggested method(s).
Expert report
The businesses emphasise that the report prepared by you will be provided to the AER in
support of the businesses' revised access arrangements. Accordingly the report may
become a public report.
The report may also be relied upon in any subsequent appeal proceedings. For that reason,
the businesses have attached a copy of the Federal Court's "Guidelines for Expert Witnesses
in Proceedings in the Federal Court of Australia".
Please read and familiarise yourself with the Code of Conduct and comply with it at all times
in the course of your engagement.
The report must contain the following:
1. The terms of reference.
2. The qualifications of the person(s) preparing the report.
3. Identify any pre-existing relationship that the person(s) have with the businesses.
4. Clearly and fully set out all the relevant facts.
2