Internal consistency of risk free rate and MRP in the CAPM

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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
Multinel Group Holdings Pty Ltd ACN 104 036 937 5. Explain the person's (persons') process of reasoning. 6. Set out each of the expert's opinions separately from the factual findings or assumptions. 7. Reference any documents relied on by the person(s). 8. Include specified wording at the end of the report stating that "[the person(s)] has made all the inquiries that [the person(s)] believes are desirable and appropriate and that no matters of significance that [the person(s)] regards as relevant have, to [the person's (persons')] knowledge, been withheld"; and 9. State that the person(s) have been provided with a copy of the Federal Court's "Guidelines for Expert Witnesses in Proceedings in the Federal Court of Australia" (Attachment 1) and that the Report has been prepared in accordance with those Guidelines. Contact Jeremy Rothfield will be the day-to-day contact for you. Yours sincerely, \"" I Jeremy Rothfield Network Regulation and Compliance Manager 3
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Internal consistency of risk free r
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7.2. Methodology ii) 43 7.3. Method
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Table of Tables Table 1: AAA to BBB
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(or higher) equity premium, thus le
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Total cost of equity (AMP method) S
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19. Material increases in demand fo
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Conclusion 23. I consider that the
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24(5) A reference tariff should all
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2. Movements in the risk free rate
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� sets the market risk premium pr
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In fact, we know from earlier studi
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4. Movements in the risk free rate
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Figure 4: Spread between AAA corpor
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Table 1: AAA to BBB spreads at 1 ye
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64. It is also common practice to u
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Figure 8: AMP method estimate of Ro
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Internal consistency of risk free rate and MRP in the CAPM

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