Risk Sharing Arrangements in Australian Regulatory Access Pricing Kevin Davis Colonial Professor of Finance Centre of Financial Studies The University of Melbourne Ph: fax:

Overview  Australian Access Pricing Regulation  an overview  the “building block” approach and target revenue modelling  Regulatory Design and Risk Sharing  Risk Assessment and the Pricing of Risk  systematic versus non systematic risk  non systematic risk issues »asymmetric risks, asset stranding  systematic risk issues »CAPM parameters, effective tax rates and franking credit valuation, leverage, real and nominal returns

The “Building Block” Approach  Target Revenue = Operating Costs + Return of Capital +Return on Capital  revenue is expected to cover expected operating and maintenance costs plus an expected “fair” rate of return on capital invested plus expectation of return of capital invested  Investment should be zero NPV  existing assets brought into regulatory framework should have market value equal to replacement cost

The Building Block Approach  For simplicity of exposition, focus on  Net Revenue (cash flow) »= Target Revenue - Operating Costs »= Return of Capital + Return on Capital  Temporarily ignore issues of taxation, real v nominal, equity v entity »assume no tax, nominal required rate of return, entity basis (required return is WACC)

Zero NPV Modelling Substitute D t = K t-1 - K t

Zero NPV Modelling  Provided that D 1 + ….+D N = K 0, ie that the allowed depreciation (return of capital) equals the initial investment, the NPV=0  and assuming that the allowed rate of return equals that used to discount the cash flows!  The precise shape of the depreciation schedule is irrelevant to this result  but it will affect the pattern of the cash flows

The Regulatory Model  Determine target revenue stream for 5 year horizon, based on  Projections of volume  Revenue to cover (efficient) operating costs, return on capital, return of capital (depreciation)  Initial price determined from year 1 target revenue and volume projections  Subsequent prices for 5 year horizon set using CPI – X rule, where X set to give Present Value of resulting revenue stream equal to that of target revenue stream  To extent operating efficiencies can be achieved, extra demand induced etc, utility retains benefit for some period and earns a higher rate of return.  Note: for electricity & gas utilities etc, approximately 50% of target revenue is return on and of capital

The Regulatory Model  The allowable cash flow pattern  must be achievable - should reflect projected demand  will involve a “desired” path for regulated prices  CPI-X smoothing of maximum average (or total) revenue is applied  such that PV of 5 year model revenues equals PV of 5 year revenues from regulated price growing at CPI-X »X has nothing to do with productivity improvements - depends on depreciation schedule properties

Fundamental Decisions  real versus nominal  is inflation reflected in return of or return on capital?  post tax versus pre tax  is tax component of target revenues implicit in (pre tax) return on capital or identified explicitly from (post tax) return on capital?  entity versus equity  is focus on return to all providers of funds or only owners?  ACCC has indicated a move from real pre tax WACC to nominal post tax return on equity framework

Regulatory Pricing Risk!  Access prices should mimic a (hypothetical) competitive outcome  Market value of business should be close to replacement value of assets  Privatization sale prices of Victoria gas utilities were over twice the replacement value of assets  Cannot be explained by potential operating efficiency gains or synergy  Unlikely to be largely due to “winner’s curse”  Unlikely to be due to underestimation of asset replacement value  Indicative of use of excessively high cost of capital in regulatory determination

Regulatory Design and Risk Sharing  How does regulatory design affect risk of the regulated entity  rate of return versus price cap regulation »possibly greater risk under latter style of regulation  Australian regulation is much like rate of return regulation despite CPI-X appearance

Regulatory Design and Risk Sharing  Relevant risk is that faced by suppliers of funds  depends on market characteristics and regulatory pricing scheme, not on the inherent characteristics of physical assets »example - Provision of USO’s pre 2000 scheme implied a cost of capital possibly below risk free rate »example - inflation risk ex ante cost of (return on) capital set for 5 years in either real or nominal terms in determining target revenue. Latter suggests inflation risk to service provider. ex post adjustment of revenue using actual CPI - X shifts inflation risk to customers

Non systematic risk and the cost of capital  CAPM only prices systematic risk  Resulting cost of capital should be used in conjunction with expected cash flows  Practitioners often add (or argue for) a “fudge factor” to CAPM estimate to compensate for non systematic risk  but such risk involves both upside and downside!  creates significant inter-temporal distortions  such risks may be allowed for in cash flow estimation

“Asymmetric” Risks  Concern often expressed that CAPM rate of return does not allow for bearing one-sided risks  catastrophes etc which prevent output or create additional costs »may be “self insured”  Difficulty is that cash flow figures used are often those viewed as most likely (modal), and cash flow distribution is skewed such that “expected” (mean) figure is lower  solution - adjust cash flows for “insurance” cost of downside risk

“Stranded Asset” Risk  Ex ante, the zero NPV requirement is that expected return of capital is 100% of original cost, however  if asset becomes stranded (no demand for the service) required cash flow will not be generated  if asset is not stranded, maximum return of capital is 100%

Stranded Asset Risk - Possible Approaches  Assign probabilities to stranding outcome and allow for depreciation schedule involving return of capital in excess of 100%  Provide ex post compensation to regulated businesses suffering stranding  Adjust allowable revenue streams prior to stranding following recognition of future possible stranding  Rely on diversification of service providers across assets, such that users of other assets bear price risk arising from stranding of one asset.

Regulatory Problems: Cost of Capital Estimation  Cost of capital “built up” from component parts  many “unknowns” »WACC formula commonly used is »CAPM parameters, tax issues, leverage & debt costs  “cherry picking” of parameter estimates by participants in decision making process  participant bias to overstatement of WACC

Company Tax Rate Effective Company Tax Rate Nominal Post Tax WACC Real Pre Tax WACC Nominal Post Tax Cost of Equity Equity B Leverage Asset  “Comparables” Equity  Market Risk Premium Valuation of Franking Credits Risk Free Rate Credit Rating Real Risk Free Rate Cost of Debt Inflation Dividend Policy

Estimating CAPM parameters  Risk free rate  Theory suggests short term rate  Practitioners use long term rate  Compromise: use current long term rate less historical “long - short” risk premium to get expected long run average of short term rate  Does “duration” of activity matter?  Should current day rate or historical average be used?

The Market Risk Premium  “Conventional Wisdom” suggests MRP of 6-8 per cent  Theory and the “Equity Premium Puzzle”  6-8 per cent not compatible with “normal” risk aversion parameters  What is historical evidence?  For Australia post WW2, arguably < 6% p.a. »compare return on equity with risk free rate for same holding period  How is return on market (and thus MRP) measured post imputation? »Partially/ fully grossed up?

Estimating Beta  Directly - regression of past returns on particular stock against past returns on market  Purchase estimates  Accounting information / cash flow analysis  Comparables - identify similar risk companies and adapt the beta estimates for those  systematic risk needs to be the same »is “market” portfolio the same »how does regulation affect risk  leverage adjustment needs to be made »“unlever” and “relever” beta

Delevering - Levering  Equity beta reflects  underlying asset (unlevered) beta  leverage  To calculate beta for similar company(ie similar business risk) with different leverage  calculate asset beta (ie delever) and then relever to get equity beta for desired leverage  Issues  tax adjustments and appropriate formula  beta of debt

Conclusions  Still a way to go in  designing optimal risk sharing arrangement in access pricing  identifying appropriate pricing of risks  Simple issues, which are often taken for granted have engendered significant controversy  One topic warranting further study is that of the impact of the regulatory arrangements on agency problems in such regulated utilities and thus on performance, financing choices, and cost of capital.