1 Draft Statement of Regulatory Principles Consultation ‘Fostering a Stable Investment Environment’ Philip Gall, Manager/Regulatory Affairs TransGrid March 2004

2 Introduction Part 1 – Asset Valuation o Incentives Depend on the Package – Asset Valuation Principles, Capex Recognition Process, Opex carry over, Level of Regulated Rates of Return o Roll Forward Approach – supported in principle but details matter o Regulatory stability vital for long life infrastructure businesses Part 2 – Setting WACC o Cessation to Hostilities – a ‘Win/Win’! o Beta - A key Parameter!

3 Roll Forward Makes Sense o Replacement cost is judgemental – do it once and move on o Actual expenditure easier to measure o Optimisation doesn’t really make sense ä Impossible to administer – ACCC methodology still not specified ä Imposes risks for which TNSPs are not rewarded ä Difficult risk for TNSPs to manage – limited value in influencing behaviour o ‘Recognition’ of capex during a regulatory period still an issue – difficult to assess whether efficient or not

4 Details Matter o Adopt principle of preservation of financial capital? o Proper process for ‘recognising’ efficient investments o Does the regulatory regime create inflation risk? ä NEC and DSoRP implies that TNSPs do not bear forecasting discrepancy (inflation) risk (i.e. the risk arising when outturn CPI is greater than forecast CPI). ä 2003 DSoRP states… “ the TNSP does not face inflation risk within the regulatory period”. ä TransGrid believes that the regulatory framework does not create inflation risk ä TransGrid roll forward proposal: Real Post Tax WACC calculating for roll forward and adjust for annual outturn CPI.

5 Need to Consult on Details o ACCC has given some consideration to the details o This needs to be shared with stakeholders o Suggest that this includes ‘worked examples’ to settle any confusion

6 Locking In? o What does this mean – will this be reviewed again in 5 years by a new ACCC/AER team? o How will ‘locking in’ be achieved? ä Correct obvious valuation anomalies first? ä Is a Code change good enough? o Improved certainty of asset valuation vital to: ä Avoid a cost ‘premium’ for customers and TNSPs ä Allow regulatory regime to focus on getting incentives for future decisions right

7 The WACC – A Cessation in Hostilities? oTransGrid believes that the nature of the debate in Australia surrounding the regulatory WACC has been detrimental to good regulatory outcomes. oIncentives to invest in long lived assets depend as much on the expected future WACC as on the currently prevailing WACC. oStatements by the ACCC that its allowed WACC is ‘conservative’ or ‘too high’ hurt investment the same as actually reducing the WACC. oBusinesses are not blameless in eliciting such comments from the ACCC. o Customers are the losers as they pay one WACC but don’t receive the full benefits of that in terms of incentives for businesses to make necessary investments

8 oThe DRP discussion paper opens up a whole new front in the debate by flagging a reduction in the TNSP’s beta based on market evidence – evidence that is claimed to support beta values as low as 0.2. oAs discussed in the following slides TransGrid believes that the discussion paper analysis of beta is flawed on a number of levels. oHowever, the most important point TransGrid wishes to make is that the uncertainty about future WACC parameters hurts investment today. oThe best contribution the ACCC could make to the current debate is to commit to maintaining current parameter values unless there is a compelling case for change. oBusinesses could be equally cautious in making counter claims about the lack of generosity implicit in the ACCC’s current parameter values. The WACC – A Cessation in Hostilities? Cont’d

9 Beta - the Discussion Paper Proposed Approach oThe ACCC’s preferred position is for ‘a move towards benchmarking an equity beta from current market evidence and incorporating an upper confidence interval’ o This involves a number of methodological steps: ä Identify comparable (independent) firms ä Define returns (for firms and market portfolio) ä Define the relevant historical period ä Calculate beta for each comparable firm ä Adjust these to uniform gearing ä Calculate the mean of these adjusted betas ä Define the desired confidence interval (90%, 95%,99%?) ä Calculate the desired upper bound oAll of these steps are problematic. But imagine that you resolve enough of them to arrive at the calculation of confidence intervals

10 Beta – the Estimation of Confidence Intervals o Estimating a 95% confidence interval appears reasonable o However, the confidence interval for what? For each TNSP’s beta? Or for the mean population beta? o The ACCC discussion paper did not deal with this question explicitly. However, it implicitly estimated the former (based on a sample of ‘infrastructure’ businesses). o TransGrid does not believe this is a sensible use of confidence intervals in the context of setting the WACC for regulated businesses. ä A 95% confidence that the population mean beta is within a given range does not imply 95% probability that each firm’s beta is within that range. ä In fact, as the sample size increases the discussion paper’s (implicit) approach is consistent with setting a 50% probability that the WACC for a TNSP will be set below the true WACC

11 Beta – the Estimation of Confidence Intervals Mean  95% confidence for population mean  95% confidence for individual  Distribution of the sample mean  Distribution of individual firm  s

12 Beta – the Estimation of Confidence Intervals o 95% upper bound for ‘population mean’ Beta versus 95% upper bound for TNSP’s beta June 2002 AGSM Sep 2002 AGSM Dec 2002 AGSM Core sample mean ACCC Pop n mean upper bound TNSP beta upper bound Combined sample mean ACCC Pop n mean upper bound TNSP beta upper bound Note the average of the combined sample is greater than 1. Note also that the ACCC figures derived using two tailed test (true upper bound is less than this)

13 Concluding Remarks o ACCC opened up unnecessary uncertainty over WACC o Closer inspection of ACCC proposal shows that beta above 1 still justified o Adopting a policy of WACC parameter change only when case for change is compelling has benefits for all