Application Martin No: gr9902 Jones Contents

Systematic risk

Systematic risk is that risk that can not be eliminated through a well-balanced and diversified portfolio. This risk is generally market related and is measured with respect to the financial market as a whole.

The CAPM provides for systematic (or non-diversifiable) risk through the equity beta, a statistical measure that indicates the riskiness of one asset or project relative to the whole market (usually taken to be the Australian stock market). The market average being equal to one, an equity beta of less than 1 indicates that the stock has a low systematic risk relative to the market as a whole. Conversely, an equity beta of more than one indicates that the stock has a relatively high risk.

Where an equity beta is calculated for a particular company, it is only applicable for the particular capital structure of the firm. A change in the gearing will change the level of financial risk borne by the equity holders. Hence the equity beta will change. It is possible to derive the beta that would apply if the firm were financed with 100 per cent equity, known as the ‘asset’ or ‘unlevered beta’. This enables comparison across companies with different capital structures. The analyst can then calculate the equivalent equity beta for any level of gearing desired. This technique is known as ‘re-levering’ the asset beta.

Non-systematic (specific) risk

Non-systematic risks are specific or unique to an asset or project and may include asset stranding, bad weather and operations risk. Such risks by their nature are specific and need to be assessed separately for each access arrangement. Importantly, specific risks are independent of the market. For an investor, exposure to the specific risk related to an asset can be reduced or countered by holding a diversified portfolio of investments. Consequently, specific risk is not reflected in the equity beta parameter of the CAPM.

A matter of significant debate in the Commission’s assessment of the Victorian access arrangement was the treatment of specific (diversifiable) risk. At the time it was suggested that an allowance for specific risk could be accommodated via a higher beta in the CAPM formulae. However, as discussed above, the equity beta is meant to reflect only market related or non-diversifiable risks. Consistency with the CAPM framework therefore requires that specific risks be factored into projected cash flows rather than the cost of capital. The Commission indicated in its Draft Statement of Regulatory Principles that this is the approach that the Commission will normally adopt with respect to identified and quantified specific risks.⁸⁸ This is consistent with the ORG’s assessment, as stated in its first consultation paper for the 2003 review of gas access arrangements:

… while events that are unique to particular businesses do not affect the cost of capital, they are not irrelevant. Rather, the price controls should be designed to ensure that the regulated entity expects to earn its costs of capital on average, taking account of all possible events.’⁸⁹

Commission’s assessment of Epic’s systematic risk (beta)

Epic proposed an asset beta (_a) range of 0.55-0.70 and an equity beta of 1.18-1.55 for the MAPS.

The Commission determined an asset beta for the MAPS of 0.50 in the Draft Decision and an equity beta of 1.16.

Epic opposed the Commission’s adoption of an asset beta of 0.50 in view of the values adopted by the Commission and other regulators in their decisions.⁹⁰

In its initial application, Epic made several observations relating to its perception of the higher risk of the MAPS compared to the Victorian gas transmission system. These included:⁹¹

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  South Australian market growth is static, with limited opportunities available;
  
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  the pipeline is dependent on two customers and is exposed to volatile electricity generation load;
  
• 
  pipeline sales to generators must compete with imported and coal fired electricity generation;
  
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  long-term gas resources are uncertain;
  
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  it is more likely that the system could be bypassed; and
  
• 
  no annual revenue adjustment for material changes in operating costs is being requested.
  

The Commission stated in the Draft Decision that it did not consider these factors indicate a higher level of systematic risk for the MAPS compared to the Victorian transmission system. Section 2.5.3 of the Commission’s Draft Decision outlines numerous submissions that counter Epic’s perception of risk stated above.

The Commission noted in the Draft Decision that submissions to the Victorian decision suggested that the ‘newness’ of the regulatory framework introduced perceived uncertainties on the part of investors. Submissions suggested that these uncertainties are a market-related risk and should be taken into account via an increase in the beta value. Whilst this treatment is no longer considered appropriate, the Commission took this argument into account at the time and assessed an asset beta of 0.55 as being appropriate for the Victorian system.

Epic does not agree that the uncertainty associated with what was a new regulatory regime in 1998 has now diminished. According to Epic:⁹²

This is not the belief that is shared by service providers. The changing views of regulators since 1998 (of which the Commission’s recent shift to determining rate of return within a post-tax framework is an important example) have added to, rather than diminished investor perceptions of risk in pipeline investments….In these circumstances, the asset beta of the Victorian Final Decision remains the minimum of the range of possible asset betas for Australian pipeline systems.

Professor Davis noted in a report prepared for the Commission that:⁹³

The modelling approach adopted by the ACCC has shifted from a “pre-tax real” to a “post-tax nominal” approach. This, in itself, is not a source of “regulatory risk” since any post-tax nominal rate of return can be converted into a pre-tax real rate of return, and the modelling replicated within a pre-tax real framework. If there does exist “regulatory risk” there is no obvious reason to believe that such risk would have a systematic element to it, which would warrant adjusting the underlying asset beta.

The Commission also noted in the Draft Decision the findings of a report prepared by Professor Davis for the South Australian Independent Pricing and Access Regulator (SAIPAR) on the WACC proposed by Envestra Limited for its distribution network in South Australia. Like Epic, Envestra⁹⁴ argued for a higher WACC than that for the Victorian distribution network on the basis of:

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  slower market growth;
  
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  a more concentrated customer base and therefore greater variability of demand; and
  
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  greater competition from alternative fuel sources.
  

Professor Davis considered that none of these arguments provided any rationale for assuming greater systematic (non-diversifiable) risk,⁹⁵ and concluded that there would appear to be no obvious reason to assume a higher asset beta for the South Australian market than for Victoria.⁹⁶

Epic disputed the relevance of Professor Davis’ report to the Commission’s assessment of the MAPS access arrangement on the basis that it ignores the fundamental difference between a distribution and a transmission system. Epic argued that the major risk differences between the distribution and transmission systems in South Australia, are;

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  the exposure of the MAPS to electricity generation load;
  
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  the MAPS reliance on South Australia’s few large industrial users, the majority of which are connected directly to the MAPS; and
  
• 
  the risk of bypass.⁹⁷
  

In response, Professor Davis stated that:⁹⁸

None of those listed [above] appear however to be relevant to assessing the systematic risk of the underlying asset (as opposed to its total risk). Unless cogent arguments can be advanced that such factors affect the degree of covariation between returns on the project and returns on the market portfolio, they are not relevant to determination of the asset beta. It is appropriate that, where relevant, such factors find reflection in the projections of expected demand used in the modelling approach to derive tariffs, or in arrangements for dealing with the possibility of asset stranding.

Likewise, the Commission does not consider it appropriate to compensate Epic for specific risk via a higher asset beta. The risk of partial stranding is a specific risk that could be ameliorated via an accelerated depreciation profile rather than an increased WACC. The Commission adopted this approach in its assessment of NT Gas’ Amadeus Basin to Darwin Pipeline (ABDP). In that instance, NT Gas provided sufficient evidence to the Commission to demonstrate that utilisation of the pipeline was likely to be significantly reduced after 2011.⁹⁹

The Commission does not consider the risk of asset stranding to be a market related or non-diversifiable risk. Rather, it is a unique or specific risk, and as such, should be accommodated in the cash flows rather than in the CAPM formulae.