Application Martin No: gr9902 Jones Contents

Interest rates and inflation

As mentioned above, the Code (section 8.30) states that the rate of return should be ‘commensurate with prevailing conditions in the market for funds.’ This implies that all information for deriving the rate of return should be as up to date as possible at the point the access arrangement comes into effect. It also means that the rate of return should match the circumstances (economic conditions) of the regulatory framework. For example, the term of the interest rate should correspond to the term of the regulatory period. Interest rates and inflation expectations are parameters set by the financial markets on a daily basis and are readily determined.

Generally, the relevant WACC for regulatory purposes should be a forward-looking concept, giving an indication of the minimum average expected commercial return on debt and equity over the access arrangement period. Selected interest rates and inflation estimates relevant to the setting of the WACC have been derived from financial market data and are shown in Table 2..

Table 2.: Current financial market interest rates and inflation expectations

Financial Indicator	Proposed by Epic (per cent p.a.)	40-day moving average ending 8 August 2000 (per cent p.a)^(a)	40-day moving average ending 6 September 2001 (per cent p.a.)^(b)
5 year government bond rate		6.10	5.61
Indexed bonds (August 2005 series)	3.39^(c)	2.97	3.30
Estimated 5 year real rate^(d)		2.97	3.32
Implied 5 year inflation expectation^(e)		3.04	2.21

Notes:

1. 
   Based on daily closing quotations as published by the Reserve Bank of Australia. The Commission finalised its calculations of WACC for purposes of the Draft Decision on 9 August 2000.
   
2. 
   Based on daily closing quotations as published by the Reserve Bank of Australia. The Commission finalised its calculations of WACC for purposes of the Final Decision on 6 September 2001.
   
3. 
   Epic calculated this as the average rate for the eight weeks to 1 March 1999.
   
4. 
   Interpolations based on indexed bond figures.
   
5. 
   Inferred from the difference between nominal and real interest rates over the corresponding period using the Fisher Equation, (1+i) = (1+i^rn)/(1+CPI), where:
   i^r = real interest rate, iⁿ= nominal interest rate and CPI = inflation rate.
   

Epic adopted the average of 5-year indexed bonds over the eight-week period to 1 March 1999 (3.39 per cent) grossed up for inflation (2.5 per cent) to establish a risk-free rate of 6 per cent.

The Commission considers that the term associated with the risk-free rate should coincide with the five-year duration of the initial access arrangement period.⁷⁰ Although, in theory, an on-the-day rate is considered the best indication of the opportunity cost of capital at any point in time, the Commission accepts that there is some merit in averaging rates over a short period to abstract from day-to-day market volatility. The Draft Regulatory Principles proposes the use of a 40-day moving average of the relevant bond rates covering the period prior to the decision analysis. The Commission has adopted this approach for the present analysis. The results at Final Decision stage are a risk-free rate of 5.61 per cent and a real risk-free rate of 3.32 per cent.

While the inflation rate is not an explicit parameter in the WACC estimation, it is an inherent aspect of the nominal risk-free rate and cost of debt parameters. It is fundamental to deriving real rates of return, which are used in the target revenue and economic depreciation calculations. It is also an important determinant of the effective tax liability. Epic applied a rate of 2.5 per cent in all of its analysis.

An indication of the rate of inflation anticipated by financial markets is provided by the difference between the nominal bond rates and rates for inflation-indexed bonds for the same term. The indexed bond series have maturity dates that do not correspond to current five or ten-year bond rates but the corresponding figures are readily derived by interpolation and are shown in Table 2.. These figures represent the real risk-free rate corresponding to the current nominal risk-free rate, based on the five-year bond yield. They indicate that the current expectation of inflation (f) over the initial regulatory period is 2.21 per cent.

The Commission will use this market-derived inflation rate in its calculations. Official forecasts of inflation are inevitably a little out of date, may be subject to institutional bias⁷¹ and do not necessarily relate to the access arrangement period under consideration.

Accordingly, the Commission considers that Epic’s revenue requirement for the access arrangement period should be recalculated using a forecast rate of inflation of 2.21 per cent and observed inflation rates where this is appropriate.