Application Martin No: gr9902 Jones Contents

Debt margin and cost of debt

Epic proposed that the appropriate margin for the cost of debt is 120-150 basis points above the relevant risk-free rate and noted that the Commission had adopted 120 basis points in the Victorian Final Decision.⁷²

The lending margin is essentially an empirical matter. In the Victoria Draft Decision the Commission proposed a debt margin of 80 basis points. However, in the period following the release of the Draft Decision there was evidence that margins might have increased because of the then growing uncertainties in global financial markets. On the basis of comments by financial institutions, the Commission adopted an assumed debt margin of 120 basis points in the Final Decision.

The Commission notes the recent decision by the Office of the Regulator General (ORG) to increase the debt margin from 1.20 to 1.50 for Victorian electricity distributors, in light of current information from capital markets.⁷³ The ORG accepted evidence provided in submissions and by market practitioners that a debt margin of 1.20 per cent might understate the benchmark borrowing costs for an efficiently financed electricity distributor.⁷⁴

The Commission also notes IPART’s Final Decision on the AGL Gas Network’s (NSW) access arrangement in which it determined a range for the debt margin of 0.90-1.10. In arriving at this decision the Tribunal considered recent corporate debt issues as a guide for the current premium on long term debt. IPART found that margins over the 10-year bond rate for five corporate debt issues that took place between June 1999 and March 2000 ranged between 80 and 100 basis points.⁷⁵

In view of this recent analysis, the Commission considers it appropriate to continue using a debt margin of 120 basis points for its calculations on the MAPS. The Commission will continue to monitor capital markets for further evidence that the debt margin is increasing or decreasing.

The 120 basis point margin in combination with the nominal risk-free rate of 5.61 per cent suggests a nominal cost of debt (r_d) figure of 6.81 for use in the WACC estimate. With an inflation rate of 2.21 per cent, the corresponding real cost of debt (rr_d) is 4.50.

The market risk premium

The market risk premium is a parameter in the CAPM that, together with the risk-free rate and firm-specific equity beta, determines the expected cost of equity in the business. Epic proposed a range of 6.0-7.0 per cent for the market risk premium. This range has been the conventionally accepted range under the classical tax system. However, as reported in the Commission’s Victoria Final Decision, Professor Davis has suggested that this may not be in keeping with the forward-looking CAPM framework favoured by the Commission. For example, the more stable inflationary environment now prevailing may mean that the relevant market risk premium is less than has been observed in the past.⁷⁶ In the Victoria Final Decision the Commission considered the probable range to be 4.5-7.5 per cent and chose to use a mid-value of 6.0 per cent.⁷⁷ More recently, in the Draft Regulatory Principles, the Commission suggested that a market risk premium of around 5 per cent may be more appropriate given the downward reassessment of the market risk premium over recent years.⁷⁸

The Commission notes that there is new information from studies of financial markets that appear to suggest that the market risk premium is now lower than it has been in past decades. The Commission acknowledges that a downward trend is not fully accepted by market participants and commentators. However, there does appear to be sufficient support to suggest that the market risk premium is now unlikely to be above 6.0 per cent.⁷⁹

The Commission has used 6.0 per cent in its WACC calculations for the MAPS. This figure is at the bottom end of the range proposed by Epic, but is the upper limit of the range considered appropriate by the Commission in light of new empirical evidence. The Commission will reconsider the appropriate level of the market risk premium over time as each regulatory decision is made and more empirical evidence becomes available.

Level of debt funding (gearing)

Epic suggested that the proportion of debt funding applicable to the MAPS be 60 per cent.

Hastings Funds Management (HFM) submitted that the Commission should choose a gearing level that relates to the sample of listed entities from which it is also calculating its equity beta. In HFM’s view, this level is in the order of 30 to 40 per cent.⁸⁰ HFM stated:

We merely ask the Commission to demonstrate that over a large sample of global electricity and gas utilities, the typical debt/asset ratio is 60 per cent. Unless the Commission chooses to ‘data-mine’ only those utilities, which meet this test, it will find that the typical ratio is 30 to 40 per cent debt/asset.⁸¹

The Commission notes Standard & Poor’s most recent global financial projections for global power companies. Standard & Poor’s estimate that the gearing ratio for global transmission and distribution power companies lies somewhere between 55 and 65 per cent.⁸²

The Modigliani-Miller theorem suggests that the relevant cost of capital should be invariant over a broad range of gearing possibilities. Therefore the gearing assumption used for WACC purposes should not be a critical one.⁸³ The Commission has tested alternative gearing ratios in its model and found these to have a minimal impact on the final revenues and tariffs derived from the model.

Therefore, for the purpose of deriving the WACC for the MAPS, the Commission considers a gearing ratio of 60:40 to be reasonable. This gearing ratio is consistent with the Commission’s other regulatory decisions and Standard & Poor’s estimate.