FINAL DECISION APA VTS gas access arrangement 2018 to 2022 Attachment 3

388 Pages·2017·4.21 MB·English

FINAL DECISION
APA VTS gas
access arrangement
2018 to 2022

Attachment 3 – Rate of return

November 2017

3-1 Attachment 3 – Rate of return | Final decision - APA VTS gas access arrangement 2018–22
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3-2 Attachment 3 – Rate of return | Final decision - APA VTS gas access arrangement 2018–22
Contents

Contents .......................................................................................................3-3
Shortened forms ..........................................................................................3-8
3 Rate of return ....................................................................................... 3-10
3.1 Final decision ................................................................................ 3-10
3.2 APA’s revised proposal ................................................................ 3-14
3.3 Assessment approach .................................................................. 3-15
3.3.1 National electricity and gas laws ............................................... 3-15
3.3.2 The overall rate of return ........................................................... 3-16
3.3.3 Allowed rate of return objective ................................................. 3-17
3.3.4 Return on debt factors in the rules............................................. 3-29
3.3.5 Rate of return Guideline ............................................................ 3-33
3.3.6 Interrelationships ....................................................................... 3-40
3.3.7 Consideration of relevant material ............................................. 3-42
3.4 Reasons for final decision ........................................................... 3-50
3.4.1 Return on equity ........................................................................ 3-51
3.4.2 Return on debt ........................................................................ 3-102
3.4.3 Gearing ratio ........................................................................... 3-138
3.4.4 Expected inflation rate ............................................................. 3-140
A Our foundation model approach ...................................................... 3-144
B Equity models .................................................................................... 3-148
B.1 Sharpe-Lintner CAPM ................................................................. 3-149
B.1.1 Submissions supporting the use of the Sharpe-Lintner CAPM as the
foundation model ................................................................................... 3-154
B.1.2 Empirical tests of the Sharpe-Lintner CAPM ........................... 3-156
B.1.3 Evidence from estimates of other models ................................ 3-165
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B.2 Black CAPM ................................................................................. 3-166
B.2.1 Empirical reliability of the Black CAPM .................................... 3-169
B.2.2 Low beta bias may not reflect ex ante priced risk .................... 3-175
B.2.3 AER's role for the theory of the Black CAPM ........................... 3-176
B.3 Fama-French model .................................................................... 3-180
B.3.1 Sensitivity to methodological choices ...................................... 3-183
B.3.2 Fama-French factors may not reflect ex ante priced risk ......... 3-187
B.4 Dividend growth model .............................................................. 3-188
B.4.1 SFG's construction of the dividend growth model .................... 3-192
B.5 Wright CAPM, historical and alternative CAPMs ..................... 3-195
B.6 Previous submissions on the multi-model approach .............. 3-201
C Historical stock returns ..................................................................... 3-204
C.1 Prevailing estimates: excess returns ........................................ 3-204
C.2 Prevailing estimates: total returns ............................................ 3-205
C.3 Arithmetic and geometric averages .......................................... 3-206
D AER's dividend growth model .......................................................... 3-211
D.1 Prevailing estimates ................................................................... 3-211
D.2 Sensitivity analysis ..................................................................... 3-212
D.3 Preferred construction of the dividend growth model ............ 3-213
D.4 Sources of potential upward bias .............................................. 3-215
E Return on equity conditioning variables ......................................... 3-220
E.1 Implied volatility .......................................................................... 3-221
E.2 Dividend yields ........................................................................... 3-222
E.3 Yield spreads .............................................................................. 3-223
F Other practitioner's return on equity estimates .............................. 3-229
F.1 Prevailing estimates: surveys ................................................... 3-230
F.2 Prevailing estimates: broker reports ......................................... 3-232
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F.3 Prevailing estimates: valuation reports .................................... 3-234
F.4 Prevailing estimates: other regulators ...................................... 3-237
F.5 Relationship between risk free rate and market risk premium in
valuation reports................................................................................ 3-239
G Empirical estimates of equity beta ................................................... 3-241
G.1 Australian empirical estimates from Henry's 2014 report ....... 3-242
G.2 Australian empirical estimates from other studies .................. 3-245
G.2.1 2017 Frontier reports for TransGrid ......................................... 3-248
G.2.2 December 2016 Frontier report ............................................... 3-250
G.2.3 September and November 2016 CEG report ........................... 3-251
G.3 International empirical estimates .............................................. 3-258
G.4 Choice of comparator set ........................................................... 3-260
G.4.1 Comparator set for Australian empirical analysis ..................... 3-261
G.4.2 Precision and stability of Australian empirical estimates .......... 3-264
G.4.3 Use of international energy firms ............................................. 3-266
G.4.4 Use of non-energy infrastructure firms .................................... 3-269
H Response to previous submissions on the equity beta ................. 3-273
H.1 Empirical analysis....................................................................... 3-273
H.2 Australian empirical estimates .................................................. 3-279
H.3 International empirical estimates .............................................. 3-283
H.4 Theoretical principles underpinnning the Black CAPM .......... 3-284
H.5 Conceptual analysis ................................................................... 3-285
H.6 Other issues ................................................................................ 3-287
I Previous MRP issues ........................................................................ 3-289
I.1 Dividend growth model .............................................................. 3-291
I.2 Wright CAPM ............................................................................... 3-294
I.3 Surveys ........................................................................................ 3-295
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I.4 Other regulators’ decision ......................................................... 3-296
I.5 Conditioning variables ............................................................... 3-297
I.6 Other market data ....................................................................... 3-297
I.7 Overall Market Risk Premium .................................................... 3-299
J Return on debt approach .................................................................. 3-301
J.1 Interpretation of the ARORO ...................................................... 3-302
J.1.1 Efficient financing costs ........................................................... 3-302
J.1.2 Benchmark efficient entity ....................................................... 3-304
J.2 Requirements under the ARORO .............................................. 3-308
J.2.1 Ex-ante efficient compensation ............................................... 3-309
J.2.2 Consistency with the NEL/NGL ............................................... 3-315
J.2.3 Requirement for a revenue-neutral transition if there is a regime
change 3-316
J.3 On-the-day and trailing average approaches ........................... 3-319
J.3.1 On-the-day approach .............................................................. 3-320
J.3.2 Trailing average approach ....................................................... 3-324
J.4 A full transition satisfies the ARORO ........................................ 3-326
J.5 An immediate (or hybrid) transition will not satisfy the ARORO ..3-
327
J.5.1 Mathematical explanation ........................................................ 3-328
J.5.2 Revised proposal of APA ........................................................ 3-331
K Return on debt implementation ........................................................ 3-348
K.1 Criticisms of our current approach ........................................... 3-348
K.1.1 Using appropriate criteria ........................................................ 3-349
K.1.2 Issues with the RBA curve ...................................................... 3-350
K.1.3 CEG's analysis of sample size ................................................ 3-355
K.1.4 Response of BVAL curve to Asciano, Mirvac and Jemena bonds . 3-
355
K.1.5 BVAL and our overall approach still likely to be conservative .. 3-359
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K.2 The Thomson Reuters curve ..................................................... 3-359
K.2.1 Implementation concerns ........................................................ 3-360
K.2.2 Immaterial in simplest case ..................................................... 3-363
K.3 Other issues ................................................................................ 3-364
K.3.1 Extrapolation method .............................................................. 3-364
K.4 Credit rating ................................................................................ 3-365
K.4.1 Comparator Set ....................................................................... 3-366
K.4.2 Current Industry Median .......................................................... 3-367
K.4.3 Equity buffer and historical credit ratings ................................. 3-369
L Annually updating the return on debt .............................................. 3-370
L.1 Approach to estimating the return on debt .............................. 3-370
L.2 Implementing the return on debt approach .............................. 3-372
L.2.1 Choice of data series............................................................... 3-372
L.2.2 Choice of data series—Extrapolation and interpolation issues 3-373
L.2.3 Choice of data series—Step-by-step guide to calculations ...... 3-375
L.2.4 Choice of data series—Contingencies ..................................... 3-378
M Equity and debt raising costs ........................................................... 3-385
M.1 Equity raising costs .................................................................... 3-385
M.2 Debt raising costs ....................................................................... 3-385
N Averaging Period – confidential appendix ...................................... 3-388

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Shortened forms
Shortened form Extended form
AARR aggregate annual revenue requirement
AEMC Australian Energy Market Commission
AEMO Australian Energy Market Operator
AER Australian Energy Regulator
ASRR annual service revenue requirement
augex augmentation expenditure
capex capital expenditure
CCP Consumer Challenge Panel
CESS capital expenditure sharing scheme
CPI consumer price index
DMIA demand management innovation allowance
DRP debt risk premium
EBSS efficiency benefit sharing scheme
ERP equity risk premium
MAR maximum allowed revenue
MRP market risk premium
NEL national electricity law
NEM national electricity market
NEO national electricity objective
NER national electricity rules
NSP network service provider
NTSC negotiated transmission service criteria
opex operating expenditure
PPI partial performance indicators
PTRM post-tax revenue model
RAB regulatory asset base
RBA Reserve Bank of Australia
repex replacement expenditure
RFM roll forward model
RIN regulatory information notice
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Shortened form Extended form
RPP revenue and pricing principles
SLCAPM Sharpe-Lintner capital asset pricing model
STPIS service target performance incentive scheme
TNSP transmission network service provider
TUoS transmission use of system
WACC weighted average cost of capital
3-9 Attachment 3 – Rate of return | Final decision - APA VTS gas access arrangement 2018–22
3 Rate of return
The allowed rate of return provides a network service provider a return on capital that a
benchmark efficient entity would require to finance (through debt and equity)
investment in its network.1 The return on capital building block is calculated as a
product of the rate of return and the value of the regulatory asset base (RAB). The rate
of return is discussed in this attachment.
3.1 Final decision
Our final decision is to reject APA's revised proposal2 and determine an allowed rate of
return of 5.75 per cent (nominal vanilla). We are satisfied that this rate of return
achieves the allowed rate of return objective (ARORO).3 That is, we are satisfied that
this allowed rate of return is commensurate with the efficient financing costs of a
benchmark efficient entity with a similar degree of risk as that which applies to APA in
providing reference services.4
This allowed rate of return will apply to APA for 2018. A different rate of return will
apply to APA for the remaining regulatory years of the 2018–2022 access arrangement
period. This is because we will update the return on debt component of the rate of
return each year to partially reflect prevailing debt market conditions in each year. We
discuss this annual update further below.
Our allowed rate of return is a weighted average of our return on equity and return on
debt estimates (WACC) determined on a nominal vanilla basis that is consistent with
our estimate of the value of imputation credits.5 We are to determine the allowed rate
of return such that it achieves the ARORO.6 Also, in arriving at our decision we have
taken into account the revenue and pricing principles (RPPs) and are also satisfied that
our decision will or is likely to contribute to the achievement of the National Gas
Objective (NGO).7 Our rate of return and APA's proposed rate of return is set out in the
following table 3-1.

1 The term network service provider relates to service providers that provide gas and electricity transmission and
distribution services.
2 APA VTS, Victorian Transmission System Access Arrangement Revised Proposal: submission response to draft
decision, 14 August 2017, p. 70.
3 NER, cl. 6.5.2(b); cl. 6A.6.2(b); NGR, cl. 87(2).
4 NER, cl. 6.5.2(c); cl. 6A.6.2(c); NGR, cl. 87(3).
5 NER, cl. 6.5.2(d)(1) and (2); cl. 6A.6.2(d)(1) and (2); NGR, cl. 87(4).
6 NER, cl. 6.5.2(b); NER, cl. 6A.6.2(b); NGR, r. 87(2).
7 NEL, s.16; NGL, s. 28.
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