392. The specific questions I have been asked to submit are set out below. The full letter, including background, is provided separately.
The ERA in its Rate of Return Guidelines proposes:
1 In respect of the risk free rate (for both the cost of debt and the cost of equity), to use as a proxy the observed yield on a 5 year term Commonwealth Government Security averaged over a 40 day period just prior to the regulatory period. (page 14 and 18). The primary basis for using the a 5 year term to maturity to estimate the risk free rate is said to be that the present value principle reflects that the term of debt should match the regulatory update period. (see Chapter 7 of the ERA’s Explanatory Statement)
2 In respect of the debt risk premium (DRP) the ERA proposes to derive the DRP from the yield to maturity of an observed sample of bonds issued by comparator firms with similar credit ratings as the regulated entity. The bond yield approach will be used with a joint weighting mechanism and the DRP will be updated annually. The criteria for selection of the bonds in the benchmark sample is set out at paragraph 103 of the Rate of Return Guidelines. (see also chapters 8 and 9 of the ERA Explanatory Statement).
Opinion
In this context ATCO Gas wishes to engage you to prepare an expert report which provides:
1. An assessment of the ERA’s approach to estimating the return on debt set out in the Rate of Return Guidelines, including:
1.1 a critique of the ERA’s reasoning for adopting a 5 year term for the risk free rate (cost of debt and cost of equity); and
1.2 an analysis of the ERA’s proposed bond yield approach to the debt risk premium and the proposal to update the DRP annually.
2. Your opinion on whether the ERA’s proposed approach to the return on debt would result in the best estimate of the return on debt that contributes to the achievement of the allowed rate of return objective and meets the requirements of Rule 87.
3. Your opinion on whether the return on debt estimate using the ERA approach would produce a result consistent with the achievement of the NGO and the RPP.
4. If in your opinion the ERA’s approach does not meet the requirements set out in paragraph 2 and 3 above, what method (or methods) for estimating the cost of debt should be used in order to produce the best estimate (or range of estimates) possible in the circumstances that complies with Rule 87 (including the matters in sub rules 87(8) to 87(12)) and the achievement of the NGO and RPP?
Mr Warwick Anderson
General Manager Network Regulation Branch Australian Energy Regulator
GPO Box 3131
Canberra ACT 2601 11 November 2013 Dear Mr Anderson
Response to AER criticisms of estimates of average term of
debt at issue
This letter is in response to the Australian Energy Regulator’s (AER’s) critique of CEG’s debt term analysis in our June 2013 report1:
“The CEG analysis used Bloomberg data only for estimating the term at issuance which does not represent the full data on debt portfolios.2 In particular, the Bloomberg dataset does not include comprehensive data on bank debt. We understand that bank debt accounts for around one third of the businesses portfolio. Given that bank debt tends to be a much shorter term at issuance, the lack of bank debt data in CEG's sample means that the term at issuance for the total debt portfolio is likely to be shorter than the estimates presented by CEG.”3
The explanatory statement does not provide a source for the claim that bank debt accounts for around one third of the businesses’ debt portfolios. Having examined the actual debt portfolios of private Australian energy network businesses regulated by the AER,4 I can confirm that drawn bank debt, on average, comprises only 11% of these businesses’ debt portfolio, which is significantly less than the amount claimed by the AER.
1 CEG, Debt strategies of utility businesses, June 2013.
2 CEG, Debt strategies of utility businesses, June 2013, footnote 3, p. 8.
3 AER, Better Regulation, Explanatory statement, Draft rate of return guideline, August 2013, p. 155.
4 Cheung Kong group (SA Power Networks, CitiPower and Powercor), Envestra, Electranet, SP AusNet,
DUET group (Multinet Gas and United Energy), and APA group. A confidential spreadsheet that will be forwarded to the AER at the same time as this letter contains the details of these portfolios. The only additional information I have relied on is the $81m value of cash and cash equivalents reported in APA’s 2013 annual report.
In addition to this use of drawn bank debt, firms also use undrawn bank debt to provide the liquidity reserves5 for credit rating and operational purposes and working capital necessary to run a business (smooth cash flows and receipts and ensure funding is available to repay debt as it falls due). Available bank debt comprises 22% on average, of the comparable businesses total available (drawn plus undrawn) debt portfolio. However, most of this is undrawn bank debt which represents 14% of total drawn debt – which is higher than the 8% estimate figure used by PwC to estimate the costs of liquidity management.6
This data suggests that CEG overestimated the proportion of available bank debt (24%) in our previous report. Consistent with this, the data of individual company’s average term of issuance is, actually, higher than estimated in our report.
The sample of businesses originally examined by us was as set out in footnote 4 but did not include (the non-listed) ElectraNet. For this sample, the simple7/weighted average of term to maturity at issue for all drawn debt is 11.3/10.6 years. However, we have also been provided debt portfolio information for ElectraNet which is another privately owned energy network business regulated by the AER (albeit not listed). Including ElectraNet in the sample reduces the simple/weighted average of term to maturity at issue of all drawn debt to 10.9/10.5 years.
These estimates treat all debt in the same way. Specifically, one dollar of short term drawn bank debt is treated equivalently (given the same weight) as $1 of debt raised by bond issuance. In our view this artificially depresses the measure of term below that which we are interested in. Specifically, we are interested in debt used to fund the regulatory asset base (RAB) – which is the debt that is compensated through the cost of debt allowance. However, liquid short term debt is used to fund liquid financial assets in addition to, or instead of, the long term fixed assets in the RAB.
In order to account for this use of bank debt each business has provided the value of cash and cash equivalents or other liquid funds put aside for the purpose of repayment of near term debt maturity. That is, short term cash assets and short term bank debt are essentially the same thing with the opposite sign (if you borrow a dollar from a liquid bank facility and hold it as a dollar in liquid cash your net debt has not increased nor has the term of your net debt altered). We have treated such liquid financial assets as ‘negative bank’ debt with the same term as the shortest term bank debt on each company’s books (the effect of which is to ‘cancel out’ that bank debt – consistent with the fact that rather than funding the RAB the bank debt is funding liquid assets). When we do this the simple/weighted average of term to maturity at issue of all drawn debt is:
5 Standard & Poor’s, Methodology and Assumptions: Liquidity Descriptors for Global Corporate Issuers,
28 September 2011
6 PwC, Debt Financing Costs, June 2013.
11.4/10.8 years for the original CEG sample of privately owned listed regulated energy companies; and
11.0/10.7 years for the original CEG sample plus ElectraNet. We have also analysed further sensitivities to this analysis.
The first sensitivity analysed is associated with the exclusion of SP AusNet. SP AusNet has some private ownership but its majority ownership is, ultimately, the Singapore Government. The Singapore Government has recently (in May of this year) agreed to sell part of its ownership to the Chinese Government owned SGID – although this sale is not yet complete. It is clear that majority ultimate ownership by the Singapore Government has been positive for SP AusNet’s perceptions in credit markets – as evidenced by the announcement by Moody’s that SP AusNet’s credit rating would likely be downgraded as a result of the sale:
The likely downgrade of SP AusNet's rating to A3 would reflect our view that the high likelihood of parental support from SP -- and which has been incorporated in the rating through a 2-notch uplift -- would no longer hold following the divestment to a minority interest. 8
If I exclude SP AusNet on the basis that its debt management policy to date is likely affected by its majority Government ownership then the simple/weighted average of the sample rises to 11.5/11.3 years. I also note that the Chinese Government, through SGID, owns 47% of ElectraNet - although I have no evidence of a similar nature to suggest that this minority shareholding give ElectraNet support in credit markets. Nonetheless, I report that also excluding ElectraNet raises the simple/weighted average of the sample to 12.1/11.5 years. Another sensitivity examined relates to by far the longest dated bond issued by the companies in the sample. This is a 60 year bond ($515m outstanding) issued by APA. This bond is callable 6 years after issue and must pay a ‘step up’ margin of an additional 1% if it is not called within the first 26 years of its life.9 The above estimates of average term ascribe a 60 year term to this bond – consistent with the full flexibility it provides APA in the management of its debt portfolio. However, the fact remains that APA can call this bond before 60 years and will be expected to do so within 26 years (before the 1% step up margin must be paid) unless it’s perceived credit risk (debt risk premium) worsens by 1% or more.
8 Moody’s investors service. Announcement: Moody's maintains review for possible downgrade of SP
AusNet and SPIAA's ratings, August 2013.
In light of the above we have included two sensitivities to the above calculations. The first treats the maturity of this bond at 26 years (the date of the first step up margin). The second simply excludes the bond from the analysis altogether.10 When we:
treat the APA bond in question as having a maturity of 26 years the simple/weighted average of term to maturity at issue of all drawn debt (treating liquid assets as negative bank debt) is:
o 10.4/9.9 years for the full sample;
o 10.7/10.3 years excluding SP AusNet; and
o 11.1/10.4 years excluding both SP AusNet and ElectraNet.
exclude the APA bond in question from the analysis the simple/weighted average of term to maturity at issue of all drawn debt (treating liquid assets as negative bank debt) is:
o 10.0/9.5 years for the full sample;
o 10.3/9.8 years excluding SP AusNet; and
o 10.6/9.9 years excluding both SP AusNet and ElectraNet.
In conclusion, based on the complete set of information provided by the businesses, the simple/weighted average term of debt at issuance for energy businesses regulated by the AER with (at least minority) private ownership is 11.0/10.7 years (treating liquid assets as negative bank debt for the purpose of this calculation). This rises to 12.1/11.5 years if firms with substantial Government ownership are excluded.
The lowest estimate of the simple/weighted average term of debt at issuance is associated with including firms with substantial Government ownership and the complete exclusion of the longest dated bond in the sample (the 60 year APA bond). Even this only brings the simple/weighted average term estimate down to 10.0/9.5 years.
10 A further potential sensitivity would be to assign the first call date as the maturity date for the bond.
This would, in my opinion, clearly be wrong. It would amount to assigning a 6 year fixed maturity to an instrument that has a potential maturity of 60 years (i.e., which provides APA with a potential control on refinance risk for up to 60). That is, it would take the bond that offers APA the longest possible maturity in its portfolio and assign it one of the shortest maturities in its portfolio. However, even if this was done the simple/weighted average across all companies, adjusted for cash and cash equivalents, would be 10.0/9.4 years (10.5/9.7 years if SP AusNet and ElectraNet were excluded).
This data strongly supports the original conclusion by CEG that the benchmark term of debt at issuance should be at least 10 years and also supports the 10 year term of debt determined by the AER in the 2009 WACC Review.
Yours sincerely
Dr Tom Hird Director
13 March 2014
Dr Tom Hird
Competition Economist Group Suite 201
111 Harrington Street SYDNEY NSW 2000
Dear Sir
ATCO GAS AUSTRALIA PTY LTD- ERA Price Determination
Level 10, 211 Victoria Square
We act for ATCO Gas Australia Pty Ltd (ATCO Gas) in relation to the Economic Regulation Authority’s review of the Gas Access Arrangement for ATCO Gas under the National Gas Law and Rules.
ATCO Gas owns and operates the Mid West and South West Gas Distribution System in WA. ATCO Gas wishes to engage you to prepare an expert report in connection with the ERA’s review of the access arrangement for the period 1 July 2014-December 2019.
This letter sets out the matters which ATCO Gas wishes you to address in your report and the requirements with which the report must comply.
Terms of Reference
Legal Framework
The terms and conditions upon which ATCO Gas provides access to its gas network are subject to five yearly reviews by the ERA. The ERA undertakes that review by considering the terms and conditions proposed against criteria set out in the National Gas Law and National Gas Rules.
Rule 76 of theNational Gas Rulesprovides that the total revenue for each regulatory year is determined using a building block approach, which building blocks include a return on the projected capital base and depreciation on the projected capital base.
basis. Rule 87 now requires that the allowed rate of return be determined such that it achieves the allowed rate of return objective, being:
…that the rate of return for a service provider is to be commensurate with the efficient financing costs of a benchmark efficient entity with a similar degree of risk as that which applied to the serviced provider in respect of the provision of reference services.
Rule 87(5) requires that in determining the allowed rate of return, regard must be had to,inter alia, relevant estimation methods, financial models, market data and other evidence.
In respect of the return on debt, the return on debt is to be estimated such that it contributes to the allowed rate of return objective. The return on debt may be estimated such that it is the same for each regulatory year of the access arrangement period, or such that it differs from year to year (Rule 87(9)).
Rules 87(10) and (11) set out other important considerations for the estimating the return on debt.
Rule 74(2) requires a forecast or estimate to be arrived at on a reasonable basis and must represent the best forecast or estimate possible in the circumstances.
As you are aware, Rule 87(13) also provides for the making of rate of return guidelines. The ERA published its Final Rate of Return Guidelines on 16 December 2013. The ERA proposes to apply the approach set out in the Guidelines to ATCO Gas. The Guidelines are no mandatory but if there is a departure from the Guidelines, the reasons for the departure must be given in the ERA’s decision (Rule 87(18)).
Also relevant is the overarching requirement that the ERA must, in performing or exercising its economic regulatory function or power perform or exercise that function or power in a manner that will or is likely to contribute to the achievement of the national gas objective (NGO).
The NGO is to promote efficient investment in, and efficient operation and use of, natural gas services for the long term interests of consumers of natural gas with respect to price, quality, safety, reliability and security of supply of natural gas.
You should also have regard to the Revenue and Pricing Principles (RPP) in section 24 of the National Gas Law.
In preparing your report you should consider the relevant sections of the National Gas Rules and Law and the ERA’s Guidelines and Explanatory Statement.
Return on Debt
The ERA in its Rate of Return Guidelines proposes:
1 In respect of the risk free rate (for both the cost of debt and the cost of equity), to use as a proxy the observed yield on a 5 year term Commonwealth Government Security averaged over a 40 day period just prior to the regulatory period. (page 14 and 18). The primary basis for using the a 5 year term to maturity to estimate the risk free rate is said to be that the present value principle reflects that the term of debt should match the regulatory update period. (see Chapter 7 of the ERA’s Explanatory
similar credit ratings as the regulated entity. The bond yield approach will be used with a joint weighting mechanism and the DRP will be updated annually. The criteria for selection of the bonds in the benchmark sample is set out at paragraph 103 of the Rate of Return Guidelines. (see also chapters 8 and 9 of the ERA Explanatory Statement).
Opinion
In this context ATCO Gas wishes to engage you to prepare an expert report which provides: 1. An assessment of the ERA’s approach to estimating the return on debt set out in the Rate
of Return Guidelines, including:
1.1 a critique of the ERA’s reasoning for adopting a 5 year term for the risk free rate (cost of debt and cost of equity); and
1.2 an analysis of the ERA’s proposed bond yield approach to the debt risk premium and the proposal to update the DRP annually.
2. Your opinion on whether the ERA’s proposed approach to the return on debt would result in the best estimate of the return on debt that contributes to the achievement of the allowed rate of return objective and meets the requirements of Rule 87.
3. Your opinion on whether the return on debt estimate using the ERA approach would produce a result consistent with the achievement of the NGO and the RPP.
4. If in your opinion the ERA’s approach does not meet the requirements set out in paragraph 2 and 3 above, what method (or methods) for estimating the cost of debt should be used in order to produce the best estimate (or range of estimates) possible in the circumstances that complies with Rule 87 (including the matters in sub rules 87(8) to 87(12)) and the achievement of the NGO and RPP?
Use of Report
It is intended that your report will be submitted by ATCO Gas to the ERA with its Access