Cost of equity

In February 2016, the Australian Competition Tribunal decided to set aside a decision made by the Australian Energy Regulatory (AER). The AER must remake its decision, using a value of tax imputation credits (gamma) of 0.25.

The QCA engaged Dr Martin Lally to provide his views on this decision and invited stakeholders to comment on gamma and Dr Lally’s views.  The views provided by Dr Lally and stakeholders will be considered by the QCA in future decisions.

On 29 August 2014, the QCA published a final decision paper on its preferred approach to estimating the market parameters for the regulatory cost of equity.

This paper considers stakeholder submissions and provides the QCA’s views on the approach it intends to use to estimate the market parameters going forward.

The QCA also engaged Dr Martin Lally to provide additional advice on a number of issues related to submissions received on the risk-free rate, market risk premium and gamma.  This advice is outlined in a paper that has also been published by the QCA.

Risk-free rate and the market risk premium

On 27 November 2012, the QCA released the discussion paper, The Risk-free Rate and the Market Risk Premium, for public comment.

The paper addressed issues relating to estimating both the risk-free rate and the market risk premium in the context of applying the CAPM to determine the cost of equity for regulated firms.

It also summarised current Australian regulatory practice in these areas, including the QCA’s approaches to estimation.

The QCA received 21 submissions from interested parties.

The QCA engaged Dr Martin Lally to:

• respond to the stakeholder submissions
• comment on related material in Aurizon Network’s 2013 Draft Access Undertaking submission on the cost of capital with respect to the risk-free rate, market risk premium and the implied cost of equity
• review related submissions on the Price Monitoring of SEQ Water and Wastewater Distribution and Retail Activities 2013–15.

The QCA received 4 submissions in response to Dr Lally’s paper.

Gamma

In October 2010, the Australian Competition Tribunal determined that the Australian Energy Regulator (AER) had erred in estimating the utilisation rate for imputation credits in its May 2010 final decisions on electricity distribution for 2010-2015 for Queensland (Energex and Ergon Energy) and South Australia (ETSA Utilities).

The Tribunal instructed the AER to engage SFG Consulting to undertake a dividend drop-off analysis to estimate that parameter. The outcome of this was a report from SFG Consulting (2011). The Tribunal has invited comment and further work on gamma.

Given the importance of gamma to the cost of capital of firms regulated by the QCA, Dr Martin Lally was engaged to review the report by SFG Consulting.  This report was published in October 2013.

Subsequently, in November 2013, we released a second paper on gamma by Dr Martin Lally that addressed a number of further issues relevant to estimating gamma.

The QCA received two submissions in response to Dr Lally’s papers.

The risk-free rate, the market risk premium and gamma are market parameters.  That is, they are estimated for the market as a whole and effectively do not vary across individual businesses.

The QCA has reviewed its estimation methodology for all three of the market parameters.

Risk-free rate and the market risk premium

The QCA's starting point in determining an appropriate return on equity is the Capital Asset Pricing Model (CAPM).  The CAPM is the model most widely used by regulators and the corporate sector for estimating the equity return that investors require for investing in the business.

These are two key market-based parameters in the CAPM:

• The risk-free rate is the base rate to which a premium for investing in a risky asset is added.
• The market risk premium is a premium that compensates an investor for the risk of investing in a diverse portfolio of risky investments relative to the risk-free rate of return.

Gamma

The Australian tax system allows companies to provide their shareholders with credits to reflect company taxes paid on profits that are distributed as dividends.  Shareholders can use these imputation, or 'franking', credits to reduce their personal tax liabilities.

Imputation credits will reduce the cost of equity of investors in a regulated firm (and hence the regulatory firm's cost of capital) because investors who own shares can reduce their tax liability. 

The parameter, ‘gamma’, represents the benefit of these credits to the firm’s investors and is the product of:

• the utilisation rate (the extent to which investors can utilise the imputation credits)
• the distribution rate (the extent to which imputation credits are distributed).

By definition gamma must be between zero and 1.

There is significant debate on how best to both define and measure gamma.