Sep 15 2022

Sorry, what was that question again?

The Australian Energy Regulator (AER) is close to finalising how the Rate of Return for network businesses will be determined over the next four years. 

The Rate of Return Instrument (RORI) is reviewed every four years and given the last RORI was released in 2018, a new instrument will be published in December this year. The importance of the instrument can’t be underestimated - it sets out how the regulator will determine the allowed rate of return for each network business and is binding for the four-year period. It comprises the return on debt and the return on equity, as well as the value of imputation credits.

It obviously has implications not just for the networks but also end users as it is a key determinant of the revenue that networks can recover from customers. The AER aims to set the rate of return to reflect the cost an efficient network would incur to raise its capital (both debt and equity) in the financial markets. This means a rate of return should be high enough to encourage network owners to build and maintain the networks that are needed, while minimising costs to users.  As the sector has continued to attract investment, it would appear on the balance of available evidence that the AER satisfied that key requirement with its 2018 RORI, validating the approach therein.

The regulator released a draft for the next Rate of Return Instrument in June and submissions closed earlier this month. The AER’s Consumer Reference Group (CRG) flagged its concerns with the potential impact on consumers based on the draft arguing in its response that the AER is “proposing to make decisions that give the benefit of the doubt to networks in the form of a higher rate of return than is otherwise justified”.

So, what should change in the 2022 instrument and what is being suggested? We take a look below.

Consistent and coherent

In the Australian Energy Council’s (AEC) view it is important to maintain a consistent and coherent approach there should remain a “high bar to change”.  This approach is also supported by the CRG, whose role is to “actively engage with consumers” and provide the AER with their insights.  The AER also sought input from an independent Expert Panel, which assessed and reported on the draft guideline.  The AEC supports the view of the Expert Panel that overall there appears to be nothing contained in the draft Rate of Return Instrument, nor in the AER’s own analysis, that would suggest it is inconsistent with achievement of the National Gas Objective (NGO) and National Electricity Objective (NEO).  

Given the current cost of living pressures, there is an even greater need to be convinced that there is something radically amiss with the outcomes that the AER’s 2022 draft would trigger. Its consistency with the AER’s 2018 Rate of Return instrument along with the comprehensive review process gives us greater confidence that bad outcomes would not be the case.

Matching the length of the of the regulatory period to the cost of equity

There are some changes to the 2018 approach, including the AER proposing to match the length of the regulatory period to the cost of equity.  In its draft Instrument the regulator proposed to use the return on Commonwealth Government Securities (GCS) with a term matching the term of the access arrangement period or the regulatory control period (typically 5 years) as the proxy for the risk-free rate. This is a change from the previous approach of using a 10-year benchmark term for the risk-free rate.   

The AEC notes the Expert Panel observations that investors will likely consider that there is a risk that the reset will not in fact replicate the cost of capital that will be faced over future regulatory periods. However, the Panel subsequently observes that it is not obvious that a 10-year term for the cost of equity addresses this risk either.  Some parties use even longer terms.  For example, Ofgem is now using a bond rate even greater than 10 years.  Considering observable trends, the AER may not be wrong to use five years if it was starting from scratch.  But since 10 years is their long standing practice, the AEC would like to still see further and more convincing rationale for change than the arguments presented to date. 

The AER’s draft reasoning suggests that using a 10-year term is likely to lead to a biased outcome because the task is to set an efficient return for the next regulatory period  (emphasis added).  Whilst it’s not obvious that a 10-year term for the cost of equity is more attractive given these investments have asset lives much longer than five years, there is not a strong case that the need for internal consistency should be the substantiation for the length of term either.  Given the AEC’s support for the AER adopting a consistent and coherent framework, we see this proposal of aligning of the term to the regulatory period as a significant amendment that must meet that same high bar to change. 

At an AER stakeholder forum in early September, the CRG proposed the further examination of term matching and to the preconditions that might apply to the alignment or otherwise of terms for inflation, debt and equity.  Based on the CRG’s reasons, the AEC supports the need for the AER to conduct further analysis of this proposal for matching the regulatory period.

An expanded role for the Dividend Growth Model in the Market Risk Premium (MRP)

The AER draft approach to set the Market Risk Premium based on estimates of historical excess returns maintains an approach consistent with the 2018 Instrument and continues a consistent and coherent approach to the rate of return framework.  The AER notes in its draft that the MRP estimate has increased materially under the Historical Excess Return (HER) estimation methodology used in making the 2018 Rate of Return Instrument, and this was due to relatively high equity returns post 2017. 

As noted by the CRG, there is an absence of empirical evidence that the prevailing approach has had a detrimental impact, and in the AEC’s view this is true. The CRG has stated in earlier submissions to the AER that the HER method is the most appropriate for long-lived assets with long-term investors  (emphasis added). 

The AEC shares the AER view that using HER does not mean an MRP estimate is backward-looking.  As the AER note, the HER is commonly used by both regulators and market practitioners to inform their estimates of the MRP when calculating a forward-looking rate of return. 

This does not mean to say that the HER method is perfect.  Whilst an academic or theoretical case can be made for greater weight to other information in determining the MRP, there is no particularly compelling case to date that there is a problem with the current method that must be addressed.  Because it is consistent with the AER’s past practice and with the principle of providing a consistent framework, and in the absence of evidence of any harm, the AEC supports the setting of the MRP based on the HER.

The NEO, NGO and the long-term interests of consumers

As noted above, the AEC has encouraged generally that the AER should maintain a consistent and coherent approach and that there should remain a “high bar to change”.  And we say that the available evidence does not support significant changes from the 2018 instrument.  But what evidence has been presented?

North Queensland’s CopperString project has been cited as partial evidence that the rate of return is set too low to attract investors.  The AEC agrees with the need for additional transmission within the NEM, and the Australian Energy Market Operator’s Draft Integrated System Plan (ISP) highlights the importance of managing the energy transition and the role of transmission projects with some $12 billion of “actionable” developments. However, the AEC notes the ISP does not mention CopperString.  This would imply that the rate of return is not the issue in this instance, but rather that the project is economically unviable as its costs far outweigh its benefits.  Any argument that the required rate of return claimed by the proponents of projects such as CopperString should influence the long-established principles of the rate of return for efficient transmission investment are very concerning.  If you’re interested, our earlier assessment of the CopperString proposals it can be found in “Copperstring 2.0: A look at the numbers”.

In contrast, the Independent Panel Report cites the fact that eight regulated network companies have been acquired by private investors since 2006, in a process that typically involves a premium for control, provides the observable market-based evidence that the revenue streams offered by regulated network businesses are attractive to investors.  Coupled with that, according to the AER 2022 report, network businesses achieved returns on regulated equity which exceed forecast returns on equity by approximately 4.2 percentage points on average, suggesting that the AER has consistently and materially erred in favour of networks and against customers.  There is no doubt whatsoever that the AER sets a rate of return that attracts investors to the sector. That is its success indicator. Now is not the time to make material changes and risk higher prices for energy consumers.

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