198. Professor Gregory‟s report states that:
the AER has used two different estimates of the risk free rate in the CAPM, giving rise to inconsistency. The MRP is simply the difference between the market return on equity and the risk free rate;
the empirical evidence suggests that the expected market return is more stable that the MRP, giving rise to an inverse relationship between the risk free rate and MRP. However, the AER has effectively assumed that the MRP is constant and this relationship with the risk free rate does not exist;
the AER‟s reliance on Goyal and Welch in support of its contention that the MRP is more stable than the cost of equity is controversial, but even assuming that historic returns are predictive of the future, the path followed by the AER is inconsistent in its risk free rate and MRP assumptions;
70 CEG, Response to AER Vic gas draft decisions: Internal consistency of MRP and risk free rate,
63 there are two internally consistent approaches open to the AER:
to estimate the expected return on the market directly and use this in conjunction with an estimate of the prevailing risk free rate; or
to use a risk free rate derived from historic measures in combination with its historically derived estimate of the MRP.
there are many logical inconsistencies made by the AER, including but not limited to:
in its interpretation of the effect of flight to quality;
in respect of its consideration of debt premiums compared to equity premiums;
ignoring IPART‟s consideration of this issue despite relying on its MRP as relevant precedent;
UK regulators (except Ofgem and ORR) make full use of the CAPM. It is common practice to make adjustments to prevailing gilt yields when these are materially different from historical averages and the MRP has been estimated with regard to an historical average; and
UK regulators tend to focus first on establishing a value for the market cost of equity which is then used as an input to their estimate of the MRP – rather than the other way around. Gregory quotes the Competition Commission (CC) as stating that it would be „illogical‟ to retain a previous range for the MRP in the face of lower risk free rates if there were no reason to believe that the market cost of equity was equivalently lower.
199. Professor Gregory‟s views about the AER‟s methodology and how it can achieve consistency in its cost of equity estimate are substantially in alignment with my own. Indeed, as it relates to theory and the AER‟s application of that theory, Professor Gregory raises many of the same points that I cover in my March 2012 and November 2012 reports as it clear from my concise summary above.
200. I note that there are differences in emphasis between how Professor Gregory expresses his views and how they are introduced in my reports. For instance, his view that the market return on equity is stable is brought forward early in his chain of reasoning, in essence as an empirical fact. In my reports this result was brought forward at the conclusion of analysis that sought to establish this as a fact. In my view, these differences likely reflect the greater acceptance of this result by regulators in the UK when compared to the AER‟s consideration of these issues. I do not believe that it reflects any important difference in the views that Professor Gregory and I expressed.
201. Professor Gregory, in noting that adjustments to gilt yields are common place in the UK, echoes the statements I have previously made that there is significant
64 regulatory precedent for an approach based on historic averages of the risk free rate in the UK.
8.3 Report of Stephen Wright
202. Professor Wright‟s report states that:
there is strong evidence that the expected market return is relatively stable over time. However, the risk free rate, and therefore the MRP, tend to be unstable and offsetting of each other. There is indirect empirical evidence for this negative relationship;
these precepts have underpinned Ofgem‟s and the CC‟s considerations of these issues, as reflected in a very stable expected market return and offsetting changes in the risk free rate and MRP;
this contrasts with the policy applied by the AER, in which the MRP is held constant and the expected market return follows the risk free rate up and down; the AER‟s proposed parameters in its Victorian draft decision imply a 300 basis point decline in the market return on equity since the previous ESC decision, and is also lower than values set in the UK. It seems plausible that the expected market return would be higher in Australia than the UK;
this inappropriate in the current Australian context where market returns are particularly high, encouraging private investment. Setting a low cost of equity for regulated firms will potentially make it difficult to attract investment to the regulated sector; and
the AER‟s choice of the risk free rate is not necessarily wrong. It is the combination of this with the historical MRP that creates the problem. It could be a compromise to adopt an historical average approach for both the risk free rate and the MRP.
203. Once again, I consider that the opinions expressed by are in accordance with those expressed in my reports. The reports of Professor Wright, Professor Gregory and myself all reach similar conclusions in respect of:
the more stable nature of the expected market return compared to the MRP; and
the unstable nature of the risk free rate and, consequently, the unstable nature of the MRP with the two being negatively related; and
the inappropriate nature of the AER‟s practice of combining the current risk free rate with an historical estimate of the MRP.
204. I consider that Professor Wright makes salient observations about the effect of the AER‟s methodology on its implied estimate of the market return on equity. These
65 observations are consistent with my analysis of why it would not be appropriate to pass through changes in the risk free rate directly into the cost of equity, which is what the AER does by holding the MRP constant.
205. I also note that Professor Wright and I are aligned in our views on the use of the prevailing risk free rate. Although the AER appears to have interpreted my views otherwise, I do not state that use of prevailing CGS yields in and of itself is the source of the problems with the AER‟s estimate of the cost of equity. Professor Wright‟s conclusion on this matter is substantively the same as mine.
206. However, I note that there is one distinction in views between Professor Wright and I in relation to the motivation for using a historical estimate of the risk free rate. Professor Wright describes this as a possible „compromise‟. In my view, this would only be a „compromise‟ in respect of the fact that estimating the CAPM using these inputs is focussed purely on estimating the cost of equity prevailing „on the day‟. If the objective, and the only objective, is to arrive at the best estimate of the cost of equity at a given point in time then I agree that the most direct estimate of this will be associated with directly estimating the market cost of equity at that point in time (relying primarily or solely on evidence taken from the then current market conditions). In this sense, using historical averages for MRP and risk free rate may be a „compromise‟ – albeit one that will result in a better estimate than using an historical average for the MRP but not the risk free rate.
207. However, an accurate „on the day‟ estimate of the cost of equity may not be the sole criteria by which to assess a methodology. Other criteria might include promoting predictability and simplicity of regulatory outcomes. In addition, the relevant objective may not be to arrive at an estimate of the cost of equity prevailing at a given time at all. Rather it may be to forecast the expected average cost of equity out over some longer term horizon, such as the 10 year horizon the AER refers to in justification for its use of an historic average MRP. That is, to arrive at a prevailing forecast of the future cost of equity over the relevant period.
208. When the potential for these other criteria/objectives are taken into account it does not follow that the use of historical average estimates for the risk free rate and MRP should be considered a „compromise‟ relative to using all „on the day‟ estimates.
8.4 Relevance of United Kingdom regulatory precedent
209. I have been asked whether differences between the United Kingdom and Australia reduce the relevance of the observations made by Professors Gregory and Wright to the AER‟s considerations. In my view, they do not.
210. Firstly and most importantly, I note that the issue of substance relates to how the CAPM should be applied. It concerns the nature of, and the relationships between: the expected market return; the risk free rate; and the MRP. Put simply, the CAPM is not a theory with borders such that it applies in some jurisdictions but not others.
66 211. Regulators in Australia and the UK apply the same CAPM formula to estimate the cost of equity. However, UK regulators apply the CAPM formula differently to the AER (and similarly to IPART) because of their concerns that applying it in the manner that the AER proposes to do would lead to an underestimate of the cost of capital. As observed by Professor Gregory, UK regulatory authorities have long recognised that underestimating the cost of capital will cause detriment to consumers in the long term.71 These issues and the approach used by UK regulators to resolve them are relevant for other jurisdictions including Australia.
212. Secondly, I also am unaware of any important differences between the objectives of regulatory regimes in Australia and the UK that would provide a basis to assume that regulatory practice in the UK has only limited relevance to Australia. I am aware that the objective of the NGL 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.
213. As noted by Professor Gregory, UK regulators recognise that underestimating the cost of capital will cause detriment to consumers in the long term. I do not consider this to be a controversial position as it applies in the Australian context. There is no reason to assume that the CAPM should be applied differently in Australia (as opposed to the UK) since in both cases the emphasis should properly be on correctly estimating the cost of equity. I have not seen any commentary from the AER that would suggest that its objectives in estimating the cost of equity and the cost of capital diverge from this.
214. In addition, I am unaware of any evidence that Australian investors would respond differently underestimation of the cost of equity than UK investors. Similarly, I am unaware of any evidence that Australian consumers would be more sanguine than their UK counterparts about reductions in quality/security of supply of energy (or other infrastructure services) as a result of underinvestment.
71 Alan Gregory, The AER Approach to Establishing the Cost of Equity – Analysis of the Method Used to
67
Appendix A Inconsistent use of historical
data
215. On page 29 of his report Lally argues that the period from 1940 to 1990 was characterised by abnormally high inflation that tended to artificially lower real bond yields. This is the period that drives Lally‟s result in his Figure 1 that MRP is more stable than the total market return, i.e., is the period where total market return and bond yields fall together – leaving the MRP series relatively constant.
216. However, on page 29, Lally argues that this is not a real description of the behaviour of the truly expected MRP because he believes the realised real yield is artificially low due to unanticipated inflation. Lally argues that the MRP could be better estimated by assuming a 3.6% real risk free rate applied in these years (as a better proxy for the rates investors expected). This naturally leads to Lally, on page 29, to arrive at a lower estimate of the historical average MRP (because he adopts a higher value for the real risk free rate and holds all else constant – thereby squeezing down the MRP series).
217. However, the same logic was not applied by Lally to the data in his Figure 1. Had Lally used his estimate of expected yields (rather than realised yields) from 1940 to 1990 his Figure 1 would give rise to a much more unstable MRP series – and more unstable than the cost of equity series. This is because the real risk free rate series would not show the dramatic dip between 1950 and 1990 and, consequently, all of the dip in total market returns in that period would „show up‟ in a dip in MRP. 218. In terms of the specific effects on standard deviation estimates, I substitute a real
risk free rate of 3.6% in the years from 1940 to 1990 into the Lally dataset. I then estimate a standard deviation in Lally‟s series of 30 year rolling average MRP of 1.7% - which is higher than the standard deviation in the 30 year rolling average total return series (1.5%). It is also the case that the negative correlation between the bond yield series and the MRP series would increase (from -0.12 go -0.39). 219. In summary, this result demonstrates Lally‟s key finding, namely, that his MRP
series is more volatile than his total return series, is driven by the behaviour of real interest rates in the period 1940 to 1990. On page 29 Lally regards this behaviour as “unusual” and driven by “abnormally high inflation”. Lally makes an adjustment to bond yields in this period the effect of which is to raise bond yields and lower the long run average MRP. However, the same adjustment would also increase the volatility of the Lally MRP series above that of the Lally total real return series – the reverse of his key finding in section 2.2 that the opposite is the case.