Patrón de flujo.

231. The ERA considered expert evidence from Associate Professor Lally on this issue and has incorrectly claimed to be implementing his advice. The error in implementing his advice ties directly back to the above logical flaw in the ERA’s position expressed above. On page 25 of Appendix 2 the ERA correctly characterises Associate Professor Lally’s advise as follows:

39. More recently, Lally (2010) considered the situation where the average debt term used by regulated businesses materially exceeds five years (that is, the term of the regulatory cycle), and where these firms use neither interest rate swaps nor credit default swaps to equate the longer term (say 10-year) debt with the regulated five year term of debt. In this scenario, the present value principle would be violated. This is because the regulator’s allowed cost of debt would diverge from those actually incurred by the firms.

…

42. Lally proposes a further scenario 3 to deal with a situation where credit default swaps are not available. In this situation, it is assumed that the regulated firm will borrow for a tenor of 10 years and use interest rate swaps to convert the ten-year risk-free rate to a five-year risk free rate. Given the difficulties with using credit default swaps to convert a 10-year debt risk premium to a 5-year one, Lally suggests the regulator should use: (i) the five-year risk-free rate, (ii) 10-year debt risk premium, (iii) annualised 10-year debt issuance costs; and (iv) the transaction costs involved with swap contracts. Whilst this would violate the NPV=0 principle, Lally suggests that this would be a slight deviation of approximately only 0.04% of the WACC per year.

…

46. In the situation where the average term to maturity is significantly longer than 5 years, Lally advocates scenario 2 if credit default swaps are readily available and transaction costs are not significant. If transaction costs are significant, or credit default swaps are not readily available then Lally advocates the third option.

232. That is, Lally’s advice is that where “the average debt term used by regulated businesses materially exceeds five years” then, if it is not possible to hedge the DRP [which Lally acknowledges is the case], the term used to estimate the DRP needs to reflect the DRP of the long term debt (10 years in this example).

233. The critical point here is what is meant by “the average debt term used by regulated businesses”. If one reads Lally then it is clear that this is the debt term at issuance:

The second option would arise only if the average debt term (from issuance to maturity) used by relevant comparator firms materially exceeded five years. For example, suppose that the average debt term of such firms is ten years. [Emphasis added.]

…

For example, a firm might seek an average debt term of 10 years so that, in conjunction with staggering of the maturity dates, approximately 10% of its debt requires roll-over in any one year.57

234. These quotes make perfectly clear that Lally’s analysis and conclusions is based on the average term at issuance of debt being longer than the regulatory period – not the average remaining term of a debt portfolio being longer than the regulatory period. (Of course, one should not have to look for quotes to demonstrate this. Lally’s analysis would make no sense if the former interpretation was adopted). 235. The ERA argues that it is following Lally’s advice:

76. The Authority will update the debt risk premium annually. This annual reset could imply a one year term, in order to meet the present value principle. However, as hedging instruments – such as credit default swaps – are not readily available in Australia, firms cannot easily hedge this debt risk premium. Lally observes that where hedging is not available, it is reasonable to adopt the average term to maturity of the debt held by the benchmark efficient firm for estimating the debt risk premium (see paragraph 46 above). This recompenses the firm for the debt risk premium component, recognising efficient financing practices, and in particular, the need to stagger the term of debt to address refinancing risk.

77. The Authority’s analysis of the debt profile of the benchmark efficient entity indicates that the term to maturity exceeds five years.

78. As a result, in line with Lally’s advice set out above at paragraph 46, the Authority considers that the appropriate term for the debt risk premium should be the term to maturity observed for the benchmark

efficient entity through the bond yield approach. That term will fluctuate according to the average term to maturity of the sample in any year. 58

236. However, when it comes to determining the “debt profile of the benchmark efficient entity” the ERA does not base the term assumption on the term at issuance (as logic and Associate Professor Lally require). Rather, the ERA bases its term estimate on the remaining term of the bonds in the ‘bond yield’ sample. There is no reason for this to be consistent with a 10 year estimate and there is every reason to expect it to be shorter59_{, which, indeed, is the case (in ATCO’s averaging period this is 5.7 years} and PwC previously estimated it to be 5.2 years)60_.

C.3

Can a debt management strategy be reconciled to the