Development of WACC guideline A consumer view AER

Development of WACC guideline A consumer view AER forum 18 September 2017 1

About the Major Energy Users, Inc v The MEU comprises over 20 large energy using companies across the NEM and in WA and NT v Industries represented include: v v v Iron and steel Cement Paper, pulp and cardboard Fertiliser and explosives Tourism & accommodation Mining v The MEU focuses on the cost, quality, reliability and sustainability of energy supplies essential for the continuing operations of the members who have invested $ billions to establish and maintain their facilities v MEU members have a major presence in regional centres across Australia, e. g. Gladstone, Newcastle, Port Kembla, Mount Gambier, Westernport, Geelong, Port Pirie, Kwinana and Darwin. 2

Key elements of WACC development q Gearing q Cost of debt q Term of debt q Structure of return on equity q Market risk premium q Equity beta q Gamma q RAB is overlooked in the analysis of WACC. Why? After all, WACC is applied to RAB While the MEU has views on each of these, due to time constraints, this presentation focuses on RAB, gearing and cost of debt 3

The network sales premium q There have been a number of networks sold in recent times. Network sales since 2014 show a purchase price of a premium (30%-65%) over the RAB q The buying price of an asset is based on the net present value of the expected revenues less costs from the assets q As opex is effectively recovered at cost, the main contributors to the revenues driving the buying price are q. The RAB*WACC and/or q. The return of capital q As the premium is above the RAB, the core conclusion about the premium is the WACC is overstated and/or the RAB is overstated q While the return of the capital is inflated by CPI, 4

A distortion in the RAB (1) q The RAB comprises items of real equipment which are used. Few, if any, of these assets (towers, transformers, switchgear, cables) owned by the networks increase in resale value, yet the RAB is increased annually by inflation. q This inflation value is locked into the RAB and in the network accounts is included as an asset revaluation reserve - an accounting construct because normally asset value increases are taken to profit under accounting rules q The return on capital is the RAB*WACC with inflation of the assets for the current year excluded, but inflation from previous years is included in the RAB and therefore attracts a return q This is in contrast to the recent decision by GMRG which considers that for non-scheme gas pipelines, an arbitrator should assess the pricing for services based on the depreciated actual cost of the pipeline X a commercial nominal return q The AER Ro. R guideline develops a commercial nominal 5

A distortion in the RAB (2) q Equity comprises the funds initially put up by investors plus subsequent investments plus those earnings retained for future investment q Equity should not include inflation if a commercial rate of return is used q But to identify the level of gearing used in the return on capital, equity is assessed as that amount remaining after the debt has been removed, so the asset revaluation reserve attracts a return on equity q The question then becomes should the asset revaluation reserve attract q. An equity return as it does now q. A debt return q. No return 6

The return on debt v A review of the annual reports of the parent companies holding network assets shows that the cost of debt actually incurred is consistently lower than the cost of debt allowed by the AER. v While the networks use many different debt approaches to minimise the cost of debt, the AER uses only publicly available corporate bond data to calculate the cost of debt which is easy to access but delivers higher debt costs v NEM regulation is based on incentives to reduce the costs to consumers (like EBSS, CESS, STPIS) v As debt is a cost to networks (like opex) consumers should benefit from driving the 7

Conclusions v Throughout the AER assessments, it takes a conservative view. While some conservatism is necessary, the outturn of the degree of conservatism has resulted in consumers paying more than is efficient v The degree of this conservatism is exemplified through network sales being at a premium to the RAB v This conservatism is applied at each stage and is both additive and in some cases geometric (eg WACC*RAB, MRP*equity beta) v The MEU considers that the AER needs to address higher than needed costs by v. Not providing a return on the inflation in the RAB v. Not allowing unnecessary higher costs of debt v. Not including excessive conservatism in WACC 8