The Australian Competition and Consumer Commission and the Victorian Office of the Regulator-General today released their final decisions on the Victorian access arrangements for natural gas pipelines.
In particular, the decisions relate to the prices which will be set for the next five years for gas transportation. The ACCC has responsibility for the regulation of transmission pipelines (the long haulage of gas from the gas fields), while the Victorian Office of the Regulator-General is responsible for the distribution network (the reticulation of gas to households and businesses).
"Although much of the discussion has focussed on the rate of return, it should be noted that the regulatory regime being put in place is CPI-X incentive-based regulation, not rate of return regulation," ACCC Chairman, Professor Allan Fels, said today. "The incentive mechanisms allow the utility owner to earn a return in excess of the nominated rate of return by retaining the benefits in the next five years resulting from market growth, efficiency improvements and refinancing benefits when these exceed forecasts."
Some commentary on this topic in recent months has arisen from a degree of misunderstanding of the WACC concept. Accordingly, the decision on WACC today has been translated into the more widely understood concept of nominal post-tax return on equity so that everyone can understand what the decision means.
Both the ACCC and the ORG have determined a real pre-tax weighted average cost of capital (WACC) of 7.75 per cent, which is equivalent to a nominal after tax return on equity of at least 13.2 per cent. A private investor may obtain a higher effective rate than this due to the tax benefits flowing from the operation of Australia's tax system. The nominal rate of return on equity originally proposed by the applicant was 14.9 per cent while the ACCC's Draft Decision arrived at a figure of 11.2 per cent.
Professor Fels said the rate of return and other features of the ACCC's decision relate solely to the established Victorian gas transmission pipelines. It should not be regarded as a precedent to be applied to other pipelines or assets in other industries, which have their own risk profiles.
"The assessment of the rate of return requires the regulator to determine a rate which is fair to both the utility owner and customers", Professor Fels said. "In other words, a rate that restricts monopoly profits yet still provides a reasonable return on the investment. In addition, the intent of the reform process at both the national and state levels is to encourage the provision of competitive inputs for Australia's existing and prospective energy intensive industries and to encourage the delivery of competitively priced gas to consumers. I believe that this decision will help to achieve those objectives." The recent gas explosion and fire at the Esso/BHPP plant in Victoria has raised comments by some observers concerning the level of risk inherent in the gas industry. Although this event occurred upstream from the transmission pipeline network at the production level, it is recognised that such events may curtail supply and result in a temporary loss of revenue to the pipeline owner.
"The ACCC has taken into account the risk of such unforeseen events occurring," Professor Fels said. In assessing an appropriate rate of return, the risk factor is reflected in the equity beta parameter which has been set by the ACCC at 1.2. The higher the equity beta, the higher the return. The average for all companies listed on the stock exchange is 1.0.
"The risk factor allowed is very reasonable, considering that the rate of return relates to an established pipeline and the utility owner is protected from inflation risk because of the use of a real rate of return," Professor Fels said. "The asset to which the WACC is being applied is also adjusted annually for inflation.
"I also welcome initiatives such as the InterConnect pipeline between New South Wales and Victoria and the proposed construction of an underground storage facility, which will reduce the risk of the supply of gas being curtailed in future." The rate of return should be viewed in conjunction with the valuation of the initial capital base which inter alia takes account of inflation on the asset values. On this occasion, the ACCC has agreed with a valuation in line with the depreciated optimised replacement costs of the transmission pipelines, which is the upper limit allowed under the Victorian gas code. The capital base is subsequently adjusted for inflation, depreciation, new capital expenditure, and at each five-yearly review may be further adjusted to remove redundant assets.
"It should be remembered that the 7.75 per cent real rate of return set by the regulatory framework is equivalent to a nominal post-tax return on equity of 13.2 per cent which is considered high by market standards," Professor Fels said.
The WACC includes a return on equity and the cost of debt, in proportion to the level of gearing. The return on equity is calculated in accordance with the Capital Asset Pricing Model (CAPM), which is in turn is based on interest rates applicable to Government bonds and the equity beta for the business.
Nominal Return on Equity % 13.2
Real Return on Equity % 10.4
Pre-Tax Nominal WACC 10.7
Pre-Tax Real 7.75
Effective Tax Rate % 36
Gearing Level % 60
Asset Beta 0.55
Equity Beta 1.20
The actual return to an investor of assets such as the Victorian gas transmission system will ultimately depend on the sale price paid to the Victorian Government for the business. Accordingly, there is no basis to support any claims that a rate of return which in any case exceeds 13 per cent post-tax return on equity would have the effect of attracting only passive investors rather than entrepreneurial investors for these assets. Moreover, as noted before, the cost of capital factor is only one element in an incentive-based price mechanism (i.e. the CPI-X mechanism) that provides opportunities for entrepreneurial behaviour even in a long established gas pipeline such as the present one.
If the focus of the comments is new investment, then it should be noted that the ACCC's decision of a real pre-tax return on capital of 7.75 per cent and nominal post-tax return on equity of 13.2 per cent applies only to the assets covered by these access arrangements. For any new major investment proposal, the Victorian and National Gas Codes provide for the possibility of a competitive tender process to determine the rate of return which takes into account any special risks that may be associated with a 'greenfields' project. In relation to other arrangements that may be proposed, i.e. where the competitive tender process is not chosen, there are a range of issues that must be taken into account and considered on a case-by-case basis. The ACCC considers that the level of returns, which are consistent with market returns, and the incentives provided for under the regulatory framework would attract a broad range of investors.
Reactions to the Draft Decision of a 7 per cent pre-tax real WACC ranged from the view of most business users and consumer groups that the figure was a little high to the view of utilities affected or potentially affected by the decision that it was much too low. There was also a body of independent and expert opinion that 7 per cent was at the bottom of the appropriate level of the WACC figure and that a modest increase would be appropriate.
The expected price fall as a result of the decision is likely to be around 13 per cent. The essential reason for this is that the exercise is designed to replace a price which has been determined in an industry with monopoly profits, with a price that should reflect outcomes that would occur in a competitive market. Such a price should provide incentives for investment but should not contain elements of excessive monopoly rents.
"Consumers should benefit from the reforms to the Victorian gas industry through improvements in efficiency and increased competition and immediately through reduced transmission charges," Professor Allan Fels said. For further information about this media release