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Jemena Electricity Networks (Vic) Ltd Jemena Electricity Networks (Vic) Ltd 2016-20 Electricity Distribution Price Review Regulatory Proposal Attachment 9-2 Rate of return proposal Public 30 April 2015 TABLE OF CONTENTS TABLE OF CONTENTS Glossary............................................................................................................................................................................ v 1. Summary................................................................................................................................................................ 1 1.1 Applying a new framework for setting the allowed rate of return ................................................................. 1 1.2 Our concerns with Recent AER decisions ................................................................................................... 2 1.3 Our views on the guideline .......................................................................................................................... 5 1.4 The rest of the Attachment .......................................................................................................................... 9 2. The changing risk profile for electricity distribution businesses ................................................................... 10 2.1 Overview.................................................................................................................................................... 10 2.2 Evolving operating risk profile.................................................................................................................... 11 2.3 Changes to electricity distribution .............................................................................................................. 12 2.4 Changing risk............................................................................................................................................. 16 3. Return on equity ................................................................................................................................................. 19 4. Return on debt .................................................................................................................................................... 87 4.1 Tenor of the benchmark debt instrument ................................................................................................... 88 4.2 Trailing average portfolio approach ........................................................................................................... 89 4.3 Transitional arrangements ......................................................................................................................... 90 4.4 Estimation procedure................................................................................................................................. 94 4.5 Averaging period...................................................................................................................................... 101 4.6 New issue premium ................................................................................................................................. 102 4.7 Annual update formula............................................................................................................................. 103 5. Debt raising costs............................................................................................................................................. 108 6. Expected inflation ............................................................................................................................................. 110 7. Illustrative calculations .................................................................................................................................... 111 List of tables Table 1–1: Previously allowed returns on equity ................................................................................................................ 4 Table 1–2: Previously allowed returns on debt................................................................................................................... 5 Table 1–3: Our proposal compared to the guideline .......................................................................................................... 5 Table 3–1: Use made by regulators of the Black, Zero-Beta and Empirical CAPM.......................................................... 26 Table 3–2: FFM and SL-CAPM estimates used in US regulatory proceedings ................................................................ 28 Table 3–3: Our concerns with the foundation model approach ........................................................................................ 35 Table 3–4: Historical MRP estimates identified by the AER ............................................................................................. 64 Table 3–5: MRP estimates from the DDM........................................................................................................................ 73 Table 3–6: MRP estimates from survey evidence ............................................................................................................ 75 Table 3–7: MRP estimates from regulatory decisions ...................................................................................................... 75 Table 4–1: Historical DRP values................................................................................................................................... 106 Table 4–2: Swap rates*.................................................................................................................................................. 106 Table 4–3: Transitional return on debt values ................................................................................................................ 107 Table 7–1: Proposed return on equity ............................................................................................................................ 111 Table 7–2: Proposed return on debt for the first year of the 2016 EDPR period ............................................................ 111 Table 7–3: Proposed rate of return for the first year of the 2016 EDPR period .............................................................. 112 Table 7–4: Alternative estimate of the equity beta ......................................................................................................... 112 Public—30 April 2015 © Jemena Electricity Networks (Vic) Ltd iii Attachment 9-2 TABLE OF CONTENTS List of figures Figure 1–1: Historical CGS yields and the Ibboston inspired SL-CAPM .............................................................................3 Figure 2–1: Reduction in solar panel prices......................................................................................................................13 Figure 3–1: Relationship between expected return and beta............................................................................................55 Figure 3–2: Range of AER MRP estimates from the dividend discount model .................................................................74 List of attachments Attachment A Credit ratings over 2002 to 2014 iv Public—30 April 2015 © Jemena Electricity Networks (Vic) Ltd Attachment 9-2 GLOSSARY GLOSSARY AEMC Australian Energy Market Commission AER Australian Energy Regulator’s CGS Commonwealth Government Securities DCF Discount Cash Flow DDM Dividend Discount Model EDPR Electricity Distribution Price Review FFM French Three Factor Model Guideline Rate of Return Guideline JEN Jemena Electricity Networks JGN Jemena Gas Networks’ MRP Market Risk Premium NEL National Electricity Law NEM National Electricity Market NEO National Electricity Objective NGR National Gas Rules OLS Ordinary Least Squares PTRM Post Tax Revenue Model RAB Regulated Asset Base RBA Reserve Bank of Australia RPP The Revenue and Pricing Principles S&P Standard and Poor’s SFG SFG Consulting SIRCA Securities Industry Research Centre of Asia-pacific SL-CAPM Sharpe-Lintner Capital Asset Pricing Model Public—30 April 2015 © Jemena Electricity Networks (Vic) Ltd v Attachment 9-2 SUMMARY — 1 1. SUMMARY 1.1 APPLYING A NEW FRAMEWORK FOR SETTING THE ALLOWED RATE OF RETURN 1.1.1 THE NEW FRAMEWORK 1. Electricity distribution networks are capital intensive with long lived assets and therefore a key aspect of the Australian Energy Regulator’s (AER’s) distribution determination is the allowed rate of return on the capital invested in our business. Rule 6.12.1 provides1 that two of the constituent decisions that form part of the over- all determination are: A decision on the allowed rate of return for each regulatory year of the regulatory control period in accordance with rule 6.5.2,2 and A decision on whether the return on debt is to be estimated using a methodology in which the allowance is potentially different for different regulatory years in the regulatory control period and, if that is the case, the formula that is to be applied in accordance with rule 6.5.2(i).3 2. Where there is uncertainty, expert evidence explains how the expected costs for electricity consumers of setting too low an allowance for the return on capital are greater than the expected costs of setting the allowance too high.4 3. An efficient allowed rate of return is particularly important. If the rate of return is inflated, customer network charges will be higher than necessary. Equally, if the rate of return is below a fair market
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