Asset risk premium relative to debt risk premium Prepared for Energy Networks Association 4 September 2020 Final www.oxera.com Final Asset risk premium relative to debt risk premium Oxera Contents Executive summary 1 1 Introduction 7 1.1 The Oxera ARP−DRP report 7 1.2 Developments since our first report 8 1.3 Scope of this report 9 2 The role of the ARP−DRP framework in assessing the WACC and financeability 10 2.1 Summary of our original application of the ARP−DRP framework 10 2.2 Amendment to the estimation of the risk-free rate 11 2.3 Employing the ARP−DRP framework for a conservative WACC estimation 11 2.4 Implications for RIIO−2 financeability 14 3 Updated evidence from the UK utilities bonds 15 3.1 Updates since the Oxera ARP−DRP report 15 3.2 Summary of main results 17 4 Response to Ofgem’s comments on ARP−DRP 23 4.1 Response to Ofgem’s comments concerning past regulatory precedents 23 4.2 Response to Ofgem’s comments concerning theoretical underpinnings of the ARP−DRP framework 25 4.3 Response to Ofgem’s comments concerning robustness of analysis across time, comparator sets and alternative assumptions concerning the cost of capital 28 4.4 Debt transaction costs 31 A1 Mathematical derivation of the ARP−DRP measure for benchmarking 32 A2 Detailed methodologies, summary statistics and sensitivity analysis of the UK utilities bonds analysis based on traded yields 33 Oxera Consulting LLP is a limited liability partnership registered in England no. OC392464, registered office: Park Central, 40/41 Park End Street, Oxford OX1 1JD, UK; in Belgium, no. 0651 990 151, branch office: Avenue Louise 81, 1050 Brussels, Belgium; and in Italy, REA no. RM - 1530473, branch office: Via delle Quattro Fontane 15, 00184 Rome, Italy. Oxera Consulting (France) LLP, a French branch, registered office: 60 Avenue Charles de Gaulle, CS 60016, 92573 Neuilly-sur-Seine, France and registered in Nanterre, RCS no. 844 900 407 00025. Oxera Consulting (Netherlands) LLP, a Dutch branch, registered office: Strawinskylaan 3051, 1077 ZX Amsterdam, The Netherlands and registered in Amsterdam, KvK no. 72446218. Oxera Consulting GmbH is registered in Germany, no. HRB 148781 B (Local Court of Charlottenburg), registered office: Rahel-Hirsch- Straße 10, Berlin 10557, Germany. Although every effort has been made to ensure the accuracy of the material and the integrity of the analysis presented herein, Oxera accepts no liability for any actions taken on the basis of its contents. No Oxera entity is either authorised or regulated by any Financial Authority or Regulation within any of the countries within which it operates or provides services. Anyone considering a specific investment should consult their own broker or other investment adviser. Oxera accepts no liability for any specific investment decision, which must be at the investor’s own risk. © Oxera 2020. All rights reserved. Except for the quotation of short passages for the purposes of criticism or review, no part may be used or reproduced without permission. Final Asset risk premium relative to debt risk premium Oxera A2.1 Detailed methodology 33 A2.2 Summary statistics 35 A2.3 Results under Approach 2 35 A2.4 Sensitivity tests 36 A3 Results of the UK utilities bonds analysis based on yields at issuance 42 A3.1 Detailed methodology 42 A3.2 Summary statistics 43 A3.3 Summary of results 43 Final Asset risk premium relative to debt risk premium Oxera Boxes, figures and tables Figure 1.1 ARP−DRP differential implied by UK energy bonds 2 Figure 1.2 Comparison of Ofgem’s ARP−DRP differential to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 3 Figure 1.3 Comparison of UK regulatory precedents to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 4 Table 1.1 Percentile ranking of Ofgem’s ARP−DRP differential 5 Figure 1.4 Comparison of the ARP−DRP differentials implied by Ofgem’s and Oxera’s estimates to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 6 Table 2.1 Original implementation methodology for the ARP−DRP cross-check 10 Box 2.1 Attenuation bias in econometrics 13 Figure 3.1 ARP−DRP differential implied by UK energy bonds 17 Figure 3.2 Comparison of Ofgem’s ARP−DRP differential to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 18 Figure 3.3 Comparison of UK regulatory precedents to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 19 Figure 3.4 Distribution of the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 20 Figure 3.5 Comparison of the ARP−DRP differentials implied by Ofgem’s and Oxera’s estimates to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds 21 Table 3.1 Comparing Oxera’s and Ofgem’s ARP−DRP differentials to that implied by contemporaneous market evidence 22 Table 4.1 Summary statistics of the DRP for UK utilities bonds, by credit rating categories and gearing of issuing firm 27 Table 4.2 Effect of the inflation assumption on ARP−DRP differential 30 Figure A2.1 Summary statistics of UK utilities sample 35 Figure A2.2 Summary of the ARP−DRP cross-check under Approach 2 36 Figure A2.3 Distribution of the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds (asset betas averaged across all UK energy regulatory precedents) 37 Figure A2.4 Distribution of the ARP−DRP differential implied by contemporaneous evidence on UK energy and water bonds 38 Figure A2.5 Comparison of the ARP−DRP differentials implied by Ofgem and Oxera CoE estimates to the ARP−DRP differential implied by contemporaneous evidence on UK energy bonds (including SSE and Centrica) 39 Figure A2.6 ARP−DRP differential under Approach 1 implied by UK energy bonds and RIIO−2 Draft Determination (debt beta of 0.15) 40 Final Asset risk premium relative to debt risk premium Oxera Figure A2.7 Summary of the ARP−DRP cross-check under Approach 2 (debt beta of 0.15) 40 Figure A2.8 The effect of the risk-free rate adjustment on the percentile ranking of Ofgem’s allowance (no convenience yield) 41 Figure A3.1 Summary statistics of UK utilities sample 43 Figure A3.2 ARP−DRP differential implied by UK energy bonds (based on yields at issuance), and RIIO−2 Draft Determination 43 Final Asset risk premium relative to debt risk premium 1 Oxera Executive summary As part of the Energy Networks Association’s response to Ofgem’s RIIO−2 Sector Specific Methodology (‘SSMD’), in March 2019 Oxera submitted evidence to Ofgem on how its proposed allowance on the cost of equity compared with the pricing of risk for these companies in the debt markets (the ‘Oxera ARP−DRP report’).1 We explained that the ARP−DRP differential can be used as a cross-check for the appropriate level of the allowed cost of equity. In this report, we update the analysis presented in the Oxera ARP−DRP report and the 2019 cost of equity update,2 by (i) including the newly available data from the bond markets; (ii) adopting a revised approach to the risk-free rate set out in a recent Oxera submission to the CMA;3 and (iii) improving the methodologies used for our analysis in response to Ofgem’s concerns set out in the RIIO−2 SSMD. In sum, three main conclusions can be drawn from this report: • The benchmarks for ARP−DRP can be employed not only as a cross-check to cost of equity, but also to obtain conservative estimates of the allowed WACC, because of the downward bias in asset beta estimation. • After adequately addressing Ofgem’s concerns set out in the RIIO−2 SSMD, our findings reveal more information to support the conclusion that Ofgem’s RIIO−2 cost of equity allowances in the Draft Determination falls below that implied by (i) contemporaneous market evidence for the cost of debt and the risk-free rate; and (ii) a mixture of contemporaneous market evidence and regulatory precedent on the asset beta and the TMR.4 This conclusion is based on the finding that the ARP−DRP differential implied by Ofgem’s allowances is low compared to those implied by the traded yields of energy bonds over the six-month period preceding the RIIO−2 Draft Determination. • Our updated analysis, incorporating various methodological improvements, finds that the ARP−DRP differentials implied by past regulatory allowances for energy companies (i.e. RIIO−1, NIE RP5 and NIE RP6) were broadly in line with those implied by contemporaneous market evidence around the corresponding determinations. In line with Ofgem’s comments in the Sector Specific Methodology Decision,5 we believe that the appropriate benchmark for the ARP−DRP differential should be derived from contemporaneous market evidence. Therefore, in this report, we focus solely on the UK utilities analysis, where the DRPs are calculated based on the daily traded yields of individual utilities bonds, over the six-month period preceding the publishing date of regulatory determinations.6 In this report, we show that the ARP−DRP differential has a role above and beyond a cross-check in the estimation of cost of equity parameters. In 1 Oxera (2019), ‘Risk premium on assets relative to debt’, 25 March. 2 Oxera (2019), ‘The cost of equity for RIIO−2’, August. 3 For Oxera’s revised approach to the risk-free rate see Oxera (2020), ‘Are sovereign yields the risk-free rate for the CAPM?’, 20 May. 4 We set out our methodology in more details in Appendix A2.1.