Aurizon Network’s WACC for the 2017 DAU Queensland Competition Authority December, 2017 Aurizon Network’s WACC for the 2017 DAU Table of Contents 1. Executive Summary ........................................................................................................................ 1 1.1 Summary of findings ............................................................................................................... 1 1.2 Capital structure and beta ........................................................................................................ 2 1.2.1 Aurizon Network’s submission on asset beta ................................................................. 2 1.2.2 Our response to Aurizon Network’s submission ............................................................ 4 1.2.3 Our estimate of the benchmark asset beta ..................................................................... 11 1.2.4 Benchmark capital structure and equity beta estimate .................................................. 15 1.3 Credit rating and cost of debt ................................................................................................ 16 1.3.1 Benchmark credit rating ................................................................................................ 16 1.3.2 Debt risk premium - overview ...................................................................................... 16 1.3.3 Our estimate of the 10 year benchmark BBB+ debt risk premium ............................... 23 1.3.4 Cross-checks of estimates ............................................................................................. 23 1.3.5 Interest rate swap costs ................................................................................................. 24 1.3.6 Stakeholder submissions ............................................................................................... 24 2. Background, Terms of Reference and outline of report ................................................................ 25 2.1 Background ........................................................................................................................... 25 2.2 Terms of Reference ............................................................................................................... 25 2.3 Outline of report .................................................................................................................... 26 3. First principles analysis ................................................................................................................. 27 3.1 Introduction ........................................................................................................................... 27 3.2 Potential comparator industries ............................................................................................. 27 3.3 Aurizon Network’s relative systematic risk - First Principles Analysis .............................. 28 3.3.1 Market power and regulation ........................................................................................ 28 3.3.2 Income elasticity of demand and the nature of the customer ........................................ 31 3.3.3 Contract duration........................................................................................................... 34 Aurizon Network’s WACC for the 2017 DAU 3.3.4 Pricing structure ............................................................................................................ 36 3.3.5 Real options .................................................................................................................. 36 3.3.6 Operating leverage ........................................................................................................ 37 3.3.7 Market weight ............................................................................................................... 39 3.3.8 Stranding risk ................................................................................................................ 39 3.4 Summary of First Principles analysis .................................................................................... 43 3.4.1 Empirical testing of ROA-GDP relationships ............................................................... 44 4. Capital structure and beta .............................................................................................................. 50 4.1 Introduction ........................................................................................................................... 50 4.2 Asset beta .............................................................................................................................. 50 4.3 Aurizon Network’s submission ............................................................................................. 51 4.3.1 Aurizon Network’s submission proposed an asset beta of 0.55 .................................... 51 4.3.2 The QCA / Incenta over-emphasised regulation and chose the wrong comparator group ....................................................................................................................................... 51 4.3.3 Weight should be given to railroad industry comparators ............................................ 54 4.3.4 Aurizon Network is subject to a range of risks ............................................................. 57 4.4 Response to Aurizon Network submission ........................................................................... 58 4.4.1 Introduction ................................................................................................................... 58 4.4.2 Response to The Brattle Group’s “common characteristics” ........................................ 59 4.4.3 Provision of weight to railroad industry comparators ................................................... 62 4.4.4 Risks faced by Aurizon Network .................................................................................. 67 4.4.5 Systematic revenue risk and investor returns ................................................................ 70 4.4.6 Empirical estimates of Aurizon Network’s asset beta .................................................. 71 4.5 Benchmark capital structure.................................................................................................. 78 4.5.1 Background ................................................................................................................... 78 4.5.2 Our assessment of Aurizon Network’s benchmark capital structure ............................ 78 Aurizon Network’s WACC for the 2017 DAU 4.6 Equity beta ............................................................................................................................ 79 4.6.1 Aurizon Network’s submission on equity beta ............................................................. 79 4.6.2 Our estimate of the benchmark equity beta ................................................................... 80 4.7 Conclusions ........................................................................................................................... 80 5. Benchmark credit rating, term of debt and debt risk premium ..................................................... 82 5.1 Benchmark credit rating ........................................................................................................ 82 5.2 Efficient term of debt ............................................................................................................ 85 5.3 The risk free rate ................................................................................................................... 86 5.4 Benchmark debt risk premium – Aurizon Network’s submission ........................................ 86 5.4.1 Introduction ................................................................................................................... 86 5.4.2 Aurizon Network’s submission ..................................................................................... 86 5.4.3 Aurizon Network’s debt risk premium proposal ........................................................... 87 5.5 Benchmark debt risk premium – response to Aurizon Network’s submission ..................... 87 5.5.1 Introduction ................................................................................................................... 87 5.5.2 PwC method is subject to estimation error and asymmetry - a single credit rating estimation is superior .................................................................................................................... 87 5.5.3 Foreign bonds and bonds with special features (call / put options) should be included in the sample ..................................................................................................................................... 89 5.5.4 Reliable third party estimates of the fair value BBB+ credit rating yield are available 91 5.5.5 The debt risk premiums of coal railing businesses are affected by a material ‘coal premium’ ....................................................................................................................................... 92 5.6 Our estimate of the benchmark debt risk premium ............................................................... 99 5.6.1 The bond sample ........................................................................................................... 99 5.6.2 Application of the PwC (2013) method .....................................................................