As part of continuing work on other cost of capital related issues, the QCA has reviewed its cost of debt estimation methodology. In addition to establishing the appropriate data sources and method for measuring the benchmark cost of debt estimate at a point in time, we have also reviewed the theoretical framework for estimating the regulatory cost of debt.
Benchmark Cost of Debt
Determining the 'benchmark' cost of debt requires relevant data and an appropriate methodology.
In Australia, regulators used to rely on estimates from proprietary data providers. However, this approach has been problematic:
- Debt market data in Australia is limited.
- Data providers' estimates are not transparent and auditable, as the estimation methodology is not publicly available.
Following the Global Financial Crisis, there were further problems: proprietary data providers' estimates diverged, some anomalies were noted and some debt tenors were no longer published.
Therefore the QCA and other Australian regulators have investigated alternative methods for estimating the cost of debt.
Trailing Average Cost of Debt
The QCA's current framework for estimating the regulatory cost of debt is based on using an 'on the day' approach which uses the benchmark cost of debt that is estimated just prior to the start of the regulatory cycle.
Recently, however, several proposals have arisen in regulatory contexts that involve moving away from a strictly 'on the day' rate and replacing it with some form of 'trailing average' (where the latter can be applied to either the total cost of debt or to only the debt risk premium).
The term 'trailing average cost of debt' refers to a moving weighted average of the cost of debt with the weights representing a portion of the total debt of a firm that is assumed to be financed each year.