The regulatory cost of equity is a component of the weighted average cost of capital. A number of inputs must be estimated or specified to determine the allowed cost of equity. These include firm-specific parameters (e.g. the asset beta), as well as parameters that are effectively market-based.
The return on equity is estimated using the Capital Asset Pricing Model (CAPM), which adds an equity risk premium to a risk-free rate, where the equity premium comprises the market risk premium scaled by the firm’s equity beta.
The allowed return on equity also needs to be adjusted to reflect the tax benefits from owning shares that pay dividends with attached imputation credits.
The QCA has reviewed its estimation methodology for all three of the market parameters: the risk-free rate, the market risk premium and gamma.
In February 2016, the Australian Competition Tribunal decided to set aside a decision made by the Australian Energy Regulatory (AER). The AER must remake its decision, using a value of tax imputation credits (gamma) of 0.25.
The QCA engaged Dr Martin Lally to provide his views on this decision and invited stakeholders to comment on gamma and Dr Lally’s views. The views provided by Dr Lally and stakeholders will be considered by the QCA in future decisions.
On 29 August 2014, the QCA published a final decision paper on its preferred approach to estimating the market parameters for the regulatory cost of equity.
This paper considers stakeholder submissions and provides the QCA’s views on the approach it intends to use to estimate the market parameters going forward.
The QCA also engaged Dr Martin Lally to provide additional advice on a number of issues related to submissions received on the risk-free rate, market risk premium and gamma. This advice is outlined in a paper that has also been published by the QCA.
Risk-free rate and the market risk premium
On 27 November 2012, the QCA released the discussion paper, The Risk-free Rate and the Market Risk Premium, for public comment.
The paper addressed issues relating to estimating both the risk-free rate and the market risk premium in the context of applying the CAPM to determine the cost of equity for regulated firms.
It also summarised current Australian regulatory practice in these areas, including the QCA’s approaches to estimation.
The QCA received 21 submissions from interested parties.
The QCA engaged Dr Martin Lally to:
- respond to the stakeholder submissions
- comment on related material in Aurizon Network’s 2013 Draft Access Undertaking submission on the cost of capital with respect to the risk-free rate, market risk premium and the implied cost of equity
- review related submissions on the Price Monitoring of SEQ Water and Wastewater Distribution and Retail Activities 2013–15.
The QCA received 4 submissions in response to Dr Lally’s paper.
In October 2010, the Australian Competition Tribunal determined that the Australian Energy Regulator (AER) had erred in estimating the utilisation rate for imputation credits in its May 2010 final decisions on electricity distribution for 2010-2015 for Queensland (Energex and Ergon Energy) and South Australia (ETSA Utilities).
The Tribunal instructed the AER to engage SFG Consulting to undertake a dividend drop-off analysis to estimate that parameter. The outcome of this was a report from SFG Consulting (2011). The Tribunal has invited comment and further work on gamma.
Given the importance of gamma to the cost of capital of firms regulated by the QCA, Dr Martin Lally was engaged to review the report by SFG Consulting. This report was published in October 2013.
Subsequently, in November 2013, we released a second paper on gamma by Dr Martin Lally that addressed a number of further issues relevant to estimating gamma.
The QCA received two submissions in response to Dr Lally’s papers.
The risk-free rate, the market risk premium and gamma are market parameters. That is, they are estimated for the market as a whole and effectively do not vary across individual businesses.
The QCA has reviewed its estimation methodology for all three of the market parameters.
Risk-free rate and the market risk premium
The QCA's starting point in determining an appropriate return on equity is the Capital Asset Pricing Model (CAPM). The CAPM is the model most widely used by regulators and the corporate sector for estimating the equity return that investors require for investing in the business.
These are two key market-based parameters in the CAPM:
- The risk-free rate is the base rate to which a premium for investing in a risky asset is added.
- The market risk premium is a premium that compensates an investor for the risk of investing in a diverse portfolio of risky investments relative to the risk-free rate of return.
The Australian tax system allows companies to provide their shareholders with credits to reflect company taxes paid on profits that are distributed as dividends. Shareholders can use these imputation, or 'franking', credits to reduce their personal tax liabilities.
Imputation credits will reduce the cost of equity of investors in a regulated firm (and hence the regulatory firm's cost of capital) because investors who own shares can reduce their tax liability.
The parameter, ‘gamma’, represents the benefit of these credits to the firm’s investors and is the product of:
- the utilisation rate (the extent to which investors can utilise the imputation credits)
- the distribution rate (the extent to which imputation credits are distributed).
By definition gamma must be between zero and 1.
There is significant debate on how best to both define and measure gamma.
Report and papers
|25 July 2016||Consultant report||Review of the ACT-s gamma decision – Dr Martin Lally||pdf, 687.97 Kb|
|26 August 2016||Submission||Aurizon Network – response to Dr Lally review||pdf, 305.42 Kb|
|26 August 2016||Submission||DBCT Management – response to Dr Lally review||pdf, 1.24 Mb|
|26 August 2016||Submission||DBCT User Group – response to Dr Lally review||pdf, 81.31 Kb|
|29 August 2016||Submission||QRC – response to Dr Lally review||pdf, 141.65 Kb|
|29 August 2014||Final report||QCA – Final Decision – Cost of Capital Market Parameters||pdf, 1.04 Mb|
|15 November 2013||Consultant report||Lally M – Estimating Gamma||pdf, 506.45 Kb|
|29 August 2014||Consultant report||Lally M – Review of Submissions to the QCA on the MRP- Risk-Free Rate and Gamma||pdf, 206.97 Kb|
|15 October 2013||Consultant report||Lally M – Estimated Utilisation Rate for Imputation Credits||pdf, 296.85 Kb|
|16 October 2013||Consultant report||Lally M – Response to Submissions on the Risk-free Rate and the MRP||pdf, 449.92 Kb|
|15 August 2012||Consultant report||Lally M – Risk-free Rate and the Market Risk Premium Report||pdf, 211.82 Kb|
|15 July 2013||Submission||Anglo American||pdf, 154.74 Kb|
|14 January 2014||Submission||AngloAmerican||pdf, 90.33 Kb|
|20 January 2014||Submission||AngloAmerican||pdf, 90.33 Kb|
|15 April 2013||Submission||Asciano||pdf, 355.22 Kb|
|15 April 2013||Submission||Aurizon – SFG Report 1||pdf, 702.43 Kb|
|15 April 2013||Submission||Aurizon – SFG Report 2||pdf, 396.67 Kb|
|15 April 2013||Submission||Aurizon – Cover Letter||pdf, 130.03 Kb|
|15 April 2013||Submission||Australian Rail Track Corporation||pdf, 173.95 Kb|
|24 October 2013||Submission||DBCT Management – Cover Letter – Apr 13||pdf, 764.21 Kb|
|24 October 2013||Submission||DBCT Management – Submission – Apr 13||pdf, 171.35 Kb|
|24 October 2013||Submission||Dr Robert Bowman – Submission – Apr 13||pdf, 64.87 Kb|
|24 October 2013||Submission||Dr Robert Bowman – Cover Letter – Apr 13||pdf, 39.23 Kb|
|24 October 2013||Submission||Origin Energy – Apr 13||pdf, 194.70 Kb|
|14 January 2014||Submission||SFG Consulting||pdf, 614.58 Kb|
|20 January 2014||Submission||SFG Consulting||pdf, 614.58 Kb|
|15 October 2013||Submission||SFG Consulting – Dividend Drop-off Estimate of Theta||pdf, 3.30 Mb|
|24 October 2013||Submission||Queensland Resources Council – Apr 13||pdf, 65.75 Kb|
|24 October 2013||Submission||Queensland Treasury and Trade – Apr 13||pdf, 734.45 Kb|
|24 October 2013||Submission||Queensland Treasury Corporation – Cover Letter Apr 13||pdf, 106.41 Kb|
|24 October 2013||Submission||Queensland Treasury Corporation – Submission Apr 13||pdf, 480.18 Kb|
|14 January 2014||Submission||Queensland Treasury Corporation||pdf, 805.08 Kb|
|24 October 2013||Submission||Queensland Urban Utilities – Apr 13||pdf, 3.03 Mb|
|24 October 2013||Submission||Rio Tinto – Apr 13||pdf, 61.37 Kb|
|24 October 2013||Submission||United Energy Multinet – Esquant Apr 13||pdf, 292.89 Kb|
|24 October 2013||Submission||United Energy Multinet – NERA – Apr 13||pdf, 1.09 Mb|
|24 October 2013||Submission||Unity Water – Apr 13||pdf, 3.11 Mb|
|14 January 2014||Submission||Unitywater||pdf, 1.79 Mb|
|24 October 2013||Submission||Vale – Apr 13||pdf, 691.10 Kb|