AER releases Rate of Return Information Paper and calls for submissions
Fast Facts.
The 2022 RORI process has been underway since November 2019, with the final 2022 RORI to be published in December 2022.
The process set out in the final 2022 RORI will be used by the AER to determine the allowed rate of return (ROR) on capital for regulated energy networks.
In the period June 2020 to November 2021, the AER released a number of working papers and received submissions on ROR inputs and justifications. This culminated in an overall ROR omnibus paper which provided indications of the AER’s preferred, preliminary and open positions on each aspect of the ROR.
The RORI Information Paper identifies six priority topics, which the AER is seeking stakeholder feedback on and directing both future Evidence Sessions towards. The six priority topics are: (a) the term of the rate of return; (b) market risk premium (MRP); (c) equity beta; (d) use of the industry Index; (e) the weighted trailing average return on debt; and (f) cross checks of the rate of return.
Written submissions on the Information Paper, and the final Omnibus Paper also released in December, are due on 11 March 2022.
Background
The Information Paper is the culmination of extensive work by the AER, including the release of a series of working papers exploring various topics relating to the rate of return and consultation with stakeholders. To date, these have included:
Energy network debt data (final working paper published 18 November 2020);
International regulatory approaches to the rate of return (final working paper published 16 December 2020);
Capital asset pricing model and alternative return on equity models (final working paper published 16 December 2020);
Term of the rate of return (final working paper published 22 September 2021);
Rate of return and cashflows in a low interest rate environment (final working paper published 22 September 2021); and
Rate of Return Omnibus Papers:
Rate of Return – Draft Debt Omnibus Paper (Draft working paper published 15 July 2021);
Rate of Return – Draft Equity Omnibus Paper (Draft working paper published 15 July 2021); and
Rate of Return – Overall rate of return Draft working paper (Draft working paper published 15 July 2021);
Overall Rate of Return, Equity and Debt Omnibus final working paper (published in December 2021).
Key Issues - the Six Areas of Priority
Term of the Rate of Return
There are typically two choices for the term of the rate of return. The first is to match it to the length of the regulatory period (typically five years). The second is to match it to the underlying asset lives (typically ten years is used to better reflect long asset lives).
In relation to the term for the cost of equity, the AER has noted “We are open on whether to match the term of equity to the length of the regulatory period or the underlying asset lives. However, we have noted that there are merits with matching the equity term to the length of the regulatory period rather than ten years”.
In relation to the cost of debt, the AER appears drawn to the weighted average term to maturity at issuance (WATMI) for informing the term of debt, with a range emerging around a conservative upper bound of WATMI (based on bank drawdown scenarios) above 10 years, and a lower band of around 8 years.
Market Risk Premium
In setting this variable, the AER intends to explore three potential options:
Maintaining its current approach and using a historical excess returns method (using both arithmetic and geometric averages). This would give less weight to other evidence such as Dividend Growth Models (DGMs), surveys and conditioning variables to inform the point estimate;
Using estimates from the DGM to inform the point estimates of the MRP, similar to its approach in the 2013 Rate of return guideline. This would involve the AER picking a point estimate from the historical excess returns range and using information from DGMs in a directional sense;
Providing more weight to the DGM alongside its current approach (a mechanical approach). This would require the AER to determine how the historical excess returns estimate(s) and DGM(s) are weighted as well as the specifications of the DGM(s) inputs.
The AER has essentially ruled out (a) estimating and employing a relationship between the MRP and the risk-free rate; (b) giving weight to the historical Commonwealth Government Securities (CGS) yield when estimating the risk-free rate; and (c) setting a floor to the risk-free rate to ensure the real risk-free rate does not become negative.
Equity Beta
The AER’s current approach uses a comparator set of nine Australian energy firms for estimating the equity beta for the benchmark business that provides the Australian regulated energy network services. Six firms have been delisted since the comparator set was initially established and currently there are three live comparator firms remaining (i.e., Spark Infrastructure, AusNet, APA).
The AER has proposed to retain this approach in the Information Paper, specifically:
To place most weight on the longest period estimates;
To retain the existing comparator set;
To continue to set a single rate of return for gas and electricity network businesses; and
To not adjusting equity beta or the rate of return for a ‘low beta bias.
Use of the Industry Debt Index
The AER has constructed an Energy Infrastructure Credit Spread Index (EICSI) from actual debt information collected from privately owned (i.e., non-government owned) network service providers that it regulates. It does this to estimate the cost of network-issued debt as a test against its estimate of the overall cost of debt. The Information Paper states that on average, the EICSI has been 18 basis points lower than the AER’s benchmark since 2014.
The AER notes in the Information Paper that, “Conceptually, we think we ought to use the EICSI to adjust our return on debt approach to remove any residual outperformance that is material and persistent. In this context ‘residual outperformance’ refers to the ability of the regulated networks to raise debt at a lower rate (for a given term and credit rating) than the broader market that is represented in the third party debt yield curves we use in determining our return on debt benchmark. We consider that adjusting for the residual outperformance, if it is considered material and persistent will result in an approach that better aligns the benchmark allowance with the actual debt costs of the networks”.
Weighted Trailing Average Return on Debt
The AER’s current approach to estimating the return on debt is a trailing average portfolio approach, where it sets the return on debt allowance as an average of (up to) ten annual return on debt estimates, which it then updates annually.
The AER has noted that the Australian Energy Market Operator’s Integrated System Plan (ISP) foreshadows a number of new large transmission projects over the next ten to fifteen years which would involve large debt raising requirements. It is concerned that this could lead to a mismatch between the allowed return on debt and the capital requirements (and cost) of regulated entities, and disincentivise investment in large capital-intensive projects.
The AER remains undecided on how best to deal with this, and is considering three options:
To maintain the current (simple trailing average) approach;
To apply a weighted trailing average that applies to all distribution and transmission network service providers, with weights based on the debt issuance assumptions in the Post Tax Revenue Model (PTRM);
To design a mechanism where the weighted trailing average only starts to apply when a large increase in the regulated asset base (RAB) (and therefore debt issuances) is forecast. Doing this would require the AER to set a threshold for the shift to a weighted trailing average, again using the debt issuance assumptions in the PTRM.
Cross Checks on the Rate of Return
The AER is considering how to apply various cross checks to compare its estimates of the rate of return against other relevant information sources in the market. The Information Paper sets out its preliminary position which is to:
Review RAB multiples, scenario and financeability testing as a sense check on the overall rate of return. The AER has noted that RAB multiples may act as a trigger for investigation and indicate if the total compensation (inclusive of the rate of return) provided to investors is sufficient;
Pay less attention to historical profitability, investment trends, other regulators’ rate of return and other practitioners’ discount rates as it considers these have greater limitations and are of less value than RAB multiples, scenario testing and financeability; and
The AER has also noted that based on current cross checks, they do not believe there are major concerns with its current approach to the rate of return (the 2018 Instrument) in the context of the total compensation provided to investors.
Next steps
The AER has invited written submissions on the Information Paper, and final Omnibus paper, which are due on 11 March 2022. The indicative timeline in the lead up to the final RORI in December 2022 is set out below.
Table 1: Indicative timeline
Our Insights
There is a broader question at play with this Information Paper, which relates to whether the AER’s current rate of return parameters are sufficient for the scale of investment that is necessary to enable the energy transition. Project risks, costs and uncertainty were key themes in TransGrid and ElectraNet’s financability of ISP projects rule changes and are issues for consideration as part of the AEMC’s current transmission review. The AER has an unenviable task – there is clearly a fine line to be drawn between providing network companies with a return that are excessive, and adequately incentivising investment. That said, network companies could be forgiven for feeling that the Information Paper appears geared more to reducing the rate of return over time rather than increasing it to meet the wall of investment required to manage the transition effectively.
This Information Paper has not been developed in a vacuum. Firstly, the 2020 ISP Step Change scenario has signalled the most significant transformation in the history of the NEM within the next 20 years, as coal-fired generation exits the system and large-scale renewable energy and distributed energy resources (DER) emerge as dominant generation sources. Enabling this transformation will require around $20Bn of new transmission investment, and significant amounts of distribution investment to enable the hosting capacity required for bi-directional DER markets. Based on current network ownership and recent acquisition activity, the majority of the equity capital to be deployed into the network sector will be sourced from overseas, with the providers of that investment operating globally and across multiple asset classes. The 2022 RORI is a pivotal document for network companies seeking to access and deploy that capital.
In addition, while there are a number of questions of detail that the AER has sought submissions on, there are two broader themes of note.
International Precedent
The first is that the AER is showing in the Information Paper a reluctance to move from established practice – page 24 of the Paper reaffirms the AER’s preliminary view of continuing to use the existing comparator set while it is becoming obvious that a shift from existing practice is necessary. This is relevant because the areas that are most sensitive to overall return (MRP and equity beta), are also the areas where the AER is increasingly out of line with its international peers.
In relation to market risk premium, the AER's primary reliance on fixed historical excess return of a broad portfolio of listed stocks above the risk-free rate is out of line with other domestic and international regulators. Other regulators place greater weight on forward looking indicators such as the Dividend Growth Model (DGM) and constant total market return estimates such as the “Wright approach” which involves subtracting the prevailing risk-free rate. The AER is aware of this and has accepted this point openly in its Omnibus Paper.
This is even more stark in relation to equity beta, where six of the nine firms in the AER’s sample of domestic comparators are no longer publicly listed regulated energy networks businesses. With AusNet’s board accepting a takeover bid from Brookfield, and the takeover of Spark Infrastructure by KKR and Partners, the AER’s sample of actual listed comparators will reduce to one (APA). The AER’s continued reliance on a comparator group that isn’t representative of equity capital fails to acknowledge the changing nature of the market and the new undiversifiable risks that network companies are facing. Indeed, the AER’s belief that “systematic risk for Australian regulated energy network businesses is relatively stable and change slowly over time”[1] is at the core of this position. It is worth noting that the AER’s current beta estimate for regulated energy networks businesses is one of the lowest made by comparable regulators.
Independent Panel
The second relates to the role of the Independent Panel. Under section 18P of the National Electricity Law, the AER must, as soon as practicable after publishing the draft RORI instrument, establish an independent panel to give the AER a written report about the instrument. This panel must consist of at least three members with requisite qualifications and experiences in a field the AER considers relevant to making a RORI, and must carry out its activities including giving the report in the way it considers appropriate[2]. Section 18P also states that the panel must give the report by consensus. The report must include the panel’s assessment of the evidence and reasons supporting the rate of return on capital or the value of imputation credits under the instrument.
It is difficult to see how this panel will be in a position to be able to challenge the AER’s work to any significant degree. The five-person panel has not yet been appointed, but must not include any person that has “been an active participants in (the) process or providing advice to participants in (the) process since it commenced in June 2020”.[3] There would be few people that have been so completely removed from this five yearly process yet be able to make a meaningful contribution to challenging the AER’s thinking, should this be required.
On balance, our view is that submissions from investors should focus not only on the substance of the questions that the AER has asked in the Information Paper but also the exam question at hand – “whether the AER’s current rate of return parameters are sufficient for the scale of investment that is necessary to enable the energy transition”. This is not an easy question to answer, because it requires an understanding that sources of capital are not equal. For the majority of the AER’s history, the allowed rate of return has not actually influenced the extent of investment in networks – most of the companies that were impacted by it were Government owned and would invest regardless of impact on shareholder returns. These times have now changed, and the Instrument now sends a signal as to the type and cost of capital that can invest profitably in Australia.
The Information Paper and final Omnibus paper are available at Rate of Return Instrument 2022 | Australian Energy Regulator (aer.gov.au)
For more information, contact Simone Rennie at srennie@renniepartners.com.au
[1] Australian Energy Regulator, Equity Omnibus Draft working paper, pages 41-42, July 2021
[2] AER, Pathway to the 2022 rate of return instrument – Position paper on 2022 Instrument Process, August 2021, p2,
[3] AER, Pathway to the 2022 rate of return instrument – Position paper on 2022 Instrument Process, August 2021, p13
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