Feedback sought on Rate of Return methodology for Network Businesses

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On 28 February 2018, the Australian Energy Regulator (AER) released three discussion papers as part of their review of the Rate of Return Guideline (an AER Guideline that must be updated every five years).
These three discussion papers will guide a concurrent evidence session that the AER will hold on 15 March. The papers relate to:

• Gearing;
• Financial performance measures;
• Risk and judgement.

rate of return

Photo by NASA on Unsplash

By Dr Drew Donnelly, Compliance Quarter. 

While the evidence session is a closed session between invited experts and the AER Board, the AER invites written submissions on the discussion papers and transcript that is to come out of the evidence session by 20 April 2018.

In today’s update, we introduce these three discussion papers. Note, this is a particularly complex area of regulation and if you think changes to the rate of return will affect your business you should read the discussion papers here (https://www.aer.gov.au/networks-pipelines/guidelines-schemes-models-reviews/review-of-rate-of-return-guideline).

Background

AER regulates the revenue that network businesses (distribution network service providers and transmission network service providers) are allowed to make in the National Electricity Market.

The allowed Rate of Return is one of the methods used by AER in making revenue determinations. It is designed to ensure that a network business can make a sufficient return on investment to fuel that investment. The Rate of Return is estimated by combining the returns on equity and debt.

The appropriate Rate of Return, AER suggests, must balance the need for network business to attract funding in order to invest in reliable networks, while not overcharging end-customers.

The three papers released by AER are intended to guide discussion on how the Rate of Return should continue to be calculated by AER. Each paper is discussed in turn.

1. Financial Performance Measures

In the first paper, AER asks whether the financial performance indicators of ‘RAB multiples’, ‘financeability’ and ‘historical profitability measures’ should continue to be used when making the new Rate of Return Guideline. These indicators are defined as follows:

• A RAB multiple is the market value of the firm (determined either through the purchase price when a transaction of the business occurs, or the existing share price) divided by its regulatory asset base (RAB). RAB multiples can provide information as to whether a regulated firm is under or over-valued;
• Financeability is a network business’s ability to meet financing requirements and raise new capital;
• Historical Profitability measures include standard accounting measures derived from financial statements such as the net profit margin and the return on assets.
AER invites comment as to whether these continue to be appropriate.

2. Gearing

Gearing is the ratio of the value of debt to total capital. Currently, the benchmark gearing ratio is set at 60:40. In arriving at the ratio, AER takes into account the following principles:

• The estimation of a gearing ratio should be consistent with the estimation of other Rate of Return parameters;
• Gearing estimates are based on both market and book values;
• The book value of gearing is likely a good proxy for the market value of gearing;
• It is inappropriate to use net debt in the calculation;
• The book value of loan notes should be removed from the book value of total debt;
• It is not clear whether or not adjusting for double leveraging is more representative of the level of gearing and, in the absence of further evidence, both will be considered;
• Gearing data of an annual frequency is likely to be sufficient.

AER seeks comment on the method used for arriving at the benchmark gearing ratio.

3. Risk and Judgement

AER seeks input into the criteria used for the exercise of its regulatory judgement with respect to Rate of Return matters. In accordance with the current Guideline, it adopts an approach that:

• Is reflective of generally accepted economic and finance principles and market information;
• Is fit for purpose;
• Is implemented in accordance with good practice;
• In using models, uses models in accordance with sound quantitative modelling;
• In using market data and other information, uses information that is credible, verifiable, comparable and timely;
• Is flexible and responsive to changing market conditions.

Read the discussion papers in full at https://www.aer.gov.au/networks-pipelines/guidelines-schemes-models-reviews/review-of-rate-of-return-guideline, and make a submission by 20 April 2018 if you wish to have your say.
Submissions can be made to RateOfReturn@aer.gov.au

If you’d like to chat to the experts at Compliance Quarter, message us here or book a call here.

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