Back where we started from

Last Friday the Australian Energy Regulator (AER) released its final decision on the Rate of Return Instrument.

This decision sets out how the AER will calculate the rate of return for the next four years for gas and electricity network businesses it regulates. The rate of return is a significant component of household energy prices, accounting for around a quarter of the total retail price.

The AER estimates a rate of return that balances the need of these capital-intensive businesses to ensure they have sufficient funds to raise capital against the importance of keeping energy prices as low as possible. This latter consideration is particularly important when bulk gas and coal prices have pushed up energy prices and consumers face all-round cost of living pressures.

Perhaps the most notable outcome of the review is that a three year process with thousands of pages of analysis produced by the AER, stakeholders and consultants, has resulted in almost no difference in the final Instrument from the previous version, published in 2018. Aside from some very minor technical tweaks the only fundamental change to the key parameters is that the market risk premium (MRP) has been fixed at 6.2% instead of 6.1%. This will add around $2 a year to the average household bill.

This is not to say that consumers can expect no change to their bills. The Instrument is a formula rather than a fixed number, as some of the parameters change with interest rates. The return on debt is based on a ten-year trailing average of corporate bonds, which means that interest rate changes flow through slowly. By sheer coincidence the AER’s published estimate of the latest value for the return on debt is 4.7%, exactly the same as in 2018, which only adds to the sense of running to stand still. But the bigger shift comes from the risk free rate, part of the return on equity. This is based on current rates for ten year government bonds. Compared to 2018, these are higher and represent around a $30 bill increase. But they dipped even lower in between and may have further to go, so the ultimate impact for customers of some networks could be significantly higher.

The lack of change does not mean that the decision was easy and uncontested. Quite the reverse, with a wide range of perspectives expressed over the course of the review. I was a member of the Consumer Reference Group (CRG), an independent group appointed by the AER to represent consumer interests in the process (1). The CRG supported the AER on some elements of the rate of return and disagreed on the others. A summary of the CRG’s position is in the table below.

Rate of return parameterAER decisionCRG viewCommentary
Return on debt

Benchmark approach: Ten year trailing average of ten year bond rate (1/3 A-rated, 2/3 B-rated)AER has collected evidence that networks can obtain debt at lower rates than its benchmark. Consumers should share in this benefit.Networks will continue to keep all the benefits of beating the benchmark. This means consumers are missing out on their fair share of these benefit.
Risk free rateEqual to 10 year commonwealth bond rateThe AER’s draft proposed a 5 year bond rate as the benchmark. This would have been a big change from the long standing use of 10-year bond rate. AER needs to review consequences of change and consistency with rest of the instrument.The proposed move to a 5 year rate would have meant more volatile but – on average – slightly lower allowed rates of return.
Market Risk Premium (MRP)Fixed market risk premium of 6.2%The evidence is consistent with an MRP of no more than 6%.The AER has avoided the pitfall of using a volatile measure of MRP known as the dividend growth model (DGM). But the MRP could have been set lower still.
BetaBeta of 0.6The AER’s evidence supports a lower beta – 0.5 would be more appropriateMissed opportunity to lower prices based on available evidence.
Gearing60% debt, 40% equityThis long-standing gearing ratio remains reasonableAn uncontroversial decision
Source: Explanatory statement, CRG submission to draft instrument

The networks for their part fought very hard (and ultimately successfully) against the proposed move to a five year term for the risk free rate. They also argued for use of the dividend growth model in setting the market risk premium and for a higher value for beta. In some respects it may look like the consumers and the networks argued each other into a stalemate given the strong element of the status quo in the final decision.

Given that there is no evidence to date of the 2018 instrument holding back network investment, this new decision is likely to be at least enough to see continuing investment. Some concerns about transmission investment are better categorised as being about the lumpiness of new capital required to build major integrated system plan (ISP) projects rather than a problem with the level of returns allowed.

So will the next review (due to be concluded in 2026) be more of the same? It seems unlikely, given a major shift took place during this review that will require the AER to take a fresh approach to some of its analysis. The last two ASX-listed regulated network business – AusNet and Spark Infrastructure – were bought out by private investors. This means a lack of market data for key parameters such as gearing and beta. So us battle-weary regulatory economists who are involved in these reviews have some new issues to look forward to next time.

(1) This blog should be taken as the author’s own personal views and does not necessarily represent the views of the CRG.