Inflationary expectations

“One cannot escape how frighteningly Orwellian the regulatory approach has become in Australia in the year 2020”. This eye-catching quote is from consultants Fairbane’s submission to the Australian Energy Regulator (AER) in respect of its review of the regulatory treatment of inflation. The rhetorical flourishes of Fairbane’s paper are a welcome contrast to the often dry tones of regulatory debate.

It turns out that Fairbane are aghast at the very idea of price regulation of natural monopolies such as gas and electricity networks. This is, shall we say, a contrarian view. But even those who still think such regulation appropriate may find the latest review Kafkaesque if not Orwellian.

Inflation, specifically the ABS’s dataset of how prices change over time – the Consumer Price Index (CPI) – plays a key role in the way Australian gas and electricity networks (NSPs) are regulated. The overall framework is even called “CPI-X” where X is an efficiency factor. This means that each year the amount of revenue that the NSPs can collect from their customers (via retailers) increases by CPI-X. If X is high enough this means that NSP revenues decrease.

The use of this formula means that the AER must determine the rate of return for the NSPs in real terms. The rate of return is what the AER calls the cost of capital. Let’s say you buy an investment property for $1,000,000. You put down a deposit of $400,000 (that’s 40%) and borrow the other $600,000 from a bank (60%) at an interest rate of 3%. That means you are 60% geared (coincidentally, that’s what the AER assumes about the NSPs). Now let’s assume you raised your deposit by forming a company and selling shares in it. You promised your shareholders you would pay them a dividend each year equal to 5 cents for every dollar share they bought (5%). In this case your overall cost of capital is:

(0.6 x 3%) + (0.4 x 5%) = 3.8%

To put another way, you would need to make a return on your investment of 3.8% each year to be able to pay back the bank and your shareholders. You’d need to charge enough rent to cover any ongoing expenses plus $38,000.

Now let’s bring inflation into the mix. Financial theory says that the returns your bank and your investors want should vary with inflation. If inflation is high, they will want more, because the underlying value of the assets they hold (the loan and the shares respectively) is going down faster and vice versa. Let’s say inflation is 2%. That would mean that the bank needs a 1% “real” return (3-2) and your shareholders need a 3% real return (5-2).

Because the AER allows prices to increase by CPI each year, it is trying to work out what the real return the lenders and shareholders of the NSPs need. It can see the nominal amount that lenders require, and there are standard techniques for working out what shareholders require (noting that in the real world companies can change their dividend year on year, so there is no firm “promise” as in our worked example above). So, it just needs to deduct the amount that lenders and shareholders are expecting inflation to be. If a bank is lending to an NSP for ten years into the future, they will need to adjust for expected inflation for the next ten years.

This is where it gets tricky. There is no definitive indicator of expected inflation. There are ways that economists can number-crunch market data to get a “market estimate” but these have well known imperfections that make them less than reliable. The regulator used to use market estimates, but the NSPs asked them to stop in 2007 due to this unreliability.

Instead the regulator turned to the Reserve Bank of Australia (RBA). The RBA has one key job – to try to keep annual inflation between 2% and 3%. As part of this job it tries to forecast inflation for the next couple of years to help it hit its target. So, the AER decided that inflation expectations should be based on the RBA forecast for two years and then the midpoint of its target (2.5%) thereafter.

This worked well for a while. The RBA is pretty good at its job. But central banks like RBA find it easier to force inflation down when it’s above target than to drag it up when it’s below target. And it’s been below target for a while as the chart below shows:

Source: ABS, RBA

Now, what inflation turns out to be is not the same as what the market expected it to be. So, the AERs method isn’t necessarily wrong. But NSPs are getting concerned, because if the AER’s forecast is too high, as they now claim, then it is taking too much off the nominal rate of return to get to its real rate of return. This would mean that they are not being allowed to raise enough revenue to pay back their lenders and shareholders.

There’s plenty of money at stake here. If the AER changed its approach (i.e. if market estimates were closer to actual expectations than their AER’s current approach) NSPs’ revenue could increase by around 18% (the actual amount depends on a number of other factors – it’s complicated!).  This also means that consumers would pay 18% more on the network portion of their bills. For an average household, this could be $95 per year or double if they have both gas and electricity.

Understandably, consumers and their representatives are more inclined to stick with the current approach. But whichever method it chooses,  the AER is still in the unenviable position of trying to forecast a number that can never be directly observed (so it can’t even check after the event how good the forecast was) with billions of dollars at stake either way. So, some responses to the AER’s consultation suggested a different approach altogether that gets them out of this problem. But a more fundamental change would require very careful thinking through to understand the implications for NSPs and consumers.

Disclosure: the author is a member of the Consumer Reference Group (CRG) that the AER has set up to advise it on consumer perspectives for the Inflation review and the Rate of Return review. Any views expressed in this article are personal views only and do not represent the views of the CRG.