A ustralian power and gas network assets are ever more detailed controversies over imperfections in finance markets and valued at over $75bn and average network statistical methodologies, almost all flexibility asset lives are 50 to 100 years. A fair return on in the regulatory system had been removed. current and future capital is therefore the key The merger of the seven main state and federal driver of business profitability and efficient regulators into a single national body also investment incentives. The Australian Energy removed the subtle differences of approach Regulator (AER) has recently reconsidered its when applying the rules. whole basis and approach to how capital Ironically, while the approach to applying allowances, for both equity and debt, are set the SL-CAPM had almost completely ossified, by issuing Rate of Return Guidelines as part of the actual allowed returns for network its Better Regulation Programme. businesses had become highly unstable To assess the significance of this rethink, it because capital markets are volatile and is important to explain how the prevailing regulatory discretion was no longer able to act regulatory structure had developed prior to the as an informal shock absorber. From the current decision. industry’s perspective, the system had also In the mid-1990s, Australia adopted a proved itself to deliver significant Thatcherite framework for the regulation of downwardly biased allowances. the power and gas industries. A key element Meanwhile, there had also been important of that framework is that businesses operating developments in finance theory. When the natural monopoly gas and electricity networks regulatory framework was initially adopted, are subject to ‘incentive based’ or RPI-X the conventional mantra recited by businesses regulation. Since network investments are and regulators alike was that ‘the SL-CAPM is capital intensive, long-lived assets that can last deeply flawed… but it is the only theory we for 50 to 100 years, the single most important have.’ However, in 2011 when the AER element of this regulation is to set a ‘fair’ formally triggered a rule change process to allowance for equity and debt capital. seek significant additional discretion in how it Originally, the market rules encouraged could apply the SL-CAPM, the network state and federal regulators to use base equity industry openly called for an intellectual allowance decisions on the Sharpe-Lintner revolution: that the adherence the SL-CAPM Capital Asset Pricing Model (SL-CAPM), itself should be re-thought. which was the state-of-the-art finance theory The Australian Energy Markets at the time, but allowed the regulators Commission (AEMC), who is responsible for extensive discretion over how to implement drafting the National Electricity Rules and the the model and where to obtain securities National Gas Rules, granted each party what it market input data. After 20 years of rule was wishing for: the AER was granted its wish changes aimed at improving predictability and to be given full discretion over how to set hard fought court and tribunal appeals into 1
AUSTRALIAN ENERGY REGULATOR RETHINKS HOW TO SET THE ALLOWED RETURNS FOR THE NETWORK SECTOR regulatory allowances for equity and debt the Dividend Growth model accorded only capital subject only to ‘broad brush’ principles; secondary weight, despite the latter’s industry was granted its wish that all widespread use by regulators in America. references to the SL-CAPM were removed The draft decision reserved particular from the National Electricity Rules and the derision for the Fama–French model, which National Gas Rules and that the AER launch a was accorded no weight at all, in part because process by which it would consider any and all it was said to lack a purely theoretical theoretical models that interested participants pedigree in that it was developed from might propose, and data from multiple sources. detailed empirical studies and with theories The immediate lesson for all parties was emerging only after the model was developed. ‘be careful what you wish for’… Shortly after the AER’s draft decision Not only did the AEMC’s decision according his work no weight at all, the effectively invite the AER to reconsider 20 University of Chicago’s Eugene Fama was years of rule reforms, tribunal appeal and awarded The Sveriges Riksbank Prize in court cases concerning the SL-CAPM, but it Economic Sciences (aka the Nobel Prize for also required the AER to compare in Economics). On that occasion the Swedish equivalent minutiae all the alternative models. Royal Academy of Sciences stated: The decision also suggested that the optimal ‘Eugene Farma, Lars Peter Hansen and approach may not be to select a single model Robert Shiller have developed empirical or data source but instead to adopt a blended methods and used these methods to reach solution. important and lasting insights about the Throughout 2013, tens of thousands of determination of asset prices. Their pages of expert reports, analytical submissions methods have shaped subsequent research and advocacy material were put to the AER in the field and their findings have been from a wide range of participants. The AER highly influential both academically and itself also procured a large number of expert ractically.’ reports and in many cases mandatory Even so, the AER’s final decision aintained consultative timeframes were over-shot by all the approach of adopting an extra-legislative parties in the process. set of decision making criteria and the same Industry proposals centred round the hierarchy of methodologies: a ‘foundation’ combined use of an updated suite of finance SL-CAPM model, secondary Black CAPM theories including the Black CAPM, the and Dividend Growth models and zero weight Fama–French three-factor model and the accorded to the Fama-French model. In Dividend Growth model, which has a moreor- another move of conservatism, the AER less equivalent incumbency amongst US considerably restricted the potential role of the energy network regulators. Dividend Growth model to the Australian However, as regulators often do, the AER context: reacted with a high degree of conservatism. It ‘We also note some US economic wrote its own set of extra-legislative regulators use the DGM extensively in decisionmaking criteria in determining which estimating the return on equity. However, models were appropriate to use and how much the DGM is not yet well accepted for use in weight they should be accorded such as the Australian context.’ whether the models were ‘well accepted’ and Meanwhile, in the US, the Federal Energy whether other Australian regulators were Regulatory Commission (FERC) is also being using the proposed models. On this basis the asked to revisit the material they use to set the AER’s draft decision reinstated the primacy of return on equity. FERC has traditionally relied the SL-CAPM model as a ‘foundation model’ on a version of the DGM known as the and alternatives such as the Black CAPM and Discounted Cash Flow (DCF) as the principal 2
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