Rate of Return Guideline: Is the Draft Determination fair?

The Australian Energy Regulator’s Rate of Return Guideline sets out the approach by which the regulator will estimate how much revenue networks can recover from customers. It comprises the return on debt and the return on equity, as well as the value of imputation credits. 

The estimation of the rate of return is complex, but it is important to get it right given it is a significant driver of regulated network revenue, and therefore of the now highly politically-charged area of consumer energy prices. The rate of return is a forecast of the cost of funds a network business requires to attract investment in its network and makes up approximately 50 per cent of its allowed revenue[i].

The current review of the Rate of Return Guideline began in July 2017 and a final decision is expected by the end of this year.

On 14 July 2017, the Council of Australian Governments (COAG) Energy Council agreed to implement a binding guideline for the rate of return components of the Australian Energy Regulator’s (AER) regulatory determinations for electricity and gas. The move to a binding Rate of Return Guideline is to improve the transparency and certainty of the regulators’ decisions, reduce the regulatory burden for all stakeholders, and provide a more robust process for the development of the rate of return. Proposed changes to legislation to implement the COAG Energy Council agreement require that the AER’s 2018 Rate of Return Guideline will be binding for four years from its finalisation, so the new guideline will be automatically applied to the AER’s regulatory decisions during that time.

Draft Strikes Reasonable Balance

A Draft AER Rate of Return determination was published in July and this strikes an overall reasonable balance between the competing demands in the process.  The National Electricity and National Gas objectives (the NEO and NGO respectively) require the process to deliver a decision that is in the long-term interest of customers.

Given that the lower the allowed rate of return the less customers pay, this would seem to be served by setting the rate of return as low as possible.  However, networks are capital-intensive businesses and the long-term interest of customers is not served by setting an inadequate rate of return that does not allow a network service provider to fund the necessary expenditure to maintain and operate the network safely and securely.

Nor will the NEO and NGO be well served by volatile decision-making that reduces investor confidence in the sector. With that point in mind, the AER has signalled that it sees this rate of return process as evolutionary rather than revolutionary.  This may have been interpreted by some stakeholders that certain parameters would be kept constant unless there was overwhelming evidence to adjust them.  But rather, it seems that the AER has used largely familiar analytical tools, techniques and sources of evidence to arrive at an overall best estimate of each of the parameters of the rate of return.  Arguably some of these estimates are conservative (that is to say, they tend to increase the rate of return) and others less so.

Ultimately, it is the overall decision that matters and on the evidence available, the Draft Determination appears reasonable in the context of the very low risk profile of regulated networks. The reaction of the capital markets, while not providing evidence that can be mechanistically fed into parameter estimation, does not suggest that the Draft Determination is materially too low.

On balance, the process itself has been extensive and multi-faceted and represents a full and fair consultation process to date. 

As part of the AER Rate of Return review process of the determination itself, in June the AER established an Independent (and expert) Panel[ii] to review and report upon the draft Rate of Return Guideline.  The Independent Panel’s report was published on 11 September 2018.

The Independent Panel describe their role in the process as advising the AER whether, in their view, “the Draft Guidelines are supported by sound reasoning, based on the available information and capable of promoting achievement of the national gas and electricity objectives”[iii].  They are not offering an opinion on whether the AER has arrived at the best estimate of the applicable rate of return or not.

For the most part, according to the Panel, the AER’s Explanatory Statement (which justifies the Draft Guidelines) has “set out in significant detail the evidence, analysis and conclusions that the AER has reached in determining each of the rate of return parameters, and the value of imputation credits, to form an overall estimate of the rate of return”[iv].  They also set out 30 recommendations for the AER to provide more clarity of its reasoning to support the decisions it has made.

These range from being more explicit about the relevance (or not) of various theoretical models or stakeholder concerns such as RAB multiples[v], to explaining the rationale for the confidentiality of the averaging period chosen by each service provider for determining the risk-free rate (which has implications for the replicability of the decision by other stakeholders), to being more consistent about the number of decimal points to which the component decisions are rounded.

Notably, some of the areas it has highlighted are ones where the judgment appears to have led to a lower parameter estimate than otherwise, while others are ones where it appears to have led to a higher parameter estimate.  In other words, there is no suggestion of systematic bias in favour of or against the networks in the way the AER has applied its judgment.

Whether the AER really needs to provide further justification of its judgment-making is essentially a philosophical question.  The nature of the rate of return decision, which is to make a forward looking estimate of the rate of return required by a hypothetical network business known as the Benchmark Efficient Entity, using evidence that almost by definition is historical in nature, means that there is not an actual true number that the AER has to find and then explain to everyone.  

The AER must ultimately make a series of judgments regarding parameter values (or formulas in the case of the risk-free rate and the cost of debt) that they consider will result in allowed revenue values that satisfy the Objectives.  As the decision-maker the AER must use its own judgement; no individual stakeholder or expert point of view should or can be considered determinative. While it is important to transparently disclose the evidence and factors that have been considered in arriving at that judgment, there is only so far the AER can go in justifying its decision to choose one parameter value over another within a plausible range.  As it is, the Explanatory Statement for the draft Guideline runs to 462 pages.  There is a risk that too much justification makes such documents impenetrable for most stakeholders.

Regardless of how well the process has been carried out and how clearly the decision has been explained those that do not agree with a regulatory decision will find some basis for criticism.  Most pertinently, the networks, for whom this decision is critical to their future profitability, have the option of seeking judicial review if they believe due process has not been carried out, and they have raised a number of issues with the process and whether decisions have been adequately justified in the Draft Determination.  In this light, the Panel’s report should be seen as a constructive input to the process, applying some fresh eyes to the Draft Determination and so giving the AER insight into ways to further buttress its decision.  If the final decision requires another 50-100 pages of extra explanation to make the decision even more robust, then we are sure the AER will consider it well worth the effort. 

[i] https://www.aer.gov.au/communication/aer-establishes-an-independent-panel-to-review-the-rate-of-return-guideline

[ii] The Independent panel members were Natalia Southern – Chair of the Panel, Scott Hempling, Stewart Myers, Geoff Frankish and Pat Duignan.

[iii] Independent Panel Review of the AER’s Rate of Return Draft guidelines, September 2018, p.II

[iv] Ibid.

[v] The ratio of the market value (or more strictly the enterprise value) of a regulated firm to its regulatory asset base (“RAB”) is known as the RAB multiple