Rate of Return: What does it mean for consumers?

Last Friday the Australian Energy Regulator (AER) released its final decision on the Rate of Return Instrument (“the Instrument”). This decision sets out how the AER will calculate the Rate Of Return (also known as the weighted average cost of capital, or WACC) for the next four years for gas and electricity network businesses it regulates. Coupled with the Regulated Asset Base (RAB), the Rate of Return forms the largest share of distribution network revenue of some 42 per cent.  Network revenues are measured in billions, so small numbers can make a big difference.  Following the AER decision, the key question for energy consumers - and also for the retailers who will have to pass the resulting network charges on to them – is what will this mean for me? Will I pay much more for energy? And if so, how much?  And why?

Setting the Instrument

The AER sets the rate of return by combining a number of parameters using a standard finance model known as the Capital Asset Pricing Model. These parameters are  set out in the table below:

Table 1: Summary of the decision and comparison with the 2018 Instrument

The italicised figures are where the parameter varies over time and represent the latest available figures at the time of the decision.

It is observable that the fixed component of the Instrument has barely changed since 2018, with only a minor tweak to the Market Risk Premium (MRP). The impact of this change on the average household bill is an increase of $2/year.  Whilst this seems a small increase, it’s a very long way from what might have been achieved.   The AER’s Consumer Reference Group (CRG), an expert panel selected to represent consumer interests during what is a very complex review, recommended alternative parameter estimates for beta, MRP and the return on debt that would have had a combined impact of reducing bills by $41.  But the AER did not accept the CRG’ss arguments.

In light of the AER’s decision on the fixed component, the variable parameters will now have the bigger impact. The risk free rate is determined from 10 year government bond rates, and these have risen sharply over the last couple of years as the Reserve Bank has ratcheted up rates to try to halt inflation.

Figure 1: 10 year government bond yields

Source: https://tradingeconomics.com/australia/government-bond-yield

While it is only 0.9 per cent higher than in 2018 (adding around $30 to a household annual bill), it is much higher than the low point in 2020 and this has driven the impact.

The other element that varies over time is the return on debt. Return on debt is based on corporate bond rates, which are higher than government bond rates (because firms sometimes go bust, but the Australian Government should always be good for its debts)though they tend to increase and decrease with them.  Unlike the more frequent changes in real bond rates, the AER uses a 10-year trailing average so rate changes only flow through slowly. Coincidentally this average is about the same as in the previous (2018) decision, even though it dipped in between with the much lower rates of 2019-2021.

The impact of this decision does not happen for every customer immediately. The AER will only apply its new decision at each network’s five yearly reset. A stylised version of the AER’s reset timetable is below, and the full list can be found here.

Figure 2: AER’s reset timetable

As shown, the first round of networks to which the new Instrument will apply includes the Victorian gas distribution businesses, plus the NSW and South Australian transmission businesses.  By the time of their final decisions in April, the 10-year bond rate may have moved again.  It’s also worth noting that the AER’s anticipated draft decision on regulated electricity prices for small consumers (the DMO) is unlikely to reflect the new changes. Whaty this means is that the $32 bill impact referenced above will not be included in what is already expected to be a significant price increase.

The biggest impact is likely to be felt by consumers of the networks who had their last reset at the time when interest rates were at their lowest level. These include electricity distribution networks in South Australia and Queensland, and the Sydney gas distribution network. These networks will see a reset in 2025. If interest rates stay where they are, the annual bill impact will be around $100.  But this number could be evenhigher if interest rates continue to rise.

While we have focussed on household consumer bill impacts, business consumers will also see their bills rise as a result of the decision. Given the wide range of consumption levels by businesses an average bill impact is not as meaningful.

Whilst the overall 2022 instrument allows only a marginally higher rate of return, it comes at a time when energy prices are a source of stress for consumers, small and large.  In its detailed 125 page report to the AER, the CRG made it clear it was not asking the AER to make a biased judgement in favour of consumers.  But the CRG made the case that the evidence points to the fact that consumers are already paying the price of previous distribution over-investment, and that the AER decision could have readily been improved in the customer’s favour.