1. Bruce Mountain Director Regulatory arrangements for the cost of capital and tax in the regulation of Victorian water companies: issues and ideas Prepared for the Essential Services Commission Melbourne 18 September 2015

2. Outline 2 Equity Debt Income tax Dividends

3. Equity: description of current arrangements Water, VIC: –Assumes private ownership & 40% of capital as equity –Capital Asset Pricing Model (exact CAPM model unspecified) –Theoretical and empirical analysis of Beta & Market Risk Premium in 2004 energy review Elsewhere, Australia: –Similar, fundamentally, to approach adopted in Vic Water. But greater endeavour in electricity (particularly AER) to find the “right” Beta and MRP. UK (for non-investor owned utilities and quasi-monopolies) –Royal Mail: CAPM initially then return on sales; –Scottish Mail, Network Rail, Northern Ireland Water: CAPM –Like ESC, little attention to financial economics theory and empirics in defining Beta or MRP. Mostly about looking at decisions of other regulators and comparing relative sectoral risk. 3

4. Equity: Issues and Ideas Vic arrangement assumes Government prices equity in operating businesses it owns, in the same way that private investors would. Many reasons why this assumption is wrong: –Government collects pre-tax return and private investors collect post-tax return; –Government sets “not for profit” objective for several companies; –Government values (and is willing to contribute towards) lower prices in the country; –Government also obtains (non-pecuniary) rewards from water businesses it owns (environmental protection, community cohesion, jobs, political support). This can be expressed, typically, in a lower (financial return) requirement. Assumption of private ownership and use of CAPM provides a reducible methodology for pricing equity. But the underlying assumption for this approach - that Government requires same return as private sector is wrong. 4

5. So, what to do? Government could set the return it requires for the equity it provides: This is, implicitly if not explicitly, the long standing approach before creation of regulatory agencies. But Gov. understandably reluctant to do this after creation of economic regulators. Practical reality (and having regard to ESC’s statutory obligations) is that the task of pricing Government equity substantially falls to ESC. We suggest ESC be guided by economic (efficiency) considerations in setting equity price: –Is the WACC derived from CAPM assuming private ownership likely to provide excessive or insufficient incentive for capital spending? –How will the ESC’s determination be reflected in the firm’s actual profits (and what can history tell us about this)? –How does the ESC’s thinking on cost of equity compare nationally and internationally? –Is the WACC likely to lead to prices that result in inefficient foregone or wasteful water consumption? We suggest ESC avoids approach in electricity network regulation of ever more arcane financial economic analysis: much better to think about the reality of the situation than assume the complexities away. Aim for roughly right rather than precisely wrong. 5

6. Debt: description of current arrangements Water, VIC –ESC estimates a BBB, 10 year Australian corporate debt benchmark, and also “actual” cost of borrowing based on Vic Government bonds plus Financial Accommodation Levy. –Approach assumes a “stand alone” business that borrows in Australian corporate bond market. Elsewhere, Australia –Same underlying assumption: “stand alone” business that borrows in Australian corporate bond market. –Many detailed differences in specification of benchmark, use of historic rolling average, measure of risk free rate etc. UK –No stand-alone assumption –Borrowing costs based on British Government bond yields plus a fixed margin (usually around 50-80 basis points) 6

7. Debt: issues and ideas We suggest debt cost for government-owned water companies based on Australian corporate bond market benchmark is problematic. –“Stand-alone” assumption rests on shaky foundations: water companies borrow from the Government, they don’t stand alone. –“Competitive neutrality” justification for ignoring Government borrowing costs not plausible (water companies have monopoly). –Reasonable to suggest some premium (to Government bond yield) to compensate development and operating risks. But Australian corporate bond does not only price this risk. –The prospect of excessive return on assets (as a result, primarily, of excessive debt allowance) has, we suggest, been significant part of explanation for excessive capital spending in electricity networks. 7

8. So, what to do? Suggest UK approach of Government bond yield plus fixed margin be considered: –more accurately reflects reality of the situation; –transparent and straight-forward; –reduces prospect of investment distortions. ESC, in consultation with Government set fixed margin (above risk free rate) having regard to debt-raising and transaction costs plus differences between Australian Government and Victorian Government borrowing costs, plus compensation for asset development and operating risks. If resulting cost of debt is lower than current arrangement, shortfalls in Government receipts can be made up through levies, as exist now. Would be helpful to consider rolling average (of risk free rate) to avoid error of “set and forget” in context of interest rate volatility. This has the potential to be done quite easily. 8

9. Tax: Description of current arrangements ESC sets post-tax WACC and adds back allowance for expected “regulatory” income tax. In regulation in Australia and UK, a post tax WACC is also the norm. Pre-tax WACC with tax wedge on debt has historically been common. 9

10. Tax: Issues and Ideas VIC water approach assumes privately owned companies: –In setting regulatory allowances, government and privately owned firms have incentive to argue for generous allowance for tax. –But, only privative firms have incentive to reduce actual tax (governments collect pre-tax profit so firm has no incentive to reduce tax). –If no incentive to reduce (and no impact to consumer if reduced) why not simply allow actual income-tax as pass-through in regulated revenue determination? Ownership-dependent tax minimisation incentives, are only part of the issue. If there is a big difference between regulatory and statutory asset value, use of “statutory” tax rather than “regulatory” tax can result in big price differences. Indeed, had the actual (statutory) tax been pass-through in regulated revenues, water prices in VIC (metropolian areas) would have been higher. 10

11. So, what to do? Taking these considerations into account, we think the case for changing the current arrangement reduces to whether the current approach is resulting in undue effort by the regulator, the companies and consumers, on tax issues. In electricity, the implementation of the post-tax approach has led to arcane argument on dividend imputation. This has added substantial transaction costs (ultimately borne by consumers), degraded the quality of the regulatory discourse and distracted regulators, companies and consumers from more worthwhile things. If the Victorian water regulatory debate falls into the same trap, we would suggest reconsideration of the use of a pre-tax WACC with adjustments for dividend imputation and differences between statutory and regulatory asset valuation. 11

12. Dividends Between 2005/6 and 2013/14, Victorian water businesses delivered after tax-profits of around $2.2bn, paid dividends to the Government of around $1.4bn and so left retained earnings of around $0.8bn. Almost half of all profits and dividends came from Melbourne Water with almost all of the remaining from the other three metropolitan water companies. Regional water companies have paid very small dividends, and the rural water companies none, reflecting much lower profits than the metropolitan companies – because much higher statutory than regulatory asset values and hence much higher statutory than regulatory depreciation. Higher statutory depreciation combined with no or very low dividends is likely to result in higher cash reserves (or more rapid repayment of debt). This might weaken the companies’ budgetary discipline and hence spending efficiency. Regulatory involvement in the water companies’ dividend policy may however undermine managerial discretion and directors’ fiduciary accountability. Prima facie the evidence on Vic-wide aggregate water sector dividends against aggregate retained earnings (the former well within the latter) does not suggest financial risk attributable to excessive payouts. The picture of retained cash surpluses for the rural and regional water companies is not clear. Information on this would be helpful in considering any change to regulatory authority with respect to company dividend policy. 12