CER Review of the Weighted Average Cost of Capital for EirGrid

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1 CER Review of the Weighted Average Cost of Capital for EirGrid A Submission by EirGrid 26 July 2013

2 1. The CER has determined to undertake a review of the Weighted Average Cost of Capital (WACC) applying to EirGrid, ESB and ESB Networks Ltd. for the period 2014 and 2015 as part of the 5 year revenue control (CER/10/206) covering the period The CER provided for such a review in its original determination if there was significant change in circumstances... to see if an adjustment is required for the remaining period. 2. EirGrid has commissioned Cambridge Economic Policy Associates (CEPA) to provide an independent assessment as to whether the WACC now needs to be altered due to such significant change in circumstances as set out in the CER s original determination. The CEPA report is attached. 3. The CEPA report notes that of all times since the setting of the WACC the conditions in the financial markets today are perhaps about as close to those that support the underlying WACC provided by CER as part of the PR3 determination as they have ever been throughout the control period to date. In that sense it is not clear that the test of significant change on which the CER s review is premised is satisfied. Certainly the change in the resultant WACC which could be expected from such a review is within the bounds of what would be considered normal in terms of the degree of variance which might be expected within a 5 year ex ante control. The same cannot be said about the degree to which the regulatory provided for WACC under-remunerated the business for the cost of capital in CEPA also identifies the significant financial loss relative to market conditions that the utilities, including EirGrid, have to this point been exposed to as the result of the setting of a WACC that has been below market parameters for the period. CEPA estimate that the WACC for the control to this point should have been of the order of 7.5%-7.65% (CEPA; page iii). Bearing in mind that these estimates are grounded in actual data CEPA estimate the degree to which the current WACC has under-provided for the period to be equivalent to a write off of 5.2% of the EirGrid RAB in the period (CEPA; page iii). This is significant. 5. When EirGrid responded to the CER s consultation on the WACC for PR3 EirGrid noted that the mid term review would need to take into account the degree to which the WACC was set at the start of the control to under-provide for the cost of capital at that time. An extract from that response paper is reproduced below. Irrrespective of the mechanism through which the review is triggered, it is crucial that any divergence between the allowed WACC and market conditions to that point in the revenue control period are taken into account. For example, the figures that derive the proposed WACC clearly do not reflect today s spot rates, which is reasonable, as it reflects the CER s expectation of the WACC over the period. The proposed WACC must therefore assume that the opportunity cost of capital will recede or moderate to some extent with a degree of market normality occurring; only on that basis would 5.95% remain appropriate. Therefore the proposed WACC is not fully providing 2

3 for today s conditions. In other words the WACC rate would need to fall substantially below the 5.95% to justify a future reduction (EirGrid response to CER/10/186; page 3) Indeed, as EirGrid noted, the 5.95% WACC rate was actually below Irish sovereign debt yields pertaining at the time on which the cost of capital was set. 6. CEPA estimates that were a WACC to be set for the period 2015 which would make up any shortfall experienced by EirGrid to that point and therefore leave both EirGrid and consumers neutral over the whole control period, then the WACC for the final year of the control would need to be 10.60% (CEPA; page iii). This would be that which would ultimately be fair to both customers and the utility. 7. Notwithstanding that the WACC for PR3 can only be looked at as a whole CEPA also set out a forward looking estimate for 2014/15. It is necessary to do so so that the WACC can be considered for the entire period. CEPA estimates an appropriate WACC for EirGrid for 2014/15 to be c.5.6% real pre tax from a possible range of 5.25% %. This 5.6% is not significantly different from the underlying WACC currently provided. 8. Moreover, as identified by CEPA, the level of uncertainty within financial markets, and particularly with respect to Irish sovereign debt remains significant. In their report CEPA set out the standard deviation of Irish 10 year government yields. In 2013 year to date it is over 6; this compares to 3 in every year from (i.e. pre crisis). The table from the CEPA report is reproduced below. Table 1: Standard Deviation of Irish Sovereign Yields Year Standard Deviation Source: CEPA Analysis 9. Indeed such is the continued level of volatility that there was a c. 50 bps jump in Irish sovereign spreads within the month of June alone. This is shown in the table below. Table 2: Recent Volatility in Irish Sovereign Yields 10 yr+ bonds All Bonds 4 th June th June th June th June Source: Irish Stock Exchange (26 th June 2013) 3

4 It therefore remains too early to state that markets have fully returned to normal and any regulatory determination at this point must be set taking such uncertainty, and the risk of getting it wrong on the downside for a second time, into account. 10. In deriving an appropriate estimate CEPA has taken into account the specific set of business characteristics which affect the EirGrid business. In particular CEPA has recognised the higher operational gearing and increased exposure to operational risk which besets the EirGrid business relative to a traditional regulated utility. As a result CEPA has set out a range for the asset beta for EirGrid of Other regulators (CAA, CAR, NIAUR) have all recognised the need to accord higher asset beta to regulated utilities with low asset base. EirGrid believes that the precedent of the application of a 0.45 Asset Beta in the case of SONI is that which is of most relevance 1 (CEPA Report: Annex A; page 35). 11. Given all of the above EirGrid believes that were the CER minded to set simply a forward looking WACC then an estimate of 5.64%, based on the parameters below would potentially be appropriate. This estimate is premised on the mid point of each of the parameters set out by CEPA in their report with the exception of the asset beta where a figure of 0.45 consistent with that set by the Utility Regulator for SONI is applied. Table 3: Parameters for Ex Ante Assessment of Cost of Capital for EirGrid /15 Parameter Estimate Risk Free Rate 2.75% Debt Premium 0.50% ERP 4.75% Asset Beta 0.45 Equity Beta 1.00 Gearing 55%* Cost of Debt 3.25% Cost of Equity (pre tax) 8.57% Pre Tax WACC 5.64% *For the purposes of this exercise EirGrid has taken the CER s previous gearing assumption of 55%. EirGrid does not necessarily believe that this is appropriate for a business of its characteristics which may require to hold more significant, currently unremunerated, equity to meet unanticipated shocks. 12. Whilst EirGrid has provided an estimate in the table above for each parameter which makes up the CAPM analysis it is the overall WACC itself which must be considered relative to the cost of obtaining finance recognising that there is a degree of correlation between the individual elements. 13. The CER must balance its obligation to protect customers and to ensure that licensees can finance their activities. As outlined above a WACC in excess of 10% would now need to be 1 Reference: An estimate of NIE T&D s Cost of Capital A report for the Utility Regulator by First Economics, December

5 set in order to leave all parties neutral to financial market conditions across the period. However, EirGrid ultimately believes that the CER should leave the WACC unaltered as having represented a best estimate, in uncertain times, as and when set at the end of This is consistent with the approach adopted by the CER more generally to setting a point estimate across the control and recognising that financial market risk is inherent in the ex ante approach to the setting of the cost of capital. 14. As set out in the CEPA paper to leave the WACC unaltered would itself result in an overall reduction in the value of RAB of 5% against the provision across the control of a market cost of capital (CEPA Report: page iii). However this risk, and the countervailing risk that from time to time the cost of capital may be set above market rates, is one which is inherent in ex ante revenue cap based regulation. 5