CONSULTATION PAPER THE DISCOUNT RATE METHODOLOGY FOR LICENSED ELECTRICITY DISTRIBUTORS PUBLISHED ON 19 SEPTEMBER 2017
Table of Contents Abbreviations and acronyms... 3 Definitions... 3 Executive summary... 4 1. Background... 5 2. The definition and function of the discount rate... 5 3. Discount rate methodologies... 5 3.1 Weighted Average Cost of Capital (WACC) for Licensed Electricity Distributors 6 4. The discount rate application by Licensed Electricity Distributors... 11 5. The use of alternative discount rate methodologies for Licensed Electricity Distributors... 12 Appendix A: Beta calculation method for Licensed Electricity Distributors... 13 Page 2 of 14
Abbreviations and acronyms ALSI BYPRP CAPM COC DBSA JSE LCC MRP NERSA NPC ROE SARB SARS WACC All Share Total Index Bond Yield Price Plus Risk Premium Capital Asset Pricing Method Cost of Capital Development Bank of South Africa Johannesburg Stock Exchange Life Cycle Costs Market Risk Premium National Energy Regulator of South Africa Net Present Cost Return on Equity South African Reserve Bank South African Revenue Services Weighted Average Cost of Capital Definitions Codes Distribution Network Licensed Electricity Distributors South African Grid Code means the Distribution Code, the Grid Code, or any other code, published by NERSA, as applicable and amended, modified, extended, replaced or re-enacted from time to time. means the distribution network of any distributor that operates at a nominal voltage of 132kV or less, as described in the Codes, as that the system may be refurbished, modified, extended or developed from time to time. refers to Municipal and Private electricity distributors licensed by NERSA means the set of documents entitled South African Grid Code published by NERSA in July 2010, version 8.0 2010 as amended, modified, extended, replaced or re-enacted from time to time. Page 3 of 14
Executive summary The National Energy Regulator (NERSA) is a regulatory authority established as a juristic person in Terms of Section 3 of the National Energy Regulator Act, 2004 (Act No. 40 of 2004). NERSA's mandate includes the regulation of the electricity supply industry. According to Section 4(ii) of the Electricity Regulation Act, 2006 (Act No. 4 of 2006) ( the ERA ), the Energy Regulator must regulate electricity prices and tariffs. NERSA is the administrative authority for the South African Grid Code ( the Grid Code ) in terms of sections 35(1) and 14(t) of the Electricity Regulation Act, 2006 (Act No. 4 of 2006). In accordance with the Act, NERSA shall ensure that the Grid Code is developed, implemented and complied with for the benefit of the industry. The licensees are required to use a NERSA-approved process to determine the Discount Rate in order to ensure that the networks are planned and built in accordance with the Grid Code requirements. These requirements also aims to ensure an orderly and economic expansion of the network infrastructure to meet future electricity demand with an acceptable level of reliability. In support of the above Code, NERSA is requesting the stakeholders to comment on the proposed Discount Rate Methodology for Licensed Electricity Distributors as set out in this consultation paper. The comments should be addressed to: Ms Nokukhanya Ndlovu at the National Energy Regulator, Kulawula House, 526 Madiba Street, Arcadia, Pretoria or emailed to: discountrate@nersa.org.za. The deadline for the submission of comments is 20 October 2017. NERSA will hold a public hearing wherein presentations may be made by interested and affected parties. After the public hearing, NERSA will consolidate all comments and a decision on the methodology will be made and published. Page 4 of 14
1. BACKGROUND Section 7.2.1 (6) of the Distribution Network Code and Section 7.7 (5) of the Transmission Network Code requires that the Discount Rate, as an economic parameter used by licensees in the distribution network planning studies, shall be determined using a NERSA-approved process. 2. THE DEFINITION AND FUNCTION OF THE DISCOUNT RATE The discount rate is the minimum cost (in percentage) that can be incurred by the company (licensee) in raising the capital. Alternatively, the discount rate is a minimum return that a company must earn on an existing asset base to satisfy its creditors, owners and other providers of capital. In network distribution planning, the discount rate is one of the main financial inputs used to calculate the life cycle cost (LCC) of the projects undertaken by the licensees. Used as one of the decision making tool, the LCC is calculated using the net present costs (NPCs) associated with the projects such as capital, operation and maintenance costs as well as technical losses. The NPCs are calculated by discounting the costs and value of the various alternatives/options of the project using the discount rate. An option with the least LCC is then chosen as best solution by the planners. The least LCC criteria is the most satisfactory criterion used by planners to justify projects and to make investment decisions in an operating environment characterised by the limited financial resources. As a result, obtaining an appropriate estimation of the discount rate is necessary and important given the role it plays in influencing the investment decision taken by the licensees to upgrade and refurbish networks at a distribution level. 3. DISCOUNT RATE METHODOLOGIES There are various methodologies of estimating and interpreting the concept of discount rate; all of which have various advantages and disadvantages. The approach followed by NERSA in developing the discount rate methodology for Licensed Electricity Distributors was the desktop research, which entailed examination of papers inclusive of methodologies used by regulators to determine the discount rate for tariff regulated licensees. The two discount rate methodologies were identified, namely: Weighted Average Cost of Capital (WACC) The WACC methodology is a popular method for determining the discount rate, adopted by many regulators. This methodology has already been endorsed by Page 5 of 14
NERSA in the determination Eskom s discount rate in its Multi-Year Price Determination (MYPD). WACC is determined by estimating the cost of debt and equity, then multiplying these costs with the weights of the capital components. Cost of capital (COC) The COC 1 methodology was developed by the Ontario Energy Board to determine the discount rate for rate-regulated entities. The COC methodology calculates the discount rate using the following parameters, namely the formula-based return on equity (ROE), the deemed long-term and short-term debt rates, as well as weightings of the respective COC parameters in the capital structure. The WACC and COC methodologies determine the cost of debt as the sum of the riskfree rate determined using the nominal government bond rate; and the spread between the licensee s bond rate and risk-free rate. Licensed Electricity Distributors such as small municipalities are not raising debt capital through bond issuance, which will make it difficult to determine the cost of debt using this principle. WACC uses several approaches to estimate the cost of equity. In deriving the formulabased ROE, which serves as proxy for the cost of equity capital, the COC methodology assumes that the regulated licensee use bonds to raise debt capital, which is not the case for some Licensed Electricity Distributors. However, limitations associated with WACC and COC methodologies does not prove the concepts futile. Both these methodologies can be used under different circumstances by making minor adjustments, for the benefit of all the Licensed Electricity Distributors. WACC is the recommended method of determining the discount rate for Licensed Electricity Distributors. 3.1 Weighted Average Cost of Capital (WACC) for Licensed Electricity Distributors The proposed WACC methodology assumes the same principles as the abovementioned methodologies only the processes of determining the WACC parameters have been modified to cater for the diverse characteristics of the Licensed Electricity Distributors, made up of the municipalities and private electricity distributors. 1 Detailed process of the COC methodology can be accessed at: https://www.oeb.ca/industry/policy-initiatives-andconsultations/cost-capital-review Page 6 of 14
The formula for the WACC methodology is given by: WACC = [Kd ( D D + E )] + [ Ke 1 tc ( E D + E )] Where: Kd = cost of debt before tax D = debt E = equity Ke = cost of equity after tax tc = company tax rate It should be noted that the standardised WACC formula has been provided with the intention of accommodating the diverse characteristics of the Licensed Electricity Distributors. The Licensed Electricity Distributors will only input parameters applicable to their operational conditions, as follows: a) Licensed Electricity Distributors without equity will be required to calculate the discount rate as the cost of debt only. b) Licensed Electricity Distributors without debt will be required to calculate the discount rate as the cost of equity only. c) Licensed Electricity Distributors not paying company tax must input zero for tc in the WACC formula. 3.1.1 Nominal cost of debt before tax The nominal cost of debt refers to the total cost or rate of interest to be paid by Licensed Electricity Distributors in raising the debt capital. The nominal cost of debt is calculated as the sum of the risk-free rate (Rf) and the debt/default premium (Dp). Alternatively, the estimate of the cost of debt may also be sourced from the lenders. 3.1.1.1 Risk-free rate The risk-free rate for Licensed Electricity Distributors can be determined using the nominal government bond with at least 10-year maturity. The 10-year nominal government bond rate for the preceding 30 days average starting from the day of determining the discount rate should be used to estimate the risk-free rate. Stakeholder Comment # 1 Stakeholders are invited to comment on whether it is appropriate to determine the risk-free rate using the 10-year nominal government bond rate, including the timeframe to be considered for the estimation purpose. Page 7 of 14
3.1.1.2 Debt/Default premium The debt/default premium is the additional amount that the borrower must pay to compensate the lender for assuming default risk. The debt premium for Licensed Electricity Distributors with bonds can be estimated as the spread between the 10- year nominal government bond rate in 3.1.1.1 and the licensee bond rate with a 10- year maturity. The majority of the Licensed Electricity Distributors are not active in the bond market, hence the loans acquired from banks [for example the Big Four Banks and the Development Bank of South Africa (DBSA)] serves as one of the main sources of debt capital. In the absence of bond issuance, the default premium can be estimated using the weighted average of the default premium rates sourced from lending banks. As the lenders/debt providers, banks using the risk rating models are in a better position to provide an appropriate estimate of the default premium rates for Licensed Electricity Distributors. Stakeholder Comment # 2 Stakeholders are invited to comment on the proposed methods of determining the default/debt premium and whether it is appropriate to source the default premium rates from the banks issuing loans to the respective Licensed Electricity Distributors. 3.1.2 Debt and equity capital The debt and equity values can be sourced from the latest annual financial information of the Licensed Electricity Distributors using the ring-fenced electricity distribution activities as reported in the Electricity Distribution Forms (D-forms). Stakeholder Comment # 3 Stakeholders are invited to comment on whether it is appropriate to use the debt and equity figures sourced from the D-forms of the Licensed Electricity Distributors to determine the discount rate. 3.1.3 Nominal cost of equity after tax In addition to debt capital, private electricity distributors source additional capital from shareholders while municipal electricity distributors source it from the public contribution, donations, grants and subsidies as well as internal income. The municipalities as the Licensed Electricity Distributors may not be required to provide monetary incentive to the capital providers for the funds provided, as a result only the cost of debt may be used as the discount rate. Page 8 of 14
All the approaches contained in this consultation paper may be used to estimate the cost of equity, assuming that all the equity capital providers will expect a return on funds provided. The Licensed Electricity Distributors will only be expected to adopt an approach in line with their operational conditions. The cost of equity may be estimated using several methodologies, namely: Dividend Growth Model; Price-Earnings Ratio; Bond Yield Plus Risk Premium (BYPRP); Capital Asset Pricing Model (CAPM); and Formula-based ROE. 3.1.3.1 The first two models, namely the Dividend Growth and Price-Earnings Ratio can be adopted by the Licensed Electricity Distributors listed in the stock exchange given that the share price is one of the inputs required for the estimation of the cost of equity using these approaches. 3.1.3.2 The BYPRP approach determines the cost of equity as the sum the observable yield on the licensee s long-term bond and the judgemental risk premium. The judgemental risk premium can be determined by the Licensed Electricity Distributors considering operational and business risks and it usually ranges from 3 to 5 per cent. 3.1.3.3 The CAPM is the popular and generally accepted approach of determining the cost of equity, calculated as follows: Ke = Rf + (β MRP) Where: Rf = Risk-free rate The risk-free rate is 10-year nominal government bond rate as determined under 3.1.1.1. β = Beta Beta is available for listed Licensed Electricity Distributors. For the unlisted Licensed Electricity Distributors, beta can be estimated using a proxy, which is determined by considering an average of at least six companies that operate as electricity distributors. The companies to be considered must be Page 9 of 14
listed in the stock exchange and have beta value. The methodology used to determine the beta is set out in Appendix A. MRP = Market risk premium The MRP can be estimated using the recent MRP studies conducted by credible entities (for example Credit Suisse) and/or calculated as a difference between the market return on the Johannesburg Stock Exchange (JSE) All Share Total Index (ALSI) and risk-free rate. 3.1.3.4 The formula-based ROE is used by other regulators and is based on the principles of BYPRP with some adjustments. The formula-based ROE is calculated as: Base ROE + 0.5(change in Risk free rate) + 0.5(change in debt premium) Where: Base ROE is sum the current risk-free rate as determined in 3.1.1.1 and judgemental risk premium. Change in the risk-free rate is calculated as the current risk-free rate minus riskfree rate of the base period. Change in the debt/default premium is calculated as the current debt premium as determined in 3.1.1.2 minus the debt premium for the base period. Base period is the period in the previous year corresponding to the current period of determining the discount rate. All of the abovementioned approaches of estimating the cost of equity are generally accepted. The private electricity distributors can use any of the approaches in line with their operational conditions. If municipal electricity distributors need to calculate the cost of equity, the BYPRP and/or formula-based ROE approach can be adopted. Stakeholder Comment # 4 Stakeholders are invited to comment on whether it is appropriate for Licensed Electricity Distributors to adopt any of the abovementioned approaches of estimating the cost of equity. 3.1.4 Company tax rate The applicable company tax rate sourced from the South African Revenue Services (SARS) should be used by Licensed Electricity Distributors to determine the discount rate. The Licensed Electricity Distributor not paying company tax should input zero for company tax rate (tc) in the WACC formula. Page 10 of 14
3.1.5 Inflation The nominal WACC before tax derived by following the abovementioned steps can be converted to real WACC using the 1-year inflation rate forecast from an independent source. Stakeholder Comment # 5 Stakeholders are invited to comment on whether it is appropriate to use the estimated inflation rate to convert nominal rates to real rates. 3.1.6 Real WACC before tax The real WACC before tax determined using the abovementioned steps is the discount rate for the Licensed Electricity Distributors. The Licensed Electricity Distributors will be required to update the real discount rate on an annual basis. Stakeholder Comment # 6 Stakeholders are invited to comment on whether it is appropriate for Licensed Electricity Distributors to update the real discount rate before tax on an annual basis. 4. THE DISCOUNT RATE APPLICATION BY LICENSED ELECTRICITY DISTRIBUTORS The discount rate derived from the WACC methodology should be used by Licensed Electricity Distributors in the distribution planning processes to discount costs, which are considered in the calculation of the LCC of the projects. The Grid Code requirements state that the licensees must use the least LCC 2 approach to justify projects and to make investment decisions. However, it should be noted that the least LCC approach is not used in isolation as the technical criteria must also be satisfied for projects to be approved and undertaken by the Licensed Electricity Distributors. Stakeholder Comment # 7 Stakeholders are invited to comment on whether the proposed application of the discount rate in the respective distribution planning processes is appropriate. 2 The application of the least life cycle cost criteria depends on the type of project undertaken by the Licensed Electricity Distributor. Page 11 of 14
5. THE USE OF ALTERNATIVE DISCOUNT RATE METHODOLOGIES FOR LICENSED ELECTRICITY DISTRIBUTORS The WACC methodology as presented in this paper is the preferred methodology of determining the discount rate for Licensed Electricity Distributors. However, the Licensed Electricity Distributors are not prohibited from considering any discount rate determination methodology that is deemed appropriate. However, if the Licensed Electricity Distributors decide to use any methodology other than the WACC recommended in this consultation paper, the chosen methodology must be submitted to NERSA for review and approval prior to implementation. Stakeholder Comment # 8 Stakeholders are invited to comment on whether it is appropriate to allow Licensed Electricity Distributors to use alternative methodologies of determining the discount rate, provided that the proposed methodology is submitted to NERSA for review and approval prior to implementation. ---END--- Page 12 of 14
Appendix A: Beta calculation method for Licensed Electricity Distributors For Licensed Electricity Distributors not publicly listed, the equity beta may be derived from a proxy beta. To make adjustments for differences in gearing between the proxy and the Licensed Electricity Distributor, the process involves unlevering and re-levering as follows: Obtaining the equity beta for the proxy company. Un-levering the beta of the proxy company by the gearing level of the proxy company. This unlevered beta is known as the asset beta. Calculating the weighted average of the asset betas for the chosen proxy companies. Re-levering the average asset beta by the capital structure of the Licensee Electricity Distributor. Note The Harris and Pringle formula, which excludes the tax shields in the notation, will be used. The following steps must be followed: Step 1 Calculate asset beta (or un-levered beta) for proxy firms The following formula must be used to determine the asset beta: βa1 = β1 1 + [ D E ] Where: βa1 = Asset beta for proxy company 1 β1 = Beta of proxy company 1 D = Debt of proxy company 1 E = Equity of proxy company 1 Note: Repeat step 1 for each of the 6 (or more) chosen proxy firms. Page 13 of 14
Step 2 Calculate weighted average asset beta of proxy firms Weigh each of the 6 (or more) proxy firm asset betas by their proportion of the total debt plus equity of the 6 (or more) proxy firms and sum the results using the following formula: n (D + E)n BaE = [ ( n ) (Ba1)n ] (D + E)n n=1 n=1 n Where: BaE = Weighted average asset beta of the proxy companies (D + E)n = Sum of the debt and equity for a specific proxy company (Ba1)n = Asset beta of the corresponding specific proxy company n n=1 (D + E)n = Sum of debt and equity for all proxy companies n = Number of proxy companies Step 3 Calculation of beta (β) for the Licensed Electricity Distributor. (Re-levering of beta). The following formula must be used to determine the beta for the Licensed Electricity Distributor: βl = βae [1 + D E ] Where: βl = Beta of the Licensed Electricity Distributor βae = The weighted average β of the proxy firms asset betas from Step 2. D = The debt of the Licensed Electricity Distributor E = The equity of the Licensed Electricity Distributor Page 14 of 14