PR4 WACC for EirGrid and October 2015 Data Update...at or above spot yields at the end of 2014 for Irish utilities and at or a little below spot yields for most other European utilities

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PR4 WACC for EirGrid and

ESB Network – October

2015 Data Update

October 2015

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reproduced without permission.

Contents

1 Introduction .................................................................................................................................................................... 1

2 Methodological Update ................................................................................................................................................ 2

2.1 Risk-free rate ......................................................................................................................................................... 2

2.2 Equity risk premium ............................................................................................................................................. 4

2.3 Debt premium ....................................................................................................................................................... 4

2.4 Asset beta ............................................................................................................................................................... 6

3 WACC Update ............................................................................................................................................................ 10

3.1 Aiming up .............................................................................................................................................................. 10

Introduction

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1 Introduction

This document provides an update on the components that were used to form our estimate for the PR4

WACC. In particular, we explore whether changes in the underlying data series that were used for our

estimates have been significant enough for us to consider methodological updates or changes in our

recommended ranges or point estimates.

The table below presents our previous draft estimates for the WACC for PR4, before aiming-up.

Table 1.1: Previous advice on overall WACC before aiming-up

High Low Point

estimate

Risk-free rate 2.10 1.75 1.90

Debt premium 1.15 0.75 1.00

Cost of Debt 3.25 2.50 2.90

ERP 5.00 4.60 4.75

Asset beta 0.44 0.31 0.37

Equity Beta 0.98 0.69 0.82

Cost of equity (post-tax) 6.99 4.92 5.81

Tax rate (%) 12.5 12.5 12.5

Cost of equity (pre-tax) 7.99 5.62 6.63

Gearing 0.55 0.55 0.55

WACC (pre-tax) 5.38 3.90 4.58

In the section below we analyse whether any methodological updates are required and explore developments

in the underlying data series that we relied on to provide our latest advice. This analysis is followed by an

update of our WACC recommendation.

Methodological Update

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2 Methodological Update

In this section we look at different WACC components and examine whether any methodological updates

are necessitated based on movements in the underlying data series. To do so, we first remind refer to our

latest advice and then examine developments since before reaching a conclusion. Where changes are material,

we also engage in a discussion of the relevant issues.

2.1 Risk-free rate

2.1.1 Latest advice

For PR4 we expected the Eurozone risk-free rate to be in the region of 1.75-2.1, with a working point

estimate of 1.9 per cent. The upper bound coincided with our most recent advice to ComReg, whilst the

lower bound reflects the potential for QE and deterioration in the Eurozone’s macroeconomic outlook and

was close to the 2000-2014 average yield of German 10-year bonds.

2.1.2 Developments

German and Irish government bond yields have been rather volatile since the end of 2014. During the first

quarter of 2015 yields maintained their decreasing trajectory; however, after that point yields increased

considerably before stabilising towards the second half of 2015 (see figure below). While exhibiting significant

volatility the observed yield levels as of 30/09/2015 (1.24 per cent for Ireland and 0.59 per cent for Germany)

are at comparable levels to the end of 2014 (1.25 per cent for Ireland and 0.54 per cent for Germany).


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Figure 2.1: 10 year nominal government bond yields (IE and DE for 01/01/2004-30/09/2015)

Source: Bloomberg, Europe Economics’ calculations.

We also look at the medium-term growth forecasts for Ireland compared to the Eurozone as a whole. The

table below summarises this information for 2015 to 2019. It can be observed that while Ireland’s growth

forecasts are materially higher than the Eurozone in the short term the gap appears to be closing as one

moves further to the future.

Table 2.1: GDP growth forecasts for 2015 to 2019 (in per cent)

2014

(Actual) 2015 2016 2017 2018 2019

Ireland 5.2 3.9 3.3 2.8 2.5 2.5

Eurozone 0.9 1.6 1.8 1.7 1.5 1.5

Source: Eurostat for actual data, IMF for Irish data (April 2015) and E&Y for Eurozone data (October 2015).

The table below offers a summary of this information going back to the period of our previous advice (early

2015). It can be observed that growth rate forecasts for 2015-2016 have increased for both Ireland and the

Eurozone while for the remaining years they remain at broadly similar levels.

Table 2.2: GDP growth forecasts for 2014 to 2018 (in per cent)

2014 2015 2016 2017 2018

Ireland 3.6 3 2.5 2.6 2.5

Eurozone 0.8 1.2 1.6 1.6 1.6

Source: IMF for Irish data (October 2014) and E&Y for Eurozone data (December 2014).


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2.1.3 Conclusion

Government bond yields have not moved significantly since our last update (Figure 2.1) while the upward

revision of forecasted growth rates does not appear to persist in the future (Table 2.1 and Table 2.2).

Therefore, there is insufficient evidence to alter our previous recommendation.

2.2 Equity risk premium

2.2.1 Latest advice

We suggested an ERP range of 4.4-5.0 (using the 2013 DMS number as a lower-bound) and a point estimate

of 4¾ influenced by our proposed adjustments to the DMS estimates1 and by the further normalisation in

the ERP, relative to our 2014 Comreg advice, entailed by an additional year having passed, by the time of the

commencement of PR4, since the end of the Irish recession.

2.2.2 Developments

Since our latest advice a more recent version of the DMS publication is available; the updated ERP figures

have dropped to 4.5 and 4.4 per cent for Ireland and Europe, respectively.

2.2.3 Conclusion

While the Irish DMS figure has dropped by 0.1 per cent, we note that our adjustments would drive the DMS

figure to approximately 4.7 per cent; as such there is no strong evidence to change our previous

recommendation of 4.75 per cent.

2.3 Debt premium

2.3.1 Latest advice

The international bonds considered the time had average spot spreads in the range 90-126 bps. The Irish

utilities bonds had a spot range of 64 to 100 basis points and a one-year average of 94-120 bps. With spreads

of euro denominated bonds having moved downwards since the Mid-Term review, we placed less weight on

recent regulatory precedent.

We thus expected the debt premium to be in the range of 75-115 bps, with a point estimate of 100 bps —

at or above spot yields at the end of 2014 for Irish utilities and at or a little below spot yields for most other

European utilities.

2.3.2 Developments

Sine our latest advice there have been two main developments: ESB issued a 12 year maturity bond during

the summer of 2015 and companies’ bond spreads have been increasing.

1 We employed two methods in order to adjust the DMS ERP estimate for Ireland to account for the high Irish yields

in the period 2009-2013. Both methods produced an estimate for every year in this period that should be added to

the respective DMS estimate after being appropriately weighted. The adjustments were in the range of 0.17 to 0.19

per cent.


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The figure below exhibits the latter point while also accounting for the new ESB bond (in bold). Throughout

the first half of 2015 spreads did not move significantly but during the third quarter they started increasing.

Figure 2.2: Spread of euro denominated Irish utilities’ bonds (bps) over the German benchmark bond

A snapshot of this information is also presented in Table 2.3 where we observe spot rates for ESB bonds

ranging from 69 (three years to maturity) up to 154 bps (12 years to maturity).2

Table 2.3: Spread of euro denominated Irish utilities’ bond over the German benchmark bond (in bps,

as of 30/09/2015)

Company Sector Years to

Maturity

Rating

(S&P)

Spread

30/09/2015

Average

(1 year)

Max

(1 year)

Min

(1 year)

BORD

GAIS Gas 3 A- 69 66 75 59

ESB Electricity 3 BBB+ 69 63 71 55



ESB Electricity 12 A- 154 143 154 126

Average 103 92 105 81 Average

ESB

112 109 113 86 Note: Years to maturity are rounded figures. Averages are raw.

Source: Bloomberg, EE calculations.

2 This is higher from the spreads observed in the end of 2014 when the three years to maturity bond had a spread of

64 and the nine years to maturity bond had a spread of 100. The 12 years to maturity bond had not been issued at

the time; for comparison, the spot rate of the nine years to maturity bond is 132 bps.


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2.3.3 Conclusion

Our previous advice was for a range of 75 to 115 bps with a point estimate of 100 bps; the currently observed

averages for Irish utility bonds are within that range hence providing insufficient evidence to support a

different range recommendation. Furthermore, our 100 bps point estimate would also not be affected; it

should also be noted that the newly issued ESB bond has the longest maturity of all bonds in this sample and

thus, as would be expected, drives average yields higher.

2.4 Asset beta

2.4.1 Latest advice

In our latest advice we expected the asset beta to be in the region of 0.31-0.44; this range was obtained by

looking at the spot asset betas of UK comparator companies and excluding the outlier Centrica from the

range-generating set, owing to its business profile being relatively more different from ESBN than the other

firms. Our central estimate was 0.37.

2.4.2 Developments

The two graphs below illustrate the main development regarding asset betas; they have increased

considerably since the end of 2014 and this effect is particularly pronounced in the UK.

Figure 2.3: Rolling 2 year asset betas of UK comparator utilities (01/01/2006-30/09/2015)


0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

National Grid SSE Pennon Severn Trent United Utilities

2010 data cut-off point Mid-Term data cut-off point End of 2014


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Figure 2.4: Rolling 2 year asset betas of European comparator utilities (01/01/2006-30/09/2015)


The figure below presents average figures for each country which has a company in our sample. Without

exception, betas have risen since the end of 2014 from 0.02 points in Spain up to 0.08 points in the UK.

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

RWE EON Veolia EDF

ENEL A2A Hera Terna

Snam Gas Natural Red Electrica REN

EDP

2010 data review Mid-Term review End of

2014


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Figure 2.5: National averages of rolling 2 year asset betas of European comparator utilities (01/01/2006-

30/09/2015)


The table below provides a snapshot of the average asset betas for each country on the last date of our

sample period (30/09/2015) and compares it to the end of our previous sample period (31/12/2014). It can

be observed that Germany and France have the highest averages in the sample (0.52 and 0.49, respectively),

UK and Spain are both at the middle of the range (0.44) while Italy and Portugal are at the lowest end of the

range (0.36 and 0.28, respectively).

Table 2.4: Average betas by country

Company 30/09/2015 30/12/2014 Change

UK 0.44 0.37 0.08

Germany 0.52 0.48 0.04

France 0.49 0.45 0.04

Italy 0.36 0.32 0.05

Spain 0.44 0.42 0.02

Portugal 0.28 0.24 0.04

Average 0.42 0.38 0.04

Source: Bloomberg, EE calculations.

2.4.3 Conclusion

The current naïve (unweighted) average of all countries’ spot betas lies at 0.42, a value which is within the

range suggested in our previous advice (0.31 to 0.44).

The average change of all countries’ asset betas as of the end of September 2015 compared to the period of

our previous advice stands at 0.04. While the UK has exhibited the most material increase within our sample

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

UK Germany France Italy Spain Portugal

2010 data review Mid-Term review End of

2014


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(0.08) we do not have any grounding to rely primarily on the UK for the determination of our point estimate

— and even the UK asset beta remains within our recommended range.

We do believe that there is evidence that asset betas continue to rise. Hence, whilst we maintain our

previously specified range of 0.31 to 0.44, we raise our recommended point estimate to 0.4 (versus 0.37 in

our previous advice), broadly reflecting the typical increases of recent months around Europe but not

completely chasing the latest data (i.e. not giving it total weight versus our previous more detailed and in-

the-round analysis, which included a number of other factors in addition to the latest data, such as regulatory

precedents).

WACC Update

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3 WACC Update

In the table below we compare our current recommendation to our previous advice with the only point of

difference being the increase in asset beta.

Table 3.1: Current versus previous advice on overall WACC before aiming-up

Previous point

estimate

New point

estimate

Risk-free rate 1.90 1.90

Debt premium 1.00 1.00

Cost of Debt 2.90 2.90

ERP 4.75 4.75

Asset beta 0.37 0.40

Equity Beta 0.82 0.89

Cost of equity (post-tax) 5.81 6.00

Tax rate (%) 12.5 12.5

Cost of equity (pre-tax) 6.63 6.86

Gearing 0.55 0.55

WACC (pre-tax) 4.58 4.74

3.1 Aiming up

In both PR3 and the Mid-Term WACC review, our final WACC recommendation included some degree of

aiming-up. We stress that, in the context of PR4, the degree of uncertainty in the WACC is less than at the

Mid-Term WACC review (as noted in that review, the degree of aiming-up was amplified by the Mid-Term

nature of the review and the risk that firms had under-recovered in 2011 and 2012) and potentially also less

than at PR3.

Our recommendation for the degree of aiming up in our previous advice was based upon a Monte Carlo

analysis using:

The ranges recommended for each building block of the WACC.

An assumption of a uniform distribution of outcomes across each range.

1000 runs.

Calculation of the standard deviation of outcomes across the runs.

Application of one standard deviation as the level of aiming up to be applied to our preferred point

estimate.

Construction of the recommended range as running from one standard deviation below the best estimate

to two standard deviations above it.

The result was a standard deviation is 0.2 percentage points, implying a recommended WACC range of 4.4

to 5.0 per cent, and producing an overall pre-tax WACC point recommendation, after aiming up, of 4.8 per

cent.

Applying the same model using our updated WACC building blocks (Table 3.1) the standard deviation remains

at the same level implying an aimed-up point estimate of 4.95 per cent.

Documents

PR4 WACC for EirGrid and October 2015 Data Update...at or above spot yields at the end of 2014 for Irish utilities and at or a little below spot yields for most other European utilities