TenneT TSO Comparison study of the WACC

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TenneT TSO

Comparison study of the WACC

Final Report

May 8, 2006

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Section 1

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Important notices

̇ This document is strictly confidential and must not be provided to, or made available, by any means, to any person other than the intended recipient.

̇ This document is for information purposes only and should not be relied upon. Accordingly, regardless of the form of action, whether in contract, tort or otherwise, and to the extent permitted by applicable law, PricewaterhouseCoopers Advisory N.V. accepts no liability of any kind and disclaims all responsibility for the consequences of any person acting or refraining from acting in reliance on the information in this document.

̇ The information used in preparing this document has been obtained from a variety of third party sources.

PricewaterhouseCoopers Advisory N.V. has not performed an audit, verification or independent validation of the data used or referred to in this report and therefore does not undertake any responsibility or liability and does not give and must not be interpreted as to be giving any (explicit or implicit) assurance for the accuracy or the completeness of the data.

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Section 2

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Management summary (1)

Section 2 - Management summary

̇ TenneT B.V. (TenneT) has engaged PricewaterhouseCoopers Advisory N.V. (PwC) to undertake an international survey of the methodology and argumentation used for setting the regulated cost of capital.

̇ Our review demonstrates that - as opposed to most regulators - DTe does not take into account several qualitative factors that justify a cautious approach. Within the DTe's defined bandwidth for the cost of capital, DTe consistently sets the parameters at the lower end of the bandwidth.

̇ A large number of regulators have adopted a cautious approach with respect to the value of the cost of capital, recognizing that the downside of setting the cost of capital too low is greater than the downside risk when setting the cost of capital too high.

̇ In the UK, regulators acknowledge that the current risk free rates and debt premiums are at historically low levels. The

regulators recognize that the cost of capital is very sensitive to the risk-free rate, as the risk-free rate is an important input into both the cost of debt and the cost of equity. Most regulators base their risk free rate on medium to long term government bonds and not on bonds with a maturity shorter than 5 years.

̇ Given this sensitivity and the considerable upward trend for the expected risk-free rate, the regulators deemed it appropriate to adopt a cautious approach and to opt for values that are more towards the upper end of the bandwidth.

̇ The UK regulators also take a cautious approach with respect to the beta. They observe that the beta’s of the comparable companies have decreased substantially during the last couple of years / months, and question whether this is due to a decrease in the actual risk profile of the companies in the peer group or whether this is due to other factors.

̇ Also in the Netherlands, there are examples of regulators adopting a cautions approach in case parameters are uncertain. E.g., in the case of TPG, which is regulated by Opta, we see that the regulator looks at the total market return as opposed to the MRP. This leads to a higher implicit MRP. We are of the opinion that this is consistent with the research performed by inter alia Siegel (1998). In times of low risk free rates the MRP is higher and vice versa.

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Management summary (2)

̇ Several other regulators have used arguments, that are not covered by the standard WACC and CAPM formulas, to take into account specific circumstances that result in a higher cost of capital:

– The Belgian regulator CREG uses an additional 20% (relative) return on equity for companies that are not listed; – In its report for Ficora, the Finnish telecom regulator, Frontier Economics suggests the use of a small firm premium; – In Australia, the regulator in Victoria adds a small premium to the cost of debt to take into account the costs related to

raising debt;

– Several regulators state that, in case beta’s can not be measured accurately, a value towards 1 should be adopted for the equity beta.

̇ We conclude that all regulators in our review demonstrate a cautious approach when determining the height of parameters and take into account qualitative assessments of the market and the likely development of market trends in the future. ̇ Our survey highlights the arguments that regulators use to justify this cautious approach.

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Management summary (3)

̇ A visual representation of the decisions of other regulators, as shown in the graph on the next page, shows that DTe is in a league of its own when it comes to determining the WACC.

̇ The first bar represents the ‘initial range’ that the regulator considered for setting the WACC. It usually represents the measured range, without giving additional consideration to specific circumstances that might increase one or more parameters.

̇ The second bar shows the adjusted bandwidth and mentions the specific parameter adjustment that led to the increase. ̇ The third bar eventually shows the actual value of the WACC as set by the regulator*.

̇ Without looking at technical indicators, it is quite striking to see that DTe is by far the most aggressive regulator, when speaking in terms of setting the WACC.

̇ Even on a nominal level, DTe is proposing one of the lowest WACC’s, lower even than the real WACC’s proposed by Ofwat and Ofgem.

̇ Furthermore, all regulators acknowledged that the decrease in interest rates should be reflected in a lower WACC. However, none of the other regulators have adopted other methods to lower the WACC (such as decreasing the measurement period for the risk free rate and the market risk premium) with the same magnitude as DTe.

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Management summary (4)

Ofwat Initial range based on the underlying data

(real) Assuming an equity beta of 1

Final proposal 7,3% real and pre-tax

Ofgem Initial range based on the underlying data

(real) Excluding lower end of the range

Final proposal 6,9% real and pre-tax

Ofcom Initial range based on the underlying data

(nominal) Excluding lower end of the range

Final proposal 10,0% nominal and pre-tax

Postcomm Initial range based on the underlying data

(nominal) Excluding lower end of the MRP range

CAA Initial range based on the underlying data

(real) Excluding lower end of the MRP range

Proposal 6,6% real and pre-tax

Ficora Initial range based on the underlying data

(nominal) Adopting (conservative) beta's other regulators

Proposal 13,9% nominal and pre-tax

ORG Initial range based on the underlying data

(nominal) Adopting (conservative) beta's other regulators

Proposal, nominal and pre-tax

ACC Initial range based on measured beta

(nominal) Adopting conservative beta

DTe Range based on methodology 2nd period

TenneT Decreasing MRP and Rf measurement period

(nominal) Proposal 6,8% nominal and pre-tax

WACC IN %

z

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Section 3

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Introduction and background

Section 3 - Introduction and background

̇ TenneT N.V. (TenneT) has engaged PricewaterhouseCoopers Advisory N.V. (PwC) to undertake an economic analysis of the determinations by other regulators with respect to deciding on the appropriate level of the cost of capital (WACC).

̇ Such an analysis should indicate that the current WACC proposal, as included in DTe’s most recent decision on TenneT’s Cost of Capital, is out of line with international best practice and represents the real danger of a WACC that is too low, which puts a healthy and stable operating environment for TenneT at risk.

̇ The main focus of this report is on the specific arguments, if any exist, that foreign regulators have recently used to deviate from the ‘measured’ WACC parameters and that have led them to err on the ‘safe’ side of the WACC bandwidth.

̇ The analysis is based on public information obtained from a variety of international regulators in a number of industries. The only limitation with respect to the scope of this analysis is the information publicly available from the different regulators. We have limited our search to the two most recent regulatory periods for each industry.

̇ Given the relatively long history of regulation within the UK and its authoritative role with respect to regulation, specific attention is given to the regulated industries in the UK.

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Section 4

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Netherlands – Transmission System Operator

Regulator: DTe

Revenue control

Section 4 - Current WACC determination(s) by the DTe

̇ Method: WACC-formula and CAPM.

̇ The risk-free rate is based on the average yield on a Dutch government bond with a maturity of 10 years, measured over a historical period of 2 and 5 years. ̇ The debt premium is determined using the credit ratings

of comparable companies.

̇ The Market Risk Premium is based on studies of Dimson, Marsh en Staunton, Ibbotson Associates and Siegel. The most weight is placed on the study of Dimson, Marsh and Staunton. The range that DTe proposes is based on the values for the arithmetic and geometric mean. The MRP used is based on the Dutch market and the global market.

̇ The beta is calculated using a small number of

comparable companies. The frequency for measuring beta’s is 2 years daily data and 5 years monthly data. The ‘raw’ beta’s are corrected with the

Vasicek-correction. To lever and unlever the beta's, the Modigliani-Miller method is used (incl. Tax).

The used beta is the lower one of the 2-years and 5-years beta.

Cost of capital forTennet third regulation period DTe

Low High

Nominal Risk Free Rate 3.7% 4.3%

Debt premium 0.8% 0.8%

Cost of debt 4.5% 5.1%

Market Risk Premium 4.0% 6.0%

Equity beta 0.58 0.58

Cost of equity 6.0% 7.8%

Gearing 0.6 0.6

Tax rate 29% 29%

Nominal pre-tax WACC 6.1% 7.4%

Average nominal pre/tax WACC

Inflation 1.25% 1.25%

Real pre-tax WACC 4.8% 6.1%

Average pre-tax WACC

Cost of capital forTennet second regulation period DTe

Low High

Cost of debt 5.6% 5.6%

Cost of equity 7.8% 7.8%

Gearing 0.6 0.6

Debt/Equity 1.5 1.5

Tax rate 35% 35%

Average nominal pre-tax WACC

Real pre-tax WACC 5.4% 5.4%

7.7%

5.4% 5.5%

2007 - 2010

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Netherlands – Electricity distribution companies

Regulator: DTe

Revenue control

̇ The Market Risk Premium is based on studies of Dimson, Marsh en Staunton, Ibbotson Associates and Siegel. Most weight is placed on the study of Dimson, Marsh and Staunton. The range that DTe proposes is based on the values for the arithmetic and geometric mean. The MRP used is based on the Dutch market and the global market.

comparable companies. The frequency for measuring beta’s is 2 years daily data and 5 years monthly data. The ‘raw’ beta's are corrected with the

Vasicek-correction. To lever and unlever the beta's, the Modigliani-Miller method is used (incl. tax).

The beta range is consistent with the upper and lower bound provided by the averages of the daily and the weekly estimates.

Cost of capital for RNB's third regulatory period DTe

Low High

Cost of debt 4.6% 5.1%

Cost of equity 5.7% 8.7%

Gearing 0.6 0.6

Tax rate 30% 30%

Real pre-tax WACC 4.7% 6.7%

Cost of capital for RNB's second regulatory period DTe

Low High

Cost of debt 5.4% 6.3%

Cost of equity 6.5% 11.2%

Gearing 0.6 0.6

Debt/Equity 1.5 1.5

Tax rate 35% 35%

Average nominal pre-tax WACC

Real pre-tax WACC 4.9% 8.2%

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Netherlands – GTS (gas)

Regulator: DTe

Cost plus regulation

̇ The Market Risk Premium is based on studies of Dimson, Marsh en Staunton, Ibbotson Associates and Siegel. Most weight is placed on the study of Dimson, Marsh and Staunton. The range that DTe proposes is based on the values for the arithmetic and geometric mean. The MRP used is based on the Dutch market and the global market.

comparable companies. The frequency for measuring beta’s is 2 years daily data and 5 years monthly data. The ‘raw’ beta's are corrected with the

Vasicek-correction. To lever and unlever the beta's, the Modigliani-Miller method is used (incl. Tax).

The beta range is consistent with the upper and lower bound provided by the averages of the daily and the weekly estimates.

Cost of capital for GTS

Low High

Cost of debt 4.8% 5.3%

Cost of equity 5.7% 8.0%

Gearing 0.6 0.6

Tax rate 30% 30%

Real pre-tax WACC 4.6% 6.2%

Average pre-tax WACC 5.4%

2006 - 2009

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Section 5

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Netherlands – Post

Regulator: Opta

Price-cap regulation

Section 5 - Netherlands

̇ Method: WACC-formula and CAPM, using the total market return to obtain the MRP.

̇ The risk-free rate is based on Dutch government bonds that have a maturity of more than 5 years. The regulator acknowledges that the investment framework spans more than five years and hence decided to use longer term bonds.

̇ The debt premium is based on the credit ratings of TPG, provided by Standard & Poors and Moody’s.

̇ The market risk premium has been derived from the total market return, which is estimated at 11%. Given the risk free rate of 5%, the market risk premium is equal to 6%.

̇ The beta has been obtained from the ‘Financieel

Dagblad’. The regulator remarks that this is the beta for TPG as a whole and not the specific postal services, but does not make a downward correction since the size of this correction is unknown.

Cost of capital for TPG

Low High

Cost of debt 5.5% 5.5%

Equity bèta 0.76 0.76

Cost of equity 9.6% 9.6%

Gearing 0.6 0.6

Tax rate 35% 35%

2002

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Section 6

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Belgium – Gas distribution network operators

Regulator: CREG

Cost plus regulation

Section 6 - Belgium

̇ For the imbursement of interest bearing debt, the

regulator uses the system of embedded costs, whereby the entire real financing costs for the funds borrowed will be charged through the regulated tariffs.

̇ The risk free rate (as an input in the cost of equity) is based on the arithmetic average of Belgian bonds with a maturity of 10 years and is annually adjusted.

̇ Given the fact that the CREG has not published its consultation document, it is unclear how the market risk premium has been derived.

̇ Also for the beta it is unclear how it is derived. It seems that a fixed value for the beta is assumed, which is only adjusted in case the expected debt / equity structure of the regulated companies change. In case there is not enough free float of the shares, a beta of 1 is assumed. ̇ An additional component that the Belgian regulator

recognizes is the illiquidity premium. Regulated

companies that are not listed on a stock exchange are allowed an additional 20% (relative) on the cost of equity.

Cost of capital CREG 2005

Nominal risk free rate 4.17%

Debt premium n.a.

Cost of debt n.a.

Market Risk premium 3.5%

Equity bèta 1.0

Cost of equity 7.7%

Gearing 0.67

tax rate n.a.

Nominal pre-tax WACC n.a.

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Section 7

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United Kingdom – Electricity (1)

Regulator: Ofgem

Price control regulation

Section 7 - United Kingdom

̇ Method: WACC-formula and aggregate return on equity method, given that CAPM was deemed insufficient in times of parameter instability and would yield results that understate the cost of equity.

̇ The risk-free rate is based on government bonds with a maturity of 5, 10 and 20 years. Ofgem recognizes that the cost of capital is very sensitive to the risk-free rate with the risk-free rate being an important input in both the cost of debt and the cost of equity.

Given this sensitivity and the considerable uncertainty surrounding the expected risk-free rate, with the

likelihood of the risk free rate going up being higher than the likelihood of the risk free rate going down, Ofgem deemed it appropriate to adopt a cautious approach and hence a relatively wide range.

̇ The debt premium is based on comparable bonds and the debt premiums on these bonds. The debt premium also includes a adjustment of 0.4% for ‘embedded debt’. According to Ofgem, the measured debt premiums seemed to be relatively low. Given the fact that there is considerable uncertainty surrounding the expected cost of debt, Ofgem has adopted a relatively wide range for the debt premium.

̇ The beta has been measured using the beta’s of

Cost of capital Ofgem

Low High

Real risk free rate 2.70% 2.70%

Cost of debt 4.10% 4.1%

Market risk premium 4.8% 4.8%

Cost of equity 7.5% 7.5%

Gearing 0.575 0.575

Tax rate 30% 30%

Real pre-tax WACC 6.9% 6.9%

Average real pre-tax WACC

Cost of capital Ofgem

Low High

Cost of debt 4.1% 4.5%

Cost of equity 5.5% 6.5%

Gearing 0.5 0.5

Tax rate 30% 30%

Real pre-tax WACC 6.0% 6.9%

Average real pre-tax WACC 6.4%

2005 - 2010

6.9%

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United Kingdom – Electricity (2)

Regulator: Ofgem

Price control regulation

Scottish Power, Scottish & Southern and United Utilities. Ofgem recognizes that the beta’s significantly

decreased during the last couple of months. They raise the question whether this is due to changes in the actual risk profile of these companies or whether this decrease might be the result of other factors.

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United Kingdom – Water (1)

Regulator: Ofwat

Price control regulation

̇ Ofwat calculates the WACC using the standard WACC formula and the CAPM model for estimating the cost of equity, but supplemented this with additional evidence from other sources, including direct evidence from the markets which they have used to assess the robustness of CAPM derived parameters.

̇ Ofwat assumes a single cost of capital for the industry as a whole, but allows a small company premium on the cost of capital ranging from 0.3% to 0.9% post tax. ̇ Ofwat based its risk free rate on a period average level

of yields on medium-term index linked gilts rather than more recent yields which appear historically low.

̇ The debt spreads on publicly traded debt issued by the water companies are lower than has been typical over recent years. Ofwat recognises that the bottom of the measured range would represent very low borrowing costs. The current very low debt spreads are unlikely to be sustained throughout the next regulatory period and there is much greater risk that spreads will rise over the period than that they will remain unchanged or fall. ̇ The regulator acknowledges that beta’s have been

declining over recent years and are currently at

historically low levels. However, Ofwat does not believe that the low beta factors reflect a real decrease in the

Cost of capital Ofwat

Low High

Cost of debt 3.30% 4.4%

Cost of equity 6.5% 8.0%

Gearing 0.55 0.55

Tax rate 30% 30%

Real pre-tax WACC 6.0% 7.6%

Cost of capital Ofwat

Low High

Cost of debt 4.0% 5.0%

Cost of equity 4.6% 6.2%

Gearing 0.5 0.6

Tax rate 30% 30%

Real pre-tax WACC 5.4% 6.7%

2005 - 2010

6.8%

2000 -2005

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United Kingdom – Water (2)

Regulator: Ofwat

Price control regulation

riskiness of the water sector but are more likely a statistical product of the increase in market volatility. In line with the approaches taken by other regulators and the Competition Commission, Ofwat has decided to use an expectation of a beta of 1 in their cost of capital assessment.

̇ With respect to the cost of equity, Ofwat states that using the CAPM model might not yield the most reliable outcomes. They also consider the dividend growth model, but eventually look at the total return on equity. The total return on equity, according to Ofwat, has proved to be, over reasonably large samples, fairly stable over time and across different markets.

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United Kingdom – Telecom (1)

Regulator: Ofcom

Price control regulation

̇ Ofcom bases future estimates of the risk free rate on prevailing market rates at the time of publication (using a number of months’ data in order to avoid very short-term fluctuations). However, during this specific review they recognised that applying this methodology would result in a historically low risk free rate. Given the current market circumstances, Ofcom decided that the use of a slightly higher risk free rate would be more appropriate. Ofcom believes that there is merit in considering a long term view of the risk free rate where the evidence suggests that current estimates may be below the long term average.

̇ Also for the debt premium, Ofcom decided that current low yields are not representative for the future. They have adopted a debt premium which is 0,4% above the, at that time, current debt premium.

̇ Ofcom based its cost of equity on its assessment of an appropriate balance between encouraging investment and short-run consumer protection. Ofcom looked at several studies, from e.g. Dimson, Marsh and Staunton, and came up with a range of 3% to 5% based on the geometric and arithmetic means of both historical and

Cost of capital Ofcom BT's copper access business

Low High

Nominal risk free rate 4.60% 4.60%

Cost of debt 5.60% 5.6%

Equity beta 0.9 0.8

Cost of equity 8.7% 8.3%

Gearing 0.35 0.30

Tax rate 30% 30%

Nominal pre-tax WACC 10.0% 10.0% Average nominal pre-tax WACC

Cost of capital Ofcom BT's other business

Low High

Nominal risk free rate 4.60% 4.60%

Cost of debt 5.60% 5.6%

Equity beta 1.2 1.1

Cost of equity 10.1% 9.7%

Gearing 0.35 0.30

Tax rate 30% 30%

Nominal pre-tax WACC 11.4% 11.4% Average nominal pre-tax WACC 11.4%

2006 - 2009

10.0%

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United Kingdom – Telecom (2)

Regulator: Ofcom

Price control regulation

adjusted historical market risk premiums. The regulator outlined its belief that the downside of setting a market risk premium too low is worse than the downside of setting the market risk premium too high. Hence the use of a market risk premium that is in the upper half of the measured bandwidth.

̇ Ofcom has calculated two beta’s for BT: one for its copper access business, which is considered to be less risky, and one for its other business(es). The beta estimates are calculated both from daily and monthly observations. Besides this, Ofcom’s view is also that some weight should be given to beta estimates measured against international indices in addition to domestic ones.

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United Kingdom – Post

Regulator: Postcomm

Price control regulation

̇ Postcomm shares the concerns of other regulators that the current return on government bonds may not be sustainable. Current returns may reflect a mismatch between supply and demand for government index-lined debt that could easily disappear over the period of the price control. In setting the real risk free rate, Postcomm decided to put more weight on longer term historical yields.

̇ The debt premium is set at 0,5%. No further information on this parameter is provided.

̇ The market risk premium is based on the results from academic studies and decisions recently taken by other regulators. Within the applicable range, Postcomm has chosen to err on the side that is more likely to be generous to the post companies.

̇ The beta estimate is based on the estimates other regulators have recently used and the results from a peer group analysis that Postcomm performed. The final estimate is right at the very top end of the range of beta estimates allowed in periodic reviews of other UK regulated businesses. This again results in an equity beta near or around 1.

The initial market risk premium range was 3,5% - 5%. However, Postcomm deemed it more appropriate to put more weight on the higher end of this range and moved the range to 4% - 5%.

In the Postcomm consultation document the range 3,5% -5% is shown in the calculations, which results in an average nominal pre-tax WACC of 7,8%. They then state to have adopted a WACC of 8,0%.

Cost of capital Postcomm

Low High

Cost of debt 3.00% 3.0%

Cost of equity 5.7% 7.2%

Gearing 0.20 0.20

Tax rate 30% 30%

Nominal pre-tax WACC 7.2% 8.8% Average nominal pre-tax WACC

2006

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United Kingdom – Civil Aviation

Regulator: Civil Aviation Authority

Price control regulation

̇ The cost of debt is based on a study that the CAA has conducted on the actual and projected financing costs of the licensed business(es) of NATS.

̇ The market risk premium is based on the results from academic studies and decisions on the market risk premium taken by other regulators. The bandwidth for the market risk premium is 3.5% to 5% and CAA has adopted a market risk premium that is slightly above the midpoint of this range (4.5%).

̇ The beta estimate is quite arbitrarily set at 0.6. The assumption here is that the beta for NATS should fall between that of water or electricity distribution

companies and the airports sector. CAA has decided that an asset beta of 0.6 adequately reflects the risks that shareholders bear.

Cost of capital CAA National Air Traffic Services

Low High

Cost of debt 3.9% 3.9%

Cost of equity 8.3% 10.8%

Gearing 0.64 0.64

Corporate tax rate 30% 30%

Effective tax rate 18% 18%

Real pre-tax WACC 5.9% 6.9%

Adopted real pre-tax WACC

Cost of capital CAA

Heathrow, Gatwick, Stansted and Manchester Airports' price caps

Low High

Cost of debt 3.8% 3.8%

Cost of equity 5.6% 6.9%

Gearing 0.30 0.20

Corporate tax rate 30% 30%

Effective tax rate 15% 15%

Real pre-tax WACC 6.7% 8.6%

Average real pre-tax WACC 7.6%

2003 - 2008 2006 - 2010

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Section 8

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Finland – Mobile telecom

Regulator: Ficora

Price control regulation

Section 8 - Finland

̇ Frontier Economics has advised the Finnish

Communications Regulatory Authority in setting the cost of capital for Finnish mobile telecommunications

networks.

̇ Ficora based its risk free rate on the average yield on a 10 year Finnish government bond, measured over a period of 2 and 5 years.

̇ The debt premium is based on the debt premiums in place for a number of appropriate comparators. ̇ The analysis on the market risk premium takes into

account the survey evidence from UK financial institutions and the estimates of US market risk

premium from academic models of MRP expectations. The upper end of the range is consistent with the international evidence on the arithmetic and geometric mean and other survey evidence on the MRP.

̇ The beta is derived using the beta’s of listed comparable companies. A Blume adjustment is applied to the

measured ‘raw’ beta. The measuring frequency is both monthly and daily data over 4 years and 11 months.

̇ Frontier Economics suggests that Ficora considers the

application of a small firm premium.

Cost of capital Ficora

Low High

Cost of debt 5.3% 5.8%

Cost of equity 9.5% 12.7%

Gearing 0.3 0.1

Tax rate 29% 29%

2006 - unknown

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Finland – Gas transmission network operators

Regulator: Energy Market Authority

Rate of return regulation

Section 8 - Finland

̇ The cost of capital is calculated using the standard WACC formula and the CAPM model for estimating the cost of equity, where an additional risk premium is included to take into account the specific risks for the gas transmission network operators in Finland.

̇ EMA states that the investment horizon for equity should be several years, which justifies the use of the yields on longer term bonds as a proxy for the risk-free rate, whereupon the maturity of the bond will then

correspond to the length of the investment horizon of an equity investment.

Based on expert options, the EMA will use the average yield on a five-year Finish government bond in May of the previous year.

̇ The debt premium is determined at 0.6%. ̇ Based on expert opinions, without giving further

clarification on who these experts are, EMA applied a market risk premium of 5%.

̇ Based on expert opinions, without giving further

clarification on who these experts are, EMA applied an asset beta of 0.3.

The table above is taken from a working document of the Energy Market Authority, entitled ‘Guidelines for

assessing reasonableness in pricing of natural gas transmission network operations for 2005 – 2009’. We have not been able to verify whether the numbers shown above have actually been used in the final cost of capital.

The tax rate to be used by the EMA has been estimated to be 29%, similar to the tax rate provided in the Frontier Economics report for Ficora.

Cost of capital EMA

Low High

Cost of debt 4.1% 4.1%

Additional risk premium 3.0% 3.0%

Cost of equity 8.3% 8.3%

Gearing 0.2 0.2

Tax rate 29% 29%

2005 - 2009

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Finland – National transmission network operators

Regulator: Energy Market Authority

Rate of return regulation

Section 8 - Finland

̇ EMA states that the investment horizon for equity should be several years, which justifies the use of the yields on longer term bonds as a proxy for the risk-free rate, whereupon the maturity of the bond will then

correspond to the length of the investment horizon of an equity investment.

Based on expert options, the EMA will use the average yield on a five-year Finish government bond in May of the previous year.

̇ The debt premium is determined at 0.6%. ̇ Based on expert opinions, without giving further

clarification on who these experts are, EMA applied a market risk premium of 5%.

̇ Based on expert opinions, without giving further

clarification on who these experts are, EMA applied an asset beta of 0.3.

The table above is taken from a working document of the Energy Market Authority, entitled ‘Guidelines for

assessing reasonableness in pricing of national transmission network operations for 2005 – 2007’. We have not been able to verify whether the numbers shown above have actually been used in the final cost of capital.

The tax rate to be used by the EMA has been estimated to be 29%, similar to the tax rate provided in the Frontier Economics report for Ficora.

Cost of capital EMA

Low High

Cost of debt 4.1% 4.1%

Cost of equity 5.7% 5.7%

Gearing 0.4 0.4

Tax rate 29% 29%

2005 - 2007

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Section 9

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Australia – Electricity transmission network

Regulator: ACCC

Revenue cap

Section 9 - Australia

̇ The risk free rate is measured as the 10 day moving average for the 10 year nominal Commonwealth bond as per the decision date.

̇ The debt premium is, per the date of the decision, derived from the 10 day moving average benchmark debt margin over the government bond yield for comparable corporate bonds with a term of 10 years. ̇ The ACCC recognises that there is substantial amount

of research undertaken on the MRP, but that there still is continuing debate as to the appropriate value. The Energy Market Reforms Forum indicated that the MRP has fallen to 3% - 4% over recent years. However, the ACCC is cautious that this may partially reflect short-term market trends and opts for maintaining its current estimate.

̇ The regulator noted that measured beta’s for comparable firms have fallen significantly and that, given the uncertainty surrounding the beta, they decided to adopt a conservative equity beta value of one.

Cost of capital ACCC for EnergyAustralia

Low High

Cost of debt 6.9% 6.9%

Cost of equity 12.0% 12.0%

Gearing 0.6 0.6

Tax rate 30% 30%

Franking credit value 0.50 0.50

2006 - 2010

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Australia; Victoria – Electricity distribution (1)

Regulator: Office of the Regulator-General

Revenue cap

̇ The ORG used the average of the observed yields on Commonwealth Government inflation-linked bonds over the 20 day period ending on 31 July 2005 as the real risk-free rate. They used a linear interpolation to derive a proxy for the yield for an instrument with a remaining term of exactly 10 years.

̇ The debt premium is, per the date of the decision, derived from the average of the 20 day period

benchmark debt margin over the government bond yield for comparable corporate bonds with a term of 10 years. Additional to the debt premium a small premium is added to reflect debt raising transaction costs.

̇ In setting the market risk premium, ORG made sure that the value did not understate the expected market risk premium. Rather than placing sole weight on any single methodology, ORG has used historical observations, calculated an implied market risk premium from current share prices and took into account assumptions about investors’ expected growth in dividends.

Cost of capital ORG

Low High

Real Risk Free Rate 2.6% 2.6%

Cost of debt 4.1% 4.1%

Cost of equity 8.6% 8.6%

Gearing 0.6 0.6

Tax rate 30% 30%

Real pre-tax WACC 8.4% 8.4%

Cost of capital ORG

Low High

Real Risk Free Rate 3.5% 3.5%

Cost of debt 5.0% 5.0%

Cost of equity 9.5% 9.5%

Gearing 0.6 0.6

Tax rate 30% 30%

Real pre-tax WACC 9.7% 9.7%

Average nominal pre/tax WACC 9.7%

2006 - 2010

8.4%

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Australia; Victoria – Electricity distribution (2)

Regulator: Office of the Regulator-General

Revenue cap

̇ The regulator acknowledges that beta’s have fallen considerably since the last regulatory period and makes the remark that these changes are unlikely to be the result of a decrease in the risk profile of the electricity companies. In view of the problems with interpreting recent market evidence and the regulator’s view of the importance of creating a stable, predictable and

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Section 10

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New Zealand – Gas services

Regulator: Commerce Commission

Price control

Section 10 - New Zealand

̇ The risk free rate is obtained by taking the one-month average on a 3-year government bond.

̇ The debt premium is based on the actual premiums that the businesses pay on top of the risk free.

̇ The market risk premium is based on a study into historical evidence from several academic studies, as well as international markets.

̇ The beta is based on the beta’s obtained from a peer group analysis, consisting mainly of US companies. Additional upward adjustments have, quite arbitrarily, been applied to take into account the different regulatory system and the risk profile of the New Zealand gas businesses compared to US electricity lines businesses.

Commerce Commission

Low High

Cost of debt 6.2% 6.2%

Cost of equity 9.2% 9.2%

Gearing 0.4 0.4

Tax rate 33% 33%

2005 - 2007

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New Zealand – Lines businesses

Regulator: Commerce Commission

Price control

Section 10 - New Zealand

̇ The risk free rate is obtained by taking the one-month average on a 3-year government bond.

̇ The debt premium is based on the actual premium that has been calculated for the gas services.

̇ The market risk premium is based on a study into

historical evidence from several academic studies, using data on the New Zealand, US and international markets. The market risk premium is also chosen so that it is in line with the MRP for the gas services.

̇ The beta is based on the beta’s obtained from a peer group analysis, consisting solely of US companies. An additional upward adjustments has, quite arbitrarily, been applied to reflect the difference in regulatory regime.

Commerce Commission

Low High

Cost of debt 7.5% 7.5%

Cost of equity 10.4% 10.4%

Gearing 0.4 0.4

Tax rate 33% 33%

2006 - 2008

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Section 11

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Additional premiums

Section 11 - Overview other regulatory decisions

Regulator / date Reasons given for premium Premium to the WACC CREG (2004) - Illiquidity of non-listed companies 20% additional return

on the cost of equity Ofwat (2004) - Higher equity trading costs 0.3% - 0.9% premium

- Costs of raising debt and equity capital on the post-tax WACC Ofgem (2002) - Relative small company size 0.8% premium on

- Cross-reference to 2000 Competition post-tax cost of

Commission decision equity

Oftel (2002) - Oftel suggested a small firm premium 1.35% premium on for mobile service providers, no specific post-tax cost of

reason provided equity

Competition - Impact of lower trading liquidity on cost 1% premium on

post-Commission (2000) of Equity tax cost of equity

- Market evidence on the impact of company Cost of debt 0.9% higher size on the cost of debt for small companies Ofwat (1999) - More limited access to capital markets 0.4% - 0.75% premium

- Lower liquidity on post-tax WACC

- Higher issue costs

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Gearing and beta estimates

Regulator Case Gearing Equity beta Asset beta Basis for decision

DTe 2005, TenneT 60% 0.58 0.28 lower one of the 2 year daily and 5 year weekly Bayesian adjusted beta estimates based on comparator companies DTe 2005, GTS 60% 0.43 - 0.59 0.21 - 0.29 2 year daily and 5 year weekly Bayesian adjusted beta

estimates based on comparator companies

DTe 2005, RNBs 60% 0.47 - 0.74 0.23 - 0.36 2 year daily and 5 year weekly Bayesian adjusted beta estimates based on comparator companies

CREG Gas, 2005 67% 1.0 n.a. n.a.

Ofgem Electricity, 2004 57.5% 1.0 n.a. Cautious approach, equity beta of 1 assumed due to instability of the underlying parameters

Ofwat Water, 2004 55% 1.0 n.a. Cautious approach, equity beta of 1 assumed due to instability of the underlying parameters

Ofcom Telecom, 2005 30% - 35% 0.8 - 0.9 n.a. 2 year daily and monthly raw beta estimates based on comparator companies

Postcomm Postal services, 2005 20% 0.81 - 0.94 0.65 - 0.75 Beta estimates based on comparator companies, midpoint of range is 'guesstimated' not calculated. Measurement unknown. Ficora Mobile telecom, 2005 10% - 30% 1.4 - 1.43 1.1 - 1.3 4 years and 11 months monthly and daily Blume adjusted

beta estimates based on comparator companies

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Gearing and beta estimates

Regulator Case Gearing Equity beta Asset beta Basis for decision

Competition Telecom, 2003 10% 1.0 - 1.6 1.11 - 2.11 Daily and monthly beta estimates for BT and O2 Commission

Competition BAA, 2002 25% 0.8 - 1.0 0.6 - 0.75 5 year monthly Bayesian adjusted beta estimates

Commission for BAA adjusted upwards because of increased future risk

Ofgem Transco, 2001 62.5% 1.0 0.38 5 year monthly Bayesian adjusted beta estimates for comparable UK utilities

Competition Sutton and East 50% 1.0 0.5 5 year monthly and 5 year and 1 year daily beta estimates for Commission Surrey Water, 2000 water, electricity and gas sectors

Competition Mid-Kent Water, 2000 50% 1 0.5 5 year monthly and 5 year and 1 year daily beta estimates for

Commission water, electricity and gas sectors

ORR Railtrack, 2000 50% 1.1 - 1.3 0.55 - 0.65 5 year monthly Bayesian adjusted beta estimates for Railtrack and comparable UK utilities

Ofgem NGC, 2000 60% 1.0 0.4 5 year monthly Bayesian adjusted beta estimates for NGC and comparable companies, and regulatory precedent from Ofgem, Ofwat and ORR

Ofgem PES, 1999 50% 1.0 0.5 5 year monthly Bayesian adjusted beta estimates Ofwat Water, 1999 50% 0.7 - 0.8 0.35 - 0.4 5 year monthly Bayesian adjusted beta estimates

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For further information please contact: Professor Dr Jan Willem Velthuijsen Tel. no.: +31 20 568 6993

e-mail: jan.willem.velthuijsen@nl.pwc.com

http://www.pwc.com/

GUIDANCE NOTE: Please use the relevant copyright statement for each territory if different from the statement below.

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Appendix 1

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Information sources

Appendix 1 - Information sources

Reports and other used documents:

- Australian Energy Regulator (2006). Directlink Joint Venturer Application for Conversion and Revenue Cap. Decision.

- Australian Energy Regulator (2005). NSW and ACT transmission network revenue cap. Energy Australia 2004-05 to 2008-09. Decision. - Australian Competition & Consumer Commission (2004). Statement of principles for the regulation of electricity transmission revenues.

Decision.

- Australian Competition & Consumer Commission (2003). Final Determination for model price terms and conditions of the PSTN, ULLS and LCS services.

- Australian Competition & Consumer Commission (2004). Final decision. Airservices Australia. Price Notification.

- Australian Competition & Consumer Commission (2002). Decision. Australian Rail Track Corporation. Access Undertaking. - Aurtorité de Régulation des Communications électroniques et des Postes (2005). Décision no 05-1079 de ARCEP en date du 6

décembre 2005 fixant le taux de rémunération du capital employé pour évaluer les coûts et les tarifs des activité fixes régulées de France Télécom pour les années 2006 et 2007.

- Civil Aviation Authority (2001). Economic regulation and the Cost of Capital

- Commerce Commission (2005). Determination for TSO Instrument for Local Residential Service for period between 1 July 2002 and 30 June 2003.

- Commerce Commission (2002). Final Report, Part IV Inquiry into Airfield Activities at Auckland, Wellington, and Christchurch International Airports.

- Commerce Commission (2004). Gas Inquiry 2004.

- Commission de régulation de l’énergie (2005). Expose des motifs.

- Commission de régulation de l’énergie (2005). Proposition tarifaire pour l’utilisation des résaux de distribution de gaz naturel. - Commission de régulation de l’énergie (2005). Proposition de la Commission de régulation de l’énergie du 26 octobre 2005 du tarif

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Information sources

- Consignia (2002). Allowed profit I: Cost of capital – for the UK Inland Mails business of Consignia. Paper prepared for Postcomm’s review of the price control for 2003.

- Frontier Economics (2005). Cost of capital for mobile telecommunications networks in Finland. A working paper prepared for Fictora. - Frontier Economics (2006). The cost of capital for TenneT. A report for DTe.

- Lally, M. (2005). The Weighted Average Cost of Capital for Electricity Lines Businesses, paper prepared for the Commerce Commission. - Ofcom (2005). Ofcom’s approach to risk in the assessment of the cost of capital.

- Office of the Rail Regulator (2000). The periodic review of Rail Track’s access charges: Final conclusions. - Ofgem (2004). Electricity Distribution Price Control Review. Final Proposals.

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Information sources

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Appendix 2

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Glossary of terms and abbreviations

Term

Definition

Appendix 2 - Glossary of terms and abbreviations

̇ rf Risk-free rate

̇ rd Pre-tax debt premium

̇ re Equity premium

̇ rm Market return

̇ ra unlevered cost of capital

̇ a asset bèta ̇ e equity bèta ̇ d debt bèta ̇ T Tax ̇ D Debt ̇ E Equity

̇ WACC Weighted Average Cost of Capital

̇ MRP Market risk premium

̇ Credit Spread Additional charge on the risk free rate that debt providers request in order to be compensated for the additional risk

TenneT TSO Comparison study of the WACC

TenneT TSO

Comparison study of the WACC

Table of Contents

Section 1

Important notices

Section 2

Management summary (1)

Management summary (2)

Management summary (3)

Management summary (4)

Section 3

Introduction and background

Section 4

Netherlands – Transmission System Operator

Regulator: DTe

Revenue control

Netherlands – Electricity distribution companies

Regulator: DTe

Revenue control

Netherlands – GTS (gas)

Regulator: DTe

Cost plus regulation

Section 5

Netherlands – Post

Regulator: Opta

Price-cap regulation

Section 6

Belgium – Gas distribution network operators

Regulator: CREG

Cost plus regulation

Section 7

United Kingdom – Electricity (1)

Regulator: Ofgem

Price control regulation

United Kingdom – Electricity (2)

Regulator: Ofgem

Price control regulation

United Kingdom – Water (1)

Regulator: Ofwat

Price control regulation

United Kingdom – Water (2)

Regulator: Ofwat

Price control regulation

United Kingdom – Telecom (1)

Regulator: Ofcom

Price control regulation

United Kingdom – Telecom (2)

Regulator: Ofcom

Price control regulation

United Kingdom – Post

Regulator: Postcomm

Price control regulation

United Kingdom – Civil Aviation

Regulator: Civil Aviation Authority

Price control regulation

Section 8

Finland – Mobile telecom

Regulator: Ficora

Price control regulation

Finland – Gas transmission network operators

Regulator: Energy Market Authority

Rate of return regulation

Finland – National transmission network operators

Regulator: Energy Market Authority

Rate of return regulation

Section 9

Australia – Electricity transmission network

Regulator: ACCC

Revenue cap

Australia; Victoria – Electricity distribution (1)

Regulator: Office of the Regulator-General

Revenue cap

Australia; Victoria – Electricity distribution (2)

Regulator: Office of the Regulator-General

Revenue cap

Section 10

New Zealand – Gas services

Regulator: Commerce Commission

Price control