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• WACC Estimates

70. WACC is the weighted average cost of debt and equity capital raised at the margin. Like the asset base, it is relevant both for determining prices and for assessing performance. The Commission has determined what it considers to be an appropriate WACC for gas pipeline businesses within New Zealand.^III A discussion of WACC issues is contained in Chapter 9 (Weighted Average Cost of Capital).

71. Key determinants of WACC are the risk-free rate, leverage, debt premium, market risk premium, asset beta and leverage.

• risk-free rate: the Commission has adopted a three-year term for the risk-free rate for gas pipeline businesses on the basis that this most closely proxies the likely time horizon of price setting in the gas pipeline industry. The three-year risk-free rate averaged over July 2003 was 0.050.
• market risk premium: the Commission's conclusion is that the appropriate mid-point estimate for the TAMRP is 0.07.
• beta: the Commission has adopted a mid-point asset beta for the gas businesses of 0.5. Although the characteristics of gas transmission and distribution differ in some respects, there is insufficient information available to justify applying different betas.
• leverage: the Commission has adopted an optimal leverage of 40% based on analysis of comparable businesses. It used this leverage weight in determining the debt premium and in determining WACC.
• debt premium: In determining the debt premium, the Commission has considered the actual premiums that the businesses pay above the risk-free rate, as well as costs to businesses with similar credit risk. The Commission is of the view that a debt margin of 0.012 would be appropriate for the gas businesses assuming 40% leverage.

WACC Estimates

72. A WACC estimate can be derived drawing on the estimates for the various parameters discussed above. These parameter values translate into a cost of equity of 0.092 and a point estimate of WACC of 0.072.

73. The point estimate on WACC reflects five parameters over which there is significant uncertainty i.e., the market risk premium and four components of the asset beta. Such parameter uncertainty results in uncertainty over WACC and this can be formalised in a probability distribution for WACC. In translating the uncertainty over parameter values into a distribution for WACC, it has been assumed that the parameters are independent.

74. Assuming "normality" in the WACC distribution, the percentiles of the WACC distribution are derived as shown for 2003 in Table 4 below:

75. The Commission has used the WACC at the 50th percentile in its base case analysis ("mid-point WACC").

^IIIIn formulating the views expressed on WACC in this Report, the Commission obtained advice from Dr Martin Lally. A copy of his report to the Commission is contained on the Commission's website under Regulatory Control Inquiry on Gas Pipelines.