I agree that these two versions of the present Value principle exist, with the first version merely being that one used by a regulator to operationalise the second version. See section 5.3 of that report for further discussion of this proposal. Consistency with the building block model The NGR prescribe the use of the building block model when the AER is calculating the total revenue allowance. The building block model has a long history in regulation in Australia. An important principle of the building block model is the present value principle. In a 2011 paper on public utility regulation in Australia, Dr Darryl Biggar explained the origins of the building block model and its goals. Lally states: ...the Building Block model requires use of the risk free rate at the beginning of the regulatory period and therefore the rate should be averaged over a short period as close as practical to the start of the regulatory period. Rates averaged over a much longer historical period would be inconsistent with the Building Block model. As this decision is consistent with the present value principle, it is also consistent with the building block model. Consistency with the Capital Asset Pricing Model (CAPM) The AER has applied the CAPM consistently. Envestra proposed the Sharpe-Lintner CAPM be applied for this decision. The AER accepts that proposal. The AER has also ensured that there is consistency within the CAPM. The Sharpe-Lintner CAPM is described by the following equation: (1) E(Ri) = Rf + - Rf] β.[E(Rm) Where: E(Ri) is the return on the investment Rf is the risk free rate is the equity beta β E(Rm) is the expected market return The term in the [ ] brackets can also be simplified to:
I agree that these two versions of the present Value principle exist, with the first version merely being that one used by a regulator to operationalise the second version. See section 5.3 of that report for further discussion of this proposal. Consistency with the building block model The NGR prescribe the use of the building block model when the AER is calculating the total revenue allowance. The building block model has a long history in regulation in Australia. An important principle of the building block model is the present value principle. In a 2011 paper on public utility regulation in Australia, Dr Darryl Biggar explained the origins of the building block model and its goals. Lally states: ...the Building Block model requires use of the risk free rate at the beginning of the regulatory period and therefore the rate should be averaged over a short period as close as practical to the start of the regulatory period. Rates averaged over a much longer historical period would be inconsistent with the Building Block model. As this decision is consistent with the present value principle, it is also consistent with the building block model. Consistency with the Capital Asset Pricing Model (CAPM) The AER has applied the CAPM consistently. Envestra proposed the Sharpe-Lintner CAPM be applied for this decision. The AER accepts that proposal. The AER has also ensured that there is consistency within the CAPM. The Sharpe-Lintner CAPM is described by the following equation: (1) E(Ri) = Rf + β.[E(Rm) - Rf] Where: E(Ri) is the return on the investment Rf is the risk free rate β is the equity beta E(Rm) is the expected market return The term in the [ ] brackets can also be simplified to:
Envestra%20-%20Final%20Decision%20-%20Part%203_0.docx