The Australian 10 year government bond has fallen from 2.7% in 2018 to around 1.0% this quarter. Over the same period of time, there has been a divergence in listed infrastructure stock prices. Transurban has gained around 30%, Sydney Airport has gained around 10% and Spark Infrastructure is down 10%.
Infrastructure assets are often stereotyped as long-lived monopoly assets generating long-term stable cash flows. As such, lower long-term interest rates should provide a benefit, pushing up valuations. The chart above compares Spark Infrastructure – an investor in regulated utilities – with Transurban and highlights the folly of stereotypes. Not all infrastructure assets benefit from lower interest rates. Rather than being thought of as a bond proxy, it is probably better to think of Australian regulated utilities as a lagging floating rate note. In this context, falling risk-free interest rates present a significant challenge for future equity returns, particularly in the context of regulated assets that have historically been purchased at substantial premiums to their regulatory asset base.
For regulated assets, allowable revenues are set by the Regulator and calculated on an allowable rate of the return basis (the regulatory weighted average cost of capital or WACC). Lower interest rates feed through into lower WACCs via both the cost of debt and the cost of equity.
In November 2018 the laws were amended to require the AER to publish binding instruments demonstrating calculations of the regulated WACC that would apply to all regulatory decisions. In December 2018, the AER published guidance on the “Rate of Review Instrument” and an explanatory statement. The Rate of Return Instrument sets out the AER’s approach to estimating the cost of equity and debt. The AER determined that the nominal pre-tax cost of equity in 2018 would have been 6.4%.
Since the last rate of return guidance provided by the AER, base rates have fallen considerably.
The cost of equity is estimated using the CAPM, a component of which is an estimation of the risk-free rate. The risk-free rate is estimated via the 10-year government bond rate and averaged over 20 to 60 consecutive business days on the date prior to the determination of the regulated return. If the AER repeated their determination on the cost of equity today, keeping all other parameters the same, the cost of equity would fall from 6.4% to 4.6% since late 2018.
While, the cost of equity is reset at each regulatory decision, the AER updates the cost of debt on a staggered basis at each regulatory reset. That is, the cost of debt is estimated based on a 10-year trailing average of BBB and A benchmark curves. This means the cost of debt will tend to feed in over time (and presumably – in broad terms – will match the refinancing of the utility’s debt portfolio).
Australian infrastructure equity investors have historically targeted equity IRRs in the low double digits. For Australian investors, this has shifted to the high single digits as base rates and return expectations have fallen. This is in stark contrast to the mechanical application of current regulatory frameworks, at 1% base rates, this would see allowable equity returns fall to sub 5%!
Whether this is fair or not, and whether equity investors were overpaid in the past or not, is a question for another day (and another newsletter article). The key point we would make is that allowable equity returns on Australian regulated assets are likely to fall sharply and, to the extent that these returns fall short of investor expectations, the strong asset value premiums would be expected to dissipate (it is important to remember that most recent Australian transactions have seen investors pay 1.3-1.6x the regulatory asset base).
Furthermore, similar to the experience of UK water investors over the period 2008-10, any investor that is hoping for an investor friendly regulator, in the current politically charged environment regarding electricity prices is likely to be sorely disappointed. The government and regulators on their behalf will be wanting to ensure that the impact of lower base rates flows through to lower network charges to the maximum extent possible.