Cost of debt

On 24 April 2015, we released a final decision on its cost of debt approach. We decided to retain an on-the-day approach in preference to a trailing average cost of debt.

This decision was made after considering all submissions received in response to our issues paper and draft report.

The decision should be read in conjunction with the accompanying technical paper by Dr Martin Lally.

PricewaterhouseCoopers (PWC) developed a methodology for the QCA for estimating the benchmark cost of debt.

The PWC report recommends both appropriate data sources and a methodology for estimating the cost of debt.

The QCA received 3 submissions from interested parties.

The QCA released a final decision paper on 29 August 2014 that provides an outline of the QCA’s future approach to estimating the benchmark cost of debt in future regulatory reviews.

As outlined in this paper, the QCA proposes that the PwC econometric approach be used as the primary method for generating the benchmark cost of debt estimates in future regulatory reviews, with reference made to third party data provider estimates as a ‘cross-check’.

As part of continuing work on other cost of capital related issues, the QCA has reviewed its cost of debt estimation methodology.  In addition to establishing the appropriate data sources and method for measuring the benchmark cost of debt estimate at a point in time, we have also reviewed the theoretical framework for estimating the regulatory cost of debt.

Benchmark cost of debt

Determining the ‘benchmark’ cost of debt requires relevant data and an appropriate methodology.

In Australia, regulators used to rely on estimates from proprietary data providers.  However, this approach has been problematic:

• Debt market data in Australia is limited.
• Data providers’ estimates are not transparent and auditable, as the estimation methodology is not publicly available.

Following the global financial crisis, there were further problems: proprietary data providers’ estimates diverged, some anomalies were noted and some debt tenors were no longer published.

Therefore the QCA and other Australian regulators have investigated alternative methods for estimating the cost of debt.

The QCA’s current framework for estimating the regulatory cost of debt is based on using an ‘on the day’ approach which uses the benchmark cost of debt that is estimated just prior to the start of the regulatory cycle.

Recently, however, several proposals have arisen in regulatory contexts that involve moving away from a strictly ‘on the day’ rate and replacing it with some form of ‘trailing average’ (where the latter can be applied to either the total cost of debt or to only the debt risk premium).

The term ‘trailing average cost of debt’ refers to a moving weighted average of the cost of debt with the weights representing a portion of the total debt of a firm that is assumed to be financed each year.