CAPITAL STRUCTURE ISSUES IN THE ALLOWED RATES OF RETURN OF REGULATED

UTILITIES IN THE PHILIPPINES

Rate Determination:

A Tough Balancing Act

RESEARCH QUESTIONS

What does evidence indicate so far regarding the rates of return that have been determined for the

electricity and water distribution utilities in the country?

How do the actual costs of debt of regulated utilities compare with the cost of debt in their

regulator-prescribed WACC?

How have regulated utilities responded to the prescription of an “optimal” capital structure in the

determination of water and power rates in the Philippines?

DATA AND METHODOLOGY

• financial analysis, using information from the 2007 to 2016 audited financial statements of selected Philippine utilities

• Sample• Water Distribution

• Manila Water Company (MWC)

• Maynilad Water Services Inc. (MWSI)

• Electricity Distribution• Manila Electric Company (MER)

• Visayan Electric Company Inc. (VECO)

ALLOWED RATE OF RETURN FOR PRIVATE ELECTRICITY DISTRIBUTION UTILITIES

• RA 9136 Sec. 43 (f) - In the public interest, establish and enforce a methodology for setting transmission and distribution wheeling rates and retail rates for the captive market of a distribution utility, taking into account all relevant information, including the efficiency or inefficiency of the regulated entities. The rates must be such as to allow the recovery of just and reasonable costs and a reasonable return on rate base (RORB) to enable the entity to operate viably. The ERC may adopt alternative forms of internationally-accepted rate-setting methodology as it may deem appropriate…

RETURN ON RATE BASE METHODOLOGY VERSUS THE PERFORMANCE BASED RATE METHODOLOGY

Note: Corporate income tax in revenue requirement is set to zero in ERC rate decisions, pursuant to Republic vs Meralco (G.R. No. 141314 Nov. 15, 2002)

Source: ERC Case no. 2005-041 dated 12 July 2010

ALLOWED RATE OF RETURN FORMULA

ERC (2009), Rules for Setting Distribution Wheeling Rates for Privately Owned Electricity Distribution Utilities Entering Performance Based Regulation (Fourth Entry Point)

WHY 40%

USA UK “Small Asia”1

Sample 8 4 13

Average 33% 53% 26%

Minimum 27% 46% 0%

Maximum 44% 58% 91%

In the 2013 Rate Rebasing, the RO considered that “40% gearing is reasonable and appropriate for a water utility operating in the Philippines where regulatory

precedent now has a history of 15 years.”

Source of basic data: Bloomberg1 Malaysia, Singapore, Taiwan, Thailand, Vietnam, Philippines

IS THERE AN OPTIMAL LEVEL OF LEVERAGE?

Irrelevance Theory

• A firm’s market structure is independent of its capital structure (Modigliani and Miller 1958)

Tradeoff Theory

• Debt has tax benefits, but exposes a firm to bankruptcy costs.

Pecking Order

• Firms will use internal finance as much as possible before resorting to external finance, and will then use debt sources in preference to equity.

A PREFERENCE FOR DEBT?

• Debt is generally cheaper than equity.

• Debt has tax benefits.

• The cost of financial distress is less explicit.

>> Debt can reduce actual cost of capital, but expose the utility to higher risk of financial distress.

ALLOWED RETURN: 2012 TO 2015 (ERC CASE NO. 2010-069 RC, 6 JUNE 2011)

Low Mid High

Gearing (Debt) ratio 45.00% 40.00% 35.00%

Asset beta 0.276 0.6 0.65

Risk free rate (60-day average, 20

year US$ Bond Yield)4.70% 4.32% 4.57%

Country risk premium 1.21% 1.46% 1.71%

Risk free rate used in WACC 8.80% 9.80% 10.79%

Debt margin 2.00% 2.50% 3.00%

Cost of debt (pre-tax nominal,

peso)10.80% 12.30% 13.79%

Market risk premium 6.00% 6.00% 6.00%

WACC, post tax nominal 11.36% 13.79% 16.17%

WACC, final (75th percentile) 14.97%

Implied Cost of Equity = 16.75%

ALLOWED RETURN, MMLA WATER CONCESSIONAIRES

• Art. 9.4. … the rates for water and sewerage services provided by the Concessionaire shall be set at a level that will permit the Concessionaire to recover over the 25-year term of the Concession … operating, capital maintenance and investment expenditures efficiently and prudently incurred, Philippine business taxes and payments corresponding to debt service on the MWSS Loans and Concessionaire Loans incurred to finance such expenditures, and to earn a rate of return (… “Appropriate Discount Rate”) on these expenditures for the remaining term of the Concession in line with the rates of return being allowed from time to time to operators of long term infrastructure concession agreements in other countries having a credit rating similar to that of the Philippines.

ALLOWED RETURN, MMLA CONCESSIONAIRES

2008-2012 2013-2017

Real Risk-Free Rate 6.30% 2.41%

Equity Beta 1.0 0.83

Market Risk Premium 7.00% 8.27%

Cost of Equity 13.30% 9.30%

Debt Premium 1.50% 2.00%

Tax Rate 31.00% 0.00%

Cost of Debt 5.40% 4.41%

Gearing Ratio 50.00% 40.00%

ADR 9.30% 7.35%MWSS Regulatory Office (Sept 2013), Resolution No. 13-009-CA. In Re: Rate Rebasing Determination for Manila Water Company, Inc. for Charging Years 2013 to 2017

ALLOWED RETURN: IMPACT ON REVENUE REQUIREMENT

Manila Water's Net Future Cash Flows Maynilad's Net Future Cash Flows

2013 to 2037 2013 to 2037

in billion pesos (2013 prices) in billion pesos (2013 prices)

Total Receipts 407.389 100% Total Receipts 672.542 100%

Concession fees, AWTIP &

Regulatory fees 20.216 5%

Concession fees, AWTIP &

Regulatory fees 21.539 3%

Capital Expenditures 149.92 37% Capital Expenditures 234.078 35%

Operating Expenditures 123.241 30% Operating Expenditures 181.812 27%

Working capital and income

tax 1.915 0%

Working capital and income

tax 2.016 0%

Opening Cash Position, at

2013 prices excluding return 8.99 2%

Opening Cash Position, at

2013 prices excluding return 36.51 5%

Total Expenditure 304.282 75% Total Expenditure 475.955 71%

Net Cash Flows to

Concessionaire 103.107 25%

Net Cash Flows to

Concessionaire 196.587 29%

FINDINGS

GEARING RATIOS

Gearing ratios based on book values were higher than the “optimal” gearing based on the regulator-prescribed WACC/ADR; however, for the two companies with stock price information, gearing ratios based on the market values of debt and equity approached the regulator-prescribed ratios.

COST OF DEBT

Actual costs of debt were lower for the electricity utilities vis-à-vis the water utilities. At the same time, allowed rate of return for debt was also higher for the former; thus, allowing them to earn a bigger premium on debt than was prescribed in their WACC.

COST OF EQUITY

MWC MER PSEI

Mean monthly return 1.32% 2.76% 1.09%

Equivalent annual rate 15.86% 33.16% 13.08%

Standard deviation of monthly

returns 7.40% 14.79% 5.68%

Standard error of the estimate 0.61% 1.22% 0.47%

Range of “true” annual return 1.20%-30.51% 3.88%-62.44% 1.85%-24.32%

Regulatory Cost of Equity 11.3% 16.75%

There is some evidence that actual average monthly returns may be higher but also more variable for electricity than for water utilities. Moreover, regulatory costs of equity may be said to be within the range of the true cost of equity for the two distribution utilities under the assumption of normally distributed returns.

CREDIT METRICS

There is evidence that the utilities in the study were strong in the financial metrics used by credit rating agencies to assess default risk (i.e., utilities have adequate cash flow for interest coverage and debt repayment).

CONCLUSIONS AND AREAS FOR FURTHER STUDY

• Sampled utilities’ capital structure policies and decisions seem to indicate a prudent use of leverage.

• With caveat related to limited data, the study finds no evidence that returns given to equity are excessive.

• There is evidence of a rather wide gap between the actual and regulatory-prescribed cost of debt for electricity utilities that may be worth examining further.

• The sample should be extended to determine if the finding of financial strength and prudent use of leverage is not limited to the very large utilities in the study.

• Regulations should be enhanced to encourage utilities to ensure their good credit standing.

THANK YOU