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Morningstar | Ongoing Regulatory Headwinds for AusNet

AusNet Services appears fairly valued at current prices around AUD 1.77, offering a partly franked yield of 5.5%. Distributions should be able to grow in the near term, but there’s risk following its next round of regulatory resets. The regulatory environment will remain tough for the foreseeable future and will limit long-term earnings and distribution growth. There is no change to our AUD 1.65 per security fair value estimate. While AusNet is a solid company, it lacks an economic moat because heavy-handed regulation offsets monopoly benefits. This is highlighted by ongoing regulatory attacks to improve utility bill affordability.

When Australian gas and electricity networks were first privatised, investors were assured of fair treatment as networks could appeal regulatory decisions to an independent tribunal, allowing them to challenge the many assumptions used to set tariffs. The networks were fairly successful in appeals, which helped limit the damage to earnings from tough regulatory decisions, thereby frustrating the government and regulator’s efforts to improve utility bill affordability for households and businesses. Rather than accepting the tribunal’s decisions as fair, the government decided to get rid of the appeals process, known as limited merits review, in 2017. The unfettered regulator can now push even harder to reduce tariffs, at the expense of network investors.

A key recent regulatory change impacting the whole industry is reducing allowed returns. Allowed returns on equity are set using the capital asset pricing model, and by tweaking the economic assumptions therein the regulator is reducing allowed returns on equity to a little more than 6%, down more than 40% over the past 10 years. Additionally, the regulator is cutting allowances to cover interest expense. Previously, it provided enough to cover an interest rate applicable to BBB-rated bonds. Going forward, it will use a mix of BBB and A-rated interest rates to determine allowances.

The regulator is also reducing the amount of money it provides utilities to cover tax, bringing this amount more into line with actual tax payments. This change has more of an impact on distribution networks, compared with transmission networks. Network cash flows have benefited, in timing at least, from the regulator depreciating refurbishment capital expenditure in its calculations while the networks immediately deducted refurbishment capital expenditure in their tax accounts. The former boosts accounting profit and thus the tax allowance provided to the networks, while the latter reduces profit and thus tax payments. In this way, the networks have received more in tax allowances than needed to cover tax payments. However, this is just a timing benefit and the cash flows should reverse over time as assets depreciate faster in tax accounts. Nonetheless, getting more cash now and less later is better because of the time value of money, with surplus cash helping fund reinvestment in networks to drive greater profits.

For under attack utilities, a key positive is that regulatory resets typically only occur once every five years, meaning it takes time for new, unfavourable regulatory changes to impact. AusNet’s next regulatory reset is at its electricity distribution network in 2020, followed by its electricity transmission network in 2022 and small gas distribution network in 2023. In the meantime, asset values continue to grow. AusNet’s regulated asset base, or RAB, is growing by around 3.5% per year to fiscal 2021 due to reinvestment in the networks and inflation. RAB is a key determinant of earnings and growth will partly offset the damage to earnings from lower allowed returns. The firm’s unregulated business will also grow, to an anticipated AUD 1 billion in 2021 from AUD 630 million today, as new wind and solar farms seek connections to the grid. AusNet will also seek further operational efficiencies to reduce costs as much as possible.