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Level 7, 261 George Street Sydney NSW 2000 www.guerdonassociates.com ABN 67 112 483 940 Tel +61 2 9270 2900 Fax +61 2 9270 2999 17 February 2016 Risk-adjusted Excess Total Shareholder Return Methodology Summary To promote transparency between executive pay and shareholders, it is important that the methods used to measure long-term performance are clearly explained. Spark Infrastructure uses risk-adjusted excess Total Shareholder Return (TSR), relative to the S&P/ASX 200, to determine the percentage of an executiveβs Long Term Incentive (LTI) that will vest. The measure used to determine risk-adjusted excess TSR used is Jensenβs alpha (πΌ). Alpha incorporates an adjustment for the relative risk of the security, in the same way that investment markets do. Specifically, Spark uses a 4-year period over which its risk-adjusted excess TSR is tested against a peer group. A grant is made on a certain date, and 4 years later, risk-adjusted excess return is assessed to determine the percentage of the grant that will vest. The peer group used is the S&P/ASX 200 companies at the date the grant is made. If companies in this group cease to trade during the performance period, they are removed from the peer group, as they can no longer serve as a point of comparison. The methodology below breaks down the process used to calculate risk-adjusted TSR and the resulting Spark ranking and vesting outcome. As with other forms of TSR calculations, these calculations use data that is publicly available. This ensures that the percentage of an LTI that vests is not based on discretion or a judgement call. It is based on transparent, factual risk and return data and a well-established process. Rationale for using risk-adjusted TSR measures Investors know that risk and return are related to each other. In general, if risk is high, then there is an expectation of higher returns, and vice versa. Investors in Spark securities generally want stable returns and lower than average risk. Ideally, Sparkβs long-term performance would be benchmarked against a group of similar companies, with equivalent risk and return expectations. However, because there are too few of these to form a viable peer group, a broader group of companies is required. The S&P/ASX 200 was chosen because it is a well-established benchmark in relation to Australian securities. However, it introduces many companies with significantly higher systemic risk than Spark. In fact, Spark is ranked below the 10th percentile within the S&P/ASX 200, based on beta (π½), the measure of systemic risk used to calculate πΌ . There are many factors influencing returns, including systemic risk (e.g. economic and political) and non-systemic risk (e.g. management skills and judgement). If we can adjust for the systemic risk, then the variability in adjusted returns should be more strongly related to management performance. TSR (share price appreciation + dividends), though commonly used to benchmark longterm performance, fails to take into account the riskiness of an investment in a particular company. For example, two companies could have the same shareholder return, but one may be much riskier than the other. While it is a common method, it is unfair to deliver higher reward to executives who achieve returns that put investor capital more at risk than executives who deliver the same return for less risk. Ranking companies by their risk-adjusted return, over a specific period, provides a comparison that more closely GLOBAL GOVERNANCE AND EXECUTIVE COMPENSATION NETWORK Sydney β Melbourne Shanghai β Beijing β Singapore - Los Angeles β New York β London β Geneva β Zurich reflects how investment decisions are actually made. That is, when making an investment decision, an investor will have a requirement for a company return that is informed by the perceived risk associated with the company. Methodology The method uses data that is publicly available, so is transparent. Risk is a concept central to calculating risk-adjusted TSR. Spark calculates risk-adjusted excess returns using Jensenβs Alpha (πΌ). The calculation incorporates a measure of a companyβs relative risk called beta (π½) and the risk free rate. The risk free rate is the theoretical rate of return on an investment that has no risk. Although there is no such thing as zero risk, government bond yields are used for the risk free rate because their risk is very close to zero. The risk-adjusted returns formulae are detailed in the following section β The Maths. The following steps describe the process: Step 1: Calculate Beta (π½) Beta is the numerical measurement of a securityβs risk compared to the entire market. The market is defined as the peer companies, being the constituents of the S&P/ASX 200. So, if π½ equals 1 for a certain security, then we know that its return moves inline with market fluctuations. If π½ is greater than 1, the securityβs returns are more volatile than the market. If π½ is less than 1, then the securityβs returns are less volatile. Step 2: Calculate capital asset pricing model (CAPM) required return Required return is the sum of the risk free rate and a risk premium, based on the systemic risk of the security. For this calculation, three numbers are needed: the risk free rate (based on the Australian government bond yield), the average market return for the period, and beta. Step 3: Calculate Alpha (πΌ) πΌ is calculated by subtracting the CAPM required return from the actual TSR of each peer company. This is done for every trading day and then compounded over the performance period. Step 4: Calculate Vesting Peer companies (including Spark) are sorted in descending order based on πΌ and Sparkβs percentile rank is calculated. Vesting is calculated according to the following scale: ! ! ! Percentile rank below 51: 0% of LTI grant vests Percentile rank from 51 to 75: vesting increases on straight-line basis from 30% to 100% Percentile rank above 75: 100% of LTI grant vests 2 The Maths Table 1: Calculating cap-weighted beta Variable Daily return Daily cap-weighted market return Average company returns Average cap-weighted returns Formula π¦! = Note Calculate for each trading day (i) in the performance period for each company in the peer group. i=1 is the first trading day and share price0 is the closing price the day before the performance period. (πβπππ πππππ! + π·ππ£πππππ! ) β1 πβπππ πππππ!!! ! !!!(πππππ¦ πππ‘π’ππ! β ππππππ‘ πππππ‘ππ! ) ! !!!(ππππππ‘ πππππ‘ππ! ) π₯! = π¦= π₯= Cap-weighted beta π½= ! !!! π¦! Calculate for each company, where m is the number of trading days in the performance period. π₯! Where m is the number of trading days in the performance period. π ! !!! Calculate for each trading day in the performance period, where n is the number of peer companies, including Spark. π ! !!!(π₯! β π₯)(π¦! β ! ! !!!(π₯! β π₯) Calculate for each company in the peer group. This is the slope of the best-fit line between daily return and daily cap-weighted market return, where y is the daily return and x is the daily cap-weighted market return and m is the number of trading days in the performance period. π¦) Table 2: Calculating risk-adjusted excess return (πΌ) Variable Average daily risk free rate Formula π= ! Note (1 + π΄πππ’ππ πππ π ππππ πππ‘π ) β 1 Daily CAPM return π! = π + π½ β (π₯! β π) Daily excess return πΌ! = π¦! β π! Risk-adjusted excess return πΌ={ ! !!! Calculate the compound daily risk free rate for the performance period, where m is the number of trading days. The annual risk free rate is the zero coupon forward rate for the performance period from the Reserve Bank of Australia. This is the capital asset pricing model (CAPM) return and is calculated for each trading day in the period for each company in the peer group. Calculate for each trading day in the period for each company in the peer group. Calculate the compound returns for each company in the peer group, where m is the number of trading days in the period. 1 + πΌ! } β 1 Table 3: Calculating percentile rank and vesting outcome Variable Formula/Process Spark rank Order the constituents by risk-adjusted excess return and calculate the Spark ranking from lowest to highest Spark percentile rank πππππ ππππ β 100 ππ’ππππ ππ ππππ π‘ππ‘π’πππ‘π ππ π‘βπ ππππ ππππ’π (π) 0% if the Spark percentile rank is below 51 Percentage vesting 100% if the Spark percentile rank is 75 or higher πππππ πππππππ‘πππ ππππ β 51 β !""%!!"% Guerdon Associates Pty Ltd ABN 67 112 483 940 !"!!" + 30% if Spark ranking is between 51 and 75 www.guerdonassociates.com This document is private and confidential. It is provided for the sole use of Spark Infrastructure. Guerdon Associates is a professional remuneration adviser. For specific accounting, tax and legal advice we recommend advice from specialists in these fields. 3