Estimating the cost of capital: recommendations for UKRN regulatory guidance
Estimating the allowed return on regulatory capital is related to, but distinct from the cost of capital, as it reflects policy decisions overlaid on a technical assessment of the weighted average cost of capital (WACC).
Our report is commissioned by Anglian Water Services Ltd, Heathrow Airport Holdings Ltd, and Scottish Hydro Electric Transmission plc, and responds to the UK Regulators Network (UKRN) consultation on the regulatory guidance on the cost of capital.
We make the following recommendations in our report.
- Consistency in regulatory policy should not mean an inability to respond to sector-specific challenges, where this is warranted by evidence.
- Integration of debt-based cross-checks be formalised in selecting a point estimate from the capital asset pricing model (CAPM) range.
- The total market return (TMR) estimate should be relatively stable through time, with sufficient policy flexibility to respond to significant changes in market conditions. This can be achieved by a weighted average of the Stable TMR and Stable equity risk premium (ERP) approaches, applying a deadband, or an embedded cost of equity. Regulators should consult on the calibration of these policy choices.
- Listed company betas may be biased estimates of the notional company beta, where there is out-/under-performance against notional assumptions. Several options exist for correcting this bias and regulators should investigate these.
- UKRN guidance should specify that consumer welfare is maximised by adopting a point estimate above the mid-point.
- UKRN guidance should not rule out a particular value/range for the CPIH inflation assumptions without a robust evidence base.
These recommendations are detailed in our report, and we consider these necessary, proportionate, and implementable across the aviation, energy, and water sectors.
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Peter Hope, CFA
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