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Risk premium on assets relative to debt

A fundamental principle of finance is that holders of assets, with higher risk, expect a higher return. This principle underlines the financial models (e.g. the capital asset pricing model, CAPM) used by all UK regulators, and regulators in other countries. A breach of this principle would suggest that investors are willing to take on risk without adequate compensation, or even have an appetite for risk, rather than being risk-averse. This would conflict with both theory and empirical evidence that investors are risk-averse.

In our February 2018 report for the ENA on setting the appropriate cost of equity for RIIO-2, we compared the output from a CAPM-based calculation of the cost of equity with evidence from debt markets.

This report develops the evidence base to ensure that the allowed returns, set by the regulator for equity, are commensurate with the risk associated with operating and owning the associated assets. This is intended to help determine whether the building blocks of the CAPM add up to a realistic estimate of the cost of equity capital. While there is much discussion on the individual building blocks of the CAPM—including the riskfree rate, the asset and equity betas and the equity risk premium—there is little discussion on whether the resulting overall cost of equity capital provides a ‘sensible market-based’ result.

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