Utility Regulation in Competitive Markets

Utility Regulation in Competitive Markets

Problems and Progress

Edited by Colin Robinson

This significant new volume contains incisive chapters on a number of prominent concerns, including changes in the British system of utility regulation, the spectrum allocation question, liberalisation of EU energy markets, security of supply issues, reform in the European postal sector, the future of rail regulation, the cost of capital and Ofcom’s strategic approach to regulation. Chapters on each topic are followed by comments from regulators, competition authority chairmen and other experts in the relevant fields. By confronting the most important international developments in utility regulation, the authors offer practical policy recommendations for an effective way forward.

Chapter 7: Cost of capital: some current issues

Julian Franks

Subjects: economics and finance, competition policy, public sector economics

Extract

Julian Franks1 INTRODUCTION This chapter has three themes. First, how should regulators approach the issue of leverage? Can and should they intervene to limit a regulated firm’s leverage, for example, by restricting it if they can, or incentivising the company to do so, if they cannot, in order to maintain minimum credit ratings. If firms cannot maintain adequate credit ratings, is this a signal of excessive leverage or does it reflect an inadequate price cap and rate of return calculated by the regulator? Second, although the capital asset pricing model (CAPM) has become the favoured model for calculating the cost of capital by regulators, there is considerable doubt about its adequacy among finance scholars. The empirical evidence for the CAPM is far from firm and other models are widely used in empirical studies in the academic field. The question is whether regulators should use these other models as a cross-check, at least on the CAPM. Third, given that the cost of capital of a company is a composite one that reflects a variety of risks within the company, should regulators recognise these differences in risk by applying different costs of capital to separate parts of the business? This issue is particularly important when some parts of the business are regulated and others are not, or when the customers of the regulated businesses and the risks of the assets being used are different. Finally, the issue of cost of capital is a very controversial one and...

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