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Edited by Michael A. Crew and David Parker
Chapter 7: Regulation and the Cost of Capital
7 Regulation and the cost of capital Tim Jenkinson Introduction The cost of capital is one of the most important factors that regulators, and companies, have to estimate. The appropriate cost of capital for regulated industries has been debated extensively in many countries, in particular the US with its general (although not exclusive) reliance on rate of return regulation. However, in recent years, the cost of capital debate has been particularly active in the UK, where regulation tends to be on the basis of price caps (or, in some cases, revenue caps). This chapter reviews the way that regulators in the UK (including the Competition Commission1) have estimated the cost of capital, and discusses some important issues that remain unresolved. With the regulatory asset values (RAVs) of the UK water, energy and rail networks alone approaching £100 billion,2 even small changes in the allowed return on such asset bases can have significant implications for customer bills. In addition, these are by no means the only assets where the rate of return is regulated: certain airports, parts of mobile phone networks, the air traffic control system, the Royal Mail, and even Yellow Pages are also subject to explicit regulation. Furthermore, in many competition cases, the relationship of the observed rate of return to the estimated cost of capital is a key concern. The main issues discussed in this chapter are closely related. First, we discuss the difficulties observed in practice in estimating risk, and the appropriate equity cost of capital....
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