Regulators consult on common approach to setting the cost of capital

The UK Regulators’ Network (UKRN) has issued the nine recommendations in its newly published draft guidance for regulators on the methodology for setting the cost of capital.

The recommendations

1. Notional company: regulators should continue to estimate the allowed rate of return in price controls based on the weighted average cost of capital for a notionally financed firm within their sector.

2. CAPM: regulators should continue to use the capital asset pricing model (CAPM) as their primary approach for estimating the cost of equity.

3. Risk-free rate: to estimate the real risk-free rate (RFR) within the CAPM, regulators should use recent yields on the index-linked gilts, with a maturity which matches the assumed investment horizon for their sector.

4. Equity risk premium: regulators should estimate the equity risk premium (ERP) within the CAPM as the difference between the total market return (TMR) and the risk-free rate (RFR). The TMR should be primarily based on historical ex post and historical ex ante evidence.

5. Equity beta: regulators should estimate equity beta for the notional company using comparable listed companies and standard regression techniques (i.e. ordinary least squares). Where the listed comparator has different gearing to the notional company, regulators should continue to de-lever and re-lever the raw equity beta.

6. CAPM point estimate: the RFR, TMR and (re-levered) equity beta assumptions should be combined using the CAPM to produce a cost of equity range. The mid-point of the range should be used as the central estimate for the CAPM cost of equity.

7. Cross-checks: regulators should only deviate from the mid-point of the CAPM cost of equity range if there are strong reasons to do so.

8. Cost of debt: regulators should estimate an allowance for an efficient company under the notional financial structure, with actual debt costs suitably benchmarked against other market evidence.

9. Gearing: the notional gearing assumption should reflect the balance of risks facing the regulated company and a wide range of benchmarks on gearing levels, not just that of the actual company (or companies) in question.

The work has been undertaken following BEIS’ review of economic regulation which set out the expectation that regulators would work towards greater consistency, and towards a common methodology for the WACC in setting price controls. The consultation is open until 16 November, and UKRN will publish a final version in early 2023.

UKRN said the guidance was not binding but the expectation is regulators would “commit to having regard to this guidance in their future price control decisions where this is permitted by their statutory duties and deviate only where they consider there are good reasons to depart from it”.

It added that the recommendations should be reviewed periodically.