Regulators seek greater alignment on cost of capital

(by Karma Loveday)

The UK Regulators Network (UKRN) is consulting until 19 August on revised guidance for setting the methodology on cost of capital.

This updates its March 2023 guidance to reflect new developments such as higher interest rates and recent Competition and Markets Authority decisions, and to identify areas where further cross-sector alignment can be achieved.

The UKRN said most original recommendations remain appropriate, but there is scope to align further on the detail behind the following recommendations to increase consistency and transparency:

• Recommendation 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. 

• Recommendation 2 – CAPM: Since the cost of equity is not directly observable, it must be estimated using a widely accepted method. Regulators should continue to use the capital asset pricing model (CAPM) as their primary approach for estimating the cost of equity. 

• Recommendation 3 – Gearing: The notional gearing assumption should reflect the regulator’s assessment of the balance of risks facing the regulated company, a wide range of benchmarks on gearing levels, and overall regulatory policy objectives – not just that of the actual company (or companies) in question. 

• Recommendation 4 – Risk-free rate: To estimate the real risk-free rate (RFR) within the CAPM, regulators should use recent yields on index-linked gilts, with a maturity which matches the assumed investment horizon for their sector. 

• Recommendation 5 – Equity risk premium: [This recommendation is under review pending the outcome of this consultation.] 

• Recommendation 6 – Equity beta: Regulators should estimate equity beta for the notional company using comparable listed companies and standard regression techniques. Where the listed comparator has different gearing to the notional company, regulators should continue to de-lever and re-lever the raw equity beta. 

• Recommendation 7 – 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. 

• Recommendation 8 – Cross-checks: Cross checks may be used to sense check the CAPM derived point estimate. However, regulators should only deviate from the mid-point of the CAPM cost of equity range if there are strong reasons to do so. 

• Recommendation 9 – 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. 

The new guidance contained the following areas of increased alignment compared to the 2023 version:  

• Choosing a data cut-off no further back than six months from the publication of final determinations to derive estimates for the risk-free rate and equity beta. 

• Using index-linked gilts as the sole proxy for the risk-free rate assumption.

• Using a one-month averaging period for the risk-free rate assumption (except where there is clear evidence of atypical market volatility in this period). 

• Basing 'ex-post' TMR estimates on a one-year holding period arithmetic average of real equity returns, rather than more complex approaches.

• Using two-, five- and ten-year windows and daily data as a starting point for estimating equity beta.

• Considering novel market cross-checks against a new framework focusing on the dual themes of defensibility and implementability, featured in the 2018 academic review. 

• Reflecting recent evidence on inflation dynamics in the setting of real-terms allowances, to limit the role of forecast risk in driving inflationary gains and losses.

  
  

The UKRN said its purpose remains as in 2023: to promote a common approach where issues are shared across sectors, especially for common parameters and the overall framework for estimating allowed returns, in ultimate pursuit of greater consistency and reduced uncertainty around price control outcomes.

UKRN said its 2023 guidance “has had a demonstrably positive impact… Recent regulatory decisions and methodologies have referenced the UKRN guidance extensively and, particularly around the range of Total Market Return in recent decisions and proxies used to derive Risk-Free Rate, there is markedly closer alignment than prior to the introduction of the guidance.”