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The cost of capital is a fundamental consideration in regulated industries, influencing investment decisions, regulatory outcomes, and financial stability. This publication explores 10 hot topics that are currently shaping cost of capital discussions, including climate change objectives, stability and predictability of regulatory approaches, diminishing comparator firms, and competition for the right to supply. It also examines emerging trends, such as the impact of large-scale investments in renewable energy and the challenges of estimating market risk premiums. Backed by extensive research and regulatory case studies from Australia, New Zealand, and the UK, this paper offers valuable insights for policymakers, industry professionals, and investors.
Cost of capital plays a crucial role in determining regulated revenues, investment attractiveness, and financial resilience in capital-intensive industries. This paper identifies and examines 10 key topics currently influencing regulatory cost of capital decisions, including climate change considerations, evolving methodologies for estimating the market risk premium, and the impact of diminishing publicly listed comparator firms. The study provides a comparative analysis of regulatory approaches from key jurisdictions such as Australia, New Zealand, and the UK, offering insights into best practices and emerging challenges. Additional areas of interest include the role of reasonableness checks, financeability testing, and competition in infrastructure investment. By addressing these pressing issues, this publication serves as a resource for regulators, businesses, and investors seeking to understand and navigate the complexities of cost of capital determinations.
The cost of capital is of major importance for infrastructure and utility businesses because they are capital-intensive. The Australian Energy Regulator (AER) estimates that the return on capital is typically about half of the total revenue of the electricity and gas networks itregulates.1
Furthermore, small changes in the cost of capital lead to very large changes in regulated revenues. The AER estimates that a 1% change in the cost of capital results in an 8.2% changeto regulated revenues. Regulated revenues for electricity networks in Australia were $12 billion in 2022, so a 1% change in the cost of capital would shift revenue by about $1 billion.
Consequently, estimates of thecost of capital are strongly contested. Consumers and regulated businesses tryto persuade regulators to employ lower or higher values. This has generated debate across almost all elements of the cost of capital and there is rich and extensive literature on the subject, including litigation in the courts.
In more recent times (at least in Australia and New Zealand), the field of debate has narrowed as approaches have become more settled. There is still active engagement on a range of hot topics including:
In this paper, I first provide an overview of each of the 10 hot topics. In the second half ofthe paper, I briefly touch on a range of other topics that did not make the top 10.
The terminology in this space is often truncated and used imprecisely. For the most part,this doesn’t seem to matter much because the meaning can usually be ascertained from the context (especially where formulae are employed). However, in some situations, precisionis critical.
For the purposes of this paper, I will use the term Cost of Capital to refer to the cost to afirm of raising debt and equity capital. This is termed the weighted average cost of capital(WACC). The rate of return is the other side of the coin; it is the return investors expect from providing capital to a firm. Regulators typically try to set the rate of return used in their determinations to match the cost of capital the firm faces, so the distinction does not bindin our context.
There are myriad subcategories that can arise. For example, returns can be realized,expected, or required; they can be pre-tax or post-tax, nominal or real. Where precisionmatters, I will spell it out.
Key regulatory decisions
In this paper, I have focused on the:
• New Zealand Commerce Commission (NZCC) – new Input Methodologies publishedDecember 2023
• Australian Energy Regulator (AER) – new Rate of Return Instrument published February2023; and
• Ofgem Network price controls 2021-2028 (RIIO-2)
There are many topics that could be included in the top 10, and different analysts are likely to have different choices. The following are the topics that seem most important and relevant in my view.
Many countries now include climate change objectives in their utility regulation. In New Zealand, the Climate Change Response (Zero Carbon) Amendment Act (the Zero Carbon Act) applies. The NZCC explicitly considered this legislation in its 2023 review ofthe Input Methodologies.
The NZCC considered this aspect from two perspectives:
In conclusion, the NZCC decided that specific adjustments to the cost of capital were not necessary. Instead, itpointed to the flexibility in the regulatory determinations to respond appropriately. It highlighted adaptability in demand and expenditure forecasts (including expenditure to increase resilience) and pass-through mechanisms andre-openers. It did make some adjustments to increase the flexibility availablein these mechanisms.
In Australia, the National Electricity, Gas and Retail Laws were amended in September 2023 to introduce an energy emissions objective. The addition is included in section 7(c):
The objective of this Law is to promote efficient investment in, and efficientoperation and use of, electricity services for the long-term interests of consumersof electricity with respect to —
(a) price, quality, safety, reliability and security of supply of electricity; and
(b) the reliability, safety and security of the national electricity system; and
(c) the achievement of targets set by a participating jurisdiction —
(i) for reducing Australia's greenhouse gas emissions; or
(ii) that are likely to contribute to reducing Australia's greenhouse gasemissions.
The AER’s most recent decisions were almost finalized before the legislation came intoeffect, but the amendments were anticipated in the proposals it received and its decisions.The results are most evident in forecasting and resilience expenditure.
It is common to see different regulators taking different approaches to key elements of the cost of capital. At times these differences can be quite material. Nevertheless, once anapproach is employed there is considerable momentum to continue the chosen approach. The AER provides a clear example of this momentum. In its process, both consumers and regulated businesses submitted there should be a “high barfor change”. The AER went on to explain the outcome of its considerations as follows:
We did not enter this process with the expectation of making only minimal changes.Instead, we have undertaken an extensive and open review, exploring all aspectsof the rate of return in detail. As we progressed through our review, we found thatthe approach outlined in the 2018 Instrument is supported by data and financial principles
When considering our decision, the approach in the 2018 Instrument has deliveredoutcomes that are align with the relevant risks. Therefore, we believe the NEO andNGO are best advanced by largely continuing our current approach. Minimisingchange is likely to promote stability and predictability which in turn supportsefficient investment. We do not consider the criteria for making material changes to our approach have been met.
Regulated utilities are attractive to investors because they are stable, low-risk businesses that offer consistent revenues andreturns. This preference for stability extends to the regulatory framework and approach.
Typically, when regulators set the cost of capital, they do so by exercising regulatory judgment about a rangeof individual inputs, which are then brought together to generate a result.This is most prominent in the cost of equity, where it is not possible to observe expectations directly.
Consequently, once the resultis derived, regulators tend to want to step back and ask themselves whether the result seems reasonable. However, there are considerable difficulties inassessing overall reasonableness. Firstly, the data available is no better (andmore likely worse) than the data used to estimate the individual components.Secondly, and more importantly, indicators of reasonableness are heavilyinfluenced by factors outside of the cost of capital. For example, theprofitability of regulated businesses depends on the impact of incentiveschemes and the ability to outperform the regulator’s opex and capexdeterminations. Therefore, any use of reasonableness checks is subject to ahigh degree of judgment.
Nevertheless, reasonableness checks play acentral role in regulatory decision making. In 2012, the NZCC undertook a rangeof reasonableness checks of its final WACC. These checks were then reviewed bythe New Zealand High Court on appeal. The High Court observed that:
[1210] The comparative information against which the Commission tested itsWACC estimates comprised:
(a) yields on five-year Government stock and BBB+ corporate debt.
(b) estimates of the long-run historical returns earned by New Zealand investorson investments of average risk (over the period 1900-2009);
(c) estimates of future returns expected by New Zealand investors on investmentsof average risk.
(d) estimates of post-tax WACC in other regulatory contexts especially in NewZealand, Australia and the United Kingdom.
(e) independent estimates of the post-tax WACC for New Zealand monopolies;and
(f) estimates of the post-tax WACC using other approaches including the classicalCAPM.
The Court then went on to concludethat the Commission’s cost of capital satisfied the reasonableness test, butthe appellants would not if they were successful:
[1228] We therefore agree with Commission’s conclusion that those independentestimates support the robustness and reasonableness of its WACC estimate. Theydo not, to use the Commission’s words, identify any oddity or other like outcome inthe Commission’s estimates, such as might have required the Commission to changeits approach. Moreover, those independent estimates strongly suggest that theWACC estimates that would result from allowing in full the appellants’ appealsagainst the Commission’s cost of capital IMs would be considerably more than thosethat would be appropriate given the Part 4 purposes.
Similarly,the AER undertook substantial cross-checking in its 2022 rate of returnInstrument process. The cross-checks included: regulated asset base (RAB)multiples, financeability tests, scenario testing, historical profitability,investment trends, other regulators’ rate of return and analysts’ discountrates. The AER concluded:
We have explored a range of measures that might provide some insight into thesuitability of our overall rate of return. All these measures suffer limitations, butcollectively may provide a sense-check of our overall outcome.After reviewing the available cross-checks, a balanced assessment of theperformance of the 2018 Instrument leads us to reasonably conclude that the 2018Instrument has broadly performed adequately.
Among the cross-checks, RABmultiples are the most controversial, with some participants arguing that theyhave no value while others say they have great value. In respect of RABmultiples, the AER concluded:
Overall, our further investigation leads us to conclude that our current and expectedrates of return are at least sufficient (as part of the overall regulatory compensationto investors) and that the allowed return has not been below investor expectations.
The AER observed that cross-checkshave also been employed by Ofgem and Ofwat:
For example,Ofgem uses the following cross-checks for its cost of equity estimate:
However, in its most recent decision, Ofgem made noadjustment to the rate of return based on the findings of cross-checks.Further, Ofgem’s latest draft decision (ED2 from June 2022) shows that CAPM isused without adjustment even though cross-checks supported lower values,stating that: ‘…we do not adjust the results […] because we are mindful that nocross-check is perfect, and we are confident that CAPM should remain the primary model.’
The Water Services Regulation Authority in the UK (Ofwat)has recently discussed the use of cross-checks in its draft methodology forPR24,611 stating that it intends to ‘set the allowed return on equity on thebasis of the CAPM [and does] not envisage departing from the CAPM-derivedestimate of the allowed return, unless there is strong and compelling evidencefrom market-based cross-checks.’ Further, Ofwat notes that ‘there should be a high evidential bar for movingaway from [a] central estimate [and] expect that any adjustment would be modestand would in any case lie within the endpoints of the CAPM derived cost of equity range.’
Ofwat proposed to use the market-to-asset ratio analysis(that is, RAB multiples) as the main cross-check in determining the allowedcost of equity, noting that ‘[Ofwat does] not envisage departing from theCAPM-derived central estimate of the allowed return, unless there is strong and compelling evidence from market-based cross-checks such as MAR analysis.’
Ofwat’s recently published final methodology for PR24 proposes that there is not ‘sufficiently strong evidence from ourMAR-based cross-check to choose a point estimate other than our centralCAPM-derived point estimate.’
I was delighted that MCC's work was completed on time, and within budget, helping us deliver important changes and improvements, to the benefit of our stakeholders. MCC's report is published on the CCC website.
I am delighted to recommend MCC Economics. Specifically, I worked closely with PJ, who helped us with our Nuclear and CCUS projects. PJ helped us develop new policies and answer questions from our stakeholders. His support helped us deliver important changes and improvements, to the benefit of our stakeholders.
MCC Economics has helped us better understand the most important issues for our stakeholders, including: charges, shareholder returns, debt payments and inflation impacts.
I am delighted to recommend PJ and his team at MCC Economics. We've been working together on National Policy Statements to help meet net zero targets for 2030 and 2050. We initially appointed MCC Economics to support us on offshore wind consultation analysis and have recently reappointed MCC Economics to undertake a larger consultation analysis role across all sectors, including hydrogen, CCUS and networks. I can confirm that PJ and his team have shown excellent spreadsheet skills, alongside very good project management, planning and analysis skills, helping us deliver important changes, and continuous improvements, to the benefit of our stakeholders.
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