The Cost of Equity for Utilities – An International Perspective

Wed May 10 10:33:00 EDT 2017
Dr. Richard Hern

Getting the cost of equity (CoE) right is one of the key tasks of the regulatory process; setting it too low threatens utilities’ ability to attract capital, yet regulators have to balance this risk with preserving customer interest and keeping bills affordable.

In the UK, the upcoming price control reviews in the water (PR19), energy (RIIO2), and airport (H7) sectors will be made in an environment of negative real interest rates; however, at the same time, utility betas (a measure of risk that is priced in by investors) are returning to more “normal” levels. At a recent Cost of Capital Conference that included representatives from the UK Civil Aviation Authority, Ofcom, Ofgem, and Ofwat, Managing Director Dr. Richard Hern discussed the likely impact of the ultra-low interest rate environment and of increasing beta risk on companies’ expected CoE allowances.

In “The Cost of Equity for Utilities—An International Perspective,” Dr. Hern shows that UK regulators have been setting lower CoE allowances in the wake of falling interest rates, but precedents from the US and Scandinavia show that not all regulators have followed suit. In fact, there are good reasons—grounded in financial theory and seen in the empirical data—that indicate the CoE need not fall in times of falling interest rates.