NERA Director Dr. Richard Hern and Associate Director Tomas Haug
presented on cost of capital issues at the Water UK Cost of Capital
Seminar at the London Stock Exchange.
The conference brought together over 60 finance professionals
form the City, water sector, and other regulated industries to discuss
the challenges of financing regulated businesses in the current
financial climate, and best approaches for the long-term.
In their first presentation, Dr. Hern and Mr. Haug discussed
different methodologies to estimate a risk-free rate. They show that the
standard regulatory methodology of estimating the risk free rate based
on yields to maturity of Index Linked Gilts (ILGs) is no longer
reliable. Yields on all UK ILGs are biased downwards relative to the
yield that investors would require from ordinary risk-free investments.
Prices on the gilt market are inflated by the need for pension funds to
meet FRS17 and IAS19 accounting requirements. Other regulators (such as
the Essential Services Commission (2007) in Australia) have also
recently noted that index linked bonds are not a reliable basis for
estimating the risk free rate, and have used other data.
In order to correct these problems, Dr. Hern and Mr. Haug
proposed that UK regulators take account of evidence on interest rate
swap data in deriving its estimate of the risk-free rate for regulatory
decisions. Swap rates (adjusted for credit default risk) provide a basis
for estimating risk-free rates without the need for subjective
assumptions or adjustments to overcome distortions. They showed that
measures of the UK risk-free rate based on swap data provide results
that are more consistent with international data on the risk free rate.
In a second presentation, Dr. Hern discussed alternative
approaches to the Capital Asset Pricing Model (CAPM), traditionally
relied upon by UK regulators. Because the CAPM allows a wide range of
answers, Dr. Hern argued that it is important that regulators use other
models such as Dividend Growth Models (DGM) as a cross-check on the CAPM
results, ideally at an early stage in the review processes to allow for
proper consideration of the results.
The Seminar was chaired by Julian Franks, Professor of Finance at the London Business School.