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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.