Innovation and Reward

How Cost of Capital Regulation Fails to Deliver Benchmark Returns

Economic & Financial Consulting

May 23, 2016

Index Arrows

Price regulated industries are commonly allowed to recover a benchmark return on invested capital. Over time, these regulated returns may be changed to remain in line with a benchmark opportunity cost of capital. This introduces a disconnect between the returns observed for a regulated entity and non-regulated companies of similar risk.

The reason is that non-regulated companies are expected to generate returns on their market value (which is affected by the cost of capital) whereas a regulated company is allowed a return on its book value (which is not affected by the cost of capital). This denies regulated entities the value of the capital gains otherwise associated with falling costs of capital, such as after the resolution of initial uncertainty associated with market entry or innovation.

Exploring the disconnect
Investors can choose between different assets with different levels of risk. To attract or justify reinvesting capital, companies must therefore offer competitive returns to investors. On this basis, companies face a cost of capital equal to their investors’ expected alternative return (or opportunity cost).

This principle is generally accepted in finance theory whereby the value of uncertain future cash flows can be determined by discounting these with their cost of capital. It is also reflected in regulated prices through the inclusion of the cost of capital in the cost base that regulated entities are allowed to recover.

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