Introduction John Earwaker john_earwaker@first-economics.com - PowerPoint PPT Presentation

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Cost of Capital Conference Thursday 4 May 2017 Introduction John Earwaker john_earwaker@first-economics.com Starting Point for Todays Discussion Allowed costs of capital in the regulated sectors are heading down WACC = g x K d + ( 1

Cost of Capital Conference Thursday 4 May 2017 Introduction John Earwaker john_earwaker@first-economics.com
Starting Point for Today’s Discussion • Allowed costs of capital in the regulated sectors are heading down WACC = g x K d + ( 1 – g ) x K e • Lower interest rates imply lower allowed returns (see over)
Corporate Bond Yields (%)
Four Key Questions for Discussions 1. Has the cost of equity changed in recent years? 2. How should regulators deal with natural uncertainty about future market conditions? 3. Does it matter if lower returns put pressure on financial ratios? 4. Should regulators be setting RPI-, CPI- or CPIH- stripped rates of return?
Q1: Has the Cost of Equity Changed? • Regulators have been factoring real, after-RPI total equity market returns of ~6.5% into cost of capital calculations (see over) • This is equivalent to close to a 10% nominal return • Have equity investors’ expectations shifted down in line with lower interest rates? • Or are future returns likely to be in line with long- term historical averages?
Expected Market Returns Equity market return assumptions in recent regulatory reviews (real, after RPI) Decision Equity market return assumption Year CAA, Heathrow/Gatwick Airports 6.25% 2014 Competition Commission, NIE 6.5% 2014 Ofgem, RIIO-ED1 6.5% 2014 Ofwat, PR14 6.75% 2014 CMA, Bristol Water 6.5% 2015 Ofcom, BT Openreach 6.1% 2016 Utility Regulator, GD17 6.5% 2016
Q2: How to Deal with Market Uncertainty? • People have not been very good at predicting financial markets • Is it now obvious that regulators should be adjusting allowed rates of return within period? • If it is, what are the key design issues?
Q3: What is a ‘ financeability ’ constraint? • There is a view that financial ratios / credit ratings put a floor on allowed returns • Is this right? • The alternative view is that if ratios and ratings come under pressure, this shows that regulated companies need to finance more of their RABs and/or investment through equity
Q4: RPI or CPI or CPIH ? • Some of the discussion today will reference the cost of capital in RPI-stripped terms • Regulators have been signalling a move away from RPI • Is CPIH or CPI the better alternative?

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