Training Module on Electricity Market Regulation - SESSION 5 - Cost of Capital

Experience you can trust.
http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5
Training on Regulation
A webinar for the European Copper Institute
Webinar 5: Cost of Capital
Dr. Konstantin Petrov / Dr. Daniel Grote
14.12.2009

14.12.2009 1
Agenda
b) Weighted Average Cost of Capital (WACC)
a) Concept and Regulatory Objectives
1. Definition of Cost of Capital
c) Cost of Debt
d) Cost of Equity
2. Quantification of Cost of Capital
a) Capital Asset Pricing Model (CAPM)
c) Arbitrage Pricing Theory (APT)
d) Dividend Growth Model (DGM)
e) Comparable Earnings Model (CEM)
e) Capital Structure (gearing)
f) Treatment of Taxes
f) Regulatory Precedents
b) Fama-French 3-factor Model

14.12.2009 2
a) Definition and Regulatory Objectives
• Cost of capital is a measure of the financial return that investors seek for the risk they are
taking on by investing in the company
• Regulatory objectives
– Provide sufficient return to encourage investments
– Refer to capital market performance where it is possible
– Consider adequately the risk of regulated industry
– Provide incentives to employ optimal capital structure (minimal cost of capital)

14.12.2009 3
b) Weighted Average Cost of Capital (WACC) (1)
Cost of Equity Cost of Debt
Equity Share Debt ShareTaxes
WACC
• The cost of capital (allowed rate of return) is usually determined as the Weighted Average
Cost of Capital (WACC)
• WACC comprises of cost of equity and cost of debt weighted by their shares
• WACC may include corporate taxes
• WACC is applied in almost all European jurisdictions and worldwide

14.12.2009 4
1. Definition of Cost of capital
b) Weighted Average Cost of Capital (WACC) (2)
Cost of Equity
No default risk
No reinvestment risk
+
Market risk measure
*
Base Equity
Premium
Country Risk
Premium
Risk-free rate + Debt premium
Risk-free rate Beta Risk Premium
Premium for average
risk investment
Debt / Equity ratio
E = Equity D = Debt
Tax rateCost of Debt Gearing
T = Tax
D
E+D
WACC (post-tax) = Cost of equity + Cost of Debt (1-T)
E
E+D* * *

14.12.2009 5
c) Cost of Debt
• Calculated as sum of the risk free rate and debt risk premium (debt spread)
• Availability of market data essential
• Risk free rate
– Is the expected return on an asset which bears no risk at all, no default risk
– Estimated on the basis of appropriate long-term government bond yields
• Debt risk premium
– Is the interest paid on corporate bonds over and above a comparable risk-free bond
– Can be obtained by observing published credit ratings that specialist credit rating
agencies assign to the company

14.12.2009 6
d) Cost of Equity (1)
• Calculated as sum of the risk free rate and equity risk premium adjusted by beta coefficient
• Availability of market data essential
• Risk free rate
– Is the expected return on an asset which bears no risk at all
– Estimated on the basis of appropriate long-term government bond yields
• Beta coefficient
– Is an attempt to examine how the return on the investment co-varies with the return on
the market portfolio
– Direct estimates are not possible unless a company is publicly traded
– An estimate of a company’s equity beta can be calculated from an estimate of its asset
beta (based on international experience)
• Equity risk premium

14.12.2009 7
• Equity risk premium
– The usual regulatory practice is to use historical data on national capital market returns
and arithmetic averages
Country Regulator Industry Range of Equity risk premium Last decision
Min Max Date Equity risk premium
ACCC TSO (electricity) 6.0% 6.0% 2005 6.0%Australia
ESC DSO (electricity) 6.0% 6.0% 2005 6.0%
Belgium CREG DSO (gas) 3.5% 3.5% 2006 3.5%
TSO (gas) 5.0% 5.0% 2004 5.0%
Finland EMA
TSO (electricity) 5.0% 5.0% 2004 5.0%
Electricity generation 5.25% 5.25% 2005 5.25%
Ireland CER
TSO/DSO (electricity) 5.25% 5.25% 2005 5.25%
TSO (electricity) 4.0% 6.0% 2005 5.0%
DSO (electricity) 4.0% 7.0% 2005 5.0%Netherlands DTe
DSO (gas) 4.0% 6.0% 2005 6.0%
New Zealand Commerce Commission DSO (gas) 5.5% 7.5% 2005 7.0%
UK Ofgem DSO (electricity) 2.5% 4.5% 2004 4.5%
d) Cost of Equity (2)

14.12.2009 8
e) Capital Structure (gearing)
• The regulators aim to approximate the optimal financing
(= minimisation of cost of capital)
of the regulated service providers
• Usually standardised
• Regulators set targets
• Objective is to minimize cost of capital
• Equity part usually between
40 % and 50 %
Cost of debt
WACC
Cost of
capital
Cost of equity
Optimal cost
of capital
Debt / equity ratio
(gearing)

14.12.2009 9
f) Treatment of Taxes
• Corporation tax is a charge on corporate profits
• It may be incorporated in the assessment of cost of capital
• Pre-tax WACC, corporate tax included in the equity return allowed via the WACC
• Post-tax WACC, corporate tax included as a separate item in the allowed revenue, tax
shield effect incorporated in the debt return allowed via the WACC

14.12.2009 10
Overview
Quantification
Models
Capital Asset
Pricing Model
(CAPM)
Arbitrage
Pricing
Theory (APT)
Dividend
Growth Model
(DGM)
Regulatory
Precedents
Comparable
Earnings
Model
Fama-French
3-factor model

14.12.2009 11
a) Capital Asset Pricing Model (CAPM)
• The most common model applied in practice (also for regulatory purposes) to determine a
theoretically appropriate required rate of return of an asset
• Discussion in finance about the theoretically exact model, but to date CAPM remains the
basic model that provides a fairly good representation (rough proxy) of the real world
• Total risk of portfolio = specific risk + systematic risk
– specific (unsystematic) risk
 components uncorrelated with general market movements
 company specific individual risk, can be diversified away by investing in the market
– systematic risk
 common to all assets in the market (market risk)
 risk for being in the market
 cannot be reduced by diversification
 stock owners only compensated for systematic risk

14.12.2009 12
a) Capital Asset Pricing Model (CAPM) – Formula
or
E(Ra) = Rf + β ( E(Rm) – Rf ) + ε
Expected return
on individual
capital asset a
Risk-free rate
of interest
sensitivity of
asset returns
to market
returns
Expected
return of the
market
Risk-free rate
of interest
market premium or
equity risk premium
Error
term
systematic or
non-diversifiable
risk
specific or
diversifiable
risk
*
E(Ra) - Rf = β ( E(Rm) – Rf )
β (beta) times market premium=individual risk premium
*

14.12.2009 13
a) Capital Asset Pricing Model (CAPM) – Security Market Line
• Relationship between security returns and market returns
– The Security Market Line (SML) describes a relation between beta and the asset's
expected rate of return
– The slope of the SML is equal to the market risk premium (E(Rm) – Rf ) and reflects the
investment’s degree of risk aversion at a given time
Relatively
risky assetsMarket
portfolio
Relatively
safe assets
Error term (ε)
risk-free rate
of return
Expected
rate of return
systematic risk (β)0
E(Rm)
1
Rf
Security Market Line (SML)
Expected
return of
the market
High risk
premium
Low risk
premium

14.12.2009 14
b) Fama-French 3-Factor Model (1)
• Most popular alternative to CAPM in finance research (not yet much applied in the regulatory
context)
• Expands the CAPM with additional factors for firm size and book-to-market ratios found in a
number of empirical studies
E(Ra) = Rf + β ( E(Rm) – Rf ) + γ (SMB) + δ (HML) + ε
Expected return
on individual
capital asset a
Risk-free
rate of
interest
Sensitivity of
returns of
asset a to
market
returns Expected
return of the
market
Error
term
Risk-free
rate of
interest
Expected returns
of small minus
big (SMB) stocks
Expected returns
of high minus low
book-to-market
(HML) stocks
Sensitivity of
returns of
asset a to
returns of
small over
big stocks
Sensitivity of
returns of
asset a to
returns of
high over low
book-to-
market
stocks
* * *

14.12.2009 15
b) Fama-French 3-Factor Model (2)
• Market risk
– β = 1 asset moves with the market
– β < 1 asset moves less than the market, less risk + lower than market return
– β > 1 asset moves more than the market, higher risk + higher than market return
• Size effect
– Empirical observation that investors have received additional returns by investing in stocks
of companies with a relatively small market capitalization (size premium)
– γ close to 0, large capitalization portfolio
– γ close to 1, small capitalization portfolio
• Value effect
– Empirical observation that investors have received additional returns for investing in stocks
of companies with high book-to-market values (value premium)
– δ close to 0, portfolio with low book-to-market ratio
– δ close to 1, portfolio with high book-to-market ratio

14.12.2009 16
c) Arbitrage Pricing Theory (APT)
• The Arbitrage Pricing Theory (APT) assumes that the expected return of a stock depends
on the fundamental macroeconomic factors influencing it
• The risk premium of a stock is associated with the stock’s sensitivity to each of these
macroeconomic factors
• If the price of an asset deviates from its expected price based on the influencing factors,
investors will sell or buy the asset and bring the price back in line with the returns expected
by the model (arbitrage)
• Possible factors to be considered are economic growth, interest rates, inflation, fuel prices,
consumer spending
• Open question: Which factors to include and how to weight them?
E(Ra) = Rf + βa1 ( F1 ) + βa2 ( F2 ) + … + ε
Risk-free
rate of
interest
Expected return
on individual
capital asset a
Sensitivity of
returns of
asset a to
factor 1
Factor 1 Sensitivity of
returns of
asset a to
factor 2
Factor 2 Error
term
Additional
factors
* *

14.12.2009 17
d) Dividend Growth Model (DGM)
• The Dividend Growth Model (DGM) or Dividend Discount Model values a stock with the
present value of the dividend stream from that stock
• Requires forecasting of the future distribution of dividends
• The company growth regarded as constant (in one stage specification of the model)
• Usually used as supporting model to examine the accuracy of the CAPM results
Re = + g
D1
P0
Cost of Equity
expected
dividend
current
share price
rate of
growth in
dividend

14.12.2009 18
e) Comparable Earnings Model (CEM)
• The Comparable Earnings Model (CEM) estimates the cost of capital from the historical
returns on equity for entities or industries of comparable risk
• The cost of capital is related to the average rate of return over a historic period
• It is based on accounting data which is affected by accounting policy
• Difficult to select comparable company and appropriate period

14.12.2009 19
f) Regulatory Precedents
• The costs of capital of regulated firms is benchmarked against decisions of other regulatory
authorities in other countries or for other sectors in the same country
• Countries or companies from other sectors may not be comparable due to differences in:
– Regulatory regime
– Sector specifics
– Political and social environment
• Decision dependent on the accuracy of decision making of other regulators

Experience you can trust.
End of Webinar 5
KEMA Consulting GmbH
Kurt-Schumacher-Str. 8, 53113 Bonn
Tel. +49 (228) 44 690 00
Fax +49 (228) 44 690 99
Dr. Konstantin Petrov
Managing Consultant
Mobil +49 173 515 1946
E-mail: konstantin.petrov@kema.com

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Training Module on Electricity Market Regulation - SESSION 5 - Cost of Capital