Paying the full WACC?

ASSESSING THE IMPACT OF BREXIT ON FIRMS’ COST OF CAPITAL

As part of Frontier’s wider series on the economic impact of Brexit, we have published a paper seeking to evaluate the consequences of the UK referendum result for the cost of capital in regulated utilities in the UK. This bulletin, which summarises its main findings, carries an important warning to regulators and investors: don’t react too quickly to market signals, which in the volatile environment created by uncertainty about the route to Brexit may prove misleading.

Regulators periodically set the maximum revenues that monopoly network companies are allowed to earn from customers. These revenue allowances have two key components:

  • first, they must allow these utilities the opportunity to earn a fair return to equity investors;
  • second, they must allow the utilities to make sufficient revenues to cover the efficient cost of debt finance that they may have raised.

Collectively, these allowances are known as the Weighted Average Cost of Capital (WACC).

Many in the regulated utility sector need to understand the effect of the referendum vote on required returns. This bulletin summarises the evidence that is emerging from capital markets postreferendum on the key metrics that are relied on by UK regulators in order to estimate the WACC. We then assess how this evidence may influence regulatory decisions, given existing practice and precedent. Finally, we focus on the new challenges for regulators and regulated companies, given what the emerging data may be telling us about the potential weaknesses of existing methods in the particular circumstances of a long-drawn-out Brexit.

In this bulletin, we consider the cost of equity and the cost of debt in turn, before drawing together the conclusions for regulatory policy.

COST OF EQUITY

The result of the referendum on Britain’s membership of the EU has brought significant economic uncertainty to the UK. As discussed in Frontier’s previous bulletin in the series, a particular question-mark hangs over the trading arrangements that may eventually be established between the UK and the EU and elsewhere.

The investment hiatus suggested by recent surveys could be a signal that the required cost of equity for investors has increased following the Brexit vote.

While definitive data are not yet available, recent surveys are providing growing evidence that investors are interpreting this uncertainty over prospects for the UK economy as a new – and material – risk, and are therefore raising their required rate of return. In other words, the investment hiatus suggested by such surveys could be a signal that the required cost of equity for investors has increased following the Brexit vote.

However, estimating the cost of equity in current circumstances is by no means straightforward. Regulators need to identify the forward-looking expected return an investor requires at the time of investing. But this required return is not directly observable, because it will be influenced by buying prices as well as investors’ (private) beliefs about the future cashflows that can be generated. Regulators can, of course, observe realised returns on equity shares traded in the market (calculated from share prices and dividend yields), but these may prove to be a poor indicator of future requirements and investor behaviour.

For these reasons, the task of estimating the cost of equity inevitably contains an element of judgment and, as a result, regulators tend to employ various methods, drawing evidence from a range of sources in order to build a reliable overall picture. Among regulators in the UK, there is however a broad consensus that the most practical framework within which to pull together and assess these different strands of evidence about the cost of equity is the capital asset pricing model (CAPM).

This framework requires the estimation of three individual components:

  • the risk-free rate (RFR), which represents the rate of return required by investors from risk-free assets;
  • the equity risk premium (ERP), which represents the incremental expected return that investors require in future to invest in equities in general; and
  • the beta coefficient, which provides an indication of the volatility of the investments in question relative to that of the market as a whole.

In our paper, we examine emerging evidence on each of these components of the CAPM model individually to see if there are any clear signs of an increase in the cost of equity. We find that:

  • the possibility of a further round of Quantitative Easing and a “flight-to-safety” by institutional investors may lead to a lower yield on government bonds (and corporate bonds with strong credit ratings), and this may act to pull down the RFR; but –
  • emerging evidence – such as the surveys pointing to an investment hiatus and higher volatility in the equity market – may imply a higher equity risk premium, counteracting the lower RFR; and
  • higher volatility in the equity market may also lead to greater uncertainty in measuring the cost of equity, and may also lower current estimates of the equity beta.

As with so much else of the fallout from the referendum vote, the devil will be in the detail.

As with so much else of the fallout from the referendum vote, therefore, the devil will be in the detail: regulators will need to study the evidence carefully and weigh up these pluses and minuses before reaching conclusions about the direction of travel for the cost of equity in their respective industries.

COST OF DEBT

If the cost of equity creates some headaches for regulators, the cost of debt compounds this with two further challenges:

  • First, while there is broad consensus across UK regulators on the appropriate framework for estimating the cost of equity, the approach to establishing the allowed cost of debt has historically been more varied. This lack of uniformity creates more freedom for regulators to explore new ideas and solutions, but it also creates additional uncertainty – and therefore risk – for the regulated companies.
  • Moreover, the data that are usually used to inform debt allowances are expressed in nominal terms. However, UK regulators set a real cost of capital allowance – and therefore must incorporate an inflation forecast to convert from a nominal to a real cost of debt allowance.

Fortunately, there are some pointers that regulators and industries can follow to help navigate these challenges. In our paper, we examine in turn nominal debt and inflation expectations, and assess the consequences for regulatory policy given emerging data trends following the referendum. We find
that:

  • as noted above, falling yields on government bonds have been matched by falls in A- and BBB- rated bond indices, suggesting that the Brexit vote could lead to cheaper debt for some utilities; but –
  • other utilities, notably UK water companies, may be concerned about their continued access to European Investment Bank loans – which have historically allowed them to borrow at attractive rates – following Brexit.

Meanwhile, a weaker pound sterling may put inflationary pressure on the economy in the short term, pushing down the real cost of debt. If regulators were to factor this into the estimation of the WACC at upcoming price controls, this would lead to lower allowed returns. But regulators should bear in mind the medium-term inflation outlook is highly uncertain, since the inflationary pressures brought about by exchange rate movements may themselves be offset by weaker domestic demand as Britain’s economy slows.

THE OVERALL WACC

Since the net effect of all these movements on the final WACC is far from certain, it is important that regulators do not react prematurely to emerging market data.

If regulators react rapidly to emerging market data or emphasize different pieces of evidence, this may lead to a wider distribution of WACC outcomes across the different infrastructure sectors, relative to the norms that existed before the Brexit vote. Such an outcome might send confusing signals to investors, at a time when they are most anxious for the reassurance of consistency.

As with so much else of the fallout from the referendum vote, the devil will be in the detail.

The longer-term economic effects will depend on the form of trading and economic relationship that the UK negotiates with the EU and the rest of the world. Since the outcome, and even the timing, of the separation process continue to be unknown, further financial market volatility is widely expected.

Regulators will therefore need to be careful in interpreting market data, and seeking to make consistent estimates that are appropriate for price controls spanning several years. If the WACC is genuinely lower as a result of the Brexit vote, and if regulators can translate this into lower bills for customers, this would be good news. But setting the allowed return too low off the back of market evidence that may prove to be ephemeral will deter much-needed investment.

Mechanistic estimates based on short-term market data are therefore likely to be inappropriate for regulators, the utilities they oversee and – ultimately – consumers. Regulators may, therefore need to exercise a greater degree of judgment on the one hand; while, on the other, consider the use of automatic stabilisers such re-openers or indexing methods, to manage the risk of extreme outcomes within regulatory periods.

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