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