Electricity Markets Regulation - Lesson 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 CapitalDr. Konstantin Petrov / Dr. Daniel Grote

14.12.2009

14.12.2009 2

http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5

Agenda

b) Weighted Average Cost of Capital (WACC)a) Concept and Regulatory Objectives

1. Definition of Cost of Capital

c) Cost of Debtd) Cost of Equity

2. Quantification of Cost of Capitala) 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

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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)

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b) Weighted Average Cost of Capital (WACC) (1)

Cost of Equity Cost of Debt

Equity Share Debt Share Taxes

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

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1. Definition of Cost of capital

b) Weighted Average Cost of Capital (WACC) (2)

Cost of Equity

No default riskNo reinvestment risk

+

Market risk measure

*

Base Equity Premium

Country Risk Premium

Risk-free rate + Debt premium

Risk-free rate Beta Risk Premium

Premium for averagerisk investment

Debt / Equity ratio

E = Equity D = Debt

Tax rateCost of Debt Gearing

T = Tax

DE+D WACC (post-tax) = Cost of equity + Cost of Debt (1-T)E

E+D* * *

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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

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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

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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)

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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)

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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

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2. Quantification of Cost of Capital

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

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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

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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


market premium or equity risk premium

Error term

systematic or non-diversifiable

risk

specific ordiversifiable

risk

*

E(Ra) - Rf = β ( E(Rm) – Rf )

β (beta) times market premium=individual risk premium

*

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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

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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


capital asset a


Sensitivity of returns of asset a to

market returns Expected

return of the market

Error term


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

* * *

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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

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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



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

* *

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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 = + gD1

P0

Cost of Equity

expected dividend

current share price

rate of growth in dividend

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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

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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.http://www.leonardo-energy.org/training-module-electricity-market-regulation-session-5

End of Webinar 5

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Dr. Konstantin PetrovManaging ConsultantMobil +49 173 515 1946 E-mail: [email protected]

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Electricity Markets Regulation - Lesson 5 - Cost of Capital