The QCA investigated how different forms of regulation affect risk, risk allocation, and the regulated firm’s cost of capital.
The form of regulation affects and allocates risks amongst the regulated firm, its customers, and taxpayers. If the form of regulation transfers risk away from the firm and to customers (or vice versa), then the regulator should adjust the firm’s cost of capital to reflect the reallocation of that risk.
At present, decisions on the cost of capital and revenue requirement are made separately from decisions about the form of regulation. There is strong theoretical and empirical evidence that supports the idea that these aspects of regulation should be jointly determined.
On 22 November 2012, we released the discussion paper, ‘Risk and the Form of Regulation’ for public comment.
The discussion paper identifies and develops key propositions that relate to how different forms of regulation affect risk, risk allocation, and the regulated firm’s cost of capital.
The project is now closed. The QCA may rely on aspects of this analysis from time to time to inform its views on certain matters.
The cost of equity capital for regulated firms is estimated using the Capital Asset Pricing Model (CAPM). Applying the CAPM in a regulatory context, investors in the regulated firm are compensated for the risk that they cannot diversify away by holding a wide-ranging portfolio of assets—that is, investors in the regulated firm are compensated based on their exposure to ‘non-diversifiable’ risk.
This project principally addresses the potential impact of the form of regulation on the regulated firm’s risk and cost of capital. For example, revenue caps transfer volume-related risk from the regulated firm to its customers. This is because firms are able to increase prices if volumes decrease to ensure the revenue cap or target can be met.