Cost of cupital

Calculating the cost of capital

for the regulated electricity
distribution companies
The ‘cost of capital’ is a n importantfigurefor the UKS regulated industries: in part it determines billions of
pounds of customer bills, investor returns and stock market value. This article reviews and applies finance
theory to arrive at a current rangefor the DNOs’ cost of capital. The midpoint of the resultant range, 7.5%,
is significantly higher than the 6.5% currently set by OFGEM, which implies that the DNOs are not being
allowed to make sufficient returns to compensate their investorsfor the risks associated with a n electricity
distribution business. A review of recent UK regulatory determinations of the cost of capital shows
unnecessary risk in the regulatory process; this article callsfor investment in a common, less subjective U K
regulatory approach to calculating the cost of capital.

by Mike Lockett
he cost of capital is one of the factors Debt capital: investors lend money to the

T in the distribution price control that

determine the revenue a DNO (distri-
bution network operator-previously
referred to as a public electricity supplier or
PES) is allowed to collect from its franchised
company in various forms.

The company has to offer an interest rate to

customers (see Reference 1 for a discussion
of the factors). An appropriate cost of capital
figure has to strike a balance between minim-
ising customer bills and allowing company
investors a fair return. In the current regulatory
regime, the cost of capital is negotiated
between the DNOs and OFGEM, and is
reviewed every five years. The current rate of
6 3 % came into effect in April 2000.
This article provides an overview of a
number of key financial concepts; a glossary
of financial terms is provided. For those who
may be interested in reading more on these
issues, Corporate Financial Management’
provides a reader-friendly discussion from a
UK perspective.
Cost of capital theory
Debt, equity, gearing and WACC
Every company needs capital (money) to fund
its operations. Investors provide this money in
two general forms:
Equity capital: investors purchase a stake in
the company-they become shareholders.
induce investors to part with their money. A
company’s ‘cost of capital’ can be described as
the rate of return a company has to offer
investors to compensate them for their ‘time-
value of money’.
The time-value of money is determined by
three factors:
1 Impatience to consume: even in a world
without inflation and risk, investors prefer to
have money available to them ‘now’rather than
in the future.
2 Inflation: investors require compensation for
reduced purchasing power caused by inflation.
3 Risk: investors require compensation for the
risk that their investment may not be returned,
or may not earn as much as expected. The
compensation required or ‘risk premium’ is
commensurate with the perceived risk of the
investment: a higher risk demands a higher
return.
Items 1 and 2 together make the ‘risk-free’rate
of return. The risk premium is added to give
the total required return, or time-value of
money.
Debt capital costs the company less than

POWER ENGJNEERING JOURNAL OCTOBER 2002 251

Cost of capital

Table 1 Effect of gearing on returns to equity providers

return on total capital employgd- 5 10 15 20

earnings before interest payments (fmillion) [A] 5 10 15 20
I gearing = 0%
interest payments Q 10% on fOmillion (fmillion) [B] 0 0 0 0
’ equity earnings (Emillion) [C=A-B] 5 10 15 20
’ equity return on f 1OOmillion (%) [C/100] 5 10 15 20
gearing = 25%
interest payments @ 10% on E25million (fmillion) [D] 2.5 2.5 2.5 2.5
equity earnings (Emillion) [E=A-D] 2.5 7.5 12.5 17.5
eauitv return on E75million (%) FEY751 3.3 10 16.7 23.3
gearing = 50%
interest payments @ 10% on f50million (fmillion) [q 5 5 5 5
equity earnings (€million) [G=A-F] 0 5 10 15
eauitv return on f50million (%) IG/501 0 10 20 30
j gearing = 75%
~ interest payments @ 10% on f75million (Emillion) [HI 7.5 7.5 7.5 7.5
equity earnings (fmillion) [J=A-H] -2.5 2.5 7.5 12.5
equity return on E25million (%) [J/25] -1 0 10 30 50

equity capital; debt can be secured against the In addition to being cheaper than equity,
firm’s assets-similar to a household debt capital offers the advantage of being tax
mortgage-thus reducing risk for the lender efficient. Current UK tax law allows companies
and keeping interest rates down. Equity capital to make debt interest payments before calcu-
providers can make unlimited returns if the lating taxable profits. With a current UK
firm prospers, but risk losing their entire corporate tax rate, t , of :30%,every pound of
investment if the firm folds, and consequently interest paid out reduces the company’s tax bill
they demand a higher interest rate to by 30 pence. This reduction is known as the
compensate for this higher risk. A company’s ‘debt tax shield, and reduces the debt interest
cost of capital can be derived by taking the rate by a factor of (1 - t ) .
weighted average of the cost of debt and the The weighted average cost of capital can be
cost of equity to arrive at the weighted average expressed as:
cost of capital (WACC).
‘Gearing’ describes the ratio of debt to total
capital employed: g = D/(D + E), where D and E
are, respectively, the total value of debt and where:
equity capital used by the company. Gearing
kd = cost of debt-the debt interest rate
describes the ‘capital structure’ of a company.
A company with 50% gearing funds its k, = cost of equity-the equity interest rate
operations half with debt capital and half with t = corporate tax rate
equity capital. g = gearing, D/(D + E)

1 Effect of gearing on
returns to equity capital
providers

252 POWER ENGINEERING J O U R N A L OCTOBER 2002

 Cost of capital

Now to the disadvantage of using debt capital:

debt introduces financial risk. Let us look at an
example company; for clarity we will ignore
corporate taxation. The company raises 5100
25 r --c expected return p
,)
+ risk measured by standard deviation (%) /
million of capital for use over the forthcoming 20 -
year. Let us assume that the debt interest rate is
lo%, and that there are only four possible
outcomes in terms of the return the company 15 -
makes: 5%,lo%, 15% and 20%. Table 1 shows
the returns to equity providers at four different
10 -
gearing levels; Fig. 1 shows this graphically. As
gearing increases, so long as the company
makes a return greater than the cost of debt, 5 -
equity providers make greater returns-the
company’s earnings are ‘geared up’; however, if
the company performs poorly the equity 0
provider risks greater losses. 0 25 50 75
gearing, %
If we further assume that each of the four
‘return on total capital employed outcomes has
a similar probability of 0.25, we can calculate rate). The market perceives this company to be 2 Effectof gearing on
an expected return and standard deviation of higher risk than at the time the debt was issued; expected value and
standard deviation of
return for the company at each level of gearing; vice versa if the bond is trading at greater than
equity returns
standard deviation is a measure of financial face value.
risk. The results are shown in Fig. 2. As gearing In theory, when estimating the cost of debt
increases the equity providers’ expected return capital companies should use the current yield
increases, but so does the standard deviation of on their bonds, as this gives an indication of the
the return. As expected return increases so market’s current perception of the risk asso-
does the risk that the desired return may not ciated with the particular company and the
actually occur. return required to compensate for this.
In practice the costs of both debt and equity Alternatively (or in addition), the effective
capital change as a consequence of changes in interest rate can be used (the bonds percentage
gearing level. This is discussed further below coupon adjusted upwards slightly to take
(see also Fig. 8). account of issuance costs). This reflects the
cost of the company’s existing or ‘embedded
Cost ofdebt capital debt: a historical, fixed interest rate determined
Companies can raise debt capital via a wide by the markets at the time of issue. This does
range of debt instruments; for a comprehensive not represent a theoretical current cost of debt
description see Reference 2 , part IV. capital for use in WACC calculations, but is
Companies know what their debt costs useful for companies (such as the DNOs) that
them: they have explicit interest repayment have to ensure they can service their existing 3 portfolio
rates with banks and other lenders. Larger interest payments. diversification
companies that have issued bonds can use the
effective interest rate and the current market
percentage yields on their bonds.
Typical plain or ‘vanilla’bonds are sold by a
company to debt providers for a nominal fee,
usually Ll00. The company pays the bond-
holder an annual coupon of, say, L l O or IO%,
and repays the bonds face value at some future
redemption date. Bonds change hands in the
market at a price that reflects the market’s
current view of the risk associated with the
issuing company. If, for example, a company’s
LlOO, 10%bonds are currently trading in the
market at L50, the L l 0 coupon represents a
+ undiversifiable
risk

number of shares in portfolio

20% current yield (the annual debt interest

POWER ENGINEERING JOURNAL OCTOBER 2002

Cost of cavital
4 Portfolio theory A company cannot simply use the interest
rate of its most recent debt issuance. Con-
sideration should be given to effective and
(where available) market rates on the
company’s range of existing debt instruments.
Cost of equity capital
A company’s cost of equity capital is equal to
the percentage return on its shares-the
interest rate demanded by equity investors.
Capital asset pricing model (CAPM)
CAPM is a simple and intuitively appealing
model; it links the company’s cost of equity to
a single factor, beta-the responsiveness of the
company’s share returns to the level of
economic a~tivity.~ It is the principal model
used by OFGEM and other UK regulators.
(i) Risk-averse investors and portfolio theory
CAPM requires that risk can be measured by
standard deviation of equity returns: an
investment with a high standard deviation
5 Efficient frontier of
portfolio investment of return presents more risk to the investor
options and capital than an alternative investment with a lower
market line standard deviation.
‘54
CAPM (and other asset pricing models)
assume that investors are risk-averse. That is, if
faced with two investment options of similar
risk, investors will choose the one offering the
highest returns; and if faced with two
investments offering similar returns, investors
will choose the one with the lowest risk.
Portfolio theory suggests that risk-averse
investors should invest in a portfolio of equities
(risky assets), rather than putting all their
money into just one. Divtzrsqying from a single
equity to a portfolio of equities reduces the
investor’s exposure to the fortunes of an
individual company, and hence reduces the
risk of the total investment. As more and more
shares are added to the portfolio, the unique or
unsystematic events affecting each company
tend to cancel out until only systematic risk
remains (see Fig. 3 ) .
Given two equities, each with its own level
of risk and return, the return on a portfolio
investment in the two is equal to the weighted-
average of the two individual returns. However,
provided that the returns on the two equities
do not vary in an identical manner over time
(i.e. they have a covariance of less than l),then
spreading an investment across these two
equities will produce a portfolio risk less than
the weighted-average of the two individual
risks. Consider the example in Fig. 4; A, B and
C are individual equities, any one of which
could be selected by a risk-averse investor,
depending on the investor’s degree of risk-
aversion. However, in this example A and C
have a covariance of less than 1, and therefore
the curved line between A and C represents the
range of risk-return positions available from
forming a portfolio of A and C at various
weighting; point D is cine such portfolio. A
risk-averse investor would choose portfolio D
over equity B, as the two options offer the same
risk but D offers a higher return.
Of course, the investor could consider
making investments in A, B and C which would
produce an entirely new curve. If we consider
the hundreds of equities on a stock exchange,
there are an infinite number of portfolio
investment options; in this case, the efficient
frontier of investment options can be described
by a parabolic equation. The term ‘efficient’is
demonstrated in Fig. 5. E is an inefficient
portfolio: a risk-averse investor would select
either F (same risk, higher return), or G (same
return, lower risk), or some other point on the
efficient frontier, to match their individual risk-
return preference.
POWER ENGINEERING JOURNAL OCTOBER 2002

(ii) Separation theorem and capital market line
Now consider the situation where a risk-jree
asset exists, such as reputable government
bonds. This asset will, by definition, have a
zero standard deviation of return. If we assume
that investors can invest or borrow at the risk-
free interest rate (Rj), then the capital market
line (CML) can be drawn (see Fig. 5).
The CML is defined by a straight line from Rj
(the risk-free rate) impacting tangentially on
the efficient frontier. The point of tangency, m,
defines the market portfolio of equities. The
investor can create any point on the CML by
making an investment in the market portfolio,
and either borrowing or investing (lending) at
the risk-free rate. Low risk-return portfolios
can be created by investing in both the market
portfolio and the risk-free asset (portfolio J, for
example); high risk-return portfolios can be
created by borrowing at the risk-free rate and
investing in the market portfolio (portfolio H,
for example).
All points on the CML are either on or above
the efficient frontier and therefore would be
selected by a risk-averse investor in preference
to an alternative portfolio on the efficient
frontier. Consequently, the investor’s decision
is simplified (separated) into two decisions: (a)
how much to invest or borrow at the risk-free
rate, and (b) how much to invest in the market
portfolio. This is the basis of the separation
theorem.
Portfolio theory and the separation theorem
result in a linear relationship between risk
and return. All investors hold the market
portfolio-no other combination of risky
assets (equities) is as desirable.
(iii) From the capital market line to the
security market line-beta
William Sharpe3 was the first to develop and
use the concept of equity beta: the relative
responsiveness of the return of an individual
share compared to the market portfolio’s
return. Beta can be calculated by regressing the
historical returns of an individual share against
the market portfolio’s historical returns (five
years of monthly data is usually used, see
Fig. 6).
Beta can be expressed mathematically as:
where p is covariance, (s’ is variance, subscript
i denotes the individual share, and m denotes
POWER ENGINEERING JOURNAL OCTOBER 2002
Cost of capital
+.
return on the market portfolio, Rm,36
the market portfolio; the subscript i m denotes 6 Estimating beta using
i relative to m. historical data
Starting with the equation for his capital
market line, Sharpe proved mathematically
that provided: (a) the investor already holds
the market portfolio of equities, m, (b) beta is
measured relative to the market portfolio, and
(c) the individual share is a component of the
market portfolio, then beta can be used in the
following CAPM formula to calculate the
individual share’s expected return:
where E(R) denotes an ‘expected return’ value,
and Rf is the risk-free rate. The term in square
brackets is the equity risk premium (ERP)
and represents the expected market return in
excess of the risk-free rate. Or, to express the
capital asset pricing model in a simple form:
expected return, = risk-jree rate +
(beta,,,,x ERP) (4)
Sharpe effectively redefined the risk-return
relationship: beta is used to measure risk, and
expected return is a linear function of beta. The
result is known as the security market line
(SML) and can be represented graphically (see
Fig. 7).
The return on a high beta share (beta > 1)
demonstrates high volatility-a 1%change in
the market portfolio return results, on average,
in a greater than 1% change in the individ-
ual share’s return-consequently investors
demand a higher expected return than the
market portfolio. Vice versa for a low beta share
(beta < 1).
The regression process used to determine
255
Cost of capital
7 Security market line beta eliminates movements in the individual
share’s return caused by unique events (the
scatter of the data points in Fig. 6). Beta is
therefore a measure of the non-diversifiaiable or
systematic risk of the individual share relative
to the market portfolio. The expected return
figure generated by eqn. 3 only compensates
the investor for the systematic risk associated
with the individual share. This is acceptable
provided that the investor combines the share
in a market portfolio, thus eliminating the
share’s unsystematic risk.
(iv) Problems with CAPM
CAPM and the theories on which it is based
(portfolio theory and the separation theorem)
require a number of assumptions to be made:
no taxes
risk-averse investors
no transaction costs when buying and selling
shares
perfect information-all investors know
everything there is to know about a company
when deciding how much to pay for a share
risk can be measured by standard deviation
all investors are able to borrow and lend at
the risk-free rate.
These theoretical assumptions cannot be fully
satisfied; for example, investors clearly didn’t
have ‘perfect information’ about Enron and
WorldCom before they collapsed. In addition,
there are practical problems when applying the
model; the true market portfolio consists of a
share in every asset throughout the world:
equities, metals, real estate, cash, human
capital, art etc. In practice, investors have to
use a market index as a proxy for the true
market portfolio; for example the FTSE All
256
Share Index in the UK or :Standard & Poor’s 500
in the USA.
Empirical studies show that, despite past
successes, CAPM has not been particularly
good at estimating the cost of equity recently:
test data from the 1990s show that the actual
security market line is shallower than CAPM
predicts (i.e. low beta shares have higher
returns than CAPM predicts and vice versa for
high beta shares).* Nevertheless CAPM is in
widespread use throughout the world, and is
the principal model used by UK regulators.
Given CAPMs theoretical and practical
inadequacies, the results it produces should be
treated with reasoned scepticism.
Dividend growth model
(i) Theory
The dividend growth model (DGM) is the most
widely used method in US regulated industries,
and is used in support of the CAPM by many
UK regulators. It is simple to understand and
apply. However, its bold assumptions about
constant growth, and the numerous methods
of estimating growth rates produce cost of
equity estimates that are no more than a rule of
thumb.
In 1962 Gordon (see Reference 2) showed
that, if the company’s dividends, D, grow at a
constant rate to infinity, gd,”,then the current
share price, PO,can be presented as:
(5)
Numerical subscripts denote time in years.
Rearranging gives:
Or, alternatively:
k, = dividend yield + growth in dividends (7)
The company’s cost of equity is equal to its
dividend yield plus annual growth in dividends
(both expressed as a percentage). Eqn. 7 is
known as the dividend growth model (DGM),
or sometimes the Gordon growth model.
(ii) Problems with DGM
For the DGM to hold, dividends must grow
at a constant rate to infinity. This is clearly
unrealistic for most firms; only stable firms will
offer an approximate fit with the model. From
POWER ENGINEERING JOURNAL OCTOBER 2002

eqn. 5 it is clear that the model only applies
where gdtv is less than he. As gd,v approaches he
the share price tends to infinity, which is clearly
nonsense.
How should we forecast growth in divi-
dends? Historical dividend data can be an
unreliable guide, especially if the company has
changed over recent years; expert city analysts’
predictions are rarely reliable to more than two
years into the future, not to infinity as required
by the model; and accounting data on profit
growth can be manipulated (within accounting
rules, of course). There is no simple answer.
The DGM makes a very bold assumption
that simply does not hold in practice:
dividends cannot be expected to grow at a
constant rate to infinity. In addition the DGM
struggles to cope with high-growth companies,
and there is no reliable measure of dividend
growth. The DGM should be used with
caution, but is useful as a comparison for other
methods.
Additional models
There are other financial models, but none is as
simple to use as CAPM and DGM. The multi-
factor arbitrage pricing theory (APT) is more
flexible and more accurate than CAPM, but it
is difficult to understand, apply and interpret.
APT links equity returns to a number of macro-
economic factors, rather than the single factor
used in CAPM (the return on the market
portfolio); for example, oil prices, interest
rates, inflation, GNP growth etc. A mass of data
is analysed statistically to determine which of
these factors were historically correlated with
equity returns, and a model is constructed to
predict future returns, and hence the cost of
equity capital for the company in question. In
contrast multi-factor regression models use
company-specific data such as profits,
accounting ratios, firm size etc. to predict the
cost of equity capital.
Given the large amounts of data involved in
applying these models, they are much more
cumbersome to use and consequently prove to
be less popular. None of the UK regulators uses
them.
Capital structure
The discussion and examples above show that
the mixture of debt and equity used to fund a
company can be altered. Different gearing
levels result in different company WACCs, and
different levels of risk and return for investors.
The capital structure debate is concerned with
POWER ENGINEERING JOURNAL OCTOBER 2002
Cost of capital
altering the company’s gearing level so as to
arrive at an optimum, minimum WACC.
It was stated above that debt is cheaper than
equity, and therefore one might assume that the
company should use as much debt as possible
to minimise its WACC; however, it was also
shown that debt introduces financial risks
which are borne by investors.
As gearing increases from zero, equity
investors are exposed to additional financial
risk and demand a higher equity interest rate.
Initially, this is outweighed by the benefits of
cheaper, tax-efficient debt and the WACC
reduces. However, above a certain gearing level
the marginal benefits of debt are more than
offset by marginal costs from financial risk
factors such as the risk of cashflow problems,
risk of bankruptcy etc. and the WACC begins
to rise. If the gearing level gets too high, the
costs of both debt and equity begin to rise
sharply, causing a steep rise in the WACC.
In practice there is an optimal capital
structure and minimum WACC, but un-
certainty about the costs and benefits of debt
means that the exact shape of the WACC curve
is almost impossible to calculate. It would
appear that the best we can do is make an
educated guess at the company’s optimal
gearing level (see Fig. 8 ) .
Applying the theory
In addition to the problems applying the
models listed above, there are particular issues
for the DNOs. No longer are any of the DNOs
quoted on a stock exchange, which means
that key components of CAPM (beta), DGM
(dividend yield) and capital structure models
(market gearing level) cannot be calculated.
Given these difficulties, it is more appropriate 8 Optimal capital
to calculate a range for the cost of capital, structure
257
Cost of capital
rather than a single figure. The approach
described below follows finance theory as
closely as possible. Where practical compro-
mises prove necessary, these too are made with
regard for underlying theory.
The DNOs are regulated on an RPI-X basis-
revenues and asset values are inflated each year
by the retail price index, less an efficiency
factor X. Consequently, as inflation is already
built into the regulatory process, the cost of
capital is determined on a real basis, i.e. net of
inflation.
Cost of debt capital
Real risk-free rate
Reputable government bonds are essentially
free from default risk (e.g. UK or US bonds,
not Argentinean bonds). The UK Government
issues both conventional and index-linked
bonds or ‘gilts’. The face value of an index-
linked gilt (ILG) is inflated each year by the
retail price index and so it attracts a lower
interest rate than its ‘conventionap counter-
part. ILG yields can be used to estimate the real
risk-free rate.
ILG prices (and therefore current yields) are
determined by highly liquid and well-analysed
financial markets: hundreds of analysts and
traders are involved in setting market prices
through their buy and sell transactions. Conse-
quently, forward-looking market rates are
appropriate for use in estimating the real risk-
free rate. However, market rates demonstrate
significant volatility in the short term, and
therefore rolling averages over previous years
should be used. Using up to five year rolling
average yields on UK ILGs with more than
five years to redemption results in a real risk-
free rate in the range 2.5% to 3.0% (see, for
example, OFGEMs discussion4).
Debt risk premium (DRP)
The cost of debt can be considered as a generic
risk-free rate plus a company-specific debt risk
premium that reflects the market’s perception
of the risk associated with lending to the
company. The DNOs have a licence condition
that obliges them to maintain ‘investment
grade’ status on their debt, as assigned by
credit rating agencies Standard Q Poor’s (S&P)
and Moody’s Investors Service (Moody’s). The
lowest investment grades are BBB- and Baa3,
respectively. As a company gears up, more and
more cash is required to fund debt interest
payments; credit ratings give an indication of
the company’s ability to pay up. At higher
258
gearing levels debt interest rates tend to vary
with gearing-the comp,any may have a fixed
interest rate (bond coupon), but the price at
which its bonds trade in the market determines
the current yield (and hence DRP): a measure
of the market’s current perception of the risk
associated with lending money to the company.
The majority of the DNOs maintain their
debt at levels above the lowest investment
grade; at the last distribution price control
review in 1999, the PES!? had an average DRP
of approximately 1.40X5If we assume that the
DNOs may have to gear up to fund future
expenditure programmes, but remain within
their ‘investment grade’ licence condition, then
an appropriate DRP is 2.5%, this being the
average currently attracted by BBB and BBB-
(SQP) corporate bonds (data from Barclays6).
A DRP range of 1.4% to 2.5% is used in this
analysis.
Inflation risk premium (IRP)
The majority of DNO bonds are the ‘con-
ventional’ type, and consequently investors
are exposed to inflation risk: the risk that
inflation will rise unexpectedly, and signifi-
cantly reduce the real value of future bond
coupons they receive. To compensate for this
investors require an inflation risk premium.
An estimate of the IRI’ can be made by sub-
tracting actual inflation from past indicators of
inflation. The IRP has received relatively little
attention in terms of studies to determine its
value; the few current available estimates place
it in the range 0.6% to 0.9% (see, for example,
O X E W discussion7).
Real cost of debt
Combining these constituent figures leads to a
range of 4.5% to 6.4% for the real cost of debt
(see Table 2).
Cost of equity capital
As for debt we will determine a real interest
rate.
Capital asset pricing model
(i) Equity risk premium (ERP)
Referring to eqn. 3, the equity risk premium is
the expected return on the market portfolio in
excess of the risk-free ra1.e. Historical estimates
of the ERP are derived by subtracting historical
government bond yields from stock market
returns. Forward-looking estimates can be
derived by surveying investor opinion.
Unlike for the risk-free rate, forward-looking
POWER ENGINEERING JOIJRNAL OCTOBER 2002
 Cost of cupitul

Table 2 Real weighted average cost of capital for the DNOs

~ low high !
real risk-free rate (%I IAl 2.5 3.0 ,
~ debt debt risk premium (%) [B] 1.4 2.5 1
I inflation risk premium (%) [C] 0.6 0.9 I

~ real me-tax cost of debt (%I ID = A+B+Cl 4.5 6.4

i CAPM equity risk premium (%) [E] 4.0 5.0
, equity beta [q 0.8 1.1
, real post-tax cost of equity (%) [H = A+(E.F)] 5.7 8.5
1 DGM dividend yield (%) [J] 4.0 5.0
real dividend growth (%) [Kl 2.0 3.0 ’
real post-tax cost of equity (%) [L = J+K] 6.0 8.0
1 taxation corporate tax rate (%) IJI 30 30
WACC real post-tax cost of equity (%) [HI 5.7 8.5
real pre-tax cost of equity (%) [M = H/(1-T)]
real pre-tax cost of debt (%) [D]
8.14
4.5
12.14
6.4
,
gearing (%) [GI 50 60
OFGEM real pre-tax WACC (YO) [GD + (1-G)Ml 6.32 8.70 ~

amroach
real post-tax WACC gross of debt shield (%) [GD + (1-G)H] 5.1 0 7.24 ,
textbook real post-tax WACC net of debt shield (%) [GD(l-T)+ (1-G)H] 4.43 6.09 I
approach I

estimates of ERP are not derived directly from
the market, and consequently contain an
element of subjective judgment and bias.
The Competition Commission8 found that
forward-looking estimates of the ERP tend
‘not to be derived from rigorously-structured
surveys’. ERP estimates should be based
primarily on historical data, but with regard for
investor opinion.
Surveying a number of historical and market
estimates of ERP leads to a range of 4.0%
to 5.0% (see, for example, Competition
Commission’ and Barclays’).
(ii) Beta
Determining beta for a company that is not
listed on a stock exchange proves problematic:
industry sector betas or comparable company
betas can be used to provide a reasonable
estimate. However, for the DNOs there are no
directly comparable companies. We could use
the other regulated companies: water, Transco,
NGC etc., or we could use US electricity
utilities; but none of these shares the exact
same regulatory and commercial environment.
These betas only give a guide.
A great deal of subjective judgment has to go
into setting a beta value for the DNOs. The best
we can propose is a ‘reasonable’range of 0.8 to
1.1.Remember that, by definition, the average
company on the stock exchange has a beta risk
level of 1.0.The proposed range reflects, on the
one hand, that regulated electricity companies
may be considered lower than average risk due
to their stable demand and regulated income;
but on the other that this stable environment
enables them to maintain high gearing levels
with associated financial risks.
(iii) Real CAPM cost of equity
In summary, this leads to a real CAPM cost of
equity in the range 5.7% to 8.5% (see Table 2).
Real DGM cost of equity
(i) Dividend yield
Dividend yield presents this year’s or next year’s
anticipated dividends as a percentage of the
current share price. Again, as the DNOs are not
listed on a stock exchange, we have to use
comparable companies and industry sector
averages as a guide. Figures for UK and US
utilities show that a range of 4.0% to 5.0% is
appropriate (figures from Datastream).
(ii) Dividend growth rate
As described above, there are a number of
methods of estimating growth rate, each with
its associated problems. A good rule of thumb
is to use real growth in gross national product.
UK economic data shows that over time
aggregate company earnings tend not to
change significantly as a percentage of GNP-
i.e. the ‘average’company will show dividend
growth in line with GNP growth. A suitable
range for real growth in GNP is 2.0% to 3.0%
(see, for example, OFGEM”)
(iii) Real DGM cost of equity
This results in a range for the real DGM cost of
equity of 6.0% to 8.0%, which is broadly

POWER ENGINEERING J O U R N A L OCTOBER 2002 259

Cost of capital
current bond yields,
9 OFGEM and textbook
treatments of taxation
10 Competition
Commission
terminology for
treatment2 taxations
260
consistent with the CAPM range
Capital structure
Gearing level
In theory, current market values of debt and
equity should be used to determine the gearing
level. Again, these are not available for the
DNOs so we have to make do with ‘book‘
values derived from accounting data.
In their 1999 determination of the cost of
capital for the PESs, OFGEM assumed an
optimum gearing level of 50%, on the basis
that this would allow the PESs to maintain
investment grade status on their debt. There
may be scope to increase this assumed
optimum gearing level: Midlands Electricity
operates at approximately 60% gearing and
maintains BBB- (S&P) and Baa3 (Moody’s)
credit ratings.6 A suitable gearing range for this
analysis is 50% to 60%.
Taxation
The ‘textbook approach and the ‘OFGEM
regulatory approach to calculating the
weighted average cost of capital differ
fundamentally. The textbook WACC can be
used to discount cashflows from a range of
investment options to arrive at a net present
value for each, thus allowing the most
favourable to be chosen. The OFGEM WACC,
on the other hand, is applied to the value of a
DNO’s regulated asset base (RAB) to allow
sufficient cash to be generated to compensate
equity providers, debt providers and the tax
authorities. The two ;approaches use the
same constituent figures, but apply taxation
adjustments in different ways. The two
resultant WACC figures apply in different
contexts and should not be compared directly.
Confusion arises because the two approaches
use similar ‘before tax’ ,and ‘after tax’ termi-
nology, but with different meanings. Fig. 9
summarises the two approaches.
The OFGEM ‘before tax’ WACC inflates the
cost of equity by a factor of l/(l-t). When this
resultant percentage figure is multiplied by the
value of the RAB it generates sufficient cash to
fund capital providers and the tax authorities.
The Competition Commission* recognised
the confusion caused by the conflicting termi-
nology, and proposed an alternative, which is
used henceforth in this article (see Fig. 10).
Note that eqn. 1 calculates the ‘post tax WACC
net of debt shield.
Real weighted average cost of capitalfor the
DNOs
There is close correlation between the cost of
equity calculated using the DGM and CAPM
approaches. The CAPM figure was used in the
final WACC calculation, as this was the less
arbitrary of the two methods; this is consistent
with OFGEMs use of the two models.
The results show a range for the real pre-tax
WACC (the approach used in the regulatory
process) of 6.32% to 8.70% with a mid-point of
7.51% (see Table 2).
Regulatory approach
Textbook application of cost of capital theory is
designed to calculate a suitable discount rate.
This differs fundamentally from the regulatory
process, which is designed to agree an
appropriate amount of allowable revenue. The
regulators want the lowest acceptable figure as
this results in low customer bills, whereas the
companies want the highest acceptable figure
as this increases returns to their shareholders.
The Competition Commission plays an
important role in the regulatory process. If the
companies and their regulator cannot reach
an agreement, the Competition Commission
POWER ENGINEERING JOURNAL OCTOBER 2002
 Cost of cupitu2

Table 3 Example of inconsistent UK regulatory approaches to determining the real risk-free rate and
equity risk premium

real risk free rate-

I regulatory report range and method ERP-range and method j
1, OFGEM
. . I
(May 1999)-PES 2.0%-2.5% 3.0%-4.2%
I initial documentlo average of ILG spot yields bottom end of historical averages
over previous 2 and 3 years and top end of market surveys ~

; OFGEM (Aug 1999)-PES 2.25%-2.75% 3.25%-3.75%

, draft document5 spot market yields on ILGs narrower range around May figures; 1

and conventional gilts more emphasis on market opinion I

1 OFGEM (Dec 1999)-PES 2.5% 3.5% I

r final determination” middle of August range; middle of a range of investor

confirmed by ILG and
I conventional gilt spot yields
; OFWAT (NOV1999)- 2.5%-3.0%
final determination” current yields on ILGs and
conventional gilts of mixed
maturity (time to redemption)
surveys quoted in August report.
3.0%-4.0%
forward-looking average of a
range of market predictions
I

; OFGEM (June 2000)- 2.5%-2.75% 3.5%

, NGC draft document4 spot, 2-, 3- and 5-year moving review of historical and forward-looking
I averages of current yields on estimates: emphasis on the latter ,
I ILGs with >5 years to redemption
1 ORR (December 1998)- 2.25%-3.0% 3.0%-4.0% I

I Railtrack, initial proposal13 spot yields on lLGs and market surveys and regulatory
I
conventional gilts of mixed precedent ,
1 maturity (as per OFWAT method) 1

i ORR (October 2000)- 3.0% 4.0% ,

I Railtrack, final determinati~nl~central case from Competition from Competition Commission
I Commission (2000) (2000)
, OFGEM (September 2001)- 2.75% 3.5% ,
, Transco Final Determinati~n~~
current yields on ILGs and average of past trends, market
conventional ailts; allowance for survevs and OFGEM models
an anticipatedrise in rates
MMC (Mav 1995)- 3.5%-3.8% 3.5%-4.5% I

’ Scottish HYdrol6’ reference to ‘the relevant literature’ reference to ‘the relevant literature’ 1

: MMC (1998)--Cellnet and 3.5%-3.8% 3.5%-5.0%

j Vodafone17 average redemption yields consideration of historic and forward- I
on ILGs from 1986-1998 looking data: reference to previous ~

, MMC reports I
i Competition Commission 3.0% 4.0%
j (2000)-Sutton and East ILG spot yields adjusted for ‘best estimate’ based on historical ~

1 Surrey WateP anticipated increase in rates averages and a range of utility and I
investor surveys of future expectations ~

makes the final determination; consequently
the companies and regulators pay particular
regard to the Competition Commission’s
approach to calculating the cost of capital.
A review of recent regulatory WACC deter-
minations by OFGEM, the Office of Water
Services (OFWAT), the Office of Rail Regula-
tion (ORR), the Monopolies and Mergers
Commission (MMC) and the Competition
Commission shows evidence of unnecessary
risk in the regulatory process:
Regulators frequently use arbitrary, subject-
ive judgment to set cost of capital figures.
Despite a stated desire for consistency over
time and between regulators, the evidence
shows that this does not occur in practice.
Regulators (and companies) make selective
use of regulatory precedent to support and
justify their negotiating positions.
Regulators often cite seemingly authoritative
reports (including their own) in order to
support their proposals; however, examina-
tion of these references often leads to a trail
of citations with little substance.
For example, see the range of figures and
methods used to determine the real risk-free
rate and equity risk premium in Table 3.
These regulators calculate the cost of capital
primarily using CAPM with DGM in support,
but because of the issues described above,
regulatory cost of capital determinations are
essentially subjective judgments based on data

POWER ENGINEERING JOURNAL OCTOBER 2002 261

Cost of cupitul

that links a share's return to its covariance with the market portfolio, as
1
risk-returncombinations available by lending or borrowing at the risk-free
investing in the market portfolio
of debt and equity capital employed in the firm. Measured by the gearing ,

strument. Not index-linked

o a bondholder, usually expressed as a percentage of ,
inal debt interest rate
as a percentage of its current market value. A market-

n one equity (share) in order to reduce financial risk

company's cost of equity is equal to its dividend yield plus

olio investment options offering minimum risk at each level

d market portfolio return minus the risk-free rate

ments in a number of assets (diversification) to reduce overall risk

en offered two investment options with similar risk, selects the

on; and when offered two investments with similar return, selects

k-free investment. Reputable government bonddgilts

le, the investor's investment decision is simplified '

: how much to invest or borrow at the risk-free rate
market portfolio

nated through diversification. Also known as '

262 POWER ENGINEERING JO(JRNAL OCTOBER 2002


which meets the requirements of the two
theoretical models to only a partial extent.
Conclusions
The cost of capital is a significant figure for
the regulated UK utilities (not just electricity
distribution); in part it determines billions of
pounds of market value, customer bills and
returns to capital providers.
The current DNO real cost of capital of 6.5%
is towards the low end of the range produced
in this article, which indicates that the
companies may not be making sufficient
returns to compensate capital providers for the
risks associated with a regulated electricity
distribution business.
Textbook finance theory suggests that
calculating the cost of capital for a company is
a mechanical process. However, theoretical
problems with financial models and practical
problems applying them turns the process into
an estimation exercise. The DNOs face
additional problems because they are not
quoted on a stock exchange and they face an
inconsistent UK regulatory regime (so far as
cost of capital determinations are concerned).
Investors, companies and customers would
all benefit from the reduced risks associated
with a common, less subjective approach to
calculating the cost of capital. In theory
more consistent regulation with lower inherent
risk would result in lower customer bills as
investors would be willing to accept a
commensurately lower cost of capital.
Companies and regulators across all UK
regulated industries should work together to
agree a common approach to calculating the
cost of capital, including investigation into
the use of additional financial theories such
as arbitrage pricing theory and multi-factor
regression models. The more relevant, theor-
etical evidence that can be presented, the less
subjective the regulatory decision-making
process will become. It is important that the
Competition Commission be involved in
determining the common approach as it has
the final say in any dispute between a company
and its regulator.
Acknowledgments
The author would like to thank Jonathan
Ashcroft at Midlands Electricity, Stuart Cooper
at Aston Business School and Prof. Glen Arnold
at Salford University for their assistance with
the research that enabled this article to be
written. The views in this article are those of
POWER ENGINEERING J O U R N A L OCTOBER 2002
Cost of capita2
the author, and not necessarily of any person,
company or organisation mentioned herein.
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pricing of electricity distribution services’, Power
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2 ARNOLD, G. C.: ‘Corporate Financial Management’
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‘
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2002-Final proposals’, September 2001, www.
ofgem.gov.uWpublidpub2OOl.htm,pp. 76-82
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reference under section 12 of the Electricity Act
1989’ (The Stationery Office, London, May 1995)
17 MMC: ‘Cellnet and Vodafone: Reports on references
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0 IEE: 2002
Mike Lockett is Head of Project Management at
Aquila Networks (Midlands Electricity), PowerProjects,
George Road, Erdington, Birmingham B23 7QJ, UK,
e-mail: mike.lockett@aquila-networks.co.uk He is an
IEE Member, and occasionally lectures for the Finance
Department at Aston Business School.
263