Some of our research papers are in the form of guidelines, while others are frameworks or principles for how we may review issues.
The cost of capital is the rate of return that investors require to invest in a firm.
Elements of the cost of capital
Investment can be funded with equity capital and / or debt capital. Therefore the cost of capital is a weighted average of the returns on equity and on debt.
The weights represent the relative importance of equity and debt in the regulated firm’s capital structure.
The regulated firm and the cost of capital
Where a regulator sets prices (for businesses with market power), the regulator typically has to specify ‘an allowed cost of capital or rate of return on capital’.
What happens if the cost of capital is set too high/too low?
If the cost of capital is set too high for a regulated firm then profits will be higher than required to ensure appropriate investment occurs and final prices to customers will be too high.
If the cost of capital is set too low investors in the regulated firm may be attracted to other investment opportunities and investment in the regulated firm can decline.
The QCA has reviewed its cost of capital methodology for regulated businesses.
As part of this review, the QCA released discussion papers covering various aspects of the cost of capital for public comment. The QCA has released decision papers on the cost of capital related to:
- market parameters – risk-free rate, market risk premium and gamma
- benchmark cost of debt estimation methodology
- trailing average cost of debt.
Forms of regulation can be thought of as the different types of regulation, or regulatory controls, applied to the regulated firm in setting its allowed revenue or prices.
Examples of forms of regulation include:
- price caps
- revenue caps
- average cost pricing
- menu regulation
- ancillary mechanisms, such as cost pass-throughs and unders and overs accounts.
The form of regulation affects incentives for efficient operation and how risk is allocated to regulated firms.
We have investigated the implications of the form of regulation on efficiency, cost forecasts and the risk allocated to regulated firms.
We have developed general pricing principles to apply to regulated monopoly activities.
Pricing principles are used to guide our decisions on the level and structure of prices for the monopoly activities we regulate.
It is important that regulated firms know about the QCA’s broad principles and regulatory processes – certainty about the regulatory context helps the regulated firms and their customers when they make planning and operational decisions.
See our projects for more information on our pricing principles.