The Cost of Capital for the UK Water Sector
Regulation Initative Working Paper No. 28
40 Pages Posted: 17 Oct 2002
Date Written: May 1999
This paper examines the issues of the appropriate cost of capital for companies operating in the regulated water industry in the UK. This issue is of importance at the current time because the water regulator Ofwat is currently in the final stages of its periodic review of prices to set for the coming five years 2000-2004. The plan for this paper is as follows. The following section summaries the board debate on the cost of capital. Section then focuses on the most important element in this debate, the appropriate market risk premium. Section 4 examines the specific and somewhat sparse evidence cited by Ofwat on the equity risk premium. We argue that this evidence can be reasonably interpreted rather differently, yielding an estimated rather higher than that proposed by Ofwat. Section 5 then reveiws the boarder UK debat on the cost of capital. Section 6 examines the riskiness of the water sector. Section 7 compares estimates of the cost of capital from Ofwat and a 'convenitional' approach with the procedure used by the MMC. Both the other procedures give an estimate some 1-1.5% higher than that proposed by Ofwat. Section 8 then draws together the principle arguments of the previous sections and underscores the risks articulated above that the current reveiw risk setting too low a cost capital to the detriment of the long run performance of the UK water section. An important point is that even the straight application of the MMC procedure for estimating the cost of capital which we judge is subject to downward biases results in a higher estimate of the cost of capital than OFWAT has een proposing in its consultation documents.
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