A Few Things Transport Regulators Should Know About Risk and the Cost of Capital
17 Pages Posted: 20 Apr 2016
Date Written: July 1, 1999
A methodology for measuring the cost of capital, calculating the measure of market risk, and estimating the impact of various regulatory regimes on market risk in the transport sector.
In reviewing contracts, establishing price limits, or arbitrating conflicts, regulatory agencies and policy advisors face significant information asymmetry in determining the appropriate allowed rate of return, or discount rate. The information gap is especially important in determining the degree of market risk - often a critical component of the cost of capital demanded by operators.
Alexander, Estache, and Oliveri consider various methodological problems in the transport sector in establishing the link between regulatory regime and degree of market risk. The results of quantitative studies confirm that even for the transport sector - where there is intermodal competition and where contracts are often shorter and regulatory decisions may be less pressing than for utilities - the choice of regulatory regime greatly affects the degree of market risk a company faces. This has important implications for regulatory agencies and actions.
When a regulatory agency undertakes a price review, or when issues arise about concession contracts, it is important that regulators assess correctly the required rate of return and cost of capital. They must also assess correctly the level of risk, which affects the required rate of return and the cost of capital.
Most regulators in developing countries have a problem: The regulated companies are unquoted or undertake many activities for a range of industries and even sectors. For them this methodology for measuring the cost of capital, calculating the measure of market risk, and estimating the impact of various regulatory regimes on market risk may be useful.
This paper - a product of Governance, Regulation, and Finance, World Bank Institute - is part of a larger effort in the institute to increase understanding of infrastructure regulation.
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