Regulatory Risk, Cost of Capital and
Investment Decisions in the
Telecommunications Industry:
International Comparisons
Anastassios Gentzoglanis
University of Sherbrooke
Department of Finance and CEREF
Centre for the Study of Regulatory Economics and Finance
Faculty of Business Administration
Sherbrooke, Quebec, Canada, J1K-2R1
Phone: +(819) 821-8000 X2958
e-mail : [email protected]
The Context
• There is an increasing theoretical and
empirical interest in studying the
relationship between changes in
regulatory policies and investment in
infrastructure in the telecommunications
industry worldwide.
Goals of the Study
• Develop a model and examine the
theoretical relationship between changes
in regulatory policies and investment.
• Examine empirically the different treatment
of the capital cost across jurisdictions.
• Explain the difference in regulatory
practice in using MRPs in various
regulatory settings
• Offer some policy recommendations
The Setting (I)
• There are two approaches dealing with the
theoretical question whether there is a socially
optimal capital structure for the regulated firm.
• The first one assumes that the firm decides on
its capital structure to influence the price set by
the regulator.
• The second one recognizes the role of the
regulator and it is the regulator who influences
the firm's capital structure.
The Setting (II)
• The first approach is more akin to the American
regulatory environment where regulated firms
are long established and regulators tend to take
the firm's capital structure as given.
• The regulator determines the allowed rate of
return by considering the debt/equity ratio of the
firm and its respective cost.
• The allowed rate of return or cost of capital is a
weighted average of the cost of debt and the
cost of equity evaluated at book value.
The Setting (II)
• In Europe, privatization and regulation are
recent experiences and regulators do not
generally take the firm's capital structure
as given.
• Rather, it is endogenously determined
either by the regulator or by shareholders
who maximize the shares returns.
Optimal capital structure for
regulated firms
Optimal debt Ratios in Various Regulatory Settings
Regulatory agency
Water companies (Ofwat, 1999)
Optimal debt ratio
45%-55%
Rail track (ORR, 1999)
50%
Public electricity suppliers (Ofgem,
1999)
50%
National Grid Company (Ofgem,
2000)
60%-70%
Transco (Ofgem, 2001)
Mobile phone operators (Oftel, 2001)
62.5%
10%-30%
Source: De Fraja, G., and C. Stones, (2003), "Risk and Capital Structure in the Regulated Firm" WP, University of York.
Business risk vs. Consumer risk
• If regulators' objective is to maximize
social welfare, the choice of an optimal
capital structure has a direct effect on the
cost of capital, the price paid by
consumers and the return on investment.
• An increase in debt may imply an increase
in the price variability (consumer risk) and
eventually an increase of business risk for
the regulated companies.
Business risk vs. Consumer risk
• If consumers are risk averse, they prefer
less price variability.
• Consumer risk is reduced when regulators
set lower debt ratios but the latter
increases the cost of capital and therefore
the overall cost of providing the service.
• There is thus a tradeoff between
consumer risk and debt ratios.
The Model
• Following De Fraja, and Stones, (2003), let’s
assume that telcos choose their capital ratios.
• Lenders, shareholders and consumers are risk
averse.
• Regulators' objective is the maximization of
consumers' expected utility.
• Result: The set of prices that the firm can charge
depends on its capital structure and, hence, its
cost of capital.
Prices as a function of a firm’s
capital structure
• There are two prices, low (pL) and high
(pH)
• When the cost of capital is high (more
equity than debt), the regulated firm
chooses a high price (pH)
• When the cost of capital is low, the price
chosen by the firm is low (pL) too.
Capital structure and risk in
regulated industries
Figure 1
Capital structure and risk in regulated industries
p
pH
Y
Modigliani, Miller
proposition (cost of capital
is independent of debt)
E(p)
pL
Ď/(D+E)
D*/(D+E)
D/(D+E)
Source: De Fraja, G., and C. Stones, (2003), "Risk and Capital Structure in the Regulated Firm" WP, University of York.
Prices and optimal capital
structure
• At debt levels higher than Ď, the firm has
difficulties in paying its debt and interests,
be at the high or low state of the world.
• The difference in price at these higher
levels of debt is increasing.
• Debt levels lower than Ď would not be
chosen by the regulators, since they are
weakly dominated by Ď.
Prices and optimal capital
structure
• As the level of debt increases, the cost of
capital decreases, up to the point Y
(dashed line), where the return on equity is
independent from the level of debt.
• While the choice of the capital structure is
firm's responsibility, in this setting, the
regulator by selecting prices obliges the
regulated firm to choose its debt/capital
ratio as well.
Prices and optimal capital
structure
• It can thus be argued that the regulator is
determining, de facto, the firm's capital
structure.
• In that setting, the regulator has a
preferred capital structure which is
supposed to maximize consumer welfare
subject to the cost of capital constraint.
Prices and optimal capital
structure
• The regulator's optimal capital structure is at a
level of debt D* to the right of Ď.
• At higher levels of debt, there is more price
volatility and hence risk for the consumer.
• The optimal capital structure is determined at the
point where the benefits of an expected price
reduction equal the costs of the increase in price
volatility.
• Regulatory governance and practice play a
decisive role in determining the optimal capital
structure.
Regulatory Practice and
Investment Performance
• Regulators around the world use
alternative methodologies and local
realities in assessing the utilities cost of
capital with different impact on risk and
investment decisions.
• In Europe, although the practice is not
uniform, the CAPM is primarily used to
determine the rate of return on equity
within the WACC framework.
Regulatory Practice and
Investment Performance
• In the UK, regulators have chosen to express
WACC in real terms, using real risk free rates of
20-year maturity government bonds.
• Market risk premium (MRP) is another key
variable in the cost of capital estimations.
• UK regulators use a wide range of premiums
ranging from 2.5% (for the airports) to 5% in the
telecommunications sector (Oftel, 2001).
Regulatory Practice and
Investment Performance
• In France, l'Autorité de regulation des
telecommunications (ART) uses the WACC to
estimate the cost of capital for interconnection
rates and universal service offerings.
• The ART does not provide details on the range
of MRPs used and there is no information on the
values adopted for leverage or taxation levels
used by the authority in the cost of capital
estimates.
Regulatory Practice and
Investment Performance
• In the US, the FCC (Federal Communications
Commission) does not use the WACC in
regulatory proceedings.
• The FCC uses specific price caps formulas in
setting rates for local exchange carriers (LECs).
• Price caps are set by taking into account the rate
of inflation minus the X-factor estimated using
the TFP analysis.
• The WACC is used in electricity and gas
distribution and occasionally is some state –
based regulatory hearings.
Regulatory Practice and
Investment Performance
• Whenever State regulators use the WACC, they
estimate the cost of capital as a weighted
average of the pre-tax cost of debt and the posttax cost of equity and therefore the impact of
taxation is captured in the regulated cash flows
(vanilla form WACC).
• The use of regulatory mechanisms such as
sliding scale earnings sharing formulas allow
regulated firms to earn more than the cost of
capital determined by these formulas and this
acts as an incentive to investment.
Regulatory Practice and
Investment Performance
• Whenever the WACC is used, the most common
methodology to set the equity component of the
WACC is the DCF and risk premium analysis.
• The use of the CAPM is restricted in crosschecking the results obtained by the use of other
methodologies.
• The use of the DCF and RPA make little
reference to the risk-free rate of return, therefore
there is no debate as to the allowed nominal
returns on equity by the regulators.
Average post-tax real rates of
return internationally
North America
United Kingdom
Australia
Return on equity
8.8%
6.9%
10.1%
Return on debt
4.8%
4.4%
4.6%
Vanilla WACC
6.6%
5.6%
6.8%
Real rates of return
internationally: A Critique
• These results do not account for country-specific
differences
• The CAPM used to estimate these returns has
its own weaknesses, especially high standard
errors and volatile betas.
• Differences in regulatory regimes and especially
the methods used to calculate the regulatory
asset base (RAB) may result in risk asymmetry
that investors are unable to avoid through
diversification.
Real rates of return
internationally: A Critique
• Failure to account for these limitations
may result in flawed comparisons across
jurisdictions and lead to a regulatory error.
Risk and market risk premiums
(MRP) across countries
• Market risk differs across countries and so
market risk premiums (MRP), the premium over
and above the risk free rate.
• For meaningful international comparisons, the
plain vanilla WACC should be adjusted to take
into account of these differences.
• Nevertheless, the market risk premium (MRP) is
an expected one and not directly observable.
• Therefore, the choice of an appropriate rate is
necessarily ad hoc.
Dimson et al., estimates of
annual market risk premiums
Annual Market Risk Premiums Across Countries (1900-2001)
Country
Premium over bonds
Australia
7.9%
Canada
5.7%
France
6.7%
Ireland
4.5%
Netherlands
6.4%
UK
5.5%
US
6.7%
Range of values for MRP in
various regulatory settings
Regulatory values for Market Risk Premiums Across Countries
Range of MRPs
MPR based on most typical MRP
provided
Australia
5.0-6.0%
6%
Canada
5.0-5.5%
5%
France
-
-
Ireland
5.0-6.0%
5.5%
Netherlands
4.0-7.0%
5.5%
UK
2.5-5.0%
3.5%
US
6.0-8.5%
6.0%
Country
Reasons explaining the difference
in regulatory practice
• There may be two explanations:
– Differences in market structures and
– Differences in taxation in various countries
Stock markets and industry
structure
• Roll (1992) examined and compared the behavior of
international stock markets as a function of each
country's industry structure.
• Over the period 1989-91, he found that approximately
50% of the equity returns in major developed economies
could be explained by the industry composition of the
stock exchange index.
• Furthermore, the size of a firm may affect negatively its
beta. Higher betas are generally associated with smaller
firms.
• If a country's stock index, such as Canada, is comprised
of small firms, its MRP would be higher than the MRP of
other countries having larger firms listed in their stock
exchanges (US for instance).
Market Capitalization Across
Countries -1999
Country
Market Capitalization (billion US)
Share of world market
Australia
235.7
1.4%
Canada
338.3
2%
France
729.0
4.3%
Ireland
37.9
0.2%
Netherlands
477.1
2.8%
UK
1801.4
10.6%
US
8707.1%
51.2%
Conclusion
• Globalization, market integration, the internationalization
of investors and national tax rates and industry structure
are all important factors to be taken into account for
choosing an appropriate MRP to be used by the
regulators in various countries.
• It is only when regulators would recognize the
importance of these factors in determining the MRP to
be earned by investors that telecommunication firms
would get the right incentives to invest in new broadband
technologies.
• Major differences in investment performance would
persist internationally when historical un-adjusted market
premiums are used by regulators in setting prices and
interconnection charges.