Cost of capital and WACC in the utility, electricity and gas sector, energy projects comparison calculation

THE COST OF CAPITAL FOR GAS AND ELECTRICITY INFRASTRUCTUREs:

Practices in the financing firms and approaching regulators

March 2008

The cost of capital is generally calculated as the weighted sum of the costs of different sources of financing used by the firm i.e. equity and debt, as they are traditionally understood. The Weighted Average Cost of Capital is a fundamental element in corporate financing. Financial analysts and investors systematically use it to valuate and select their investments, whether in shares or industrial projects.

It also serves as a discounting rate applied to future cash flows to produce a net discounted value, or a threshold value for estimating the profitability of an investment. In network industries subject to regulations, the WACC is also determined by regulators who directly influence operator revenues. Applied to the Regulated Asset Base (RAB) to obtain the cost of capital, the rate set is a sensitive value in the pricing of cost-oriented infrastructures (operational and investment costs have a more explicit nature).

The cost of debt before taxes is usually modelled by the formula: CD = Rf + d,

where Rf is the rate without risk;
and d is the credit risk premium, measurement of a higher return in compensation for the risk of failure to pay.

The Capital Asset Pricing Model is most often used to determine the cost of capital after taxes:

CE = Rf + β.EMRP,

where: EMRP is the market risk premium, additional profitability that shareholders expect for holding on to risky assets rather than safer investments;
and beta measures the exposure of the firm to market or systemic risks.

Thus, considering the privileged fiscal treatment of the debt, the expression after taxes of the cost of capital is:

CMPC = (1-g).( Rf +β.EMRP)+g.(1-t) ( Rf +d), where g is the debt leverage and t the tax rate

The problem of determining parameters

In theory, the parameters of the WACC used in corporate finance are determined in an exclusively prospective manner over the period of investment (even if, sometimes, for this purpose, past trends are used as a reference). For example, the beta calculated using market data is reduced to an economic beta, stripped of the effects of debt on the company’s risk profile and then “re-indebted” with a forecasting lever.

The WACC used for pricing calculations must constantly be updated according to the most recent data, like the risk-free rate in force. For regulators, concerns about the stability of the rate, invariable during the regulation period, is the primary consideration in their evaluation. This provides a certain level of visibility for operators. Regulated rates therefore differ because they integrate "standardised", rather than prospective, parameters. For example, an operator whose financial structure is clearly "sub-optimal", and likely to remain so for some time, should not be overpaid. We should note that for parameter g, regulators of energy infrastructures consider accounting values (percentage of RAB) rather than market values, as is the practice in traditional corporate finance.

Compared to brokerages, regulators are finally confronted with the issue of differentiation between prescriptive WACCs according to the type of infrastructure. In this respect, beta is the most difficult parameter to determine. However, this should not lead us to choose a value corresponding to that of a group with multiple businesses which includes the entity under consideration, even if the reasoning underlying its profile for specific risks is based essentially on qualitative considerations. Definition of the WACC is simple. Estimation of each of the parameters it comprises is, on the other hand, a complex exercise when it is performed with a level of precision commensurate with the stakes. In practice, financial analysts tend to neglect this calculation and communicate essentially on the various developments likely to affect forecasted cash flows. Alternative methods, such as Arbitrage Pricing Theory, which circomvents the choice of a single financial structure in the updating of cash flows, are also used. With the RAB, regulators have less leeway to adjust prices without affecting WACC. Furthermore, today they must communicate, even consult, more openly on this rate, or rather the rates by type of asset. Nevertheless, these choices sometimes remain insufficiently justified or analytically robust despite appearances

A practical example: estimation of WACC for French gas and electricity infrastructures

At the instigation of the French Energy Regulatory Commission and in cooperation with the consultancy PMP, Zelya performed an original study of WACC in two phases. The first consisted in an “intelligent” benchmarking of rates applied by other European regulators. In themselves, these are of little interest when we want to compare them to the French situation. Therefore they were processed a second time, infrastructure by infrastructure, initially so that they covered the same definitions (rates before and after taxes, nominal or real) and the same economic context (taxes). Then they were adjusted in relation to the various BAR, which also do not cover the same perimeters for the regulators. Finally, a more qualitative process concerned appreciating the impact of the regulatory system (price cap, pass-through, volume risk, etc) on the risk profile of the business compared to the French framework. This enabled to compare foreign rates in a more relevant manner than “raw” benchmarking. The second phase is a more traditional “internal calculation”, parameter by parameter. This was based on a multitude of sources including data gathered from regulators, economic literature and market information reprocessed using Bloomberg data. To differentiate the analysis by business, an operator’s benchmark (beta, g) was also necessary. Comparison of the results and former regulated rates therefore enabled regulators to make a highly informed choice of the new rates to apply.

Author: Djibril Diakité

Djibril Diakité has aslo performed numerous studies in Europe on this topic for other business sectors.

djibril(-at-)zelya.com