A re-examination of the foundations of the cost of capital for regulatory purposes

Abstract

In regulatory proceedings, few issues are more hotly debated than the cost of capital. This article seeks to formalise the theoretical foundation of cost of capital estimation for regulatory purposes. We find that several common regulatory practices lack a solid foundation in the theory. For example, the common practice of estimating a single cost of capital for the regulated firm suffers from a circularity problem, in that the estimate of the cost of capital depends on the regulated revenue allowance which, in turn, depends on the cost of capital. This problem is especially severe in the context of a multi-year regulatory period. We also show that, in the context of a multi-year regulatory period the cost of capital cannot be expressed as a weighted average of the cost of equity and the cost of debt. In addition, the relevant cost of debt cannot normally be estimated using the yield-to-maturity on a corporate bond. We suggest possible directions for reform of cost of capital practices in regulatory proceedings.