Chapter 10 - Asymmetric Risk: Theory and Examples

Abstract

This chapter addresses the presence of asymmetric risk affecting the value or usefulness of utility assets adversely, how this risk is reflected in capital markets and the measured cost of capital, and possible adjustments needed in regulatory allowances to compensate for it. In situations where the distribution of returns facing a regulated company includes a material asymmetry, setting the allowed rate of return at the observed market cost of capital may not be sufficient for the risk the utility investors bear. This chapter describes why this is the case, using the example of how junk bonds are priced to reflect default risk versus how stocks are priced to reflect black swan events. It examines the California energy crisis and the natural gas price deregulation process of the mid-1980s. Even when it is agreed that there is an asymmetric risk of material adverse events, it can be difficult for traditional regulatory procedures to address the problem. Solutions may involve trying to avoid the problem rather than compensate it in advance, but the preferred approach will depend heavily on the circumstances. The chapter discusses potential future asymmetric risks facing the utility sectors, including impacts of fracking on the gas pipeline industry or the risks of stranded capital investments in electric utility infrastructure if flat or falling demand persists or even accelerates.