Optimal WACC in tariff regulation under uncertainty

Abstract

In the regulation of network tariffs, the compensation for the opportunity costs of capital through the Weighted Average Costs of Capital (WACC) plays a crucial role. Determining the appropriate level for the WACC is, though, problematic because of the uncertainty about the future conditions in capital markets. When the WACC is set above the future opportunity costs of capital, consumers will pay too much, while when the WACC is below that level, network operators may be unable to finance investments affecting quality of network services. In this paper, we explicitly take this uncertainty into account when we determine the optimal WACC for the tariff regulation of an electricity network. By trading off consumer surplus and expected disruption costs in the electricity grid, we conclude that from a social-welfare perspective in most cases the optimal WACC in tariff regulation is above the historical mean costs of capital. Only in case of high uncertainty about the true costs of capital while network operators are able to quickly increase investment levels, the optimal WACC is below the historical mean because then it is less likely that the WACC is constantly insufficient to cover actual costs of capital. However, when network operators cannot quickly increase investment levels the optimal WACC is always above the historical mean cost of capital.