Risk Factors in Energy Utility Returns: An Augmented-Four-Factor Model

Abstract

In this paper we utilise the risk factors from both the finance and energy economics literatures to develop an improved asset pricing model (the Augmented-Four-Factor Model or AFFM) in the context of the European energy utility sector. In addition, we undertake inter-sectoral and inter-temporal analyses using the risk factors in our AFFM. Our results show our AFFM captures the greatest proportion of returns relative to other models. Further, stock market risk factors (most notably the market, size, value and momentum premia) explain a much greater proportion of average returns than term and commodity risk factors. Our inter-sectoral results show that, relative to other sectors, energy utilities are defensive stocks over the period analysed (1996 to 2013). However, our inter-temporal analysis shows that market beta has been increasing through time, from 0.710 in 1996 to 1.037 in 2013; the European energy utility sector is becoming increasingly exposed to systematic risk. Further, despite regulatory changes, designed to counteract the dominance of big energy utilities, the size premium has increased over time. Finally, the value and momentum premia are evident one to two years after the three EU energy sector liberalisation packages of 1996 and 1998, 2003, and 2009. In particular, the energy sector becomes extremely distressed following the third liberalisation package.