Economic Regulation - IATA

The WACC is typically fixed in advance for the whole
regulatory period. The cost of debt is set in relation to
the firm’s balance sheet and its credit rating. The cost of
equity component is calculated using the Capital Asset
Pricing Mechanism (CAPM). The CAPM links the return
an investor earns on an asset to the return on risk-free
assets and the return on the equity market as a whole.
In other words, it sets the cost of equity in accordance
with the risk for the firm against the market average.
The weight applied to the debt and equity components is
subjective, sometimes based on a projected or targeted
gearing levels rather than the actual gearing level at the
time of the review.
However, the process involved in calculating the WACC
raises some issues that need to be taken into account:
Regulatory discretion.
On some occasions a range for the WACC has been
calculated in detail, but the regulator has determined
a value at the high end of the range based on its own
perception of risk 14 .
Changes in gearing levels.
The gearing level of a regulated firm can change
significantly, especially if new investment is funded
primarily through debt. Firms can be allocated an excessive
WACC based on their capital structure at the start of the
period, even though debt funded new investment actually
increases gearing levels and lowers the actual WACC.
A regulator can attempt to anticipate this by using a
projected gearing level (e.g. for NATS in the UK) or an
assumption of the optimal gearing level for the firm
during the regulatory period.
Low interest rates have given
regulated firms a windfall.
With historically low interest rates over the last few years,
the actual WACC has typically been lower than levels
allowed for by regulators. Though the WACC is set on the
basis of the cost of equity and debt, firms have typically
relied on debt as the main source of external finance for
new investment.
For example, across all of the UK regulated infrastructure
companies there have only been two equity rights issues
since privatisation. Debt-led investment has not only
enabled the difference between the lower cost of debt
and the WACC to be reaped by regulated firms rather
than customers, but it has also constrained the options
for management with regard to new investment through
the need for higher and faster cash-flow returns.
14
For example, in the UK CAA’s 2003 regulatory review of BAA’s London airports it calculated a range of 5.67% to 8.76% for the WACC (midpoint
7.21%), but determined a final value of 7.75% based mainly on its own assumption of the risks associated with investment at Heathrow.