Decoding the cost of capital

Decoding the cost of capital

Are stock prices of peer companies informative about a firm’s cost of capital?

Since energy networks are natural monopolies, their prices are regulated, with public authorities determining the return on capital that network providers are allowed to receive. For this purpose, authorities often use the CAPM (Capital Asset Pricing Model) and estimate this model (and its key parameter “beta”) based on data about stock prices of peer companies. To get a reliable estimate of beta and the cost of equity, it’s important  to ensure that the data from peer companies provides sufficiently accurate information about these companies.

Authorities often impose criteria for the selection of peer companies which are based on the availability of sufficiently informative stock prices, often measured by the stocks’ liquidity.

In a study for the Dutch regulator ACM, we analysed and compared selection criteria with the aim to support ACM in deciding which criterion they could use.  

The bid-ask spread: simple, conceptually sound and well-established

Based on the literature and on experience from other European countries, we derived a long list of potential criteria and liquidity measures, and provided a conceptual assessment of the various candidates.

As a result of our comparison of liquidity measures and selection criteria, we suggested the bid-ask-spread of the stock to ACM. The bid-ask spread of a stock is the difference between the bid and ask prices offered by the market maker for a particular stock. It is not only a conceptually sound measure for liquidity, but it is also successfully used by other regulatory authorities in Europe and is accepted as appropriate criterion by market participants in these countries.

Practical considerations for a regulated setting

As well as a theoretical review of the criterion, we considered the practical computational challenge involved in calculating each metric. Some measures rely on assumptions to be made and are less objective, which could present challenges for regulators. The bid-ask spread, like some other measures, is more computationally straightforward and uses data from widely available sources, a beneficial point for regulators.

Impact on regulatory decisions

Following a robust analysis of the available selection criteria, our report made a recommendation to use the bid-ask spread as the primary liquidity criterion, with other metrics considered as useful supporting criteria. We also noted that regulators may exercise some discretion around the choice of a specific threshold for the bid-ask spread, which may take other considerations into account, such as whether a minimum number of comparators is required. Following our report, ACM has implemented our suggestions in their recent regulatory review.