Getting real about returns

An alternative cross-check to the cost of capital

The Weighted Average Cost of Capital (WACC) is the tool of choice to set a reasonable level of return on the capital invested in utilities.

Allowed returns have fallen since the GFC

Since the Global Financial Crisis (GFC), expansionary monetary policies have driven down interest rates. This has led to significant reductions in the cost of debt for regulated utilities, which has fed directly into a lower allowed WACC.

Furthermore, UK regulators have substantially reduced their estimates of the cost of equity. However, the impact of lower interest rates on the cost of equity is not clear-cut. The problem is that the cost of equity is unobservable, and there is a range of estimation methods, all with high margins of error. Unlike the cost of debt, the cost of equity cannot be observed because future equity cashflows are unknowable.

A fall in interest rates caused by quantitative easing could be consistent with a lower expected return on equity (ROE). However, investor switching from equities to bonds due to heightened risk aversion could be consistent with a higher expected ROE. Both forces could have been at play, making direct inference of the cost of equity uncertain. 

This uncertainty leads to indirect estimation, using methods such as the Capital Asset Pricing Model (CAPM). The CAPM method is endorsed by academics and practitioners alike. However, although the risk-free rate is based on government bond yields and is straightforward to calculate, the total market return (TMR) cannot be observed and requires indirect estimation.

It seems that the most honest answer to the question whether a lower RFR automatically leads to a lower cost of equity is: ‘we do not know for sure because we cannot observe the cost of equity.’

This brings us to cross-checks, which regulators often carry out to test that their cost of equity estimates are within a reasonable range. There are various cross-checks available and we do not attempt to cover them here. Instead we propose a different approach, to cross-check if the allowed rate of return is in line with business fundamentals.

An alternative cross-check – profitability metrics of benchmarks

Although the cost of equity (expected ROE) cannot be observed, we can observe the realised profitability of the underlying business. This can provide a reasonable cross-check, because it is directly comparable to what the regulator sets – an allowed level of profitability for the business.  

The Figures show the profitability of the entire UK and US equity markets using Bloomberg data. The accounting measure we use is return on common equity (net income after tax divided by the book value of the equity).

Figure 1   ROE of FTSE All Share companies compared with the risk-free rate

Source:   Bloomberg

Note: Return on equity is shown on the left axis and Gilt yield is shown on the right axis.

Figure 2 shows the profitability of equity capital in the US.

Figure 2  ROE of US S&P 500 versus 10-year Treasury bond yield

Source:   Bloomberg data

Note: Return on equity is shown on the left axis and Treasury bond yield is shown on the right axis.

The charts show fluctuating levels of profitability over the period, but without any discernible falling trend, even though government bond yields have declined significantly over the period.

What could explain this apparently surprising result? There are two, not mutually exclusive, hypotheses:

  • First, the cost of equity has been relatively stable, regardless of the trend in interest rates.
  • Second, the cost of equity has decreased with interest rates, but there has been no corresponding reduction in profitability levels.

Hypothesis 1 has been discussed above, and we conclude that it may or may not be true. Hypothesis 2 would be an interesting finding but runs counter to the simple economic proposition that profitability converges to the cost of capital over time. The potential reasons that could support this hypothesis are set out in Figure 3.

Figure 3  Profitability and financing costs

Source:   Frontier

What should a regulator make of this evidence?

  • If hypothesis 1 is true, regulators need to reconsider the validity of finance models that link falling interest rates to a lower cost of equity.
  • If hypothesis 2 is true, regulators should study the reasons why profitability can diverge from the cost of equity and consider how these reasons apply to regulated utilities.

This paper suggests that regulators should consider whether the disconnection between profitability in the wider market and lower interest rates has lessons for setting the allowed WACC. Click below to download the paper in full.

Getting real about returns
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