Idiosyncratic Risk and the Cost of Capital – The Case of Electricity Networks

We analyze the treatment and impact of idiosyncratic or firm-specific risk in regulation. Regulatory authorities regularly ignore firm-specific characteristics, such as size or asset ages, implying different risk exposure in incentive regulation. In contrast, it is common to apply only a single benchmark, the weighted average cost of capital (WACC), uniformly to all firms. This will lead to implicit discrimination. We combine models of firm-specific risk, liquidity management and regulatory rate setting to investigate impacts on capital costs. We focus on the example of the impact of component failures for electricity network operators. In a simulation model for Germany, we find that capital costs increase by approximately 0.2 to 3.0 percentage points depending on the size of the firm (in the range of 3% to 40% of total cost of capital). Regulation of monopolistic bottlenecks should take these risks into account to avoid implicit discrimination.

Schober, Dominik, Stephan Schaeffler and Christoph Weber (2014), Idiosyncratic Risk and the Cost of Capital – The Case of Electricity Networks, ZEW Discussion Paper No. 14-010, Mannheim.