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Idiosyncratic risk and the cost of capital: the case of electricity networks

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  • Dominik Schober
  • Stephan Schaeffler
  • Christoph Weber

Abstract

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, 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 $$\sim $$ ∼ 0.2 to 3.0 % points depending on the size of the firm (in the range of 3–40 % of total cost of capital). Regulation of monopolistic bottlenecks should take these risks into account to avoid implicit discrimination. Copyright Springer Science+Business Media New York 2014

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  • Dominik Schober & Stephan Schaeffler & Christoph Weber, 2014. "Idiosyncratic risk and the cost of capital: the case of electricity networks," Journal of Regulatory Economics, Springer, vol. 46(2), pages 123-151, October.
    • Handle: RePEc:kap:regeco:v:46:y:2014:i:2:p:123-151
    DOI: 10.1007/s11149-013-9242-7
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    More about this item

    Keywords

    Idiosyncratic/firm-specific risk; Discrimination; Incentive-based and quality regulation; Liquidity management ; Size effects; Electricity networks; G32; G33; L51; L94;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L94 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Electric Utilities

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