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

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  • Schober, Dominik
  • Schäffler, Stephan
  • Weber, Christoph
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    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 (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. --

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    Bibliographic Info

    Paper provided by ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research in its series ZEW Discussion Papers with number 14-010.

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    Date of creation: 2014
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    Handle: RePEc:zbw:zewdip:14010

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    Keywords: Idiosyncratic/firm-specific risk; discrimination; incentive-based and quality regulation; liquidity management; size effects; electricity networks;

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