Two Concerns about the Cost of Capital Methodology used in Regulated Pricing Decisions

Abstract

This paper raises two new concerns about the cost of capital methodology that is employed by Australian regulators when determining the prices that regulated entities may charge. The identified errors in current practice both tend to underestimate the required rate of return, and so may be causing an underinvestment in important infrastructure. The first error arises from an inconsistency in the way that cost of equity and cost of debt are typically determined. The second error is to assume that existing shareholders and their board of directors will happily approve a major expansion that is to be financed by new issues that will bring existing shareholders no benefits.