Ofcom's approach to risk in the assessment of the cost of capital - first consultation

Executive summary

Introduction

1.1 This consultation asks for the views of respondents on a number of issues relating to risk and return, in particular the permissible returns calculated for the companies regulated by Ofcom. It focuses on Ofcom’s approach to estimating companies’ weighted average cost of capital and the relevance of real options in the assessment of risk associated with new services. These factors can directly affect financial outcomes for firms in the industry, being a key input used by Ofcom in its analysis relating to, for example:

• setting charge controls and price caps;
• conducting competition analysis, e.g. predation and margin squeeze tests; and
• valuing the future cash flows that are associated with, for example, licence applications.

1.2 In each of these cases, Ofcom is required to estimate what a reasonable rate of return is, and in each case the financial implication for the firm concerned may be significant. This is a key part of Ofcom’s duties in regulating the communications industry. It is a component in Ofcom’s calculations in a number of access pricing contexts, where starting charges and/or X factors in “ RPI minus X” type regulation are set by Ofcom, for example:

• the Network Charge Control (“NCC”);
• Wholesale Line Rental (“WLR”); and
• Partial Private Circuits (“PPCs”).

1.3 Ofcom’s view of a reasonable rate of return is also an important part of its financial analysis in the context of its ex post regulatory duties, e.g. when considering complaints under the Competition Act.

1.4 Ofcom’s ongoing Strategic Review of the telecommunications sector (referred to as the Telecoms Strategic Review, or “Telecoms Review”) is one of the key drivers of Ofcom’s decision to review the issues covered in this consultation. In Phase 2 of the Telecoms Review, Ofcom proposed the principle that it should promote a favourable climate for efficient and timely investment and stimulate innovation, in particular by ensuring a consistent and transparent regulatory approach. Ofcom also proposed that regulation should be targeted on ensuring real equality of access to enduring economic bottlenecks, creating the scope for deregulation in other areas.

1.5 Taken together, these proposed principles imply that in setting the regulated returns that BT is permitted to make from wholesale access to its network, Ofcom should reflect the varying characteristics of different parts of BT's network. The Telecoms review suggested that three core considerations should affect the regulated return that BT should be permitted to make from providing wholesale access to different parts of its network. There are sometimes trade-offs to be made between these considerations. The considerations are:

• the relative importance of incentives for BT to invest. Where investments are risky, it is important that regulated returns reflect the degree of risk that BT faces at the time that it makes the investment;
• the scope for investment by competing network providers. If effective competition as a result of investment by competing providers is in prospect, it is important that regulation does not harm such prospects; and
• the need to protect consumers from excessive charging, for services provided in parts of the network which are enduring economic bottlenecks

1.6 As outlined above, Ofcom sets the returns that BT is permitted to make from wholesale access to its network through a number of regulatory instruments, an assessment of BT's cost of capital being a key component of many of these. This consultation discusses how Ofcom might assess the cost of capital of BT and other operators in a manner consistent with the principles proposed in the Telecoms Review.

1.7 Some parts of this consultation discuss issues in the context of fixed networks, and are therefore of particular relevance to BT and its direct competitors. Ofcom’s intention is that the analytical approach outlined in this consultation will however apply equally to all the sectors that it regulates, including mobile communications and the audio-visual and audio broadcasting industries.

1.8 Similarly, the principles outlined in this document, particularly with regard to the equity risk premium, are equally applicable to communications markets in the Kingston Upon Hull area (and hence to Kingston Communications) as they are to the broader UK context (although the size and nature of this market and incumbent are such that there may be other important factors to consider that are not dealt with in this consultation).

1.9 Ofcom’s proposed views may influence how investors perceive the attractiveness of certain markets and companies, particularly in the context of fixed regulated networks, but also in the case of, for example, cable and mobile networks. Ofcom considers that it has a duty to ensure that regulatory uncertainty does not prove a barrier to investment, and recognises that many investment decisions critical to the evolution of the communications sector will be made in the coming years. By maximising the clarity of its approach in this area, Ofcom aims to ensure regulatory transparency and minimise regulatory risk, thus promoting a favourable climate for efficient and timely investment in addition to promoting competition.

Scope of this consultation

1.10 This consultation asks for the views of respondents on a number of specific aspects of Ofcom’s proposed policy approach to the cost of capital and other aspects of risk and return. This review is not intended as a comprehensive investigation into all aspects of cost of capital estimation. It does not, for example, discuss a number of issues that are relevant to estimating the cost of capital such as the risk free rate, inflation risk premium, optimal gearing, taxation adjustments, or detailed estimation techniques for the company’s beta. Instead, it focuses, and requests the views of stakeholders, on the following specific areas:

• the appropriate approach to estimation of the Equity Risk Premium (ERP) within the Capital Asset Pricing Model (CAPM) framework;
• the appropriate treatment of variations in risk across different activities and projects in the context of both:
  • systematic risk, i.e. risk that which can not be diversified away; and
  • specific risk, i.e. risk specific to a given company or project
• whether and how the value of real options might be incorporated into regulators analysis.

Key proposals in this consultation

1.11 Ofcom makes a number of proposals in this document. The most important of these are discussed in the subsections below.

Ofcom’s preferred asset pricing model

1.12 Ofcom considers that the CAPM remains the most appropriate basis for estimating the cost of capital and will continue to use it as its preferred methodology in most circumstances.

Ofcom’s approach to ERP estimation

1.13 Under the CAPM, the ERP reflects the extra return that investors require in return for investing in equities rather than a risk free asset. It is a market, rather than company-specific, factor. The calculation of a forward-looking ERP entails a significant degree of judgement, and, as will be outlined in Section 3, a wide range of estimates can be derived using commonly-used estimation techniques. Traditionally, Ofcom has considered that the downside risk associated with taking too low a value for the ERP (discouraging discretionary investment) is more detrimental to the interests of consumers than taking too high a value (leading to higher prices to customers) and has tended to the higher end of the possible range. Having reviewed its approach in this area, Ofcom remains of this view, and requests the views of stakeholders on its proposal that values of 4.0% or 4.5% might be appropriate alternatives to 5% as central estimates of the ERP.

Ofcom’s approach to modelling variations in systematic risk within the CAPM

1.14 Regulators in the communications industry, including Ofcom, have traditionally assessed the cost of capital at a company level¹. However, companies commonly make investment decisions at a project or activity level, and reflect variations in systematic risk between different activities.

1.15 Ofcom believes that, in principle, it may be appropriate to reflect differences in risk within corporate groups in its financial analysis. In the context of systematic risk, this would mean allowing different costs of capital on different projects, since this type of risk is modelled within the CAPM. One way to achieve this in practice would be to vary, or “disaggregate”, the beta, the parameter that reflects the systematic risk of a particular company in the CAPM. Analysis carried out on behalf of Ofcom by The Brattle Group in the early part of 2004 indicated a central estimate of 1.3 for the equity beta of BT group. This estimate reflects the, appropriately weighted, average level of systematic risk of all BT activities (which may vary significantly). Ofcom believes that it should consider whether, and if so how, to reflect some of the most important of these variations in systematic risk its financial analysis, whilst ensuring consistency with this overall group beta estimate.

Ofcom’s initial view on the relevance of real option theory to regulation

1.16 If the riskiness of a firm’s investment is modelled using the CAPM and Net Present Value (NPV) analysis, then, as will be outlined in Section 3, the systematic risk faced by investors is taken into account via an estimate of the firm’s Weighted Average Cost of Capital (WACC). Present values should be calculated based on expected cash flows so that the rewards from successful investments are expected to be sufficient to pay for the losses associated with unsuccessful investments. This analysis does not, however, explicitly take into account the extent to which risk can be mitigated by the adoption of certain investment strategies (e.g. investing later in order to “wait and see” how a market develops, or investing early in order to gain a first mover advantage). Ofcom’s initial view is that, under certain circumstances, it should take account of such factors by using a real options approach to financial analysis. In particular, Ofcom proposes that, in some cases, the option to wait and see which is surrendered when an investment decision is made may have a value that it is appropriate to take into account in its analysis. In the context of the most important current or near future regulated products, Ofcom’s initial view is that the value of these options is likely to be greatest in the cases of :

• next generation access networks; and
• (to a lesser extent) next generation core networks

1.17 Ofcom’s initial view is that wait and see options are unlikely to have a significant net value in the case of the other major access products currently offered by BT. As will be discussed in Section 6 of this consultation, any attempt to quantify the value of these options would give rise to a number of methodological issues.

Implications of this consultation

1.18 The overall, i.e. net, financial impact on stakeholders of the proposals in this document are difficult to assess, since, from the perspective of each stakeholder, some implications would be favourable whereas others would be unfavourable:

• other things being equal, the return permitted on all regulated access products would go down owing to the use of a revised ERP;
• the regulated returns permitted on some lower risk investments would go down owing to equity beta disaggreggation, whilst the overall company cost of capital calculated under the CAPM would remain the same; and
• the regulated returns allowed for some risky new investments could increase through taking account of the value of real options

1.19 Ofcom believes that these proposals are consistent with its duties relating to the promotion of competition and encouraging efficient investment under the Communications Act and the proposed regulatory principles set out in the Telecoms Review.

¹The terms “firm” and “company” are both used frequently used throughout this document. The latter term is based on a standard economic interpretation of a “firm” as an institution that hires factors of production and that organizes those factors to produce and sell goods and services. In places, Ofcom has used the term, “company” to emphasise that a particular discussion relates to a firm that is owned by two or more shareholders, but the use of this term is not intended to reflect the issues brought about by the legal ownership of a particular form of firm (e.g. the issuing of shares).