Privatisation spawned a whole new industry in the UK dedicated to coming up with numbers for the cost of capital for regulated utilities. It absorbed some of the brightest minds from the university post-graduate economics faculties and built very complex mathematical models which only the few could understand.
Some of the answers given are seriously inaccurate, often serving the vested interests of those who pay them the most to come up with the numbers. The private but not the public interests have been well served, returns over the past 30 years have been excessive, and regulators have failed to challenge the assumptions of the models that lie behind the numbers.
To see why this is the case, we need to go back to the basics. We need to sort out what the risks are, to see why the conventional approaches of the capital asset pricing model (CAPM) and the weighted average cost of capital (WACC) are not fit for purpose. In particular, the risk-free concept, the claims about diversification, and the analysis of the regulatory asset base (RAB) all need to be revisited.
The WACC has incentivised widespread financial engineering, exhausting the balance sheets for purposes other than investing to modernise the infrastructures, a prime objective of privatisation. As we shall see, the CAPM + WACC has been pretty disastrous for customers, resulting in higher prices and returns, less scope for future balance sheet-financed investment and with little evidence of exceptional operating efficiencies driven by the incentives to make super-normal profits. Recent crises at Thames Water have served to illustrate how this can play out in unacceptable leakage, sewage spills into rivers and insufficient investment in new water resources. It did not need to be like this, and it should not be allowed to go on like this.
The basics start with the concept of risk (and how this plays out in the “riskless rate of return” in the CAPM), the equity risks in utilities, and the way risk is shared between taxpayers, customers and shareholders. This brings us to the RAB, and the very different risks that investors face when buying into RABs, as opposed to operating the utility networks (operating expenditure, OPEX) and doing capital investment (CAPEX) projects. With the RAB risks identified and distinguished from the OPEX and CAPEX, the opportunity arises to do away with the WACC completely, using a split cost of capital and tradeable RABs (both discussed below), and to use system regulation auctions and competition to retreat from the need to explicitly estimate the cost of capital for all but the very residual utility operations. With these steps, the public interest is much better met, and the CAPM can be sidelined.
Risk
If the question to which these numbers are designed to answer is the cost of risk, then the starting point is to understand what risk is. Risk arises because of uncertainty. We don’t know what the future will bring. Investing is always a stab in the dark, and that “dark” is what investors try to penetrate and where possible mitigate. When it comes to utilities, it can be especially hard, because utilities are characterised by high sunk fixed costs and low to zero marginal costs. This creates a special additional problem to the usual ones of demand, OPEX and CAPEX, management and management failures, and so on. High fixed and sunk costs and near-zero marginal costs always expose investors to the time-inconsistency problem. Once the asset has been built on the investors’ expectations of the future returns they will receive to recover both the CAPEX and the OPEX, the counterparty has an incentive to renege on paying for the CAPEX, so that only the OPEX is recovered.
The reason why this is an opportunistic option is that the assets are worth operating, once built, as long as they cover their variable costs, and make some contribution, however small, to the fixed costs. An investor therefore needs to look very hard at the counterparty. In most cases this is government and the regulators. What are their incentives? Might they behave opportunistically? Might they renege on promises to pay the fixed costs? Because these incentives are so powerful, investors look to contracts that guarantee that the government and regulators will commit and sustain their commitments. These political and regulatory risks are layered on top of all the other conventional risks.
Regulation is best seen as a sort of contract, within a repeated game, which sets the rules of the game and commits the regulators (and hence the state) to honour their side of the bargain, making sure that the investors can shelter under some sort of explicit or implicit guarantee that the utility or regulated entity can finance its functions and avoid expropriation. The RABs, the contracts-for-differences (CfDs) for renewables and nuclear power, Private Finance Initiatives (PFIs) and Power Purchasing Agreements (PPAs) are all contracts that commit the government and the regulators to the investors.
You might now be thinking that the cost of capital is all about contract analysis and contract risk. You might think that investors go through the possible future scenarios, peering into the darkness, and decide in advance what might happen in each circumstance, and crucially what happens in the event of the unexpected. Who bears each and every risk, and what happens when the unexpected happens might seem to be the obvious questions to ask. They are, but, surprisingly, the cost of capital industry spends very little time on actually analysing these sorts of risk. Instead, it assumes away most of the uncertainty and focuses instead on diversification and portfolios of assets.
The capital asset pricing model
The CAPM is the bible of the cost of capital industry. It is what the economics of finance focuses on. It is based on a set of assumptions that are very demanding and assumes that the fog of uncertainty can be viewed in two ways: through the subjective expected utility model, and through portfolio diversification.
Subjective expected utility reduces the future to a set of probabilities. This is the killer assumption. Everything that might happen can be captured by these probabilities, which means that utility and hence profit maximisation can be defined. Gone is the radical uncertainty which allows for a murkier darkness. Assuming that the probabilities exist and add up to 1 conveniently gets rid of the hazier possibilities advanced by Frank Knight, George Shackle – and indeed John Maynard Keynes in his treatise on probability.[1] Subjective expected utility takes the human condition and puts it into the framework of the calculus of marginal utility. It is also the critical assumption that allows for the diversification of portfolios at the heart of the CAPM.
There is little doubt that the future could be reinterpreted as if it is characterised in these ways. But this does not mean that it is. Indeed, were it all to be about probabilities, much of what makes life (and, with it, economic activity) interesting would be assumed away.
Nor is it necessarily helpful, except to the neatness of the CAPM, to assume that anything outside the model is a “shock”.[2] For example, Putin’s invasion of Ukraine might be called an exogenous shock, “news” that is then calibrated into the models. Yet all the historical analysis and understanding, all the risk assessment and careful studies of the behaviours of dictators does give us quite a lot to go on. The invasion was not predicable in utility-maximising terms, but it was also not entirely a random shock. Some wrote about these things and considered that a further Ukrainian war would contribute to Putin’s long-term plans. Few CAPM calculations of the cost of capital took it seriously, and even fewer in the CAPM industry incorporated it in their estimates for the utilities which would in due course be significantly affected by the invasion and aftermath. Treating such events as exogenous to the cost of capital is a neat analytical trick, but that does not make them unanalysable; there are very few genuine random shocks.
Once the future has been reduced to probabilities, the CAPM can get on with its really restrictive assumptions. These are loosely or tightly based around quasi-perfect financial markets and the absence of interesting things like taxes, transition costs, regulation and restrictions. Perfect competition is at the opposite polar extreme to the circumstances of utilities. Most are systems, rather than simply bundles of discrete assets; most are monopolies (natural or otherwise). All have great social and environmental externalities and all have public good elements. Assuming perfect competition is like assuming that the car drives only backwards when you want to go forward.
The CAPM assumes that risk is something that can mostly be and is diversified away. It reduces risk to the category of only what cannot be diversified. If every future event is covered by probabilities, if knowledge and information are common, and if there are deep and liquid asset markets where no one can corner the market, and there are no externalities and so on, then almost any risk can be matched against its opposite, and hence be diversified away.
Better still, in a Walrasian general equilibrium, time itself is effectively concertinaed back to the present: if you know the future then everything can be decided now. Expected utility opens up that future, but only a bit. Radical uncertainties about the future and our place in it – what might be called the human condition – are banished by assumption.
Not surprisingly, investors do not behave as the CAPM model dictates. The point of managers and of proper investment analysts is widely recognised. The world can be reinterpreted as if it conforms to the CAPM, but this does not mean that it does. It is consequentially hard to think of a way of refuting it, since it is in essence a classification (as is utility maximisation). Within its own terms, everything can be reinterpreted as conforming to the model.
Yet the CAPM remains the “only game in town” and all the utility rates of return are set on the basis of the CAPM. So, it is worth delving a little deeper into its structure.
CAPM and the price of time
The CAPM introduces a sharp distinction between debt and equity, and it is the cost of debt and, in particular, the “riskless rate of return” that is its anchor.
The first point to make is that there is no riskless rate of return, because no future state is known with certainty. There is no pure cost of time. There is always risk.
Why do we all regard money today as more valuable than the promise of money tomorrow, even if that promise is made by governments? The answer is partly that we don’t know what that future may bring, we don’t necessarily trust governments, and we don’t know whether we will be dead.
The CAPM ignores the fact that there is no riskless counterparty. It links the cost of time to the cost of government debt, and uses the return on government bonds as a proxy for the riskless rate. Governments come and go; populists play to the present rather than the future. One reason our economies are so unsustainable is because most democracies encourage and reflect our desire to live beyond our means, environmentally and otherwise. We live in unsustainable economies. Unsustainable economies will not be sustained.[3] Hence there is no risk-free cost of capital, and no pure single price of time.
This is reflected in the economic experience of the period since the great stock market collapse in 1999/2000. The FTSE100 peaked then at a level higher than its value in late 2022, over 20 years later. Real interest rates have been negative, there have been financial crises, asset bubbles and widespread quantitative easing. It could be argued that this reflected the possibility that the cost of time was actually negative, and indeed that is what is implied by calculating a CAPM value on the basis of the cost of government debt.
A moment’s reflection would tell you that that the negative real cost of debt is anything but sustainable, and would lead to inflation, and in turn to major losses for those holding gilts. That indeed is what has happened. So much for negative risk-free rates.
CAPM and the debt premium
Having assumed a riskless rate, the CAPM then looks to a premium for the risk to debt holders in utilities. How much more risky is, say, Severn Trent’s debt than that of the government? The answer turns on the risks of default by the government and by Severn Trent. That is what investors worry about.
Governments across the world are now clearly engaged in partial default. Gilts have been “printed” by the Bank of England, the US Federal Reserve, the European Central Bank, and the Japanese and Chinese central banks. Debt has been monetarised, and inflation has been widely eroding its value.
The risk to Severn Trent’s debt holders is that the contract guarantee to finance its functions which comes via statute through the regulator is not honoured. Why might this be the case? What collateral do the debt holders in Severn Trent have?
The guarantee has been widely interpreted to mean that it is to finance the efficient carrying out of the company’s functions. Debt investors therefore have to worry about whether the company is in fact efficient, and if it is not, the debt holders need to rely on the equity holders being able to make good any shortfalls.
They should worry in the case that the gearing is very high – that there is not enough of an equity buffer to absorb the management’s inefficiency, should the company be deemed inefficient. This might be called the Thames Water problem.[4] The risk to the debt holders depends on the risk of the equity holders.
The twist here is in regard to the RAB, which is discussed in detail below. If the collateral for the debt holders is the RAB, and if the RAB is an accounting number in the regulated accounts, and if the duty to finance functions includes a duty to honour the debt, and if the debt is in total less than or equal to the RAB, and as long as the scale of the inefficiency is not so great as to overwhelm the equity, then the risk of the debt is not necessarily greater than that of government bonds. Indeed, it is possible that it could be less, in as far as the Severn Trent debt holders may have a claim to the collateral of the physical pipes and other assets.
In the event of a company failure, the Special Administrator provided in the case of most of the utilities would protect the debt holders first. Since Severn Trent has a price cap that allows it to pass through inflation, the comparison is with government indexed-linked gilts.
None of this assumes that the business to which the debt adheres is without risk. Risk never goes away; some party always bears it. The first absorber of the equity risk is the customers, and if they cannot pay then it is taxpayers provided that the government and the regulators honour the RAB.
But if governments and regulators behave opportunistically, the cost of debt should reflect this political and regulatory risk, in respect of not honouring all or part of the RAB. In this sense, the sharp separation of debt and equity in the CAPM is illegitimate: there are just investments, with risks, which all have equity risk characteristics. Political and regulatory risk exists; there is no risk-free rate to apply. Debt is not sharply different in kind from equity; it is different in degree and the ways in which different bits of risk are allocated.
You might now be thinking that the RAB adds little that is special to the calculation of the cost of capital. This would be wrong, provided that the guarantee to finance functions is tied to the RAB and provided it can be upheld through the courts. The issue turns on whether the RAB contract really does eliminate the ability of government and regulators to behave opportunistically. If it does, then what the RAB does is transfer that risk to the taxpayers. The taxpayers – and the owners of the government bonds – are exposed to the equity risk that is thereby transferred. Time inconsistency is now a game between gilt owners and taxpayers, and the playing out of the incentive for the government to pander to current voters and in effect expropriate future voters and taxpayers. Quantitative easing is just one example of generationally passing the parcel of the expropriation. There may be little or no risk in the RAB and there may be more risk to gilt holders as a result. Buying a RAB asset may just be buying a contract with the government.
There is one final twist to the risk of debt in utilities. The contract between the regulator and the government has multiple dimensions. The licences are incomplete and, in some cases (like water), vague. Utilities are subject to taxation and to the possibility of windfall taxes, and governments have a hand in environmental regulation and enforcement. There are multiple regulators too. Almost all these regulatory contracts are incomplete, and as a result there can be lots of arm-twisting. The result is deadweight loss.
Take the current affordability crisis. Government can threaten to intervene and impose windfall taxes and companies frequently bow to the political and regulatory pressures and do not insist on the letter of the periodic reviews. Regulators have lots of discretion, and as a general rule tend to add more and more complexity every time a periodic review comes around. This complexity and vagueness allows regulators to effectively renege on the contract, under the threat of multiple other costs to the regulated entity, or simply by changing the law.
All of the above suggests that investors in utility debt should carry out detailed analyses of the various dimensions of risk. In theory, debt owners like equity owners could diversify their debt portfolios. In practice, they often do not and in some instances they cannot: there are prudential and other financial regulations which limit the scope for such diversification. Governments are elephants in the room for the diversification of risks.
The equity risk premium
The CAPM treats equity sharply differently from debt (which it isn’t, for the reasons set out above). On equity, the model makes a further neat distinction between, on the one hand, the equity risk generally to a diversified portfolio of shares and, on the other hand, the beta coefficient, which represents the specific non-diversifiable risks of the particular company shares. From this distinction the CAPM then goes on to analyse each bit. (The CAPM assumes that there are distinct and pure utilities to which the share prices relate, not businesses that combine utility and non-utility elements.)
(i) The portfolio equity risk premium
Imagine a world in which debt and equity are distinct and separate, where all and every equity risk had been identified for each share, where all currency risk is evaluated and optimally diversified, and so on. In this fantasy land, it is possible to construct a portfolio of perfect diversification. The return on this portfolio is calculated, separate from the debt risks. The obvious question is why, if it is perfectly diversified, there is any equity risk at all, over and above the risk of debt. If each and every equity risk can be diversified, why does the portfolio as a whole command an equity premium?
The answer the CAPM industry offers is: “well, that is what the return in the past has been.” This does not answer the “why” question; nor does it explain why the past should be defined in particular periods and be a good predictor of the future.
Let’s start with the data and the period. There is lots of relevant data over the last 100 years. The data tells us what returns an investor would have made holding a portfolio over a specific period of time. This, however, is not the cost of capital: it is the return on a portfolio of shares, none of which operated in a state of perfect competition. The actual return can be a reward for monopoly, market power, the exploitation of a host of market failures, entrepreneurial actions and frequently just luck. It is not the equity risk premium.
The CAPM industry takes its sophistication one step further, for it is obvious that what happened in, say, 1914–1945 is unlikely to be a good indicator of what happened in, say, 1990–2020, the privatisation years. Since most in the CAPM industry are paid by some company or regulator to come up with an answer, and since all the parties have a vested interest in the answer, the temptation is to start with an answer (say a high number that a privatised utility might want to advance its interests) and then interrogate the data to come up with a period that supports this vested interest. “Tell us the answer and I’ll come up with a period to prove it” is a temptation in the cost of capital industry.
This is particularly problematic for the period 2000–20, when real interest rates were negative. This created a series of asset bubbles, and so returns on a portfolio of shares in this period would have been extremely high by longer-term comparative periods. What this tells us is something very important: the equity premium is linked to the cost of debt, not what the CAPM assumes in separating out the two. With an historically low cost of debt, this produces outcomes that may be (and were) very costly to consumers. It also feeds into the financial engineering between equity and debt, which is explored further below under the split cost of capital.
Back to the “why” question. It is not convincing to say that the risk of owning equity is determined by the rewards that equity owners have earned in the past. One possibility is that the management might muck up the business. Another related possibility is that the future is actually not covered by probabilities but is subject to radical uncertainties of the Knightian variety we met earlier. The perfect competition assumption does not admit of a principal–agent problem: managers may not do what owners want. In perfect competition, they act solely in the interests of profit maximisation, subject to the law. Managers do not capture economic rents, and bad management can be observed because of the information that is available. This is clearly nonsense, especially given the concentration of most major product markets, and the dominance of a small number of very large companies.
In reply, it could be argued that the equity premium is just the result of supply and demand. It is what investors have demanded in order to supply capital. This is not convincing either. Think about the arguments concerning secular stagnation and think of the necessity to invest of the major suppliers of savings, like pension funds. If the alternative is cash with zero return, there can be periods when the required equity premium to meet the demand for investment might be very low. Rather than ask the question: “what does the long-run data show?”, a better question might be: “why has it varied so much in the past?”
(ii) The beta coefficient
Next up is the beta coefficient – the variance of the specific share to the portfolio. The first question is why should a share be volatile relative to the portfolio? If diversification is perfect, it is hard to see any risk in the probabilistic setting that could not be diversified away, and hence any reason why the beta coefficient should not converge on the equity premium for the portfolio as a whole.
It turns out that the data suggests that utilities have relatively low beta coefficients. Consider the impact of the duty to finance efficient functions, and hence the regulators’ guarantee on returns. In a regulatory regime of pure rate of return, the beta coefficient should equal zero. Why might it be higher? Perhaps because of the efficiency incentives? But why could not someone else capture these factors and offer a hedge? Why can’t they be diversified?
This translates into a central issue in privatisation. The advocates and defenders of the UK model describe it as having high-powered incentives– more incentives to make abnormal profits in return for more risk, with the expectation that the UK will display a higher cost of capital and much higher efficiency performance. There are all sorts of problems with this argument, not least that there really isn’t much evidence to say it is true. Water companies in the UK, for example, are not very different from their nationalised comparators in much of Europe, and in any event the operating costs are small compared with the sunk capital invested in these networks.
There is no convincing evidence that privatised sectors have attracted better managers as part of this search for higher efficiencies, and no evidence to suggest that high executive salaries in the regulated utilities have caused better performance.
There is also not much evidence that water and utility CAPEX is efficient, and especially when bundled into five-year periods.
Not only is it legitimate to ask whether this is “a price worth paying” by customers (and some taxpayers), but also why the companies need this extra return to encourage them to be efficient. Below it will be shown how the system regulator model can partially solve this through the competitive bidding for contracts, with negotiated residual contracts addressing what cannot be put out to tender. A higher equity return is not the only way to incentivise management, even if it works. There are other, neater ways.
There is one further consequence of applying a higher cost of capital. If this is used in project analysis and discounting cash flows in the companies’ business plans, it will create a bias towards shorter-term projects against longer-term ones. In utilities this matters. Some of the assets have expected lives beyond 100 years.
(iii) The WACC and the great financial engineering
Given that the utilities are financed by a combination of equity and debt, the regulators have chosen to set a WACC at periodic reviews, instead of applying a cost of debt to the debt and, separately, a cost of equity to the equity. This is a profound and fundamental error that has had vast consequences, almost all of them detrimental to customers.
It is obvious – and it should have been obvious to governments and regulators – that a WACC over-rewards debt and under-rewards equity. That is what averaging does. Not surprisingly, this open goal allowed the companies to engage in massive financial engineering, reducing the equity to debt ratio through special dividends, share buy‑backs and other financial devices. Balance sheets that were designed to provide the basis for switching from pay-as-you-go in the public sector to pay-when-delivered in the private sector—and hence enable borrowing to pay for investment—were instead used to create extra rewards by, in effect, mortgaging the companies and stuffing them with debt. There was also no incentive to reinvest profits in the companies. For example, in water, profits = dividends. Electricity distribution shows a similar pattern.
This terrible outcome was wholly avoidable. Instead of setting the WACC, the regulators should have set a split cost of capital: the cost of debt applied to debt, and the cost of equity applied to equity.
The tradeable RAB model
Separating out the costs of debt and equity enables a further refinement to the cost of capital determination. Suppose there is no equity risk in the RABs. Recall this is because the equity risks are transferred to the taxpayers and government bond holders through the guarantees in the RABs. The RABs should be financed with debt which is of equivalent or lower risk to that on gilts. Equity is not relevant to RABs properly defined, because there is no equity risk to the RAB owners. It has been transferred elsewhere.
If RABs are funded like gilts and if the regulators guarantee the RABs, then as separate financial entities, they can be separated for investors too. Instead of having to buy a bundled RAB+equity concertinaed into a single share price or a utility bond across the company as a whole, investors could instead opt for separable tradeable RAB debt instruments. They would be approximations to indexed-linked gilts and trade at a premium or discount to indexed-linked gilts as per the discussion of the RAB risks above. There would an active market in these RAB debt-based assets, and the cost of capital in respect of debt for these RAB assets would be set in the market in real time. It would not need to be estimated by the cost of capital industry and the CAPM would add nothing to this.
Think how much the financial costs would fall. The cost of debt for the RABs would be close to that of gilts, there would be no WACC return, no financial engineering, and the sheer scale of the regulators’ mistakes in their ex ante estimate of the cost of debt and the WACC would be avoided. This latter point is important: regulators got the forecasts of interest rates badly wrong in every periodic review from privatisation from 1990 onwards, and the interval between the actual out-turn interest rate and the forward ex ante interest rate set by regulators is probably the largest source of abnormal returns to the privatised utilities. The corollary is in effect a tax on customers paid to investors.
Eventually the regulators realised the scale of their mistakes and started to index the cost of debt and hence reflect the sharply falling interest rates that characterised the period from 1990 to 2020.
Tradeable RABs open up new sources of finance. The offering could be not only to pension and life companies, but also to retail investors as a relatively secure option beyond cash. Better still, it is not obvious why the utility customers could not have a stake in the companies via tradeable RABs.
System regulation and contracting
The split cost of capital and the tradeable RABs greatly reduce the appeal of the CAPM Both improve the efficiency of finance and both would reduce the overall cost of capital. It remains to go beyond CAPM for the equity risk.
There are two approaches to this. The first is to employ alternative models, like the dividend growth model. The second is to circumvent setting the cost of capital at all. The alternative models may have attractive properties, but in the main they are not needed in the system regulation model described below.
The value of a share is the discounted sum of future dividend payments plus the scrappage/residual value. The dividend growth model takes the expected dividends and then discounts these. The problem is obvious: what should the discount rate be? The regulator could fix the dividends, and the market could then reveal the implied cost of capital from the prices that investors pay for the shares.
This is where Tobin’s Q comes in. If a share is priced “correctly”, the market value of the assets would be equal to the current-cost valuation of the assets, where the assets are valued in terms of their modern equivalent assets.
Current-cost accounting (CCA) is especially relevant to utilities because their assets typically have very long lives and hence there is bound to be lots of technical change over the asset lives. The services the utility needs to deliver are effectively required in perpetuity, and hence the modern equivalent assets are best regarded as assets-in-perpetuity.
But what are the modern equivalent assets worth? How are their prices determined? This is the famous circularity in the valuation of capital. It needs a discount rate, and hence a cost of capital.
There is a way out of this dilemma. All assets everywhere have an implied cost of capital. For almost everything in the economy this cost of capital is internalised in prices. If you buy a tractor and pay, say, £100,000 for it, the price includes the manufacturer’s and the distributor’s cost of capital. But you will not bother to enquire what that is, provided you can choose between alternative tractors. Competitive markets avoid the need for an explicit calculation of the cost of capital. (They reveal the multiple costs of capital of the multiple providers.)
What this approach to market pricing achieves is to circumvent the need to fix a single cost of capital. Yet the problem remains that the utilities are natural monopolies, and hence there is little chance that competition will determine market prices that properly incorporate a reasonable but not excessive return. A partial solution to this problem is provided by the system regulation model.
The system regulation model starts with a system architecture and incorporates, on a system basis, the outputs required to meet the various obligations, legal requirements and citizens’ requirements. This is an iterative process, as described in “The Systems Regulation Model”.[5]
Where this model comes into the cost of capital territory is by avoiding it. The system regulator auctions the requirements to a wide variety of potential bidders. In the catchment model, bidders will include water companies, direct contractors, farmers and land managers, flood defence interests, and so on. The requirements are auctioned by the system operator, rather like the utilities do now to the contractors they use to do the works. The utilities do not typically examine the cost of capital of their contractors’ contracts; they look at the bid prices along with all the other relevant information about the bidder. In principle, and provided there is enough competition, there is no need to ex ante estimate the cost of capital.
The snag is that, for some of the works, there will be only one bidder, and this is likely to be the incumbent utility. Even here, there can be unbundling of the works and the scale of the problem can be reduced. Water companies can bid against each other for these residual monopoly contracts. Where this fails, there will have to be a negotiated contract, and this will probably include a mark-up. Builders, for example, typically incorporate their “profit” margin and someone will have to adjudicate on this aspect.
The tradeable RABs further reduce the scale of the problem, because the completed capital investments are transferred into these RAB assets, whose cost of capital is determined in real time by the tradeable RABs market. All that is left is the cost of capital for OPEX and CAPEX. On OPEX the cost of capital is a small element, and on CAPEX the asset side is protected from default risk through the RAB.
What the tradeable RAB—based upon a splitting out of the cost of capital, plus the system regulator contracting model—does is to turn as much of the cost of capital towards market determination and unbundle the residual commitments. The chances of massive mistakes, as made under the CAPM and WACC over the last 30 years, are greatly diminished. The auctioning of renewable electricity generation projects illustrates how the overall costs can be reduced and how the cost of capital question can be partly avoided for what are largely sunk and fixed-cost projects – much like utilities.
A new financial framework
It is time to consign the CAPM to the sidelines, and for the Competition and Markets Authority and the economic regulators to take stock of the scale of the errors they have made. Much but not all of this damage is permanent. The excess returns have been made, the balance sheets have been geared up for financial engineering purposes, and the investments that should have been made through privatisation and the creating of private sector balance sheets have not been delivered. The privatised industries are not markedly more efficient than many public sector comparators, and almost certainly any relative efficiency gains are not worth the excess returns that customers have paid for them. British infrastructure generally is not in a good place as a result of the 30+-year privatisation experiment.
It does not have to be like this. The pressing needs of a major modernisation of the water and sewerage systems, the need to put the electricity distribution systems in a resilient state that meets the net zero objectives, the need to build out an electric car charging system, the sorry state of the railways; all point to an urgent need to sort out the mess.
It is not rocket science to solve this. It requires abandoning the CAPM, abandoning the WACC, using a combination of system planning, auctions and competition. It requires an immediate end to the financial engineering and the dominance of financial interests over the needs of the economy and its systems. It needs systems planning, system regulators and a much wider field of companies delivering the national interests.
[1] Knight, F.H. (1921), Risk, Uncertainty and Profit, Boston: New York, Houghton Mifflin Company. Shackle, G.L.S. (1969), Decision Order and Time in Human Affairs, 2nd edn, Cambridge University Press. Shackle, G.L.S. (1972), Epistemics and Economics, Cambridge University Press. Keynes, J.M. (1921), “A Treatise on Probability”, 1st edn, Macmillan & Co.
[2] The CAPM describes the shocks as “systemic risks”, as opposed to “unsystemic risks” that can be diversified away. Systemic risks change everything, and these are identified in the CAPM through overall movements in stock markets.
[3] See Helm, D. (2023), Legacy: How to Build the Sustainable Economy, forthcoming, Cambridge University Press.
[4] Helm, D.H. (2023), “What to do about Thames Water”, 30th August.
[5] Helm, D. (2019), “The Systems Regulation Model”, 12th February.
