MCC Economics: Cost of Capital – 10 Hot Topics

The cost of capital is of major importance for infrastructure and utility businesses because they are capital-intensive. The Australian Energy Regulator (AER) estimates that the return on capital is typically about half of the total revenue of the electricity and gas networks it regulates. Furthermore, small changes in the cost of capital lead to very large changes in regulated revenues. The AER estimates that a 1% change in the cost of capital results in an 8.2% change to regulated revenues. Regulated revenues for electricity networks in Australia were $12 billion in 2022, so a 1% change in the cost of capital would shift revenue by about $1 billion. Consequently, estimates of the cost of capital are strongly contested. Consumers and regulated businesses try to persuade regulators to employ lower or higher values.

This has generated debate across almost all elements of the cost of capital and there is rich and extensive literature on the subject, including litigation in the courts. In more recent times (at least in Australia and New Zealand), the field of debate has narrowed as approaches have become more settled.

There is still active engagement on a range of hot topics including:

1. Climate change
2. Stability and predictability of approach 
3. Reasonableness checks 
4. Diminishing set of publicly listed comparator firms
5. The term for estimating the cost of equity
6. Accommodating large new investment
7. The market risk premium
8. Stranding risk for gas networks
9. Competition for the right to supply
10. Merits review