Ofcom’s approach to risk in the assessment of the cost of capital - second consultation

This document was amended on 24/06/05 due to transcription errors in paragraphs 4.51, 4.52 and Figure 6

Executive Summary

Introduction

1.1 Ofcom’s consultation document, Ofcom’s approach to risk in the assessment of the cost of capital (http://www.ofcom.org.uk/consult/condocs/cost_capital/condoc.pdf, “the first consultation”) was published on 26th January 2005.

1.2 This document (“the second consultation”) asks for further views of stakeholders in relation to a subset of the areas discussed in the first consultation. Ofcom has gathered further evidence and carried out further analysis in these areas, and considers it important to seek the views of stakeholders before finalising its decision via a published statement.

1.3 The first consultation discussed Ofcom’s approach to estimating companies’ Weighted Average Cost of Capital (“WACC”) and the relevance of real option theory in the assessment of risk associated with new services. These factors can directly affect financial outcomes for firms in the industries that Ofcom regulates, being key inputs 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.

1.4 In each of these cases, Ofcom is required to assess what a reasonable rate of return is, an assessment which may have a significant financial implication for the firms concerned.

1.5 Further, in the Strategic Review of Telecoms (“the telecoms review”) Ofcom proposed the principle that it had a duty to promote a climate for efficient investment.

1.6 As outlined in the first consultation, there are a number of key considerations that Ofcom is obliged to take into account when calculating a reasonable rate of return. The most important of these considerations (which may at times be in conflict with each other) are:

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

1.7 Section 3 and Section 4 of this second consultation discuss issues relating to beta estimation in the context of BT, and are therefore of particular relevance to BT and its direct competitors. Ofcom’s intention, however, is that a comparable analytical approach outlined in this consultation may apply equally to all the sectors that it regulates, including mobile communications and the audio-visual and audio broadcasting industries (where similar economic and policy considerations apply, subject to the availability of a comparable standard of evidence).

Key proposals in the first consultation

1.8 The first consultation included the following key proposals:

• a suggested range of 4.0% to 5.0% as a reasonable range for the equity risk premium (“ERP”);
• Ofcom should, in certain circumstances, reflect differences in risk between projects in its financial analysis, with differences in systematic risk modelled via cost of capital estimates, and differences in specific risk reflected in cash flow estimates;
• Ofcom should calculate a distinct equity beta for BT’s copper access business (suggested beta values being between 0.9 and 1.2, compared to a BT group average of 1.3); and
• real options theory is applicable to regulation in certain circumstances, and the financial analysis carried out by Ofcom should reflect the value of real options in such cases.

1.9 The closing date for responses to the first consultation was 5th April 2005. Ofcom received responses from a number of stakeholders in relation to all of these proposals. Whilst a number of responses were supportive of Ofcom’s proposed approach, some others questioned the validity of some of the evidence used by Ofcom in the first consultation, particularly in relation to BT’s equity beta.

1.10 Based on these responses, in this second consultation Ofcom presents further evidence and analysis regarding BT’s equity beta only. Based on this further evidence, this consultation makes further proposals in relation to BT’s equity beta, in terms of both the group estimate and the appropriate level of disaggregation, and asks for stakeholder comments.

The full document can be found below