Idiosyncratic risk and the cost of capital: the case of electricity networks

We analyze the treatment and impact of idiosyncratic or firm-specific risk in regulation. Regulatory authorities regularly ignore firm-specific characteristics, such as size or asset ages, implying different risk exposure in incentive regulation. In contrast, it is common to apply only a single benchmark, the weighted average cost of capital, uniformly to all firms. This will lead to implicit discrimination. We combine models of firm-specific risk, liquidity management and regulatory rate setting to investigate impacts on capital costs. We focus on the example of the impact of component failures for electricity network operators. In a simulation model for Germany, we find that capital costs increase by <InlineEquation ID="IEq1"> <EquationSource Format="TEX">$$\sim $$</EquationSource> <EquationSource Format="MATHML"> <math xmlns:xlink="http://www.w3.org/1999/xlink"> <mo>∼</mo> </math> </EquationSource> </InlineEquation>0.2 to 3.0 % points depending on the size of the firm (in the range of 3–40 % of total cost of capital). Regulation of monopolistic bottlenecks should take these risks into account to avoid implicit discrimination. Copyright Springer Science+Business Media New York 2014