Risk and Capital Structure in the Regulated Firm

Risk Sharing, the Cost of Equity and the Optimal Capital Structure of the Regulated Firm

“…This model considers the more general case where the firm's cost of equity is determined by the covariance of its returns with the market return. As a result it is shown, in contrast to De Fraja and Stones (2004), that some variation in prices is optimal regardless of the firm's capital structure and not just once it reaches a certain level. In addition, it becomes possible to derive the conditions for a social optimum.…”

“…They conclude that, when consumers are risk averse, there is a social optimum where consumers carry some risk and are willing to accept a degree of price variability in return for a lower expected price. The model developed in this paper is, in some respects, similar to that in De Fraja and Stones (2004), but it is significantly different in its treatment of the cost of equity. In particular, they assume that the cost of equity is simply a function of the level of debt as a proxy for the relationship between the firm's cost of equity and investment risk.…”

“…However, in the present model management do not play a role and may be assumed to act merely as the agent of the shareholders. This simplifies the analysis, and it can be shown that including the assumptions regarding management used by De Fraja and Stones (2004) has no material effect.…”

“…It is not surprising, therefore, that risk, the cost of capital, and capital structure continue to be the subject of much debate between regulators and regulated utilities in the UK. 5 The socially optimal capital structure for a regulated firm has previously been considered by De Fraja and Stones (2004). They conclude that, when consumers are risk averse, there is a social optimum where consumers carry some risk and are willing to accept a degree of price variability in return for a lower expected price.…”

“…For example, Ofwat (1991) and WSA/WCA (1991) contain a particularly extensive exchange of views on these issues that took place between the water industry and its regulator shortly after privatization, and a detailed report on the cost of capital was recently compiled for the energy regulator by Wright et al (2006). 6 De Fraja and Stones (2004) also allow for the firm to be run by a management that has its own utility function and can reduce costs by exerting effort. However, in the present model management do not play a role and may be assumed to act merely as the agent of the shareholders.…”