A Cost of Capital and Capital Markets Primer for Utility Regulators

Utility service is provided through investments in infrastructure that is constructed to last for multiple decades, making utilities among the most capital-intensive industries. Investors supply capital to a utility with the expectation of earning a return, which is influenced by the utility's creditworthiness and the overall market conditions. The cost of capital is a critical component of effective cost-based ratemaking and developing cost-reflective tariffs. It represents the minimum return that investors require to supply capital to a utility. The cost of capital is influenced by various factors, including the utility's capital structure, debt and equity financing, and the overall market conditions. Understanding the capital markets and estimating the cost of capital are essential for utility regulators to design rates that are based on actual cost of service and to effectively engage the public and key stakeholders in the decision-making process. The National Association of Regulatory Utility Commissioners (NARUC) has developed a Cost Reflective Tariff Toolkit with the support of the United States Agency for International Development (USAID) - Energy Division, Office of Energy & Infrastructure. This toolkit is intended to provide utility service regulators in countries with emerging economies with practical guidance on designing rates that are based on actual cost of service. The toolkit includes several short practical primers, one of which is the Cost of Capital and Capital Markets Primer for Utility Regulators. The primer focuses on describing the capital markets and a set of pathways that regulators in countries with emerging economies may want to consider when estimating the cost of capital for use in determining the utility revenue requirement in ratemaking. The pathways are based on U.S. utility regulators' practices in estimating the cost of capital and include some observations to incorporate regional differences between the U.S. and countries with emerging economies. The primer is organized into eight sections, starting with an introduction that explains the objective, scope, and organization of the primer. Section 2 provides a capital markets overview, which discusses the role of investors in supplying capital to utilities and the factors that influence the cost of capital. Section 3 provides a cost of capital overview, which explains the importance of understanding the cost of capital in ratemaking and developing cost-reflective tariffs. Section 4 describes the capital structure components, which include debt and equity financing. Section 5 describes the cost rates of debt and preferred stock, which are influenced by the utility's creditworthiness and the overall market conditions. Section 6 explains cost of common equity methodologies, which include various financial models that estimate the cost of common equity. Section 7 summarizes how the preceding concepts are combined to estimate a utility's weighted average cost of capital. The weighted average cost of capital (WACC) is a critical component of ratemaking and is used to determine the utility revenue requirement. It represents the minimum return that investors require to supply capital to a utility and is influenced by the utility's capital structure, debt and equity financing, and the overall market conditions. The WACC is estimated by combining the cost rates of debt and preferred stock with the cost of common equity, which is estimated using various financial models. In conclusion, the Cost of Capital and Capital Markets Primer for Utility Regulators provides utility service regulators in countries with emerging economies with practical guidance on designing rates that are based on actual cost of service. The primer focuses on describing the capital markets and a set of pathways that regulators may want to consider when estimating the cost of capital for use in determining the utility revenue requirement in ratemaking.