Consultant Report on Estimation of Equity Risk Premium (TASK 2 AND 3)

The report aimed to provide answers for Task 2 and 3 of the Terms of Reference, which involved establishing the rate of return for electricity supply at regulated tariffs activity and illustrating different methods of establishing the rate of return for electricity distribution activity. The report concluded that estimating the equity risk premium for Moldova is a critical issue for the National Association of Regulatory Utility Commissioners (ANRE). The equity risk premium is a direct input into the tariff methodology used and is the most subjective input as well. The ongoing tariff debate with Union Fenosa highlighted the importance of accurately estimating the equity risk premium. To estimate the equity risk premium, nine different methods were utilized, including Survey, Country Sovereign Credit Rating, Country Risk Scores, Bond Default Spread, Credit Default Spread, Equity Market Volatility, and the Contingent Claims Approach. However, due to the lack of available data for Moldova, proxies were developed and utilized for estimation based on equivalent data from other emerging economies. The report also discussed the importance of determining the risk-free rate, which was decided to be the US Treasury Bill. Two periods were calculated using historical data, resulting in estimates of 3.5% and 1.4%. The second period is significantly lower than the first and is likely due to the global economic downturn experienced during that period. The results of the equity risk premium estimation are presented in Table 1, which shows a range of estimates from 11.9% to 23.6%. The average of these estimates is 17%, which was used to calculate the equity risk premium for Moldova. The report also provided the answers to Task 2 and 3 of the Terms of Reference. For Task 2, the answer is the equation Equity Riskm = Rf + ERPm, where Rf is the risk-free rate in the US (1.4%), ERPm is the equity risk premium for Moldova (17%), and Equity Riskm is the required rate of return for Moldova (26.4%). For Task 3, the answer is the equation WACCm = .65% * (Equity Required Rate of Returnm) + .35% * (Cost of Debt (7.5%)), where Equity Required Rate of Returnm is the required rate of return for Moldova (26.4%). The report also noted that the Weighted Average Cost of Capital (WACC) is a simple average of numbers and is both common financial knowledge and written within the Tariff Methodology of ANRE. The report emphasized that the equity risk premium is a critical input into the tariff methodology used by ANRE and is the most subjective input as well. The accurate estimation of the equity risk premium is essential for determining the required rate of return for Moldova, which in turn affects the regulated tariffs activity.