7 - Linking Regulatory Theory to Practice through Finance

Summary

Finance theory and practice drive the translation of the theoretical approaches to regulation into operational guidelines. The guidelines define a financial model to assess the net present value of all allowed costs and demand-related variables and the resulting allowed rate of return. The cost component accounts for the expenditures needed to meet all services, investments and quality obligations, net of any possible subsidies. Costs can be assessed at either their observed or their efficient level depending on the regulatory guidelines adopted.The demand forecast is typically based on long-term needs to be able to identify the investment requirements of the sector.The discount rate used to assess the net present value of costs and revenue is the cost of capital allowed by the regulator.The cost of capital is estimated as a weighted average cost of capital (WACC) of equity and of debt, with the weights reflecting the relative importance of the two sources of financing. This cost of capital is used to set the upper bound for the allowed rate of return. The average price for the regulated service should be set to ensure that the allowed rate of return is consistent with the allowed cost of capital.