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Executive summary

Introduction

1.1 This statement sets out Ofcom’s views on a number of issues relating to risk and return, in particular the returns appropriate for companies regulated by Ofcom. It marks the conclusion to two Ofcom consultations:

• Ofcom’s approach to risk in the assessment of the cost of capital, 26 January 2005 (http://www.ofcom.org.uk/consult/condocs/cost_capital/) – “the first consultation”; and
• Ofcom’s approach to risk in the assessment of the cost of capital, 23 June 2005 (http://www.ofcom.org.uk/consult/condocs/cost_capital2/) - “the second consultation”

1.2 This statement focuses on Ofcom’s approach to estimating companies’ weighted average cost of capital and discusses Ofcom’s regulatory approach to real options. These factors can directly affect financial outcomes for firms in the communications industry, being a key input used by Ofcom in its analysis relating to, for example:

• ex ante duties, such as setting charge controls and price caps;
• ex post duties, such as conducting competition analysis, when considering stakeholder complaints relating to allegations of anticompetitive conduct; and
• valuing the future cash flows that are associated with, for example, licence applications.

1.3 Estimating a reasonable rate of return is therefore a key part of Ofcom’s duties in regulating the communications industry, and the financial implications for the firms concerned may be significant.

1.4 Ofcom’s wide ranging Strategic Review of Telecoms (“the telecoms review”) drove the decision to examine the issues covered in this statement. In the telecoms review, Ofcom set out as a fundamental regulatory principle that Ofcom should promote a favourable climate for efficient and timely investment and stimulate innovation, in particular by ensuring a consistent and transparent regulatory approach. This statement is intended as a significant step in achieving this aim. The telecoms review also proposed that regulation should be targeted on ensuring real equality of access to enduring economic bottlenecks, creating the scope for deregulation in other areas. On the 23 June 2005 Ofcom published details of the regulatory settlement intended to achieve this, of which the cost of capital is a necessary part.

1.5 Mindful of these regulatory duties and objectives, there are a number of key considerations that Ofcom will take into account when calculating a reasonable rate of return. The most important of these considerations are:

• the impact on incentives for companies to invest. Where investments are risky, it is important that regulated returns reflect the degree of risk that companies face in making investments
• the scope for investment by competing network providers. If there is a prospect of effective competition as a result of investment by competing providers, it is important that regulation does not harm such prospects; and
• the need to protect consumers from excessive charging for services provided in markets in which there are enduring economic bottlenecks. Scope of this statement

1.6 This statement deals with a broad range of issues related to estimating the cost of capital, including the appropriate value for the equity risk premium, accounting for variations in risk with a firm, and accounting for real options in a regulatory context.

1.7 However, it also has a particular focus on BT’s cost of capital given its importance in the context of the telecoms review and in relation to a number of imminent Ofcom decisions e.g. valuing BT’s copper access network, and the network charge controls. In particular this statement addresses BT’s equity beta and discusses an appropriate equity beta for BT’s copper access business. It concludes with Ofcom’s final estimates of BT’s costs of capital.

1.8 These BT specific issues are of direct relevance to BT, its competitors and customers. However, it is Ofcom’s view that the analytical approach outlined in this statement should serve as a starting point for Ofcom’s approach to risk and return in all the sectors that it regulates, including mobile communications and the audio-visual and audio broadcasting industries (where similar economic and policy considerations apply and subject to the availability of a comparable standard of evidence the same approach may apply).

Key conclusions

The appropriate value for the Equity Risk Premium

1.9 Under the Capital Asset Pricing Mechanism, the Equity Risk Premium (“ERP”) reflects the extra return that investors require for investing in equities rather than a risk free asset. It is a stock market, rather than company-specific, factor.

1.10 Ofcom noted in the first consultation that the calculation of a forward-looking ERP entails a significant degree of judgement and a wide range of estimates can be derived by commonly-used estimation techniques. As explained in the first and second consultation, Ofcom considers that the downside risk associated with taking too low a value for the ERP (discouraging discretionary investment) is more detrimental to the interests of consumers than taking too high a value (leading to higher prices to customers) and has tended to the higher end of the possible range. But, given the need to protect consumers, it would not be appropriate for Ofcom to err too strongly in this direction.

1.11 Having reviewed its approach in this area and on review of the available evidence and responses on this issue Ofcom believes that values in the range 4.0% to 5.0% are reasonable. Within this range Ofcom takes the view that 4.5% is the appropriate value for it to use in estimating a company’s cost of capital. This represents a reduction of 0.5% from Ofcom’s previously applied value of 5.0%. The basis for this decision is discussed in detail in Section 4 of this statement.

Ofcom’s approach to modelling variations in risk within the firm

1.12 In the first consultation, Ofcom proposed that it should, in certain circumstances, reflect differences in risk between projects in its financial analysis, with differences in systematic risk modelled via cost of capital estimates, and differences in specific risk reflected in cash flow estimates

1.13 Ofcom believes that, under certain circumstances, it may be appropriate to reflect differences in risk within corporate groups in its financial analysis. In the context of systematic risk, this would mean allowing different costs of capital on different projects. One way to achieve this in practice would be to vary, or “disaggregate”, the beta, the parameter that reflects the systematic risk of a particular company in the CAPM.

1.14 The basis for this decision is discussed in Section 5.

BT’s group equity beta

1.15 Under the CAPM, a company’s equity beta reflects the systematic risk that it faces relative to the average company in the market. In the first consultation, Ofcom based its analysis in relation to disaggregating BT’s beta on a group equity beta estimate for BT of 1.3. In their responses to the first consultation, some of the companies that depend on BT for wholesale inputs argued that the use of this figure was inappropriate, based on an analysis of more recent evidence in this area, and that Ofcom should revisit its estimate of this parameter.

1.16 In the second consultation Ofcom presented further analysis on the level of BT’s group equity beta. After consideration of responses to the second consultation Ofcom takes the view that the appropriate value for BT’s group equity beta is 1.1.

1.17 The basis for this decision is discussed in Section 6.

Disaggregation and BT’s copper access beta

1.18 Ofcom and, previously, Oftel have traditionally assessed the cost of capital at a company-wide level. However, companies commonly make investment decisions at a project or activity level, and reflect variations in systematic risk between different activities.

1.19 In the first consultation, Ofcom proposed that it should reflect some of the most important of these variations in systematic risk in its financial analysis. In particular, Ofcom proposed disaggregating its estimate of BT’s equity beta in order to reflect Ofcom’s view of the differing levels of systematic risk faced by different parts of BT’s business.

1.20 Stakeholder responses to this proposal were divided. A number of firms, particularly those that have invested in the furthest-reaching network infrastructure, were opposed to assessing risk at a project level, with BT and the cable companies particularly opposed to estimating the risk of BT’s copper access business on a standalone basis. Competitors and customers of the incumbents were, broadly speaking, in favour of assessing risk at a disaggregated level and therefore estimating a distinct equity beta for BT’s copper access business.

1.21 The strongest argument cited by stakeholders against estimating an equity beta for BT’s copper access business was that, in the absence of pure play comparators (i.e. companies that only offered copper access services); a beta for BT’s copper access business could not be estimated with any reliability. In their responses to the first consultation, BT, argued that each of the pieces of evidence used by Ofcom to assess the level of systematic risk faced by BT’s copper access business were flawed, and that this meant that the use of a single group estimate was preferable.

1.22 In the second consultation, Ofcom carried out further analysis of this issue and consulted on this new evidence. Having assessed stakeholder responses to both the first and second consultations, Ofcom remains of the view that it is appropriate to apply a disaggregated approach to beta estimation in relation to BT’s copper access business. Ofcom’s view is that it is reasonable to disaggregate BT’s group beta of 1.1 into two components which broadly relate to BT’s copper access network business with an equity beta of 0.9 and the rest of BT (including retail calls, broadband, and leased lines) with an equity beta of 1.23.

1.23 The basis for this decision is discussed in Section 7.

BT’s cost of capital

1.24 In carrying out its duties in relation to BT, Ofcom takes the view that it is appropriate to apply BT’s copper access network business beta or the beta for the rest of BT as appropriate.

1.25 Based on Ofcom’s views on the ERP and BT’s beta, Section 8 provides an estimate of the weighted average cost of capital (“WACC”) for BT’s two component parts on a pre tax nominal basis (see Section 8 of this document for details):

• copper access network business –10.0%; and
• the rest of BT – 11.4%.

Taking account of real options

1.26 If the riskiness of a firm’s investment is modelled using the CAPM and Net Present Value (NPV) analysis, then, as outlined in Section 3, the systematic risk faced by investors is taken into account via an estimate of the firm’s Weighted Average Cost of Capital (WACC). Cash flows should be calculated in such a way as to ensure that the rewards from successful investments within the portfolio are expected to be sufficient to pay for the losses associated with unsuccessful investments. This analysis does not, however, explicitly take into account the extent to which risk can be mitigated by the adoption of certain investment strategies (e.g. investing later in order to “wait and see” how a market develops, or investing early in order to gain a first mover advantage). It may not, therefore effectively mimic the signals given by a competitive market with regard to risky, non reversible investments.

1.27 In the first consultation, Ofcom proposed that, under certain circumstances, it should take account of such factors by using a real options approach to financial analysis. In particular, Ofcom proposed that, in some cases, the option to wait and see which is surrendered when an investment decision is made may have a value that it is appropriate to take into account in its analysis. In the context of the most important current or near future regulated products, Ofcom’s initial view was that the value of these options is likely to be greatest in the cases of:

• next generation access networks; and
• (to a lesser extent) next generation core networks.

1.28 Ofcom received responses from a number of stakeholders in relation to the issue of real options. These responses discussed both:

• the “theoretical” case for the use of a real options framework, and
• whether, and how, real options might be used as a policy tool in practice.
  

1.29 Section 9 of this document provides a summary of these responses. In the light of these responses Ofcom concludes that, going forward, its analysis should take account of the value of real options where appropriate. This section expands somewhat on the analysis set out in the first consultation by making clear that Ofcom’s approach to taking account of real options would seek to reflect the conditions that would prevail under competition, not to underpin the investment decisions and returns of a dominant firm.

1.30 Ofcom proposes to assess the value of real options on a case-by-case basis, and encourages stakeholders to make submissions to Ofcom on this subject in cases where they feel that wait and see options have a significant value. Should the theoretical case for real options be demonstrated, Ofcom would then determine in consultation with stakeholders whether and how best to put this into practise. Ofcom considers that Next Generation Access may prove to be such a case and will consider this possibility in more detail as part of the Review of its forthcoming review of Ofcom’s regulatory approach in this area.

Impact of Ofcom’s conclusions

1.31 The overall net, financial impact on stakeholders of the conclusions in this statement are difficult to assess, since, from the perspective of each stakeholder, some implications would be favourable whereas others would be unfavourable:

• other things being equal, the return permitted (and hence prices) on all regulated prices for access products would go down owing to the use of a revised ERP; and
• in cases where a project or activity-specific approach to assessing risk is taken:

o the regulated returns permitted, and hence prices, on some lower (higher) risk investments would go down (up) owing to equity beta disaggregation, whilst the overall company cost of capital calculated under the CAPM would remain the same;
o the regulated returns (and hence prices) allowed for some risky new investments could increase through disaggregation and taking account of the value of real options; and

• the estimated cost of capital for BT will fall, because of lower estimates for the ERP, the risk free rate and the group equity beta.

1.32 Ofcom believes that its conclusions are consistent with, amongst others, its duties relating to the protection of consumers, the promotion of competition and encouraging efficient investment under the Communications Act and the regulatory principles set out in the telecoms review.

The full document is available below

• Ofcom’s approach to risk in the assessment of the cost of capital - Final Statement [pdf]
  Full print version
• Discussion of Responses to "Beta Analysis of British Telecommunications: Update June 2005" - August 2005 [pdf]
  Full print version
• Responses to the consultation : Ofcom's approach to risk in the assessment of the cost of capital - PwC Response [pdf]
  Full print version

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