We propose small adjustments to the Norwegian regulatory WACC

The Norwegian regulator’s approach to determining the regulatory WACC has essentially remained unchanged since 2013. In a new report, we conclude that the current approach has worked well but identify some room for improvement. Our recommendations would result in a slightly lower WACC in the near term.

The Norwegian energy regulator (RME) regulates the income of Norwegian network companies. A key component of the regulatory model is the determination of a reference interest rate, specifically a nominal pre-tax rate determined as a weighted cost of capital (WACC). The rate underpins the determination of a reasonable rate of return for network companies assuming that they operate, develop and use their networks efficiently.

Norwegian law obligates the regulator to regularly review its regulatory models, including those used to determine the WACC. THEMA Consulting Group, in collaboration with NERA Economic Consulting, conducted an external assessment of RME’s current WACC methodology.

Overall, we conclude that the model has performed well relative to similar processes in other countries.

The Norwegian model has ensured that the WACC has risen in line with rising commercial interest rates. This is partly because the cost of debt is updated annually, but it also due to the fact that increases in market interest rates have mirrored increases in inflation and thus been captured in the model’s risk-free interest rate. Other regulatory WACCs have not fared as well, for example because the reference rates they use are set over longer periods. Such models can create a significant delay before changing market conditions are captured in the regulatory WACC.

Other regimes can also be undermined by lengthy legal proceedings, such as those observed in Sweden and Germany. These processes tend to undermine the predictability and stability of the regulatory regime.

That said, the Norwegian model would not have fared as well if high market interest rates had come despite low inflation and can still potentially give rise to significant deviations between market interest rates and the regulatory WACC.

We assessed the individual parameters of the model in detail. In general, these are well-grounded both theoretically and empirically. However, there are some areas where the current model could be improved.

The allowed cost of equity cost includes an adjustment for inflation. Currently, this adjustment is made based on a five-year average of past and expected rates of inflation. We recommend that RME use an average for a longer period (e.g. 10-year forecasts). The current approach risks over- or undercompensating investors in network companies. In contrast, a longer period average would make regulated returns more stable and improve alignment with forward-looking market expectations.

The estimated cost of debt is calculated using market interest rates and an industry-specific credit premium. We recommend that this premium be based on indices of bond interest rates for power sector companies as produced by NBP (Nordic Bond Pricing). At present, the approach excludes debt raised by companies like Statnett, which accounts for a significant share of network company capital in Norway. We recommend that the relevant index include all relevant companies, including Statnett.

The proposed model would reduce the WACC in the short-term. However, the long-term WACC is expected to be similar to that produced under the current model.

Finally, RME should state clearly that key paraments like the long-term real interest rate will be reassessed at regular intervals to capture changes in long-term market expectations. It may also want to make explicit that future assessments will consider the relationship between the risk-free interest rate and the market premium, which we understand reflects practice to date and is in line with current practice in several European countries.

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