Book Description

December 1996 How does choice of regulatory regime affect the level of shareholder risk in regulated companies? A new study shows that investors bear the greatest nondiversifiable risk with price caps and the least with rate-of-return regulation. Evidence about how choice of regulatory regime affects the level of shareholder risk for the regulated company has traditionally focused on studies in the United Kingdom and the United States. Broad comparisons of price-cap-based regimes (as practiced in the United Kingdom) with rate-of-return regulation (as practiced in the United States) show price-cap-based regimes to be associated with higher levels of shareholder risk (as measured by the beta value) than rate-of-return regulation is. But so few countries were compared that other factors could be at work. Alexander, Mayer, and Weeds broaden the investigation by studying more countries (including regulated utilities in Canada, Europe, and Latin America), doing a sectoral comparison to control for some risks related to factors other than the regulatory regime, and use narrower classifications for regulatory regime. They also look at such recent evidence as the move from relatively pure price caps in the U.K. electricity sector to a mixed-revenue/price-cap-based system. The results of their survey are in line with results from earlier research. They find that investors bear the greatest nondiversifiable risk with price caps and the least nondiversifiable risk with rate-of-return regulation. Once governments and regulatory agencies quantify how the choice of regulatory regime affects the average level of shareholder risk, they can weigh the relative merits of various options not only in terms of incentives for cost reduction but also in terms of the allowable level of investor profit. This paper - a product of the Private Sector Development Department - is part of a larger effort in the department to improve understanding of the impact of regulation on infrastructure firms.