Friday, 8 November 2019

WACC-y

I don't understand WACC, the Weighted Average Cost of Capital.

No, don't look at me like that - I do understand the mechanics of the thing, and have had my fair share of meetings pinning down appropriate beta comparators, the extent of the market risk premium, Brennan-Lally tax adjustment, and due allowance for the curvature of the earth.

No, what I mean is, I don't understand WACC as a regulatory concept.

Bear with me. I can see WACC as an accounting concept. A firm's balance sheet is made up of  equity and debt, and each comes with a cost: what you have to pay the owner shareholders to invest their risk capital, and what you have to pay lenders to lend. And the overall cost of the whole balance sheet is the weighted average of the two costs, WACC. All good.

But you'll often see a regulated firm described as "earning its WACC" (with subtext, "and no more"). No, it isn't. The firm is earning its return on equity. Its lenders are earning their return on debt. Neither of them is earning WACC.

In fact I can't see why (with one potential exception) regulators take the interest they do in the cost of a firm's debt. The standard regulatory equation in rate of return regulation (certainly as it's been implemented in New Zealand under Part IV of the Commerce Act) is
Allowed revenue minus (efficient) opex minus (efficient) investment minus (economic) depreciation = allowed interest costs plus allowed return on equity
But why do regulators give a fig about the interest costs? They're a cost that the regulated firm has every incentive to minimise: it's paid away to the third-party suppliers of credit, not a return to the firm itself.

The standard formulation makes little sense to me. Why shouldn't the equation be squarely focused on the return to equity:
Allowed revenue minus (efficient) opex minus (efficient) investment minus (economic) depreciation minus actual interest costs = allowed return on equity (ROE)
It's more logical: the only return that matters in a market economy is the ROE. And the rejigged version of the equation is both simpler and less restrictive.

It's simpler, because at the moment rate of return regulation goes through a whole process determining the "appropriate" cost of borrowing for the regulated entity - typically by establishing what a company of similar credit standing in that industry would pay, for debt of a maturity equal to the period of regulation (often five years). It would be simpler just to write down what it actually paid, not mess about guessing what a firm just like it might have paid.

It's less restrictive, because it would not risk imposing unnecessary and possibly inefficient constraints on the maturity of the debt raised. Right now, there'll be many a corporate treasurer who reckons that we are at a cyclical low point in borrowing costs, and will be keen to lock in currently attractive prices for as long as possible. If they're right, paying a bit more than you'd pay today for five year debt in order to issue ten or fifteen year debt could well work out cheaper - maybe a lot cheaper - in the long run, benefiting consumers. Allowing the regulated entity only the five year cost could be counterproductive.

The current formulation also potentially inhibits other efficient approaches to borrowing. There are good rationales, for example, to match the maturity of debt to the working maturity of the assets they finance. In regulated industries, the assets tend to be very long lived indeed. What is the logic of not compensating the regulated entity for the actual cost of doing the sensible thing?

And many treasurers will want to avoid a concentration of debt maturities falling due around the same time: you don't want to be going around the money markets with a large begging bowl if it happens to be in the middle of the next GFC.  Rather, a prudent treasurer will have a mix of maturities: on average they might approximate to the five year maturity the regulator will allow, but equally they mightn't. Why impose a penalty (or subsidy) on what a prudent maturity mix actually costs?

A purely ROE-focused approach, one which drops determining an "appropriate" cost of debt, is a better way to go as a general rule, but I mentioned one possible exception. That's where the debt providers are associated parties. Let's suppose the regulated entity is owned by a private equity company. It could fund its "debt" from a financing vehicle in the group, and stream above-market "interest" payments effectively to itself. But in normal circumstances most companies borrow at arm's length from banks and the capital markets. A quick check that its funders are not interlinked, and in most cases you'd be done.

There is one aspect of debt that regulators should properly monitor, and that is excessive leverage. With an effectively guaranteed income, there could well be a moral hazard risk of the regulatee putting in $10 of equity and a squillion dollars of debt, juicing the ROE if all goes well and lumbering the bondholders and any operator-of-last resort if it doesn't. A maximum leverage ratio, or as a more market-oriented option, a minimum investment grade debt rating, might be a useful regulatory adjunct. But beyond that, leave it to the corporate treasurer to figure out the cheapest financing bundle.

A final benefit of an exclusively ROE-based approach is stopping some game-playing. Quoting the WACC that the regulator has allowed can be deceptive. The regulator can say, "See how effective we've been? We only allowed them 6%!". The regulatee can play the same game: "See how unfair they've been? They only allowed us 6%!". In both cases - particularly at today's interest rates - the WACC is low because the debt component is low. The regulator may not in fact be especially effective; the regulatee may not in fact be hard done by. It's only the ROE that can answer those questions.

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