Returns calculations for regulated Utilities (WACC and cost-of-equity)

[BlackCat]

Hello All, Is anyone familiar with the formulas that regulators use to determine a utility's profits?  eg: water, electricity.  Also Netlink trust around end 2023.

I'm looking at a utility company (CKI  HK:1038) which is having its price reset this year with higher cost-of-equity and WACC - see slide 10.  Can I estimate what effect would this have on profits?

First, the basics.  Do I understand these terms correctly?
  - Cost-of-equity is the return the shareholders should get on their shares.
  - WACC is the average cost of capital for the new utility company: this averages the costs of both debt AND equity. 
    To calculate WACC, you must assume a particular allocation between debt and equity
    eg: If half the capital was debt (eg: interest rate of 1%) and half equity (cost-of-equity of 3%), then WACC is 2%

Second, an example.  The best example I can google is rate-of-return regulation (p6).  Roughly:

1) Calculate the base capital (original amount invested).  eg: 1 million dollars
2) Apply the WACC to that.  eg: At 2%, we need a return of 20k to both cover interest and give a return to shareholders.
3) Add annual operating expenses.   eg: 30k per year.  Plus depreciation.  eg:  50k per year.   
   So our company needs 100k revenue per year to cover costs and return shareholders their cost-of-equity (3%).
4) That 100k is after tax, add in taxes if they were paid.  eg: If tax rate is 20%, we need 120k revenue per year.

This 120k is the final 'required revenue'.  It is divided by the expected number of customers, and appears on our utility bills.


Is this correct so far?

[Choon]

Hello All, Is anyone familiar with the formulas that regulators use to determine a utility's profits?  eg: water, electricity.  Also Netlink trust around end 2023.

I'm looking at a utility company (CKI  HK:1038) which is having its price reset this year with higher cost-of-equity and WACC - see slide 10.  Can I estimate what effect would this have on profits?

First, the basics.  Do I understand these terms correctly?
  - Cost-of-equity is the return the shareholders should get on their shares.
  - WACC is the average cost of capital for the new utility company: this averages the costs of both debt AND equity. 
    To calculate WACC, you must assume a particular allocation between debt and equity
    eg: If half the capital was debt (eg: interest rate of 1%) and half equity (cost-of-equity of 3%), then WACC is 2%

Second, an example.  The best example I can google is rate-of-return regulation (p6).  Roughly:

1) Calculate the base capital (original amount invested).  eg: 1 million dollars
2) Apply the WACC to that.  eg: At 2%, we need a return of 20k to both cover interest and give a return to shareholders.
3) Add annual operating expenses.   eg: 30k per year.  Plus depreciation.  eg:  50k per year.   
   So our company needs 100k revenue per year to cover costs and return shareholders their cost-of-equity (3%).
4) That 100k is after tax, add in taxes if they were paid.  eg: If tax rate is 20%, we need 120k revenue per year.

This 120k is the final 'required revenue'.  It is divided by the expected number of customers, and appears on our utility bills.


Is this correct so far?

In this case, cost of equity is the allowable return that the regulator is allowing the infrastructure company to earn on the equity invested by the infrastructure company in a project. Thus for example, regulator and company may argue about what is the appropriate Beta to apply to calculate cost-of-equity.

Steps 1-4 are a building block methodology to establish allowable revenue rates. This building block methodology can be applied for a rate-of return regulation or a price-cap regulation. So what is more important is whether the infrastructure project is regulated under a ROR or a price-cap.

ROR would be better for the infrastructure company since there's a higher chance that the company can indeed earn its allowable rate-of-return. It however is less efficient from public interest perspective since ROR provides no incentives for a company to be cost-efficient.

Price-cap establishes the prices for the next e.g. 5 years. Thus if the company manages to outperform its operating costs projections agreed with the regulator (via the building block), it can earn a higher return than the allowable return. The reverse applies. Thus less certainty than the ROR. But from the public interest perspective, its is theoretically more efficient.

Overall, my take is that infrastructure projects are not worth the effort for a retail value investor. Too many man-made constructs to understand (length of concession, regulatory model, concession fees, when can concession be revoked) and on top of all these, one still have to take into consideration the regulatory and public sentiment towards any public concession. SBST and SMRT also used to have a WACC concept until the whole system was overhauled.

There are easier companies to understand and analyse.

[BlackCat]

Thanks for your reply Choon!  It helps to clear it up.  So in theory, an X% reduction in WACC leads to an X% reduction in shareholder returns (excluding interest rate and efficiency changes).

I think the company I'm looking at is under a price cap.  They commented how their efficiency has lead to excess returns.  So this comes back to bite them in the next 5 years.

You are right, the actual calculations are exceedingly complex (Northumbrian water, here).  After looking for a few minutes, there's no way I'll put in the time and effort understand them.  And a model that complex can justify anything.

I became interested in utilities searching for dividend stock alternatives to SGX Reits (usually sg shopping malls or 30-year industrial properties).  Apart from Brookfield Industrial Trust and some US (natty/refined) pipeline companies hit by falling crude, haven't found much.  They are mostly too expensive (low CFO/yield per share, plus high US witholding tax), too indebted, or have increasing competition.

[weijian]

The best dividend stocks are actually businesses that grow, have earnings quality, do not need much capex and hence return the money via dividends (either willingly or because it has to satisfy its majority shareholder's requirements). This is something that d.o.g. drilled into the syllabus some time ago.

Similarly as Choon mentioned, personally I had to learn the hard way of expecting dividends from infrastructure or utilities stocks due to the regulatory risks involved (Heads i don't win, tails i lose). These stocks are actually more for capital gains because their downside (fixed rates) is capped - so it is a little similar to value investing concept of "buying a dollar with 50cents". Again, this was something that d.o.g. drilled into the syllabus.

[specuvestor]

Actually I think capped downside is not the same as good upside. If payments to investors are consistent, they are likely to trade more like bonds and are actually interest rate sensitive. However unlike bonds which will mathematically goes to PAR over time, these utilities or even REITS will have significant upside in this ZIRP environment due to diminished oportunity costs. So we have to understand the drivers correctly. In a non low interest rate environment it will generally go back to its "boring" form, unless there is some growth catalyst.

As to returns calculation the concept and principle is quite similar but the maths can be quite different, like say NetLink Trust vs say rails in Comfort Delgro. So generally we just need to roughly understand the drivers rather than the precise maths, especially when it is in a portfolio eg trust.