Estimating the cost of equity for performance based regulation: Important consequences from finance theory.

All forms of economic regulation rely on observing the regulated firm's costs which necessitates estimating the firm's cost of capital including the cost of equity. Performance-based regulation (PBR) combines increased efficiency incentives with explicit performance-achievement rewards. It is attracting both increasing academic attention and greater application in electricity regulation. The standard textbook approaches to the Capital Asset Pricing Model (CAPM) incorrectly describe the asset beta as simply a measure of risk. More correctly, it is a measure of risk per unit of expected return. This interpretation makes the use of the CAPM to determine allowed rates of return problematic. The incentives in Performance Based Regulation exacerbate this problem. Regulators who base part of their decision on "judgement" should rely more on that judgement and develop approaches that focus on regulatory, rather than market, outcomes. • The correct interpretation of the CAPM shows that the asset beta is related to the variance per unit of expected return. • Performance-based regulation is replacing both rate of return regulation and price/revenue cap regulation. • The incentives in PBR invalidate the simple application of market returns on equity as the allowed rate of return. [ABSTRACT FROM AUTHOR]