Estimating the cost of equity for the regulated energy and infrastructure sectors in India

The cost of equity capital is a key input used by regulators to fix permissible rates of return and determine regulated tariffs. Investors also need an appropriate hurdle rate to make investment decisions. Regulators worldwide often use a single-factor model to estimate the cost of equity. The empirical literature shows that such a model has limited efficacy in explaining stock returns, while other factors also capture the risk involved in the market. This study is perhaps the first to apply three asset pricing models-the capital asset pricing model (CAPM) and the Fama-French three- and five-factor models-to estimate the cost of equity for the Indian energy and infrastructure sectors. We find that the reasonable rate of return fixed by the respective regulator based on the CAPM is often higher than this study's estimated cost of equity (using CAPM). The spread between the regulated return across the identified energy and infrastructure sectors is estimated using a single-factor model, and our estimation using the three-factor model is relatively lower. The spread increases when we apply the recent five-factor model for regulated utilities. The study can guide policymakers and regulators in estimating and fixing reasonable rates of return for the infrastructure sectors.

Automated summary

The cost of equity capital is crucial for regulators and investors, with a single-factor model showing limited efficacy in estimating stock returns. This study is the first to use three asset pricing models to estimate the cost of equity for the Indian energy and infrastructure sectors, providing insights for policymakers and regulators in setting reasonable rates of return. The study reveals that the reasonable rate of return calculated using the capital asset pricing model could be higher than the estimated cost of equity, and different asset pricing models can lead to varying estimates of return spread in regulated sectors.