The empirical CAPM: Estimation and Implications for the Regulatory Cost of Capital

In calculating the cost of capital for regulated businesses, the New Zealand Commerce Commission uses the Capital Asset Pricing Model to estimate the cost of the equity component of capital, a procedure that involves assuming particular values for unobservable key parameters. This thesis proposes, instead, to estimate these parameters from market data. The principal result is that estimates of these parameters differ significantly from the values assumed by the Commerce Commission. Applying these estimates to two recent cases involving the electricity line and gas pipeline businesses, the estimated costs of capital for the entities involved are 3.5% to 5.5% more than those obtained by the Commission, but the associated confidence intervals are wider. One implication of these findings is that the Commissions approach systematically understates the uncertainty surrounding cost of capital estimates.