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Dan Harris
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A new report by economists at The Brattle Group offers a common set of guidelines for EU-based National Regulatory Authorities (NRAs) to use when calculating an allowed rate of return – typically a weighted average cost of capital (WACC) – for electronic telecommunications operators with significant market power (SMP).

NRAs currently use a variety of methodologies to estimate WACCs, which can result in cross-country pricing differences for reasons other than economic fundamentals. To address this issue, the European Commission’s Directorate-General for Communications Networks, Content and Technology (DG Connect) engaged The Brattle Group to develop a harmonized WACC methodology to be used by the NRAs. Brattle economists Dan Harris and Richard Caldwell, lead authors of the report, shed more light on the issue at hand and the positive results of the guidelines they put forth.

Why were you compelled to do this report?
In some circumstances, National Regulatory Authorities (NRAs) for electronic communications in the European Union (EU) may set maximum wholesale price caps for access to the networks of operators with significant market power (SMP). NRAs are required to set these price caps at levels which allow SMP operators to earn a reasonable rate of return on their investments, or in other words, to earn their weighted average cost of capital (WACC). The problem is that NRAs often employ different methodologies to estimate WACC, so that the resulting estimates differ between Member States for reasons other than market fundamentals. These differences may then distort market participants' investment decisions, dragging investment to jurisdictions with relatively more generous WACCs at the expense of those with less generous WACCs, and in the process distort the EU’s digital single market. To address this issue, the European Commission asked The Brattle Group to develop common guidelines for NRAs when estimating WACCs in the EU's telecoms sector. The guidelines covered so-called legacy networks, such as copper networks used for the provision of voice and broadband services, as well as Next Generation Access (NGA) networks, which are used for fiber-based telecoms services.

What was the outcome of your analysis? 
WACC estimation requires NRAs to estimate multiple underlying parameters and values. Estimating each parameter may require several assumptions and calculations. Subjective differences can arise during this multi-step process, even if the overall goal of the analysis – the WACC – remains consistent across NRAs. Our study therefore began by analyzing the alternative approaches used to estimate each relevant parameter. We carefully considered the alternatives, and then recommended the ones we considered most appropriate for EU NRAs given the broader industry and economic context for their analysis.

We did not develop our guidelines in a vacuum. NRAs have established methodologies and practices for WACC estimation, and modifying NRAs’ existing methodologies has itself a potential cost in the form of increased regulatory uncertainty. Our approach attempts to strike a delicate balance between eliminating subjective differences between NRAs’ WACC estimates, without imposing undue change and uncertainty.

The result is a kind of ‘recipe book’ that NRAs can use to estimate WACC. The recipe book identifies which parameters should have a common value across all EU Member States, and which can remain different. For example, we recommend common values for the Market Risk Premium and the ‘beta’ value for legacy networks, since investors can easily diversify across Europe and beyond. At the same time, we recognize that the cost of debt and debt levels can vary across Member States. Our guidelines also recommend a single calculation methodology or data source for some parameters in the interests of harmonization, while always recognizing that other methodologies and data sources may be available and potentially valid.

We outline several reasons why the WACC for NGA networks is likely to be higher than for legacy networks, and recommend that NRAs use financial modeling techniques to quantify the additional risk ‘premium’.

What is the impact to regulators? 
NRAs confront many difficult choices in setting price caps, and even face the risk that the European Commission could potentially challenge their WACC methodology. With our report, NRAs now have a detailed set of guidelines and can rest assured that the Commission is unlikely to challenge any WACC decision that is consistent with the guidelines. We are pleased to hear that the Commission has received positive feedback from NRAs about the guidelines, in particular from smaller NRAs who have fewer resources to dedicate to WACC estimation, and who are grateful for the practical help our report provides.

What is the potential impact to non-regulators? 
Access tariffs are a significant cost for many network users, and the WACC an important element of the tariff determination. Our report will help network users better understand and predict how NRAs derive access tariffs, and how tariffs might evolve as financial conditions change. The report thereby enhances the transparency of the tariff setting process, and attempts to ensure that network users pay tariffs that reflect underlying economic fundamentals.

For more information, please visit the news item or the report.