21 January, 2022

Thinking beyond the WACC – the investment hurdle rate and the seesaw effect

Executive summary

The European Commission has set out ambitious goals for investment in very high-capacity networks (VHCNs). Beyond the immediate benefits these platforms confer on users, they are additionally expected to make a much broader economic contribution. This will take place via network effects, through promoting productivity growth, by enhancing social and economic resilience (as demonstrated during COVID-19) and by assisting in the process of de-carbonisation.

The investment challenge
The investment challenge that VHCNs represent is complex and non-incremental since it involves building new infrastructure that will co-exist with legacy networks, which may face competition in terms of overlapping build and for which the additional willingness to pay is uncertain – and may be weak. So the investment environment involves significant market risk.

Investor expectations are also influenced by regulation that tends to cap upside investment returns but cannot provide a hedge against demand and revenue disappointments (including the risk of regulatory opportunism, i.e., denying full cost recovery once the investment has been sunk). Where new network investment is either regulated directly or must compete with regulated networks, regulation therefore introduces an asymmetric risk for investors. Efforts to address this investment challenge are non-trivial and likely to be (at best) only partially successful – reflecting the fact that, where returns are regulated (either now or in the future), this will necessarily cap the associated upside.

Any potential investor will be evaluating the prospective returns on telecoms in Europe versus options to invest in other regions and other sectors. Given the uncertainties involved, past experience will be an important consideration in this process. This represents a headwind for European telecoms investment because the returns generated here have underperformed markets locally and globally.

The benefits of raising the cost of capital for legacy investment
It is against this backdrop that the cost of capital in its wider sense should be evaluated. The question is not simply what the estimated cost of capital is, as a potential input for setting a price control, but what impact can policy and regulation have on risk and required returns for telecoms investment in Europe?

As legacy network investments deliver services that are potential substitutes for those provided over VHCN platforms, the estimated cost of capital utilised in setting legacy price controls is immediately relevant to those evaluating the feasibility of VHCN investments. Under-estimating the weighted average cost of capital (WACC) on legacy infrastructure will actively incentivise customers to remain on legacy offerings and avoid upgrading to faster bandwidths. In turn, this will impede the take up and/or undermine the pricing (and hence economic viability) of VHCN services – directly contrary to the thrust of the EC’s objectives.

Additionally, investors also know that new investment will, over time, become legacy investment, so the approach to regulation of legacy investment will be a central consideration in forming a view regarding anticipated returns for new investment.

In setting out the approach for estimating the cost of capital for legacy investment, the 2019 Commission Notice on the WACC specifically identifies promoting investment. However, the approach that has been used in the BEREC reports on WACC parameters do not reflect this.

Read the full executive summary and report at the link below. 

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