On 25 July, the Joint Regulators Group (the "JRG") adopted a common approach to discounting in cost-benefit analyses which involve private investment for a public benefit.
The use of a cost-benefit analysis is common when a regulator is considering intervening in a market in which there is no profit incentive for firms to invest but where investment would bring benefits to consumers or the wider public. In such circumstances, the JRG members agree, regulators' analysis of costs should include a discount for all costs, including the investing firm's financing costs. The common approach therefore takes into account the cost to the firm of financing its capital outlay. The level of this discount is based on the firm's own Weighted Average Cost of Capital.
For certain regulators, including Ofcom, this marks a change in approach to cost-benefit analyses. Ofcom have traditionally excluded financing costs from discounting when weighing up the costs of investment. The comparative effect of the new approach will generally be to reduce the net present value (for discounted cash flow purposes) of an investment, a figure which can play a crucial role in the decision as to whether to intervene.
The JRG is composed of regulators from a wide range of sectors including rail, energy, aviation, communications and post. The statement issued by the JRG is for guidance; as always, regulators must have regard to their own duties and the particular context of their sector. It is worth noting that the common approach to discounting is based on the methodology employed by the water industry regulator, Ofwat. Ofcom have been known to depart from common regulatory practice led by Ofwat in the past and have been supported by the Competition Commission in doing so (see the Competition Commission's recent determination in British Telecommunications plc v Office of Communications Competition Appeal Tribunal case number 1187/3/3/11). The impact of the best practice guidance in any given sector therefore remains to be determined.
The JRG statement can be viewed here.