Question

A monopoly water company provides consumers with water supply, sewerage and wastewater treatment services. The local regulator of the company has to establish a price that the company is allowed to charge its customers. Under rate- of-return regulation, the regulator will set a price that equals the cost of providing water services, including an allowance for the cost of capital used by the company.

(i) When computing the cost of capital, should the regulator compensate the providers of capital for the risk they bear by investing in the water company?

(ii) What particular type of risk, relevant or irrelevant, should the commission compensate them for and why?

Answer 1

(i) When computing the cost of capital, should the regulator compensate the providers of capital for the risk they bear by investing in the water company?
Answer:
When Computing the cost of capital, the regulator must compensate the provider of capital for the risk they bear because even though its a monopoly business, local regulator is fixing the price so that he cannot exploit the consumer. Also, since they are investing huge amount in water company, their should be reward for risk beard. As an alternate option, regulator can fix the little higher price for certain year and later (like after 5 years) premium price can be reduced and nominal price can be charged. In the initial years, it takes time to meet the break even point and then gain profit, so the price can be reduced later.

(ii) What particular type of risk, relevant or irrelevant, should the commission compensate them for and why?
Answer:
Relevant risk , also known as Systematic risk fluctuation of returns due to macroeconomic factors. This is mostly affected by external factors.
   Irrelevant risk, also known as Unsystematic risk is the risk caused by internal factors like labor strike, production issues, etc.
   As per the case, since the price is regulated by (external) regulator, so there is relevant risk. In case regulator set the price that does not include cost of capital, so company has to reduce the cost of production to maximize profit.
Also there is irrelevant risk because to maximize profit, cost of production should be minimized. If regulator set the price excluding cost of capital, and producer cannot reduce the cost of water treatment, then company is exposed to irrelevant risk or Unsystematic risk.