The power and gas markets look very different today from what we were anticipating three to four years ago. Gas has gone from seeming shortage to seeming abundance with recent spot prices falling...
Shale Gas and Pipeline Risk
Contrast this concept with the yield to maturity on a junk bond.
A junk bond’s cost of capital— i.e., its average rate of return—reflects the possibility that the bond might default. Its stated yield to maturity, however, is calculated on the assumption that the bond doesn’t default. The yield to maturity therefore equals the bond’s cost of capital plus a default premium. The default premium is compensation for the asymmetry generated by the fact that bondholders get no more than the promised interest rate if the company does well, but might get less if the company does poorly.
Note that the asymmetry also affects the bond’s cost of capital, since the odds of default are higher in bad economic times. Thus, the yield to maturity on corporate bonds provides an example of both of the possible effects of an asymmetric return distribution: the need for a default premium, and an increase in the cost of capital.
Asymmetric risks, by definition, give rise to an asymmetric return distribution. If the event or events giving rise to material downside risk don’t come to pass, the company operates within the standard regulatory rules, expecting to earn its allowed rate of return on average. But if the event or events do occur, the company gets substantially less. The asymmetry means the company won’t expect to earn its allowed rate of return on average over the long run, so an allowed return equal merely to the cost of capital wouldn’t provide a fair opportunity to earn the cost of capital on average. That is, the average of an expected return equal to the cost of capital if the event doesn’t occur, and an expected return less than the cost of capital if the event does occur, necessarily is less than the cost of capital.
An asymmetry risk premium over and above the cost of capital in the allowed rate of return, akin to the default premium in a junk bond’s yield, would be required to give the company a fair chance to earn its cost of capital on average.
Markets Vs. Regulated Returns
The changing gas market creates new competitive threats for many pipelines. In some ways the risks facing a rate-regulated company that’s also exposed to competition are higher than they’d be under either pure regulation or pure competition.
The problem arises in the way North American regulation sets the return on and of capital. Usually, capital charges equal a book-value rate base times a rate of return that includes compensation for inflation, plus depreciation and taxes. Competition doesn’t set capital charges explicitly; instead, they’re implicit in competitive prices. But a basic feature of competition is that the price of a competitive good doesn’t depend on the age of the assets used in its production—the price of tomatoes doesn’t depend on the age of the tractor. The price of a regulated service traditionally does depend on the age of the assets employed, however. Therefore, the capital charges implicit in competitive prices logically must differ from those under rate regulation.
This logical inference proves to be correct.