Political and Regulatory Risk in Water Utilities: Beta Sensitivity in the United Kingdom

UK utilities are generally regulated by the periodic setting of a price cap (the RPI-X mechanism). To establish these caps, regulators must determine what returns are appropriate on the capital employed by utilities. This paper addresses the issue of the level of risk inherent in investment in the equity of regulated water utilities in the UK. It uses the techniques of the Kalman Filter to estimate daily betas for the major utilities in the period from privatisation to mid-1999. The paper demonstrates that water utilities' risk is time-variant. It demonstrates, also, that there have been significant political and regulatory influences in the systematic risk faced by water utility shareholders. It finds beta to display little evidence of cyclical variation across the regulatory review cycle. The paper also confirms that significant excess returns have been generated over the history of the privatised water sector and suggests that over-estimation of systematic risk faced by investors in the sector may imply further excess returns in the next regulatory review period.