The Regulatory Policy Institute Research Group

The nature of regulatory risk

Delivered as part of ‘Regulatory risk and the cost of capital in the utilities‘, Occasional seminars and conferences 1996

Regulatory risk is a controversial topic. Firstly, does the presence of an industry regulator create regulatory risk, and, secondly, if regulatory risk does exist, should investors be compensated in the form of extra return? This study investigates these issues for UK regulated businesses, and, importantly, it also investigates whether the notion of regulatory risk should be widened to include the actions of one industry regulator imparting risk upon the whole regulatory sector. Capital market data is collected in connection with an announcement concerning a possible change in the regulatory regime for elctricity companies. We find substantial evidence of a consistent market reaction to the announcement acroos the electricity and water industries, with less compleeing evidence for other regulated companies. The market reaction is not explained as an adjustment for systematic risk. Therefore the conclusions from this evidence are that regulatory risk is present, that this risk may not be confined to an industry, and it is risk that does not require compensation in the form of additional return – it is unsystemic risk.

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