Risk and Economic Regulation

Every year in the UK nearly 6,000 people are hurt by their trousers, and another 10,000 by their socks and tights to the extent that they need hospital treatment. The point here is not to alarm you that your trousers are out to get you, but that life is full of risk. Risk is part of life and you successfully make risk assessments every day. In business, investors make risk assessments too, the riskier the investment decision the higher the return they want.

Managing risk in regulated industries

In a regulated industry, where investments often have long lead times and even longer periods before a return is earnt, managing risk is key. One of the roles of the regulator is to manage that risk and create a stable environment for long term investment. Regulators consider and discuss risk at length when coming to their control decisions. For example, Heathrow’s regulator, the CAA, explicitly includes an adverse shock generator in its passenger forecasts and an uplift in the WACC to account for adverse demand shocks.

The unexpected

But what if the unexpected, like say covid, happens? The recent price control settlements at Dublin and Heathrow airports are instructive in this regard. As you would expect the airports dived down one trouser leg of risk, arguing that covid has made them more risky and so their investors should earn higher returns. The airlines argued that because of how the regulators intervened to insulate the airports from shock, that we were in the less risky trouser leg.

It’s too early to tell which trouser leg we are in, and who is right, and the respective Dublin and Heathrow regulators have chosen to deal with both day to day risk and covid in different ways. The CAA for example has built a comprehensive risk offset system with adverse shock adjusters in its volume forecasts and deadbands etc which should in theory at least, lead to lower costs of capital. The downside of the CAA approach is of course increased regulatory costs and the opportunity for gaming. The CAR hasn’t followed the CAA’s approach opting for a more traditional WACC adjustment approach.

It’s a truism that risk needs to be paid for and time will tell which regulator is right. But with both airports making money and passenger volumes bouncing back, it does seem that the covid recovery is well underway. At this stage it seems like your trousers are no more risky post covid than they were pre covid.