Review of approaches to estimate a reasonable rate of return for investments in telecoms networks in regulatory proceedings and options for EU harmonization : executive summary.
Date: 2016-07-14
Institutions: Directorate-General for Communications Networks, Content and Technology
Subjects: information technology, investment, investment policy, regulation of telecommunications, tariff ceiling, telecommunications industry, telecommunications policy, transmission network

Review of approaches to estimate a 
reasonable rate of return for 
investments in telecoms networks 
in regulatory proceedings and 
options for EU harmonization 

SMART 2015/0007 

EXECUTIVE SUMMARY 

Richard Caldwell 

A study prepared for the European Commission 

DG Communications Networks, Content & Technology by: 

Lucia Bazzucchi 

Francesco 

Pass

Digital 
Single 
Market 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
 
 
 
   
 
 
 
 
 
     
 
This study was carried out for the European Commission by 

Prepared by: 

Dan Harris 

Richard Caldwell 

Lucia Bazzucchi 

Francesco Lo Passo 

Prepared for: 

Directorate-General  for  Communications  Networks,  Content  and  Technology 

(DG CONNECT) 

Internal identification 
Contract number: 30 – CE -0735332/00-55 
SMART number 2015/0007 

DISCLAIMER 

By the European Commission, Directorate-General of Communications Networks, Content & Technology. 

The information and views set out in this publication are those of the authors and do not necessarily reflect the 

official  opinion  of  the  Commission.  The  Commission  does  not  guarantee  the  accuracy  of  the  data  included  in 

this study. Neither the Commission nor any person acting on the Commission’s behalf may be held responsible 

for the use which may be made of the information contained herein. 

Reproduction is authorised provided the source is acknowledged. 

ISBN 978-92-79-58522-7 

doi:10.2759/781385 

© 2016 – European Union. All rights reserved. Certain parts are licensed under conditions to the EU. 

 
 
 
 
 
 
 
 
 
 
 
I.  Abstract  

National  Regulatory  Authorities  (NRAs)  for  electronic  communications  in  the  EU  may  set 

maximum wholesale price caps for access to the network of operators with Significant Market 

Power  (SMP)  when  certain  market  conditions  exist.  In  setting  these  caps,  the  Regulatory 

Framework  for  telecommunications  indicates  that  NRAs  should  allow  SMP  operators  a 

reasonable rate of return on their investments. NRAs typically estimate the weighted average 

cost of capital (WACC) of the operator to determine this reasonable return. However NRAs 

often use different methodologies, so that the resulting WACCs differ for reasons other than 

market fundamentals. These differences may distort market participants' investment decisions 

and ultimately the digital single market. In this report, we develop guidelines for a common 

WACC  methodology  in  the  EU's  telecoms  sector.  We  highlight  areas  where  we  consider  it 

would  be  appropriate  to  set  single  EU-wide  values  for  WACC  parameters.  Where  we 

conclude  this  is  not  appropriate,  we  recommend  a  common  EU-wide  methodology  to 

estimate  a  parameter  value  specific  to  a  Member  State.  Our  report  assesses  the  reasonable 

return  on  investments  for  ‘legacy’  copper  networks  and  Next  Generation  Access  (NGA) 

networks. 

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II.  Summary of Main Findings and Recommendations   

II.A. THE WACC FOR LEGACY NETWORKS  

Below  we  summarise  the  main  conclusions  for  the  calculation  of  the  parameters  of  the 

WACC for legacy networks.   

Risk-Free Rate 

  Deriving the risk-free rate from the yields on the NRA’s ‘domestic’ bonds (being the 

government  bonds  for  the  Member  State  where  the  NRA  has  jurisdiction)  is 

reasonable in most cases. A ‘risk-free rate’ derived in this way is in practice the sum of 

a true risk-free rate plus a country-risk premium (see section Error! Reference source 

not found.); 

 

Including  the  country-risk  premium  in  the  WACC  is  reasonable,  since  it  will 

compensate the SMP operator for specific country and regulatory risks actually borne. 

A  country  risk  ‘uplift’  on  the  WACC  is  the  most  practical  way  to  compensate  SMP 

operators for such risks; 

  However,  use  of  the  domestic  bond  likely  represents  an  upper  limit  to  fair 

compensation for such country risks not otherwise compensated through cash flows. 

If the NRA uses the domestic bond to estimate the ‘risk-free rate’, no other adjustment 

to the WACC for other risks is required; 

  Use of the domestic bond to determine the risk-free rate is not reasonable where: 

–  The domestic bond is extremely illiquid; 

–  The domestic bond presents a significant risk of default; 

  We suggest alternative ways for the NRA to estimate a risk-free rate in such cases; 

 

It is likely that ‘Quantitative  Easing' (QE) programs have depressed country spreads, 

so  that  the  country  spread  will  tend  to  underestimate  country  risk.  In  this  case  it  is 

reasonable  for  NRAs  to  make  an  upward  adjustment  to  observed  yields  when 

estimating the risk-free rate, while the QE program is in place. An upward adjustment 

of  up  to  1  percentage  point  seems  reasonable.  The  adjustment  should  take  into 

account both the credit rating of the MS and the term of the QE program (see section 

VI.A.2).  

  Deriving the risk-free rate using yields on longer term, so 10-year or 20-year bonds, 

seems reasonable, because:  

– 

It  will  be  broadly  consistent  with  the  historical data  used  to  estimate the  Equity 

Risk Premium (ERP);  

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–  Using a longer dated bond will approximate the so-called Empirical Capital Asset 

Pricing Model (ECAPM), and hence should lead to a more accurate estimate of the 

cost of equity (see section VI.A.3.b);  

However,  we  recommend  that,  if  NRAs  estimate  the  ERP  using  data  on  historical 

returns, when using a 10-year bond as the risk-free rate they should apply an upward 

adjustment  of  around  40  basis  points.  This  is  because  the  standard  source  used  by 

NRAs  to  derive  historical  ERP  estimates  (the  study  by  Dimson,  Marsh  and 

Staunton)calculates  historical  return  premiums  relative  to  20-year  bonds  (i.e.  the 

equity  premium  over  risk-free  20-year  bonds),  which  typically  have  a  higher  yield 

than  10-year  bonds.  Hence,  combining  a  10-year  bond  as  the  risk-free  rate  with  an 

ERP  based  on  historical  data  risks  underestimating  the  cost  of  equity.  Alternatively, 

NRAs  could  correct  for  this  effect  by  making  an  upward  adjustment  to  the  ERP 

estimate (see section VI.A.3.a).   

 

It is reasonable to estimate the risk-free rate based on an average yield over a period of 

time, but this averaging period should not exceed 12 months (see section VI.A.4).  

  NRA’s should use bond yield data from a reliable source including the relevant central 

bank, or a large data provider such as Bloomberg. 

Inflation  

 

If  necessary,  NRAs  should  convert  nominal  yields  to  real  yields  using  the  Fisher 

equation (see section VI.B.1);  

  NRAs  should  use  forward-looking  estimates  of  inflation.  Ideally  these  estimates 

should be for a time period equal to the maturity of the bond from which the NRA is 

estimating the risk-free rate, although in practice this is not always possible because of 

the limited time horizon of inflation forecasts (see section VI.B.2);  

  Non-Eurozone NRAs should use inflation forecasts for their currency zone. NRAs in 

the  Eurozone  should  use  a  Eurozone-wide  inflation  estimate  from  Eurostat,1  unless 

they  can  demonstrate  that  the  marginal  investor  in  the  SMP  is  ‘local’  (see  section 

VI.B.3). 

1   Eurostat and the national statistical institutes compile inflation forecasts based on the Harmonised 
Index of Consumers Prices (HICP), which is the reference inflation rate adopted by the ECB. More 
information can be found on the ECB website: 
https://www.ecb.europa.eu/stats/prices/indic/forecast/html/table_hist_hicp.en.html  

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Beta 

  Absent compelling reasons to the contrary, EU NRAs should use a common beta for 

legacy network activities. The beta should be estimated from a sample of firms based 

on criteria which we discuss; 

  NRAs  should  calculate  betas  using  daily  returns over  a two-year  period. A  two  year 

period  is  an  appropriate  compromise  between  using  recent  data  (which  is  likely  to 

better reflect the expected future beta) while at the same time producing a reasonable 

number of observations and hence reducing statistical errors (see section VI.C.1);  

  When calculating daily betas, NRAs should apply an adjustment to the calculated beta 

to account for the possibility that some of the reaction of the share price may occur 

before or after the reaction of the index (a so-called Dimson adjustment). We do not 

recommend  that  NRAs  apply  other  adjustments  such  as  Bayesian,  Blume  or  Vasicek 

adjustments (see section VI.C.2); 

  The  CAPM  is  based  on  the  idea  that  investors  need  only  be  compensated  for  non-

diversifiable  risk.  At  the  same  time,  it  seems  unlikely  that  investors  diversify  their 

investments  globally.  We  think  the  use  of  a  wider  European  (rather  than  national) 

index is consistent with the idea that, while investors may not be globally diversified, 

investors in European telcos are at least diversified across Europe. It is also consistent 

with the use of Europe-wide data to estimate the ERP (see section VI.C.3); 

  NRAs  do  not  need  to  compute  betas  themselves,  but  could  rely  on  ‘off  the  shelf’ 

estimates  from  data  providers,  such  as  Bloomberg,  Morningstar,  or  others,  or  even 

recent beta estimates by other NRAs; 

  Equity  betas  must  be  unlevered  to  obtain  an  asset  beta.  We  present  a  number  of 

reasonable  unlevering  formulas.  The  best  way  to  minimise  errors  as  a  result  of 

unlevering and relevering is to use a target level of gearing close to the average of the 

sample of firms from which asset betas are estimated (see section VI.C.5);  

  Using the median of the calculated asset betas, rather than the arithmetic average, will 

tend to produce a beta estimate that is less dependent on the chosen comparators.  

  There are no ‘pure play’ legacy network firms, or firms that approximate a pure play. 

There is no clear relationship between asset betas and revenue sources. Accordingly, 

there  is  significant  uncertainty  associated  with  the  asset  beta  estimate  for  a  legacy 

network.  Based  on  the  available  evidence,  an  asset  beta  range  of  0.50  to 0.67  would 

seem reasonable. This range reflects the upper and lower 95% confidence interval for 

the median asset beta based on our beta estimates for of a range of suitable firms active 

in the European telecoms market; 

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  NRAs should recalculate beta for each new regulatory period, but exercise discretion 

in updating the beta value used in the WACC estimate. Significant variations in beta 

estimates from one regulatory period to another should be duly justified (see section 

VI.C.10). 

Equity Risk Premium  

  There is significant debate and uncertainty regarding predictions of the ERP, largely 

because it involves a prediction of the excess returns that investors expect today, and 

predictions  are  inherently  uncertain.  There  is  no  academic  consensus  as  to  whether 

the historical data or estimates based on dividend growth models are superior. Given 

this uncertainty, in our view it would be wrong to be over prescriptive regarding the 

methodology  for  estimating  the  ERP,  since  this  would  assume  that  we  ‘have  the 

answer’ (see section VI.D). 

  However, we do think that there is room to narrow the debate on the ERP based on a 

common set of principles: 

–  First, NRAs could agree to estimate the ERP based on historical data on the excess 

return of stocks over bonds, as reported by  Dimson, Marsh and Staunton (DMS). 

Survey  data  tends  to  be  unreliable,  and  ERP  forecasts  from  Dividend  Growth 

Models tend to be sensitive to input assumptions which include analysts' forecasts 

of future dividends. In contrast, the historical data is stable, because it  is hard for 

one  additional  year  to  change  the  average  of  over  100  years’  worth  of  data. 

Stability,  predictability  and  a  lack  of  volatility  are  desirable  in  a  regulatory 

context.  The  historical  ERP  provides  a  good  ‘anchor’  for  estimates  and  prevents 

large changes in the ERP from one regulatory period to the next.  

–  Second,  NRAs  should  base  their  ERP  estimates  on  the  arithmetic  average  of  the 

historical  excess  returns.  Given  that  there  are  some  proponents  of  using  the 

geometric  average,  and  some  arguments  in  favour  of  this  approach,  NRAs  could 

also use a weighted average of the arithmetic and geometric average that take the 

academic  research  on  the  topic  into  consideration.  However,  we  do  not 

recommend an ERP estimate based only on the geometric average.  

–  Third,  NRAs  could  make  reasonable  adjustments  to  the historical  data,  informed 

by  other  sources  of  evidence  on  the  ERP  from,  for  example,  Dividend  Growth 

Models.  NRAs  should  avoid  a  ‘mechanical’  application  of  historical  data,  which 

could for example result in an erroneously lower estimate of the ERP when stock 

markets have fallen.  

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 

In our view, the final ERP estimate will often be, and perhaps should be, the result of 

a combination of data and judgement. At the same time, it would be desirable to have 

a single ERP value for the EU. This is because there is no good theoretical reason why 

the ERP should vary across MSs, and differences in the ERP across MSs could distort 

investment decisions.  

  Based  on  the  current  evidence,  in  our  view  an  ERP  of  5-5.5%  over  bonds  would  be 

reasonable.  

Total Returns Methodology  

  We  have  considered  the  use  of  a  total  returns  methodology.  Rather  than  estimating 

the risk-free rate and ERP separately, a total returns methodology estimates the cost 

of  equity  by  simply  looking  at  the  long-run  average  historic  returns  to  equity,  and 

reasons that equity holders would expect to earn in future the average of the returns 

that  they  have  earned  in  the  past.  This  would  be  an  alternative  to  using  the  CAPM 

(see section VI.E).  

  We  do  not  recommend  applying  this  methodology,  for  two  reasons.  First,  equity 

returns are not in fact particularly stable over time. Second, the total returns method 

is  looking  at  returns  for  the  whole  market,  which  by  definition  has  a  beta  of  one. 

Accordingly, the method will only give the correct expected return on equity for the 

SMP if the equity beta of the SMP is one or close to one. This is generally not the case.  

Gearing  

  Gearing,  defined  here  as  net  debt  over  value,  should  be  calculated  using  the  market 

value of equity (see section VI.F.1);  

  The book value of debt can be used, as long as the firm has an investment grade credit 

rating.  If  the  firm  does  not  have  an  investment  grade  rating,  then  it  should  not  be 

used for WACC estimation; 

  The value of financial leases should be included in the value of debt; 

  The WACC is not highly sensitive to the choice of gearing, and the ‘optimum’ level of 

gearing will logically vary between MSs, as tax rates vary between MSs; 

 

In any case, the target level of gearing should not exceed 50-55%, which is the upper 

end of gearing observed for the telecoms sector in our sample of firms. 

Debt Premiums and Betas  

  The  credit  rating,  debt  premium  and  target  gearing  level  should  be  consistent.  For 

example, the NRA could choose a target credit rating, and then select the gearing level 

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and  debt  premium  that  would  be  consistent  with  that  rating  in  the  NRA’s  MS  (see 

section VI.G); 

  NRAs  should  look  at  yield  data  on  bonds  with  the  appropriate  credit  rating  as  the 

main input to the debt premium; 

  Using a 10-year debt maturity should reflect a typical debt maturity for a large firm, 

and it should be possible to find yields for generic corporate bonds with this maturity; 

  NRAs could calculate the debt premium by reference to a period consistent with the 

calculation of the risk-free rate; 

  NRAs  should  estimate  debt  premia  before  making  any  adjustment  to  yields  on 

government bonds to account for the effect of QE programs; 

  Using  ‘generic’  bond  indices  can  tend  to  understate  the  required  debt  premium  for 

smaller  debt  issuances.  NRAs  should  give  more  weight  to  the  SMP’s  actual  bonds, 

providing they are consistent with the target credit rating;  

  NRAs can either calculate ‘bottom up’ debt betas, or else use ‘rules of thumb’ based on 

credit ratings. 

Taxes  

  NRAs should adjust the WACC for taxes using the marginal corporate tax rate in  the 

MS where the price control takes effect (see section VI.H);  

  The MS should adjust the cost of equity for taxes by simply dividing the after-tax cost 

of equity by one minus the tax rate. 

  NRAs should adjust the nominal cost of equity and WACC for taxes, not the real cost 

of equity (see section VI.H.2). 

II.B.  THE WACC FOR NGA NETWORKS   

Consistent with the Commission’s Recommendation on costing and non-discrimination, the 

expectation is that in most cases there will be no need to set a price control and hence WACC 

for NGA networks. Hence, we would expect the discussion below to apply only in a minority 

of cases.2 

2   Commission  Recommendation  of  11.9.2013  on  consistent  non-discrimination  obligations  and  costing 
methodologies to promote competition and enhance the broadband investment environment, ¶52 p.11.  

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II.B.1.  Do NGA Networks require a ‘WACC Premium’?  

The second major question we address in this report is whether an NGA network requires a 

premium  over  the  WACC  of  a  legacy  network.  We  call  this  the  NGA  network  WACC 

premium.  

We note that if there was a listed firm that only carried out NGA network activities – a ‘pure 

play’  NGA  firm  –  then  we  could  measure  the  WACC  premium  directly.  However,  at  the 

present  time  no  such  firm  exists.  Therefore  we  have  to  rely  on  theoretical  arguments  to 

address the WACC premium.  

The WACC should only compensate for systematic risk. Non-systematic risks must be dealt 

with, but not through the WACC. Hence, the question becomes – are there reasons to think 

that  NGA  network  investments  have  a  higher  systematic  risk  than  legacy  networks?  We 

think there are, for several reasons. 

First,  building  an  NGA  network  involves  a  commitment  to  make  large  capital  investments 

over  several  years.  This  means  that  the  ‘capital  leverage’  of  new  NGA  networks  is  high 

relative to a mature legacy network. The presence of the large capital spending commitments 

‘squeezes’  earnings  in  the  case  of a  macroeconomic  shock  decreasing  revenues,  and  thereby 

increases the correlation between systematic events such as an economic downturn and the 

value  of  the  asset.  Hence,  capital  leverage  increases  the  asset  beta  for  an  NGA  network, 

relative to a legacy network, at least in the network build-out phase.   

Second,  NGA  networks  are  –  relative  to  a  mature  legacy  network  –  long-lived  investments 

with payoffs extending far into the future. This means that the value of the investment will 

vary  more  strongly  with  macroeconomic  conditions,  as  the  investment  will  be  affected  by 

uncertain macroeconomic risks over a longer period of time, in a manner analogous to a long-

term bond. As a result, the value of long-lived investments like a new NGA network will be 

more sensitive to changes in macroeconomic conditions, and hence will have a higher beta, 

than a legacy network which has a shorter remaining life.  

Third, demand for NGA services is likely to be more sensitive to income than the demand for 

legacy network services. Consumers must be persuaded to move away from legacy networks 

and pay more for faster services on an NGA network. In the event of a systematic downturn, 

as  incomes  fall  we  would  expect  this  switching  process  to  slow  down,  as  consumer  reduce 

spending.  While  demand  for  NGA  services  is  uncertain  and  risky  in  general,  it  seems 

reasonable to suppose that a significant part of the NGA demand risk is systematic. This will 

increase the beta for NGA networks, relative to legacy networks. 

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II.B.2.  Measuring the WACC Premium  

NRAs  have  employed  a  variety  of  methods  to  quantify  the  NGA  WACC  premium.  While 

these  methods  may  have  merit,  the  differences  between  the  approaches  followed  result  in 

inconsistencies that could distort investment decisions within the internal market.  

In our view the only way to quantify the NGA WACC premium  with sufficient accuracy is 

through detailed financial modelling of an NGA network investment and a legacy network. 

We  propose  to  use  the  legacy  network  as  a  benchmark  from  which  to  assess  the  premium 

required for the NGA network. In essence, the modelling exercise would reason that the asset 

beta  for  the  NGA  network  would  be  proportional  to  the  revenue  volatility  of  the  network. 

For example, suppose that the modelling exercise found that  revenue volatility for the NGA 

network was 30% higher than for the legacy network, and we had estimated an asset beta for 

the legacy network of 0.5. We would estimate the asset beta of the NGA network as 0.5 x (1 + 

30%) = 0.65. This asset beta would then determine the required NGA WACC premium. We 

discuss how a ‘beta decomposition’ exercise could be a useful sense check on the value of the 

calculated  NGA  asset  beta,  but  that  this  method  also  suffers  from  a  number  of  practical 

difficulties. We note that the cost of debt for an NGA network investment is also likely to be 

higher for a given level of gearing, and discuss how an NRA can control for this.  

In the previous section on legacy networks, we concluded that the default assumption is that 

the asset beta for legacy networks is the same across the EU, unless the NRA can provide good 

reasons to think otherwise. In the case of NGA networks, we reverse this conclusion. While 

all EU NRAs could use the same methodology to calculate the NGA WACC premium, there 

are reasons to believe that the value of the premium would differ between MSs. For example, 

the  relationship  between  systematic  changes  in  demand  for  NGA  network  services  and 

changes in consumer income could differ between MSs to an extent that is not the case for 

legacy  networks.  This  is  largely  because  NGA  services  are  a  ‘premium’  product,  so  that 

demand for the service may be more sensitive to changes in income in some MSs than others. 

Capital investment costs for a given NGA network topology could also differ across the EU, 

for example because construction costs differ. This would  result in different capital leverage 

in each MS. This issue is largely absent for mature legacy networks. These and other factors 

could lead to differences in the NGA WACC premium across the EU.  

We  explain  that  different  NGA  network  topologies,  such  as  Fibre-to-the-Cabinet  (FTTC) 

Fibre-to-the-Distribution-Point  (FTTD),  and  Fibre-to-the-Home  (FTTH),  could  have 

different  costs  of  capital,  because  the  capital  intensity  and  demand  sensitivity  of  these 

investments will differ from one another. The WACC premium could also be different for the 

10 | brattle.com 

wholesale  and  retail  divisions  of  the  company,  and  depending on  the  type  of  customer that 

the NGA network is serving.  

The modelling exercise we propose could estimate the different WACC premia required for 

different network configurations. Indeed, only a technique based on the financial modelling 

of  the  actual  network  investments  made  will  be  able  to  identify  the  different  risk  premia 

required with sufficient accuracy.  

11 | brattle.com 

 
 
European Commission 

Review of approaches to estimate a reasonable rate of return for 
investments in telecoms networks in regulatory proceedings and 
options for EU harmonization  

Luxembourg, Publications Office of the European Union 

2016 – number of pages: 12  

ISBN 978-92-79-58522-7 

doi:10.2759/781385 

12 | brattle.com 

 
 
 
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