## 1. **INTRODUCTION**

Information on the link between the degree of market risk and the regulatory regime type is important to regulators of privatized utilities with strong residual monopoly powers. It allows a better understanding of what drives the main concerns of the regulated companies and in particular it quantifies these concerns. This is important not only for assessing the rate of return demanded by bidders for projects but to determine the level of profits for a project or company at the time prices have to be reviewed by the regulators as a part of a normal review or as part of a conflict resolution process.' Establishing the right level of forecasted, allowed, profits is difficult and can easily lead to a situation where either the company:

- will not want to invest, if too low a level of return has been allowed as a result of a underestimation of the level of risk; or

- will either over-invest and/or make abnormal profits if too high a level of return has been allowed.

This paper considers the issue of market risk and regulatory regimes from the view point of transport sector regulators. It builds on an initial study undertaken by Alexander, Mayer and Weeds in 1995, which established a methodology for measuring market risk and also considered a way in which regulatory regimes could be evaluated for utilities. The methodology followed to measure risk **in** the sector is summarized in Section 2. This section also considers a series of additional issues, some of which arise from the problems raised by the transport sector and others associated with expanding the analysis applied to the measure of market risk. Section 3. then presents the key quantitative results of the paper. Section 4 considers the link between the type of regulatory regime and the level of market risk while Section 5 concludes.

# **2. HOW** TO **MEASURE RISK?**

There are three areas where grasping the methodology and its constraints is important. They are:

- the measurement of the cost of capital;

- the calculation of the measure of market risk; and

- the estimation of the impact of alternative regulatory regimes on the measure of market risk.

### **2.1** MEASURING THE COST OF CAPITAL

Before nmeasuring risk, the first step is to agree on a benchmark that is comparable across firms and across sectors to which these risk measures will apply. The cost of capital is the most common benchmark used in developed countries by companies and regulators alike. Although the definition of the cost of capital is itself a challenging task that has generated a lot of literature, the key issue for many developing countries is to get it done somehow. Indeed, the regulators need to get a good

> Although the need for prnce regulation is less in the transport sector than in other utility and infrastructure sectors, owing to the potential for the existence of real multi-modal competition, there are still many examples of 'price reviews' For example, in some countries multi-modal competition is not feasible. Hong Kong and Singapore represent such cases when **it** comes to passenger services from buses and metro services Equally, the UK has established an industry structure that leads to a need to consider the access charge for both passenger and freight raii services to the track infrastructure. Brazil has a system where certain classes of freight customer may be deemed captive even though the potential for multi-modal competition does exist So, price reviews and other forms of behavioral regulation may be necessary for the transport sector.