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The Cost of capital for the electric power industry
2004-02-29
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Author: Woojin Youn(Industrial Competitiveness Division)
The cost of capital is considered a crucial determinant of investment. In the regulated utility sectors like the electric power industry, the cost of capital has continued to be a controversial issue.The regulator sets price limits for those parts of the industry where firms have significant market power. In setting price limits, the regulator need to decide what would constitute a fair rate of profit. On the part of firms, their revenue stream is not completely determined by market forces, and nor are their stock returns. In the electric power industry of Korea, there has been a tendency for the regulating authorities to permit a rather low cost of capital. The fair rate of return was determined by market interest rates, and did not take into account the risk characteristics of regulated firms, thus under-estimating the true cost of capital. restructuring of the industry and the enhancement of their service capacity. The lower than expected cost of capital will also deter new entrants from investing in ge
rating plants, thereby impeding the progress of competition. This is ironic in the sense that the under-investment and insufficient service mix in publicly owned electricity sectors is one of the motivations for privatization.2) Fortunately, in a recent reform of the Electricity Business Act, the method for determining the fair rate of return on investment has been modified to reflect the true cost of capital. Therefore, we need to incorporate revisions in the calculation of the cost of capital for the industry, which this paper is concerned with.
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