View from City Road: A small matter of methodology

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The Independent Online
IT IS hard not to feel some sympathy for the Monopolies and Mergers Commission as it tries to referee the lively scrap between British Gas and Ofgas, its implacable industry regulator, over the rate of return the beleaguered fuel company is entitled to earn on its gas pipeline business.

It is one thing to weigh the pros and cons of dominant market shares in the tinned pea, shoe polish or luxury fountain pen market. It is a quite different matter to decide between two sets of exceptionally arcane arguments about required financial returns which appear roundly to contradict one another despite using the same methodology.

The bulk of the gap between Ofgas, with its range of 2.5 to 5 per cent current cost returns, and British Gas, with its 6.7 per cent target, is not to do with factors specific to British Gas and its pipeline business.

Instead the difference between the two camps is over the basic methodology of the Capital Asset Pricing Model and Weighted Average Cost of Capital, which both use to back up their arguments.

Each side's estimates of risk-free returns, equity risk premiums and debt costs, which are fundamental to the exercise and ought to be common ground, are wildly at variance.

There is certainly plenty to argue about in assessing the specific riskiness or otherwise of British Gas's pipeline business, and the use by Ofgas of international comparisons is obviously dubious given the differing commercial, regulatory and accounting regimes.

But if the basic methodology is so subjective this suggests that the MMC may decide to side with the consumer. A yield of 7 per cent at 274p, down 4p, recognises this likely dead end for British Gas.