Incorporating political and geopolitical risk into the cost of capital

In summary

• Heightened political and geopolitical risks are the new normal faced by regulated utilities 
• Despite this and the fact that utilities are hard hit by the risks, they are poorly reflected in the weighted average cost of capital (WACC) used for price controls  
• While some countries add an explicit country or political risk premium on top of the equity risk premium, the approach is poorly suited to the UK 
• But there are still ways UK regulators could better reflect these risks within the WACC  

Political and geopolitical risk has become one of the most powerful forces shaping the cost of capital for regulated utilities. UK government policy is more interventionist and less predictable; geopolitical tensions, from Russia’s invasion of Ukraine to shifting US tariff policy and now Iran, have reshaped global capital markets; and investors increasingly price political instability as a core component of risk. 

Yet UK economic regulators still anchor price controls on the capital asset pricing model (CAPM) to estimate the cost of equity, and a weighted average cost of capital (WACC), which blends the cost of debt and equity into a single number. The approach is, on its face, largely silent on political and geopolitical risk. 

That matters, as the WACC is among the most consequential numbers in any price control. A small, 50 basis point change in the cost of equity can shift allowed revenues by hundreds of millions of pounds over a control period. 

In its standard form, the cost of equity is: r_e = r_f + β · ERP

The expected return on equity is the risk-free rate plus a risk-adjusted premium (based on the company’s risk relative to the market). In this equation, political and geopolitical risk can, in principle, enter through three channels: 

• The risk‑free rate, since yields on UK gilts and other sovereign bonds embed expectations about inflation, fiscal credibility and macro‑political stability. Episodes like the 2022 gilt market turmoil showed how quickly political shocks can move the “risk‑free” benchmark 
• The equity risk premium (ERP), since global risk premia rise when geopolitical tensions increase. Wars, sanctions, trade disputes and tariff volatility are all reflected, to some degree, in the ERP 
• The beta, because if political or geopolitical risk affects regulated utilities differently from the market as a whole, their beta may change. For example, sectors that are more exposed to energy prices, sanctions or domestic policy intervention may see higher systematic risk 

However, CAPM is designed to price systematic risk, which cannot be diversified away. That forces a distinction. 

Systematic political and geopolitical risk reflects global geopolitical instability, war, sanctions and supply chain disruptions. It will include broad trade and tariff regimes and macro-level fiscal and monetary uncertainty. These affect global markets and are not diversifiable. They are captured by the CAPM primarily through the risk-free rate and ERP. 

Idiosyncratic political risk, by contrast, describes UK-specific policy volatility, such as changing net zero timelines, sector-specific interventions (like bill freezes and windfall taxes) and shifts in regulatory philosophy or statutory duties. It would also include reputational and political pressure on particular industries.  

These risks are not well captured by CAPM and are often better handled through cash‑flow mechanisms and regulatory design, rather than by loading the WACC. 

Not only does CAPM not adequately capture political and geopolitical risk, but regulated sectors feel these risks more acutely than others. Utilities are not just exposed to markets; they are exposed to policy: 

• Price controls are policy instruments, so governments influence regulatory mandates, affordability priorities and expectations around investment and net zero 
• Net‑zero and security policy are volatile, and changes in decarbonisation targets, support schemes, planning rules or security requirements (such as those around telecoms vendors, for example) can materially alter risk 
• Geopolitical shocks feed directly into costs, with energy prices, commodity inputs and supply chains all sensitive to global events. For some sectors, this is a first‑order driver of risk 
• Regulatory independence is constrained by politics. In the water and energy sectors, especially, political pressure can shape regulatory behaviour, even where regulators are formally independent 

Consequently, investors in these sectors demand a premium for political and geopolitical risk, while the regulatory model fails to recognise it explicitly. 

By using CAPM, most UK regulators treat political and geopolitical risk as implicitly embedded in the risk‑free rate (sovereign and macro‑political risk), the ERP (global market and geopolitical risk) and the beta (sector‑specific exposure to systematic shocks).  

This implicitly assumes that UK‑specific political risk is fully reflected in global equity markets, that regulated utilities’ exposure to political risk is proportional to the market’s exposure, that geopolitical shocks affect all sectors similarly and that political risk is broadly stable over time. 

All these assumptions are increasingly contestable. 

Some international regulators, particularly in emerging markets, add an explicit country or political risk premium on top of the ERP. For the UK, however, such an approach could be problematic. It risks double-counting risks already captured in gilts and global ERPs. It also introduces highly subjective judgments, which undermines the predictability of the WACC framework. 

However, there are ways that regulators could better reflect political and geopolitical risk within the WACC, without fundamentally altering their approach:

• Let systematic geopolitical risk flow through the risk‑free rate and ERP. For global political and geopolitical risk, such as from wars, sanctions and global trade tensions, the cleanest approach is to let it be reflected in higher or more volatile risk‑free rates and higher ERP estimates, based on market data. This keeps CAPM internally coherent and avoids ad hoc add‑ons. It does, however, require regulators to be honest about the fact that today’s ERP may be structurally higher than in more benign geopolitical periods 
• Reflect sector-specific political exposure in beta only where it is clearly systematic. Where political or geopolitical risk affects a regulated sector in a way that is clearly correlated with the wider market, such as energy networks’ exposure to global energy prices or telecoms’ exposure to security-driven vendor bans, there is a case for recognising this in the beta. This is subject to two caveats, however. First, the beta is estimated from historical data, so unprecedented political shocks will not be fully captured. Second, it is important that the beta does not become a dumping ground for every perceived risk; it must remain anchored in observable market evidence 
• Use regulatory design and cashflow mechanisms for idiosyncratic political risk. For UK-specific and sector-specific political risk (bill freezes, sudden policy reversals and bespoke interventions, for example), there may be more appropriate tools – uncertainty mechanisms and reopeners; pass-through arrangements for certain exogenous costs; asymmetric risk protections where downside risk is clearly skewed; and project-specific premia or guarantees for politically exposed investments. This keeps the WACC focused on systematic risk while acknowledging that political decisions can materially affect cash flows 

Heightened political and geopolitical risk, along with increasing scrutiny of investors’ returns in regulated entities, make utilities increasingly vulnerable.  

Underestimating risk in the WACC (therefore reducing the prices utilities may charge) may deter investment and risk the financial viability of the regulated entity, especially in long‑lived, irreversible assets. Over‑estimating risk, by contrast, risks imposing unnecessary costs on consumers and damaging legitimacy.  

Simply ignoring risk, meanwhile, or pretending it is “in there somewhere” – as the current approach risks doing – undermines efficiency, transparency and trust. 

Ultimately, incorrectly accounting for risks increases the potential for high-profile failures, such as that of Thames Water. 

A CAPM‑based WACC can serve well as the backbone of UK price controls, but only if regulators are clear, disciplined and transparent about where that risk sits in the framework, and where it does not. Regulators need to be explicit about three things: 

• Which political and geopolitical risks they regard as systematic, and how these are reflected in the risk‑free rate, ERP and the beta 
• Which risks they regard as idiosyncratic, and how these are addressed through regulatory design and cash‑flow protections 
• And how their approach might evolve if the geopolitical environment becomes structurally more volatile 

Political and geopolitical risk can no longer be considered temporary aberrations; they are here to stay. Regulators must enable utilities to cope with an uncertain future.