An important specific application of the cost of capital is in public sector regulation of certain companies that are in a monopolistic position, by virtue of what they do. The most important examples are utility companies, providing electricity, water, gas, rail and telephone services. For such companies, an estimate of the cost of capital is used to set the rate of return that the company is allowed to make on its capital. The cost of capital is one of the estimated costs that determine the price for the product that the regulator allows the company to charge. Thus regulators are obliged to provide and justify an explicit figure for the cost of capital, and this figure has a direct effect on the regulated company's income and on the prices paid by its customers. This differs from the situation in an unregulated company in a competitive market, in which the main impact of its estimated cost of capital is on internal investment decisions (capital budgeting); projects are valued automatically on the basis that the company pursues the pricing and other policies that maximise value. An issue that is distinctive to regulated companies is that the behaviour of the regulator affects the value of the company and can affect the risk of the returns to shareholders.

This chapter considers the role of the cost of capital in the price-setting process in the United States and United Kingdom, and discusses the effect of regulatory policy on risk.