3. APPROACH TO BUILDING A BENCHMARK Establishing a benchmark required rate of return or weighted average cost of capital (WACC) for generation companies requires estimates of: • The required rate of equity return/cost of equity (COE); • The required rate of debt return/cost of debt (COD); and • The mix of debt and equity in the capital structure - also referred to as the level of gearing.
It is also important to specify whether a post- or pre-tax estimate is being derived.
This section ot the report provides an overview of the approach we have adopted to establishing our estimate of the benchmark WACC - a series of appendices provide more detailed information on the approach adopted and the data used in deriving the estimate. Our esumate is reported in the following section and includes a high-level discussion of the results.
3.1. Overall approach When determining a benchmark for the WACC of the PPAs in the power sector in Portugal there are two choices of approach that стік! be used, specifically: • a WACC based on the observed rates demanded for PPAs that had the same structure and risk as those in Portugal could be developed; or • a generic WACC could be developed for (i) pure generators, (ii) good comparators, (iii) integrated utilities, (iv) transmission utilities, and (v) renewable energy companies only.
While the former approach would provide a clear benchmark against which the Portuguese PPAs could be measured the following problems arise: • the level of information available on the WACC (both the headline rate and the true expected rate which incorporates additional returns) for each PPA is likely to be limited and also confidential;1 • even if the information is available, the number of PPAs signed in any one vear is unlikely to be significant, so meaning that the pool of observations for any one year is limited; and • within this pool, the PPAs which match the risk profile, maturity and overall structure of those against which the benchmark is being com pared are likely to be even more limited.
Consequendy, while this approach should yield a good benchmark against which the actual PPAs can be measured the reality is that implementing the approach would be, at best, difficult if not impossible.
Additional returns refer to the types of payment that might be expected to arise from setting targets in the PPA at a level which any company would expect to beat - say a low availability target that should allow the company to earn abnormal returns wirb ou r operating above normal levels of efficiency.
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