RIIO-3 Draft Determination: Step-by-step guide to calculating Cost of Equity

Ofgem’s RIIO-3 Draft Determinations, released on 1 July 2025, set out headline cost-of-equity allowances. But the CAPM methodology to calculate Cost of Equity is complex, and in practice, only specialist economic consultancies have been able to reverse-engineer each gearing, beta and risk-free-rate results.

The step-by-step reconstruction presented here turns that black box into a transparent, replicable workflow, enabling investors, network operators and policymakers to refresh the numbers as markets evolve. Future instalments from Vallorii will apply the same forensic approach to determinations from Ofwat, CAA, and other regulators.

Ofgem RIIO-3 DD Methodology

📄 Reference: RIIO-3 Draft Determination (Finance Annex) (opens in a new tab)

Overview

This repository documents our reconstruction of Ofgem's RIIO-3 DD cost of equity (CoE) methodology. Our goal is to replicate Ofgem's calculations as accurately as possible.

Occasionally, we must make assumptions in the calculation process. We document our assumptions explicitly.

The methodology covers 3 sections:

• A. Beta Calculation – estimation of company-specific betas, unlevering, and re-levering using notional gearing
• B. Risk-Free Rate (RfR) Calculation – derivation of the RfR from government bond yields and an RPI-CPIH wedge adjustment
• C. Cost of Equity Calculation – calculating Cost of Equity using Notional Beta and Risk Free Rate

Unless stated otherwise, we use Factset as our data source.

General Parameters

• Cut-off date: March 30, 2025
• Total Market Return (TMR) Range: 6.80 % – 6.90 %
• Notional gearing: 60 % for GD&T, 55 % for ET (gearing is the only difference between GD&T and ET)
• Debt beta: 0.075
• Estimation Window of the Raw Beta regression: 10 years
• Comparator companies, and their market proxy:
  • National Grid (NG-GB, FTSE All Share)
  • Severn Trent (SVT-GB, FTSE All Share)
  • United Utilities (UU-GB, FTSE All Share)
  • Pennon (PNN-GB, FTSE All Share)
  • Enagás (ENG-ES, STOXX Europe 600)
  • Red Elec (RED-ES, STOXX Europe 600)
  • Terna (TRN-IT, STOXX Europe 600)
  • Snam (SRG-IT, STOXX Europe 600)
  • Italgas (IG-IT, STOXX Europe 600)

Section A: Beta Calculation

There are 3 steps to calculate beta:

1. Gearing calculation steps

Gearing is necessary to de-lever and re-lever Raw Beta later in step 3.

1.1: Interpolate gearing data

• Compute gearing for past 10 years as net debt / enterprise value (EV) using data from annual reports (or data providers like Bloomberg and Factset)
• Interpolate gearing from annual to daily frequency by forward-filling (to avoid look-ahead bias)

1.2: Apply rolling average

• Calculate the 10-yr rolling mean on the cut-off date. This keeps the gearing horizon identical to beta horizon
• Why rolling average? Since beta regression is estimated over a 10-year window, the gearing used for unlevering should represent the same time period to ensure consistency between the beta estimation window and the gearing measurement period

2. Raw Beta regression

Note: Raw Beta is also commonly referred to as “Levered Beta”.

Raw beta is estimated by regressing daily company stock returns against daily market proxy returns. The slope coefficient from this regression represents the company's systematic risk relative to the market.

• Market proxy: FTSE All-Share (UK stocks) or STOXX Europe 600 (EU stocks)
• Use dividend- and split-adjusted closing price to calculate daily returns for both the company and market proxy
• Adjusted prices are necessary because dividends and stock splits create artificial price jumps that would distort return calculations and bias beta estimates

3. Transform Raw Beta to Notional Beta

Transforming Raw Beta to Notional Beta requires 3 steps:

1. Calculate unlevered beta
2. Calculate asset beta
3. Calculate Notional beta

3.1 Unlevered Beta

• Each company's beta is unlevered using its own gearing at each estimation window
• The Harris-Pringle formula is applied for unlevering:

Where:

• β_U = Unlevered beta
• β_L = Levered beta
• G = Gearing (net debt / enterprise value)
• T = Tax rate

Ofgem does not incorporate a tax-rate adjustment, meaning T is set to 0.

3.2 Asset Beta

Compute asset beta for each company at each estimation window, using the unlevered beta, debt beta, and gearing

Where:

• β_A = Asset beta
• β_U = Unlevered beta
• β_D = Debt beta
• G = Gearing (net debt / enterprise value)

3.3 Notional Beta

First, identify the minimum and maximum asset betas across companies:

• For the Mar 30 cut-off date, determine the maximum and minimum asset betas across all comparator companies
• Assumptions:
  • In Table 16, pg 56, Ofgem calculates 10-year asset betas ranging from a low of 0.32 (UU) to a high of 0.44 (Snam), but chooses its final asset beta range as 0.30-0.45
  • Our calculations produce a range of 0.32 (UU) to a high of 0.44 (Snam), and we do not manually adjust the range

Second, calculate Notional Beta from the min and max asset beta:

Where:

• β_N = Notional beta
• β_A = Asset beta
• G_N = Notional gearing (60 % for GD&T, 55 % for ET)
• β_D = Debt beta (0.075)

This formula re-levers the asset beta using the notional gearing to produce the notional equity beta.

For example, assuming min and max asset betas of 0.30 and 0.40 (at 55 % gearing and 0.075 debt beta):

• min β_N = (0.30 − (0.55 × 0.075)) / (1 − 0.55) = 0.58
• max β_N = (0.45 − (0.55 × 0.075)) / (1 − 0.55) = 0.91
• mid β_N = (0.375 − (0.55 × 0.075)) / (1 − 0.55) = 0.74

Which corresponds to Ofgem's "Equity Beta" determination on Table 18 (page 59):

Section B: Risk-Free Rate Calculation

1. Yield Selection

• Retrieve the yield of the 20-year British government bond yield, Real Zero Coupon from the Bank of England (data field “IUDLRZC”) (opens in a new tab)
• Ofgem set its risk-free rate based on the daily average yield for the month of March 2025
• Therefore, we set the base risk-free rate on any given date based on the rolling average yield for the previous 30 calendar days

2. Inflation Wedge Adjustment

• Ofgem applies a geometric 20-yr mean of RPI − CPI forecasts from 2027 to 2031, finding this is 0.11 %
• We take this 0.11 % to be exogenous, and apply it as an uplift to the yield from step 1

Section C: Cost of Equity Calculation

Calculating the min and max CoE

The range of CoE is calculated by propogating the minimum and maximum Notional Beta and TMR through the CoE formula:

Where:

• CoE = Cost of Equity
• RFR = Risk-Free Rate
• β_N = Notional Beta
• TMR = Total Market Return

For example, for the min and max Notional Beta of 0.58-0.91, RfR of 2.01 %, and TMR of 6.8-6.9 %, the CoE is:

• Min CoE = 2.01 % + 0.58 × (6.8 % − 2.01 %) = 4.79 %
• Max CoE = 2.01 % + 0.91 × (6.9 % − 2.01 %) = 6.46 %

Note: The small discrepancies are likely because Ofgem’s calculations use Notional Beta values to more decimal places than the rounded figures presented in Table 18.