Forecasts Send ROEs Wide of the Mark
In a recent "Offpeak" ("Forecasting is Just That," Jan. 1, 1996, p. 54), David Foti and Clay Denton report data showing the percentage of error found in various seven-year forecasts of natural gas prices (1988-94) produced by the American Gas Association (A.G.A.), Energy Information Administration (EIA), DRI/McGraw-Hill (DRI), Gas Research Institute, and WEFA Group. These errors ranged from approximately 50 to 95 percent.
What does that say about utility ratemaking, where regulators sometimes rely on a 20-year horizon?
Until recently, the Federal Energy Regulatory Commission (FERC) has calculated just and reasonable rate of return on equity (ROE) using the traditional Discounted Cash Flow (DCF) model, which posits that investors require an ROE equal to the sum of the expected yield for the next period, plus the anticipated (by investors) long-term growth rate (g) in cash flow (dividends). The simplified constant-growth version of this model is: r = D1/Po + g, where Po is an estimate of the current price of the stock, D1 denotes the next-period expected dividend, and g indicates the expected annual growth rate in dividends. The FERC estimates the next-period expected dividend by adjusting the indicated dividend for one half-year of expected growth. The adjustment factor = 1 + g/2.
For many years, the FERC determined the requisite growth term g using financial forecasts (Value Line, Zack's, IBES, and others) of the rate of earnings growth for natural gas pipelines or electric utilities. It then converted these earnings-growth forecasts to