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Rate Unbundling: Are We There Yet? A Reality Check

Fortnightly Magazine - June 1 1996

should equal 180 basis points, given an 18-percentage-point drop in the common equity ratio. Yet, AT&T's 1995 beta of 0.85 is 0.05 higher than its 1995 beta of 0.80. If one can assume a 7-percent risk premium in 1995 in the CAPM computation, then the beta-derived ROE investment cost rate should be only 35 basis points higher (7% x. 0.5). Compare this increase of 35 basis points, attributable to higher business risk according to the authors, with the increase in financial risk of 180 basis points inherent in AT&T's higher common equity cost rate for 1995. These data suggest a perceived decrease in business risk attributable to competition, even though investment risk rose overall. That higher overall investment risk can be attributed to the rise in financial risk related to the decline in common equity ratio (em from 58 to about 40 percent.

Similar computations for the seven RHCs also fail to confirm the authors' conclusions. For example, based upon an assumed equity-risk premium of 7 percent and the current beta difference between AT&T and the average for the RHCs of 0.12 (0.85 - 0.73), the ROE investment risk difference is 84 basis points (0.12 x 7%). However, when one takes into account the incremental difference of 10 percentage points in common equity ratio (50 percent for the RHCs versus 40 percent for AT&T), there is implied a greater net difference in financial risk (em 100 basis points more for AT&T. This higher financial risk exceeds the investment risk differential of 84 basis points implied solely by the difference in beta. Since investment risk represents the sum of business and financial risk, the end result (relying on beta difference) indicates that the business risk for AT&T stands lower than the average risk for the RHCs, in spite of AT&T's exposure to more competitive risk than the RHCs. This result suggests a conclusion opposite to that advanced by the authors. It implies that the market perceives a greater risk in regulation than in competition.

Moreover, if beta is flawed, as some suggest, or if the market is not efficient, then flaws will also appear in the authors' quantification of a higher business risk for generation and a lower business risk for T&D.

The Trouble With Beta

There is reason to believe beta is flawed. The R2 term (coefficient of determination of the regression analysis which gives rise to beta) for a utility beta generally ranges between less than 0.10 to 0.30. Thus, 70 to 90 percent of the stock price movement used to develop the betas have nothing to do with company-specific risk. In fact, Fama and French have concluded2 that beta seems to have no role in explaining the average returns on New York, American, or NASDAQ stock exchanges for 1963-1990. Reporting on that work prior to publication, the New York Times found other experts in agreement: "[F]inance experts say that Professors Fama and French have presented the most conclusive evidence against beta." The Times confirmed that conclusion from Fama: "'The fact is,' Professor Fama said in a recent telephone interview, 'Beta