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Rate Unbundling: Are We There Yet? A Reality Check

Fortnightly Magazine - June 1 1996

as the sole variable explaining returns on stocks is dead."3 However, Fischer Black later rebutted Fama and French, saying: "Beta is a valuable investment tool if the line is as steep as the CAPM predicts. . . . The evidence that prompts such statements implies more uses for beta than ever."4

All this suggests that analysts should avoid relying exclusively on any single model for cost of common equity, including the CAPM. Nevertheless, we do not mean to say that the CAPM cannot help quantify an ROE or ROE differentials between utilities or between electric generation and T&D. However, we do suggest using other tools to minimize the estimating error. Keep in mind that every method or model employed to estimate ROE involves subjective judgment: Every method is flawed in one way or another.

"Pure Plays" and Benchmarks

Morse et al. assert that bond-rating criteria published by Standard & Poor's (S&P) reflect a belief by S&P that electric generation is more risky than T&D. Of course, S&P may be correct that the majority of business risk faced by electric utilities arises from the generation function. However, S&P does not offer any direct quantification of the ROE generation differential vis-a-vis T&D. Nor does S&P offer any comparisons of ROE differentials between electric and gas utilities, or between electric and telephone companies (the two proxies employed by the authors).

The authors also rely upon a finding by the FERC that granted market-based rates for electric wholesale generators which, it is claimed, are at least an approximation for "pure play" generation companies. Specifically, the authors cite the cases of Ocean States Power I5 and II.6

In the Ocean States cases, the authors state that the FERC-approved, market-based rates included an ROE 15 percent higher than the FERC's generic benchmark ROE for electric utilities (i.e., 115 percent of generic ROE). However, the opinion of the FERC on common equity cost rates is often disputed, even by its own staff. Thus, FERC staff recently relied upon a risk-premium method to estimate the market-required cost rate for common equity based upon state ROE findings. State findings over time have been higher than FERC findings, according to FERC staff.

More important, however, is the fact that the Ocean States analysis appears out of date.

In January 1992, after it had issued the Oceans States I opinion, the FERC abolished its Generic Benchmark Rate of Return on Common Equity for electric utilities.7 According to the FERC, in its Ocean States II decision, the generic rate had not produced many of the benefits envisioned for it in 1984. Also, the FERC has since rejected the method used in its generic ROE formula.

The generic ROE was derived using a discounted cash flow (DCF) model with a single-stage growth rate factor. In each of its quarterly calculations from 1984 through 1991, the FERC had applied essentially the same single-stage growth rate. Subsequently, several FERC staff members testified that the DCF model was unreliable when used by itself and added in a risk-premium calculation to determine the appropriate ROE. Moreover, since 1994 the