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The Wires Charge: Risk and Rates for the Regulated Distributor

Fortnightly Magazine - September 1 1997

management activities is needed.%n4%n Also, regulators must recognize the tax advantages of debt over equity when calculating the income tax liabilities associated with the wires business.

Of the five bankruptcies that have occurred in the electric utility industry since the Great Depression, only one was not directly related to investments in generation assets. The singular exception was Tucson Electric, and even there, generation assets created the biggest problem of all electricity assets in resolving the financial distress. Never has transmission or distribution added to a utility's financial difficulties.

Moreover, the overwhelming majority of price disparities in the U.S. appear attributable to differences in the embedded cost of generation. Generation capital has historically come in much larger lumps than wires, making unexpected changes in demand more problematic and vicious.

Debt, Equity and Beta

To assess the proper rate of return for unbundled wires services, we start from the possibly heroic assumption that the return and capital structure allowed in the past was fair and equitable. The allowed return is termed the weighted average cost of capital.

In basic financial economics, the weighted average cost of capital is the return to each component of the capital structure (debt, preferred stock, common stock) multiplied by its share in the capital structure.%n5%n The WACC is composed of three factors: the debt-equity ratio, the equity beta and the debt rate.%n6%n By evaluating these three factors separately for generation and for wires, the right rate of return for the unbundled wires assets will emerge. The first step is to forecast the equity component.

The equity return to a common stock is based on the way the price fluctuates compared with other stocks in the market. A simple way to do this is to use the capital asset pricing model. CAPM says that equity return depends on beta. Beta is a measure of the statistical relation between the stock price movements of one firm and the movement in the overall market; it is a financial statistic reported by financial services such as the Value Line Investment Survey. The CAPM equation says that equity return is equal to the risk-free rate of return plus beta times the overall risk premium to equity assets.

In mid-summer, the risk-free rate was 6.6 percent.%n7%n The risk premium on common equities historically has been 7 percent. So, the expected return to the market portfolio of common stocks is 13.6 percent. Using CAPM, a firm with a beta of 1 is predicted to make an equity return of 13.6 percent for the coming year. A firm with a beta of 2 is expected to make 20.6 percent.

The historical equity beta for utilities has been around 0.7. This beta gives an expected equity return to electricity stocks of 11.5 percent.%n8%n In other words, the financial market has acted over the long term as if it expected public utility commissions to allow an equity return of 11.5 percent in bundled, rate-regulated electric utilities. Indeed, this expectation is approximately correct based on the equity returns allowed by various commissions as reported in the FERC Form 1 filings