States continue to set ROE in price cap plans, stranded cost hearings, and some merger reviews.
In spite of a decline in the frequency of traditional utility rate cases, regulators at the state public utility commissions still have occasion to fix a target rate of return on common equity (em or ROE (em as a benchmark to determine what level of earnings is appropriate in a given setting.
And, as regulators in one state will often view an ROE set by a sister commission as the most reliable evidence of what should be reasonable in their own case, Public Utilities Fortnightly here revives a past feature for at least one more go-round: a survey of recent PUC determinations of ROE allowances for electric and gas distribution utilities.
This year's survey covers decisions issued between Jan. 1, 1997 and Sept. 30, 1998. During this period ROE determinations were seen not just in traditional rate cases, but in other proceedings, such as industry restructuring plans, investigations on stranded cost recovery, merger approval cases, and even in decisions approving performance-based regulation or nontraditional price-cap plans. Merger proposals sometimes come with a rate plan designed to win regulator approval, prompting a check on implied ROE to evaluate the new rates. Moreover, in price-cap plans especially, regulators will often rely on an initial ROE-based benchmark as a start point for periodic adjustments based on inflation, productivity changes, and other indexes.
ROE, a fundamental part of utility regulation, represents the amount included in rates to allow the utility to earn a "profit" on capital invested in the form of shares of common stock. It's what attracts investors to utility stock.
Nevertheless, the task of determining how much investors expect to earn from utility stocks is often one of the most contentious aspects of a PUC proceeding. It requires a judgement about risk, plus the latest economic and regulatory trends. Should regulators give weight to investor expectations of greater risk imposed by competition and restructuring? Should this greater risk outweigh the fact that the cost of long-term debt has fallen dramatically in recent months?
Last year regulators in Connecticut urged an equal consideration of both factors (em competitive risk and lower debt costs:
[T]he expected increase in industry risk due to competition must be considered in the context of the economic and interest rate environment that has reduced industry risk ¼ Near-term economic projections forecast continued modest inflation growth which, all else being equal, lowers industry risk and investors' required return. Although investors may consider equity holdings to be riskier over the next several years, the industry will likely be less risky than the market as a whole and will take measures to offset its risks. Docket No. 97-05-12, Dec. 31, 1997, 183 PUR4th 187 (Conn.D.P.U.C.).
However, recent cases from appellate courts suggest that competitive risk may well outweigh any easing of credit markets in setting ROEs. (See News Digest, "Courts," Public Utilities Fortnightly, Nov. 15, 1998, p. 19.) According to an appeals court in North Carolina, in a decision issued Sept. 1, 1998, the uncertainty over electric restructuring