Gas Distribution: Now a Higher-Risk Business

Deck: 
The rise in equity risk premiums for local gas utilities may come as a surprise.
Fortnightly Magazine - September 1 2002
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The rise in equity risk premiums for local gas utilities may come as a surprise.

Equity risk premiums for natural gas distributors have hit a ten-year high. Moody's Gas Distribution Index showed a jump to a 5.4 percent equity risk premium in December 2001 and has averaged an approximate five percent equity risk premium in 2002, while historically equity risk premiums have averaged 3.4 percent above the yield of 30-year Treasury bonds over the last 10 years. The variation in equity risk premiums over time and in relation to the level of interest rates, as shown in Figure 1, calls into question some commonly used analytical methods-particularly what is called the ex post risk premium analyses, or historical yield spread method, which typically uses extremely long 60- to 70-year periods.

Notwithstanding its widespread use, there is a serious conceptual problem with using the ex post or historical yield spread method to determine risk premiums.

Typically, under the ex post method, the risk premium is calculated as the difference between the historical holding period returns on an index of stocks for a particular past period and the returns from an index of bonds for the same past period. The historical risk premium is then added to a company's current bond yield or to the current yield of a Treasury security to determine the cost of equity.

This is expressed as follows:
Ke = Kd + historical equity/debt spread
where: Ke = cost of equity
Kd = cost of debt

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