The Missouri Public Service Commission has directed Kansas City Power & Light Co. to offer stand-by electric services to self-generation customers at market-based prices.
as reported by Ibbotson Associates. 1
The validity of using ex post premiums determined in markets from long-ago periods is called into question, with improvements and advances in market efficiencies, portfolio theory, the creation of options and futures markets, financial regulations and reporting, and the increased availability and quality of investor information. The earned returns from long ago are simply not representative of today's markets.
The risk premium method of estimating the cost of equity is an intuitively appealing and widely used approach for determining the required return on common equity capital. Naturally, one might point out that a benefit of a risk premium analysis, particularly from a utility ratemaking standpoint, is that it uses a longer time-period perspective and is less vulnerable to a particular capital market environment. However, the methodology used to calculate equity risk premiums should be consistent with financial theory regarding risk aversion and required returns. Consequently, equity risk premiums should be calculated using an ex ante methodology over a period long enough to ensure the robustness of the analysis, but not so long as to be obsolete.
ROE: How Much Return for the New Risks?
The required return on equity for the 1992 to 2001 period for Moody's Gas Distribution Index can be determined using a non-constant growth, quarterly-compounded discounted cash flow (DCF) model: 2
Po(1-fc) = E Dt/(1+k)^t = (Dn(1+gn))/(k-gn) * (1/(1+k))^t
A two-stage model was used to take advantage of the explicit dividend forecasts that are available from Value Line (annual dividends for years one and four were given, while years two and three were interpolated). The long-term constant rate of growth was calculated using the earnings retention (b times r) method and Value Line's three- to five-year expected return on equity (r) and expected retention rate (b). The stock prices used were the average of the high and low prices for the relevant month. A three percent adjustment for flotation costs was included.
As shown in Figure 1, the equity risk premiums ranged from approximately two percent to 5.4 percent over the 10-year period. It is interesting to note that the premiums vary in relation to the level of interest rates, with the premiums being larger when interest rates are lower. Furthermore, in the current, low-interest rate environment, the risk premium for the index is approximately 500 basis points. The variation in premiums relative to interest rates for the natural gas distributors are consistent with those found by Brigham, Shome, and Vinson 3 for electric utilities and industrial companies.
In conclusion, the appeal of the risk premium method derives from its theoretic simplicity. Equity is riskier than debt because the return to equity investors is a residual return (i.e., equity investors are not paid until debt holders have been paid) and is less certain than the yield on bonds. Therefore, investors require a higher return on equity capital than on debt capital. By determining the premium required by investors for the additional risk associated with equity capital, the cost of equity can be estimated, given the required return on debt.
- Ibbotson Associates'