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Business & Money

Today's volatile markets upset the discounted cash flow model, and others.
Fortnightly Magazine - February 15 2003

with many regulatory issues, the devil is in the details. Nevertheless, in principle, an automatic adjustment mechanism could work in much the same way as a well-structured performance-based regulation scheme: providing the utility with an incentive to improve efficiency, while sharing some of the benefits of those improvements with ratepayers.

Whatever the solution, traditional reliance on the DCF needs rethinking by regulators. At the very least, regulators should no longer rely solely on the DCF to set allowed returns. As long as markets remain volatile-and it seems unlikely that the utility industry will return to its "widows and orphan" days-efficiency and equity considerations both suggest more explicit treatment of that market volatility in determining utilities' cost of equity and allowed rates of return. The DCF need not be abandoned-yet-but its use needs to be modified to account for the very different financial markets that face utilities today.

Foundations of the DCF 7

The DCF is based on the efficient market hypothesis (EMH), which states, in essence, that the price of a stock today is determined by all of the available information about that stock. Given the "rogue's gallery" of recent corporate accounting scandals, it might be tempting to conclude the EMH is simply wrong. But this is too harsh. Once those scandals were exposed, the EMH quickly adjusted the stock prices of the offending companies.

The DCF model assumes that the sock price today equals the expected value of all future cash flows associated with that stock, including any dividend payments and appreciation in the stock's price. 8 In this framework, the cost of equity for a utility can be shown to equal the stock's current dividend yield plus the expected long-term growth in earnings, i.e., 9

k = (D0 / P0) + g

A number of different versions of the DCF have been used, based on different treatment of dividend payments, differences between short-term and long-term earnings and growth rates, and even "non-constant" growth rate models. All of these different versions, however, are based on the same underlying capital market theory.

Before consolidation in the natural gas and electric utility industries, and befoe it became popular for utilities to diversify into unregulated activities, the cost of equity could be calculated for most publicly held utilities. Of course, unlike unregulated firms, regulators themselves, in part determine the earnings growth component "g," which introduces a circular logic problem into the DCF calculation. 10

To get around these problems, most DCF estimates presented in utility rate cases rely on proxy groups of "similar" utilities, although what constitutes a "similar" utility is more art than science. Indeed, the choice of proxy groups can have a significant effect on the ultimate cost of equity derived. Moreover, the availability of proxy companies has decreased as mergers and restructuring has reduced the number of independant utilities on which comparisons could be made. 11

  1. National Association of Regulatory Utility Commissioners (NARUC), "Utility Regulatory Policy in the United States and Canada, Compilation," 1996. The author also relied on a study of utility commission rate case decisions between 1993 and 2001