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Perspective

It is hard tyo foresee abandoning the discounted cash flow method relied upon so heavily for the past couple of decades.
Fortnightly Magazine - May 15 2003

earnings" analyses, presumed dead after the advent of the well-grounded financial theories like DCF and CAPM, have risen from the ashes of past regulation to be considered a genuine rate of return technique. Furthermore, sound theoretical models are often sacrificed on the altar of ad hoc adjustments, when staff or company analysts scramble to move a model's results down or up for a never-ending variety of reasons that are impossible to verify empirically or theoretically.

It remains true today that most rate case issues, with the exception of major cost items, are capable of being settled in relatively short order except for rate of return, where the old issues are continually battled out. So, what are the options to reduce the scope of the interminable fighting over rate of return?

Previous Attempts to Standardize Rate of Return Analysis

Rate of return techniques abound, but very little time and attention is paid to determining which have practical usefulness. The theories that underlie the empirical determination of the cost of capital have become increasingly arcane and irrelevant to the practical ratemaking world, where common sense, believability, and simplicity determine which techniques an administrative law judge or commissioner will use to set the allowed return. At times it seems that the goals of theoretical accuracy and usefulness are mutually exclusive attributes in rate of return models used in utility rate cases.

Although much time is spent discussing the technical aspects of rate-of-return techniques, we never get around to establishing criteria for determining whether they are any good in real rate cases.

Both FERC and the New York Public Service Commission tried to regularize rate of return investigations by concentrating on the method (or methods) involved. FERC's generic rate-of- return process, begun in 1986, ended in a fog of adjustments for a seemingly endless procession of "special cases." The 1991-1993 Generic Financing Proceeding in New York, which was designed to produce an objective standard for setting the fair rate of return, has not streamlined the process. On the contrary, the outcome of that generic proceeding (which was never adopted by the commission in New York) continues to haunt New York rate cases like a dusty book of alchemy from ancient times-understandable only to those who witnessed its creation.

The methods adopted in New York, for example, were overly complex, ad hoc, and led inevitably to further expensive fights and litigation when the financial winds shifted. Both proceedings consumed a great amount of time, effort, and expense in an attempt to establish generic rules in the first place. In a larger sense, there was so much ground to make up that the proceedings could not be said to have been worthwhile-even if durable rules had come out of them.

Why the Appeal of the DCF?

The DCF method has endured for most of the past two decades for three basic reasons:

  • It rests on a solid, straightforward theoretical base;
  • It capitalizes on the depth of U.S. capital markets-meaning analysis can use "proxy groups" of publicly traded companies in the same industry to manage the variability of individual