William Catacosinos has resigned as chairman of MarketSpan Corp., the utility formed to replace the troubled Long Island Lighting Co. Catacosinos is under investigation by...
allowed in utility rate cases across the United States can help ensure that a utility's rates are, in fact, allowing for the adequate recovery of, and return on, utility investments. Of course, such benchmarking of allowed returns and depreciation rates cannot be a substitute for proper cost of capital and depreciation studies. They also must recognize the credit rating agencies' dissatisfaction with currently authorized returns, and consider industry trends, changes in financial market conditions, and unique circumstances of individual utilities.
Benchmarking Allowed Rates of Return
The following example from a recent rate case is indicative of what regulatory commissions frequently face when deciding on an allowed rate of return. The particular utility filed for a rate increase requesting a return on equity (ROE) in the range of 11.5 percent to 12 percent. The commission staff argued that the appropriate ROE was between 8.5 percent and 9.5 percent, while public counsel provided testimony supporting a range of 10 percent to 10.25 percent. The commission analyzed the three expert recommendations and set the allowed ROE at 10 percent, finding that the low end of public counsel's cost of equity recommendation was most reasonable.
As it turns out, public counsel's recommendation also approximated the mid-point of all recommendations presented to the commission in this case: 10.25 percent is the midpoint between the low end of staff's recommendation (8.5 percent) and the high end of the utility's recommendation (12.0 percent); and the allowed ROE of 10 percent is the midpoint between the low end of staff's and the utility's recommendations (8.5 percent and 11.5 percent, respectively).
But how reasonable were these experts' recommendations? And was the public counsel's midpoint reasonable in that it represented adequate compensation for investors' capital? This, of course, is the $64,000 question-and it is extremely difficult to answer with great precision.
On an after-the-fact basis, the answer almost certainly is that the allowed ROE of 10 percent was not adequate. The utility was later downgraded by S&P based on a rationale that specifically pointed to the rate order's low allowed ROE and low depreciation allowances. In fact, the return allowed in this rate order marked the single lowest allowed ROE of all 18 electric utility rate orders issued by state commissions in that year. And even worse, the 10 percent ROE immediately became important "precedent" against which disputes over the allowed return would be evaluated in the commission's subsequent rate cases.
How could the reasonableness of the experts' recommendations have been evaluated when their recommendations initially were presented to the commission? We find that the comprehensive review of returns allowed in recent regulatory orders of other commissions can be used as a valuable benchmark to assess the likely adequacy of experts' rate of return recommendations.
For example, Figure 1 shows the range of ROEs that state regulatory commissions have allowed in each year from 1995 through the third quarter of 2002. (The chart is based on a two-year moving average to ensure a sufficient number of rate cases and avoid excess variability of the shown rate of return ranges. It also excludes