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21st Century ROEs: What Is Reasonable?

How to benchmark return on equity (ROE) and depreciation expense in utility rate cases.
Fortnightly Magazine - October 15 2003

a result, setting an appropriate allowed rate of return must account for industry trends, changes in financial market conditions, and unique circumstances of the individual regulated entity. For example, with respect to industry trends, it may be important to recognize factors such as changing risks due to increased competition or a rapidly (and often unpredictably) changing regulatory environment. It may also be important to reflect changes in financial market conditions, such as the industry's access to new capital and trends in interest rates.

Important company-specific factors may include the firm's specific risk profile relative to industry averages or infrastructure investment requirements that may put downward pressure on various financial ratios, such as free cash flow and interest coverage. To facilitate transmission infrastructure investments, for example, recently allowed ROEs have been in (and even above) the 12 to 13 percent range. In considering any company-specific factors, however, it is also important to avoid regulatory adjustments that appropriate benefits the company achieved through superior performance. For example, the Federal Energy Regulatory Commission will not generally lower a pipeline's ROE if its lower risk is the result of the pipeline's own efficiency. Reducing the allowed return simply because a company was able to reduce its business risk through superior performance relative to others in the industry would eliminate the very incentives that give rise to such performance gains. 6

Benchmarking Depreciation Rates

Similar to the benchmarking of allowed rates of return, comprehensive benchmarking of depreciation rates can help commissions evaluate the likely reasonableness of experts' proposed depreciation rates. The example of another recent rate case can illustrate the benefits of such comparisons. In this case, the difference between the staff's and the company's recommended depreciation rates accounted for more than $100 million in annual revenue requirements. While the company proposed to increase average depreciation rates from approximately 3 percent to 3.4 percent per year, the staff's depreciation witness recommendation decreased average depreciation rates from approximately 3 percent to 2.2 percent. (An average depreciation rate of 2.2 percent is equivalent to an average depreciation life of 45 years, while a depreciation rate of 3.4 percent is equivalent to 29 years.)

Figure 2 shows how depreciation rates associated with the utility's preexisting depreciation rates and the experts' recommendations compared to average depreciation that regulators allowed in recent years for other utilities in the country. The figure shows that: (1) the utility's currently effective actual depreciation rates of 3 percent are approximately equal to the 25th percentile of average depreciation rates (i.e., the first quartile) of other utilities in the country; (2) the company's proposed depreciation rates of 3.4 percent are consistent with the median of other utilities' average depreciation rates; and (3) the staff's proposed 2.2 percent depreciation rate is below the fifth percentile (i.e., well below the mainstream) of average depreciation rates that regulatory commissions have allowed for other U.S. utilities.

Of course, a comparison of utilitywide averages for depreciation rates can be misleading because different asset types-such as production, transmission, and distribution assets-tend to have different depreciation lives. As a result, for example, the range