Liam Baker, vice president for regulatory affairs at US Power Generating, questions whether his company’s power plants and control systems in New York and Massachusetts must comply with the...
The industry requires new analytical tools to incorporate the realities of today's higher risk operating and investment environment into the equity allowance process.
During the past 10 years, capital investment in regulated electric utility assets has slowed considerably. While a tremendous amount of capital was committed to new unregulated generation, capital investment in the regulated business has not kept pace with depreciation. With a "return to basics" mantra now common in the industry, coupled with the recognition of under-investment and heightened reliability concerns, most companies are now facing significant capital expenditure programs. According to the Energy Information Administration, the investment required to replace aging infrastructure and keep pace with growing energy demand amounts to $400 billion over the next 20 years. 1 In addition to these impending capital expenditures, most utilities have experienced a significant escalation of operating costs in the recent past, resulting in decreased operating margins.
Because of these factors, many utilities are considering or have filed for rate relief. For many companies, this represents the first such filing in several years. However, due to the low interest rate environment, companies filing new cases risk living with a much lower return on equity. As Figure 1 shows, authorized returns have trended down during the last decade, and some recent awards have reached single digits.
While allowed returns have decreased, risk in the regulated utility business has increased. In fact, investor risk, as measured by standard deviation in earned return on ratebase, has doubled since the mid-1990s. (See Figure 2, p.27.) If risk is increasing, why are allowed ROEs trending down? The overall decrease in interest rates is the likely driver of this downward trend. However, the traditional methods of determining ROE are contributing factors. Critically, these approaches do not reflect the rising level of industry risk, nor do they empirically account for firm-specific risks, which directly affect an investor's requirement for equity returns.
The question, as posed by an author in this publication earlier this year (Feb. 15, 2003), becomes: "Is there a better approach for estimating the appropriate equity allowance for a particular utility than the traditional methods we have relied upon for the past 30 years?" Can more rigor and insight into the underlying business risks and operating conditions be infused into the determination of appropriate rates of return?
Ernst and Young LLP believes it is possible, and the company has developed a rigorous approach for estimating an equity allowance that is based on differentiating and highlighting the increased risks in the industry and the idiosyncratic risks faced by a particular company. Why is this relevant? To raise the magnitude of capital necessary to support the infrastructure needs of America's electric industry over the next two decades, equity returns will need to be commensurate with the risks of the industry. If not, investors will allocate capital to companies offering superior return-risk profiles, and management teams will continue to abstain from capital investments in regulated assets and deploy excess capital in the payment of dividends and debt reduction.
Do Current Methodologies Work?
All methodologies for imputing