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Commission Watch

The industry requires new analytical tools to incorporate the realities of today's higher risk operating and investment environment into the equity allowance process.
Fortnightly Magazine - October 15 2003

3). As the chart illustrates, after several years of a consistent modified Sharpe ratio of approximately 2 to 2.5, this return-risk measure has plunged below 1.6 for four consecutive years. 10 This clearly illustrates that for the industry as a whole, investors are taking on far more risk relative to return than they have in the past.

With the appropriate industry return-risk ratio specified and the firm specific external risk factor quantified, the equity allowance calculation for a particular company is then ready to be solved. Continuing the hypothetical example above and using 2.3 as the Sharpe ratio, the company-specific equity allowance would be 12.56 percent. This appears to be a healthy return when compared with recent rate case decisions. However, two things should be noted. First, the number calculated reflects the idiosyncratic risks of the company analyzed. As such, it is a fair return for this company, because the company faces greater risks than other utilities, and as such, requires the higher return to attract adequate investment dollars. Second, because this methodology reflects the individual risks of particular companies, it does not always produce 12 percent returns. For some companies, this methodology will show that they are less risky than the utility group as a whole, and therefore it will suggest a lower equity allowance.

To illustrate how this methodology compares to two of the more established methodologies, we analyzed two actual utility operating companies and calculated equity allowance using the DCF, Comparable Earnings, and the new Operating Approach (see Figure 4, p.29).

The analysis provides some interesting findings. First, the operating approach demonstrates that riskier companies merit higher equity allowance, while companies that have lower relative risk merit lower equity allowance. Second, since the DCF model does not focus specifically on measuring relative risk, the answer provided for these two companies is in contrast to their relative risk profile, suggesting a lower return for the company exposed to greater risk. Lastly, the risk premium method is unable to draw a distinction among the relative risk for these two companies, suggesting that investors require the same return, even though the companies have different risk profiles.

In addition to the more intuitive, and we would argue, more efficacious answers provided from the operating method, there are a few implementation issues that also work to its benefit.

  • The operating method does not rely upon choosing and defending a peer group for the analysis. The model is built on using all utility operating companies over a size threshold. In the analysis above, 114 companies were used, significantly more than the handful used in many filings.
  • There is no need to justify why a holding company Beta is applicable for the operating company. All the foibles of Beta are avoided in this approach.
  • The operating approach does not require a traded stock price or dividend to calculate a dividend yield. Since both of these variables stem from the holding company, arguing about their applicability to the operating company is avoided.
  • Since this approach uses 11 discrete variables to calculate an appropriate equity allowance, there is