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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

cost of capital require assumptions. Currently, commissioners rely on the following methodologies for determining a particular firm's cost of equity:

Historically the discounted cash flow (DCF) method has been the backbone of rate case testimonies, and it is the preferred method among state commissions for computing a cost of equity. However, both the DCF method and the other traditional cost-of-equity calculations have fundamental limitations. The DCF method, for example, is an effective means to measure cost of equity in a company/industry that has stable growth rates, leverage ratios, and dividend payouts; but it cannot account for volatility of future earnings and is incapable of addressing changes in firm or industry risk profile over the course of time.

The Risk Premium and Comparable Earnings methods, similarly, are academically sound, but each under-compensates for risk, measured as a function of increasing or decreasing volatility of future cash flows.

The fourth method, the capital asset pricing model (CAPM) approach, best addresses the issue of volatility as a source of investor risk. However, many difficulties exist in applying CAPM theory to a utility holding company, and several academic studies questioned the ability of the CAPM to enable the estimation of equity cost on a forward-looking basis.

These weaknesses have rarely been exposed in the ratemaking forum because of the relative stability prevalent in the utilities industry prior to the restructuring activities of the past decade. The utility industry had been adopted as a case study for optimal use of the DCF and other traditional methods. However, recent upheavals in the fuels and power markets, coupled with the uncertainty over RTOs, provider-of-last-resort responsibility, and the future of competition have added elements of risk that did not exist in previous years. As a result, the use of the same methodologies and same underlying assumptions has created a significant problem. In fact, the standard deviation of industry returns 2 for the regulated portion of the business has increased from approximately 2 percent to 4 percent (a doubling of risk), yet traditional methods are suggesting the only impact on allowed return should be the result of lower yields on government bonds. Intuitively, this does not make sense. Why are current methodologies ineffective in accounting for changes in volatility?

  • Discounted Cash Flow Method: The DCF method has two components: dividend yield and long-term earnings growth. Dividend yield is positively correlated with interest rates, and will either increase or decrease as a function of interest rate movements. Long-term earnings growth 3 is nearly impossible to predict with so much fundamental uncertainty in the current regulatory environment. Since neither variable adequately accounts for changes in volatility, the traditional DCF method will not reflect any changes in the business environment across the industry, nor will it incorporate differences in operating conditions between firms. The result is an equity allowance that is not appropriate from a reward-risk perspective.
  • Capital Asset Pricing Model: The key component of the CAPM, Beta, is a measure of the slope of the regression line of company returns versus market returns. In theory, this methodology should be best suited to address