Despite the hype about cheap gas, pipeline constraints are creating new risks. New England’s wholesale power prices ran three times as high this past February compared to the same month in 2012....
- not an over-dependence on one variable for the answer like there is with the DCF approach. With the DCF approach, the range of outcomes is highly driven by what experts estimate for growth.
Another benefit that stems from the operating approach is that since the methodology quantifies the effects of various industry factors, companies can use the results of this analysis to have a dialogue with regulators regarding the financial impact of certain regulatory policies. It may be the case for instance that a company would be willing to accept a slightly lower equity allowance if the commission would consider changing a regulatory policy that increases the company's variability of returns.
In the real world there is no such thing as the perfect model for economic and financial events. This is also true when regulators set an allowed return. In these dynamic times, regulated utilities and their regulators should explore alternative methods. This is especially true when firms and regulators determine an allowed rate of return. Using the operating approach, an opportunity now exists to use a different, and academically sound, approach to analyzing the cost of capital for firms in the electric utility industry. Meaningful dialogue between firms and commissioners regarding the appropriate return-risk measure can open up a fresh new angle of analysis that has not been present within the ratemaking context. If firms and commissioners augment their current methodologies with the fresh perspective described above, progress can be made in attracting more capital to this industry, and more importantly, in improving the allocation of that capital to the appropriate infrastructure investments and to the firms managing the most risk.
- Referenced in EPRI's Electricity Sector Framework for the Future, Volume I, p. 34 (Aug. 6, 2003).
- Defined as Net Operating Profit After-Tax/Ratebase. For conservatism purposes, this measure eliminates the impact of highly leveraged capital structures. A three-year trailing average has been used to smooth the trend lines and reduce the impact of outliers.
- Argument over the use of earnings growth or dividend growth is moot as the only long-term source of dividends is earnings. Also, since "long-term" growth rates are clearly required by the model because it assumes this rate in perpetuity, it is theoretically invalid for this rate to be greater than the long-term GDP growth rate.
- An interesting topic of study as the movement in utility stock prices has become more dependent upon the movement in interest rates and "event-specific phenomena" such as regulation/deregulation decisions, severe weather, and plant shutdowns.
- The well-known Professor Stewart Myers encourages this practice in a 1978 publication: "Use more than one model when you can. Because estimating the opportunity cost of capital is difficult, only a fool throws away useful information."
- The Sharpe ratio is a measure of excess return per unit of excess risk defined as: (Expected Return - Risk Free Rate)/Standard Deviation of Returns.
- For those who are statistically inclined, the model is (RORBc,t) = y0 + y1
(Equity Allowance) y2(Regulatory Risk) + y3
(Operational Risk) + y4(Franchise Risk) + y5
(Managerial Factors) + et where;
RORB = Return on Rate