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....
- changes in the risk profile of the industry. However, most utility operating companies are part of larger holding companies (many of which are engaged in unregulated and/or unrelated businesses), making pure Beta calculations difficult. Also, in the recent past returns on utility stocks (inclusive of yield) have not demonstrated meaningful correlation with the returns on broad equity market indexes, such as the S&P 500. 4
- Bond Yield Plus Risk Premium Analysis: Since this analysis relies on past spreads between bond yields and equity returns, the methodology has no ability to account for changes in the risk environment.
- Comparable Earnings Approach: Its circular logic is self-fulfilling as the analysis depends upon commission-set returns to determine the appropriate allowed return for the subject firm. If the commission-set returns for peer group firms have been computed using only the methodologies above, no analysis of change in the risk profile of the firm or the industry in which it competes can be incorporated.
In sum, traditional methods rely on the assumption that the electric utility industry has not and will not change. These methods assume growth rates will remain predictable, dividend payouts will continue ad infinitum, challenges faced by management remain constant, and market values will fluctuate only as a function of interest rates. These assumptions may have held true for a long period of time, but they are quite tenuous in an era of regulatory uncertainty and structural change. What is needed is a methodology that allows firms and commissions to:
- Identify factors affecting realized utility returns;
- Quantify the impact of these factors and assess significance at the firm-specific level;
- Quantify risk at the firm-specific level;
- Determine an appropriate return-risk ratio for firms in the industry from an investor's perspective; and
- Compute the cost of equity capital for a firm based upon specific operating characteristics and a consistent return-risk measure.
The Operating Approach to Equity Allowance
Many readers of this article will have an entrenched view of the appropriate method for establishing equity allowance and will have dismissed this next section before even reading it. This is quite unfortunate. Right now, the industry requires new analytical tools to incorporate the realities of today's operating and investment environment into the equity allowance process. 5 Since no existing equity allowance methodology sufficiently compensates for these risks, Ernst & Young has developed an approach that is based on the financial concept of the Sharpe Ratio, which measures unit of additional reward per unit of risk. 6
The fundamental concept behind using the Sharpe Ratio to calculate equity allowance is that it calculates required return directly from the level of risk of an industry, or a specific company. As such, if risk increases, reward needs to increase commensurately. Otherwise, investors will be exposed to too much risk relative to return and will therefore choose to invest elsewhere.
The key to this approach then is to accurately identify and assess the risks inherent in the industry, and more importantly, identify how much of the risk in the industry is applicable to each company. In other words, if the risk in