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Return On Equity: Regulators Trust, but Verify

Some recent utility rate proceedings cast doubt on new ROE models and “risk adders.”

Fortnightly Magazine - November 2006

The results of Public Utilities Fortnightly’s annual survey of rates of return on equity (ROE) authorized for major electric and natural-gas utilities broadly show a continuing decline in the level of debate over issues specific to restructuring of the electric market. The survey also reveals a subtle shift back to investor requirements and overall business risks faced by regulated energy companies.

For example, in a gas rate case decided in Nevada, regulators rejected an ROE “risk adder” proposed by a natural-gas local distribution company and reminded the utility that hard evidence such as credit ratings and regulatory rulings are what makes the difference in a rate-case setting.

The Illinois Commerce Commission reviewed the underpinnings of the traditional ROE process when it rejected a proposal by a party to a major electric rate case to switch to a completely new approach, purportedly based on direct evidence from the investment-banking community. As it turned out, the so-called “investment-bank analysis” produced an ROE estimate much lower than any produced by the standard financial models normally relied upon in rate cases. The commission concluded it had no way to know what assumptions investment bankers use when putting a value on utility stocks, or whether such an estimate might satisfy the legal requirement for just-and-reasonable rates in a regulated market.

The Risk Adder

In its most recent natural-gas rate case, Sierra Pacific Power Co. asked the Nevada Public Utilities Commission (PUC) to approve a risk-premium adder when estimating the ROE investors would demand before investing in the company. Sierra Pacific argued that it faced an unusually risky position in the near term due to factors such as rapid customer growth and projected increases in capital expenditures. The PUC said the utility had failed to put forth any evidence that the premium adder is necessary for capital attraction. More to the point, the PUC noted that the company could not explain why it has been able to improve its credit rating from a “B” to a “BB” bond rating since the last rate case, when the current ROE of 10.25 percent did not include a risk-premium adder. Finally, the commission pointed to its own recent actions that would reduce risk perceived by investors in the near term, including:

1) Commission statements and orders that indicate the PUC is satisfied with the company’s procurement strategy policies;

2) Regulatory changes that cause an annual review by the PUC of Sierra Pacific’s annual energy supply plan, which informs the commission of short-term purchase plans and number trends, thus decreasing the likelihood of future disallowances;

3) Regulatory changes to allow utilities to file annually for two energy cost adjustments if necessary, which is helpful in avoiding large deferred energy balances; and

4) Regulatory changes and commission orders that allow for an equity premium adjustment to Sierra Pacific’s ROE for construction projects that are deemed critical facilities. Re Sierra Pacific Power Co., Docket Nos. 05-1005

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