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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

et al. , 248 PUR4th 364, April 27, 2006 (Nev. P.U.C.)

An Investment-Bank Analysis

In a major rate case involving electric delivery services provided by Commonwealth Edison Co. (ComEd), a coalition of groups representing small consumers looked to recent valuations of utility assets conducted by investment banks to support a new approach to estimating a rate of return that would attract investors to utility stocks. (The recently terminated plan for a merger of ComEd parent, Exelon, and Public Service Enterprise Group [PSEG], a New Jersey company, provided current market data and an opening to pitch the novel approach.) Using this new method, the consumer groups suggested that investors would favor investment in ComEd so long as a 7.75 percent equity allowance was included in rates. The alliance of consumer groups had estimated ComEd’s cost of equity by inference from the weighted average cost of capital (WACC) calculated by Morgan Stanley for the merger of Exelon and PSEG. All other parties to the Illinois Commerce Commission (ICC) case used complex financial models to gauge ROE requirements and came up with much higher estimates, including the utility’s offered 11 percent, the 10.19 percent presented by the commission staff, and 9.9 percent favored by a large industrial users group.

Predictably, ComEd responded that the new method presented by consumer groups could not possibly be reasonable because the 7.75 percent ROE it produced is more than 100 basis points below any ROE recently approved in the United States.

The consumer groups explained that because the cost of common equity is not a directly observable number, regulatory commissions have had to rely on subjective models, such as the capital-asset pricing model and the discounted cash flow model, to estimate a utility’s cost of common equity. The consumer parties argued that recent merger activity in the electric industry could provide more direct evidence on cost of equity, and a unique opportunity to move away from the complex financial models. With this in mind, the groups hired an expert to recommend a cost of common equity based on a review of electric utility stock valuations conducted by three leading investment banks—Morgan Stanley, JP Morgan, and Lehman Brothers—for the merger between Exelon and PSEG. According to the groups, the valuations done by the three investment banks are a far more reliable indicator of investor needs than the subjective models used to bridge evidentiary gaps “that arise because the level of return required to induce real investors to provide capital for the firm is not directly observable.”

The ICC rejected the new approach, finding that while the consumers had portrayed their method as more objective than standard models, it was impossible to know what assumptions were made by the investment bankers, and whether the result was appropriate in a regulated setting. The commission noted that the expert had relied on WACC figures published by the investment firms as the basis for the estimates. To back out the cost of equity from the investment bankers’ WACC estimates, the expert first had to make numerous assumptions, the PUC found.

The commission said it