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2008 ROE Survey - Rates, Risks & Regulators

Economic uncertainties raise doubts about utility returns.

Fortnightly Magazine - November 2008

this perspective, financial-model results are the central focus, and absent extraordinary circumstances, the regulator should set the ROE at its best estimate of the utility’s cost of equity.

An opposing view also was offered by the PSC: The cost of equity is just one of several factors that direct a regulatory body toward the proper ROE. In this view, during normal economic times, the financial models provide estimates as to the minimum acceptable return, and not necessarily the fair return. The fair return, under this method, typically lies above the cost of equity.

The Wisconsin PSC chose the latter view, explaining that the cost of equity represents the starting point in the ROE analysis, and in most cases does not represent the target rate of return for ratemaking. The PSC said setting the return on equity at the cost of equity, by definition, is a minimalist policy that would allow the utility barely to compete for capital. [See Re Northern States Power Co., Wisconsin, 264 PUR4th 236, No. 4220-UR-115, Jan. 8, 2008 (Wis. P.S.C.).]

Stock Prices and Interest Rates

Stock prices and interest rates are fundamental inputs in models used in setting ROE awards. Interest rates frequently are cited as a benchmark. The so-called “risk-free rate” readily is observable in the market for government securities. The base rate is identified for the test period under review and a premium above that amount is chosen that represents the increase necessary to cover additional risk associated with stocks and to attract utility stock investors. If rates for government securities are low, many would argue that ROE awards should follow.

Another example of how changes in interest rates might affect ROE awards is found in a recent decision by the California Public Utilities Commission (PUC). In that case, the PUC adopted a new, multi-year cost-of-capital mechanism (CCM) for the major California energy utilities. Under the new plan, the costs of capital used in setting rates for the utility companies— i.e., costs for long-term debt, preferred stock and common equity—will be set every three years in a full cost-of-capital proceeding. However, changes in interest rates that occur outside of a 100-basis point deadband under a 12-month measurement period would trigger adjustments to the capital cost rates of the utilities. [See Re Southern California Edison Co., 265 PUR 4th 161, D. 08-05-035, (Cal. P.U.C. 2008).]

As for stock prices, a review of this year’s rate cases shows the discounted-cash-flow (DCF) method remains the gold standard for financial modeling of utility cost of capital. (Other methods that directly assess the cost of risk-free investments also are used.) The DCF method uses as input the stock prices and dividend payments of companies with comparable risk. The most recent stock price is the one used when calculating dividend yield and growth rates under the DCF. As described in Dr. Roger Morin’s text on utility cost of capital, The New Regulatory Finance:

Conceptually, the stock price to employ is the current price of the security at the time of estimating the cost of equity, rather than some historical high-low or weighted